Chapter 8: Costs

Costs in the short run

- Must take opportunity cost into account: opportunity cost=value of the next-best
activity that you can no longer afford
- Profit for the entrepreneur is included in the cost curves of the firm

The total cost of producing the various levels of output is simply the cost of all the factors of
production employed. If Katlego owns his own capital, its implicit rental value is an
opportunity cost the money Katlego could have earned if he had sold his capital and invested
the proceeds in, say, a government bond Suppose Katlego’s capital is fixed at 120 machine-
hr/hr, the rental value of each of which is r=R3.75/machine hr for a total capital rental of
R450/hr.

- Fixed costs (overhead costs): Cost that does not vary with the level of output in the
short run (the cost of all fixed factors of production). Property taxes, insurance
payments, interest on loans and other payments.
FC = rK0 where r is rental price per unit, K0 is fixed amount of capital
- Sunk costs: costs the firm has already paid but cannot recover. Insurance is a sunk
cost and a fixed cost
- Variable cost: costs that vary with the level of output in the short run (the cost of all
variable factors of production). To calculate VC for any level of output, for this
example we simply multiply the amount of labour needed to produce that level of
output by the hourly wage rate.
VCQ1=wL1 where w is hourly wage and L1 is an hourly wage
- Total cost: all economic cost of production, the sum of variable cost and fixed cost
TCQ1= FC+VCQ1
= rK0 + wL1
Graphing the total, variable and fixed cost curves
- The shape of the variable cost curve is related to the shape of the short run
production function. The connection arises because the production function tells us
how much labour we need to produce a given level of output, and this quantity of
labour, when multiplied by the wage rate gives us the variable cost.
In Fig. 8.1 that 58 units of out-put require 5 units of labour, which, at a wage rate of
R150/person-hr, gives rise to a variable cost of (5)(150) = 750/hr. So, in Fig. 8.2, the output
level of 58 is plotted against a variable cost of R750/hr. Similarly, note from the production
function that 43 units of output require 4 units of labour, which, at the R150 wage rate, gives
rise in Fig. 8.2 to a variable cost of R600/hr. Note in Fig. 8.1 that L = 4 is the point at which
diminishing returns to the vari-able factor of production set in. For values of L < 4, there are
increasing returns to L, which means that increments in L produce successively larger incre-
ments in Q in that region. Put another way, in this region a given increase in output, Q,
requires suc-cessively smaller increments in the variable input, L. As a result, variable cost
grows at a diminishing rate for output levels less than 43. For example, if the variable input
labour increases by 100 per cent from 2 to 4 units, output increases by 207 per cent (from 14
units to 43 units). This is reflected in Fig. 8.2 by the concave shape of the variable cost curve
for output levels between 0 and 43. Once L exceeds 4 in Fig. 8.1, we enter the
region of diminishing returns. Here, successively larger increments in L are required to
produce a given increment in Q. In consequence, variable cost grows at an increasing rate in
this region. For example, if the variable input labour increases by 33.3 per cent from 6 to 8
units, output increases by only 19.4 per cent, from 72 to 86 units. This is reflected in the
convex shape of the variable cost curve in Fig. 8.2 for output levels in excess of 43. Because
fixed costs do not vary with the level of output, their graph is simply a horizontal line. Figure
8.2 shows the fixed, variable and total cost curves (FC, VC and TC) for the production function
shown in Fig. 8.1. Note in the figure that the vari-able cost curve passes through the origin
which means simply that variable cost is zero when we produce no output.
Other short run costs
- Average fixed cost: the fixed cost divided by the quantity of output
AFCQ1=FC/Q1 =rKO/Q1
- Average variable cost: variable cost divided by the quantity of output
AVCQ1=VC/ Q1 =wL1/Q1
- Average total cost: the total cost divided by the quantity of output. ATC = AFC + AVC
ATCQ1=AFCQ1 + AVCQ1
=(rK0+wL1)/Q1
- Marginal cost: change in total cost that results from a one-unit change in the output.
The additional production cost of the last unit produced.
MCQ1=TCQ1/Q or dTC/dQ
=VCQ1/Q

