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Cost Concepts in Economics

Chapter 9: Kay and Edwards

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Agenda Opportunity Cost Long Versus Short-Run Cost Concepts Revenue Concepts Production Rules in Short and

Long-Run Size in Long-Run

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Opportunity Costs The value of the product not

produced because an input was used for another purpose.

The income that would have been received if the input had been used in its most profitable alternative use.

It denotes the real cost of using an input.

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Short Versus Long Run The short run is a period of time

sufficiently short that only some of the variables can be changed.

The long run is a period of time that all variables can be changed.

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Types of Costs Variable Costs

These costs exist only if production occurs. E.g., fuel for tractor, seed, etc.

Fixed Costs These cost exist whether production occurs or

not. In the long-run there are no fixed costs. Can be both cash and non-cash expenses. E.g., depreciation on tractors and buildings,

etc.

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Types of Costs Cont. Sunk Costs

Is an expenditure that cannot be recovered.

In essence, it becomes part of fixed costs.

E.g., pre-harvest costs.

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Cost Concepts Total Fixed Costs (TFC)

The summation of all fixed and sunk costs to production.

Total Variable Costs (TVC) The summation of all variable costs to

production. Total Costs (TC)

The summation of total fixed and total variable costs.

TC=TFC+TVC

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Cost Concepts Cont. Average Fixed Costs (AFC)

The total fixed costs divided by output. Average Variable Costs (AVC)

The total variable costs divided by output. Average Total Costs (ATC)

The total costs divided by output. The summation of average fixed costs and

average variable costs, i.e., ATC=AFC+AVC.

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Cost Concepts Cont. Marginal Costs

The change in total costs divided by the change in output.

TC/Y The change in total variable costs

divided by the change in output. TVC/Y

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Side Note on Marginal Cost How can marginal cost equal both

the change in total cost divided by the change in output and the change in total variable cost divided by the change in output when variable costs are not equal to total costs? Short answer: fixed costs do not

change.

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Side Note on Marginal Cost Cont. We want to show that MC = TVC/Y when

TVC TC. We know that TC = TFC + TVC This implies that TC = (TFC + TVC) This implies that TC = TFC + TVC We know that TFC = 0 Hence, TC = TVC Divide the previous by Y, we obtain TC/Y = TVC/Y MC = TVC/Y

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Graphical Representation of Cost Concepts

$

Y

TC

TVC

TFC

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Graphical Representation of Cost Concepts Cont.

$

Y

ATC

MC

AVC

AFC

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Notes on Costs MC will meet AVC and ATC from

below at the corresponding minimum point of each. Why?

As output increases AFC goes to zero.

As output increases, AVC and ATC get closer to each other.

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Example of Cost Concepts

Y TFC TVC TC AFC AVC ATC MC

10

30

48

65

81

96

108

116

120

117

1000

1000

1000

1000

1000

1000

1000

1000

1000

1000

1000

1600

2000

2200

2600

3200

4000

5000

6200

7600

2000

2600

3000

3200

3600

4200

5000

6000

7200

8600

100

33.33

20.83

15.38

12.35

10.42

9.26

8.62

8.33

8.55

100

53.33

41.67

33.85

32.10

33.33

37.04

43.10

51.67

64.96

200

86.67

62.50

49.23

45.45

43.75

46.30

51.72

60.00

73.51

30

22.22

11.76

25

40

66.67

125

300

-466.67

X

10

16

20

22

26

32

40

50

62

76

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Revenue Concepts Revenue (TR) is defined as the

output price (py) multiplied by the quantity (Y).

Average revenue (AR) equals total revenue divided by output (Y), i.e., TR/Y, which equals py.

Marginal Revenue is the change in total revenue divided by the change in output, i.e., TR/Y.

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Short-Run Decision Making In the short-run, there are many

ways to choose how to produce. Maximize output. Utility maximization of the manager. Profit maximization.

Profit () is defined as total revenue minus total cost, i.e., = TR – TC.

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Short-Run Decision Making Cont. When examining output, we want to

set our production level where MR = MC when MR > AVC in the short-run. If MR AVC, we would want to shut

down. Why?

If we can not set MR exactly equal to MC, we want to produce at a level where MR is as close as possible to MC, where MR > MC.

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Intuition for Setting MR = MC Suppose MR < MC. This implies that by producing

more output, you have a greater addition of cost than you do revenue. Hence you would not make the

change.

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Intuition for Setting MR = MC Suppose MR > MC. This implies that by producing

more output, you have a greater addition of revenue than you do cost. Hence you would make the change.

You would stop increasing output at the point where the trade-off in additional revenue is just equal to the trade-off in additional costs.

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Why Shutdown WhenMR < AVC If MR < AVC, this implies that you

are not bringing in enough revenue from each unit produced to cover your variable costs.

Hence you could minimize your loss if you were to shutdown.

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Why Produce When ATC > MR > AVC When MR < ATC, the company is

making a loss. Why would it produce?

Since the firm is making something above and beyond its variable cost, it can put some of that revenue towards fixed cost. This implies that it minimizes its loss by

producing.

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Profit Scenario Graphically$

Y

ATC

MC

AVC

AFC

MR = py

Profit

ATC

Yprofit

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Loss Minimizing Graphically

$

Y

ATC

MC

AVC

AFC

Loss

ATC

Yloss

MR = py

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Shutdown Decision Graphically

$

Y

ATC

MC

AVC

AFC

Loss = A + B

ATC

Yloss

MR = py

A

B

If we did not produce: loss = B

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Production Rules for the Long-Run To maximize profits, the farmer

should produce when selling price is greater than ATC at the production level where MC = MR.

To minimize losses, the farmer should not produce when selling price is less than ATC, i.e., shutdown the business.

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Note on Cost Concepts The producer’s supply curve is the

part of the MC curve that is above the shutdown point.

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Long-Run Average Costs The long run average cost (LRAC) curve

is the envelope of the short run average cost curves when the size of the operation is allowed to increase or decrease.

Note that a short run average cost curve exists for every possible farm size, as defined by the amount of fixed input available.

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Long-Run Average Costs Cont. In a competitive market, the long

run optimal production will occur at the lowest point on the LRAC, i.e., economic profits are driven to zero.

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Size in the Long-Run A measure of size in the long run

between output and costs as farm size increases (EOS) is the following: EOS = percent change in costs

divided by percent change in output value

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Size in the Long-Run Cont. If this ratio of EOS is less than one, then

there are decreasing costs to expanding production, i.e., increasing returns to size.

If this ratio is equal to one, then there are constant costs to expanding production, i.e., constant returns to size.

If this ratio is greater than one, then there are increasing costs to expanding production, i.e., decreasing returns to size.

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Economies of Size This exists when the LRAC is decreasing. Also known as increasing returns to size. Usually occurs because of full utilization of

capital (tractors and buildings) and labor. Also occurs because of discount pricing for

buying in bulk and selling price benefits for selling large quantities.

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