Chapter 11 - Costs Flashcards
Total Cost equation
TC =rK +wL
r = cost of Capital
w = cost of Labour (wage)
TC = FC + VC
rK = Fixed Cost
- also known as ‘overhead costs’
wL = Variable Cost
Law of DR and Variable Costs
- AVC curve decreases with Q when there are increasing returns to the variable factor
- Concave shape
- AVC curve increases with Q when there are diminishing returns to the variable factor
- Convex shape
VC = 0 when there is no output
Average Fixed Cost (definition)
is fixed cost divided by the quantity of output
FC/Q
or wK/Q
Average Variable Cost (definition)
is variable cost divided by the quantity of output
VC/Q
or wL/Q
Average Total Cost (definition)
is total cost divided by the quantity of output
ATC = AFC + AVC
ATC = (VC+FC)/Q
ATC = (rK+wL)/Q
Marginal Cost (definition)
is the change in total cost divided by the change in quantity
MC = ∆TC/∆Q
= dTC/dQ
Geometrically = Slope of TC at that level of output
- but also the slope of VC as VC and TC are parallel
Cost of expanding output = MC
Similar curvature to VC due to the reasons of LDR
- Upward sloping when LDR is set
- Downward sloping for when LDR not set
When MC < AVC then AVC will fall with output
When MC > AVC then AVC will increase with output
Why does the minimum point on the AVC curve occur for a smaller unit of output than min point on ATC?
This is because AFC declines continuously and ATC continues to fall due to this, even though AVC has begun to turn upward!
Minimum cost condition for e
Equating the Marginal Costs!
Doesn’t require average cost levels in the two processes to be the same and can be different values!
Relationship between MP, AP, MC and AVC
MP cuts AP at the maximum value of the AP curve
& MC cuts the AVC curve at the minimum value of AVC curve
MC = ∆VC/∆Q
when Labour is only variable factor… ∆VC = ∆wL
therefore, MC = ∆wL/∆Q
since ∆L/∆Q = 1/MP it follows… MC = w/MP
Similarly, AVC = VC/Q = wL/Q since L/Q = 1/AP
it follows… AVC = w/AP
Why does MC cut AVC and ATC at their lowest points?
Average costs are decreasing as long as MC is less than them, and increasing if MC is more than average costs
therefore MC cuts both ATC and AVC at their minima!
Isocost Line (definition)
locus of input bundles each of which costs the same amount
slope of isocost line = - w/r
is the negative ratio of the ratio of input prices!
Isoquant (definition)
is a line which shows a combination of inputs that yield the same output
slope of isoquant = - MPL/MPK
Maximum output for a given cost condition!
Minimum cost condition
where the isocost line is tangent to the isoquant!
it follows that…
MP(L)/MP(K) = w/r
MPL/w = MPK/r
this equation tells us that when costs are minimum, the extra output we get from the last euro spent on an input must be the same for all the inputs
economic interpretation:
- MPL/w is the extra output gained from the last euro spent on L
- MPK/r is the extra output gained from the last euro spent on K
Another way to describe is the Marginal Rate of Technical Substitution, at the optimising bundle must be the same as the slope of the isocost line
Trade Union and production at minimum costs
The mix of the two skill categories the firm chooses to use will depend strongly on relative prices
Enactment of law
- Wage rises
- firm increases employment of skilled labour
Output Expansion Path
It is the set of cost-minimising input bundles when the input price ratio is fixed at w/r
- with fixed input prices, represents the least costly ways of producing corresponding levels of output
- In LR OEP is analogue to income-consumption curve
- no need to distinguish between total, fixed, variable costs since all costs are variable!
- LTC curve will always pass through the origin because in the LR the firm can liquidate all of its inputs