Graphing the short-run average and marginal cost curves

- Since FC does not vary with output, average fixed cost declines steadily as output
increases. When AFC falls with output is often referred to as spreading overhead
costs.
- As output shrinks towards zero, AFC grows without bounds, and it falls ever closer to
zero as output increases. At very high production levels it will strive towards zero, but
will be just bigger than zero.
- average variable cost at any level of output Q, which is equal to VC/Q, may be
interpreted as the slope of a ray to the variable cost curve at Q
- Recall that, because TC = FC + VC, it follows that ATC = AFC + AVC (simply divide both
sides of the former equation by output). This means that the vertical distance
between the ATC and AVC curves at any level of output will always be the
corresponding level of AFC. Thus the vertical distance between ATC and AVC
approaches infinity as output declines towards zero, and shrinks towards zero as
output grows towards infinity. Note also in Fig. 8.5 that the minimum point on the
AVC curve occurs for a smaller unit of output than does the minimum point on the
ATC curve. Because AFC declines continuously, ATC continues falling even after AVC
has begun to turn upwards. Between Q2and Q3 the magnitude of the decrease in
AFC is greater than the increase in AVC, but at production levels greater than Q3 the
magnitude in the increase in AVC is greater than the decrease in AFC.
- In terms of its role in the firm’s decision regarding how much output to produce, by
far the most important of the seven cost curves is the marginal cost curve.
Remember that marginal cost at any level of output may be interpreted as the slope
of the total cost curve at that level of output. A firms typical operating decision
involves the question of whether to expand or contract its current level of output.
The cost of expanding output is equal to marginal cost. Notice in the top panel in Fig.
8.5 that the slope of the total cost curve decreases with output up to Q1, and rises
with output thereafter.4 This tells us that the marginal cost curve, labelled MC in the
bottom panel, will be downward sloping up to Q1 and upward sloping thereafter. Q1
is the point at which diminishing returns set in for this production function, and
diminishing returns are what account for the upward slope of the short-run marginal
cost curve. When MC is less than average cost (either ATC or AVC), the average cost
curve must be decreasing with output; and when MC is greater than average cost,
average cost must be increasing with output.
Allocating production between two processes
Faced with the problem of dividing a given production quota between two production
processes in such a way as to produce the quota at the lowest possible cost. Let QT
be the total amount to be produced, and let Q1 and Q2 be the amounts produced in the first
and second processes. the marginal cost in either process at very low levels of output is
lower than the marginal cost at QT units of output in the other. The values of Q1 and Q2 will
be the ones that result in equal marginal costs for the two processes. To see why, suppose
the contrary: that is, sup-pose that the cost-minimizing allocation resulted in higher marginal
cost in one process than in the other. We could then shift one unit of output from the
process with the higher marginal cost to the one with the lower. Because the result would be
the same total output as before, but at a lower total cost, the initial division could not have
been the cost-minimizing one.
The relationships between MP, AP, MC and AVC
- In Chapter 7 we saw that the marginal product curve cuts the average product curve
at the maxi-mum value of the AP curve . In this chapter, marginal cost curve cuts the
average variable cost curve at the minimum value of the AVC curve
- MC = ΔVC/ΔQ. When labour is the only variable factor, ΔVC = ΔwL, so that ΔVC/ΔQ is
equal to ΔwL/ΔQ. If wage rates are fixed, this is the same as wΔL/ΔQ. And since
ΔL/ΔQ is equal to 1/MP, it follows that
MC=w/MP
- AVC = VC/Q = wL/Q, and since L/Q is equal to 1/AP, it follows that
AVC=w/AP
:. minimum value of marginal cost corresponds to the maximum value of MP and minimum
value of AVC corresponds to the maximum value of AP.

Costs in the long run

In the long run all inputs are variable by definition. The choice of what input combination
depends on the relative prices of capital and labour.

