Partly Based on the Notes Prepared by Fernando Quijano

COSTS OF PRODUCTION AND

THE THEORY OF SUPPLY

Managerial Economics, Lecture 5

Dr. YANG, Nan

Outline
7.1
7.2
7.3
7.4
8.3
8.4
8.5
8.6
8.7
8.8

Measuring Cost: Which Costs Matter?

Costs in the Short Run
Costs in the Long Run
Long-Run versus Short-Run Cost Curves
Marginal Revenue, Marginal Cost, and Profit Maximization
Choosing Output in the Short Run
The Competitive Firms Short-Run Supply Curve
The Short-Run Market Supply Curve
Choosing Output in the Long-Run
The Industrys Long-Run Supply Curve

7.1 Measuring Cost: Which Costs Matter?

Economic Cost versus Accounting Cost

accounting cost
equipment.
economic cost

Actual expenses plus depreciation charges for capital

Cost to a firm of utilizing economic resources in production.

Opportunity Cost
opportunity cost Cost associated with opportunities forgone when a firms
resources are not put to their best alternative use.
Economic cost = Opportunity cost + accounting cost

 Sunk Costs, Fixed Costs and Variable Costs

sunk cost

Expenditure that has been made and cannot be recovered.

Because a sunk cost cannot be recovered, it should not influence the firms
decisions.
total cost (TC or C) Total economic cost of production, consisting
of fixed and variable costs.
fixed cost (FC) Cost that does not vary with the level of output and that can
be eliminated only by shutting down.
variable cost (VC)

Cost that varies as output varies.

MARGINAL COST (MC)

marginal cost (MC) Increase in cost resulting from the production of one
(marginally) extra unit of output.
Fixed cost does not change as the firms level of output changes.
Hence, marginal cost is equal to the increase in variable cost or the
increase in total cost that results from an extra unit of output.
VC

MC

TC

AVERAGE TOTAL COST (ATC)

average total cost (ATC)

Firms total cost divided by its level of output.

average fixed cost (AFC)

Fixed cost divided by the level of output.

average variable cost (AVC)

Variable cost divided by the level of output.

Example: Sunk Cost, Fixed Cost, Variable Cost, and Marginal Cost

Sunk costs: license fee, sanitation

approval, WESTERN FOOD
lampbox, the menu board, etc.
Fixed costs: rent, cooks wage,
owners outside option, etc.
Variable costs: utilities, food
ingredients, second/third cooks
wage, etc.
Marginal costs for a fish n chips:
the fish, the chips, the tartar sauce,
the gas for cooking the dish, etc.
Average costs: divide the relevant
costs by the total number of dishes
sold.

7.2 Costs in the Short Run

The Determinants of Short-Run Cost

Suppose labor is changeable in the short-run. The change in variable cost

is the per-unit cost of the extra labor w times the amount of extra labor
needed to produce the extra output dL.
MC

VC

The extra labor needed to obtain an extra unit of output is dL/dq = 1/MPL. As
a result,
MC

MP

DIMINISHING MARGINAL RETURNS AND MARGINAL COST

Diminishing marginal returns means that the marginal product of labor
declines as the quantity of labor employed increases.
As a result, when there are diminishing marginal returns, marginal cost
will increase as output increases.

(7.1)

 The Shapes of the Cost Curves

FIGURE 7.1
COST CURVES FOR A FIRM

In (a) total cost TC is the

vertical sum of fixed cost
FC and variable cost VC.
In (b) average total cost
ATC is the sum of average
variable cost AVC and
average fixed cost AFC.
Minimum ATC and AVC
is achieved when
ATC=MC, AVC=MC.
When ATC>MC, producing
one unit more incurs MC
and reduces ATC.
When ATC<MC, producing
one unit less saves MC
and reduces ATC.

7.3 Cost in the Long Run

The Cost-Minimizing Input Choice: how to select inputs to produce a given
output at minimum cost. (With the example of two inputs: capital and labor)
Please note the analogs to the consumers problem!
THE PRICE OF CAPITAL AND LABOR
The price of capital is its user cost, given by r = Depreciation rate + Interest rate.
The price of labor is the wage w.
The Isocost Line (budget line)

All combinations of labor and capital that can be purchased for a given cost.
with slope dK/dL = (w/r)
The Production function (utility function), Isoquant Line (indifference curve)

All combinations of labor and capital that can be purchased for a given cost.
,

Choosing Inputs (Determine a optimal consumption bundle)

FIGURE 7.3
PRODUCING A GIVEN
OUTPUT AT MINIMUM COST

Isocost (budget) line C1 is

tangent to isoquant
(indifference) curve q1 at A.
Input price change? Total
cost change?
marginal rate of technical
substitution of labor for
capital (MRTS) (MRS)

MRTS

/
/

MP MP

satisfies

MRTS

MP MP

Cost Minimization with Varying Output Levels

expansion path (income-consumption curve) Curve passing through
points of tangency between a firms isocost lines and its isoquants.

