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COST ANALYSIS

Chapter 6 slide 1. COST ANALYSIS. General Principles: - Only Differential Costs Matter. Ignore Costs that are fixed across Options. - Opportunity Costs Should Not be Ignored. Starting a Business. Examples. Revenues $200 K Expenses -$110 K. MBA Degree

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COST ANALYSIS

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  1. Chapter 6 slide 1 COST ANALYSIS General Principles: - Only Differential Costs Matter. Ignore Costs that are fixed across Options. - Opportunity Costs Should Not be Ignored. Starting a Business Examples Revenues $200 K Expenses -$110 K MBA Degree City-Owned Land Surplus Factory Space Your Wage -$65 K Cost of Capital $100 K at 15% -$15 K $10 K Economic Profit

  2. 6.2 ORDERING A BEST SELLER Demand: P = 24 - Q MC = $12 per book MR = 24 - 2Q = 12 Q = 6 hundred, P = $18 Cont. = (18 - 12)(600) = $3,600. A. Find optimal Q and P. MC = 12 + 4 (Opp Cost) Q = 4 hundred, P = $20. Cont. = (20 - 16)(400) = $1,600. B. Suppose average book earns $4 and shelf space is limited. MC = 4 + 6 (Opp Cost) MR = 18 - 4Q = 10, Q = 2 hundred, P = $14. Cont. = (14 -16)(200) + (6 - 12)(200) = -$1,600. C. Suppose demand falls to P = 18 - 2Q. How many of the 400 books should the store sell and how many should it return for $6 each?

  3. AC MC 6.3 Example: MC = Wage/MPL COST ANALYSIS Short-Run Cost Behavior Diminishing Marginal Productivity leads to Increasing MC. W = $12/Hr, MPL = 4/Hr then MC = $3/unit

  4. SAC1 SAC2 SAC3 LONG-RUN COST 6.4 The shape of LR average cost depends upon returns to scale. Flat LAC reflects Constant Returns to Scale. With plant fixed, SAC is U-shaped and lies above LAC. Constant LAC reflects Constant Returns to Scale.

  5. 6.5 OPTIMAL OUTPUT In either case, the firm’s Optimal output occurs where: MR = MC Low Demand versus High Demand MR MC Demand AC P* MR Q* Q*

  6. P* Q* 6.6 THE SHUT-DOWN RULE 1. In the long run, the firm should shut down when: P < AC. 2. In the short run, the firm should produce Q* because: P > AVC. AC MC AVC MR Demand

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