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Chapter 7: Costs and Cost Minimization

In this chapter we will cover:

Different Types of Cost -Explicit and Implicit Costs

-Opportunity Costs-Economic and Accounting Costs

Isocost LinesCost MinimizationShort-Run and Long-Run situations

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Explicit Costs: Costs that involve an exchange of money

-ie: Rent, Wages, Licence, Materials

Implicit Costs: Costs that don’t involve an exchange of money

-ie: Wage that could have been earned working elsewhere; profitability of a goat if used mowing lawns instead of for meat

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Definition: Value of the next best alternative; total benefit of choosing the next best option

IE: Instead of opening his own Bait shop, which cost $5,000 per month to run (explicit cost), Buck could have worked for Worms R Us for $2,000 per month (implicit cost).

His opportunity cost is $2,000 (alternate wage) + $5,000 (the amount he WOULDN’T have to pay each month) = $7,000

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Economic Costs

Economic Costs = Explicit + Implicit Costs

• Economists & Accountants calculate costs differently:

– Economists are interested in studying how firms make production & pricing decisions. They include all costs.

Accounting Costs = Explicit Costs

Accounting Costs– Accountants are responsible for keeping track

of the money that flows into and out of firms. They focus on explicit costs.

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EconomicCosts

Revenue

EconomicProfit

ImplicitCosts

ExplicitCosts

Revenue

AccountingProfit

ExplicitCosts

Economist’sView

Accountant’sView

Profit: Economists vs Accountants

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One of the goals of a firm is to produce output at a minimum cost.

This minimization goal can be carried out in two situations:

1)The long run (where all inputs are variable)

2)The short run (where some inputs are not variable)

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Suppose that a firm’s owners wish to minimize costs…

Let the desired output be Q0

Technology: Q = f(L,K)

Owner’s problem: min TC = rK + wL K,L Subject to Q0 = f(L,K)

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From the firm’s cost equation:

TC0 = rK + wL

One can obtain the formula for the ISOCOST LINE:

K = TC0/r – (w/r)L

The isocost line graphically depicts all combinations of inputs (labour and capital) that carry the same cost.

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Isocost curves are similar to indifference curves, and the tangency condition of cost minimization is also similar to the tangency condition of consumers:

MRTSL,K = -MPL/MPK = -w/r