MicroEconomics theory and application 12th by browning an zupan chapter 08

 Detail the typical shapes of a firm’s short-run cost curves. See how a firm will choose to combine inputs in its production process in the long run when all inputs are variable.. Meas

MICROECONOMICS: Theory & Applications

By Edgar K Browning & Mark A Zupan

John Wiley & Sons, Inc.

12 th Edition, Copyright 2015

Chapter 8: The Cost of Production

Prepared by Dr Della Lee Sue, Marist College

 Detail the typical shapes of a firm’s short-run cost curves.

 See how a firm will choose to combine inputs in its

production process in the long run when all inputs are

variable

 Show how input price changes affect a firm’s cost curves

 Differentiate between a firm’s long-run and short-run cost

Learning Objectives (continued)

 Explain the impact of learning by doing on production cost

 Understand how the minimum efficient scale of production

is related to market structure

 Describe how cost curves can be applied to the problem of controlling pollution

 Cover economies of scope—is it cheaper for one firm to produce products jointly than it is for separate firms to

produce the same products independently?

 Overview how cost functions can be empirically estimated through surveys and regression analysis

8.1 THE NATURE OF COST

Delineate the nature of a firm’s cost—explicit as well as implicit.

The Nature of Cost

 Recall:

 Explicit costs – arise from transactions in which the firm

purchases inputs or the services of inputs from other

parties

 Implicit costs – costs associated with the use of the

firm’s own resources and reflect the fact that these

resources could be employed elsewhere

 Opportunity cost reflects both explicit and implicit costs

8.2 SHORT-RUN COST OF

PRODUCTION

Outline how cost is likely to vary with output in the short run and various measures of shortrun cost.

Measures of Short-Run Cost

 Total fixed cost (TFC) – the cost incurred by the firm that

does not depend on how much output it produces

 Total variable cost (TVC) – the cost incurred by the firm

that depends on how much output it produces

Fixed versus Sunk Costs

 Fixed cost – input cost that is invariant to the output level

selected by the firm; relevant cost even when output is zero

 Sunk cost – cannot be recouped through the sale of inputs

Table 8.1

Five Other Measures of Short-Run Cost

 Total cost (TC) – the sum of total fixed and total variable cost at each

output level

 Marginal cost (MC) – the change in total cost that results from a

one-unit change in output

 Average fixed cost (AFC) – total fixed cost divided by the amount of

output

 Average variable cost (AVC) – total variable cost divided by the

amount of output

Behind Cost Relationships

 A firm’s costs are determined by its production function:

 Input combinations (quantities)

 Input prices

 The shape of the TVC curve is determined by the shape of the TP curve, which in turn reflects diminishing marginal returns

Figure 8.1 – From Total Product to

Total Variable Cost

8.3 SHORT-RUN COST CURVES

Detail the typical shapes of a firm’s short-run cost curves.

Figure 8.2 - Short-Run Total and

Per-Unit Cost Curves

 As a result, the MC curve will first fall and then rise.

 Thus, the law of diminishing marginal returns lies behind the MC curve.

Average Cost

 The average product curve rises, reaches a maximum, and then falls, due to the law of diminishing marginal productivity.

 As a result, the AVC curve will fall and then rise.

 The AFC curve declines over the entire range of output as the amount

of total fixed cost is spread over ever-larger rates of output.

 The ATC curve is the sum of AFC and AVC It measures the average unit cost of all inputs, both fixed and variable, and must also be U- shaped.

Figure 8.3 – Graphical Derivation of

Average and Marginal Cost Curves

8.4 LONG-RUN COST OF

PRODUCTION

See how a firm will choose to combine inputs in its production process in the long run when all inputs are variable.

Isocost Lines

 An isocost line is a line that identifies all the combinations

of capital and labor, two factor inputs, that can be purchased

at a given total cost

 The line intersects each axis at the quantity of that input that the firm could purchase if only that input were purchased

 The slope of an isocost line is (minus) the ratio of input

prices, w/r, indicating the relative prices of inputs

Figure 8.4 - Isocost Lines and the Run Expansion Path

Long-Least Costly Input Combination

 A point of tangency between an isocost line and an isoquant show the least costly way of producing a given output level

 Alternatively, a point of tangency shows the maximum

output attainable at a given cost as well as the minimum

cost necessary to produce that output

Interpreting the Tangency Points

Golden rule of cost minimization: a rule that says that to

minimize cost, the firm should employ inputs in such a way that the marginal product per dollar spent is equal across all inputs

If the firm is not producing at a

tangency point…

 Whenever MPL/w > MPK/r, a firm can increase output

without increasing production cost by shifting outlays from capital to labor

 Whenever MPL/w < MPK/r, a firm can increase output

without increasing production cost by shifting outlays from labor to capital

The Expansion Path

The expansion path is a curve formed by connecting the

points of tangency between isocost lines and the highest respective attainable isoquants

Is Production Cost Minimized?