The Expansion Path and Long-Run Costs

To move from the expansion path to the cost curve, we follow three steps:
1. Choose an output level represented by an isoquant. Then find the point of
tangency of that isoquant with an isocost line.
2. From the chosen isocost line, determine the minimum cost of producing
the output level that has been selected.
3. Graph the output-cost combination.

The Expansion Path and Long-Run Costs

FIGURE 7.6
A FIRMS EXPANSION PATH
AND LONG-RUN TOTAL
COST CURVE
expansion path (incomeconsumption curve)
In (a), the expansion path
illustrates the lowest-cost
combinations of labor and
capital that can be used to
produce each level of
output in the long run
In (b), the corresponding
long-run total cost curve
measures the least cost of
producing each level of
output.

7.4 Long-Run versus Short-Run Cost Curves

The Inflexibility of Short-Run Production

FIGURE 7.8
THE INFLEXIBILITY OF
SHORT-RUN PRODUCTION
In the short run, a firms cost of
production may not be
minimized because of
inflexibility of capital inputs.
1. Output is initially at level q1,
(using L1, K1).
2. In the short run, output q2
can be produced only by
increasing labor from L1 to
L3 because capital is fixed
at K1.
3. In the long run, the same
output can be produced
more cheaply by increasing
labor from L1 to L2 and
capital from K1 to K2.

FIGURE 7.9
LONG-RUN AVERAGE AND
MARGINAL COST

Minimum LAC is achieved

when LAC =LMC, LAC
=LMC.
When LAC>LMC, producing
one unit more incurs LMC and
reduces LAC.
When LAC<LMC, producing
one unit less saves LMC and
reduces LAC.
There is no such thing as
long run fixed/variable costs

 Economies and Diseconomies of Scale

As output increases, the firms average cost of producing that output is

likely to decline, at least to a point. This can happen for the following reasons:
1. Workers can specialize in the activities at which they are most productive.
2. Scale can provide flexibility.
3. Bigger purchasing power when buying input in large quantities

economies of scale Situation in which output can be doubled for

less than a doubling of cost.

Wal-Mart, the US retailer taking over the world by stealth, The Guardian, 2010.
Wal-Mart's founder, Sam Walton, opened a discount store in 1951. a retail
empire that spans 8,100 stores in 15 countries generating $401bn of revenue
annually. Four of America's 10 richest individuals are from Wal-Mart's lowprofile Walton family.
Wal-Mart's executives say the company is "saving people money so they can live
better.
"With the scale the company has, the economies of scale it can command, it
basically extracts every last nickel out of its suppliers."

The Diffusion of Wal-Mart

and Economies of Density.
Thomas Holmes (Univ. of
Minnesota)

 On the one hand, on the other

At some point, however, it is likely that the average cost of production

will begin to increase with output. This can happen for the following reasons:
1. Managing a larger firm may become complex and inefficient.
2. The advantages of buying in bulk may be disappearing. At some point,
available supplies of key inputs may be limited, pushing their costs up.
3. Financing costs-liquidity.

diseconomies of scale Situation in which a doubling of output requires

more than a doubling of cost.

Expansion pushed Digital Domain from Titanic to bankruptcy, Rueters, 2011

Digital Domain Media's filing for bankruptcy protection on Tuesday (DDM)
started when James Cameron launched the special effects powerhouse for his
film "Titanic. The company, which created special effects for this summer's
blockbuster "The Avengers" and the "Transformers" (in two years) agreed to
finance a Hollywood film, open an animation studio, help run studios in Abu
Dhabi and China, and to create a college in Florida to award four-year
animation degrees.
"The problem is that the investments were costing more than they were able to
bring in."

