C H A P T E R 5: The Cost of Production

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C H A P T E R 5: The Cost of Production by Mind Map: C H A P T E R  5: The Cost of Production

1. Measuring Cost: Which Costs Matter?

1.1. Economic Cost versus Accounting Cost

1.1.1. accounting cost

1.1.1.1. Actual expenses plus depreciation charges for capital equipment.

1.1.2. economic cost

1.1.2.1. Cost to a firm of utilizing economic resources in production.

1.1.3. opportunity cost

1.1.3.1. Cost associated with opportunities forgone when a firm’s resources are not put to their best alternative use.

1.1.3.1.1. The concept of opportunity cost is particularly useful in situations where alternatives that are forgone do not reflect monetary outlays.

1.1.3.1.2. Economic cost = Opportunity cost

1.2. Sunk Costs

1.2.1. ● sunk cost Expenditure that has been made and cannot be recovered.

1.2.2. Because a sunk cost cannot be recovered, it should not influence the firm’s decisions.

1.2.3. Example: consider the purchase of specialized equipment for a plant.

1.2.3.1. The expenditure on this equipment is a sunk cost. Because it has no alternative use, its opportunity cost is zero.

1.2.3.2. Thus it should not be included as part of the firm’s economic costs.

1.2.4. A prospective sunk cost is an investment. Here the firm must decide whether that investment in specialized equipment is economical.

1.3. Example 7.1

1.3.1. Case study

1.4. Fixed Costs and Variable Costs

1.4.1. ● total cost (TC or C)

1.4.1.1. Total economic cost of production, consisting of fixed and variable costs.

1.4.2. ● fixed cost (FC)

1.4.2.1. Cost that does not vary with the level of output and that can be eliminated only by shutting down.

1.4.2.1.1. Fixed cost does not vary with the level of output—it must be paid even if there is no output.

1.4.2.1.2. The only way that a firm can eliminate its fixed costs is by shutting down.

1.4.3. ● variable cost (VC)

1.4.3.1. Cost that varies as output varies.

1.4.4. FIXED OR VARIABLE?

1.4.4.1. Over a very short time horizon—say, a few months—most costs are fixed.

1.4.4.1.1. Over such a short period, a firm is usually obligated to pay for contracted shipments of materials.

1.4.4.2. Over a very long time horizon—say, ten years—nearly all costs are variable.

1.4.4.2.1. Over a very long time horizon—say, ten years—nearly all costs are variable. Workers and managers can be laid off (or employment can be reduced by attrition)

1.4.4.2.2. much of the machinery can be sold off or not replaced as it becomes obsolete and is scrapped.

1.5. Fixed versus Sunk Costs

1.5.1. Shutting down doesn’t necessarily mean going out of business. Fixed costs can be avoided if the firm shuts down a plant or goes out of business.

1.5.2. Sunk costs, on the other hand, are costs that have been incurred and cannot be recovered.

1.5.2.1. When a firm’s equipment is too specialized to be of use in any other industry, most if not all of this expenditure is sunk, i.e., cannot be recovered.

1.5.2.2. When a firm’s equipment is too specialized to be of use in any other industry, most if not all of this expenditure is sunk, i.e., cannot be recovered.

1.5.3. fixed costs affect the firm’s decisions looking forward, whereas sunk costs do not

1.5.3.1. a prospective sunk cost is different and, as we mentioned earlier, would certainly affect the firm’s decisions looking forward.

1.6. Example 7.2

1.7. Marginal and Average Cost

1.7.1. ● marginal cost (MC)

1.7.1.1. Increase in cost resulting from the production of one extra unit of output.

1.7.1.1.1. Because fixed cost does not change as the firm’s level of output changes, marginal cost is equal to the increase in variable cost or the increase in total cost that results from an extra unit of output.

1.7.1.2. Formula

1.7.2. ● average total cost (ATC)

1.7.2.1. Firm’s total cost divided by its level of output.

1.7.3. ● average fixed cost (AFC)

1.7.3.1. Fixed cost divided by the level of output.

1.7.4. ● average variable cost (AVC)

1.7.4.1. Variable cost divided by the level of output.

2. Costs in the Short Run

2.1. Diminishing marginal returns

2.1.1. Diminishing marginal returns means that the marginal product of labor declines as the quantity of labor employed increases.

2.1.2. As a result, when there are diminishing marginal returns, marginal cost will increase as output increases.

2.1.3. As a result, when there are diminishing marginal returns, marginal cost will increase as output increases.

2.1.3.1. Formula 7.1

2.2. The Shapes of the Cost Curves

2.2.1. Figure 7.1

2.2.1.1. the vertical distance between the ATC and AVC curves decreases as output increases

2.2.1.1.1. average total cost is the sum of average variable cost and average fixed cost

2.2.1.1.2. the AFC curve declines everywhere

2.2.1.2. Total cost is a flow

2.2.1.2.1. the firm produces a certain number of units per year. Thus its total cost is a flow—for example, some number of dollars per year.

2.2.1.3. Knowledge of short-run costs is particularly important for firms that operate in an environment in which demand conditions fluctuate considerably.

2.2.1.4. Knowledge of short-run costs is particularly important for firms that operate in an environment in which demand conditions fluctuate considerably.

2.2.1.4.1. When might management want to expand production capacity to avoid higher costs?

3. Costs in the Long Run

3.1. The User Cost of Capital

3.1.1. Annual cost of owning and using a capital asset, equal to economic depreciation plus forgone interest.

3.1.1.1. Formula 1

3.1.1.1.1. the interest (i.e., the financial return) that could have been earned had the money been invested elsewhere

3.1.1.2. Formula 2

3.1.1.2.1. the user cost of capital as a rate per dollar of capital:

3.2. The Cost-Minimizing Input Choice

3.2.1. how to select inputs to produce a given output at minimum cost.

3.2.1.1. For simplicity, we will work with two variable inputs:

3.2.1.1.1. labor (measured in hours of work per year)

3.2.1.1.2. capital (measured in hours of use of machinery per year).

3.2.2. If the capital market is competitive, the rental rate should be equal to the user cost, r. Why?

3.2.2.1. Firms that own capital expect to earn a competitive return when they rent it.

3.2.2.1.1. This competitive return is the user cost of capital.

3.2.2.1.2. This competitive return is the user cost of capital.

3.2.2.2. Capital that is purchased can be treated as though it were rented at a rental rate equal to the user cost of capital.

3.3. The Isocost Line

3.3.1. ● isocost line Graph showing all possible combinations of labor and
capital that can be purchased for a given total cost.

3.3.1.1. Formula 7.2

3.3.1.1.1. rewrite Formula 7.2

3.3.1.2. Slope of the isocost line

3.3.1.2.1. the isocost line has a slope of ΔK/ΔL = −(w/r)

3.4. Choosing Inputs

3.4.1. Figure 7.3

3.4.2. Figure 7.4

3.4.3. When a firm minimizes the cost of producing a particular output, the following condition holds

3.4.3.1. Rewrite

3.4.3.2. Formula 7.3

3.4.3.2.1. Recall that in our analysis of production technology, we showed that the marginal rate of technical substitution of labor for capital (MRTS) is the negative of the slope of the isoquant and is equal to the ratio of the marginal products of labor and capital:

3.4.4. Example 7.4