Cost & Production Theory

Firms seek to produce any given quantity of output (Q) at lowest cost.

Firms are cost minimizers.

Costs C = rK + wL r is the price of capital, w is the wage Cost is the sum of each input quantity

multiplied by its price when input prices reflect all costs including opportunity costs

Economic Costs are Opportunity Costs Economic Cost includes both

implicit and explicit costs Explicit Costs – payment to others Implicit Costs – cost of owned

inputs, or other costs that do not generate explicit payments

Costs and Output Long-Run Total Cost or LTC

Combinations of Cost and Output Q (C1,Q1), (C2,Q2), (C3,Q3)

Long-run average cost LAC = (LTC/Q)

Long-run marginal cost LMC = ΔLTC/ΔQ

Short-run vs. Long-run Long-run: all inputs variable Short-run: one or more inputs fixed

Total Product: Q = f(K0,L) Average Product of Labor: APL = Q/L Marginal Product of Labor: MPL = ΔQ/ΔL

Law of diminishing marginal product As more labor is employed with a fixed

amount of capital, labor’s marginal product (MPL) eventually declines

Watch the video Microeconomics The Law of

Diminishing Returns: Econ Concepts in 60 Seconds http://youtu.be/M7rA4VfvdAw

Short-run Costs Total Cost = rK0 + wL = TC Total Fixed Cost = rK0 = TFC Total Variable Cost = wL = TVC TC = TFC + TVC Average Fixed Cost: AFC = TFC/Q Average Variable Cost: AVC = TVC/Q Average Total Cost: ATC = TC/Q

Short-run Marginal Cost SMC = ΔTC/ΔQ

ΔTFC/ΔQ = 0 SMC = ΔTVC/ΔQ = ΔTC/ΔQ

SMC = AVC at its minimum SMC = ATC at its minimum

Watch the videos Episode 23: Cost Curves

http://youtu.be/UI-LL8-dVAs

Cost Curves MC, ATC, AVC, and AFC: Econ Concepts in 60 Seconds http://youtu.be/S3iLMfm6CGY

Short-run Cost & Product AVC and MC are inversely related

to APL and MPL MPL > APL implies MC < AVC Max MPL corresponds to Min MC MPL = APL implies MC = AVC MPL < APL implies MC > AVC

Short-run and Long-run Cost Short-run and long-run costs are

equal ONLY at a long-run optimum The quantity where short-run fixed K0

minimizes long run cost ATC = LAC

Only at the minimum of LAC are all average and marginal costs equal LAC = LMC = ATC = SMC

Watch the video 9.2 - Long-Run Cost Structure

http://youtu.be/8I6BIuCGuaE

Economies of Scale Economies of scale: LAC is decreasing

Costs increase less than proportionately with output

Diseconomies of scale: LAC increasing Costs increase more than proportionately

with output Constant returns to scale: LAC = LMC

Costs increase exactly in proportion to output Minimum Efficient Scale or MES

The quantity at which economies of scale end and constant returns begin

Watch the video Economies and Diseconomies of

Scale.mp4 http://youtu.be/6TW-o1NqV0I

Economies of Scope A firm can produce two products

together more cheaply than producing each product separately, or C(X,Y) < C(X) + C(Y)