Choosing the optimal input combination

- objective of most producers is to produce any given level and quality of output at the
lowest possible cost, and produce as much output as possible from any given
expenditure on inputs
Eg. Let us begin with the case of a firm that wants to maximize output from a given level of
expenditure. Suppose it uses only two inputs, capital (K) and labour (L), whose prices,
measured in rands per unit of input per day, are r = 40 and w = 80, respectively. What
different combinations of inputs can this firm purchase for a total expenditure of C =
R4000/day? Any of the input combinations on the locus labelled B (isocost line: a set on
input bundles each of which costs the same amount) can be purchased for a total
expenditure of R4000/day. The slope of the isocost line is the negative of the ratio of the
input prices, −w/r. Here, we superimpose the isocost line onto the isoquant map. In Fig. 8.11,
the tangency point (L*, K *) is the input combination that yields the highest possible output
(Q0 ) for an expenditure of C.

The problem of producing the largest output for a given expenditure is solved in essentially
the same way as the problem of producing a given level of output for the lowest possible
cost. The only difference is that in the latter case we begin with a specific isoquant (the one
that corresponds to the level of output we are trying to produce), and then superimpose a
map of isocost lines, each corresponding to a different cost level. Output is fixed and costs
vary. As shown in Fig. 8.12, the least-cost input bundle (L*, K* ) corresponds to the point of
tangency between an isocost line and the specified isoquant (Q0). In Fig.8.12, the least cost
input bundle (L*, K *) corresponds to the point of tangency between an isocost line and a
specified isoquant (Q0). One can produce a quantity of Q0 with input combinations that
correspond to point A and B but that will then be at a cost of C3. Slope of isoquant is -
MPL/MPk. Combining this with the result that minimum cost occurs at a point of tangency
with the isocost line (whose slope is −w/r), it follows that
MPL*/MPK* =w/r where K* and L* minimum cost values of K and L
MPL*/w = MPK*/r
MP L* is simply the extra output obtained from an extra unit of L at the cost-minimizing point.
w is the cost, in rands, of an extra unit of L. The ratio MPL*/w is thus the extra output
we get from the last rand spent of L. MPK*/r is the extra output we get from the last rand
spent on K.
Whenever the ratios of marginal products to input prices differ across inputs, it will always
be possible to make a similar cost-saving substitution in favour of the input with the higher
MP/P ratio (except in the case of corner solutions). More generally, we may consider a
production process that employs not two but N inputs, X1 X2, . . . , XN. In this case the
condition for production at minimum cost is a straightforward generalization
MPX1/PX1 = MPX1/PX2 = MPXN/PXN

The relationship between optimal input choice and long-run costs

 - output expansion path: The locus of tangencies (minimum cost input combinations)
traced out by an isocost line of given slope as it shifts outwards into the isoquant
map for a production process.
The curve labelled EE in Fig. 8.14 shows the firm’s output expansion path. It is the set of cost-
minimizing input bundles when the input price ratio is fixed at w/r. Thus, when the price of K
is r and the price of L is w, the cheapest way to produce Q1 units of output is to use the input
bundle S, which contains K1 * units and L1* units of L and costs TC1. The bundle S is one point
on the output expansion path. Output level Q2 is associated with bundle T, which has a total
cost of TC2 and so on.

- In the long run there is no need to distinguish

between total, fixed and variable costs, since all
costs are variable and nothing is fixed any more
- Long run total cost curve: The LTC curve will
always pass through the
- origin, because in the long run the firm can
liquidate all of its inputs. If the firm elects to
produce no output, it need not retain, or pay for,
the services of any of its inputs.
Long run marginal cost (LMC) is the slope of the
long-run total cost-cruve.
LMCQ=LTC/Q
LMC is the cost to the firm, in the long run, of expanding its output by one unit
Long-run average cost (LAC) is the ratio of long-run total cost to output:
LACQ=LTCQ/Q
The slope of the LTC curve is diminishing up to the output level Q1 and increasing thereafter,
which means that the LMC curve takes its minimum value at Q1. The slope of LTC and the
slope of the ray to LTC are the same at Q3 which means that LAC and LMC intersect at
that level of output. And again as before, the traditional average–marginal relationship
holds: LAC is declining whenever LMC lies below it, and rising whenever LMC lies above it

