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Measuring Cost: Which Costs Matter?:Cost in the Short Run

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Microeconomics ­ECO402
VU
­
Lesson 18
Introduction
The production technology measures the relationship between input and output.
Given the production technology, managers must choose how to produce.
To determine the optimal level of output and the input combinations, we must convert from
the unit measurements of the production technology to dollar measurements or costs.
Measuring Cost: Which Costs Matter?
Accounting Cost vs. Economic Cost
­ Accounting Cost
·  Actual expenses plus depreciation charges for capital equipment
­ Economic Cost
·  Cost to a firm of utilizing economic resources in production, including opportunity cost
Opportunity cost.
­ Cost associated with opportunities that are foregone when a firm's resources are not put
to their highest-value use.
An Example
­ A firm owns its own building and pays no rent for office space
­ Does this mean the cost of office space is zero?
Sunk Cost
­ Expenditure that has been made and cannot be recovered
­ Should not influence a firm's decisions.
An Example
­ A firm pays $500,000 for an option to buy a building.
­ The cost of the building is $5 million or a total of $5.5 million.
­ The firm finds another building for $5.25 million.
­ Which building should the firm buy?
Fixed and Variable Costs
­ Total output is a function of variable inputs and fixed inputs.
­ Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs)
plus the variable cost (the cost of the variable inputs), or...
TC = FC + VC
­ Fixed Cost
·  Does not vary with the level of output
­ Variable Cost
·  Cost that varies as output varies
Fixed Cost
­ Cost paid by a firm that is in business regardless of the level of output
Sunk Cost
­ Cost that have been incurred and cannot be recovered
Personal Computers: most costs are variable
­ Components, labor
Software: most costs are sunk
­ Cost of developing the software
92
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Microeconomics ­ECO402
VU
Pizza
­ Largest cost component is fixed
A Firm's Short-Run Costs ($)
Rate
Fixed
Variable Total
Marginal Average
Average
Average
of
cost
cost
cost
cost
fixed
variable
total
output FC
VC
TC
MC
cost
cost
cost
AFC
AVC
ATC
0
50
0
50
1
50
50
100
50
50
50
100
2
50
78
128
28
25
39
64
3
50
98
148
20
16.5
32.7
49.3
4
50
112
162
14
12.5
28
40.5
5
50
130
180
18
10
26
36
6
50
150
200
20
8.3
25
33.3
7
50
175
225
25
7.1
25
32.1
8
50
204
254
29
6.3
25.5
31.8
9
50
242
292
38
5.6
26.9
32.4
10
50
300
350
58
5
30
35
11
50
385
435
85
4.5
35
39.5
Cost in the Short Run
Marginal Cost (MC) is the cost of expanding output by one unit. Since fixed costs have no
impact on marginal cost, it can be written as:
Δ VC
Δ TC
=
=
MC
ΔQ
ΔQ
Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus
average variable cost (AVC). This can be written:
TFC
TVC
=
+
ATC
Q
Q
Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus
average variable cost (AVC). This can be written:
TC
ATC = AFC + AVC or
Q
The Determinants of Short-Run Cost
­ The relationship between the production function and cost can be exemplified by either
increasing returns and cost or decreasing returns and cost.
­ Increasing returns and cost
·With increasing returns, output is increasing relative to input and variable cost and total cost
will fall relative to output.
­ Decreasing returns and cost
·With decreasing returns, output is decreasing relative to input and variable cost and total cost
will rise relative to output.
For Example: Assume the wage rate (w) is fixed relative to the number of workers hired.
Then:
ΔVC
MC =
ΔQ
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Microeconomics ­ECO402
VU
VC = wL
wΔL
MC =
ΔQ
ΔQ
ΔMPL =
ΔL
ΔL
1
ΔL for a 1 unit ΔQ =
=
ΔQ
ΔMPL
In conclusion:
w
MC =
MPL
94
Table of Contents:
  1. ECONOMICS:Themes of Microeconomics, Theories and Models
  2. Economics: Another Perspective, Factors of Production
  3. REAL VERSUS NOMINAL PRICES:SUPPLY AND DEMAND, The Demand Curve
  4. Changes in Market Equilibrium:Market for College Education
  5. Elasticities of supply and demand:The Demand for Gasoline
  6. Consumer Behavior:Consumer Preferences, Indifference curves
  7. CONSUMER PREFERENCES:Budget Constraints, Consumer Choice
  8. Note it is repeated:Consumer Preferences, Revealed Preferences
  9. MARGINAL UTILITY AND CONSUMER CHOICE:COST-OF-LIVING INDEXES
  10. Review of Consumer Equilibrium:INDIVIDUAL DEMAND, An Inferior Good
  11. Income & Substitution Effects:Determining the Market Demand Curve
  12. The Aggregate Demand For Wheat:NETWORK EXTERNALITIES
  13. Describing Risk:Unequal Probability Outcomes
  14. PREFERENCES TOWARD RISK:Risk Premium, Indifference Curve
  15. PREFERENCES TOWARD RISK:Reducing Risk, The Demand for Risky Assets
  16. The Technology of Production:Production Function for Food
  17. Production with Two Variable Inputs:Returns to Scale
  18. Measuring Cost: Which Costs Matter?:Cost in the Short Run
  19. A Firm’s Short-Run Costs ($):The Effect of Effluent Fees on Firms’ Input Choices
  20. Cost in the Long Run:Long-Run Cost with Economies & Diseconomies of Scale
  21. Production with Two Outputs--Economies of Scope:Cubic Cost Function
  22. Perfectly Competitive Markets:Choosing Output in Short Run
  23. A Competitive Firm Incurring Losses:Industry Supply in Short Run
  24. Elasticity of Market Supply:Producer Surplus for a Market
  25. Elasticity of Market Supply:Long-Run Competitive Equilibrium
  26. Elasticity of Market Supply:The Industry’s Long-Run Supply Curve
  27. Elasticity of Market Supply:Welfare loss if price is held below market-clearing level
  28. Price Supports:Supply Restrictions, Import Quotas and Tariffs
  29. The Sugar Quota:The Impact of a Tax or Subsidy, Subsidy
  30. Perfect Competition:Total, Marginal, and Average Revenue
  31. Perfect Competition:Effect of Excise Tax on Monopolist
  32. Monopoly:Elasticity of Demand and Price Markup, Sources of Monopoly Power
  33. The Social Costs of Monopoly Power:Price Regulation, Monopsony
  34. Monopsony Power:Pricing With Market Power, Capturing Consumer Surplus
  35. Monopsony Power:THE ECONOMICS OF COUPONS AND REBATES
  36. Airline Fares:Elasticities of Demand for Air Travel, The Two-Part Tariff
  37. Bundling:Consumption Decisions When Products are Bundled
  38. Bundling:Mixed Versus Pure Bundling, Effects of Advertising
  39. MONOPOLISTIC COMPETITION:Monopolistic Competition in the Market for Colas and Coffee
  40. OLIGOPOLY:Duopoly Example, Price Competition
  41. Competition Versus Collusion:The Prisoners’ Dilemma, Implications of the Prisoners
  42. COMPETITIVE FACTOR MARKETS:Marginal Revenue Product
  43. Competitive Factor Markets:The Demand for Jet Fuel
  44. Equilibrium in a Competitive Factor Market:Labor Market Equilibrium
  45. Factor Markets with Monopoly Power:Monopoly Power of Sellers of Labor