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CHAPTER 7: Analysis of Costs

Assumption: firm always produces output at the lowestpossible cost

Total Cost = Fixed Cost + Variable Cost

Represents the lowest total dollar expense needed to produceeach level of out put q. TC rises as q rises.

Fixed costs- sometimes called overhead or sunk costs, theyconsist of items such as rent for factory or office space, etc.

This must e paid even if the firm produces no output, and they

do not chan!e even if output chan!es.

Variable costs- are those which vary as output chan!es. "i.e.materials required to produce output#.

$e!ins at % when quantity is %. &art of total cost that !rows with

output.

Marginal cost

'enotes the extra or additional cost of producin! ( extra unit of

output.

)ncremental for a finite-step chan!e in output

*s the cost for infinitesimal chan!e in output measured y the

tan!ent

+lope of the total cost curve

Aerage cost

Total cost divided y the total numer of units produced

* by comparing average cost with price or average revenue,businesses can determine whether or not they are making aprofit.

Aerage cost = total cost!o"t#"t= TC!$=AC

Aerage fixed cost= FC!$

*as firm sells more output, it can spread its overhead cost overmore and more units.

Aerage ariable cost= ariable cost diided by o"t#"t

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AVC=VC!$

* When MC of an added unit of output is below its AC, its AC isdeclining. And, when MC is above AC, AC is increasing. At thepoint where MC euals AC, the AC curve is flat. !or the typical"#shaped AC curve, the point where MC euals AC is also thepoint where AC hits its minimum level.

%ortant R"les:

hen mar!inal cost is elow avera!e cost, it is pullin! avera!e

cost down

hen C is aove *C, it is pullin! *C up

hen C ust equals *C, *C is neither risin! nor fallin! and is at

its minimum. /ence, the ottom of a 0-shaped *C,C1*C1minimum *C.

2irms searchin! for the lowest avera!e cost of production should

look for the level of output at which mar!inal costs equalavera!e costs.

$he AC curve is always pierced at its minimum point by therising MC curve.

'(at deter&ines a fir&)s cost c"re*

price of inputs like laor and land are important factors

influencin! costs. /i!her rents and wa!es mean hi!her cost.

* if technological improvements allow the firm to produce thesame output with fewer inputs, the firm%s cost will fall, and thecost curve will shift down.

* $he relationship between cost and production helps use&plain why average cost curves tend to be "#shaped.

(ort r"n,laor and materials costs are typically variale costs, while

capital costs are fixed.

-ong r"n- all costs are variale and none are fixed.

'(y is t(e cost c"re .,s(a#ed*

Consider the short run in which capital is fixed ut laor is

variale. )n such situation, there are diminishin! returns to

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variale factors "laor# ecause each additional unit of laor hasless capital to work with. *s a result, the mar!inal cost of outputwill rise ecause the extra output produced y each extra laorunit is !oin! down. )n other words, diminishin! returns to thevariale factor will imply an increasin! short-run mar!inal cost.

* assumption: !irms minimi'e their costs of production.

it simply states that the firms should strive to produce itsoutput at the lowest possible cost and thereby have thema&imum amount of revenue left over for profits or forother ob(ectives.

-east,cost co&bination3 start y calculatin! the mar!inal product ofeach input. Then divide the mar!inal product of each input y its factorprice.

$he cost#minimi'ing combination of inputs comes whenthe marginal product per dollar of input is eual for allinputs.

-east,cost r"le3 to produce a !iven level of output at least cost, afirm should uy inputs until it has equali4ed the mar!inal product perdollar spent o each input.

Marginal Prod"ct of -!Price of -=Marginal #rod"ct of A!Price ofA

"bstit"tion R"le3 )f the price of one factor falls while all other factorprices remain the same, firms will profit y sustitutin! the now-cheaper factor for the other factors until the mar!inal products perdollar equal for all inputs.

%nco&e state&ent- statement of profits and loss

5et income"profit#1 total revenue- total expenses

/e#reciation3 measures the annual cost of a capital input that acompany actually own itself.

0alance s(eets- picture of financial conditions on a !ive date.

Assets "valuale properties or ri!hts owned y the firm#

-iabilities"money or oli!ations owed y the firm#

1et 2ort("or net value, equal to total assets minus total liailities#

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toc3- represents the level of a variale

Flo2- represents the chan!e per unit of time

6$he income statement measures the flows into and out of thefirm, while the balance sheet measures the stocks of assets

and liabilities at the end of the accounting year.

Total assets 1 total liailities 7 net worth

1et 2ort(1 assets 8 liailities

4##ort"nity cost

est alternative for!one

value of the most valuale !ood or service for!one.

easure of what has een !iven up when we a make a decision.

* )ead summary and concepts and appendi&

-a2 of /i&inis(ing Ret"rns

*s we increase one input and hold other inputs constant, the mar!inalproduct of the varyin! input will, at least after some point, decline.