Costs 7

Chapter Outline
7.1 Costs That Matter for
Decision Making:
Opportunity Costs
7.2 Costs That Do Not Matter
for Decision Making: Sunk
Costs
7.3 Costs and Cost Curves
7.4 Average and Marginal
Costs
7.5 Short-Run and Long-Run
Cost Curves
7.6 Economies in the
Production Process
7.7  Goolsbee/Levitt/
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 Introduction 7
Costs and the manner in which costs are structured are key to
a firm’s production decisions
• How much to produce?
• Whether to expand or shrink in response to changing market
conditions?
• Whether to switch to producing a different product?

We began thinking about costs with the expansion path

introduced in the last chapter; now, we examine cost structures
more intimately
• Introducing different types of costs
• Differentiating between short-run and long-run

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 7
Costs That Matter for
7.1 Decision Making:
Opportunity Costs

Costs are thought about differently in economics than in

accounting
• Accounting cost includes the direct costs of operating a
business, including costs for raw materials
• Economic cost is the sum of a producer’s accounting and
opportunity costs
• Opportunity cost is the value of what a producer gives up by
using an input
Inclusion of opportunity cost means an economist’s
interpretation of what constitutes profit will generally be
different from an accountant’s
• Accounting profit is a firm’s total revenue minus accounting cost
• Economic profit is a firm’s total revenue minus economic cost

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 7
Costs That Matter for
7.1 Decision Making:
Opportunity Costs

Opportunity costs occur everywhere in a production

process
• By choosing to start a business, you may give up your salary at
your current position
• When you invest in building a factory, you give up any other
investment opportunities
• By choosing to use an office building you own, you cannot rent it to
someone else

Why does this distinction matter?

• When firms make decisions on the use of inputs, they consider
these opportunity costs
• Economists try to describe behavior; it is necessary to understand
opportunity costs to know how firms make decisions

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Economic vs. Accounting Cost figure it out

Jim’s Consulting is owned by James Smith. For the past

year, Jim’s Consulting had the following revenues and costs
Revenues
$600,000
Supplies
$20,000
Electricity and water $10,000
Employee salaries $300,000
Jim’s salary
$250,000
James has the option of shutting down and renting out the
building he owns for $60,000 per year. Additionally, James
could go work for a larger consulting house for $275,000
per year.
Answer the following questions:
1. What is Jim’s Consulting’s accounting cost?
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Economic vs. Accounting Cost figure it out

1. Accounting cost is the direct cost of operating a

business, including supplies, utilities, and salaries
Accounting cost = $20,000 + $10,000 + $300,000 + $250,000 =
$580,000
2. Economic cost includes the opportunity cost of
ownership. In this case, the opportunity costs include
the forgone rent ($60,000) and the difference between
James’ current salary and what he would earn if he took
another job ($25,000)
Economic cost = $580,000 + $60,000 + $25,000 = $665,000
3. Economic profit is simply revenues minus economic
cost,
Economic profit = $600,000 – $665,000 = –$65,000
While accounting profit is positive, economic profit is
negative, and James could do better by shutting down his
business and taking his outside opportunities
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7.2
Costs That Do Not Matter for
Decision Making: Sunk Costs 7
While opportunity costs should be considered when making
decisions, sunk costs should be ignored
Sunk costs are a form of fixed costs: the cost of the firm’s
fixed inputs, independent of the quantity of the firm’s output
• Buildings, operating permits, durable equipment
• These costs are partially avoidable; some money can be recovered

Sunk costs cannot be recovered once spent

• Licensing fees, long-term lease contracts, etc.
• Specific capital such as uniforms, menus, signs, etc.
Sunk costs cannot be recouped and therefore should not be
considered if a firm is deciding whether or not to close

