Description
concept of cost theory, types of cost and cost curves. It includes the envelope relationship between short-run and long-run average cost curves.
Cost theory
The Meaning of Costs
? Opportunity costs
? meaning of opportunity cost ? examples
? Measuring a firm’s opportunity costs
? factors not owned by the firm: explicit costs
? factors already owned by the firm: implicit costs
Costs
? Short run – Diminishing marginal returns results
from adding successive quantities of variable factors to a fixed factor ? Long run – Increases in capacity can lead to increasing, decreasing or constant returns to scale
Costs
? In buying factor inputs, the firm
will incur costs ? Costs are classified as:
? Fixed costs – costs that are not related directly to
production – rent, rates, insurance costs, admin costs. They can change but not in relation to output ? Variable Costs – costs directly related to variations in output. Raw materials, labour, fuel, etc
Costs
? Total Cost - the sum of all costs incurred in
production
? TC = FC + VC ? Average Cost – the cost per unit
of output
? AC = TC/Output
? Marginal Cost – the cost of one more or one
fewer units of production ? MC = TCn – TCn-1 units
Marginal Product and Costs Suppose a firm pays each worker $50 a day.
Units of Labor 0 1 2 3 4 5 6
Total Product 0 10 25 45 60 70 75
MP 10 15 20 15 10 5
VC 0 50 100 150 200 250 300
MC 5 3.33 2.5 3.33 5 10
A Firm’s Short Run Costs
Average Costs
Average Total cost – firm’s total cost divided by its level of output (average cost per unit of output)
ATC=AC=TC/Q
Average Fixed cost – fixed cost divided by level of output (fixed cost per unit of output)
AFC=FC/Q
Average variable cost – variable cost divided by the level of output.
AVC=VC/Q
Marginal Cost – change (increase) in cost resulting from the
production of one extra unit of output
Denote “?” - change. For example ?TC - change in total cost
MC=?TC/?Q
Example: when 4 units of output are produced, the cost is 80, when 5 units are produced, the cost is 90. MC=(90-80)/1=10
MC=?VC/?Q
since TC=(FC+VC) and FC does not change with Q
Cost Curves for a Firm
TC
Cost 400
($ per year)
300
Total cost is the vertical sum of FC and VC.
VC
200
Variable cost increases with production and the rate varies with increasing & decreasing returns.
100
Fixed cost does not vary with output
50
0 1 2 3 4 5 6 7 8 9 10 11 12 13
FC
Output
Average total cost curve (ATC)
The average fixed cost curve is a rectangular hyperbola as the curve becomes asymptotes to the axes. The average variable cost is a mirror image of the average product curve . The average total cost curve is the sum of AFC and the AVC.
? When both the curves are falling, the ATC which is
the sum of both is also falling. ? When AVC starts to rise, the average fixed cost curve falls faster and hence the sum falls. Beyond a point, the rise in AVC is more than the fall in AFC and their sum rises. ? Hence the ATC is an U shaped curve
? AVC = W.L/Q
= W/AP = W. 1/AP Hence AP and AVC are inversely related. Thus AVC is an inverted U shaped curve
? MC = Change in TC = d (WL)/dQ
= WdL/dQ = W(1/MP) Hence The Marginal cost is the inverse of the MP curve.
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 ;
where MPL=?Q/?L
MC =w/MPL,
With diminishing marginal returns: marginal cost increases as output increases.
Average and marginal costs
MC
Costs (£)
Diminishing marginal returns set in here
x
fig
Output (Q)
The Relationship Between MP, AP, MC, and AVC
Average and marginal costs
MC
AC
AVC
Costs (£)
z y x AFC
fig
Output (Q)
Shift of the curves
TC’ TC
Cost 400
($ per year)
VC
300
200 150 100 FC’
50
0 1 2 3 4 5 6 7 8 9 10 11 12 13
FC
Output
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.
The Envelope Relationship
? In the long run all inputs are flexible, while in the
short run some inputs are not flexible. ? As a result, long-run cost will always be less than or equal to short-run cost.
