CHAPTER 7: Analysis of Costs Assumption: firm always produces output at the lowest possible cost Total Cost = Fixed

Cost + Variable Cost Represents the lowest total dollar expense needed to produce each level of out put q. TC rises as q rises.

Fixed costs- sometimes called overhead or sunk costs, they consist of items such as rent for factory or office space, etc. This must e paid even if the firm produces no output, and they do not chan!e even if output chan!es.

Variable costs- are those which vary as output chan!es. "i.e. materials required to produce output#. $e!ins at % when quantity is %. &art of total cost that !rows with output.

Marginal cost 'enotes the extra or additional cost of producin! ( extra unit of output. )ncremental for a finite-step chan!e in output *s the cost for infinitesimal chan!e in output measured y the tan!ent +lope of the total cost curve

A erage cost Total cost divided y the total num er of units produced

* by comparing average cost with price or average revenue, businesses can determine whether or not they are making a profit. A erage cost = total cost!o"t#"t= TC!$=AC A erage fixed cost= FC!$ *as firm sells more output, it can spread its overhead cost over more and more units. A erage ariable cost= ariable cost di ided by o"t#"t

AVC=VC!$ * When MC of an added unit of output is below its AC, its AC is declining. And, when MC is above AC, AC is increasing. At the point where MC e uals AC, the AC curve is flat. !or the typical "#shaped AC curve, the point where MC e uals AC is also the point where AC hits its minimum level.

%&#ortant R"les: ,hen mar!inal cost is elow avera!e cost, it is pullin! avera!e cost down ,hen -C is a ove *C, it is pullin! *C up ,hen -C .ust equals *C, *C is neither risin! nor fallin! and is at its minimum. /ence, the ottom of a 0-shaped *C, -C1*C1minimum *C. 2irms searchin! for the lowest avera!e cost of production should look for the level of output at which mar!inal costs equal avera!e costs.

$he AC curve is always pierced at its minimum point by the rising MC curve. '(at deter&ines a fir&)s cost c"r e*

price of inputs like la or and land are important factors

influencin! costs. /i!her rents and wa!es mean hi!her cost.

* if technological improvements allow the firm to produce the same output with fewer inputs, the firm%s cost will fall, and the cost curve will shift down. * $he relationship between cost and production helps us e&plain why average cost curves tend to be "#shaped. +(ort r"n, la or and materials costs are typically varia le costs, while capital costs are fixed. -ong r"n- all costs are varia le and none are fixed. '(y is t(e cost c"r e .,s(a#ed*

Consider the short run in which capital is fixed ut la or is

varia le. )n such situation, there are diminishin! returns to

varia le factors "la or# ecause each additional unit of la or has less capital to work with. *s a result, the mar!inal cost of output will rise ecause the extra output produced y each extra la or unit is !oin! down. )n other words, diminishin! returns to the varia le factor will imply an increasin! short-run mar!inal cost. * assumption: !irms minimi'e their costs of production. it simply states that the firms should strive to produce its output at the lowest possible cost and thereby have the ma&imum amount of revenue left over for profits or for other ob(ectives. -east,cost co&bination3 start y calculatin! the mar!inal product of each input. Then divide the mar!inal product of each input y its factor price. $he cost#minimi'ing combination of inputs comes when the marginal product per dollar of input is e ual for all inputs.

-east,cost r"le3 to produce a !iven level of output at least cost, a firm should uy inputs until it has equali4ed the mar!inal product per dollar spent o each input. Marginal Prod"ct of -!Price of -=Marginal #rod"ct of A!Price of A +"bstit"tion R"le3 )f the price of one factor falls while all other factor prices remain the same, firms will profit y su stitutin! the nowcheaper factor for the other factors until the mar!inal products per dollar equal for all inputs. %nco&e state&ent- statement of profits and loss 5et income"profit#1 total revenue- total expenses /e#reciation3 measures the annual cost of a capital input that a company actually own itself. 0alance s(eets- picture of financial conditions on a !ive date. Assets "valua le properties or ri!hts owned y the firm# -iabilities "money or o li!ations owed y the firm# 1et 2ort( "or net value, equal to total assets minus total lia ilities#

+toc3- represents the level of a varia le Flo2- represents the chan!e per unit of time 6$he income statement measures the flows into and out of the firm, while the balance sheet measures the stocks of assets and liabilities at the end of the accounting year. Total assets 1 total lia ilities 7 net worth 1et 2ort( 1 assets 8 lia ilities 4##ort"nity cost

est alternative for!one

value of the most valua le !ood or service for!one. -easure of what has een !iven up when we a make a decision.
* )ead summary and concepts and appendi& -a2 of /i&inis(ing Ret"rns *s we increase one input and hold other inputs constant, the mar!inal product of the varyin! input will, at least after some point, decline.