Sunk Costs

Sunk CostSunk Cost - A cost, once paid, - A cost, once paid, that can never be recovered.that can never be recovered. For instance, you buy a license to For instance, you buy a license to

sell food. Whether you sell the food sell food. Whether you sell the food or not - you have paid for this cost or not - you have paid for this cost and can not sell it or get your and can not sell it or get your money back in any way.money back in any way.

Sunk CostEconomics believe that Sunk Economics believe that Sunk

Cost does not matter. The Cost does not matter. The reason being that it has been reason being that it has been paid paid

As marginal thinkers, we are As marginal thinkers, we are always concerned with future always concerned with future costs and benefits since the costs and benefits since the past cannot be changed.past cannot be changed.

Sunk CostFor instance, if you are in line at For instance, if you are in line at

Wal-Mart and the other line is Wal-Mart and the other line is going faster - should you switch going faster - should you switch lines? lines?

YesYes. It doesn’t matter how long . It doesn’t matter how long you have “committed” to one lane you have “committed” to one lane - your goal is to get out fastest - your goal is to get out fastest and you pick shortest lane. and you pick shortest lane.

What is done - is done.What is done - is done.

Economic CostsExplicit Costs Explicit Costs (Accounting Costs) (Accounting Costs)

- out of pocket payments to - out of pocket payments to owners of factors of productionowners of factors of production• Examples: wages, payment to Examples: wages, payment to

power companypower companyThese are are the types of costs These are are the types of costs

we normally think of. These are we normally think of. These are costs that are paid with cash.costs that are paid with cash.

Economic CostsImplicit CostsImplicit Costs - opportunity costs - opportunity costs

for which there are no explicit for which there are no explicit payments.payments.• Example: foregone rent if own Example: foregone rent if own

building, entrepreneur who gives up building, entrepreneur who gives up wages to run own companywages to run own company

These are the types of costs we These are the types of costs we rarely think of when considering rarely think of when considering cost. That is because they involve cost. That is because they involve no cash changing hands.no cash changing hands.

Economic Costs

Total CostTotal Cost (TC) - the total (TC) - the total opportunity cost of all opportunity cost of all resources used in resources used in production.production.

•TC = Explicit Costs + Implicit TC = Explicit Costs + Implicit CostsCosts

Normal Profits Accounting ProfitsAccounting Profits - -

Total Revenue - Explicit CostsTotal Revenue - Explicit Costs Economic ProfitsEconomic Profits ( () - ) -

Total Revenue - Total Economic Costs Total Revenue - Total Economic Costs

= TR - (Explicit Costs + Implicit = TR - (Explicit Costs + Implicit Costs)Costs)

In this class, we typically focus on In this class, we typically focus on

economic profitseconomic profits ( (

Normal ProfitsNormal ProfitsNormal Profits - the minimum payment - the minimum payment

the owner of an enterprise would take the owner of an enterprise would take to keep his resources employed in his to keep his resources employed in his business.business.• A firm earning only a normal profit is said A firm earning only a normal profit is said

to earn zero economic profits.to earn zero economic profits.

Example: If you gave up a $50,000 / year Example: If you gave up a $50,000 / year job to start your own business, you should job to start your own business, you should earn earn at leastat least $50,000 at that business or $50,000 at that business or you would not earn your you would not earn your opportunity costopportunity cost..

Cost ExampleAccounting Profit = TR - Explicit CostAccounting Profit = TR - Explicit Cost $200,000 = $1,000,000 - $800,000

Implicit Cost = Opportunity Cost of:Building = $100,000Management = 50,000Normal Profit = 50,000

Economic profit = TR - Total Economic CostEconomic profit = TR - Total Economic Cost

0 = $1,000,000 - $800,000 - $200,000

Product CurvesTotal ProductTotal Product (TP) (Production (TP) (Production

Function) - gives the maximum Function) - gives the maximum amount of output that can be amount of output that can be produced given any level of produced given any level of inputs used in production.inputs used in production.• Q = f(L | K)Q = f(L | K)• Output (Q) is a function of (f) the Output (Q) is a function of (f) the

amount of inputs used labor (L) amount of inputs used labor (L) and capital (K)and capital (K)

600

500

400

300

200

100

0

1 2 3 4 5 6 7 8

Total Output

Number of Workers

Number TotalWorkers Output

0 01 1002 2503 3604 4405 5006 5407 5508 540

The Total Product The Total Product CurveCurve

TPTP

600

500

400

300

200

100

0 1 2 3 4 5 6 7 8

Total Output

Number of Workers

TPTP

The Total Product The Total Product CurveCurve

Product Curves

Marginal Product of LaborMarginal Product of Labor (MP(MPLL) ) the additional output the additional output that is produced by an that is produced by an additional unit of labor.additional unit of labor.

