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Managerial

Economics
MBAFT 6103

Today
Cost Curves

Overview

1. Motivation: HiSense
2. Long Run Cost Functions
Shifts
Long run average and marginal cost functions
Economies of scale

3. Short Run Cost Functions


4. Relationship between Long Run & Short Run Cost
Functions
5. Economies of Scope
6. Learning by Doing

Motivation: Hisense

Chinese Electronics Manufacturer --- pcs, mobile
phone, TVs, refrigerators, air cons
Very high growth from 1990
Entered the U.S. Market in 2005
Concerns --- how production cost will change as
volume goes up? How changes in input prices will
affect cost? Short-run? Long-run?
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Long-Run Cost Function



Once again, solve managers cost minimization
problem for given Q and factor prices (w,r). You get
optimal input choices: L* and K*.
The long run total cost function relates minimized total
cost to output, Q, to the factor prices (w and r).
TC(Q,w,r) = wL*(Q,w,r) + rK*(Q,w,r)

Long-Run Total Cost Curve: Graphically

K0

Long-Run Total Cost Curve: Graphically

Long-Run Total Cost Curve: Graphically


K
Q1
Q0

TC

K1
K0

L0 L1

TC = TC0
TC = TC1

TC1=wL1+rK1
TC0 =wL0+rK0

Q0

Q1 Q

Change in Relative Price


K
TC1/r
TC0/r

-w1/r

Q0

-w0/r

L
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Change in Relative Price shifts TC up


TC

TC(Q) after

TC(Q) before

How do we know that total cost will go up?

Q
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Long-run Average Cost


and Marginal Cost Curves

The long-run average cost function (LRAC) function gives a
firms cost per unit of output.
AC(Q,w,r) = TC(Q,w,r)/Q
The long-run marginal cost function measures the rate of
change of total cost as output varies, holding constant input
prices.
MC(Q,w,r) = TC(Q,w,r)/Q
MC, therefore, equals the slope of TC(Q)
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Average Cost & Marginal


Cost Curves: Relation

Assume w and r are fixed:
If average cost is decreasing as quantity increases,
then average cost is greater than marginal cost, That
is, if AC(Q) decreases in Q, then AC(Q) > MC(Q).
If average cost is increasing as quantity increases, then
average cost is less than marginal cost, That is, if AC(Q)
increases in Q, then AC(Q) < MC(Q).
If average cost is neither increasing nor decreasing as
quantity increases, then average cost is equal to
marginal cost, That is, if AC(Q) remains the same in Q,
then AC(Q) = MC(Q).
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Average and Marginal Cost Curves

MC

AC

AC at minimum when AC(Q)=MC(Q)

Q
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Related Concept:
Economies of Scale

If average cost decreases as output rises, all else
equal, the cost function exhibits economies of scale.
Similarly, if the average cost increases as output rises,
all else equal, the cost function exhibits diseconomies
of scale.
What would you do as a manager if there is economies
of scale at the point at which you are operating?

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Related Concept: Output


Elasticity of Total Cost

The percentage change in total cost per one percent
change in output is the output elasticity of total cost,
TC,Q = (TC/Q)(Q/TC) = MC/AC
If TC,Q < 1, MC < AC, so AC must be decreasing in Q.
Therefore, we have economies of scale.
If TC,Q > 1, MC > AC, so AC must be increasing in Q.
Therefore, we have diseconomies of scale.
If TC,Q = 1, MC = AC, so AC is just flat with respect to Q.
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Output Elasticity of Total Cost



Example: For Selected Manufacturing Industries in India

Industry
Iron and Steel
Cotton Textiles
Cement
Electricity and Gas

TC,Q
0.553
1.211
1.162
0.3823

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Short-Run Cost Function



The short run total cost function gives the minimized total cost of
producing Q units of output, when (at least) one input is fixed at a
particular level. The short-run total cost curve (STC) has two
components: the total variable cost curve (TVC) and the total
fixed cost curve (TFC).
The total variable cost function is the minimized sum of
expenditures on the variable inputs at the short run cost minimizing
input combinations.
The total fixed cost function is a constant equal to the cost of the
fixed input.
If the fixed input is capital, K = K0, then for given Q
STC(Q,K0) = TVC(Q,K0) + TFC(K0)
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Short-Run Average Cost


and Marginal Cost

Similar to long-run average cost function, short run average
cost function for producing Q when K=K0:
SAC(Q,K0) = STC(Q,K0)/Q
The short run marginal cost :
SMC(Q,K0) = STC(Q,K0)/Q

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Long-Run and Short-Run


Cost Curves: Relation

The firm can minimize costs at least as well in the long
run as in the short run because it is less constrained.
Hence, the short run total cost curve lies everywhere
above the long run total cost curve.
In the special case when the quantity is such that the
amount of the fixed inputs just equals the optimal
long run quantities of the inputs, the short run total
cost and the long run total cost will be the same.

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Long-Run and Short-Run Cost Curves


STC(Q,K0)

Total Cost

TC2
TC1
TC0

TC(Q)

Q0

Q1

Q
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Summary: Cost Functions


STC = TVC + TFC
SAC = AVC + AFC
where:
SAC = STC/Q
AVC = TVC/Q (average variable cost)
AFC = TFC/Q (average fixed cost)
The SAC function is the VERTICAL sum of
the AVC and AFC functions

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Summary: Cost Functions


Rs.

SMC

SAC

AVC

AFC
0

Q
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Summary: Cost Functions


Rs.

SAC(Q,K3)

SAC(Q,K1)
SAC(Q,K2)

Q1

Q2

AC(Q)

Q3

Q (units)
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Next
Perfectly Competitive Market

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