.
- For constant returns to scale production: doubling outputs exactly doubles cost
- For decreasing returns to scale: a certain percentage increase in all inputs will lead to
a smaller percentage increase in output, and additional units of production will
become more expensive to produce, it gives rise to an upward-curving LTC curve and
upward-sloping LAC and LMC curves. Remember that, when LAC is increasing, it
implies that LMC lies above it.
- Increasing returns to scale: increase in all inputs will lead to a larger per-centage
increase in output, and total cost will increase at a decreasing rate, LAC and LMC
curves under increasing returns to scale is not the linear form shown in this
particular example, but the fact that they are downward sloping.
The relationship between long-run and short-run cost curves
- Let us consider first in greater detail the relation-ship between long-run and short-
run total costs. LTC curve is generated by plotting the Q value for a given isoquant
against the corresponding total cost level for the isocost line tan-gent to that
isoquant.
Fig. 8.19 Q = 1 is associated with a long-run total cost of LTC1, Q = 2 with LTC2, and so on.
When K is variable, as it and all other factors are in the long run, the expansion path is given
by the line 0E. Now suppose, however, that K is fixed at K2* , the level that is optimal for the
production of Q = 2. The short-run expansion path will then be the horizontal line through
the point (0,K2* ),which includes the input bundles X, T and Z. The short-run total cost of
producing a given level of output say, Q = 1 – is simply the total cost associated with the
isocost line that passes through the intersection of the short-run expansion path and the Q =
1 isoquant (point X in Fig. 8.19), namely, STC1. Note in Fig. 8.19 that short-run and long-run
total costs take the same value for Q = 2, the output level for which the short-run and long-
run expansion paths cross. For all other output levels, the isocost line that passes through
the intersection of the corresponding isoquant and the short-run expansion path will lie
above the isocost line that is tangent to the isoquant. Thus, for all output levels other than Q
= 2, short-run total cost will be higher than long-run total cost. Although a firm can expand
along the long-run expansion path in the long run, it may be forced to expand along the
more expensive short-run expansion path in the short run. The short-run and long-run total
cost curves that correspond to the isoquant map of Fig. 8.19 are shown in Fig. 8.20. Note in
Fig. 8.19 that the closer output is to Q = 2, the smaller the difference will be between long-
run and short-run total cost.
STC curve is tangent to LTC curve at Q=2. STC curve intersects with the vertical axis at rK2*,
the fixed cost associated with K2*units of K. The production process whose isoquant map is
shown in Fig. 8.19 happens to be one with constant returns to scale. Accordingly, its long-run
aver-age and marginal cost curves will be the same horizontal line
For the output level at which a given ATC is tangent to the LAC, the long-run marginal cost
(LMC) of producing that level of output is the same as the short-run marginal cost (SMC).
Thus LMC(Q1 ) = SMC(Q1 ), LMC(Q2 ) = SMC(Q2 )and LMC(Q3) = SMC(Q3). Note also that each
point along a given ATC curve, except for the tangency point, lies above the corresponding
point on the LAC curve. Note, finally, that at the minimum point on the LAC curve in Fig. 8.22
(Q = Q2) the long-run and short-run marginal and average costs all take exactly the same
value. Note also in Fig. 8.22 that the SMC curves are always steeper than the LMC curve. So
the cost of that extra unit will be higher in th.e short run than in the long run, which is
another way of saying SMCQ1+1 >LMCQ1+1

- The production level at which the firm reaches the minimum turning point of its LAC
curve is also known as the minimum efficient scale (MES). In theory, this means that
if a firm reaches that production level while servicing half of the market there will be
room in the market for only two firms that operate efficiently. Normally the MES is
not a specific output level, but rather a range of output levels at which the firm
experiences constant returns to scale.

