Chapter 7

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Economics for Management Studies

The Cost of Production 11-10-28 9:21 PM 7.1 – MEASURING COST: WHICH COSTS MATTER? Economic Cost versus Accounting Cost • Accounting Cost – actual expenses plus depreciation charges for capital equipment • Economic Cost – cost to be a firm utilizing economic resources in production, including opportunity cost Opportunity Cost • Opportunity Cost – cost associated with opportunities that are forgone when a firm’s resources are not put to their best alternative use Sunk Cost • Sunk Cost – expenditure that has been made and cannot be recovered • No alternative use therefore, opportunity cost is zero • Should not influence the firm’s decisions • Prospective sunk cost is an investment o Decided if its economical (if it will lead to large enough revenue to cover its cost) Marginal and Average Cost Marginal Cost (MC) • Marginal Cost – increase in cost resulting from the production of one extra unit of output • MC = ΔVC/Δq = ΔTC/Δq Average Total Cost (ATC) • Average Total Cost – firm’s total cost divided by its level of output • ATC = AFC + AVC • Average Fixed Cost (AFC) – fixed cost divided by the level of output, FC/q o Declines as the rate of output increases • Average Variable Cost (AVC) – variable cost divided by the level of output, VC/q 7.2 – COST IN THE SHORT RUN The Determinants of Short-Run Cost • Fixed wage, w • MC = ΔVC/Δq = w  ΔL/Δq MPL = Δq/  ΔL MC = w/MPL • High MP means that labour requirement is low, as is the marginal cost - MP and MC run parallel Diminishing Marginal Returns and Marginal Cost • MPL declines as the quantity of labour employed increases o MC will increase as output increases The Shapes of the Cost Curve • Fixed cost = distance between TC curve and VC curve curve • MC crosses AVC and ATC at their min points The Average-Marginal Relationship • The distance between ATC and AVC declines because AFC declines as q rises. • ATC is always greater than AVC and MC is rising, the min point of the ATC curve must lie above and to the right on the min point of the AVC curve Total Cost as a Flow • Firm produces a certain number of units per year thus TC is a flow (some $ amount per year) • If the firm is currently producing at a level of output at which marginal cost is sharply increasing, and if demand may increase in the future, management might want to expand production capacity to avoid higher costs. 7.3 – COST IN THE LONG RUN The User Cost of Capital • Assume capital is rented (even if its purchased) • User Cost of Capital - annual cost of owning and using a capital asset, equal to economic deprecation plus forgone interest o User Cost of Capital = Economic Depreciation + (Interest Rate) (Value of Capital) o r = Depreciation rate + Interest Rate The Cost-Minimizing Input Choice • How to select inputs to produce a given output at minimum cost o 2 inputs: labour @ wage rate, w and capital The Price of Capital • Capital expenditure as a flow ($ per year) • Account for the forgone interest • Price of capital is its user cost, given by r Rental Rate of Capital • Rental Rate – cost per year of renting one unit of capital o Rental rate = r • Capital that is purchased can be treated as though it were rented at a rental rate equal to the user cost of capital • Treat sunk cost as fixed cost and spread it over time Isocost Line • Isocost Line – graph showing all possible combinations of labour and capital that can be purchased for a given total cost • C = wL + rK  K = (C/r) – (w/r)L o It tells us that if the firm gave up a unit of labor ( and recovered w dollars in cost) to buy w/ r units of capital at a cost of r dollars per unit, its total cost
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