Ch07.docx

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Ch07

CHAPTER7

THECOSTOFPRODUCTION

TEACHINGNOTES

Thekeytopicsinthischapterare

∙accountingversuseconomiccostsofproduction,

∙definitionsoftotal,average,andmarginalcostintheshortrunandlongrun,

∙agraphicalrepresentationoftotal,average,andmarginalcost,and

∙costminimization,graphicallyinthechapter,andmathematicallyintheappendix.

Itisimportanttodistinguishbetweenaccountingandeconomiccostssothatstudentswillunderstandthatzero（economic）profitisafeasiblelongrunequilibrium.Itisimportanttospendtimeonthecostcurvedefinitionsandgraphbecausetheyformthefoundationforwhatwillbecoveredinchapter8（firmsupply）.Thecostminimizationproblemisusefulforexplainingwhichinputsthefirmshouldusetoproduceagivenquantityofoutput,andthisdiscussiondrawsonthediscussionofisoquantsfromchapter6.Itisalsopossibleatthispointtodiscussthebasicconceptofhiringinputsuntilthewageisequaltothemarginalrevenueproductoftheinput（chapter14）.Thechapteralsocontainsthreesectionsthatcanbecoveredasspecialtopics（productionwithtwooutputs,dynamicchangesincosts,andestimatingcost）,orcanbeskippedaltogether.

Opportunitycostformstheconceptualbaseofthischapter.Whilemoststudentsthinkofcostsinaccountingterms,theymustdevelopanunderstandingofthedistinctionbetweenaccounting,economic,andopportunitycosts.Onesourceofconfusionistheopportunitycostofcapital,i.e.,whytherentalrateoncapitalmustbeconsideredexplicitlybyeconomists.Itisimportant,forexample,todistinguishbetweenthepurchasepriceofcapitalequipmentandtheopportunitycostofusingtheequipment.Theopportunitycostofaperson’stimealsoleadstosomeconfusionforstudents.

Followingthediscussionofopportunitycost,thechapterdivergesintwodirections:

onepathintroducestypesofcostandcostcurves,andtheotherfocusesoncostminimization.Bothdirectionsconvergewiththediscussionoflong-runaveragecost.

Whilethedefinitionsoftotalcost,fixedcost,averagecost,andmarginalcostandthegraphicalrelationshipsbetweenthemcanseemtediousand/oruninterestingtothestudent,bothareimportantintermsofunderstandingthederivationofthefirm’ssupplycurveinchapter8.Doingalgebraicornumericalexamplesintableformishelpfulforsomestudentsintermsofseeingtherelationshipsbetweenthedifferentcosts.Explainthateachfirmhasauniquesetofcostcurvesbasedonitsownparticularproductionfunctionandresultingtotalcostfunction.Discusstheimportanceofreturnstoscaleanddiminishingreturnsinexplainingtheshapesofthecostcurves.Pointouttheclearrulesthataveragecosttendstobeu-shapedintheshortrunandmarginalcostwillhitaveragecostandaveragevariablecostattheirrespectiveminimumpoints.Onceyouhavesuccessfullydevelopedthecostcurvegraph,youcanthentakeitandaddressthequestionsoffindingtheprofitmaximizinglevelofoutputandderivingthefirm,andhenceindustry,supplycurve.

Thecostminimizationproblemisusefulforaddressingadifferenttypeofquestion,namelywhatquantityoftheinputsshouldthefirmusetoproduceagivenlevelofoutput.Pointouttostudentsthatthenecessaryconditionforcostminimization,wheretheratioofthemarginalproductsisequaltotheratiooftheinputcosts,isverysimilartothenecessaryconditionforprofitmaximization.

Aclearunderstandingofshort-runcostandcostminimizationisnecessaryforthederivationoflong-runaveragecost.Withlong-runcosts,stressthatfirmsareoperatingonshort-runcostcurvesateachlevelofthefixedfactorandthatlong-runcostsdonotexistseparatelyfromshort-runcosts.Exercise（6）illustratestherelationshipbetweenlong-runcostandcostminimization,withanemphasisontheimportanceoftheexpansionpath.Stresstheconnectionbetweentheshapeofalong-runcostcurveandreturnstoscale.

QUESTIONSFORREVIEW

1.Afirmpaysitsaccountantanannualretainerof$10,000.Isthisaneconomiccost?

Explicitcostsareactualoutlays.Theyincludeallcoststhatinvolveamonetarytransaction.Animplicitcostisaneconomiccostthatdoesnotnecessarilyinvolveamonetarytransaction,butstillinvolvestheuseofresources.Whenafirmpaysanannualretainerof$10,000,thereisamonetarytransaction.Theaccountanttradeshisorhertimeinreturnformoney.Therefore,anannualretainerisanexplicitcost.

2.Theownerofasmallretailstoredoesherownaccountingwork.Howwouldyoumeasuretheopportunitycostofherwork?

Opportunitycostsaremeasuredbycomparingtheuseofaresourcewithitsalternativeuses.Theopportunitycostofdoingaccountingworkisthetimenotspentinotherways,i.e.,timesuchasrunningasmallbusinessorparticipatinginleisureactivity.Theeconomic,oropportunity,costofdoingaccountingworkismeasuredbycomputingthemonetaryamountthattheowner’stimewouldbeworthinitsnextbestuse.

