Costs

Production function gives technically feasible combinations of inputs- Isoquants *Isocost functions: Opportunity set

wL + rK = Tentative Budget

Production function and isocost functions are superimposed and solved for arriving at the optimal combination.

Point of tangency

Mathematically, slopes are equal

Equating the slopes we can solve for L and k

Work out one example.

Data requirements

Output levels, levels of inputs and their prices

These are the data require to arrive at Cost functions

An Example

An Example: Short run production fn:Q = 5*60 0.5 L 0.5 Q = 5 60L Q2 = 1500L

L = Q2/1500; K = 60
R=5 w=10

Short run cost figures for different Qs: Q 0 L K FC VC TC 300 366.67

0 60 300 0 300 66.7

100 6.67

200 26.67 300 266.7 566.7

Short Run Cost Fn

How will it look? What will it reflect?

Short run cost Fn

It will reflect the behaviour of the MP of the variable inputs. That is eventually diminishing MP.

Graphical representation

MP

MC

Var input

SR Total cost

TC

Q of output

Long run total cost fn

How does returns to scale affect total costs?

Therefore, how does it affect average cost?

And so, how does it affect Marginal cost?

Costs are Economic

Valuing a resource based on: Opportunity cost - economic cost when there is no explicit cash outflow ; NO economic cost when there is a cash outflow!! The concept of relevant cost In the long run, there is no such thing as a free lunch.

Long run

In the long run, scale expansion can lead to:

- returns to scale - change in the process resulting in varying input proportions - change in input prices because of buyer power due to large scale

Long run in the context of costs

All these impact costs:

Economies and diseconomies of scale

Long run cost functions

Longrun cost functions are similar but NO fixed factor input. The fixed factor is interpreted as technology. Estimated empirically. Cubic form to accommodate economies of scale in the long run and diminishing returns in the short run. Eg: TC= 200 +5Q -0.04Q2 + 0.001Q3

Family of cost functions

Average Total Cost

Average Fixed Cost

Average Variable Cost Marginal cost

Shapes of this? Reflects the corresponding Production function. Increasing returns corresponds to deceasing cost Decreasing returns corresponds to increasing cost. * A cubic fn captures both the phases.

Mathematically, Marginal Cost(MC) is the derivative of TC dTC/dQ is therefore the Marginal Cost. Given TC function, we can get the MC Fn. In the example,Given TC=200+5Q-.04Q2+0.001Q3,

MC=dTC/dQ=5-0.08Q+0.003Q2
AC=TC/Q=200/Q+5-0.04Q+0.001Q2

We can derive AVC and AFC also

Min of the AC can also be derived as dAC/dQ =0 This will give us that level of output at which AC is MINIMUM.

A problem

A Problem: Given TC=100,000Q-1000Q2+10Q3 A firm is planning to enter with a capacity of 25 million.Given that the going price is Rs.75000 per million and that the seller cannot change this price, should he go ahead?

Solution: AC= 100000-1000Q+10Q2 dAC/dQ=-1000+20Q=0 20Q=1000 Q=50 mill At 50 mill , AC=75,000 which is equal to the price. The firm should set up a capacity of 50 million.

Economies of scope

C(q1,q2) < c(q1)+c(q2) Index:((C(q1)+C(q2)- C(q1,q2))/C(q1,q2)

Measurement of economies of scale

Cost-output elasticity?

Ec : (C /C) / (Q /Q)

MC/AC When Ec < 1; when Ec > 1 or = 1?? SCI(scale economies index) = 1 -Ec

Profits

*Profit is max where the difference between TR and TC is MAX. This is at the level of Q* *At Q* slopes of TC and TR are equal. * Same as saying MC is equal to MR

With MC and MR(in the first set of ppts) we can define profit maximizing output as: That level of output at which MC=MR

Profit maximization

Is this condition sufficient?

Second order condition:That point beyond which MC exceeds MR. Third condition: Does the price cover the AC at this optimal level?

First order condition: dTR/dq = dTC/dq which is MR = MC Second order condition: For a maximum is d2 / dq2 < 0( profit). So d2TR / dq2 < d2TC/dq2 That is, MC should cut MR from below.

Supply curve

Derivation: The context- Price taking firm The Profit maximizing rule becomes: MC = MR , since MR = P, becomes MC = P

So at different Prices, MC = P happens at different quantities.

Supply curve is derived from the rising part of the MC curve above the minimum Average Cost.

Market Supply curve

Aggregation of individual supply curves.

Thus the two forces interact to determine the equilibrium price.

What the equlibrium price will be depends on the relative strengths of the players who constitute the forces of demand and supply. *The relative strengths of the players on the Supply side depends on the kind of Market structure they are operating in.

That takes us on to Market structures.