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COST FUNCTIONS

Reference : Chapter 10 ;Nicholson and Snyder (10 th Edition)

Definitions of Costs
It is important to differentiate between
accounting cost and economic cost
the accountants view of cost stresses outof-pocket expenses, historical costs,
depreciation, and other bookkeeping entries
economists focus more on opportunity cost
Opportunity costs are what could be
obtained by using the input in its best
alternative use

Definitions of Costs
Labour Costs
To both economist and accountants,
labour costs are very much the same
thing: labour costs of production
(hourly wage)

Definitions of Costs
Capital Costs (accountants and
economists differ)
accountants use the historical price of
the capital and apply some
depreciation rule to determine current
costs
the cost of the capital is what someone
else would be willing to pay for its use
(and this is what the firm is forgoing by
using the machine)
we will use v to denote the rental rate for
capital

Definitions of Costs
Costs of Entrepreneurial Services
accountants believe that the owner of a
firm is entitled to all profits
revenues or losses left over after paying all
input costs

economists consider the opportunity


costs of time and funds that owners
devote to the operation of their firms

Example
IT programmer, she does a new software on her
free time and sells it by 5000.
Accounting profits=5000. This seems like a
good project
Economist profits=5000 minus what she could
have earned working for a firm in her time. Might
not seem such a good project any more
part of accounting profits would be considered
as entrepreneurial costs by economists

Economic Cost

The economic cost of any input is the


payment required to keep that input
in its present employment
the remuneration the input would
receive in its best alternative
employment

Another example
A shop owner
If her accounting profits are
smaller than the rental price of the
physical shop, it means that she is
having losses as she could obtain
more money by no running the
shop but renting it
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Two Simplifying Assumptions


There are only two inputs
homogeneous labor (l), measured in
labor-hours
homogeneous capital (k), measured in
machine-hours
entrepreneurial costs are included in capital
costs

Firms cannot influence the input


prices, they are given (they do not
depend on firms decisions on the
inputs to be used)

Economic Profits
Total costs for the firm are given by
total costs = C = wl + vk

Total revenue for the firm is given


by
total revenue = pq = pf(k,l)

Economic profits () are equal to


= total revenue - total cost
= pq - wl - vk
= pf(k,l) - wl - vk
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Economic Profits
Economic profits are a function of
the amount of capital and labor
employed
we could examine how a firm would
choose k and l to maximize profit
We will do later on

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Minimizing costs
For now
we will assume that the firm has
already chosen its output level (q0) and
wants to minimize its costs
We will examine the inputs that the firm will
choose in order to minimize costs but
produce q0 (kind of a compensated
demand)

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Cost-Minimizing Input Choices


Mathematically, we seek to
minimize total costs given q =
f(k,l) = q0
Setting up the Lagrangian:
L = wl + vk + [q0 - f(k,l)]

First order conditions are


L/l = w - (f/l) = 0
L/k = v - (f/k) = 0
L/ = q0 - f(k,l) = 0

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Cost-Minimizing Input
Choices

Dividing the first two conditions we


get
w f / l
v

f / k

RTS (l for k )

The cost-minimizing firm should


equate the RTS for the two inputs
to the ratio of their prices
This is subject to the same
reservations as with utility (if RTS
is strictly decreasing, no corner

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Cost-Minimizing Input
Choices

Cross-multiplying, we get
fk fl

v w

For costs to be minimized, the marginal productivity per dollar


spent should be the same for all inputs
The solution to this minimization problem for an arbitrary level
of output q0 give us the contingent demand functions for
inputs:

lc=lc(w,v,q0); kc=kc(w,v,q0)
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Contingent Demand for


Inputs

The contingent demand for input would be


analogous to the compensated demand
function in consumer theory
Notice that the contingent demand for input is
based on the level of firms output. So, it is a
derived demand.

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Graphically.Cost-Minimizing Input Choices


We fix the isoquant of output q0.
k per period
C1
C3

Costs are represented by


parallel lines with a slope
of -w/v

C2

C1 < C2 < C3
q0

l per period
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Graphically. Cost-Minimizing Input Choices


The minimum cost of producing q0 is C2
This occurs at the
tangency between the
isoquant and the total
cost curve

k per period
C1
C3
C2
k*
q0

l*

The optimal
choice is l*, k*
l per period
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Total Cost Function


The total cost function gives the
minimum cost incurred by the firm
to produce any output level with
given input prices. C = C(v,w,q)
We can compute it as:
C = C(v,w,q)=w*lc(v,w,q)+ v*kc(v,w,q)

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Average Cost Function


The average cost function (AC) is
found by computing total costs per
unit of output
C(v ,w , q )
average cost AC (v ,w , q )
q

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Marginal Cost Function


The marginal cost function (MC) is
found by computing the change in
total costs for a change in output
produced
C(v ,w , q )
marginal cost MC(v ,w , q )
q

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Graphical Analysis of
Total Costs
Suppose that k1 units of capital and
l1 units of labor input are required to
produce one unit of output
C(q=1) = vk1 + wl1