3.Pleaseexplainwhetherthefollowingstatementsaretrueorfalse.

a.Iftheownerofabusinesspayshimselfnosalary,thentheaccountingcostiszero,buttheeconomiccostispositive.

True.Sincethereisnomonetarytransaction,thereisnoaccounting,orexplicit,cost.However,sincetheownerofthebusinesscouldbeemployedelsewhere,thereisaneconomiccost.Theeconomiccostispositive,reflectingtheopportunitycostoftheowner’stime.Theeconomiccostisthevalueofthenextbestalternative,ortheamountthattheownerwouldearnifhetookthenextbestjob.

b.Afirmthathaspositiveaccountingprofitdoesnotnecessarilyhavepositiveeconomicprofit.

True.Accountingprofitconsidersonlytheexplicit,monetarycosts.Sincetheremaybesomeopportunitycoststhatwerenotfullyrealizedasexplicitmonetarycosts,itispossiblethatwhentheopportunitycostsareaddedin,economicprofitwillbecomenegative.Thisindicatesthatthefirm’sresourcesarenotbeingputtotheirbestuse.

c.Ifafirmhiresacurrentlyunemployedworker,theopportunitycostofutilizingtheworker’sservicesiszero.

False.Theopportunitycostmeasuresthevalueoftheworker’stime,whichisunlikelytobezero.Thoughtheworkerwastemporarilyunemployed,theworkerstillpossessesskills,whichhaveavalueandmaketheopportunitycostofhiringtheworkergreaterthanzero.Inaddition,sinceopportunitycostistheequivalentoftheworker’snextbestoption,itispossiblethattheworkermighthavebeenabletogetabetterjobthatutilizeshisskillsmoreefficiently.Alternatively,theworkercouldhavebeendoingunpaidwork,suchascareofachildorelderlypersonathome,whichwouldhavehadavaluetothosereceivingtheservice.

4.Supposethatlaboristheonlyvariableinputtotheproductionprocess.Ifthemarginalcostofproductionisdiminishingasmoreunitsofoutputareproduced,whatcanyousayaboutthemarginalproductoflabor?

Themarginalproductoflabormustbeincreasing.Themarginalcostofproductionmeasurestheextracostofproducingonemoreunitofoutput.Ifthiscostisdiminishing,thenitmustbetakingfewerunitsoflabortoproducetheextraunitofoutput,sincetheextracostreferstotheextracostofthelabor.Iffewerunitsoflaborarerequiredtoproduceaunitofoutput,thenthemarginalproduct（extraoutputproducedbyanextraunitoflabor）mustbeincreasing.Notealso,thatMC=w/MPL,sothatifMCisdiminishingthenMPLmustbeincreasingforanygivenw.

5.Supposeachairmanufacturerfindsthatthemarginalrateoftechnicalsubstitutionofcapitalforlaborinhisproductionprocessissubstantiallygreaterthantheratiooftherentalrateonmachinerytothewagerateforassembly-linelabor.Howshouldhealterhisuseofcapitalandlabortominimizethecostofproduction?

Tominimizecost,themanufacturershoulduseacombinationofcapitalandlaborsotherateatwhichhecantradecapitalforlaborinhisproductionprocessisthesameastherateatwhichhecantradecapitalforlaborinexternalmarkets.Themanufacturerwouldbebetteroffifheincreasedhisuseofcapitalanddecreasedhisuseoflabor,decreasingthemarginalrateoftechnicalsubstitution,MRTS.HeshouldcontinuethissubstitutionuntilhisMRTSequalstheratiooftherentalratetothewagerate.TheMRTSinthiscaseisequaltoMPK/MPL.AsthemanufacturerusesmoreKandlessL,theMPKwilldiminishandtheMPLwillincrease,bothofwhichwilldecreasetheMRTSuntilitisequaltotheratiooftheinputprices（rentalrateoncapitaldividedbywagerate）.

6.Whyareisocostlinesstraightlines?

Theisocostlinerepresentsallpossiblecombinationsoflaborandcapitalthatmaybepurchasedforagiventotalcost.Theslopeoftheisocostlineistheratiooftheinputpricesoflaborandcapital.Ifinputpricesarefixed,thentheratioofthesepricesisclearlyfixedandtheisocostlineisstraight.Onlywhentheratioorfactorpriceschangeasthequantitiesofinputschangeistheisocostlinenotstraight.

7.Assumethemarginalcostofproductionisincreasing.Canyoudeterminewhethertheaveragevariablecostisincreasingordecreasing?

Explain.

Marginalcostcanbeincreasingwhileaveragevariablecostiseitherincreasingordecreasing.Ifmarginalcostisless（greater）thanaveragevariablecost,theneachadditionalunitisaddingless（more）tototalcostthanpreviousunitsaddedtothetotalcost,whichimpliesthattheAVCdeclines（increases）.Therefore,weneedtoknowwhethermarginalcostisgreaterthanaveragevariablecosttodeterminewhethertheAVCisincreasingorde