Chapter - 7 Cost of Production

Chapter 7
The Cost of
Production
Topics to be Discussed
Measuring Cost: Which Costs Matter?
Cost in the Short Run
Cost in the Long Run
Long-Run Versus Short-Run Cost

Curves
Chapter 7
Slide 2
Topics to be Discussed
Production with Two Outputs-Economies of Scope
Dynamic Changes in Costs--The

Learning Curve
Estimating and Predicting Cost
Chapter 7
Slide 3
Introduction
The production technology measures

the relationship between input and
output.
Given the production technology,

managers must choose how to
produce.
Chapter 7
Slide 4
Introduction
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.
Chapter 7
Slide 5
Measuring Cost:
Which Costs Matter?
Economic
Economic Cost
Cost vs.
vs. Accounting
Accounting Cost
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
Chapter 7
Slide 6
Measuring Cost:
Which Costs Matter?
Opportunity cost.
Cost
associated with opportunities that

are foregone when a firms resources
are not put to their highest-value use.
Chapter 7
Slide 7
Measuring Cost:
Which Costs Matter?
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?
Chapter 7
Slide 8
Measuring Cost:
Which Costs Matter?
Sunk Cost
Expenditure
that has been made and

cannot be recovered
Should
Chapter 7
not influence a firms decisions.
Slide 9
Measuring Cost:
Which Costs Matter?
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
Chapter 7
building should the firm buy?
Slide 10
Choosing the Location

for a New Law School Building
Northwestern University Law School

1) Current location in downtown
Chicago
2) Alternative location in Evanston
with the main campus
Chapter 7
Slide 11


3) Choosing a Site
Chapter 7
Land owned in Chicago
Must purchase land in Evanston
Chicago location might appear

cheaper without considering the
opportunity cost of the downtown land
(i.e. what it could be sold for)
Slide 12


3) Choosing a Site
Chapter 7
Chicago location chosen--very costly
Justified only if there is some intrinsic

values associated with being in Chicago
If not, it was an inefficient decision if it

was based on the assumption that the
downtown land was free
Slide 13
Measuring Cost:
Which Costs Matter?
Fixed
Fixed and
and Variable
Variable Costs
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
Chapter 7
Slide 14
Measuring Cost:
Which Costs Matter?
Fixed
Fixed and
and Variable
Variable Costs
Costs
Fixed Cost
Does
not vary with the level of output
Variable Cost
Cost
Chapter 7
that varies as output varies
Slide 15
Measuring Cost:
Which Costs Matter?
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
Chapter 7
Slide 16
Measuring Cost:
Which Costs Matter?
Personal
Computers: most costs

are variable
Components,
Software:
Cost
Chapter 7
labor
most costs are sunk
of developing the software
Slide 17
Measuring Cost:
Which Costs Matter?
Pizza
Largest
Chapter 7
cost component is fixed
Slide 18
A Firms Short-Run Costs ($)

Rate of
Output
Fixed
Cost
(FC)
050
150
250
350
450
550
650
750
850
950
1050
1150
0
50
78
98
112
130
150
175
204
242
300
385
Variable
Cost
(VC)
50--10050
12828
14820
16214
18018
20020
22525
25429
29238
35058
43585
Total
Cost
(TC)
-----5050
2539
16.732.7
12.528
1026
8.325
7.125
6.325.5
5.626.9
530
4.535
Marginal
Cost
(MC)
--100
64
49.3
40.5
36
33.3
32.1
31.8
32.4
35
39.5
Average
Fixed
Cost
(AFC)
Average
Variable
Cost
(AVC)
Average
Total
Cost
(ATC)
Marginal Cost (MC) is the cost of

expanding output by one unit. Since
fixed cost have no impact on marginal
cost, it can be written as:
VC TC
MC
Q
Q
Chapter 7
Slide 20
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
Chapter 7
Slide 21
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
Chapter 7
Slide 22
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.
Chapter 7
Slide 23
The Determinants of Short-Run 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.
Chapter 7
Slide 24
For Example: Assume the wage rate