To produce m units of output


(assuming constant returns to scale)
C(q=m) = vmk1 + wml1 = m(vk1 + wl1)
C(q=m) = m C(q=1)

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Graphical Analysis of
Total Costs
Total
costs

With constant returns to scale, total


costs
are proportional to output
AC = MC
C

Both AC and
MC will be
constant
Output
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Graphical Analysis of
Total Costs
Suppose instead that total costs start
out as concave and then becomes
convex as output increases
one possible explanation for this is that
there is a third factor of production that
is fixed as capital and labor usage
expands
total costs begin rising rapidly after
diminishing returns set in
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Graphical Analysis of
Total Costs
Total
costs

Total costs rise


dramatically as
output increases
after diminishing
returns set in
Output
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Graphical Analysis of
Total Costs
Averag
e and
margin
al
costs

MC is the slope of the C curve


MC
AC

min AC

If AC > MC,
AC must be
falling
If AC < MC,
AC must be
rising

Output
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Shifts in Cost Curves


The cost curves are drawn under the
assumption that input prices and the
level of technology are held constant
any change in these factors will cause
the cost curves to shift

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Properties of Cost Functions


1. Homogeneity:
If the input prices are multiplied by
an amount t, the total cost is
multiplied by the same amount
cost minimization requires that the ratio of
input prices be set equal to RTS, a
doubling of all input prices will not change
the levels of inputs purchased

2. Nondecreasing in q, v, and w
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3. Concave in input prices


The cost function increases less than
proportionally when one input price
increases because the firm can
substitute it by other inputs
As the expenditure function in
consumer theory

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TC is concaveity of Cost
Function

The cost function C(v,w1,q1) is concave


in input prices.

Costs

Pseudo Cost
C(v,w,q1)

C(v,w1,q1)

w1

w
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Reaction to input prices increases


If the price of an input increases, the cost
will increase
If firms can easily substitute another input
for the one that has risen in price, there
may be little increase in costs
It is important to measure the substitution
of inputs in order to predict how much
costs will be affected by an increase in the
price of an input (possibly due to a tax
increase)

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Input Substitution
A change in the price of an input will
cause the firm to alter its input mix
We wish to see how k/l changes in
response to a change in w/v, while
holding q constant
k

v
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Input Substitution
Rather than the derivative, we will use the elasticity:

(k / l ) w / v
s

( w / v) k / l
gives an alternative definition of the elasticity of substitution
in the two-input case, s must be nonnegative
large values of s indicate that firms change their input mix
significantly if input prices change. Hence, costs will not
change so much
It can me estimated using econometrics

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Shephards Lemma

Shephards lemma (a trick to obtain


the contingent demand functions
from the cost function)
the contingent demand function for any
input is given by the partial derivative of the
total-cost function with respect to that
inputs price
See example 10.4 in the book
As we obtained the compensated demand
from the expenditure function in consumer
theory
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Short-Run, Long-Run Distinction


Economic actors might not be
completely free to change the amount
of inputs
Economist usually assume that it takes
time to change capital levels, while
labor can be changed quickly
Economist say that the short run is
the period of time in which some of the
inputs cannot be changed
Long-run is when the period of time
when all the inputs can be changed
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Short-Run, Long-Run Distinction


Assume that the capital input is
held constant at k1 and the firm is
free to vary only its labor input
The production function in the
short run becomes
q = f(k1,l)
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Short-Run Total Costs


Short-run total cost for the firm is
SC = vk1 + wl

There are two types of short-run


costs:
short-run fixed costs are costs
associated with fixed inputs (vk1)
short-run variable costs are costs
associated with variable inputs (wl)
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Short-Run Total Costs

In the Short-run:

Cannot decide the amount of fixed inputs. The


firm does not have the flexibility of input
choice
to vary its output in the short run, the firm
must use nonoptimal input combinations
the RTS will not be equal to the ratio of input
prices
Consequently, short-run costs will be equal to
or larger than long-run costs

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Short-Run Total Costs

Because capital is fixed at k1,


the firm cannot equate RTS
with the ratio of input prices.
Notice that short run costs will be
Equal or larger than the
long run cost

k per period

k1

q1

q2

q0
l1

l2

l3

l per period
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Short-Run and Long-Run costs


The short run cost depend on the amount
of fixed capital available
There is no a unique short run cost curve.
There will be as many as possible levels of
capitals are
The short run cost of producing q1 will be
equal to the long run cost when the
available capital in the short run is the
same as the optimal level of capital for the
long run (see q1 and k1 in the previous
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graph).

Short-Run Marginal and


Average Costs
Remember that short run costs are given
by:

SC = vk1 + wl
The short-run average total cost (SAC)
function is
SAC = total costs/total output = SC/q

The short-run marginal cost (SMC) function


is
SMC = change in SC/change in output = SC/q 41

Relationship between ShortRun and Long-Run Costs


SC (k2)

Total
cost
s

SC (k1)
C
SC (k0)

q0

The long-run
C curve is
the minimum of
Short-run ones

q1

q2

Output
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Some Illustrative Cost Functions

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