Key issues

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Key issues

• 1. measuring costs
• 2. short-run cost minimization
• 3. long-run cost minimization
• 4. costs are lower in long run
• 5. costs of producing multiple goods
  simultaneously

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Two-step procedure to choose technology

• 1. pick all technologically efficient production
  processes
• 2. from these technologically efficient
  production processes, pick the one that is
  economically efficient (minimizes cost)

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Two reasons to study costs

• 1. understanding relationship between costs of
  inputs and production helps us determine least
  costly way to produce
• 2. relationship between output and costs
  determines nature of an industry
• how many firms are in the industry
• how high price is relative to cost

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Business vs. economic costs

• business costs only explicit costs (out of
  pocket)
• economic costs explicit cost implicit cost
  opportunity cost
• opportunity cost
• value of best alternative use of the resource
• classic example "There's no such thing as a free
  lunch"
• What have you given up to study opportunity
  costs

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Cost of running your own firm

• explicit cost 40,000 per year (rent, materials,
  wage payments)
• instead of paying yourself a salary, you keep any
  profit at year's end
• your labor opportunity cost 25,000/year you
  could have earned working for another firm
• business cost 40,000
• economic cost 65,000 40,000 25,000

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Its exactly this sort of attitude toward work,
Orville, that has kept you from owning your own
business.
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Capital costs

• capital is a durable good a product that is
  usable for years
• capital may be rented or purchased

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If capital is rented

• rental payment is the opportunity cost
• using the rental rate avoids 2 measurement
  problems
• don't have to worry how to allocate the initial
  purchase cost over time
• any adjustment in the cost of capital over time
  is reflected in the rental rate

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If capital is purchased

• firm's bookkeeper may
• expense cost by recording purchase price when
  it's made, or
• amortize cost by spreading it over life of
  capital according to IRS's arbitrary rules
• economists amortize capital cost based on its
  opportunity cost at each moment of time
• amount that firm could charge others to rent
  capital
• thus, economists always use rental rate

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Depreciate a business vehicle

• Toyota Land Cruiser (sports utility vehicle) and
  Cadillac Seville (car) both cost 45,000
• tax law lets you depreciate Land Cruiser in 6
  years vs. 23 for Seville
• after 5 years depreciated 42,408 for Land
  Cruiser vs. 14,460 for Seville
• reason
• Land Cruiser weighs more than 6,000 pounds and
  Seville doesn't
• Congress uses 6,000 pounds as a criterion to
  distinguish between trucks and cars

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Short-run cost measures

• fixed cost (F) production expense that does not
  vary with output
• variable cost (VC) production expense that
  changes with quantity of output produced
• total cost (C)
• C VC F

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Sunk fixed cost

• usually assume fixed cost is sunk expenditure
  that cannot be recovered
• opportunity cost of capital is zero
• because you can't get this expenditure back no
  matter what you do, so ignore it when making
  decisions
• example walk out of a bad movie early,
  regardless of what you paid to attend
• otherwise, fixed cost is avoidable

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Marginal cost (MC)
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Average cost concepts
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Short-Run Cost Curves
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MC curve cuts AC and AVC at their minimum points

• AC and AVC curves fall when MC is below them, and
  rise when MC is above them
• therefore, MC cuts AC and AVC curves at their
  minimum points

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Solved problem

• if short-run cost function is
• C 125 2q q2
• what are the
• fixed cost
• variable cost
• average cost
• average fixed cost
• average variable cost?

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Answer
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Production function determines shape of cost curve

• production function shows how many inputs needed
  to produce a given level of output
• firm's cost multiply quantity of each input by
  its price and sum

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Solved problem

• if a janitorial service firm's only variable cost
  is wage payments where
• wage w 8 per worker per an hour
• each worker cleans 4 offices per hour
• what are the
• variable cost
• average variable cost
• marginal cost of cleaning one more office?

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Answer
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Answer (continued)
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Norwegian printing firm

• short-run AC curve is U-shaped even though AVC is
  strictly upward sloping
• firm's capital is fixed at 100

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Short-Run Cost Curves for a Printing Firm
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Cost effects of 10 specific tax
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Effects of a Specific Tax on Cost Curves
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Cost effects of lump-sum tax
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Lump-sum tax California

• 800-per-year tax is levied for the privilege
  of doing business in California

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Lump-sum tax New York

• 900,600 for three-year license to sell hot
  dogs in front of NY City's Metropolitan Museum of
  Art

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Long-run costs

• firm adjusts all its inputs so its cost of
  production is as low as possible
• if capital and other variable can be varied, no
  LR fixed costs (F 0)
• then LR total cost LR variable cost
• C VC

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Input choice

• choose from all technologically efficient
  combinations of inputs, the economically
  efficient combination of inputs

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Costs of input bundles
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A Family of Isocost Lines
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Properties of isocost lines
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Cost minimization for Norwegian printing firm
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Equivalent cost-minimizing rules

• to pick lowest-cost combination of inputs
  to produce a given level of output when isoquants
  are smooth
• lowest-isocost rule pick bundle of inputs where
  lowest isocost line touches isoquant
• tangency rule isoquant is tangent to isocost
  line MRTS ratio of the input prices w/r
• last-dollar rule last dollar spent on one input
  produces as much extra output as last dollar
  spent on any other input

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Derivation of last dollar rule
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Cost minimizing vs. output maximizing

• with smooth isoquants firm determines best
  factor proportions by either
• cost minimizing what is the lowest cost, C, at
  which the firm can produce output q?
• output maximizing What is the most output, q,
  that can be produced at cost C?