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7.2
Costs That Do Not Matter for
Decision Making: Sunk Costs 7
Sunk Costs and Decisions
Once incurred, sunk costs should not affect decision making
Consider a business deciding whether to close down
• Some of the costs associated with the business are unavoidable
(e.g., permits, loss of value in kitchen equipment, uniforms)
• Others costs disappear when operations cease (e.g., wages for
employees, raw materials, phone bills)
 If staying open will generate some revenue, what should the firm
do?
• Stay open as long as operating revenues exceed operating
costs
• Operating revenue is the money a firm earns from selling its
output
• Operating cost is the cost a firm incurs in producing its output
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If
7-8
7.2
Costs That Do Not Matter for
Decision Making: Sunk Costs 7
Sunk Costs and Decisions
Often people and firms allow sunk costs to influence decisions
• Usually, this means continuing down one path because of a prior
investment (e.g., going to a baseball game because you bought
season tickets even if the weather is horrible and there is something
else you would rather do)
The sunk cost fallacy refers to the mistake of letting sunk
costs affect a firm’s operating decisions

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 Application 7
Do Sunk Costs Matter?
Economists and others have shown that
consumers and businesses often consider sunk
costs in decision making
• For instance, people will choose to endure a blizzard
to use season passes to the theater, even if they would
never purchase those tickets outright
• Businesses may “throw good money after bad” with Images: [Link]

respect to investment projects, even when better

alternatives exist
 Is this rational behavior?

McAfee, et al. (2009) provide a number of reasons

why considering sunk costs may be rational
• Informational Content – The expenditure “sunk” in
an investment may correlate with the additional
Citation: McAfee, R. P., H. [Link], S. H. Mialon, 2009. Do Sunk Costs Matter? Economic Inquiry 48(2):
investment
323–336 . required for completion; large losses
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correlate with high variance and high option value
 Application 7
Do Sunk Costs Matter?
• Reputational Concerns – Sometimes, when
investments are publicly known, it may be rational to
“finish what you start” (e.g., buying a ski pass with
your friends; a coordinated investment project)
• Financial and Time Constraints – Large past
expenditures may preclude future expenditures on
new projects; time constraints may make investment a
“one-shot” choice Images: [Link]

Citation: McAfee, R. P., H. M. Mialon, S. H. Mialon, 2009. Do Sunk Costs Matter? Economic Inquiry 48(2):
323–336 .
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7.3 Costs and Cost
Curves 7
Economic analysis of costs divides operating costs into two

• Fixed cost (FC ) is the cost of the firm’s fixed inputs,

categories

independent of the quantity of the firm’s output (e.g., office

• Variable cost (VC ) is the cost of inputs that vary with the
lease)

quantity of the firm’s output (e.g., raw materials)

The sum of fixed and variable costs is a firm’s total cost

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7.3 Costs and Cost
Curves 7
Flexibility and Fixed versus Variable Costs
• Time horizon is the chief factor determining flexibility of different
input levels
• Over short time horizons, many inputs are fixed costs (e.g., in a
single day for a restaurant most costs are fixed, including labor and
capital)
• As the time horizon expands, wait staff can be hired or fired, new
capital can be purchased, and space can be expanded
Other Factors Affecting Flexibility
• The presence (or lack) of active capital rental and resale markets
allow some capital expenditures to become variable (e.g., renting
an extra crane)
• Labor contracts may lead to stickiness in labor inputs; it may be
difficult to fire workers, and firms may become reluctant to hire
unless absolutely necessary
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7.3 Costs and Cost
Curves 7
Deriving Cost Curves
• A cost curve is the mathematical relationship between a firm’s
production costs and output
• Curves associated with fixed, variable, and total costs will have
different shapes
• Consider Fleet Foot, a shoe company that produces running shoes
• Costs can be represented by a table or a graph

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7.3
Costs and Cost
Curves 7

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7.3Costs and Cost
Curves 7
Figure 7.1 Fixed, Variable, and Total Costs
Cost
($/week)
$300 TC is the sum of VC
and FC
250
Total cost (TC )
200
Variable cost (VC )
150

100

50
Fixed cost (FC )

0 1 2 3 4 5 6 7 8
9 10 11 12
Quantity of shoes (pairs)
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7.3 Costs and Cost
Curves 7
The fixed cost curve is horizontal
• Costs do not vary with output; they are $50 per week regardless of
production
Variable costs change with the amount of output, and the
variable cost curve is therefore not constant
• The slope of the variable cost curve is always positive
• In this example, the curve becomes flatter as output rises from 0 to
4 pairs, then becomes steeper as the number of pairs produced per
week increases
The total cost curve is the sum of variable cost and fixed cost
• The total cost curve will have the same shape as the variable cost
curve, but it will be shifted up at each level of output by the
amount of fixed costs

