8 Theory of cost co site oe fay f Y r + 1 ed Store RUE New ke Te allege tock ES ie rai cmt ste tn ran or i = Seren probe rae “i Vent Con Is an additional driver's cost of road congestion the same as all the other current drivers? Short-run costs, ‘Average costs Marginal cost “Average and marginal cost relationship Is marginal cost just some adjustment to average cost? Why will average costs rise with increases in ‘ouput? Application: Shapes of the short-run average variable cost curves How are short- and long-run cost curves related? Shifting in the cost curves Input price change How will marginal cost shift with a change in fixed cost? New technologiesTheory of cost 393 SIVE (ke) sic sive Tre TFC (ke) severe: 00 on per nit ‘output SATC SAVC AFC eee woos 4 i AT Figure 8.8 Short-run cost curves. Short-run total cost is the sum of short-run total variable cost and total fixed cost. Dividing these costs by output results in short-run average total cost equaling short-run average variable cost plus average fixed costs. Short-run ‘marginal cost is the slope of the short-run total cost curve as well as the slope of the a short-run total variable cost curve, The short-run average cost curves and the marginal cost curve are U-shaped due to the Law of Diminishing Marginal Returns. where STVC(K*) = 3g —2q° +6q and TFC(K*) = g ‘Average costs Think of parents as being the totals and their offspring the averages and the marginal. This illustrates how short-run costs can be further classified as short-run average total cost (SATC), short-run average variable cost (SAVC) and average fixed cost (AFC). We derive all of these average costs by dividing the short-run total cost by output. Specifically, for a fixed level of capital K°, STC(K° sare(se) = TED —saverk*) + AFCUR"), where STVC(K? SAVC(K®) = “_ and AFC(K®) = CH) q304 Theory of cost For the cost curves in Figt ® SAVC(K®) and AFC(K*)= 7 This yields SATC(K*) = 3q? —24+6 +7. AFC is conti given that TFC infinity, and as output approaches infinity, AFC ten positive but declines as output increases, SATC an « each other as output increases. ally declining as outpnt increases. However, i is always a positive number, s positive andq is nonnegative, As output tends toward zero, AFC approaches ds toward zero, Because AFC is always .d SAVC never intersect, but approach Short-run average total cost (SATC). Short-run total cost divided by output. E-g., the total expenses for operating a bicycle stop divided by the number of bicycles sold. Short-run average variable cost (SAVC). Short-run total variable cost divided by output. Eg, the wage bill divided by the number of bicycles sold. ‘Average fixed cost (AFC). Total fixed cost divided by output. E.g., the fixed rent paid on a warehouse for storing bicycles divided by the number of bicycles sold. Recall that LAC, for some level of output, corresponds to the slope of a chord from the origin intersecting the LTC curve at that output level. Similarly, SAVC, for some level of output, is the slope of a chord through the origin intersecting the STVC curve at that output level. At first, as output increases, the chord is tilting downward, so the slope is declining, which corresponds to SAVC declining (Figure 8.8). At the tangency of the chord and STVC, SAVC is at a minimum, q = 1.5. To the right of the tangency, the chord is tilting upward ‘as output increases, which corresponds to SAVC increasing. As illustrated in Figure 8.8, the ae U-shaped characteristic of SAVC is due to the Law of Diminishing Marginal Returns. SATC is the sum of SAVC and AFC. Similar to SAVC, the slope of a chord through the origin intersecting STC is SATC at the output level of the intersection, SATC is also U-shaped due to the Law of Diminishing Marginal Returns and reaches a minimum at the gency of a chord through the origin and STC, q = 2 (Figure 8.8). For the cost curves in Figure 8.8, jq-2=0=4 >0, minimum,Theory of cost 305 =0=>q=2, x +4, >0forg>0, minimum q Marginal cost Short-run marginal cost (SMC) for a fixed level of capital K* is defined as ASTC(K*) aSTC(K aSTVC(K®, SMO = tim “STAD i) _ OSTY Gee aye 34 34 Recall that STC and STVC are vertically parallel, Due to the Law of Diminishing Marginal Returns, SMC may at decline, reach a minimum at the point of inflection of STC and STVC, and then rise with incr in output. For the cost curves in Figure 8.8, SMC(K°) = 2q°—49+6, Oe =4g-4=0>9=1, =4>0, minimum. ag Short-run marginal cost (SMC). In the short run, the additional cost associated with ‘an additional increase in output. E.g, a bicycle shop's additional cost of selling another bicycle. Example 8.5 Deriving short-run cost curves Continuing with the production function q = LK in Example 8.2, assume capttal is fixed at K®. In the short run, the firm will determine STC =min(wL+ vk), s.t.q=LK°, where only input L is variable. The Lagrangian is then L(L, 2) = WL + vk? + 4(q- LEO), The FOCs are aL sae SEW 8K? =O, ac ie oA KaeTheory of cost 305 Marginal cost Short-run marginal cost (SMC) for a fixed level of capital K° is defined as Nn SMC(K") = lim —— (K*) _ STVC(K*) a0 Aq . aq STC and STVC are vertically parallel. Due to the Law of Diminishing Marginal MC may at first decline, reach a minimum at the point of inflection of STC and ‘STVC, and then rise with increases in output. For the cost curves in Figure 8.8, =2q' —4q+6, Short-run marginal cost (SMC). In the short run, the additional cost associated with an additional increase in output. E.g., a bicycle shop's additional cost of selling another bicycle. Example 8.5 Deriving short-run cost curves Continuing with the production function q = LK in Example 8.2, assume capital is fixed at K®. In the short run, the firm will determine STC =min(wl+vk°), st. q=LK°, where only input L is variable. The Lagrangian is then £(L.2) = wht vO + 4(q— LK), ‘The FOCs are aL = itK°=0, ae ac Of -g-UK°=0. an aE306 Theory of cost From these FOCs, SMC = 4* = w/K®. SMC for this technology is constant across output. Solving the second FOC for L* yields L* = q/K °, which is called the conditional short-run demand function for labor, Substituting this conditional labor demand function into the objective function yields the cost function STC = wh* + vk = waq/K° + vk, where STVC = wa/K® and TFC = vK®, The remaining short-run cost functicns are SAIC === Ret where SAVC = w/K® and AFC = vK°%q. By minimizing STC with respect to the fixed input capital, we derive the LTC function from this STC function: aSTC wq aK Ke Solving for K yields the long-run conditional capital demand function: K = (wq/v)'?. Substituting this long-run demand function into STC results in the same LTC as determined in Example 8.3: itc= ae 4+ v(wq/v)"/2 = 2(qwvy'/2 Cost ve SMC SATC SAVE SATC w/e SAVE = SMC