(w) is fixed relative to the number of
workers hired. Then:
VC
MC
Q
VC wL
Chapter 7
Slide 25
Continuing:
VC wL
wL
MC
Q
Chapter 7
Slide 26
Continuing:
Q
MPL
L
L
1
L for a 1 unit Q
Q MPL
Chapter 7
Slide 27
In conclusion:
w
MC
MPL
and a low marginal product (MP)

leads to a high marginal cost (MC)
and vise versa.
Chapter 7
Slide 28
Consequently (from the table):

MC
decreases initially with increasing

returns
0 through 4 units of output
MC
Chapter 7
increases with decreasing returns
5 through 11 units of output
Slide 29
Biaya jangka pendek suatu perusahaan

(Rp)
Rate of
Output
Fixed
Cost
(FC)
050
150
250
350
450
550
650
750
850
950
1050
1150
0
50
78
98
112
130
150
175
204
242
300
385
Variable
Cost
(VC)
50--10050
12828
14820
16214
18018
20020
22525
25429
29238
35058
43585
Total
Cost
(TC)
-----5050
2539
16.732.7
12.528
1026
8.325
7.125
6.325.5
5.626.9
530
4.535
Marginal
Cost
(MC)
--100
64
49.3
40.5
36
33.3
32.1
31.8
32.4
35
39.5
Average
Fixed
Cost
(AFC)
Average
Variable
Cost
(AVC)
Average
Total
Cost
(ATC)
Cost Curves for a Firm

Total cost
is the vertical
sum of FC
and VC.
Cost 400
($ per
year)
TC
VC
Variable cost
increases with
production and
the rate varies with
increasing &
decreasing returns.
300
200
Fixed cost does not

vary with output
100
50
0
Chapter 7
10
11
12
FC
13
Slide 31
Output

Cost
($ per
unit)
100
MC
75
50
ATC
AVC
25
AFC
0
Chapter 7
10
11
Output (units/yr.)
Slide 32
The line drawn from

the origin to the
tangent of the
variable cost curve:
Its slope equals AVC
The slope of a point

on VC equals MC
Therefore, MC = AVC
at 7 units of output
(point A)
400
VC
300
200
A
100
Chapter 7
TC
FC
1
10
11
12
Slide 33
13
Output
Unit Costs
AFC
falls
continuously
MC < AVC or
MC < ATC, AVC &
ATC decrease
Cost
($ per
unit)
100
MC
75
When
When
MC > AVC or
MC > ATC, AVC &
ATC increase
Chapter 7
50
ATC
AVC
25
AFC
0
10
11
Output (units/yr.)
Slide 34
Unit Costs
MC
= AVC and ATC

at minimum AVC and
ATC
Minimum
AVC
occurs at a lower
output than minimum
ATC due to FC
Cost
($ per
unit)
100
MC
75
50
ATC
AVC
25
AFC
0
10
11
Output (units/yr.)
Chapter 7
Slide 35
Operating Costs for Aluminum Smelting

($/Ton - based on an output of 600 tons/day)
Variable costs that are constant at all output levels
Electricity
Alumina
Other raw materials
Plant power and fuel
Subtotal
Chapter 7
$316
369
125
10
$820
Slide 36
Operating Costs for Aluminum Smelting

($/Ton - based on an output of 600 tons/day)
Variable costs that increase when output exceeds 600 tons/day
Labor
Maintenance
Freight
Subtotal
Total operating costs
Chapter 7
$150
120
50
$320
$1140
Slide 37
The Short-Run Variable

Costs of Aluminum Smelting
Cost
($ per ton)
1300
MC
1200
1140
AVC
1100
300
Chapter 7
600
900
Output (tons/day)
Slide 38

The
The User
User Cost
Cost of
of Capital
Capital
User Cost of Capital = Economic