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7.4 Average and Marginal
Costs 7
Understanding the cost structure of firms is important, but to
understand how costs affect production decisions, we must
introduce two related measures: average cost and marginal
cost

• Average fixed cost (AFC )AFC FC / Q

Average cost is simply cost divided by output

• Average variable cost (AVC

AVC) VC / Q

• Average total cost (ATC )ATC TC / Q FC  VC / Q

FC / Q  VC / Q  AFC  AVC

Returning to the shoe example

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7.4
Average and Marginal
Costs 7

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7.4 Average and Marginal
Costs 7
Figure 7.2 Average Cost Curves
Average cost AFC always falls as quantity
($/pair) rises. This is because it is
being averaged across more
$70 and more units.
60 Average total cost (ATC )
50
40 Average fixed cost (AFC )

30
Average variable cost (AVC )
20
10

0 1 2 3 4 5 6 7 8
9 10 11 12
Quantity of shoes (pairs)
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7.4 Average and Marginal
Costs 7
Marginal cost is another deciding factor in firms’ production
decisions
• The additional cost of producing an additional unit of output
MC TC / Q

• Returning to the previous table,

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7.4
Average and Marginal
Costs 7

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7.4Average and Marginal
Costs 7
Figure 7.3 Marginal Cost
Marginal cost
MC falls at first
($/pair)
because AFC is
$80 falling. Eventually
70 MC rises.
Marginal cost (MC )
60
50
40
30
20
10

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of shoes (pairs)

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Picture Framing Shop figure it out

Frame de Art is an art framing shop in a small town. Frame de

Art has one storefront ($500 per week), and can hire workers
for $300 per week per worker. The table below shows how
output of framed art (in hundreds-per-week) varies with the
number of workers
Labor Framed Art
(workers per week) (hundreds per week)

0 0
1 1
3 2
6 3
11 4
20 5

Calculate the marginal cost of 100 to 500 framing jobs for

Frame de Art (assume labor to be the only variable cost)

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Picture Framing Shop figure it out
The simplest way to solve this is to add several columns to the
previous table representing fixed, variable, and total costs
MC
Marginal cost is simply TC / Q and is measured in
dollars

Labor Framed Art Fixed Variable Total Marginal

(workers per week) (hundreds per Cost Cost Cost Cost
week)

0 0 $500 $300 × 0 = $0 $500 —

1 1 500 $300 × 1 = 300 800 300

3 2 500 900 1,400 600

6 3 500 1,800 2,300 900

11 4 500 3,300 3,800 1,500

20 5 500 6,000 6,500 2,700

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7.4 Average and Marginal
Costs 7
Relationships Between Average and Marginal Costs
• Since fixed costs do not change when a firm expands output,
marginal cost only depends on variable cost
MC VC / Q TC / Q 
 Example: What happens when marginal cost is less than
average total cost? For example, consider your GPA. What
happens to your 3.0 average when you get a 2.5 for the
semester?
• The same holds with costs; when marginal cost is less than the
average total cost, producing another unit will reduce average total
cost, and vice versa
This observation helps to determine when average total costs

Average total costs are minimized when ATC = MC

are minimized
•
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7.4 Average and Marginal
Costs 7
Figure 7.4 The Relationship Between Average and
Marginal Costs
MC always
crosses AVC
Average cost and ATC at
and marginal their minimums.
MC
cost ($/unit) ATC
Minimum AVC
ATC

Minimum
AVC
Quantity

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Minimizing Costs figure it out

Suppose a firm’s total cost curve is

TC 10Q 2  6Q  60
and marginal cost

Answer the following questions:

1. Find expressions for the firm’s fixed cost, variable
cost, average total cost, and average variable cost
2. Find the output level that minimizes average total
cost
3. Find the output level that minimizes average
variable cost

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Minimizing Costs figure it out

1. Find the firm’s fixed cost, variable cost, average total

cost, and average variable cost

Fixed cost does not vary with output, so solve for total cost when
output equals
TCzero
2

