CHAPTER 10

Costs
 The Cost-Minimization Problem
 Considera firm using two inputs to make one output.
 The production function is
y = f(x1,x2).
 Take the output level y ≥ 0 as given.
 Given the input prices w and w , the cost of an input
1 2
bundle (x1,x2) is w1x1 + w2x2.
 The Cost-Minimization Problem
 Forgiven w1, w2 and y, the firm’s cost-minimization
problem is to solve

min w 1x1 + w 2x 2
x1 ,x 2 ≥ 0

subject to f ( x1 , x 2 ) = y.
 Iso-cost Lines
x2 Slopes = -w1/w2.

c” ≡ w1x1+w2x2

c’ ≡ w1x1+w2x2

c’ < c”

x1
A curve that contains all of the input bundles that
cost the same amount.
The Cost-Minimization Problem
x2
All input bundles yielding y’ units
of output. Which is the cheapest?

f(x1,x2) ≡ y’
x1
The Cost-Minimization Problem
x2
All input bundles yielding y’ units
of output. Which is the cheapest?

f(x1,x2) ≡ y’
x1
The Cost-Minimization Problem
x2
All input bundles yielding y’ units
of output. Which is the cheapest?

f(x1,x2) ≡ y’
x1
 A Perfect Complements Example of Cost
Minimization
 The firm’s production function is
y = min{ 4x1 , x 2 }.
 Input prices w1 and w2 are given.
 What are the firm’s conditional demands for inputs 1
and 2?
 What is the firm’s total cost function?
A Perfect Complements Example of
Cost Minimization
x2
4x1 = x2

min{4x1,x2} ≡ y’

x1
A Perfect Complements Example of
Cost Minimization
x2 Where is the least costly
4x1 = x2
input bundle yielding
y’ output units?

min{4x1,x2} ≡ y’

x1
 A Perfect Complements Example of
Cost Minimization
x2 Where is the least costly
4x1 = x2
input bundle yielding
y’ output units?

x2* = y min{4x1,x2} ≡ y’

x1* x1
= y/4
A Perfect Complements Example of
Cost Minimization

So the firm’s total cost function is

c( w 1 , w 2 , y ) = w 1x*1 ( w 1 , w 2 , y )
*
+ w 2x 2 ( w 1 , w 2 , y )
y  w1 
= w1 + w 2y =  + w 2  y.
4  4
 Short-Run & Long-Run Total Costs
 In the long-run a firm can vary all of its input levels.
 Consider a firm that cannot change its input 2 level
from x2’ units.
 How does the short-run total cost of producing y
output units compare to the long-run total cost of
producing y units of output?
 Short-Run & Long-Run Total Costs
 The long-run cost-minimization problem is
min w 1x1 + w 2x 2
x1 ,x 2 ≥ 0

subject to f ( x1 , x 2 ) = y.
 The short-run cost-minimization problem is
min w 1x1 + w 2x ′2
x1 ≥ 0
subject to f ( x1 , x ′2 ) = y.
 The extra constraint in the short run is that x2 = x2’.
Short-Run & Long-Run Total Costs
y ′′′ Long-run costs are:
c( y ′ ) = w 1x1′ + w 2x ′2
x2 Long-run c( y ′′ ) = w 1x1′′ + w 2x ′′′
2
y ′′ output c( y ′′′ ) = w 1x1′′′+ w 2x ′′′
2
expansion
y′ path
x ′′′
2
x ′′2
x ′2

x1′ x1′′ x1′′′ x1

Short-Run & Long-Run Total Costs
y ′′′ Short-run Long-run costs are:
c( y ′ ) = w 1x1′ + w 2x ′2
x2 output c( y ′′ ) = w 1x1′′ + w 2x ′′′
2
y ′′ expansion c( y ′′′ ) = w 1x1′′′+ w 2x ′′′
2
path
y′
x ′′′
2
x ′′2
x ′2

x1′ x1′′ x1′′′ x1

Short-Run & Long-Run Total Costs
y ′′′ Short-run Long-run costs are:
c( y ′ ) = w 1x1′ + w 2x ′2
x2 output c( y ′′ ) = w 1x1′′ + w 2x ′′′
2
y ′′ expansion c( y ′′′ ) = w 1x1′′′+ w 2x ′′′
2
path
y′ Short-run costs are:
c s ( y ′ ) > c( y ′ )
x ′′′
2
x ′′2
x ′2

