Fundamentals of Economics

HS 108

The Cost of Production

Chapter 7 The Cost of Production

Kalandi Charan Pradhan,

School of Humanities and Social Sciences,
Indian Institute of Technology Indore

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 CHAPTER 7 OUTLINE

7.1 Measuring Cost: Which Costs Matter?

7.2 Cost in the Short Run

7.3 Cost in the Long Run

7.4 Long-Run versus Short-Run Cost Curves

Chapter 7 The Cost of Production

7.5 Production with Two Outputs—Economies of Scope

7.6 Dynamic Changes in Costs—The Learning Curve

7.7 Estimating and Predicting Cost

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 7.1 MEASURING COST: WHICH COSTS MATTER?

Economic Cost versus Accounting Cost

● accounting cost Actual expenses

plus depreciation charges for capital
equipment.

● economic cost Cost to a firm of

utilizing economic resources in
production, including opportunity cost.
Chapter 7 The Cost of Production

Opportunity Cost
● opportunity cost Cost associated with
opportunities that are forgone when a
firm’s resources are not put to their best
alternative use.

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 7.1 MEASURING COST: WHICH COSTS MATTER?

Sunk Costs
● sunk cost Expenditure that has
been made and cannot be
recovered.

Because a sunk cost cannot be recovered, it should not

influence the firm’s decisions.

For example, consider the purchase of specialized equipment

Chapter 7 The Cost of Production

for a plant. Suppose the equipment can be used to do only

what it was originally designed for and cannot be converted
for alternative use. The expenditure on this equipment is a
sunk cost. Because it has no alternative use, its opportunity
cost is zero. Thus it should not be included as part of the
firm’s economic costs.

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 7.1 MEASURING COST: WHICH COSTS MATTER?

The Northwestern University Law School has been located in Chicago. However, the
main campus is located in the suburb of Evanston.
In the mid-1970s, the law school began planning the construction of a new building
and needed to decide on an appropriate location.
Should it be built on the current site, near downtown Chicago law firms?
Should it be moved to Evanston, physically integrated with the rest of the university?
Chapter 7 The Cost of Production

Some argued it was cost-effective to locate the new building in the city because the
university already owned the land. Land would have to be purchased in Evanston if
the building were to be built there.
Does this argument make economic sense?
No. It makes the common mistake of failing to appreciate opportunity costs. From an
economic point of view, it is very expensive to locate downtown because the property
could have been sold for enough money to buy the Evanston land with substantial
funds left over.
Northwestern decided to keep the law school in Chicago.

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 7.1 MEASURING COST: WHICH COSTS MATTER?

Fixed Costs and Variable Costs

● total cost (TC or C) Total economic

cost of production, consisting of fixed
and variable costs.

● fixed cost (FC) Cost that does not

vary with the level of output and that
Chapter 7 The Cost of Production

can be eliminated only by shutting

down.
● variable cost (VC) Cost that varies
as output varies.

The only way that a firm can eliminate its fixed costs is by
shutting down.

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 7.1 MEASURING COST: WHICH COSTS MATTER?

Fixed Costs and Variable Costs

Shutting Down
Shutting down doesn’t necessarily mean going out of business.
By reducing the output of a factory to zero, the company could eliminate the
costs of raw materials and much of the labor. The only way to eliminate fixed
costs would be to close the doors, turn off the electricity, and perhaps even sell
off or scrap the machinery.

Fixed or Variable?
Chapter 7 The Cost of Production

How do we know which costs are fixed and which are variable?
Over a very short time horizon—say, a few months—most costs are fixed.
Over such a short period, a firm is usually obligated to pay for contracted
shipments of materials.
Over a very long time horizon—say, ten years—nearly all costs are variable.
Workers and managers can be laid off (or employment can be reduced by
attrition), and much of the machinery can be sold off or not replaced as it
becomes obsolete and is scrapped.

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 7.1 MEASURING COST: WHICH COSTS MATTER?