Depreciation + (Interest Rate)(Value
of Capital)
Chapter 7
Slide 39

The
The User
User Cost
Cost of
of Capital
Capital
Example
Delta
buys a Boeing 737 for $150 million

with an expected life of 30 years
Chapter 7
Annual economic depreciation =

$150 million/30 = $5 million
Interest rate = 10%

Slide 40

The
The User
User Cost
Cost of
of Capital
Capital
Example
User
Cost of Capital = $5 million + (.10)

($150 million depreciation)
Chapter 7
Year 1 = $5 million +
million) = $20 million
(.10)($150
Year 10 = $5 million +
million) = $15 million
(.10)($100
Slide 41

The
The User
User Cost
Cost of
of Capital
Capital
Rate per dollar of capital

r
Chapter 7
= Depreciation Rate + Interest Rate
Slide 42

The
The User
User Cost
Cost of
of Capital
Capital
Airline Example
Depreciation
Rate
Rate = 1/30 = 3.33/yr
of Return = 10%/yr
User Cost of Capital

r
Chapter 7
= 3.33 + 10 = 13.33%/yr
Slide 43

The
The Cost
Cost Minimizing
Minimizing Input
Input Choice
Choice
Assumptions
Two
Inputs: Labor (L) & capital (K)
Price
The
Chapter 7
of labor: wage rate (w)
price of capital
R = depreciation rate + interest rate
Slide 44

The
The
User
Cost
Input
The
TheCost
Cost
UserMinimizing
Minimizing
Cost of
of Capital
Capital
Input Choice
Choice
Question
If
capital was rented, would it change the

value of r ?
Chapter 7
Slide 45

The
The
User
Cost
Input
The
TheCost
Cost
UserMinimizing
Minimizing
Cost of
of Capital
Capital
Input Choice
Choice
The Isocost Line

C
= wL + rK
Isocost:
A line showing all combinations

of L & K that can be purchased for the
same cost
Chapter 7
Slide 46

The
The Isocost
Isocost Line
Line
Rewriting C as linear:
K
= C/r - (w/r)L
Slope
Chapter 7
of the isocost:
is the ratio of the wage rate to rental cost of

capital.
This shows the rate at which capital can be

substituted for labor with no change in cost.
Slide 47
Choosing Inputs
We will address how to minimize cost

for a given level of output.
We
will do so by combining isocosts with

isoquants
Chapter 7
Slide 48
Producing a Given
Output at Minimum Cost
Capital
per
year
Q1 is an isoquant
for output Q1.
Isocost curve C0 shows
all combinations of K and L
that can produce Q1 at this
cost level.
K2
Isocost C2 shows quantity

Q1 can be produced with
combination K2L2 or K3L3.
However, both of these
are higher cost combinations
than K1L1.
CO C1 C2 are
three
isocost lines
K1
Q1
K3
C0
L2
Chapter 7
L1
C1
L3
C2
Labor per year
Slide 49
Input Substitution When

an Input Price Change
Capital
per
year
If the price of labor

changes, the isocost curve
becomes steeper due to
the change in the slope -(w/L).
This yields a new combination

of K and L to produce Q1.
Combination B is used in place
of combination A.
The new combination represents
the higher cost of labor relative
to capital and therefore capital
is substituted for labor.
K2
K1
Q1
C2
L2
Chapter 7
L1
C1
Labor per year
Slide 50
Isoquants and Isocosts and the

Production Function
MRTS - K
MPL
Slope of isocost line K

and MPL
Chapter 7
MPK
MPK
r
Slide 51
The minimum cost combination can

then be written as:
MPL
MPK
Minimum
cost for a given output will

occur when each dollar of input added to
the production process will add an
equivalent amount of output.
Chapter 7
Slide 52
Question
If
w = $10, r = $2, and MPL = MPK,

which input would the producer use
more of? Why?
Chapter 7
Slide 53
The Effect of Effluent