•MPMPLL = = TP/TP/LL

Number Total Average MarginalWorkers Output Product Product

0 0 0 01 100 100 1002 250 125 1503 360 120 1104 440 110 805 500 100 606 540 90 407 550 78.6 108 540 67.5 -10

Marginal ProductMPL = TP/L

InputsCapital and Labor are Capital and Labor are

examples of examples of inputsinputs in in production.production.

Inputs can take on two forms - Inputs can take on two forms - fixed and variable.fixed and variable.

A fixed input is an input that A fixed input is an input that doesn’t change as you produce doesn’t change as you produce more quantity.more quantity.

Inputs

A variable input is one that A variable input is one that changes as you produce more changes as you produce more quantity.quantity. for example: Labor: As I make for example: Labor: As I make

more sandwiches, I use more more sandwiches, I use more Labor.Labor.

Short RunShort RunShort Run - period of time in - period of time in

which one input is fixed.which one input is fixed. For example: if it takes me 2 For example: if it takes me 2

months to install a new months to install a new machine, then the machine, then the short runshort run is 2 months.is 2 months.

Product CurvesLaw of Diminishing ReturnsLaw of Diminishing Returns - as more of - as more of

a variable input is added to a fixed a variable input is added to a fixed input, a point is eventually reached input, a point is eventually reached where the marginal product of the where the marginal product of the variable input starts to decline.variable input starts to decline.

Why?Why?• As we add more labor to a fixed amount of As we add more labor to a fixed amount of

capital, each worker has fewer units of capital, each worker has fewer units of capital to work with. Eventually each capital to work with. Eventually each worker will produce fewer output than the worker will produce fewer output than the previous worker.previous worker.

Law of Diminishing ReturnsA key word in the law, though, is A key word in the law, though, is

““eventuallyeventually”. At first marginal ”. At first marginal product ought to go product ought to go upup as we as we add workers, since they can take add workers, since they can take advantage of specialization and advantage of specialization and other methods of improving other methods of improving output. But EVENTUALLY output output. But EVENTUALLY output will will fallfall for the next worker. for the next worker.

Shape of Product CurvesTotal ProductTotal Product

• Law of diminishing marginal Law of diminishing marginal returns tells us it must eventually returns tells us it must eventually have a lower slope.have a lower slope.

Marginal ProductMarginal Product• Law of diminishing marginal Law of diminishing marginal

returns tells us it must be returns tells us it must be eventually downward sloping.eventually downward sloping.

Total Product

TP

L0

TPTP

MPL = TP/L

TP

L

Total Product

L0

TPTP

L

MPMP

TPL

MP = 0MP = 0Diminishing ReturnsDiminishing Returns

Law of Diminishing Returns and Cost Curves

Relationship between product Relationship between product curves and cost curvescurves and cost curves

If each unit of labor produces less If each unit of labor produces less additional output eventually, in order additional output eventually, in order to produce each additional unit of to produce each additional unit of output we need to hire increasing output we need to hire increasing amounts of inputs (labor), amounts of inputs (labor),

so when MP decreases, MC increases.so when MP decreases, MC increases.

Relationship: Production and Cost

MP MC

Q0

MPMP

MCMC

When MP is increasing, MC is decreasingWhen MP is increasing, MC is decreasingWhen MP is decreasing, MC is increasingWhen MP is decreasing, MC is increasingWhen MP is maximum, MC is minimumWhen MP is maximum, MC is minimum

Relationship: Production and Cost

TP&Cost

0

TPTP

TVCTVC

Cost CurvesTotal Fixed CostTotal Fixed Cost (TFC) - costs which (TFC) - costs which do do

not vary with output.not vary with output.• the costs of fixed inputs (capital)the costs of fixed inputs (capital)

Total Variable CostsTotal Variable Costs (TVC) - any cost (TVC) - any cost that that varies with the quantity of output varies with the quantity of output producedproduced..• the costs of variable inputs (labor)the costs of variable inputs (labor)

Total CostTotal Cost (TC) - sum of all costs of (TC) - sum of all costs of productionproduction• TC = total fixed costs + total variable costsTC = total fixed costs + total variable costs