The Long-Run Cost Function
? LRAC is made up for
SRACs
? SRAC curves represent
various plant sizes ? Once a plant size is chosen, per-unit production costs are found by moving along that particular SRAC curve
The Long-Run Cost Function
? The LRAC is the lower envelope of all of the
SRAC curves.
? Minimum efficient scale is the lowest output level
for which LRAC is minimized
Is LRAC a function of market size? What are implications?
The Envelope Relationship
? The envelope relationship explains that:
?
?
At the planned output level, short-run average total cost equals long-run average total cost. At all other levels of output, short-run average total cost is higher than long-run average total cost.
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC
2
SRAC3
SRAC5 SRAC4
Costs
1 factory 2 factories 3 factories 4 factories
5 factories
O
fig
Output
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC
2
SRAC3
SRAC5 SRAC4
LRAC
Costs
O
fig
Output
Envelope of Short-Run Average Total Cost Curves
LRATC
Costs per unit
SRMC1
SRATC1 SRMC2
SRATC4
SRMC4 SRATC2 SRATC3 SRMC3
0
Q2
Q3
Quantity
Envelope of Short-Run Average Total Cost Curves
Costs per unit
LRATC
SRMC1 SRATC1 SRMC2 SRATC4
SRMC4 SRATC2 SRATC3 SRMC3
0
Q2
Q3
Quantity
The Learning Curve
? Measures the percentage
decrease in additional labor cost each time output doubles. ? An “80 percent” learning curve implies that the labor costs associated with the incremental output will decrease to 80% of their previous level.
The LR Relationship Between Production and Cost
? In the long run, all inputs are variable.
? What makes up LRAC?
Production in the Long run
? Economies of scale
? specialisation & division of labour ? indivisibilities ? container principle ? greater efficiency of large machines
? by-products
? multi-stage production ? organisational & administrative economies ? financial economies
Production in the Long run
? Diseconomies of scale
? managerial diseconomies ? effects of workers and industrial relations ? risks of interdependencies
? External economies of scale ? Location
? balancing the distance from suppliers and
consumers ? importance of transport costs ? Ancillary industries-by products
? Internal economies and diseconomies
affect the shape of the LAC ? External Economies affect the position of the LAC ? External Diseconomies may cause increase in prices of the factors of production
Economies of Scope
? There are economies of scope when the costs
of producing goods are interdependent so that it is less costly for a firm to produce one good when it is already producing another. ? S = TC(QA)+TC(QB )- TC(QA QB) TC(Q A,QB )
Economies of Scope
? Firms look for both economies of scope and
economies of scale.
?
Economies of scope play an important role in firms’ decisions of what combination of goods to produce.
Summary
? An economically efficient production process
must be technically efficient, but a technically efficient process may not be economically efficient. ? The long-run average total cost curve is Ushaped because economies of scale cause average total cost to decrease; diseconomies of scale eventually cause average total cost to increase.
Summary
? Marginal cost and short-run average cost curves
slope upward because of diminishing marginal productivity. ? The long-run average cost curve slopes upward because of diseconomies of scale. ? The envelope relationship between short-run and long-run average cost curves shows that the short-run average cost curves are always above the long-run average cost curve.
Summary
? Marginal cost and short-run average cost curves
slope upward because of diminishing marginal productivity. ? The long-run average cost curve slopes upward because of diseconomies of scale. ? The envelope relationship between short-run and long-run average cost curves shows that the short-run average cost curves are always above the long-run average cost curve.
Summary
? Marginal cost and short-run average cost curves
slope upward because of diminishing marginal productivity. ? The long-run average cost curve slopes upward because of diseconomies of scale. ? The envelope relationship between short-run and long-run average cost curves shows that the short-run average cost curves are always above the long-run average cost curve.
Revenue
? Total revenue – the total amount received from
selling a given output ? TR = P x Q ? Average Revenue – the average amount received from selling each unit ? AR = TR / Q ? Marginal revenue – the amount received from selling one extra unit of output ? MR = TRn – TR n-1 units
doc_104696954.pptx
concept of cost theory, types of cost and cost curves. It includes the envelope relationship between short-run and long-run average cost curves.