Fees on Firms Input Choices
Firms that have a by-product to

production produce an effluent.
An effluent fee is a per-unit fee that

firms must pay for the effluent that
they emit.
How would a producer respond to an

effluent fee on production?
Chapter 7
Slide 54

The Scenario: Steel Producer

1) Located on a river: Low cost
transportation and emission
disposal (effluent).
2) EPA imposes a per unit effluent
fee to reduce the environmentally
harmful effluent.
Chapter 7
Slide 55

The Scenario: Steel Producer

3) How should the firm respond?
Chapter 7
Slide 56
The Cost-Minimizing
Response
to
an
Effluent
Fee
Capital
(machine
hours per
month)
5,000
Slope of
isocost = -10/40
= -0.25
4,000
3,000
2,000
1,000
0
Chapter 7
Output of 2,000
Tons of Steel per Month
5,000
10,000 12,000 18,000
20,000
Waste Water
(gal./month)
Slide 57
The Cost-Minimizing
Response
to
an
Effluent
Fee
Capital
(machine
hours per
month)
Slope of
isocost = -20/40
= -0.50
5,000
F
4,000
3,500
Prior to regulation the

firm chooses to produce
an output using 10,000
gallons of water and 2,000
machine-hours of capital at A.
Following the imposition

of the effluent fee of $10/gallon
the slope of the isocost changes
which the higher cost of water to
capital so now combination B
is selected.
3,000
2,000
1,000
E
0
Chapter 7
5,000
Output of 2,000
Tons of Steel per Month
10,000 12,000 18,000
20,000
Waste Water
(gal./month)
Slide 58

Observations:
The
more easily factors can be

substituted, the more effective the fee is
in reducing the effluent.
The
greater the degree of substitutes,

the less the firm will have to pay (for
example: $50,000 with combination B
instead of $100,000 with combination A)
Chapter 7
Slide 59
Cost minimization with Varying Output

Levels
A firms
expansion path shows the

minimum cost combinations of labor and
capital at each level of output.
Chapter 7
Slide 60
A Firms Expansion Path

Capital
per
year
The expansion path illustrates

the least-cost combinations of
labor and capital that can be
used to produce each level of
output in the long-run.
150 $3000 Isocost Line
100
Expansion Path
$2000
Isocost Line
C
75
B
50
300 Unit Isoquant
A
25
200 Unit
Isoquant
50
Chapter 7
100
150
200
300
Labor per year

Slide 61
A Firms Long-Run Total Cost Curve

Cost
per
Year
Expansion Path
F
3000
E
2000
1000
100
Chapter 7
200
300
Output, Units/yr
Slide 62
Long-Run Versus
Short-Run Cost Curves
What happens to average costs when

both inputs are variable (long run)
versus only having one input that is
variable (short run)?
Chapter 7
Slide 63
The Inflexibility of
Short-Run Production
E
Capital
per
year
The long-run expansion

path is drawn as before..
Long-Run
Expansion Path
A
K2
Short-Run
Expansion Path
K1
Q2
Q1
L1
Chapter 7
L2
L3
F
Labor per year
Slide 64
Long-Run Versus
Long-Run Average Cost (LAC)

Constant
Chapter 7
Returns to Scale
If input is doubled, output will double

and average cost is constant at all
levels of output.
Slide 65
Long-Run Versus

Increasing
Chapter 7
Returns to Scale
If input is doubled, output will more

than double and average cost
decreases at all levels of output.
Slide 66
Long-Run Versus

Decreasing
Chapter 7
Returns to Scale
If input is doubled, the increase in

output is less than twice as large and
average cost increases with output.
Slide 67
Long-Run Versus

In
Chapter 7
the long-run:
Firms experience increasing and
decreasing returns to scale and
therefore long-run average cost is U
shaped.
Slide 68
Long-Run Versus

Long-run
marginal cost leads long-run

average cost:
Chapter 7
If LMC < LAC, LAC will fall
If LMC > LAC, LAC will rise
Therefore, LMC = LAC at the

minimum of LAC
Slide 69
Long-Run Average
and Marginal Cost
Cost
($ per unit
of output
LMC
LAC
Output
Chapter 7
Slide 70
Long-Run Versus
Question
What
is the relationship between longrun average cost and long-run marginal

cost when long-run average cost is
constant?
Chapter 7
Slide 71
Long-Run Versus
Economies and Diseconomies of