x1′ x1′′ x1′′′ x1

Short-Run & Long-Run Total Costs
y ′′′ Short-run Long-run costs are:
c( y ′ ) = w 1x1′ + w 2x ′2
x2 output c( y ′′ ) = w 1x1′′ + w 2x ′′′
2
y ′′ expansion c( y ′′′ ) = w 1x1′′′+ w 2x ′′′
2
path
y′ Short-run costs are:
c s ( y ′ ) > c( y ′ )
x ′′′
2 cs ( y ′′ ) = c( y ′′ )
x ′′2
x ′2

x1′ x1′′ x1′′′ x1

Short-Run & Long-Run Total Costs
y ′′′ Short-run Long-run costs are:
c( y ′ ) = w 1x1′ + w 2x ′2
x2 output c( y ′′ ) = w 1x1′′ + w 2x ′′′
2
y ′′ expansion c( y ′′′ ) = w 1x1′′′+ w 2x ′′′
2
path
y′ Short-run costs are:
x ′′′
2 c s ( y ′ ) > c( y ′ )
x ′′2 c s ( y ′′ ) = c( y ′′ )
x ′2 c s ( y ′′′ ) > c( y ′′′ )

x1′ x1′′ x1′′′ x1

 Short-Run & Long-Run Total Costs
A short-run total cost curve always has
£
one point in common with the long-run
total cost curve, and is elsewhere higher
than the long-run total cost curve.
cs(y)
c(y)
F=
w 2x ′′2
y′ y ′′ y ′′′ y
EXAMPLE: THE BLACK DISCIPLES: ∆TC
COSTS OF A TYPICAL FIRM ∆Q

Supply Side
Fixed Total Average Marginal
Cost of Dealers' Pay to Hired
Output Cost Cost Costs Cost
Drugs Wages Board Fighters
(Q) (FC) (TC) (AC) (MC)
0 2700 0 0 0 0 2700 - -

p 21
500 2700 833 1584 833 167 6117 12.23 6.83
1000 2700 1667 3167 1666 333 9533 9.53 6.83
1500 2700 2500 4750 2499 500 12949 8.63 6.83
2000 2700 3333 6333 3332 667 16365 8.18 6.83
2500 2700 4167 7917 4166 833 19782 7.91 6.83
3000 2700 5000 9500 5000 1000 23200 7.73 6.84
3500 2700 5833 11082 5832 1167 26614 7.60 6.83
4000 2700 6667 12664 6664 1333 30028 7.51 6.83
4500 2700 7500 18205 7497 1916 37818 8.40 11.20
5000 2700 8333 23745 8330 2499 45608 9.12 15.58

The data here is from the actual records of Black Disciples,

a Drug Gang in Chicago’s Cabrini Green, run by “JT”
 In case you’re wondering about the data..
 Sudhir Venkatesh (2004) was a sociology graduate student at
U-Chicago who landed up in the projects in Chicago to do a
survey of life there

 On his first day there, they held him for twenty-four hours, as
gang members debated whether, and if so who, should kill him,
but..

 ..he was neither black nor white -- he was brown, with waist-
length hair….they didn’t know what to make of him and they let
him go. He came back and spent four years with the gang in
the projects..

 When the gang was indicted by the Federal Government, one

of the senior members (Booty) gave its account books to
Venkatesh.
 Cost Concepts Applied
 Marginal Cost (MC):
Cost of producing a particular unit of output
 Fixed Cost (FC) – costs that don’t vary with output level
 e.g. death benefits to murdered gang members, legal costs,
bribes to police and other officials, cost of guns.
 Unlike with our book production example, these are not all
one-time fixed costs
 Variable costs (VC) − The sum of the marginal costs of the
units produced. In our example, variable costs include:
 Wagesto gang members (Only £3.30 an hour!).
 Payments to “Board Members”– 20% of sales revenue
 Total Cost = Fixed Cost + Variable Costs,

 Average Cost = TC / Q = (FC/Q)+(VC/Q)

 COST CURVES OF DRUG GANG
50000
Fixed Cost
40000 (FC)
Variable
30000
Cost (VC)