7.5 Production with Two OutputsEconomies of Scope

economies of scope Situation in which joint output of a single firm
is greater than output that could be achieved by two different firms when each
produces a single product.
diseconomies of scope Situation in which joint output of a single firm is
less than could be achieved by separate firms when each produces a single
product.
Bundling and Nonlinear Pricing in Telecommunications, LUO Yao (UToronto)
Bundling land line telephone and ADSL internet saves costs for the service
provider (signals transmitted in a same cable).
Using data from the China Telecom, Luo estimates the cost saving for
bundling1Mbps internet with phone to be 2.60 CNY/month, for 2 Mbps 3.27
CNY/month.
Such cost complementarity also appears in cable TV (production technology),
financial services (synergy of human resources), etc..

8.3 Marginal Revenue, Marginal Cost, and Profit Maximization

profit

Difference between total revenue and total cost.

(q) = R(q) C(q)

marginal revenue
output.

Change in revenue resulting from a one-unit increase in

FIGURE 8.1
PROFIT MAXIMIZATON IN
THE SHORT RUN
A firm chooses output q*, so that
profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve) is
equal to marginal cost (the slope
of the cost curve).

d/dq = dR/dq dC/dq = 0

MR(q) = MC(q)

Demand and Marginal Revenue for a Competitive Firm

FIGURE 8.2
DEMAND CURVE FACED BY A COMPETITIVE FIRM
A competitive firm takes the market price of the product as given, choosing its output
on the assumption that the price will be unaffected by the output choice.
In (a) the demand curve facing the firm is perfectly elastic,
even though the market demand curve in (b) is downward sloping.

The demand curve d facing an individual firm in a competitive market is

both its average revenue curve and its marginal revenue curve. Along this
demand curve, marginal revenue, average revenue, and price are all equal.

Profit Maximization by a Competitive Firm

A perfectly competitive firm should choose its output so that marginal cost
equals price:
MC(q) = MR = P
When MC<MR, producing one more unit costs MC more but leads to an
increase of MR on revenue. So, further production increases profit.
When MC>MR, producing one less unit saves MC on costs and leads to a loss
of MR on revenue. So, refraining from production increases profit.
12,

10,

4 ,

12

3,

Open for thanksgiving?

Holiday shopping marathon starts as consumer sentiment shaky, Rueters, 2012
This year, Target Corp has joined Wal-Mart and Gap Inc in being open at least part
of the day, and some retailers will be open throughout the day, a trend that began
to take hold in 2011.
"It's a finite pie - if you can get a bit more by being open, then do it," O'Shea (a
Moodys senior analyst) said.
But crowds were thin at the flagship Lord & Taylor on 5th Avenue, where workers
voluntarily signed up for holiday shifts for an extra compensation day and holiday
pay.

8.4 Choosing Output in the Short Run

Short-Run Profit Maximization by a Competitive Firm
FIGURE 8.3
A COMPETITIVE FIRM
MAKING A POSITIVE
PROFIT

In the short run, the

competitive firm
maximizes its profit by
choosing q* at which
marginal cost MC is
equal to the price P (or
marginal revenue MR).
The profit of the firm is
measured by the
rectangle ABCD.
Any change in output,
whether lower at q1 or
higher at q2, will lead to
lower profit.

Output Rule: MC = MR

8.5 The Competitive Firms Short-run Supply Curve

The firms supply curve is the portion of the marginal cost curve for which
marginal cost is greater than average variable cost.

FIGURE 8.6
THE SHORT-RUN SUPPLY
CURVE FOR A COMPETITIVE
FIRM
In the short run, the firm
chooses its output so that
marginal cost MC is equal to
price as long as the firm
covers its average variable
cost.
The short-run supply curve is
given by the crosshatched
portion of the marginal cost
curve.

8.6 The Short-Run Market Supply Curve

FIGURE 8.9
INDUSTRY SUPPLY IN THE
SHORT RUN
The short-run industry supply
curve is the sum of the supply
curves of individual firms.
The third firm has a lower
average variable cost curve
than the first two firms.
The market supply curve S
begins at price P1 and
follows the marginal cost
curve of the third firm MC3
until price equals P2, when
the other two join.
For P2 and all prices above
it, the industry quantity
supplied is the sum of the
quantities supplied by each
of the three firms.

8.7 Choosing Output in the Long Run

Long-Run Profit Maximization
FIGURE 8.13
OUTPUT CHOICE IN THE
LONG RUN
The firm maximizes its profit
by choosing the output at
which price equals long-run
marginal cost LMC.
In the diagram, the firm
increases its profit from
ABCD to EFGD by
increasing its output in the
long run.

The long-run output of a profit-maximizing competitive firm is the point at which

long-run marginal cost equals the price.