Scale
Economies
of Scale
Increase in output is greater than the

increase in inputs.
Diseconomies
Chapter 7
of Scale
Increase in output is less than the

increase in inputs.
Slide 72
Long-Run Versus
Measuring Economies of Scale
Ec Cost output elasticity

% in cost from a 1% increase
in output
Chapter 7
Slide 73
Long-Run Versus
Measuring Economies of Scale
Ec (C / C ) /( Q / Q)
Ec (C / Q) /(C / Q) MC/AC
Chapter 7
Slide 74
Long-Run Versus
Therefore, the following is true:

EC
EC
< 1: MC < AC
Average cost indicate decreasing economies
of scale
= 1: MC = AC
Average cost indicate constant economies of
scale
EC >
Chapter 7
1: MC > AC
Average cost indicate increasing diseconomies

of scale
Slide 75
Long-Run Versus
The Relationship Between Short-Run

and Long-Run Cost
We
will use short and long-run cost to

determine the optimal plant size
Chapter 7
Slide 76
Long-Run Cost with

Constant Returns to Scale
Cost
($ per unit
of output
With many plant sizes with SAC = $10

the LAC = LMC and is a straight line
SAC1
SAC2
SMC1
SMC2
SAC3
SMC3
LAC =
LMC
Q1
Chapter 7
Q2
Q3
Output
Slide 77
Long-Run Cost with

Observation
The
optimal plant size will depend on the

anticipated output (e.g. Q1 choose SAC1,etc).
The
long-run average cost curve is the

envelope of the firms short-run average cost
curves.
Question
What
would happen to average cost if an output

level other than that shown is chosen?
Chapter 7
Slide 78
Long-Run Cost with Economies

and Diseconomies of Scale
Cost
($ per unit
of output
SAC1
SAC3
SAC2
$10
$8
B
SMC1
SMC3
LMC
SMC2
Q1
Chapter 7
LAC
If the output is Q1 a manager

would chose the small plant
SAC1 and SAC $8.
Point B is on the LAC because
it is a least cost plant for a
given output.
Output
Slide 79
Long-Run Cost with

What is the firms long-run cost

curve?
Firms
can change scale to change

output in the long-run.
The
long-run cost curve is the dark blue

portion of the SAC curve which
represents the minimum cost for any
level of output.
Chapter 7
Slide 80
Long-Run Cost with

Observations
The
LAC does not include the minimum

points of small and large size plants?
Why not?
LMC
is not the envelope of the short-run

marginal cost. Why not?
Chapter 7
Slide 81
Production with Two

Outputs--Economies of Scope
Examples:
Chicken
farm--poultry and eggs
Automobile
company--cars and trucks
University--Teaching
Chapter 7
and research
Slide 82
Production with Two

Economies of scope exist when the joint

output of a single firm is greater than the
output that could be achieved by two
different firms each producing a single
output.
What are the advantages of joint

production?
Consider
an automobile company producing

cars and tractors
Chapter 7
Slide 83
Production with Two

Advantages
1) Both use capital and labor.
2) The firms share management
resources.
3) Both use the same labor skills and
type of machinery.
Chapter 7
Slide 84
Production with Two

Production:
Firms
must choose how much of each to

produce.
The
alternative quantities can be

illustrated using product transformation
curves.
Chapter 7
Slide 85
Product Transformation Curve

Each curve shows
combinations of output
with a given combination
of L & K.
Number
of tractors
O2
O1
O1 illustrates a low level

of output. O2 illustrates
a higher level of output with
two times as much labor
and capital.
Number of cars
Chapter 7
Slide 86
Production with Two

Observations
Product
transformation curves are

negatively sloped
Constant
returns exist in this example
Since
the production transformation

curve is concave is joint production
desirable?
Chapter 7
Slide 87
Production with Two

