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ECON 201COST: CONCEPTS and SHORT RUN
COSTS
The Firm’s Cost
• Like Opportunity Cost which individuals,
businesses also face costs.
• A firm’s total cost of producing a given level of
output is the opportunity cost of the owners’
everything they must give up in order to produce
that amount of output.
• The notion that the cost of production is the
opportunity cost of production is the core of
economists’ thinking about costs.
• This helps businesses in determining which costs
are relevant and which ones are not.
Sunk Cost: Illustration
• Suppose that last year, A & B Pharmaceutical
company spent $10 million in developing a new
drug to treat acne that if successful would have
generated millions of dollars in annual sales
revenue. At first, the drug seem to work as
intended. But then, just before launching
production, management discovered that the
drug did not cure acne at all. Rather it was
remarkably effective in curing a rare under arm
fungus. In this smaller less lucrative market,
annual sales would just be $30,000. Now
management must decide: should they sell the
drug as an anti- fungus remedy? Discuss
• Decision Option 1: The company should not sell the drug.
You don’t sell something for $30,000 a year when it cost
$10m to make it.
• Option 2: The company should go ahead and sell the drug.
If they don’t, they would be wasting that huge investment
of $10m.
• Economist’s Response: Neither approach is correct since
both considers the $10m development cost in the decision
process. The economist believes that this cost is completely
irrelevant to the decision.
• The development cost has been paid already and the
company will not get this money back whether it decides to
sell this new drug in the smaller market or not.
• Because the $10 m is not part of the opportunity cost
associated with the two options, the economist sees this as
sunk cost.
• What should be considered are the costs that
depend on the decision about producing the
drug namely, the actual cost of actually
manufacturing it and marketing it for the
smaller market.
• If these costs are less than the $30 000, then
the company will earn in annual revenue and
should therefore produce the drug.
Otherwise, it shouldn’t.
Sunk Cost
• This refers to cost that has been paid or must be paid
regardless of any future action being considered.
• Future payment could also be sunk cost if an unavoidable
commitment to pay it has already been made. Eg.
Employment contract with research scientist legally binding
the company to pay salary for 3 years even if he/she is laid
off. All three years of salary are sunk cost for the company
because they must be made no matter what the company
decides to do.
• Sunk Costs should not be considered when making
decisions.
Example of Sunk Cost
• An example of obvious sunk costs can be found in the
construction industry. Let's say a construction company has
begun development of a new, housing sub-division. The lots
have been purchased and initial construction materials have
been purchased and delivered and framing has begun. A total
of $4,000,000 has been invested.
• Suddenly, a crisis in the banking industry causes a recession
and subsequently the bottom falls out of the housing market.
The sub-division land is now worth much less than the
construction company paid for it. If the company abandons
the project, it will take a $4,000,000 loss. Some company
executives want to finish the houses and sell them to recover
at least a portion of the costs already spent -- sunk costs. But
it will cost an additional $6,000,000 to complete the project.
Explicit vs Implicit Costs
• Explicit cost
– Money actually paid out for the use of inputs
• Implicit cost
– The cost of inputs for which there is no direct money
payment
• Example: Suppose you have opened a restaurant
in a building that you already owned. Even
though you do not pay rent, it does not mean
that you are using the building for free.
• To an accountant, rent costs will be zero but to
the economist, the forgone rent is the implicit
cost.
Costs in the Short run
• Costs over a time period during which at least
one of the firm’s inputs is fixed.
• Fixed costs
–
–
–
–
Also known as overhead costs
Costs of a firm’s fixed inputs
Remain constant as output changes
Rent and Interest are examples of fixed costs
• Variable costs
– Costs of a firm’s variable inputs
– Change with output
– Wages and cost of raw materials are examples of
variable costs.
