Module 14

1. Module 14 Cost in the Short Run

2. Objectives: • Understand the relationship between the short run production function and short run costs. 2

3. Objectives: • Understand the relationship between the short run production function and short run costs. • Define total cost, total variable cost and total fixed cost. 2

4. Objectives: • Understand the relationship between the short run production function and short run costs. • Define total cost, total variable cost and total fixed cost. • Define average total cost, average variable cost, average fixed cost and marginal cost. 2

5. Objectives: • Understand the relationship between the short run production function and short run costs. • Define total cost, total variable cost and total fixed cost. • Define average total cost, average variable cost, average fixed cost and marginal cost. • Know and be able to use the cost formulas to calculate costs. 2

6. Objectives: • Understand the relationship between the short run production function and short run costs. • Define total cost, total variable cost and total fixed cost. • Define average total cost, average variable cost, average fixed cost and marginal cost. • Know and be able to use the cost formulas to calculate costs. • Understand the relationship between marginal product and marginal cost of production. 2

7. Objectives…cont’d. • Understand the relationship between marginal cost and average total cost and marginal cost and average variable cost. 3

8. Objectives…cont’d. • Understand the relationship between marginal product and marginal cost of production. • Understand the relationship between marginal cost and average total cost and marginal cost and average variable cost. • Understand what happens to average fixed cost as output increases and what this implies about the average total cost and average variable cost curves. 3

9. Objectives…cont’d. • Understand the relationship between marginal product and marginal cost of production. • Understand the relationship between marginal cost and average total cost and marginal cost and average variable cost. • Understand what happens to average fixed cost as output increases and what this implies about the average total cost and average variable cost curves. • Be able to graph the cost curves. 3

10. Objective 1 Understand the relationship between the short run production function and short run costs • Costs are derived from the production function. 4

11. Objective 1 Understand the relationship between the short run production function and short run costs • Costs are derived from the production function. • Consider a simple 2-input short run production function, like the one we used for the Acme Box Company: Q = f (L, K0) where L= the variable input, labor and K0 = the fixed input, capital 4

12. Objective 1 Understand the relationship between the short run production function and short run costs • Costs are derived from the production function. • Consider a simple 2-input short run production function, like the one we used for the Acme Box Company: Q = f (L, K0) where L= the variable input, labor and K0 = the fixed input, capital • From the production function we can write an expression for total cost. Total Cost = Labor Costs + Capital Cost = Total Variable Cost + Total Fixed Cost 4

13. Objective 2 Define Total Fixed Cost, …. • Total Fixed Costs (TFC) refers to the total expenditure by the firm for fixed inputs. 5

14. Objective 2 Define Total Fixed Cost, …. • Total Fixed Costs (TFC) refers to the total expenditure by the firm for fixed inputs. • Fixed costs do not change when firms increase or decrease their output. The lay person thinks of fixed costs as overheads. 5

15. Objective 2 Define Total Fixed Cost, …. • Total Fixed Costs (TFC) refers to the total expenditure by the firm for fixed inputs. • Fixed costs do not change when firms increase or decrease their output. The lay person thinks of fixed costs as overheads. 5

16. Objective 2: …total variable cost and total cost • Total Variable Costs(TVC) refer to total expenditure on variable inputs, for example, the wages paid for labor services and the cost of raw materials purchased to produce the product. 6

17. Objective 2: …total variable cost and total cost • Total Variable Costs(TVC) refer to total expenditure on variable inputs, for example, the wages paid for labor services and the cost of raw materials purchased to produce the product. • Total Costs(TC) refer to thetotal expenditure on all inputs used to produce a product. It is the sum of fixed costs and variable costs. 6

18. Objective 2: ….fixed cost, variable cost and total cost Total Cost = Total Fixed Cost + Total Variable Cost

19. Can you determine these values? 8

20. Objective 3 Define average total cost, average variable cost, average fixed cost and marginal cost • Average costs tells you how much a product costs per unit of output. In the short run, there are three average cost variables, one corresponding to each category of costs. 9

21. Objective 3 Define average total cost, average variable cost, average fixed cost and marginal cost • Average costs tells you how much a product costs per unit of output. In the short run, there are three average cost variables, one corresponding to each category of costs. 1. Average Fixed cost (AFC) 9