Observations
There
is no direct relationship between

economies of scope and economies of
scale.
Chapter 7
May experience economies of scope

and diseconomies of scale
May have economies of scale and not

have economies of scope
Slide 88
Production with Two

The degree of economies of scope measures

the savings in cost and can be written:
C(Q1) C (Q 2) C (Q1, Q 2)
SC
C (Q1, Q 2)
C(Q1)
is the cost of producing Q1
C(Q2)
is the cost of producing Q2
C(Q1Q2)
is the joint cost of producing both
products
Chapter 7
Slide 89
Production with Two

Interpretation:
If
SC > 0 -- Economies of scope
If
SC < 0 -- Diseconomies of scope
Chapter 7
Slide 90
Economies of Scope
in the Trucking Industry
Issues
Truckload
Direct
versus indirect routing
Length
Chapter 7
versus less than truck load
of haul
Slide 91
Economies of Scope
Questions:
Economies
Chapter 7
of Scale
Are large-scale, direct hauls cheaper

and more profitable than individual
hauls by small trucks?
Are there cost advantages from

operating both direct and indirect
hauls?
Slide 92
Economies of Scope
Empirical Findings
An
analysis of 105 trucking firms

examined four distinct outputs.
Chapter 7
Short hauls with partial loads
Intermediate hauls with partial loads
Long hauls with partial loads
Hauls with total loads

Slide 93
Economies of Scope
Empirical Findings
Results
SC = 1.576 for reasonably large firm
SC = 0.104 for very large firms
Interpretation
Chapter 7
Combining partial loads at an intermediate

location lowers cost management difficulties
with very large firms.
Slide 94
Dynamic Changes in
Costs--The Learning Curve
The learning curve measures the

impact of workers experience on the
costs of production.
It describes the relationship between

a firms cumulative output and
amount of inputs needed to produce a
unit of output.
Chapter 7
Slide 95
The Learning Curve

Hours of labor
per machine lot
10
8
6
4
2
0
Chapter 7
10
20
30
40
50
Cumulative number of
machine lots produced
Slide 96
The Learning Curve
The horizontal axis

measures the
cumulative number of
hours of machine
tools the firm has
produced
The vertical axis
measures the number
of hours of labor
needed to produce
each lot.
Hours of labor
per machine lot
10
8
6
4
2
0
Chapter 7
10
20
30
40
Slide 97
50
Dynamic Changes in
The learning curve in the figure is based

on the relationship:
L BN
N cumulative units of output produced

L labor input per unit of output
A, B and are constants
A & B are positive and is between 0 and 1
Chapter 7
Slide 98
Dynamic Changes in
If N 1 :
L
equals A + B and this measures labor

input to produce the first unit of output
If 0 :
Labor
input remains constant as the

cumulative level of output increases, so
there is no learning
Chapter 7
Slide 99
Dynamic Changes in
If 0 and N increases :
L
approaches A, and A represent minimum

labor input/unit of output after all learning
has taken place.
The larger :
The
Chapter 7
more important the learning effect.
Slide 100
The Learning Curve

The chart shows a sharp drop
in lots to a cumulative amount of
20, then small savings at
higher levels.
Hours of labor
per machine lot
10
8
Doubling cumulative output causes
a 20% reduction in the difference
between the input required and
minimum attainable input requirement.
0.31
0
Chapter 7
10
20
30
40
50
Cumulative number of
machine lots produced
Slide 101
Dynamic Changes in
Observations
1) New firms may experience a learning
curve, not economies of scale.
2) Older firms have relatively small
gains from learning.
Chapter 7
Slide 102
Economies of
Scale Versus Learning
Cost
($ per unit
of output)
Economies of Scale
A
B
Learning
AC1
AC2
Output
Chapter 7
Slide 103
Predicting the Labor

