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Cost & Production Theory

Cost & Production Theory. Firms seek to produce any given quantity of output (Q) at lowest cost. Firms are cost minimizers. Costs. C = rK + wL r is the price of capital, w is the wage Cost is the sum of each input quantity multiplied by its price when input prices reflect all costs

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Cost & Production Theory

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  1. Cost & Production Theory Firms seek to produce any given quantity of output (Q) at lowest cost. Firms are cost minimizers.

  2. Costs • C = rK + wL • r is the price of capital, w is the wage • Cost is the sum of each input quantity multiplied by its price • when input prices reflect all costs • including opportunity costs

  3. Economic Costs are Opportunity Costs • Economic Cost includes both implicit and explicit costs • Explicit Costs – payment to others • Implicit Costs – cost of owned inputs, or other costs that do not generate explicit payments

  4. Costs and Output • Long-Run Total Cost or LTC • Combinations of Cost and Output Q • (C1,Q1), (C2,Q2), (C3,Q3) • Long-run average cost • LAC = (LTC/Q) • Long-run marginal cost • LMC = ΔLTC/ΔQ

  5. Short-run vs. Long-run • Long-run: all inputs variable • Short-run: one or more inputs fixed • Total Product: Q = f(K0,L) • Average Product of Labor: APL = Q/L • Marginal Product of Labor: MPL = ΔQ/ΔL • Law of diminishing marginal product • As more labor is employed with a fixed amount of capital, labor’s marginal product (MPL) eventually declines

  6. Watch the video • Microeconomics The Law of Diminishing Returns: Econ Concepts in 60 Seconds http://youtu.be/M7rA4VfvdAw

  7. Short-run Costs • Total Cost = rK0 + wL = TC • Total Fixed Cost = rK0 = TFC • Total Variable Cost = wL = TVC • TC = TFC + TVC • Average Fixed Cost: AFC = TFC/Q • Average Variable Cost: AVC = TVC/Q • Average Total Cost: ATC = TC/Q

  8. Short-run Marginal Cost • SMC = ΔTC/ΔQ • ΔTFC/ΔQ = 0 • SMC = ΔTVC/ΔQ = ΔTC/ΔQ • SMC = AVC at its minimum • SMC = ATC at its minimum

  9. Watch the videos • Episode 23: Cost Curves http://youtu.be/UI-LL8-dVAs • Cost Curves MC, ATC, AVC, and AFC: Econ Concepts in 60 Seconds http://youtu.be/S3iLMfm6CGY

  10. Short-run Cost & Product • AVC and MC are inversely related to APL and MPL • MPL > APL implies MC < AVC • Max MPL corresponds to Min MC • MPL = APL implies MC = AVC • MPL < APL implies MC > AVC

  11. Short-run and Long-run Cost • Short-run and long-run costs are equal ONLY at a long-run optimum • The quantity where short-run fixed K0 minimizes long run cost • ATC = LAC • Only at the minimum of LAC are all average and marginal costs equal • LAC = LMC = ATC = SMC

  12. Watch the video • 9.2 - Long-Run Cost Structure http://youtu.be/8I6BIuCGuaE

  13. Economies of Scale • Economies of scale: LAC is decreasing • Costs increase less than proportionately with output • Diseconomies of scale: LAC increasing • Costs increase more than proportionately with output • Constant returns to scale: LAC = LMC • Costs increase exactly in proportion to output • Minimum Efficient Scale or MES • The quantity at which economies of scale end and constant returns begin

  14. Watch the video • Economies and Diseconomies of Scale.mp4 http://youtu.be/6TW-o1NqV0I

  15. Economies of Scope • A firm can produce two products together more cheaply than producing each product separately, or • C(X,Y) < C(X) + C(Y)

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