• Total fixed cost (TFC)
– The cost of all inputs that are fixed in the short
run
• Total variable cost (TVC)
– The cost of all variable inputs used in production
• Total cost (TC=TFC+TVC)
– The costs of all inputs—fixed and variable
Calculating SR Costs
• Assume the following:
– Cost of renting building space ($75)
– Cost of labour per day ($60)
Calculating Short-run Costs
Output per
day
Capital
Labour
TFC
TVC
TC
0
1
0
75
0
75
30
1
1
75
60
135
40
1
2
75
120
195
50
1
3
75
180
255
70
1
4
75
240
315
90
1
5
75
300
375
125
1
6
75
360
435
Total Cost Curves
Figure 3 The Firm’s Total Cost Curves
Dollars
TC
$435
375
TVC
TFC
315
255
195
135
TFC
0
30
90
130
160
184
Units of Output
13
The firm’s Average Costs
• Average fixed cost (AFC=TFC/Q)
– Total fixed cost divided by the quantity of output
produced
• Average variable cost (AVC=TVC/Q)
– Cost of the variable inputs per unit of output
• Average total cost (ATC=TC/Q)
– Total cost per unit of output
Marginal Cost
• Marginal Cost (MC)
–Increase in total cost from producing one more unit
or output
ΔTC
MC 
ΔQ
15
Shape of the MC
• MC curve is U-shaped
• When MPL rises, MC falls:
• At low levels of employment and output, MPL is
high → fewer additional workers required to
produce the output → lower cost of producing
additional output → falling MC
• When MPL falls, MC rises:
• At higher levels of employment and output,
diminishing returns sets → MPLS is low →
additional units of output requires additional
labour →additional cost → rising MC
Average And Marginal Costs
Figure 4 Average And Marginal Costs
Dollars
MC
$4
3
AFC
ATC
AVC
2
1
0
17
30
90
130
160
196
Units of Output
Average And Marginal Costs
• At low levels of output
– MC - below the AVC and ATC curves
– AVC and ATC slope downward
• At higher levels of output
– MC - above the AVC and ATC curves
– AVC and ATC slope upward
• U-shaped curves
• MC curve will intersect the minimum points of
the AVC and ATC curves
18
AC and MC: An illustration
Number of Tests
Taken
Total Score
Marginal Score
Average Score
0
0
1
100
100
100
2
150
50
75
3
210
60
70
4
280
70
70
5
360
80
72
-
• Since your marginal score of 50 is lower than your previous average score of
100, the second score will pull your average down to 75.
• Whenever you score lower than your previous average, it will pull your average
down.
Shape of the AVC
• At low levels of output, MC is decreases. Since
it is lower than average cost so it will pull the
AV down→ AVC decreases.
• At higher levels, MC rises ( due to diminishing
returns). Eventually, this rises above the
average→ pulling the AVC up→ 𝐴𝑉𝐶 𝑟𝑖𝑠𝑒𝑠
Shifts in the Cost curves
• The cost curves discussed so far show how cost varies
with variation in output level given constant factor
prices and fixed technology.
• Changes in either factor prices or technological
knowledge will cause the whole family of short run
curves to shift.
• Since loss of existing technological knowledge rarely
happens, changes in technological knowledge affects
the cost curves in one direction ie. Shifts cost curves
downwards.
• A rise in factor prices shifts the whole family of curves
upwards. And a fall in factor prices shifts the curves
downwards.
The Long Run
• In the short run, with a predetermined output level and
only one factor variable, there is only one technically
possible way of achieving that output.
• In the long run, all factors are variable. There is an
additional decision to make regarding how to produce
the predetermined output level.
• The firm has to make a choice from the many
technically possible methods by which the desired
output level will be produced.
• The firm has to decide to adopt a technique that uses
much capital and little labour or one that uses less
capital but more labour.
• Firms make such decisions using the simple rule of cost
minimization- where the firm chooses the least costly
method of production from the alternatives open to it.
The Principle of Substitution
• A firm producing with two inputs ( labour and
capital) will minimize the cost of producing
any given output when the following
condition is satisfied:
•
𝑀𝑃𝑘
𝑝𝑘
𝑀𝑃𝑙
=
𝑝𝑙
• Whenever the two sides of the equation
above are not equal, there are factor
substitutions that will reduce the cost of
producing any given output.
• If the LHS is greater than the RHS, then the
firm will substitute more capital units for
labour units since and additional cedi spent on
capital produces more output than labour
• For example: What substitution would the
firm make if capital costs ghc10 a unit and
has a marginal product of 40 units of output
while labour costs ghc 2 a unit and has a
marginal product of 4 units of output.
Discuss.
Discussion Question
• Suppose that a firm is producing where the
cost minimizing condition is met but the cost
of labour increases while the cost of capital
remains unchanged. What will the firm decide
in terms of substituting one input for the
other.
• The least cost method of producing any
output will now use less labour and more
capital than was required before the factor
prices changed.
Next Class
• Cost Curves in the Long run.