Chapter 8: Cost Curves

•A firm aims to MAXIMIZE PROFITS

•In order to do this, one must understand
how to MINIMIZE COSTS

•Therefore understanding of cost curves is

essential to maximizing profits

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 Chapter 8: Costs Curves
In this chapter we will cover:
8.1 Long Run Cost Curves
8.1.1 Total Cost
8.1.2 Marginal Cost and Average Cost
8.2 Economies of Scale
8.3 Short Run Cost Curves
8.3.1 Total Cost, Variable Cost, Fixed Cost
8.3.2 Marginal Cost and Average Cost
8.4 Economies of Scope
8.5 Economies of Experience
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 8.1 Long Run Cost Curves

•In the long run, a firm’s costs equal zero

when production is zero

•As production (Q) increases, the firm must

use more inputs, thus costs increase

•By minimizing costs, a firm’s typical long

run cost curve is as follows:
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 K
Q1

Q0
K1
• TC = TC0
K0
• TC = TC1

0 L0 L 1 L (labor services per year)

TC ($/yr)

LR Total Cost Curve

TC1=wL1+rK1

TC0 =wL0+rK0

0 Q0 Q1 Q (units per year) 4

•An increase in the price of only 1 input will
cause a firm to change its optimal choice of
inputs

•However, the increase in input costs will always

cause a firm’s costs to increase:
-(Unless inputs are perfect substitutes)

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 K
C1: Original isocost curve
Slope=w/r2 (TC = $200)
TC1/r
C2: Isocost curve after
Rent Increase (TC = $200)
A C3: Isocost curve after
TC0/r • Rent Increase (TC = $300)
B
• Q0
Slope=w/r2

C2 C1 C3

0 L

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 TC ($/yr)
Change in Input Prices ->
A Shift in the Total Cost Curve
TC(Q) new

300 TC(Q) old

200

Q0 Q (units/yr)
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Let Q=2(LK)1/2 MRTS=K/L,
W=5, R=20, Q=40
What occurs to costs when rent falls to 5?
Initially:
MRTS=W/R Q=2(LK)1/2
K/L=5/20 40=2(4KK)1/2
4K=L 40=4K
10=K
40=L
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Let Q=2(LK)1/2 MRTS=K/L,
W=5, R=20, Q=40
What occurs to costs when rent falls to 5?
After Price Change:
MRTS=W/R Q=2(LK)1/2
K/L=5/5 40=2(LL)1/2
L=K 40=2L
20=L
20=K
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What occurs when rent falls to 5?
Initial: L=40, K=10 Final: W=5, R=20

Initial: TC=wL+rK
TC=5(40)+20(10)
TC=400

Final: TC=5(20)+5(20)
TC=200

Due to the fall in rent, total cost falls by $200.

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 TC ($/yr)
Change in Rent

TC(Q) initial

400 TC(Q) final

200

40 Q (units/yr)
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To calculate total cost, simply substitute labour
and capital demand into your cost expression:

Q= 50L1/2K1/2 (From Chapter 7:)

L*= (Q0/50)(r/w)1/2
K* = (Q0/50)(w/r)1/2

TC = wL +rK
TC= w [(Q0/50)(r/w)1/2 ] +r[(Q0/50)(w/r)1/2 ]
TC= [(Q0/50)(wr)1/2 ] +[(Q0/50)(wr)1/2 ] 12
Let Q= L1/2K1/2, MPL/MPK=K/L, w=10, r=40.
Calculate total cost.
MRTS=w/r
K/L=10/40
4K=L

Q=L1/2K1/2 =(4K)1/2K1/2
Q=2K
K=Q/2 13
Let Q= L1/2K1/2, MRTS=K/L, w=10, r=40.
Calculate total cost.

L=4K TC = wL +rK
L=4(Q/2) TC = 10(2Q) +40(Q/2)
L=2Q TC = 40Q
Note: This total cost formula only
has EXOGENOUS variables (wage,
rent, output). 14
•When the prices of all inputs change by the
same (percentage) amount, the optimal input
combination does not change

•The same combination of inputs are purchased

at higher prices

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K (capital services/yr)

C1=Isocost curve
before ($200)
and after ($220)
a 10% increase
in input prices
A
•
Q0

C1

0 L (labor
services/yr)
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 TC ($/yr)

Example: A Shift in the Total Cost Curve

When Input Prices Rise 10%

TC(Q) new

TC(Q) old
220
200

Q0 Q (units/yr)
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Definition: The long run average cost function is
the long run total cost function divided by
output, Q.

