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AAEC 3315Agricultural Price Theory
CHAPTER 6Cost Relationships
The Case of One Variable Inputin the Short-Run
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Objectives
To gain understanding of: Cost Relationships
Fixed Costs, Variable Costs,& Total Costs Average and Marginal Costs
Cost Functions Relationships between product and cost
curves
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Cost Relationships
A manager’s goal is to determine how much to produce to maximize profits.
We established earlier that Stage II is the rational stage of production, but realized that cost and revenue information are necessary to determine at which point in Stage II to produce.
Now, let’s introduce cost relationships into production.
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Cost Definitions
Costs of Production or Economic Costs: The payments that a firm must make to attract inputs and keep them from being used to produce other products.
A firm’s cost functions show various relationships between its costs and output rate. Thus, the firm’s cost functions are determined by the firm’s production function and input prices.
Since the production function can pertain to the short run or the long run, it follows that the cost functions can also pertain to the short run or the long run.
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Cost Functions in the Short Run
Fixed Costs: Costs which do not vary with the level of production - These costs are associated with the fixed factors of production. Incurred regardless whether any output is produced
Variable Costs: Costs that vary as the output level changes - These costs are associated with variable factors of production.
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Short-Run Cost RelationshipsThe Case of One Variable Input
Costs Based on Total Output
Total Fixed Costs (TFC): costs of inputs that are fixed in the SR & do not change as the output level changes.
Total Variable Costs (TVC): costs of inputs that are variable in the Short Run, and change as output level changes, i.e., TVC = PXX
Total Costs (TC): TFC + TVC
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Total Cost Curves(Assume TFC = $80 and Px = $25
0 0 $80 1 10 $80 2 25 $80 3 50 $80 4 70 $80 5 85 $80 6 95 $80 7 100 $80 8 101 $80 9 95 $80 10 85 $80
0
X Y TFC X Y TFC
TOTAL FIXED COSTS
0
50
100
150
200
250
300
350
0 20 40 60 80 100 120
Output
Cos
t
TFC
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Total Cost Curves(Assume TFC = $80 and Px = $25
0 0 $80 $0 1 10 $80 $25 2 25 $80 $50 3 50 $80 $75 4 70 $80 $100 5 85 $80 $125 6 95 $80 $150 7 100 $80 $175 8 101 $80 $200 9 95 $80 $225 10 85 $80 $250
0
XX Y TFC TVC = Y TFC TVC = PXX
TOTAL VARIABLE COSTS
0
50
100
150
200
250
300
0 20 40 60 80 100 120
Output
Co
sts
TFC
TVC
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Total Cost Curves(Assume TFC = $80 and Px = $25
XX Y TFC TVC TC = TFC+TVC Y TFC TVC TC = TFC+TVC
0 0 $80 $0 80
1 10 $80 $25 105
2 25 $80 $50 130
3 50 $80 $75 155
4 70 $80 $100 180
5 85 $80 $125 205
6 95 $80 $150 230
7 100 $80 $175 255
8 101 $80 $200 280
9 95 $80 $225 305
10 85 $80 $250 330
0
TOTAL COSTS
0
50
100
150
200
250
300
350
0 20 40 60 80 100 120
Output
Co
sts TVC
TFC
TC
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Total Cost Curves
TOTAL COSTS
0
50
100
150
200
250
300
350
0 20 40 60 80 100 120
Output
Co
sts
TFC
TVC
TC
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Total Cost Curve Functions
TFC = 100 TVC = 6Q – 0.4Q2 + 0.02Q3
TC = TFC + TVC = 100 + 6Q – 0.4Q2 + 0.02Q3
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Short-Run Cost Relationships
Costs Based on Per Unit of Output
Average Fixed Costs (AFC): Total fixed costs per unit of output, i.e., AFC = TFC / Q
Average Variable Costs (ATC): Total variable cost per unit of output, i.e., AVC = TVC/Q
Average Total Costs (ATC): Average total cost per unit of output, i.e., ATC = TC / Y = AFC + AVC
Marginal Cost (MC): The increase in cost necessary to increase output by one more unit, i.e.,MC = ∆TC/∆QMC = (∆TVC + ∆ TFC) / ∆QMC = ∆TVC / ∆Q MC = ∂TC/ ∂Q = ∂TVC/ ∂Q
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Costs Based on Per-Unit Output
Average Fixed Costs (AFC): Average cost of fixed inputs per unit of output, i.e., AFC = TFC / Q
Average Fixed Costs
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
0 20 40 60 80 100 120
Y TFC AFC
0 80
10 80 8.00
25 80 3.20
50 80 1.60
70 80 1.14
85 80 0.94
95 80 0.84
100 80 0.80
101 80 0.79
95 80 0.84
85 80 0.94
AFC
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Costs Based on Per-Unit Output
Average Variable Costs (ATC): Total Variable cost per unit of output, i.e., AVC = TVC / Q
Y TVC AVC
0 0
10 25 2.50
25 50 2.00
50 75 1.50
70 100 1.43
85 125 1.47
95 150 1.58
100 175 1.75
101 200 1.98
95 225 2.37
85 250 2.94
Average Variable Cost
0
1
2
3
4
5
6
7
8
9
0 20 40 60 80 100 120
AFC
AVC
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Costs Based on Per-Unit Output
Average Total Costs (ATC): Average total cost per unit of output, i.e., ATC = TC / Q = AFC + AVC
Y TC ATC
0 80
10 105 10.50
25 130 5.20
50 155 3.10
70 180 2.57
85 205 2.41
95 230 2.42
100 255 2.55
101 280 2.77
95 305 3.21
85 330 3.88
Average Total Cost
0
2
4
6
8
10
12
0 20 40 60 80 100 120
AFC
AVC
ATC
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Costs Based on Per-Unit OutputMarginal Cost (MC): The increase in cost necessary to increase output by one more unit, i.e.,MC = ∆TC/∆Q= ∆TVC / ∆Q = ∂TC/ ∂Q = ∂TVC/ ∂Q
Marginal Cost
-1
1
3
5
7
9
11
13
15
-10 10 30 50 70 90 110
Y TC MC
0 80
10 105 2.50
25 130 1.67
50 155 1.00
70 180 1.25
85 205 1.67
95 230 2.50
100 255 5.00
101 280 25.00
95 305 -4.17
85 330 -2.50
ATC
AFC
AVC
MC
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Summary of Relationships Between Short-Run Cost Curves
AFC is a continuously decreasing function
AVC & ATC curves are U-shaped
The vertical distance between ATC & AVC at each output level is equal to AFC
MC crosses both AVC & ATC from below at their respective minimums
MC is not affected by fixed costs
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Relationship Among Cost Curves
TOTAL COSTS
0
50
100
150
200
250
300
350
0 20 40 60 80 100 120
Output
Co
sts
...
