EC4004 Lecture 10: CostsDr. S. Kinsella

Dates: October 17th -24th

Best of 2 attempts

10% of Final Grade

Yesterday

Production Function

Marginal Products

Diminishing Marginal Productivity

Isoquants

Marginal Rate of Technical substitution

Today: Returns to Scale; Costs

Constant Returns to Scale

Capitalper week

4

A

321

Laborper week1 2 3

(a) Constant Returns to Scale

40q = 10

q = 20

q = 30q = 40

Decreasing Returns to Scale

Capitalper week

4

A

321

Laborper week1 2 3

(a) Constant Returns to Scale

40

Capitalper week

4

A

321

Laborper week1 2 3

(b) Decreasing Returns to Scale

40q = 10 q = 10

q = 20q = 20q = 30

q = 30q = 40

Increasing Returns to Scale

Capitalper week

K2

A

q2

q1

q0

K1

K0

Laborper weekL0 L1 L2

0

Capitalper week

K1

A

q’0

q0

K0

Laborper weekL1 L00

Technical Change

Opportunity cost: cost of a good as measured by the alternative uses foregone by producing good or service.Accounting cost: concept that goods or services cost what was paid for them.Economic cost: amount required to keep a resource in its present use; the amount that it would be worth in its next best alternative use.

Labour Costs

Wage, w

The cost of capital services (machine-hours) is the rental rate (v) which is the cost of hiring one machine for one hour.

Economic profit is revenue minus all costs including these entrepreneurial costs.

Total costs = TC = wL + vK. (8.1)Assuming the firm produces only one output, total revenue equals the price of the product (P) times its total output [q = f(K,L) where f(K,L) is the firm’s production function].

Economic profits (π): Difference between a firm’s total

revenues and its total economic costs.

Capitalper week

TC1TC2

TC3

q1

K*

Laborper weekL*0

Minimizing the Costs of Producing q1

Cost minimization requires that the marginal rate of technical substitution (RTS) of L for K equals the ratio of the inputs’ costs, w/v:

The firm’s expansion path is the set of cost-minimizing input combinations a firm will choose to produce various levels of output (when the prices of inputs are held constant).

Capitalper week

TC1 TC3TC2 Expansion path

q1

q2

q3K1

Laborper weekL10

Firm’s Expansion Path

Cost Curves

Totalcost

TC

Quantityper week

(a) Constant Returns to Scale

0

Totalcost

TC

Quantityper week

(b) Decreasing Returns to Scale

0

Totalcost TC

Quantityper week

(c) Increasing Returns to Scale0

Totalcost

TC

Quantityper week

(d) Optimal Scale

0

Possible Shapes of the Total Cost Curve

Average Costs

Average cost is total cost divided by output; a common measure of cost per unit.If the total cost of producing 25 units is €100, the average cost would be:

AC = €100/25 = €4

Marginal Cost

The additional cost of producing one more unit of output is marginal cost.If the cost of producing 24 units is €98 and the cost of producing 25 units is €100, the marginal cost of the 25th unit is €2.

AC, MC

AC, MC

Quantityper week

(a) Constant Returns to Scale

0

AC, MCAC

AC

AC

MC

MC

MC

Quantityper week

(b) Decreasing Returns to Scale

0

AC, MC

Quantityper week

(c) Increasing Returns to Scale0

AC, MC

Quantityper week

(d) Optimal Scale

0 q*

Average and Marginal Cost Curves

Shifts in Cost CurvesAny change in economic conditions that affects the expansion path will also affect the shape and position of the firm’s cost curves.Three sources of such change are:change in input pricestechnological innovations, andeconomies of scope.

Next Time

Production & Supply

Chapter 9, Do Ex. 81, 8.3, 8.7

EC4004 Lecture 10: CostsDr. S. Kinsella