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The Cost of Production Each firm uses various inputs (resources) in its production activity. Commonly used inputs: labor

The Cost of Production Each firm uses various inputs (resources) in its production activity. Commonly used inputs: labor and capital Prices of inputs (wages, rents)  Cost of Production. Measuring Cost: Which Costs Matter?

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The Cost of Production Each firm uses various inputs (resources) in its production activity. Commonly used inputs: labor

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  1. The Cost of Production Each firm uses various inputs (resources) in its production activity. Commonly used inputs: labor and capital Prices of inputs (wages, rents)  Cost of Production

  2. Measuring Cost: Which Costs Matter? • It is clear that if a firm has to rent equipment or buildings, the rent they pay is a cost • What if a firm owns its own equipment or building? • How are costs calculated here?

  3. Measuring cost: • Accounting Cost – actual expenses plus depreciation charges for capital equipment. • Economic Cost – cost to a firm of utilizing economic resources in production, including opportunity cost. • Opportunity cost – the value of a highest forgone alternative; • – cost associated with opportunities that are forgone when a firm’s resources are not put to their highest-value use. • Example when economic cost differs from accounting cost: • shop owner who does not pay herself a salary and/or owns the building

  4. Economic cost. • Some costs vary with output, while some remain the same no matter amount of output • Fixed Cost (FC) – cost that does not vary with the level of output. • - have to be paid as long as the firm stays in business (even if output is zero) • Variable Cost (VC) – cost that varies as the level of output varies. • Total Cost (TC or C) – total economic cost of production, consisting of fixed and variable costs. • TC=FC+VC

  5. Which costs are variable and which are fixed depends on the time horizon • Short time horizon – most costs are fixed • Long time horizon – many costs become variable • In determining how changes in production will affect costs, we must consider if it affects fixed or variable costs

  6. A Firm’s Short Run Costs

  7. TC Cost ($ per year) 400 VC 300 200 100 FC 50 Output 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Cost Curves for a Firm Total cost is the vertical sum of FC and VC. Variable cost increases with production and the rate varies with increasing & decreasing returns. Fixed cost does not vary with output

  8. Costs that are fixed in the short run may not be fixed in the long run • Typically in the long run, most if not all costs are variable

  9. Per-Unit, or Average, Costs • Average Total cost – firm’s total cost divided by its level of output (average cost per unit of output) • ATC=AC=TC/Q • Average Fixed cost – fixed cost divided by level of output (fixed cost per unit of output) • AFC=FC/Q • Average variable cost – variable cost divided by the level of output. • AVC=VC/Q

  10. Marginal Cost – change (increase) in cost resulting from the production of one extra unit of output Denote “∆” - change. For example ∆TC - change in total cost MC=∆TC/∆Q Example: when 4 units of output are produced, the cost is 80, when 5 units are produced, the cost is 90. MC=(90-80)/1=10 MC=∆VC/∆Q since TC=(FC+VC) and FC does not change with Q

  11. A Firm’s Short Run Costs

  12. MC ATC AVC AFC Cost Curves

  13. Marginal Product and Costs Suppose a firm pays each worker $50 a day.

  14. Short-run Costs and Marginal Product • production with one input L – labor; (capital is fixed) • Assume the wage rate (w) is fixed • Variable costs is the per unit cost of extra labor times the amount of extra labor: VC=wL Denote “∆” - change. For example ∆VC is change in variable cost. MC=∆VC/∆Q ; MC =w/MPL, where MPL=∆Q/∆L With diminishing marginal returns: marginal cost increases as output increases.

  15. Shifts of the Cost Curves • Changes in resource prices or technology will cause costs to change • Cost curves shift FC increases by 100

  16. TC’ TC Cost ($ per year) 400 VC 300 200 100 FC’ FC 150 50 Output 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Shift of FC curve

  17. Summary In the short run, the total cost of any level of output is the sum of fixed and variable costs: TC=FC+VC Average fixed (AFC), average variable (AVC), and average total costs (ATC) are fixed, variable, and total costs per unit of output; marginal cost is the extra cost of producing 1 more unit of output. AFC is decreasing AVC and ATC are U-shaped, reflecting increasing and then diminishing returns. Marginal cost curve (MC) falls and then rises, intersecting both AVC and ATC at their minimum points.

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