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Week 9 chapter notes

Economics for Management Studies
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Chapter 7 The Cost of Production Notes
7.1 Measuring Cost: Which Costs Matter?
Economic Cost versus Accounting Cost
x accounting cost Æ actual expenses plus depreciation charges for capital equipment
x economic cost Æ cost to a firm of utilizing economic resources in production, including opportunity cost
Opportunity Cost
x opportunity cost Æ cost associated with opportunities that are forgone when firm’s resources are not put to best alternative use
x when estimating future probability of business, economists and managers are concerned with capital cost of plant and machinery
x this cost involves not only monetary outlay for buying and running the machinery, but also the cost associated with wear and tear
x when evaluating past performance, cost accountants use tax rules that apply to broadly defined types of assets to determine
allowable depreciation in their cost and profit calculations; but these depreciation allowances need not reflect the actual wear and
tear on the equipment, which is likely to vary asset by asset
Sunk Costs
x although an opportunity cost is often hidden, it should be taken into account when making economic decisions
x sunk cost Æ expenditure that has been made and cannot be recovered
x a sunk cost is usually visible, but after it has been incurred it should always be ignored when making future economic decisions
x because a sunk cost cannot be recovered, it should not influence the firm’s decisions
Fixed Costs and Variable Costs
x total cost (TC or C) Æ total economic cost of production, consisting of fixed and variable costs
x fixed cost (FC) Æ cost that does not vary with the level of output and that can be eliminated only by shutting down
x variable cost (VC) Æ cost that varies as output varies
Marginal and Average Cost
x marginal cost (MC) Æ increase in cost resulting from the production of one extra unit of output; MC = ¨VC / ¨q = ¨TC / ¨q
x average total cost (ATC) Æ firms total cost divided by its level of output; ATC = TC / q
x average fixed cost (AFC) Æ fixed cost divided by the level of output; AFC = FC / q
x average variable cost (AVC) Æ variable cost divided by the level of output; AVC = VC / q
7.2 Cost in the Short Run
The Determinants of Short-Run Cost
x the change in variable cost for a unit cost of the extra labour w (fixed wage) times the amount of extra labour needed to produce
the extra output ¨L Æ MC = ¨VC / ¨q = w ¨L / ¨q Æ MC = w / MPL
x diminishing marginal returns means that the marginal product of labour declines as the quantity of labour employed increases
x as a result, when there are diminishing marginal returns, marginal cost will increase as output increases
7.3 Cost in the Long Run
The User Cost of Capital
x user cost of capital Æ annual cost of owning and using a capital asset, equal to economic depreciation plus forgone interest
x User Cost of Capital = Economic Depreciation + (Interest Rate) (Value of Capital)
x the user cost of capital can also be expressed as a rate per dollar of capital: r = Depreciation rate + Interest rate
The Cost-Minimizing Input Choice
x the amount of labour and capital that the firm uses will depend on the prices of these inputs
x because there are competitive markets for both inputs, their prices are unaffected by what the firm does
x in the long run, the firm can adjust the amount of capital it uses
x even if the capital includes specialized machinery that has no alternative use, expenditures on this machinery are not yet sunk
and must be taken into account; the firm is deciding prospectively how much capital to obtain
x rental rate Æ cost per year of renting one unit of capital
x if the capital market is competitive, the rental rate should be equal to the user cost, r, because in a competitive market, firms that
own capital expect to earn a competitive return when they rent it—namely, the rate of return that they could have earned by
investing the money elsewhere, plus an amount to compensate for the depreciation of the capital
x capital that is purchased can be treated as though it were rented at a rental rate equal to the user cost of capital
The Isocost Line
x isocost line Æ graph showing all possible combinations of labour and capital that can be purchased for a given total cost
x total cost C of producing any particular output is given by sum of firm’s labour cost (wL) and its capital cost (rK): C = wL + rK
Choosing Inputs
x the marginal rate of technical substitution of labour for capital (MRTS) is the negative of the slope of the isoquant and is equal to
the ratio of the marginal products of labour and capital: MRTS = – ¨K / ¨L = MPL / MPK
x the isocost line has a slope of ¨K / ¨L = – w / r
x it follows that when a firm minimizes cost of producing a particular output, following condition holds: MPL / MPK = w / r
Cost Minimization with Varying Output Levels
x expansion path Æ curve passing through points of tangency between a firm’s isocost lines and its isoquants
x as long as the use of both labour and capital increases with output, the curve will be upward sloping
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