Cost theory
The Meaning of Costs
? Opportunity costs
? meaning of opportunity cost ? examples
? Measuring a firm’s opportunity costs
? factors not owned by the firm: explicit costs
? factors already owned by the firm: implicit costs
Costs
? Short run – Diminishing marginal returns results
from adding successive quantities of variable factors to a fixed factor ? Long run – Increases in capacity can lead to increasing, decreasing or constant returns to scale
Costs
? In buying factor inputs, the firm
will incur costs ? Costs are classified as:
? Fixed costs – costs that are not related directly to
production – rent, rates, insurance costs, admin costs. They can change but not in relation to output ? Variable Costs – costs directly related to variations in output. Raw materials, labour, fuel, etc
Costs
? Total Cost - the sum of all costs incurred in
production
? TC = FC + VC ? Average Cost – the cost per unit
of output
? AC = TC/Output
? Marginal Cost – the cost of one more or one
fewer units of production ? MC = TCn – TCn-1 units
Marginal Product and Costs Suppose a firm pays each worker $50 a day.
Units of Labor 0 1 2 3 4 5 6
Total Product 0 10 25 45 60 70 75
MP 10 15 20 15 10 5
VC 0 50 100 150 200 250 300
MC 5 3.33 2.5 3.33 5 10
A Firm’s Short Run Costs
Average Costs
Average Total cost – firm’s total cost divided by its level of output (average cost per unit of output)
ATC=AC=TC/Q
Average Fixed cost – fixed cost divided by level of output (fixed cost per unit of output)
AFC=FC/Q
Average variable cost – variable cost divided by the level of output.
AVC=VC/Q
Marginal Cost – change (increase) in cost resulting from the
production of one extra unit of output
Denote “?” - change. For example ?TC - change in total cost
MC=?TC/?Q
Example: when 4 units of output are produced, the cost is 80, when 5 units are produced, the cost is 90. MC=(90-80)/1=10
MC=?VC/?Q
since TC=(FC+VC) and FC does not change with Q
Cost Curves for a Firm
TC
Cost 400
($ per year)
300
Total cost is the vertical sum of FC and VC.
VC
200
Variable cost increases with production and the rate varies with increasing & decreasing returns.
100
Fixed cost does not vary with output
50
0 1 2 3 4 5 6 7 8 9 10 11 12 13
FC
Output
Average total cost curve (ATC)
The average fixed cost curve is a rectangular hyperbola as the curve becomes asymptotes to the axes. The average variable cost is a mirror image of the average product curve . The average total cost curve is the sum of AFC and the AVC.
? When both the curves are falling, the ATC which is
the sum of both is also falling. ? When AVC starts to rise, the average fixed cost curve falls faster and hence the sum falls. Beyond a point, the rise in AVC is more than the fall in AFC and their sum rises. ? Hence the ATC is an U shaped curve
? AVC = W.L/Q
= W/AP = W. 1/AP Hence AP and AVC are inversely related. Thus AVC is an inverted U shaped curve
? MC = Change in TC = d (WL)/dQ
= WdL/dQ = W(1/MP) Hence The Marginal cost is the inverse of the MP curve.
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 ;
where MPL=?Q/?L
MC =w/MPL,
With diminishing marginal returns: marginal cost increases as output increases.
Average and marginal costs
MC
Costs (£)
Diminishing marginal returns set in here
x
fig
Output (Q)
The Relationship Between MP, AP, MC, and AVC
Average and marginal costs
MC
AC
AVC
Costs (£)
z y x AFC
fig
Output (Q)
Shift of the curves
TC’ TC
Cost 400
($ per year)
VC
300
200 150 100 FC’
50
0 1 2 3 4 5 6 7 8 9 10 11 12 13
FC
Output
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.
The Envelope Relationship
? In the long run all inputs are flexible, while in the
short run some inputs are not flexible. ? As a result, long-run cost will always be less than or equal to short-run cost.
