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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.