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Relative factor price changes

• cause firm to change the mix of inputs used
• firm substitutes relatively less expensive inputs
  for more expensive ones
• Since r 8 kr
• original wage 24 kr, so w/r 3
• new wage 8 kr, so w/r 1

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Change in Factor Price
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Demolishing buildings U.S.

• raze through implosion (dynamite) or use
  equipment

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Demolish buildings Hong Kong

• large number of workers break top story into
  little pieces, cart it away, then demolish lower
  floors
• reason relative cost of labor is much lower in
  Hong Kong

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LR cost varies with output

• examine lowest-cost factor combination for
  various levels of output
• expansion path
• cost-minimizing combination of labor and capital
  for each output level
• curve through tangency points is LR expansion
  path
• expansion path shows same relationship between LR
  cost and output as the LR cost curve

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Expansion Path and Long-Run cost Curve
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Expansion Path and Long-Run cost Curve
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Solved Problem

• suppose that the wage rate falls (while the
  rental rate of capital remains unchanged)
• what happens to the expansion path?

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Results for Lower Wage
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Shape of LR cost curves

• reason why LR AC is U-shaped different than SR
• SR
• SR AC initially downward sloping because AFC is
  downward sloping
• SR AC later upward sloping because of diminishing
  returns
• LR
• no fixed cost in LR (usually)
• production function returns to scale determine
  shape

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Long-Run Cost Curves
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Economies of scale
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Causes of economies of scale

• returns to scale in production function
• sufficient condition for AC economies of scale
• not necessary condition
• in LR, firm may change ratio of K/L as it expands
  output, so could have economies of scale in costs
  without increasing returns to scale in production

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Costs lower in long run

• in LR, firm chooses optimal plant size level to
  minimize its LR cost given q
• because the firm cannot vary its capital in SR
  but can in LR
• SR cost ? LR cost
• SR cost gt LR cost if the "wrong" level of capital
  is used in SR

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Long-Run Average Cost as the Envelope of
Short-Run Average Cost Curves
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Long-Run Cost Curves in Printing
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Long-Run Cost Curves in Oil Pipelines
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Why LR cost ? SR cost

• firms have more flexibility in long run
• technical progress may lower cost over time
• learning by doing productive skills and
  knowledge of better ways to produce that workers
  and managers gain from experience

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Learning by Doing
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Learning by Doing
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Technical progress

• Thompson Blank (2000) tomato harvester
  1960-1997
• labor use falls
• labor for harvesting processing tomatoes fell
  from 5.3 to 0.4 hours per ton
• harvest cost fell from 50 of total cost to 33
• electronic sorter further reduced harvest cost to
  16 of total cost

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Cost of producing multiple goods

• outputs are linked if a single input is used to
  produce all of them
• mutton and wool both come from sheep
• beef and hides come from cattle
• heating fuel and gasoline come from oil
• it is less expensive to produce goods jointly
  than separately (beef hides)

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Joint production

• Laura spends one day collecting mushrooms and
  wild strawberries in the wood
• economies of scope (PPF1)
• picking only mushrooms 8 pints
• pick only strawberries 6 pints
• pick some of each 6 pints of mushrooms and 4
  pints of strawberries
• no economies of scope (PPF2)
• mushrooms grow in one section and strawberries in
  another
• PPF2 is a straight line

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Joint Production
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Measuring scope (SC)
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Scope
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Economies of scope

• refining cheaper to produce motor gasoline,
  distillate fuels, and other refined products
  together
• auto manufacturing four automobile manufacturers
• 25 less expensive (SC 0.25) to produce large
  cars together with small cars and trucks than to
  produce large cars separately and small cars and
  trucks together
• no economies of scope from producing trucks
  together with small and large cars

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Diseconomies of scope

• using railroads to transport freight and
  passengers together
• 41 less expensive (SC -0.41) to transport
  passengers and freight separately than together
• in early 1970s passenger service was transferred
  from the private railroad companies to Amtrak,
  and services are separate

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Summary

• cost minimization from all technologically
  efficient production processes, choose one that
  is economically efficient

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Measuring costs

• use economic cost explicit implicit costs
• opportunity cost value of next best alternative
  use includes both explicit and implicit costs

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2. Short-run costs

• some factors are fixed in the SR
• costs vary with only variable (nonfixed) inputs

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3. Long-run costs

• all factors can be varied, so all costs are
  variable
• AC AVC
• costs minimized where
• lowest isocost touches the relevant isoquant
• isocost is tangent to the isoquant
• last dollar spent on any input increases output
  by as much as last dollar spent on any other input

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4. Costs are lower in long run

• more flexibility in LR
• technological progress
• learning by doing

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5. Costs of producing multiple goods

• economies of scope less expensive to produce
  goods jointly rather than separately
• diseconomies of scope less expensive to produce
  separately