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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
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
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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Economic Profits
Total costs for the firm are given by
total costs = C = wl + vk
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
f / k
RTS (l for k )
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Cost-Minimizing Input
Choices
Cross-multiplying, we get
fk fl
v w
lc=lc(w,v,q0); kc=kc(w,v,q0)
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C2
C1 < C2 < C3
q0
l per period
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k per period
C1
C3
C2
k*
q0
l*
The optimal
choice is l*, k*
l per period
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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
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Graphical Analysis of
Total Costs
Total
costs
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
Graphical Analysis of
Total Costs
Averag
e and
margin
al
costs
min AC
If AC > MC,
AC must be
falling
If AC < MC,
AC must be
rising
Output
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2. Nondecreasing in q, v, and w
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TC is concaveity of Cost
Function
Costs
Pseudo Cost
C(v,w,q1)
C(v,w1,q1)
w1
w
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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
In the Short-run:
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k per period
k1
q1
q2
q0
l1
l2
l3
l per period
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SC = vk1 + wl
The short-run average total cost (SAC)
function is
SAC = total costs/total output = SC/q
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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