22. Objective 3 Define average total cost, average variable cost, average fixed cost and marginal cost • Average costs tells you how much a product costs per unit of output. In the short run, there are three average cost variables, one corresponding to each category of costs. 1. Average Fixed cost (AFC) 2. Average Variable Cost (AVC) 9

23. Objective 3 Define average total cost, average variable cost, average fixed cost and marginal cost • Average costs tells you how much a product costs per unit of output. In the short run, there are three average cost variables, one corresponding to each category of costs. 1. Average Fixed cost (AFC) 2. Average Variable Cost (AVC) 3. Average Total Cost (ATC) or simply Average Cost (AC) 9

24. Objective 3…the three “average” cost variables.. Total Cost = Average Total Cost x Quantity 10

25. Objective 3…the three “average” cost variables.. Total Cost = Average Total Cost x Quantity 10

26. Objective 3…the three “average” cost variables.. Total Cost = Average Total Cost x Quantity   10

27. Marginal Costis the addition to total cost resulting from producing one more unit of output. 11

28. Marginal Costis the addition to total cost resulting from producing one more unit of output. 11

29. Marginal Costis the addition to total cost resulting from producing one more unit of output. 11

30. Marginal Costis the addition to total cost resulting from producing one more unit of output. • Since fixed cost is constant, the equation above equals: 11

31. Marginal Costis the addition to total cost resulting from producing one more unit of output. • Since fixed cost is constant, the equation above equals: • In theshort run, marginal cost is independent of fixed costs. 11

32. Objective 4 Know and be able to use the cost formulas to calculate costs. 12

33. Objective 4 Know and be able to use the cost formulas to calculate costs. • Example: We will revisit the Acme Box Company. Suppose Acme’s Fixed Costs equals $1,000 and the firm hires labor at a constant wage of $60 per unit. 12

34. Objective 4: Calculating Costs … Suppose Acme’s fixed costs equals $1,000. 13

35. Objective 4: Calculating Costs … Acme’shires labor at a constant wage of $60 per unit of labor. Its labor are its variable cost. Labor Costs = wage rate x labor units 14

36. Objective 4: Calculating Costs … Acme’s Total Cost = Fixed Cost + Variable Cost 15

37. Objective 4: Calculating Costs … Average Fixed Cost = Fixed Cost ÷ Output 16

38. Objective 4: Calculating Costs … Average Variable Cost = Total Variable Cost ÷ Output 17

39. Objective 4: Calculating Costs … Average Total Cost = Total Cost ÷ Output , or Average Total Cost = Average Fixed Cost + Average Variable Cost 18

40. Objective 4: Calculating Costs … Marginal Cost = ∆Total Cost ÷ ∆Output, or in the short run, Marginal Cost = ∆Variable Cost ÷ ∆Output 19

41. Objective 5 Understand the relationship between marginal product and marginal cost of production. 20

42. Objective 5 Understand the relationship between marginal product and marginal cost of production. Below is a segment of the Table for the Acme Box Company. 20

43. Objective 5 Understand the relationship between marginal product and marginal cost of production. Below is a segment of the Table for the Acme Box Company. Increasing Marginal Returns segment 20

44. Objective 5 Understand the relationship between marginal product and marginal cost of production. Below is a segment of the Table for the Acme Box Company. Increasing Marginal Returns segment Diminishing Marginal Returns segment 20

45. Objective 5: ..the relationship between marginal product and marginal cost of production. • In the increasing marginal returns segment, when marginal product is rising, marginal cost is falling. 21

46. Objective 5: ..the relationship between marginal product and marginal cost of production. • In the increasing marginal returns segment, when marginal product is rising, marginal cost is falling. • In the diminishing marginal returns segment, when marginal product is falling, marginal cost is rising. 21

47. Objective 5: ..the relationship between marginal product and marginal cost of production. • In the increasing marginal returns segment, when marginal product is rising, marginal cost is falling. • In the diminishing marginal returns segment, when marginal product is falling, marginal cost is rising. • In the negative marginal returns segment, what do you think is happening to marginal cost? Yes, it is rising fast! 21

48. What then is the shape of the marginal cost curve? Objective 5: ..the law of diminishing marginal returns and the shape of the marginal cost curve 22

49. What then is the shape of the marginal cost curve? It is U-shaped. Objective 5: ..the law of diminishing marginal returns and the shape of the marginal cost curve 22

50. Objective 6: Understand the relationship between marginal cost, average total cost, and average variable cost 23