10 0  6 0  60 60 FC 
Variable cost is the portion that does vary with output
 Fixed

TC 10Q  6Q  60  VC 10Q 2  6Q
2

Average total cost is simply total cost divided by output,

10Q 2  6Q  60 60
ATC  10Q  6 
Q Q

And the same applies to variable

2
cost,
10Q  6Q
AVC  10Q  6
Q
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Minimizing Costs figure it out

2. Minimum average total cost occurs when marginal cost

is equal to average total cost
10Q 2  6Q  60
ATC MC  20Q  6
Q
10Q 2  6Q  60 20Q 2  6Q  10Q 2 60
 Q  6 2.45

So, ATC is minimized when Q = 2.45

3. Finally, average variable cost is minimized when

marginal cost is equal to average variable cost
10Q 2  6Q
AVC  10Q  6 20Q  6  Q 0
Q
And AVC is minimized when production ceases

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7.5
Short-Run and Long-Run
Cost Curves 7
We now analyze how the time horizon affects the cost structure
facing a firm
• Remember, in the short run, the amount of capital is assumed to be
fixed
Short-Run Production and Total Cost Curves
A firm’s short-run total cost curve describes the total cost of
producing various quantities of output when the amount of capital
available for use is fixed
• An easy way to see this concept in action is with a graph
• Consider the production of engines

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 7.5
Short-Run and Long-Run
Cost Curves 7
Capital and labor are used to produce engines (quantities are per
week)
Figure 7.5 Figure 7.6
Capital Total Cost

C = 360

TCSR TCLR
Z′
Long-Run Expansion Path $360

Z
$300

C = 120
Z Short-Run
X′ Expansion Path (K
Z′ Y
X′
$180

= 5)
Y
Q = 20 Q = 30 X
5 $120

X
$100

C = 180 C = 300
C = 100 Q = 10
0 0 10 20 30
Labor Output

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7.5
Short-Run and Long-Run
Cost Curves 7
Short-Run Versus Long-Run Average Total Cost Curves
Figure 7.6 shows that the short-run total cost curve will never fall
below the long-run total cost curve
• This further implies that the short-run average total cost curve will
never fall below the long-run average total cost curve
• This fact holds true for all short-run average total cost curves (each
of which corresponds to a different fixed capital level)
• This property means that the long-run ATC curve will envelop all of
the short-run ATC curves

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7.5 Short-Run and Long-Run
Cost Curves 7
Figure 7.8 The Long-Run Average Total Cost Curve
Envelops the Short-Run Average Cost Curves

Average ATCSR,10 ATCSR,30

total
($/
cost ATCSR,20 ATCLR
unit)
X′ Z'
$12

X Y Z
9

0 10 20 30 Quantity
of engines

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Production of Wind Turbines figure it out

Suppose a wind turbine producer faces a production

function
Q 0.25KL; MPL 0.25K ; MPK 0.25L

The wage rate (W) is $12 per hour, and the rental rate
on capital (R) is $22 per hour
Answer the following questions:
1. In the short run, capital is fixed at 8. What is the cost of
producing 200 turbines?
2. What should the firm do in the long run to minimize the cost of
producing 200 turbines?

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Production of Wind Turbines figure it out

1. If capital is fixed at 8 units, the amount of labor needed to

produce 200 turbines is found by solving for L
200 0.25 8  L  L 100
Total cost is therefore given by
TC RK  WL $22 8  $12 100 $1,376
2. From Chapter 6, we know that costs are minimized when the
MRTS of labor for capital is equal to the ratio of the costs of
labor to capital,
MP 0.25K K K W 12 12
MRTS LK  L      K L
MPK 0.25L L L R 22 22
Or,

 K into
 12  3 2
Q 200  0. 25
Subbing the expression for L   L [Link]
 the Lproduction
L 3 yields
 22  22
K 20.89

And finally, solving for the amount of capital used yields

Finally, total Copyright
costs© 2013
are given by
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7.5
Short-Run and Long-Run
Cost Curves 7
Short-Run Versus Long-Run Marginal Cost Curves
Just as with average costs,
• Short-run marginal cost is the cost of producing an additional
unit of output when capital is fixed
• Long-run marginal cost is the cost of producing an additional
unit of output when both capital and labor are variable

 What does this imply for the shape of the marginal

cost curves?