The Long-Run Cost Function
? LRAC is made up for
SRACs
? SRAC curves represent
various plant sizes ? Once a plant size is chosen, per-unit production costs are found by moving along that particular SRAC curve
The Long-Run Cost Function
? The LRAC is the lower envelope of all of the
SRAC curves.
? Minimum efficient scale is the lowest output level
for which LRAC is minimized
Is LRAC a function of market size? What are implications?
The Envelope Relationship
? The envelope relationship explains that:
?
?
At the planned output level, short-run average total cost equals long-run average total cost. At all other levels of output, short-run average total cost is higher than long-run average total cost.
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC
2
SRAC3
SRAC5 SRAC4
Costs
1 factory 2 factories 3 factories 4 factories
5 factories
O
fig
Output
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC
2
SRAC3
SRAC5 SRAC4
LRAC
Costs
O
fig
Output
Envelope of Short-Run Average Total Cost Curves
LRATC
Costs per unit
SRMC1
SRATC1 SRMC2
SRATC4
SRMC4 SRATC2 SRATC3 SRMC3
0
Q2
Q3
Quantity
Envelope of Short-Run Average Total Cost Curves
Costs per unit
LRATC
SRMC1 SRATC1 SRMC2 SRATC4
SRMC4 SRATC2 SRATC3 SRMC3
0
Q2
Q3
Quantity
The Learning Curve
? Measures the percentage
decrease in additional labor cost each time output doubles. ? An “80 percent” learning curve implies that the labor costs associated with the incremental output will decrease to 80% of their previous level.
The LR Relationship Between Production and Cost
? In the long run, all inputs are variable.
? What makes up LRAC?
Production in the Long run
? Economies of scale
? specialisation & division of labour ? indivisibilities ? container principle ? greater efficiency of large machines
? by-products
? multi-stage production ? organisational & administrative economies ? financial economies
Production in the Long run
? Diseconomies of scale
? managerial diseconomies ? effects of workers and industrial relations ? risks of interdependencies
? External economies of scale ? Location
? balancing the distance from suppliers and
consumers ? importance of transport costs ? Ancillary industries-by products
? Internal economies and diseconomies
affect the shape of the LAC ? External Economies affect the position of the LAC ? External Diseconomies may cause increase in prices of the factors of production
Economies of Scope
? There are economies of scope when the costs
of producing goods are interdependent so that it is less costly for a firm to produce one good when it is already producing another. ? S = TC(QA)+TC(QB )- TC(QA QB) TC(Q A,QB )
Economies of Scope
? Firms look for both economies of scope and
economies of scale.
?
Economies of scope play an important role in firms’ decisions of what combination of goods to produce.
Summary
? An economically efficient production process
must be technically efficient, but a technically efficient process may not be economically efficient. ? The long-run average total cost curve is Ushaped because economies of scale cause average total cost to decrease; diseconomies of scale eventually cause average total cost to increase.
Summary
? Marginal cost and short-run average cost curves
slope upward because of diminishing marginal productivity. ? The long-run average cost curve slopes upward because of diseconomies of scale. ? The envelope relationship between short-run and long-run average cost curves shows that the short-run average cost curves are always above the long-run average cost curve.
Summary
? Marginal cost and short-run average cost curves
slope upward because of diminishing marginal productivity. ? The long-run average cost curve slopes upward because of diseconomies of scale. ? The envelope relationship between short-run and long-run average cost curves shows that the short-run average cost curves are always above the long-run average cost curve.
Summary
? Marginal cost and short-run average cost curves
slope upward because of diminishing marginal productivity. ? The long-run average cost curve slopes upward because of diseconomies of scale. ? The envelope relationship between short-run and long-run average cost curves shows that the short-run average cost curves are always above the long-run average cost curve.
Revenue
? Total revenue – the total amount received from
selling a given output ? TR = P x Q ? Average Revenue – the average amount received from selling each unit ? AR = TR / Q ? Marginal revenue – the amount received from selling one extra unit of output ? MR = TRn – TR n-1 units
doc_104696954.pptx