That is, the (LR)AC function tells us the firm’s

cost per unit of output…

TC (Q)
AC (Q ) 
Q
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Definition: The long run marginal cost function
is rate at which long run total cost changes with
a change in output

The (LR)MC curve is equal to the slope of the

(LR)TC curve

TC (Q)
MC (Q) 
Q
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 TC ($/yr)

Average vrs. Marginal Costs

TC(Q) post
Slope=LRMC

TC0

Slope=LRAC

Q0 Q (units/yr)
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When marginal cost is less than average cost,
average cost is decreasing in quantity. That is, if
MC(Q) < AC(Q), AC(Q) decreases in Q.

When marginal cost is greater than average cost,

average cost is increasing in quantity. That is, if
MC(Q) > AC(Q), AC(Q) increases in Q.

When marginal cost equals average cost, average cost

is at its minimum. That is, if MC(Q) = AC(Q),
AC(Q) is at its minimum. 21
 AC, MC ($/yr)

“typical” shape of AC, MC

MC AC

•
AC at minimum when AC(Q)=MC(Q)

0 Q (units/yr)
22
If average cost decreases as output rises, all
else equal, the cost function exhibits
economies of scale.
-large scale operations have an advantage

If average cost increases as output rises, all

else equal, the cost function exhibits
diseconomies of scale.
-small scale operations have an advantage
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Why Economies of scale?

-Increasing Returns to Scale for Inputs

-Specialization of Labour
-Indivisible Inputs (ie: one factory can produce
up to 1000 units, so increasing output up to
1000 decreases average costs for the factory)

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Why Diseconomies of scale?

-Diminishing Returns from Inputs

-Managerial Diseconomies
-Growing in size requires a large
expenditure on managers
-ie: The owner is very passionate, but can
only manage 1 or two branches
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AC ($/yr) Typical Economies of Scale

Minimum Efficient Scale – smallest

AC(Q)
Quantity where LRAC curve reaches
Its min.

Economies of scale Diseconomies of scale

0 Q* Q (units/yr)
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Production functions and cost functions are related:
Production Function Cost Function

Increasing returns to Economies of Scale

scale
Decreasing returns to Diseconomies of Scale
scale
Constant Returns to Neither economies nor
Scale diseconomies of scale
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 Example: Returns to Scale and Economies of Scale

CRS IRS DRS

Production Function Q=L Q = L2 Q = L1/2

Labor Demand L*=Q L*=Q1/2 L*=Q2

Total Cost Function TC=wQ wQ1/2 wQ2

Average Cost Function AC=w w/Q1/2 wQ

Economies of Scale none EOS DOS

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•Economies of Scale are also related to
marginal cost and average cost:

If MC < AC, AC must be decreasing in Q.

Therefore, we have economies of scale.

If MC > AC, AC must be increasing in Q.

Therefore, we have diseconomies of scale.

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 Let Cost=50+20Q2
MC=40Q

IF Q=1 or Q=2, determine economies of

scale
(Let Q be thousands of units)

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 TC=50+20Q2
MC=40Q
AC=TC/Q=50/Q+20Q

Initially: MC=40(1)=40
AC=50/1+20(1)=70
MC<AC – Economies of Scale

Finally: MC=40(2)=80
AC=50/2+20(2)=65
MC>AC – Diseconomies of Scale 31
 8.3 Short-Run Cost Curves
•In the short run, at least 1 input is fixed
(usually capital, ie: K=K*)

•Total fixed costs (TFC) are the costs associated with

this fixed input (ie: rk)

•Total variable costs (TVC) are the costs associated

with variable inputs (ie:wL)

•Short-run total costs are fixed costs plus variable costs:

STC=TFC+TVC

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TC ($/yr)

Short Run Total Cost, Total Variable

Cost and Total Fixed Cost

STC(Q, K*)

rK* TVC(Q, K*)

TFC
rK*

Q (units/yr)
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 Short Run Costs
Example:
Minimize the cost to build 80 units if Q=2(KL)1/2 and
K=25. If r=10 and w=20, classify costs.
Q=2(KL)1/2
80=2(25L)1/2
80=10(L)1/2
8=(L)1/2
64=L
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 Short Run Costs
Example:
K*=25, L=16. If r=10 and w=20, classify costs.

TFC=rK*=10(25)=250
TVC=wL=20(64)=1280

STC=TFC+TVC=1530

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The firm can minimize costs better in
the long run because it is less
constrained.

Hence, the short run total cost curve

lies above the long run total cost
curve almost everywhere.

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 K
Only at point A is short run
TC2/r minimized as well as long run
Q1
TC1/r Long Run Expansion path

TC0/r C
Q0 • Q0 Short Run
A
K *
• •B Expansion path

0 L
TC0/w TC1/w TC2/w
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 TC ($/yr)
STC(Q)

LRTC(Q)

rK*

Q (units/yr)
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Definition: The short run average cost function
is the short run total cost function divided by
output, Q.

