Managerial economics strategy by m perloff and brander chapter 6 costs

6.2 Short-Run Costs• Fixed Cost F does not vary with the level of output; includes expenditures on land, office space, production facilities, and other overhead expenses; are often sunk

Chapter 6

Costs

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• 6.4 The Learning Curve

• 6.5 Costs of Producing Multiple Goods

efficient (minimum cost) By minimizing costs, a firm can increase its profit.

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6.1 The Nature of Costs

• Explicit and Implicit Costs

– Explicit costs are direct, out-of-pocket payments for labor, capital, energy, and materials

– Implicit costs reflect only a foregone opportunity rather than explicit,

• Relevance of Considering Opportunity Cost

– Maoyong example: Assume monthly revenue is $49k and explicit costs are

$40k, including Maoyong’s monthly wage The accounting profit is $9k and Maoyong collects $10k per month (profit + wage) However, his

opportunity cost is $11k So, he incurs an economic loss of $1k

6.1 The Nature of Costs

• Costs of Durable Inputs

– Durable inputs are usable for a long period, perhaps for many

years.

– Capital such as land, buildings, or equipment are durable inputs.

• Costs of Durable Inputs (truck example)

– There are two problems First, how to allocate the initial purchase cost over time Second, what to do if the value of the capital

changes over time.

– Solution if there is a rental market: The accountant may expense the truck’s purchase price or may amortize it over the life of the truck, following IRS rules The firm’s opportunity cost of using the truck is the amount that the firm would earn if it rented the truck

to others

– Solution if there is no rental market: The opportunity cost of

capital of using the truck a year would be the interest forgone in a year.

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6.1 The Nature of Costs

• Sunk Costs

– Sunk cost is a past expenditure that cannot be recovered

– If an expenditure is sunk, it is not an opportunity cost So we should not consider it for managerial decisions

– However, sunk costs appear in financial accounts

• Managers Should Ignore Sunk Costs

– A firm paid $300k for a parcel of land but the market value is now

$200k If the firm builds a plant on this land, the value for the firm becomes $240k

– Is it worth carrying out production on this land or should the land be sold for its market value of $200k?

– The land’s opportunity cost is $200k and the market value loss of

$100k is a sunk cost The sunk cost cannot be recovered and should not be considered in the decision The values to compare are $240 versus $200 Certainly, the firm should carry out production on this land

6.2 Short-Run Costs

• Fixed Cost (F) does not vary with the level of output; includes

expenditures on land, office space, production facilities, and other overhead expenses; are often sunk costs, but not always.

• Variable Cost(VC) changes as the quantity of output changes;

refers to the costs of variable inputs.

• Total Cost (C) is the sum of fixed and variable costs.

• F and VC should be based on inputs’ opportunity costs.

Common Measures of Cost

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6.2 Short-Run Costs

• Average Fixed Cost (AFC) falls as output rises because the

fixed cost is spread over more units.

• Average Variable Cost (AVC) or variable cost per unit of

output may either increase or decrease as output rises.

• Average Cost (AC) or average total cost may either

increase or decrease as output rises.

– Marginal cost also equals the change in variable cost from

a one-unit increase in output.

• Marginal Cost using Calculus: MC = dC/dq =

dVC/dq

– Marginal cost is the rate of change of cost as we make an

infinitesimally small change in output MC=dVC/dq because dF/q=0.

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6.2 Short-Run Costs

• Cost Curves: Total Values

– Panel a of Figure 6.1 shows the variable cost (VC), fixed cost (F), and total cost (C) curves that correspond to Table 6.1

• Graphs: Total, Variable and Fixed Costs

– The fixed cost curve, F, is a horizontal line at $48

– The variable cost curve, VC, is zero at zero units of output and rises with

output

– The total cost curve, C, is the vertical sum of the VC and F curves, so it is

$48 higher than the VC curve at every output level VC and C curves are

parallel

6.2 Short-Run Costs Figure 6.1 Cost Curves

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Table 6.1 How Cost Varies with Output

6.2 Short-Run Costs

• Cost Curves: Average and Marginal Values

– Panel b of Figure 6.1 shows the average fixed cost, average

variable cost, average cost, and marginal cost curves.