• In general, the long-run marginal cost curve will be flatter

than the short-run marginal cost curve

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7.5 Short-Run and Long-Run
Cost Curves 7
Figure 7.9 Long-Run and Short-Run Marginal Costs
Average cost ATCSR,10
ATCSR,30 MCLR
and marginal
cost ($/unit) ATCSR,20
ATCLR

$12
B

Y
9 Note that each
A short run MC
curve intersects
MCSR,10 each ATC curve at
MCSR,20 MCSR,30
its minimum.
0 10 20 30 Quantity
of engines
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7.6
Economies in the
Production Process 7
 What happens to the long-run ATC curve as a firm grows?
• The answer reveals information about economies in the production
process
• Similar to returns to scale, but focused on the cost side

Economies of scale: costs rise more slowly than production

Diseconomies of scale: costs rise more quickly than
production
Constant economies of scale: costs rise at the same rate as
output

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7.6
Economies in the
Production Process 7
of the long-run ATC curve imply for production?
 Given these relationships, what does the common “U-shape”

• At first, average cost per unit produced falls (economies of scale),

eventually, as output rises considerably, diseconomies of scale take
hold
 What factors might cause diseconomies of scale to set in?
Not the same as returns to scale
• Returns to scale describes how production changes when all inputs
are changed by a common factor
• Economies of scale does not impose this “common factor” rule in
input proportions

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Economies of Scale Figure it out

LTC = 15,000Q – 200Q2 + Q3 and its long-run

Suppose the long-run total cost function for a firm is

marginal cost function is LMC = 15,000 – 400Q + 3Q2.

Answer the following:
1. At what levels of output will the firm face economies of scale?
2. At what levels of output will the firm face diseconomies of
scale?
3. Does the long-run ATC curve exhibit a typical U-shape?

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Economies of Scale Figure it out

1. We know that when LMC < LATC, long-run average total cost
is falling, and when LMC = LATC, long-run average total costs
are minimized. First, derive the equation for LATC

Setting LMC = LATC yields

Long-run average total cost is minimized at 100 units of output;

therefore, at output levels below 100, the firm is experiencing
economies of scale
2. Similarly, at output levels above 100, the firm faces
diseconomies of scale
3. Yes, the LATC curve has the expected “U-shape”

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7.6
Economies in the
Production Process 7
Economies of Scope
A related concept is the idea of economies of scope
• Refers to the simultaneous production of multiple products at a
lower cost than if a firm made each separately
 Why might a firm observe economies of scope?
• Flexible inputs or production processes
o For instance, oil refineries can produce many different
petroleum products at the same time through distillation at a
much lower aggregate cost than if each were produced
separately
• Expertise is translatable across several products/services
o For instance, life and auto insurance

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 Application 7
Economies of Scope in the Insurance
Industry
The financial industry has long been thought to exhibit
both economies of scale and scope
• For instance, recent years have seen institutional
mergers, acquisitions, and internal expansion of
product offerings
Cummins et al. (2010) investigate whether economies of
Images: [Link]
scope exist for insurers that offer life/health insurance
and/or property-liability insurance
• Conglomeration hypothesis: operating different
business enterprises adds value by exploiting scope
economies
• Strategic focus hypothesis: firms are better off
specializing on a core business model
The authors find scope diseconomies exist, and
Citation: Cummins, J.D., M. A. Weiss, X. Xie, and H. Zi, 2010. Economies of Scope in Financial Services: A
companies offering both products may do better by
DEA Efficiency Analysis of the U.S. Insurance Industry. Journal of Banking and Finance 34(7): 1525–1539.

divesting fromCopyright
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2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e 7-44
7.7 Conclusion 7
We have now linked cost to production
• Opportunity costs, fixed costs, variable costs, sunk costs
• Marginal and average costs
• Short- and long-run costs
In the next chapters, we introduce market conditions to a
firm’s production decision
We begin with the case of a perfectly competitive market
in Chapter 8

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