Now suppose that we start at Q 1 and want to produce 1 unit of output less than before. To
do so, we shall have to move to an input bundle that contains less L and more K than would
be optimal for producing Q1− 1. In consequence, our cost savings will be smaller in the short
run than they would be in the long run, when we are free to adjust both L and K. This tells us
that LMCQ1-1 > SMCQ1-1. LMC curve is less steep than the SMC curve at Q1.

Some intuition about the ATC–LAC relationship for a given ATC curve is afforded by noting
that to the left of the ATC–LAC tangency the firm has ‘too much’ capital, with the result that
its fixed costs are higher than necessary; and that to the right of the tangency the firm has
‘too little’ capital, so that diminishing returns to labour drive its costs up. Only at the
tangency point does the firm have the optimal quantities of both labour and capital for
producing the corresponding level of output. Also note that, to the left of Q2, the firm is
experiencing increasing returns to scale because the LAC decreases as the firm increases its
output. At Q2(the minimum turning point of LAC) the firm experiences constant returns to
scale. However, if more than Q2is produced, the firm is experiencing decreasing returns to
scale, and the average cost per product increases as more units of output are produced.

The learning curve versus economies of scale

- A firm experiences economies of scale when all inputs are increased by a certain
percentage, which results in a larger percentage increase in outputs. This implies that
the average cost per product decreases as production levels increase
- From our discussion so far it may seem that a large firm will necessarily have lower
long-run average cost than a smaller firm as a result of economies of scale in
production. However, in some firms long-run average cost may decline because
workers adapt to new technology, or just because they work smarter. A firm’s
marginal and average costs may decline for the following reasons:
 When workers first undertake a task it may take them a long time. As they
become familiar with it, their speed increases.
 Managers of the production process learn by their mistakes and, over time, plan
the whole production process better to increase efficiency.
 Engineers may streamline their product designs to save time without increasing
defects. Better, specialized tools and more effective plant organization may also
lower production cost.
 Some suppliers of the materials used in the production process may also become
more efficient, pass this on via lower prices, and thus lower costs for the
manufacturer
- over time firms ‘learn’ more about the production process, thus enabling them to
decrease average production cost

- If the production process is relatively new, and production cost is high at low levels
and relatively low at high levels, this would indicate learning effects and not
economies of scale. When the learning effect is at play, the firm can decrease its
production cost irrespective of the scale of the firm’s production
ATC1 curve is downward sloping it illustrates the cost structure of a firm enjoys economics of
scale. If the firm increases its output, it will move from A to B along ATC1 as a result of
economics of scale. To decrease average production cost per unit of output the firm has to
increase its production levels. The learning effect has a different effect on the cost structure.
Move from A to C. The learning effect shifts the average cost curve of a firm downwards as
production cost at all levels of production decreases. The learning effect occurs more with
new firms rather than them experiencing economics of scale. As firms become more
established, the learning effect tends to wear off, but as new technology of production
processes are introduction, they may experience it once again.
Questions
1. Same as Example 8.1 except the price of capital r = R40/machine-hr.
2. If FC takes the value 20, what is the vertical distance between the ATC and AVC
curves in Fig. 8.5 when Q = 10?
3. Same as Example 8.4 except the total output is 12.
4. For a production function at a given level of output in the short run, the marginal
product of labour is greater than the average product of labour. How will marginal
cost at that out-put level compare with average variable cost?
5. If w = 30 and r = 60, draw the isocost lines that correspond to total expenditure of
R900 and R1800 per unit of time.
6. Suppose capital and labour are perfect complements in a ratio of one-to-one. That is,
sup-pose that Q = min (L, K). Currently, the wage is w = 5 and the rental rate is r = 10.
What is the minimum cost and method of producing Q = 20 units of output? Suppose
the wage rises to w′ = 20. If we keep total cost the same, what level of output can
now be produced, and what method of production (input mix) is used?
7. Repeat the previous exercise, but now suppose capital and labour are perfect
substitutes in a ratio of one-to-one: Q = K + L

8.
9.