Requirements of Producing a Given Output
Cumulative Output
(N)
10
20
30
40
50
60
70
80 and over
Per-Unit Labor Requirement

for each 10 units of Output (L)
1.00
.80
.70
.64
.60
.56
.53
.51
Total Labor
Requirement
10.0
18.0 (10.0 + 8.0)
25.0 (18.0 + 7.0)
31.4 (25.0 + 6.4)
37.4 (31.4 + 6.0)
43.0 (37.4 + 5.6)
48.3 (43.0 + 5.3)
53.4 (48.3 + 5.1)
Dynamic Changes in
The learning curve implies:

1) The labor requirement falls per unit.
2) Costs will be high at first and then will
fall with learning.
3) After 8 years the labor requirement will be
0.51 and per unit cost will be half
what it was in the first year of production.
Chapter 7
Slide 105
The Learning Curve in Practice
Scenario
A new
firm enters the chemical processing

industry.
Do they:
1) Produce a low level of output and sell at a
high price?
2) Produce a high level of output and sell at a
low price?
Chapter 7
Slide 106
How would the learning curve

influence your decision?
Chapter 7
Slide 107
The Empirical Findings

Study
of 37 chemical products
Average cost fell 5.5% per year
For each doubling of plant size, average

production costs fall by 11%
For each doubling of cumulative output, the

average cost of production falls by 27%
Which is more important, the economies of

scale or learning effects?
Chapter 7
Slide 108
Other Empirical Findings

In
the semi-conductor industry a study of

seven generations of DRAM
semiconductors from 1974-1992 found
learning rates averaged 20%.
In
the aircraft industry the learning rates

are as high as 40%.
Chapter 7
Slide 109
Applying Learning Curves

1) To determine if it is profitable to
enter an industry.
2) To determine when profits will
occur based on plant size and
cumulative output.
Chapter 7
Slide 110
Estimates of future costs can be

obtained from a cost function, which
relates the cost of production to the
level of output and other variables
that the firm can control.
Suppose we wanted to derive the

total cost curve for automobile
production.
Chapter 7
Slide 111
Total Cost Curve

for the Automobile Industry
Variable
cost
General Motors
Nissan
Toyota
Honda
Volvo
Ford
Chrysler
Quantity of Cars
Chapter 7
Slide 112
A linear cost function (does not show

the U-shaped characteristics) might
be:
VC Q
The linear cost function is applicable

only if marginal cost is constant.
Marginal cost is represented by .
Chapter 7
Slide 113
If we wish to allow for a U-shaped

average cost curve and a marginal
cost that is not constant, we might
use the quadratic cost function:
VC Q Q
Chapter 7
Slide 114
If the marginal cost curve is not linear,

we might use a cubic cost function:
VC Q Q Q
2
Chapter 7
Slide 115
Cubic Cost Function

Cost
($ per unit)
MC 2Q 3Q 2
AVC Q Q 2
Output
(per time period)
Chapter 7
Slide 116
Difficulties in Measuring Cost

1) Output data may represent an
aggregate of different type of products.
2) Cost data may not include opportunity
cost.
3) Allocating cost to a particular product
may be difficult when there is more than
one product line.
Chapter 7
Slide 117
Cost Functions and the Measurement of

Scale Economies
Scale
Chapter 7
Economy Index (SCI)
EC = 1, SCI = 0: no economies or
diseconomies of scale
EC > 1, SCI is negative: diseconomies of
scale
EC < 1, SCI is positive: economies of scale
Slide 118
Cost Functions for Electric Power

Scale
ScaleEconomies
Economiesin
inthe
theElectric
ElectricPower
PowerIndustry
Industry
Output (million kwh)

Value of SCI, 1955
Chapter 7
43
.41
338
.26
1109
.16
2226
.10
Slide 119
5819
.04
Average Cost of Production

in the Electric Power Industry
Average
Cost
(dollar/1000 kwh)
6.5
6.0
1955
5.5
5.0
1970
6
Chapter 7
12
18
24
30
36
Output (billions of kwh)
Slide 120
Cost Functions for Electric Power
Findings
Decline
in cost
Not due to economies of scale
Was caused by:

