Economic Analysis of Costs
Chapter 7 (cont’d)
Two Main Factors determining the cost curves:
1. Factor prices
• Prices of inputs, like labor and land, are
important ingredients of costs.
• Higher rents and higher wages mean higher
costs
2. Production Function
• Technological improvements that allow the
firm to produce the same output with fewer
inputs will result in costs falling.
Knowing both input prices and the production
function, one can calculate the cost curve.
In the previous table:
• Farmer X wants to produce wheat.
• He rented 10 acres of land (10-year lease).
– land is a fixed cost.
• Labor can be easily hired and fired.
– labor is a variable cost.
• land costs $5.5 per acre and labor costs $5 per worker.
• Using up-to-date farming methods, this farmer can
produce according to the production function shown
in the first three columns.
• Using the production data and the input-cost data, for
each level of output we calculate the total cost of
production.
Why “U-Shaped” Cost Curves (MC and AC)?
• A U-shaped cost curve means that cost falls in
the initial phase, reaches a minimum point,
and finally begins to rise.
• Why?
• Recall the SR and the LR.
• In the short run:
– Fixed factors such as plant and equipment cannot
be fully adjusted.
– Therefore, in the short run, labor costs are
typically variable costs, while capital costs are
fixed.
• In the long run:
– all inputs can be adjusted—including land, labor,
materials, and capital.
– Hence, all costs are variable and none are fixed
Relationship between Productivity Laws and the
Cost Curves:
• In the short run, when factors such as capital
and land are fixed, variable factors tend to
show an initial phase of increasing marginal
product followed by diminishing marginal
product.
• The corresponding cost curves show an initial
phase of declining marginal costs, followed by
increasing MC when diminishing returns start
to set in.
AGAIN…
• Consider the short run in which capital is fixed but
labor is variable.
• In such a situation, there are diminishing returns
to the variable factor (labor) because each
additional unit of labor has less capital to work
with.
• As a result, the marginal cost of output will rise
because the extra output produced by each extra
labor unit is going down.
• In other words, diminishing returns to the variable
factor will imply an increasing short-run marginal
cost.
How does the firm choose its INPUTS?
• Every firm must decide how to produce its
output.
• Should LG plant in Egypt produce LEDs using
more labour (i.e labour intensive techniques) or
more capital (i.e capital intensive techniques)?
• Should LG plant in Germany produce LEDs
using more labour or more capital?
Assumption
• Firms minimize their costs of production.
• This cost-minimization assumption makes
sense not only for perfectly competitive firms
but for monopolists or even non-profit
organizations like colleges or hospitals.
• It states that the firm should strive to produce
its output at the lowest possible cost and
thereby have the maximum amount of
revenue left over for profits or for other
objectives.
•
• Generally speaking, there are usually many
possible input combinations, not just two.
• But luckily, we don’t have to calculate the cost
of every different combination of inputs in
order to find the one which costs the least.
• HOW? Is there a simple way to find the
least-cost combination?
• YES.
• Start by calculating the marginal product of each
input.
• Then divide the marginal product of each input by
its factor price.
• This gives you the marginal product per dollar of
input.
• The cost-minimizing combination of inputs comes
when the marginal product per dollar of input is
equal for all inputs.
– In other words, the marginal contribution to output of
each dollar’s worth of labor, of land, of oil, and so
forth, must be just the same.
•
•
•
OPPORTUNITY COSTS
• Here, we look at costs from yet another angle.
• Recall!!! One of the principles of economics is that
resources are scarce.
– Meaning that every time we choose to use a resource
one way, we’re giving up the opportunity to utilize it
another way.
• Example: we must constantly decide what to do
with our limited time. Should we go to a movie or
study for next week’s Quiz?
– The dollar cost of going to a movie instead of studying
is the price of a ticket, but the opportunity cost also
includes the possibility of getting a higher grade in the
Quiz!!!
• Here, it is clear that making a choice in effect
costs us, not just its monetary value but also,
the opportunity to do something else.
• The value of the best alternative forgone is
called the opportunity cost.
• Any decision has an opportunity cost because
choosing one thing, in a world of scarcity,
means giving up something else.
Opportunity Costs and Balance Sheets:
• Do all opportunity costs show up on the
balance sheet?
• Not necessarily. Accountants versus
Economists
• Accountants: include transactions in which
money actually changes hands.
• Economists: always try to uncover the real
costs that lie behind the activity.
Examples of important opportunity costs that do not
show up on balance sheets:
• In many small businesses, the family may put in
many unpaid hours, which are not included as
accounting costs.
• Nor do business accounts include a rent charge
for the owner’s apartment used as the firm’s
office.
• Nor do they include the cost of the environmental
damage that occurs when a business dumps toxic
wastes into a stream.
• But from an economic point of view, each of these
is a genuine cost to the economy.