That is, the SAC function tells us the firm’s cost

per unit of output…

STC (Q)
SAC (Q) 
Q
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Definition: The short run marginal cost function
is rate at which short run total cost changes with
a change in input

The SMC curve is equal to the slope of the STC

curve

STC (Q)
SMC (Q) 
Q
40
In the short run, 2 additional average costs exist:
average variable costs (AVC) and average fixed
costs (AFC)
TFC (Q)
AFC (Q) 
Q
TVC (Q)
AVC (Q) 
Q 41
Note :
STC  TFC  TVC
STC TFC TVC
 
Q Q Q
Therefore :
SAC  AFC  AVC 42
To make an omelet, one must crack a fixed number of
eggs (E) and add a variable number of other ingredients
(O). Total costs for 10 omelets were $50. Each omelet’s
average variable costs were $1.50. If eggs cost 50 cents,
how many eggs in each omelet?

AC=AVC+AFC
TC/Q=AVC+AFC
50/10=$1.50+AFC
$3.50=AFC
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To make an omelet, one must crack a fixed number of
eggs (E) and add a variable number of other ingredients
(O). Total costs for 10 omelets were $50. Each omelet’s
average variable costs were $1.50. If eggs cost 50 cents,
how many eggs in each omelet?
$3.50=AFC
$3.50=PE (E/Q)
$3.50=0.5 (E/Q)
7=E/Q

There were 7 eggs in each omelet. 44

 $ Per Unit
Average fixed cost is
constantly decreasing, as
fixed costs don’t rise with
output.

AFC
0
Q (units per
year) 45
 $ Per Unit Average variable
cost generally
decreases then AVC
increases due to
economies of
scale.

AFC
0
Q (units per
year) 46
 $ Per Unit SAC is the
vertical sum SAC
of AVC and AVC
AFC

Equal

AFC
0
Q (units per
year) 47
 $ Per Unit
SAC
SMC
AVC

SMC
intersects
SAC and
• AVC at their
minimum
• points
AFC
0
Q (units per
year) 48
Often a firm produces more than one product,
and often these products are related:
-Pepsi Cola makes Pepsi and Diet Pepsi
-HP makes Computers and Cameras
-Denny’s Serves Breakfast and Dinner

Often a firm benefits from economies of scope by

producing goods that are related; they share
common inputs (or good A is an input for good
B). Efficiencies often exist in producing related
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products (ie: no shipping between plants).
If a firm can produce 2 products at a lower total
cost than 2 firms each producing their own
product:

TC(Q1,Q2)<TC(Q1,0)+TC(0,Q2)

That firm experiences economies of scope.

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If the cities maintains local roads, it costs are $15
million a year. If a private firm covers park
maintenance, it costs are $12 million a year. If
the city does both, it costs $25 million a year.

TC(Q1,Q2)=$25 million
TC(Q1,0)+TC(0,Q2)=$15 million + $12 million
TC(Q1,0)+TC(0,Q2)=$27 million

TC(Q1,Q2)<TC(Q1,0)+TC(0,Q2) 51
Often with practice a firm “gets better” at
producing a given output; it cuts costs by being
able to produce the good faster and with fewer
defects.

ie: The first time you calculated demand, each

question took you 15 minutes and 10% were
wrong. By the end of the course you’ll be able to
calculate demand in 8 minutes with only 5%
error (for example).
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Economies of experience are efficiencies (cost
advantages) resulting from accumulated
experience (learning-by-doing).

The experience curve shows the relationship

between average variable cost and cumulative
production volume.
-As more is produced (more experience is
gained), average cost decreases.
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AVC

The Experience Curve

Eventually the curve

Flattens out

Cumulative Output
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Economies of experience occur once, while
economies of scale are ongoing.

A large producer benefiting from economies of

scale will increase average costs by decreasing
production.

A large producer benefiting from economies of

experience may safely decrease production
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 Chapter 8 Key Concepts
Long-Run Costs:
TC=wL+rK (if labor and capital are the
only inputs
AC=TC/Q
MC=∆TC/ ∆ Q
Economies of scale summarize how average
cost changes as Q increases
Economies of scale = AC decreases as Q
increases
Diseconomies of scale = AC increases as
Q increases
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 Chapter 8 Key Concepts
Short-Run Costs
TFC=All costs of the FIXED input
TVC=All total costs of the VARIABLE
input
STC=TFC+TVC
SAC=STC/Q
SMC=∆STC/ ∆Q
AFC=TFC/Q
AVC=TVC/Q
SAC=AFC+AVC
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 Chapter 8 Key Concepts
If one firm has lower costs producing two
goods than two firms producing the goods
individually, that firm enjoys ECONOMIES
OF SCOPE
If AC decreases as cumulative output
increases, a firm enjoys ECONOMIES OF
EXPERIENCE
This effect decreases over time
Calculators are important in Econ 281

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