Lower input cost (coal & oil)
Improvements in technology
Chapter 7
Slide 121
A Cost Function for the

Savings and Loan Industry
The empirical estimation of a long-run

cost function can be useful in the
restructuring of the savings and loan
industry in the wake of the savings
and loan collapse in the 1980s.
Chapter 7
Slide 122

Data for 86 savings and loans for

1975 & 1976 in six western states
Q
= total assets of each S&L
LAC
= average operating expense
& TC are measured in hundreds of

millions of dollars
Average
operating cost are measured as

a percentage of total assets.
Chapter 7
Slide 123

A quadratic long-run average cost function

was estimated for 1975:
LAC 2.38 - 0.6153Q 0.0536Q
Minimum long-run average cost reaches its

point of minimum average total cost when
total assets of the savings and loan reach
$574 million.
Chapter 7
Slide 124

Average operating expenses are

0.61% of total assets.
Almost all of the savings and loans in

the region being studied had
substantially less than $574 million in
assets.
Chapter 7
Slide 125

Questions
1) What are the implications of the
analysis for expansion and
mergers?
2) What are the limitations of using
these results?
Chapter 7
Slide 126
Summary
Managers, investors, and economists

must take into account the
opportunity cost associated with the
use of the firms resources.
Firms are faced with both fixed and

variable costs in the short-run.
Chapter 7
Slide 127
Summary
When there is a single variable input,

as in the short run, the presence of
diminishing returns determines the
shape of the cost curves.
In the long run, all inputs to the

production process are variable.
Chapter 7
Slide 128
Summary
The firms expansion path describes

how its cost-minimizing input choices
vary as the scale or output of its
operation increases.
The long-run average cost curve is

the envelope of the short-run average
cost curves.
Chapter 7
Slide 129
Summary
A firm enjoys economies of scale

when it can double its output at less
than twice the cost.
Economies of scope arise when the

firm can produce any combination of
the two outputs more cheaply than
could two independent firms that each
produced a single product.
Chapter 7
Slide 130
Summary
A firms average cost of production

can fall over time if the firm learns
how to produce more effectively.
Cost functions relate the cost of

production to the level of output of the
firm.
Chapter 7
Slide 131
End of Chapter 7
The Cost of
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Chapter 7

Measuring Cost: Which Costs Matter?

Cost in the Short Run

Cost in the Long Run

Long-Run Versus Short-Run Cost

Production with Two Outputs-Economies of Scope

Dynamic Changes in Costs--The

Estimating and Predicting Cost

The production technology measures

Given the production technology,

To determine the optimal level of

expenses plus depreciation

to a firm of utilizing economic

associated with opportunities that

owns its own building and pays no

this mean the cost of office space

that has been made and

not influence a firms decisions.

pays $500,000 for an option to buy a

cost of the building is $5 million or a total of

firm finds another building for $5.25 million.

building should the firm buy?

Choosing the Location

Northwestern University Law School

Choosing the Location

Northwestern University Law School

Land owned in Chicago

Must purchase land in Evanston

Chicago location might appear

Choosing the Location

Northwestern University Law School

Chicago location chosen--very costly

Justified only if there is some intrinsic

If not, it was an inefficient decision if it

Total output is a function of variable

Therefore, the total cost of production

not vary with the level of output

that varies as output varies

paid by a firm that is in business

that have been incurred and cannot

Computers: most costs

most costs are sunk

of developing the software

cost component is fixed

A Firms Short-Run Costs ($)

Cost in the Short Run

Marginal Cost (MC) is the cost of

Cost in the Short Run

Average Total Cost (ATC) is the cost

Cost in the Short Run

Average Total Cost (ATC) is the cost

Cost in the Short Run

The Determinants of Short-Run Cost

relationship between the production

Cost in the Short Run

The Determinants of Short-Run Cost

returns and cost

increasing returns, output is increasing