ATC
AVC
MC
TC
TVC
TFC
AFC
Cost
s/unit
Output
Inflection Point
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Changes in Input Price
Price of Variable Input Increases The cost of producing each output level increases
VC & TC shift upward & left; TFC remains unchanged AVC, AC, & MC shift upward & left
Price of variable Input Decreases The cost of producing each output level decreases
TVC & TC shift downward & right; TFC remains unchanged AVC, ATC, & MC shift downward & right
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Working With Cost Functions
Given the total cost functions:TC = 100 + 6Q – 0.4Q2 + 0.02Q3,
TFC = 100,
TVC = 6Q – 0.4Q2 + 0.02Q3,
Average and Marginal costs
functions can be derived.ATC = TC/Q = 100/Q + 6 – 0.4Q + 0.02Q2,
AFC = TFC/Q = 1000/Q,
AVC = TVC/Q = 6 – 0.4Q + 0.02Q2, and
MC = = ∂TC/ ∂Q = ∂TVC/ ∂Q = 6 – 0.8Q + 0.06Q2
With these given:
Can you calculate the level
of output at the minimum of
AVC, and MC?
Co
sts
Output
TOTAL COSTS
.
ATC
AVC
MC
TC
TVC
Cost
s/unit
Output
Inflection Point
AFC
TFC
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Working With Cost Functions
Given the cost functions:
TC = 100 + 6Q – 0.4Q2 + 0.02Q3,
TFC = 100,
TVC = 6Q – 0.4Q2 + 0.02Q3,
ATC = TC/Q = 100/Q + 6 – 0.4Q + 0.02Q2,
AFC = TFC/Q = 100/Q,
AVC = TVC/Q = 6 – 0.4Q + 0.02Q2, and
MC = = ∂TC/ ∂Q = ∂TVC/ ∂Q = 6 – 0.8Q + 0.06Q2
Level of output at the minimum of AVC:
∂ AVC/ ∂Q = -0.4 + 0.04Q = 0 Q = 10
Co
sts
Output
TOTAL COSTS
.
ATC
AVC
MC
TC
TVC
Cost
s/unit
Output
Inflection Point
AFC
TFC
10
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Working With Cost Functions
Given the cost functions:
TC = 100 + 6Q – 0.4Q2 + 0.02Q3,
TFC = 100,
TVC = 6Q – 0.4Q2 + 0.02Q3,
ATC = TC/Q = 100/Q + 6 – 0.4Q + 0.02Q2,
AFC = TFC/Q = 100/Q,
AVC = TVC/Q = 6 – 0.4Q + 0.02Q2, and
MC = = ∂TC/ ∂Q = ∂TVC/ ∂Q = 6 – 0.8Q + 0.06Q2
Level of output at the minimum of MC:
∂ MC/ ∂Q = -0.8 + 0.12Q = 0 Q = 6.67
Co
sts
Output
TOTAL COSTS
.
ATC
AVC
MC
TC
TVC
Cost
s/unit
Output
Inflection Point
AFC
TFC
106.67
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Relationships among Product Curves and Cost Curves
The cost curves are derived directly from the production process.
TPP & TVC, APP & AVC and MPP & MC are mirror images of each other Therefore, the production function can be
transferred directly to the cost curves The three stages of a production function can
be transferred directly to the cost curves
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Relationship Between TPP and TVC
TPP
0.00
20.00
40.00
60.00
80.00
100.00
120.00
0.00 2.00 4.00 6.00 8.00 10.00 12.00
TPP
TVC
0.00
50.00
100.00
150.00
200.00
250.00
300.00
0.00 20.00 40.00 60.00 80.00 100.00 120.00
TVC
A A*
B
B*
The TVC is derived from the TPP: At “A” on TPP, 25 units of the output is being produced with 2 units of the input. The corresponding point “A*” on the TVC shows that the variable cost of producing 25 units of output is $50 (PX:$25 * 2 units of input =$50). Note similar linkage between point “B” on TPP and point “B*” on TVC.
Similar relationships can be derived between AVC & APP and between MPP & MC.
25