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The Nature of Costs

Explicit Costs

Accounting Costs

Economic Costs

Implicit Costs Alternative or Opportunity Costs

Relevant Costs

Incremental Costs

Sunk Costs are Irrelevant

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Short-Run Cost Functions

Total Cost = TC = f(Q)

Total Fixed Cost = TFCTotal Variable Cost = TVC

TC = TFC + TVC

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Short-Run Cost Functions

Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/QAverage Variable Cost = AVC = TVC/Q

ATC = AFC + AVC

Marginal Cost = TC/Q = TVC/Q

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Short-Run Cost Functions

Q TFC TVC TC AFC AVC ATC MC

0 $60 $0 $60 - - - -

1 60 20 80 $60 $20 $80 $202 60 30 90 30 15 45 10

3 60 45 105 20 15 35 154 60 80 140 15 20 35 35

5 60 135 195 12 27 39 55

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Short Run Total and per-unit costs Curves The top panel shows that TVC are zero when output is

zero and rise as output rises At point G the law of diminishing returns begins to

operate.

The TC curve has the same shape as the TVC curve and

is above it by $60(the TFC) The bottom panel shows U-shaped AVC,ATC &MC

Curves

AFC=ATC-AVC and declines continuously as outputrises

The MC curve reaches a minimum before the AVC&ATC curves and intersects it from below at the lowestpoints

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Short-Run Cost Functions

Average Variable Cost

AVC = TVC/Q = w/APL

Marginal Cost

TC/Q = TVC/Q

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Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/QLong-Run Marginal Cost = LMC = LTC/Q

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Derivation of the Long Run Total, Average &MC

From point A on the expansion path in the top panel and ofw=$10 &r=$10 ,we get point A on the LTC curve in thebottom panel is given by the slope of a ray from the origin

to the LTC curve

The LAC curve falls up to point G(4Q)because ofincreasing returns to scale. The LMC curve is given by the

slope of LTC curve and intersects the LAC curve frombelow at the lowest point on the LAC

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Derivation of Long-Run Cost Curves

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Relationship Between The Long Run& Short Run Average

Cost

In the top panel, the LAC curve is given by AB*CE*GJ*R on the assumption that the firm can build

only four scales ofplants(SAC1.SAC2,SAC3&SAC4)

In the bottom panel the LAC curve is the smoothcurve ABCDEFGHJNR on the

assumption that the firm can build a very largeor infinite number of plants in the long run

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Relationship Between Long-Run and

Short-Run Average Cost Curves

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Possible Shapes of

the LAC Curve

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LEFT-

U shaped-first increasing returns and then decreasing

returns to scaleMIDDLE-

Nearly L shaped-quickly give way to constant returnsto scale

RIGHT- LAC declines continuously as in the case of natural

monopolies

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Learning Curves

Reduction of Average Cost of Unit in Aircraft

Assembling

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Advantages of learningAs firms gain experience in the production of a

commodity or service,their average cost or productionusually declines

The learning curve shows the decline in the averageinput cost of production with rising cumulative totaloutputs overtime

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Example It might take 1000 hours to assemble the 100thaircraft

But only 700 hours to assemble the 200thaircraft

165 hours to assemble the 400th aircraft Because managers and workers become more efficient

as they gain experience

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Minimizing Costs Internationally

Foreign Sourcing of Inputs

New International Economies of Scale

Immigration of Skilled Labor Brain Drain

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Cost-Volume-Profit AnalysisTotal Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)

Breakeven Volume TR = TC

(P)(Q) = TFC + (AVC)(Q)

QBE= TFC/(P - AVC)

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EXAMPLE TFC=$200

P=$10 and AVC=$5

QB= TFC/P-AVC=$40

l f l

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Cost-Volume-Profit Analysis

P = 40

TFC = 200

AVC = 5

QBE

= 40

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Linear-cost

Volume or Break Even Chart

The slope of the TR curve refers to the product priceof $10 per unit

The vertical intercept of the TC curve refers to$200,and the slope of the TC curve to the AVC of $ 5

The firm breaks even with TR=TC=$400 at the

output(Q) of 40 units at point B

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Operating Leverage It refers to the ratio of the firms TFC to total variable

costs.

The higher the value the firm becomes moreautomated or more leveraged(substitutes fixed forvariable costs,Ex-instead of labor machinery may beinstalled))

Then its TFC will increase but its AVC fall Because of the higher overhead costs , the breakeven

output of the firm increases

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Operating Leverage = TFC/TVC

The higher the ratio ,the more leveraged the firm said

Degree of Operating Leverage = DOL

% ( )% ( )

Q P AVC DOLQ Q P AVC TFC

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Operating Leverage

Higher DOL

than TC and

therefore ahigher Q

TC has a shift

and it brakeven

point comes only

when the qtyinceases to B