• Graphs: Average Costs and Marginal Cost

– The marginal cost curve, MC, cuts the average variable cost, AVC, and average cost, AC, curves at their

minimums

– The height of the AC curve at point a equals the slope of the line from the origin to the cost curve at A

– The height of the AVC at b equals the slope of the line

from the origin to the variable cost curve at B

– The height of the marginal cost is the slope of either the C

or VC curve at that quantity.

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6.2 Short-Run Costs

• In the short run, the firm increases output by using more labor However, each extra worker increases output by a smaller amount Diminishing marginal returns to labor

determine the shape of the production function.

• The production function determines the shape of the

variable cost curve As output increases, variable cost

increases more than proportionally because of diminishing marginal returns.

• The production function determines the shape of the

marginal cost, average variable cost, and average cost

curves

Production Functions and the Shapes of Short-Run Costs Curves

6.2 Short-Run Costs

• Production Functions & Shapes of Cost Curves:

Graph Analysis

– If input prices are constant, the firm’s production function

determines the shape of the variable cost curve

• The Variable Cost Curve

– The VC and the total product curve have the same shape, Figure

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6.2 Short-Run Costs Figure 6.2 Variable Cost and Total Product

6.2 Short-Run Costs

The Marginal Cost Curve

• In the short run, capital is fixed So, the change in variable cost

as output increases by one unit, MC, is the change in the cost of labor.

• The marginal cost equals the wage times the extra labor

necessary to produce one more unit of

• Marginal cost equals wage divided by marginal product of labor.

• Marginal product of labor and marginal cost move in

opposite directions

as output changes.

MC = ∆VC/∆q ∆VC/∆q = w(∆L/∆q) MC = w/MPL

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6.2 Short-Run Costs

The Average Cost Curve

• In the short run, capital is fixed So the

variable cost is wL.

• The average variable

cost is wL divided by

output.

• Average variable cost

is the variable cost

divided by output.

• Diminishing marginal

returns to labor also

determine the shape

of the average

variable cost curve.

• The average variable

• Average product of labor and average variable cost move

in opposite directions.

AVC = VC/q VC/q = wL/q AVC = w/APL

6.2 Short Run Costs

• Short-Run Cost Summary

– In the short run, the cost associated with fixed inputs is fixed, while the cost from inputs that can be adjusted is variable.

– Given that input prices are constant, the shapes of the

variable cost and the cost-per-unit curves are determined by the production function.

– Where there are diminishing marginal returns, the variable cost and cost curves become relatively steep as output

increases, so the average cost, average variable cost, and marginal cost curves rise with output.

– The average cost and average variable cost curves fall when marginal cost is below them and rise when marginal cost is above them, so the marginal cost cuts both these average cost curves at their minimum points.

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• Technically and Economically Efficient

– From among the technically efficient combinations of inputs

that can be used to produce a given level of output, a firm

wants to choose that bundle of inputs with the lowest cost of production, which is the economically efficient combination of inputs

– To do so, the firm combines information about technology from the isoquant with information about the cost of production.

6.3 Long Run Costs

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6.3 Long Run Costs Figure 6.3 A Family of Isocost Lines

6.3 Long Run Costs

• Isocost and Isoquant Combined

– The firm minimizes its cost by using the combination of inputs on the

isoquant that is on the lowest isocost line that touches the isoquant

• Isocost and Isoquant Combined: Graph Analysis

– In Figure 6.4, the lowest possible isoquant that will allow the beer

manufacturer to produce 100 units of output is tangent to the $2,000 isocost line

– At x, the bundle of inputs are L = 50 workers and K = 100 units of capital – At x, the isocost is tangent to the isoquant, so the slope of the isocost, –

w/r = –3, equals the slope of the isoquant, which is the negative of the

marginal rate of technical substitution

– Notice, y and z also produce 100 units of output but at a cost of $3,000 The x input combination is economically efficient

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6.3 Long Run Costs Figure 6.4 Cost Minimization

6.3 Long Run Costs

• The Lowest Isocost Rule

– The firm minimizes its cost by using the combination of inputs

on the isoquant that is on the lowest isocost line that touches the isoquant

• The Tangency Rule: MRTS = - w/r

– At the minimum-cost bundle, x, the isoquant is tangent to the isocost line The slope of the isoquant (MRTS) and the slope

of the isocost are equal.

– Cost is minimized if inputs are chosen so that the last dollar spent on labor adds as much extra output as the last dollar

spent on capital Thus, spending one more dollar on labor at x

gets the firm as much extra output as spending the same amount on capital

Three Equivalent Rules to Minimize Costs in the Long-Run

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6.3 Long Run Costs

• Factor Price Changes

– How should the firm change its behavior if the cost of one of the factors changes?