20000 Total Cost

(TC)
10000

0
0 1000 2000 3000 4000 5000

Supply Side p 24
 MC and AC  MC rises eventually –
Why?
18  As capacity is reached,
16 it gets increasingly
costly to distribute more
14
drugs
12 Good dealers hard
10 to find
Competition from
8
other gangs
6
 AC first falls, then rises.
4
 Falls initially as FC is
2
divided over more
0 output,…
0 2000 4000 6000  but rises eventually due
Average Cost (AC) - Marginal Cost (MC) - to rising MC
 Marginal and Average
 Average
falls (and rises) slower
EXAMPLE: MileRace than the Marginal
Time (minutes) Therefore, with costs, the MC
curve intersects the AC curve at
Marginal Averagethe lowest point of the AC curve
Heat 1 6 6
 So it is with the MC and the AVC –
Why?
Heat 2 5 5.5
Heat 3 5.8 5.6
 MC and AC, AVC
£/output unit
MC(y)
AC(y)
AVC(y)

y
•MC curve intersects the AVC at the minimum AVC.
•Sum of Marginal Cost MC = Total Variable Cost TVC
 Marginal vs. Average: Implications
 How will it be with Marginal Product vs. Average
Product (MP vs. AP), or
 Marginal Utility vs. Average Utility (MU vs. AU)?

 Or Marginal vs. Average benefit of anything

 Marginal drops much faster than the Average

 This could be one explanation for why

 If, on average, off-side balls are more effective than leg-side
balls as per the statistics, you may still NOT want to change
the mix..
 If you love eating sushi, you still don’t choose to eat it more
often than twice a week.
 Average Total Cost (or Average Cost)
 Forpositive output levels y, a firm’s average total
cost of producing y units is

c( w 1 , w 2 , y )
AC( w 1 , w 2 , y ) = .
y
Returns-to-Scale and Av. Total Costs
£/output unit

AC(y) decreasing r.t.s.

constant r.t.s.

increasing r.t.s.

y
Returns-to-Scale and Total Costs
Av. cost increases with y if the firm’s
£ technology exhibits decreasing r.t.s.
c(y)
c(2y’) Slope = c(2y’)/2y’
= AC(2y’).
Slope = c(y’)/y’
= AC(y’).
c(y’)

y’ 2y’ y
Returns-to-Scale and Total Costs
Av. cost decreases with y if the firm’s
£ technology exhibits increasing r.t.s.
c(2y’)
Slope = c(2y’)/2y’
c(y’) = AC(2y’).
Slope = c(y’)/y’
= AC(y’).

y’ 2y’ y
Returns-to-Scale and Total Costs
Av. cost decreases with y if the firm’s
£ technology exhibits increasing r.t.s.
c(y)
c(2y’)
Slope = c(2y’)/2y’
c(y’) = AC(2y’).
Slope = c(y’)/y’
= AC(y’).

y’ 2y’ y
 Returns-to-Scale and Total Costs
Av. cost is constant when the firm’s
£ technology exhibits constant r.t.s.
c(2y’) c(y)
=2c(y’) Slope = c(2y’)/2y’
= 2c(y’)/2y’
= c(y’)/y’
c(y’)
so
AC(y’) = AC(2y’).

y’ 2y’ y
 Economic Costs vs. Accounting Costs
 Economic Costs
 Include all costs, explicit or implicit
 For instance, owners’ opportunity costs of operating a firm
is part of the economic definition of cost.

 Accounting Costs
 Include only Explicit Costs [not including owners’
opportunity costs]
 Accountants must use only those quantities that can be
observed and verified by outsiders.
 Example: Profits from Belly Dancing
 Leila (not her real name) is a secretary in the Warwick
Economics Department, who earns £35,000 a year,...
 but she wanted to run a belly-dancing school instead.
 Estimated Revenue = £50K
 Estimated Expenses = £30K
 Leila’s profits from Belly Dancing School:
 Accounting Profits = Revenue – Expenses = £20K
 Economic Profit = Revenue – Expenses – Warwick Salary
= 50K − 30K − 35K = −15K
 Result: Leila teaches belly-dancing in the evenings,
after work at Warwick.
 Why did Leila base her decision on economic profits (negative)
rather than on accounting profits (positive)?
 Main Points
 Long Run vs. Short Run Costs
 Cost Terms

 Marginal vs. Average (Costs, Benefits)

 Accounting vs. Economic Costs, Profits