2/23/2023

Chapter 7: Costs

Chapter 7 Outline
7.2 Short-Run Costs
7.3 Long-Run Costs

1
 2/23/2023

Costs
How does a firm determine how to produce a certain amount of
output efficiently?
First, determine which production processes are technologically
efficient
◦ Produce the desired level of output with the least inputs.

Second, select the technologically efficient production process

that is also economically efficient
◦ Minimize the cost of producing a specified amount of output

Because any profit-maximizing firm minimizes its cost of

production, we will spend this chapter examining firms’ costs

Short-Run Costs
Recall that the short run is a period of time in which some inputs
can be varied, while other inputs are fixed
Short run cost measures all assume labor is variable and capital is
fixed:
• Fixed cost (F): a cost that doesn’t vary with the level of output
(e.g. expenditures on land or production facilities)
• Variable cost (VC): production expense that changes with the
level of output produced (e.g. labor cost, materials cost)
• Total cost (C): sum of variable and fixed costs
C = VC + F

2
 2/23/2023

Short-Run Cost Curves

Short-Run Costs
To decide how much to produce, a firm uses measures of marginal and
average costs:
• Marginal cost (MC): the amount by which a firm’s cost changes if it
produces one more unit of output

• Average fixed cost (AFC): FC divided by output produced

AFC = F / q
• Average variable cost (AVC): VC divided by output produced
AVC = VC / q
• Average cost (AC): C divided by output produced

3
 2/23/2023

Short-Run Cost Curves

More on Marginal Cost

∆𝑇𝑉𝐶
𝑀𝐶 =
∆𝑞

∆𝑇𝑉𝐶 𝑤(∆𝐿) 𝑤
𝑀𝐶 = = =
∆𝑞 ∆𝑞 𝑀𝑃𝐿

◦ Law of diminishing marginal returns => marginal product curve of the

variable input generally rises and then falls as output increases
◦ The marginal product of labor varies with output => marginal cost
also varies with output
◦ As a result, the MC curve will first fall and then rise
◦ Thus, the law of diminishing marginal returns lies behind the MC
curve

4
 2/23/2023

More on Average Cost

𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑞

𝑇𝑉𝐶 𝑤𝐿
𝐴𝑉𝐶 = =
𝑞 𝑞
𝑤
=
𝐴𝑃𝐿
The average product curve rises, reaches a maximum, and then falls, due to
the law of diminishing marginal productivity
As a result, the AVC curve will fall and then rise
The AFC curve declines over the entire range of output as the amount of
total fixed cost is spread over ever-larger rates of output
The ATC curve is the sum of AFC and AVC. It measures the average unit cost
of all inputs, both fixed and variable, and must also be U-shaped

Marginal-Average Relationships

When marginal cost is below average (total or variable) cost,

average cost will decline
When marginal cost is above average cost, average cost
rises
When average cost is at a minimum, marginal cost is equal
to average cost

5
 2/23/2023

Production Functions and the

Shape of Cost Curves
Shape of the MC curve:

• MC moves in the opposite

direction of MPL

Production Functions and the

Shape of Cost Curves
Shape of the AC curve
• Two components:
• spreading fixed cost over output

AFC = F / q

• diminishing marginal returns to labor in

the AVC curve

• AC moves in the opposite direction of

APL

6
 2/23/2023

Short-Run Cost Summary

Costs of inputs that can’t be adjusted are fixed and costs of
inputs that can be adjusted are variable
Shapes of SR cost curves (VC, MC, AC) are determined by the
production function
When a variable input has diminishing marginal returns, VC and
C become steeper as output increases
• Thus, AC, AVC, and MC curves rise with output
When MC lies below AVC and AC, it pulls both down; when MC
lies above AVC and AC, it pulls both up
• MC intersects AVC and AC at their minimum points

Long-Run Costs and Input

Choice
Isocost line summarizes all combinations of inputs that require
the same total expenditure
• If the firm hires L hours of labor at a wage of w per hour, total
labor cost is wL
• If the firm rents K hours of machine services at a rental rate of r
per hour, total capital cost is rK
• Cost is fixed at a particular level along a given isocost line:

Rewrite the isocost equation for easier graphing:

7
 2/23/2023

Isocost Lines
Three properties of isocost lines:
1. The firm’s costs, C, and input prices determine
where the isocost line hits the axes
2. Isocosts farther from the origin have higher costs
than those closer to the origin
3. The slope of each isocost is the same and is given by
the relative prices of the inputs

Cost Minimization
This firm is seeking the least cost way of producing 100
units of output

8
 2/23/2023

Least Costly Input

Combination
A point of tangency between an isocost line and an isoquant
show the least costly way of producing a given output level
Alternatively, a point of tangency shows the maximum
output attainable at a given cost as well as the minimum
cost necessary to produce that output