– If one factor becomes relatively cheaper, the firm should substitute

factors considering the slopes of the isoquant and isocost curves

• Factor Price Changes: Graph Analysis

– In Figure 6.5, the initial wage = $24 and the rental rate of capital = $8

The lowest isocost line ($2,000) is tangent to the q = 100 isoquant at x(L

= 50, K = 100)

– When the wage falls from $24 to $8, the isocost lines become flatter:

Labor is relatively less expensive than capital now

– The slope of the isocost lines falls from –w/r = –24/8 = –3 to –8/8 = –1 – The new lowest isocost line ($1,032) is tangent at v (L = 77, K = 52)

– Thus, when the wage falls, the firm uses more labor and less capital to produce a given level of output, and the cost of production falls from

$2,000 to $1,032

6.3 Long Run Costs Figure 6.5 Effect of a Change in Factor Price

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6.3 Long-Run Costs

• In the long run, returns to scale determine the shape of the

production function, and the production function, in turn,

determines the shape of the AC curve and other cost curves.

• If a production function has increasing returns to scale at low

levels of output, constant returns to scale at intermediate levels

of output, and decreasing returns to scale at high levels of

output, the LRAC curve must be U-shaped.

• LRAC curves can have many different shapes depending whether

the production process has economies or diseconomies of scale.

• Perfectly competitive firms typically have U-shaped AC curves

Noncompetitive markets may be U-shaped, L-shaped,

everywhere downward sloping, everywhere upward sloping or have other shapes

Production Functions and the Shapes of Long-Run Costs Curves

6.3 Long Run Costs

• LRAC as the Envelope of SRAC Curves

– The long-run average cost is always equal to or below the short-run

average cost Any input combination in the short run is also available in the long run However, changing capital levels to reduce costs are only available in the long run

– In the long run, the firm chooses the plant size that minimizes its cost of production, so it picks the plant size that has the lowest average cost for each possible output level

• LRAC as the Envelope of SRAC Curves: Graph Analysis

– At q1, in Figure 6.7, the firm opts for the small plant size, whereas at q2, it uses the medium plant size

– If there are only three possible plant sizes, with short-run average costs

SRAC1, SRAC2, and SRAC3, the long-run average cost curve is the solid, scalloped portion of the three short-run curves (envelope curve)

– LRAC is the smooth and U-shaped long-run average cost curve.

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6.3 Long Run Costs Figure 6.7 Long-Run Average Cost as the Envelope of Short-Run Average Cost Curves

6.4 The Learning Curve

– For these and other reasons, the average cost of production tends to fall

over time, and the effect is particularly strong with new products

• Learning Curve and Costs

– The learning curve is the relationship between average costs and cumulative output

– The cumulative output is the total number of units of output produced since

the product was introduced

– If a firm is operating in the economies of scale section of its average cost curve, expanding output lowers its cost for two reasons Its average cost falls today because of economies of scale, and also because of learning by doing

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6.5 Costs of Producing Multiple Goods

• Joint Production is Less Costly

– If a firm produces two or more goods that are linked by a single input, the cost of one good may depend on the output level of another For example, cattle provide beef and hides.

– A firm enjoys economies of scope if it is less expensive to produce goods jointly than separately.

– It is less expensive to produce beef and hides together than separately, so there are economies of scope.

• Economies of Scope: SC = [C(q1,0) + C(0,q2) - C(q1,

q2)]/C(q1, q2)

– C(q1, 0) is the cost of producing q1 of the first good, C(0, q2) is the cost of producing

q2 of the second good, and C(q1, q2) is the cost of producing both goods together

– If SC is zero, the cost of producing the two goods separately, C(q1,0) + C(0,q2), is

the same as producing them together, C(q1, q2) There are no economies of scope.

– If SC is positive, it is less expensive to produce goods jointly than separately There

are economies of scope.

– If SC is negative, there are diseconomies of scope, and the two goods should be

produced separately.

Managerial Solution

• Managerial Problem

– Technology choice at home versus abroad: In the United States, firms use

a relatively capital-intensive technology– Will that same technology be cost minimizing if they move their

technology with a different capital-labor ratio

– If the isoquant has kinks, the firm will use a different technology only if the relative factor prices differ substantially