Chapter 5

Costs
 Introduction
• Managerial Problem
– Technology choice at home versus abroad: In the United States, firms use
relatively capital-intensive technology
– Will that same technology be cost minimizing if they move their production
abroad?
• Solution Approach
– First, a firm must determine which production processes are technically efficient
so that it can produce the desired level of output without waste. Second, a firm
should pick from these technically efficient processes the one that is also
economically efficient (minimum cost). By minimizing costs, a firm can
increase its profit.
• Empirical Methods
– When considering costs, a good manager includes opportunity costs or foregone
alternatives.
– To minimize costs, a manager should distinguish short-run costs from long-run
costs.
– Firms may reduce costs overtime based on experience or its learning curve.
– If a firm produces several goods, individual cost may depend on the cost of
producing multiple goods.

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 5.1 The Nature of Costs

• Explicit and Implicit Costs

– Explicit costs are direct, out-of-pocket payments for labor, capital, energy,
and materials.
– Implicit costs reflect only a foregone opportunity rather than explicit,
current expenditure.
• Opportunity Costs
– The opportunity cost of a resource is the value of the best alternative use
of that resource.
– Value of Manager’s Time example: Maoyong owns and manages a firm. He
pays himself only $1k per month but could work for another firm and
make $11k per month. Working for another firm is the best alternative
use of his time, so his opportunity cost of time is $11k.

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 SHORT-RUN COST
• Total Cost
A firm’s total cost (TC) is the cost of all the factors of production the
firm uses. Total cost divides into two parts:
 Total fixed cost (TFC) is the cost of a firm’s fixed factors of
production used by a firm—the cost of land, capital, and
entrepreneurship. Total fixed cost doesn’t change as output
changes.
 Total variable cost (TVC) is the cost of the variable factor of
production used by a firm—the cost of labor.
To change its output in the short run, a firm must change the quantity
of labor it employs, so total variable cost changes as output
changes.
Total cost is the sum of total fixed cost and total variable cost. That is,
TC = TFC + TVC

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 SHORT-RUN COST

Total fixed cost (TFC) is

constant—it graphs as a
horizontal line.

Total variable cost (TVC)

increases as output increases.
Total cost (TC) also increases
as output increases.

The TVC and the TC curve have

the same shape,

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The vertical distance
between the total cost
curve and the total
variable cost curve is total
fixed cost, as illustrated by
the two arrows.

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 Marginal Cost
A firm’s marginal cost is the change in total cost
that results from a one-unit increase in total
product.
Marginal cost tells us how total cost changes as
total product changes.
2. MC= ∆TC/ ∆output

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6-9 © 2014 Pearson Education, Inc. All rights reserved.
ATC= AVC= TVC AFC= TFC MC=∆TC TC= TFC+TVC TVC TFC Out
AFC+AVC O O ∆O put

-- -- -- -- 10+0=10 - 10 0
10+6= 16 6/1= 6 10/1= 10 16-10/1-0= 6 10+6=16 6 10 1
5+4.5= 9.5 9/2= 4.5 10/2= 5 19-16/2-1= 3 10+9=19 9 10 2
3.3+4= 7.3 12/3= 4 10/3= 3.3 22-19/3-2= 3 10+12=22 12 10 3
2.5+3.5= 6 14/4= 3.5 10/4= 2.5 24-22/4-3= 2 10+14=24 14 10 4
2+3= 5 15/5= 3 10/5= 2 25-24/5-4= 1 10+15=25 15 10 5
1.67+3= 4.67 18/6= 3 10/6= 1.67 28-25/6-5= 3 10+18=28 18 10 6
1.43+2.85=4.28 20/7= 2.85 10/7= 1.43 30-28/7-6= 2 10+20=30 20 10 7
1.25+3=4.25 24/8= 3 10/8= 1.25 34-30/8-7= 4 10+24=34 24 10 8
1.1+3.3= 4.4 30/9= 3.3 10/9= 1.1 40-34/9-8= 6 10+30=40 30 10 9
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 Average Cost

There are three average cost concepts:

Average fixed cost (AFC) is total fixed cost per unit of
output.
Average variable cost (AVC) is total variable cost per unit
of output.
Average total cost (ATC) is total cost per unit of output.

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 The average cost concepts are calculated from the
total cost concepts as follows:
TC = TFC + TVC
Divide each total cost term by the quantity produced,
Q, to give

TC = TFC + TVC
Q Q Q
or,
ATC = AFC + AVC
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 Short-Run Costs

Average Average
Average
Fixed Variable
Cost
Cost Cost

• Average Fixed Cost (AFC) falls as output rises because the

fixed cost is spread over more units.
• Average Variable Cost (AVC) or variable cost per unit of
output may either increase or decrease as output rises.
• Average Cost (ATC) or average total cost may either
increase or decrease as output rises.

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6-14 © 2014 Pearson Education, Inc. All rights reserved.
 Short-Run Costs

The vertical distance between ATC and

AVC curves is equal to AFC.

The marginal cost curve (MC) is U-

shaped and intersects the average
variable cost curve and the average
total cost curve at their minimum points.

• The average variable cost curve

is U-shaped.
• The average cost curve is also
U-shaped.

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 Short-Run Costs
• Graphs: Average Costs and Marginal Cost
– The marginal cost curve, MC, cuts the average variable
cost, AVC, and average cost, AC, curves at their
minimums.
– The average cost and average variable cost curves fall
when marginal cost is below them and rise when
marginal cost is above them, so the marginal cost cuts
both these average cost curves at their minimum points.

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 Example 2

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