Other Cost Curves

Marginal CostMarginal Cost (MC) - the additional cost (MC) - the additional cost of producing one more unit of output.of producing one more unit of output.•MC = MC = TC / TC / QQ

Average Variable CostAverage Variable Cost AVC = TVC / AVC = TVC / QQ

Average Fixed CostAverage Fixed Cost AFC = TFC / AFC = TFC / QQ

Average Total CostAverage Total Cost ATC = TC / QATC = TC / Q

Shape of Cost CurvesTotal CostTotal Cost

• Eventually steeper due to law of diminishing Eventually steeper due to law of diminishing marginal returnsmarginal returns

Marginal CostMarginal Cost• Eventually upward sloping due to law of Eventually upward sloping due to law of

diminishing marginal returnsdiminishing marginal returns• It is “J” shaped--rises when MP fallsIt is “J” shaped--rises when MP falls

Average Fixed CostAverage Fixed Cost• Downward sloping alwaysDownward sloping always• Take a fixed number (TFC) and divide by Take a fixed number (TFC) and divide by

increasing Q.increasing Q.

Average-Marginal RuleThe Marginal Cost & Average Cost Curves The Marginal Cost & Average Cost Curves

have to obey the average-marginal rule.have to obey the average-marginal rule.The average-marginal rule says that The average-marginal rule says that if MC if MC

is above ACis above AC (AVC or ATC), (AVC or ATC), then average then average cost must be risingcost must be rising. If MC is . If MC is below AC, below AC, then average cost must be fallingthen average cost must be falling

This implies the MC curve crosses the AC This implies the MC curve crosses the AC curves at the minimum point of both AVC curves at the minimum point of both AVC and ATC.and ATC.

Average-Marginal RuleFor example, your Grade Point Average For example, your Grade Point Average

(GPA) is an average. The marginal (GPA) is an average. The marginal grade is the next grade you get.grade is the next grade you get.

If your next grade (marginal grade) is If your next grade (marginal grade) is above your average (GPA), then your above your average (GPA), then your GPA rises.GPA rises.

If your next grade (marginal grade) is If your next grade (marginal grade) is below your average (GPA), then your below your average (GPA), then your GPA falls.GPA falls.

Total Cost

Q

TCTC$

TFCTFC

TVCTVC

MC = MC = TC / TC / QQMC is the slope of TCMC is the slope of TC

Q

TVCTVC$

Q

MCMC

Diminishing Returns -- MP decreasingDiminishing Returns -- MP decreasing MC increasingMC increasing

slope

Average Costs

Q0AFC

$

Average Costs

$

Q0

AFC

AVC

Average Costs

$

Q0

AFC

ATC

AVC

A

A*

A = A* = AFCA = A* = AFC

B*

B

B = B* = AFCB = B* = AFC

Totalproduct

TotalFixed

Cost

TotalVariable

CostTotalCost

AverageFixedCost

AverageVariable

Cost

Averagetotalcost

Marginalcost

0123456789

10

$45$45$45$45$45$45$45$45$45$45$45

$ 04585

120150185225270325390465

$ 45 90 130 165 195 230 270 315 370 435 510

$45.0022.5015.0011.259.007.506.435.635.004.50

$4542.5040.0037.5037.0037.5038.5740.6343.3346.50

$90.0065.0055.0048.7546.0045.0045.0046.2548.3351.00

$45.0040.0035.0030.0035.0040.0045.0055.0065.0075.00

Summary of Cost CurvesSummary of Cost Curves

Other Cost CurvesMarginal CostMarginal Cost (MC) - the additional cost of (MC) - the additional cost of

producing one more unit of output.producing one more unit of output.• MC = MC = TC / TC / QQ

Average Variable CostAverage Variable Cost AVC = TVC / QAVC = TVC / QAverage Fixed CostAverage Fixed Cost AFC = TFC / QAFC = TFC / QAverage Total CostAverage Total Cost ATC = TC / QATC = TC / QYou should be able to apply these definition to the You should be able to apply these definition to the

cost table and calculate the values.cost table and calculate the values.

Average-Marginal RuleMarginal Cost & Average Cost Curves have to Marginal Cost & Average Cost Curves have to obey the average-marginal rule.obey the average-marginal rule.The average-marginal rule says that The average-marginal rule says that if MC is if MC is above ACabove AC (AVC or ATC), (AVC or ATC), then average cost must then average cost must be risingbe rising.. If MC is If MC is below AC, then average cost below AC, then average cost must be fallingmust be falling

This implies the MC curve crosses the AC (AVC This implies the MC curve crosses the AC (AVC

and ATC) curves at the minimum point of both.and ATC) curves at the minimum point of both.