Interpreting the Tangency Points

𝑤
𝑀𝑅𝑇𝑆𝐿𝐾 =
𝑟

𝑀𝑃𝐿 𝑤
=
𝑀𝑃𝐾 𝑟

𝑀𝑃𝐿 𝑀𝑃𝐾
=
𝑤 𝑟
Where MRTS=Marginal Rate of Technical Substitution: the amount by which one
input can be reduced without changing output when there is a small (unit)
increase in the amount of another input
Golden rule of cost minimization: a rule that says that to minimize cost, the firm
should employ inputs in such a way that the marginal product per dollar spent is
equal across all inputs

9
 2/23/2023

If the firm is not producing at a

tangency point…
Whenever MPL/w > MPK/r, a firm can increase output without increasing
production cost by shifting outlays from capital to labor

Whenever MPL/w < MPK/r, a firm can increase output without increasing
production cost by shifting outlays from labor to capital

The Expansion Path

The expansion path is a curve formed by connecting the points of tangency
between isocost lines and the highest respective attainable isoquants

10
 2/23/2023

Expansion Path and Long-Run Cost Curve

Is Production Cost Minimized?

Cost minimization is NOT the same as profit maximization…
Cost minimization occurs at all points on the expansion
path, but profit maximization involves selecting the most
profitable output from among those on the expansion path

11
 2/23/2023

Input Price Changes and Cost

Curves
The input substitution effect is the effect of a change in the
price of an input on a firm’s relative use of the input to
produce a given level of output

Factor Price Changes

Originally, w = $24 and r = $8.
When w falls to $8, the isocost
becomes flatter and the firm
substitutes toward labor, which is
now relatively cheaper
• Firm can now produce same
q=100 more cheaply

12
 2/23/2023

Using Calculus to Minimize

Cost
Minimizing cost subject to a production constraint yields the
Lagrangian and its first-order conditions:

Rearranging terms reveals the last-dollar rule:

𝑀𝑃𝐿 𝑀𝑃𝐾
=
𝑤 𝑟

Minimizing Costs for Specific

Technologies
Example 1: perfect complements
Suppose we consider two factors are perfect complements, so that
𝑓 𝑙, 𝑘 = min 𝑙, 𝑘 . If we want to produce q units of output, we need q
units of 𝑙 and 𝑘. Then the minimal costs of production will be:
𝐶 𝑤, 𝑟, 𝑞 = 𝑤𝑞 + 𝑟𝑞

13
 2/23/2023

Minimizing Costs for Specific

Technologies
Example 2: perfect substitutes
Suppose we consider two factors are perfect substitutes, so that 𝑓 𝑙, 𝑘 = 𝑙 +
k. The minimum cost of producing y units will be If we want to produce q units
of output, we need q units w𝑞 or 𝑟𝑞, whichever is less. That is,
𝐶 𝑤, 𝑟, 𝑞 = min{𝑤𝑞, 𝑟 𝑞}

Long-Run Costs
Recall that the long run is a period of time in which all inputs can
be varied
• In the LR, firms can change plant size, build new equipment, and
adjust inputs that were fixed in the SR
• We assume LR fixed costs are zero (F = 0)
• In LR, firm concentrates on C, AC, and MC when it decides
how much labor (L) and capital (K) to employ in the
production process

14
 2/23/2023

Long-Run Cost Curves

LR total cost (LTC) shows the minimum cost at which each rate of
output may be produced, just as the expansion path does

LR marginal cost (LMC) and LR average cost (LAC) are derived from the
LTC in the same way that the short-run marginal and average curves are
derived from the short-run total cost curve

LAC is U-shaped…why?
◦ Economies of scale
◦ Diseconomies of scale

Long-Run Cost Curves

15
 2/23/2023

The Shape of LR Cost Curves

The LR AC curve may be U-shaped
• Not due to downward-sloping AFC or diminishing marginal returns,
both of which are SR phenomena, as it is for SR AC
• Shape is due to economies and diseconomies of scale
A cost function exhibits economies of scale if the average cost of
production falls as output expands
• Doubling inputs more than doubles output, so AC falls with higher
output
A cost function exhibits diseconomies of scale if the average cost of
production rises as output expands
• Doubling inputs less than doubles output, so AC rises with higher
output

The Long Run and Short Run Revisited

Summary:
◦ Long-run average cost curve (LAC): the lowest average
cost attainable when all inputs are variable
◦ Each point on the LAC is associated with a different short-
run scale of operation that the firm could choose

16
 2/23/2023

Lower Costs in the Long Run

Because a firm cannot vary K in the SR but it can in the LR, SR cost is as
least as high as LR cost
• … and even higher if the “wrong” level of K is used in the SR

The Expansion Path of a Cobb-Douglas

production function in Algebra

17
 2/23/2023

Just in case you wonder what the cost function of a Cobb-

Douglas production function looks like

I promise I
will never
ask you to
solve for this
cost function
in exam 

18