Long-Run Competitive Equilibrium

ACCOUNTING PROFIT AND ECONOMIC PROFIT
Economic profit takes into account opportunity costs. One such opportunity cost
is the return to the firms owners if their capital were used elsewhere. Accounting
profit equals revenues R minus labor cost wL, which is positive. Economic profit
, however, equals revenues R minus labor cost wL minus the capital cost, rk.
= R wL rK
ZERO ECONOMIC PROFIT
zero economic profit A firm is earning a normal return on its investment
i.e., it is doing as well as it could by investing its money elsewhere.
ENTRY AND EXIT
In a market with entry and exit, a firm enters when it can earn a positive longrun profit and exits when it faces the prospect of a long-run loss.

 long-run competitive equilibrium All firms in an industry are

maximizing profit, no firm has an incentive to enter or exit, and price is
such that quantity supplied equals quantity demanded.
When a firm earns zero economic profit, it has no incentive to exit the industry.
Likewise, other firms have no special incentive to enter.
A long-run competitive equilibrium occurs when three conditions hold:
1. All firms in the industry are maximizing profit.
2. No firm has an incentive either to enter or exit the industry because all
firms are earning zero economic profit.
3. The price of the product is such that the quantity supplied by the
industry is equal to the quantity demanded by consumers.

FIGURE 8.14
LONG-RUN COMPETITIVE
EQUILIBRIUM

Initially the long-run equilibrium

price of a product is $40 per unit
(Figure (b)).
In (a) we see that firms earn
positive profits because long-run
average cost reaches a minimum
of $30 (at q2).
Positive profit encourages entry of
new firms and causes a shift to
the right in the supply curve to S2,
as shown in (b).
The long-run equilibrium occurs at
a price of $30, as shown in (a),
where each firm earns zero profit
and there is no incentive to enter
or exit the industry.

Easy money or not?

Casino competition hots up, can S'pore IRs take the heat?, ChannelNewsAsia, 2007
luxury casino complexes coming up in Tokyo and the southern island region of
Okinawa by 2012, as Japan moves closer to an overhaul of its strict gambling laws.
Taiwan is also considering lifting its ban on casinos, while Thailand is also seen as
likely to relax its gaming laws in the coming years Closer to home, theres Genting
in Malaysia and sister companys Star Cruises vessels with casinos on board which
ply to Singapore. Goa, too, has a number of gambling ships
Singapore set to become second largest Asia-Pacific casino market, CNA, 2011
(PricewaterhouseCoopers) predicted that Singapore would overtake South Korea and
Australia this year to become the second-largest Asia-Pacific casino market behind
traditional leader Macau.
Singapores Casinos Lose Luster as Gaming Revenue Decline, Bloomberg, 2012
Genting Singapore Plc and Las Vegas Sands Corp. reported the lowest gaming
revenue in at least 18 months at their Singapore casinos

8.8 The Industrys Long-Run Supply Curve

Constant-Cost Industry
constant-cost industry

Industry whose long-run supply curve is horizontal.

FIGURE 8.16
LONG-RUN SUPPLY IN A
CONSTANT COST INDUSTRY
In (b), the long-run supply
curve in a constant-cost
industry is a horizontal line SL.
When demand increases,
initially causing a price rise,
the firm initially increases
its output from q1 to q2 (a).
But the entry of new firms
causes a shift to the right in
industry supply.
Because input prices are
unaffected by the increased
output of the industry, entry
occurs until the original
price is obtained (at point B
in (b)).

The long-run supply curve for a constant-cost industry is,

therefore, a horizontal line at a price that is equal to the
long-run minimum average cost of production.

Increasing-Cost Industry
increasing-cost industry Industry whose long-run supply curve is upward sloping.

FIGURE 8.17
LONG-RUN SUPPLY IN AN
INCREASING COST INDUSTRY
In (b), the long-run supply
curve in an increasing-cost
industry is an upward-sloping
curve SL.
When demand increases,
initially causing a price rise,
the firms increase their
output from q1 to q2 in (a).
The entry of new firms
causes a shift to the right in
supply from S1 to S2.
Because input prices
increase as a result, the
new long-run equilibrium
occurs at a higher price
than the initial equilibrium.

In an increasing-cost industry, the long-run

industry supply curve is upward sloping.

Decreasing-Cost Industry
decreasing-cost industry
downward sloping.

Industry whose long-run supply curve is

Intel co-founder Gordon Moores Moore's Law, states that the number
of transistors on a chip will double approximately every two years.