 Cost minimization is NOT the same as profit

maximization…

 Cost minimization occurs at all points on the expansion path, but profit maximization involves selecting the most profitable output from among those on the expansion path

8.5 INPUT PRICE CHANGES AND COST CURVES

Show how input price changes affect a firm’s cost curves.

Input Price Changes and Cost Curves

The input substitution effect is the effect of a change in the

price of an input on a firm’s relative use of the input to produce

a given level of output

Figure 8.5 – A Higher Input Price Shifts Cost Curves Upward

8.6 LONG-RUN COST CURVES

Differentiate between a firm’s long-run and short-run cost curves.

Long-Run Cost Curves

 LR total cost (LTC) shows the minimum cost at which

each rate of output may be produced, just as the expansion path does

 LR marginal cost (LMC) and LR average cost (LAC) are

derived from the LTC in the same way that the short-run

marginal and average curves are derived from the short-run total cost curve

 LAC is U-shaped…why?

Figure 8.6 - Long-Run Cost Curves

Economies of Scale and Diseconomies

of Scale

 Economies of scale – a situation in which a firm can

increase its output more than proportionally to its total input cost

 Reflects increasing returns to scale

 Diseconomies of scale – a situation in which a firm’s output

increases less than proportionally to its total input cost

 Reflects decreasing returns to scale

The Long Run and Short Run Revisited

Summary:

 Long-run average cost curve (LAC): the lowest

average cost attainable when all inputs are variable

 Each point on the LAC is associated with a different short-run scale of operation that the firm could choose

Figure 8.7 - Short- and Long-Run

Average Cost Curves

8.7 LEARNING BY DOING

Explain the impact of learning by doing on production cost.

Learning by Doing

 Learning by doing is associated with improvements in

productivity resulting from a firm’s cumulative output

experience

 Advantages of Learning by Doing to Pioneering Firms

 Attainment of lower production costs

 Incentive to produce more in any given period

 Limits to Advantages:

Figure 8.8 - Learning by Doing Versus Economies of Scale

8.8 IMPORTANCE OF COST CURVES

TO MARKET STRUCTURE

Understand how the minimum efficient scale of production is related to market structure.

Importance of Cost Curves to Market

Structure

 Minimum efficient scale – the scale of operations at which

average cost per unit reaches a minimum

 Impact on industry structure

 Number of firms

 Proportion of industry output by each firm

 Degree of competition

Figure 8.9 - Cost Curves and the

Structure of Industry

Table 8.2 – Minimum Efficient Plant

Scales

8.9 USING COST CURVES:

CONTROLLING POLLUTION

Describe how cost curves can be applied to the problem of controlling pollution.

Using Cost Curves: Controlling

Pollution

 Question: Can the government’s program to reduce

pollution be accomplished at the lowest possible cost?

 If marginal costs of firms differ, the total cost of pollution abatement can be reduced:

 Increase abatement when MC is less

 Decrease abatement where MC is greater

 Result: firms should operate where their MC are equal

Figure 8.10 – Cost of Pollution

Abatement

8.10 ECONOMIES OF SCOPE

Cover economies of scope—is it cheaper for one firm to produce

products jointly than it is for separate firms to produce the same products independently?

Economies of Scope and Diseconomies

of Scope

 Economies of scope – a case where it is cheaper for one

firm to produce products jointly than it is for separate firms

to produce the same products independently

 Diseconomies of scope – a case where it is cheaper for

separate products to be produced independently than for one firm to produce the same products jointly

8.11 ESTIMATING COST FUNCTIONS

Overview how cost functions can be empirically estimated through

surveys and regression analysis.

Estimating Cost Functions

Techniques:

 Surveys

 New entrant/survivor technique – method for

determining the minimum efficient scale of production in an industry based on investigating the plant sizes either being built or used by firms

in the industry

 Econometric specification

Figure 8.11 - Different Possible Cost

Functions

8.12 THE MATHEMATICS BEHIND

PRODUCTION COST*

Explain the mathematics behind production costs.

The Marginal-Average Cost

Relationship

 Analogous to the derivation of the relationship

between marginal and average product curves

 Relationship holds for both the long-run and

short-run cost curves

Cost Minimization

The firm’s input choices can be viewed as either:

 Maximizing output for a given level of total cost, or

 Minimizing the cost necessary to produce a given output

Cost Minimization

Cost Minimization

Minimizing the Cost of Pollution

Abatement

 For pollution to be reduced at the lowest possible cost, each firm must be operating where the marginal cost of pollution abatement is the same

 Lagrangian technique

 Constrained minimization

Minimizing the Cost of Pollution