Marginal and Average Costs

$

Q0

ATCATC

AVCAVC

MCMC

MC intersects ATC and AVC MC intersects ATC and AVC at their minimum valueat their minimum value

Cost Areas

$

QAFC

ATC

AVC

Q

TVC

TFC

O

D

CB

A TC = OQBCTC = OQBCTVC = OQADTVC = OQADTFC = OQBCTFC = OQBC

Costs in the Long RunLong RunLong Run - period of time in which - period of time in which allall

inputs are variable.inputs are variable.• Capital and Labor can change.Capital and Labor can change.

Think of the long run as a planning Think of the long run as a planning horizon.horizon.• Firm can estimate costs based on various Firm can estimate costs based on various

plant sizes, number of machines, etc.plant sizes, number of machines, etc.• Once it makes a decision and builds the Once it makes a decision and builds the

plant, buys the machines - moves into the plant, buys the machines - moves into the short run short run (we are stuck with their decision (we are stuck with their decision for a while).for a while).

Costs in the Long RunLong Run Average Total CostLong Run Average Total Cost (LRAC) - (LRAC) -

ATC of producing a given level of ATC of producing a given level of output when all inputs can vary.output when all inputs can vary.

LRAC curve is constructed as the LRAC curve is constructed as the least cost of all possible short run least cost of all possible short run cost curvescost curves

NOTE - No AFC in long-runNOTE - No AFC in long-run• In long run all inputs are variable, so no In long run all inputs are variable, so no

fixed costs.fixed costs.

Long Run ATC

So, the rational firm considers all So, the rational firm considers all possible amounts of fixed cost in the possible amounts of fixed cost in the long run and will only use the fixed long run and will only use the fixed cost that allows them to produce cost that allows them to produce the good cheapestthe good cheapest

In other words, as the firm increases In other words, as the firm increases quantity produced, it chooses the quantity produced, it chooses the bottom of all of the SRATC curves - bottom of all of the SRATC curves - thus creating the LRAC curve.thus creating the LRAC curve.

Q1

Long Run ATC Curve

Q0

SRATCSRATC11

SRATCSRATC22

SRATCSRATC33

SRATCSRATC44

Q2 Q3 Q4

Co

st

Long Run ATC CurveC

ost

Q0

SRATCSRATC11

SRATCSRATC22

SRATCSRATC33 SRATCSRATC44

LRATC

SRATCSRATC55

Shape of LRAC

Explained by economies and Explained by economies and diseconomies of scale.diseconomies of scale.

Economies of ScaleEconomies of Scale - decreasing - decreasing LRACLRAC

Diseconomies of ScaleDiseconomies of Scale - increasing - increasing

LRACLRAC

Economies of Scale Reasons why firms typically have economies Reasons why firms typically have economies

of scale as they begin productionof scale as they begin production• Greater specialization of resourcesGreater specialization of resources

Divide work get benefits of specialization (lower costs).

• Efficient Utilization of specialized Efficient Utilization of specialized equipmentequipment

• Reduced unit costs on inputsReduced unit costs on inputsPurchasing in large volume

Economies and Diseconomies of Scale

Diseconomies of ScaleDiseconomies of Scale - increasing - increasing LRATC of productionLRATC of production

Reason shy firms typically have Reason shy firms typically have diseconomies of scale as they diseconomies of scale as they produce “large” amounts of outputproduce “large” amounts of output• Coordination and control problems as Coordination and control problems as

firm gets largefirm gets largeConstant returns to scaleConstant returns to scale - constant - constant

LRATC of productionLRATC of production

LRAC

$

Q0

LRAC

LRAC and Scale Economies

$

Q0

LRACLRACeconomies ofeconomies of scalescale

Increasing Returns to ScaleIncreasing Returns to Scale

LRAC and Scale Economies

$

Q0

LRACLRAC

constant returnsconstant returns to scaleto scale

Constant Returns to ScaleConstant Returns to Scale

$

Q0

LRACdiseconomiesdiseconomies of scaleof scale

LRAC and Scale Economies

Decreasing Returns to ScaleDecreasing Returns to Scale

Economic costexplicit costsimplicit costsnormal profiteconomic profitshort runlong runtotal productmarginal productaverage product fixed costs

law of diminishing returnsvariable coststotal costaverage fixed costaverage variable costaverage total costmarginal costeconomies of scalediseconomies of scaleconstant returns to scale