Fixed versus Sunk Costs

Sunk costs are costs that have been incurred and cannot be
recovered.
An example is the cost of R&D to a pharmaceutical company to
develop and test a new drug and then, if the drug has been
proven to be safe and effective, the cost of marketing it.
Whether the drug is a success or a failure, these costs cannot be
recovered and thus are sunk.
Chapter 7 The Cost of Production

Amortizing Sunk Costs

● amortization Policy of treating a

one-time expenditure as an annual
cost spread out over some number of
years.

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 7.1 MEASURING COST: WHICH COSTS MATTER?

It is important to understand the characteristics of production costs and to be able to

identify which costs are fixed, which are variable, and which are sunk.
Good examples include the personal computer industry (where most costs are
variable), the computer software industry (where most costs are sunk), and the
pizzeria business (where most costs are fixed).
Because computers are very similar, competition is intense, and profitability
Chapter 7 The Cost of Production

depends on the ability to keep costs down. Most important are the variable cost of
components and labor.
A software firm will spend a large amount of money to develop a new application.
The company can try to recoup its investment by selling as many copies of the
program as possible.
For the pizzeria, sunk costs are fairly low because equipment can be resold if the
pizzeria goes out of business. Variable costs are low—mainly the ingredients for
pizza and perhaps wages for a couple of workers to help produce, serve, and deliver
pizzas.

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 7.1 MEASURING COST: WHICH COSTS MATTER?

Marginal and Average Cost

Marginal Cost (MC)

● marginal cost (MC) Increase

in cost resulting from the
production of one extra unit of
output.
Chapter 7 The Cost of Production

Because fixed cost does not change as the firm’s level of output changes,
marginal cost is equal to the increase in variable cost or the increase in
total cost that results from an extra unit of output.
We can therefore write marginal cost as

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 7.1 MEASURING COST: WHICH COSTS MATTER?

Marginal and Average Cost

Marginal Cost (MC)

TABLE 7.1 A Firm’s Costs
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Cost Variable Cost Total Cost
(Units (Dollars (Dollars (Dollars (Dollars (Dollars (Dollars (Dollars
per Year) per Year) per Year) per Year) per Unit) per Unit) per Unit) per Unit)
(FC) (VC) (TC) (MC) (AFC) (AVC) (ATC)
(1) (2) (3) (4) (5) (6) (7)
Chapter 7 The Cost of Production

0 50 0 50 -- -- -- --
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5

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 7.1 MEASURING COST: WHICH COSTS MATTER?

Marginal and Average Cost

Average Total Cost (ATC)

● average total cost (ATC)

Firm’s total cost divided by its
level of output.
Chapter 7 The Cost of Production

● average fixed cost (AFC)

Fixed cost divided by the level of
output.

● average variable cost (AVC)

Variable cost divided by the level of
output.

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 7.2 COST IN THE SHORT RUN

The Determinants of Short-Run Cost

The change in variable cost is the per-unit cost of the extra labor w times
the amount of extra labor needed to produce the extra output ΔL. Because
ΔVC = wΔL, it follows that

The extra labor needed to obtain an extra unit of output is ΔL/Δq = 1/MPL.
Chapter 7 The Cost of Production

As a result,
(7.1)

Diminishing Marginal Returns and Marginal Cost

Diminishing marginal returns means that the marginal product of labor

declines as the quantity of labor employed increases.
As a result, when there are diminishing marginal returns, marginal cost
will increase as output increases.

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 7.2 COST IN THE SHORT RUN

The Shapes of the Cost Curves

Figure 7.1

Cost Curves for a Firm

In (a) total cost TC is the

vertical sum of fixed cost
FC and variable cost VC.
In (b) average total cost
ATC is the sum of
average variable cost
Chapter 7 The Cost of Production

AVC and average fixed

cost AFC.
Marginal cost MC
crosses the average
variable cost and average
total cost curves at their
minimum points.

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 7.2 COST IN THE SHORT RUN

The Shapes of the Cost Curves

The Average-Marginal
Relationship

Consider the line drawn from

origin to point A in (a). The
slope of the line measures
average variable cost (a total
cost of $175 divided by an
output of 7, or a cost per unit
Chapter 7 The Cost of Production

of $25).
Because the slope of the VC
curve is the marginal cost ,
the tangent to the VC curve
at A is the marginal cost of
production when output is 7.
At A, this marginal cost of
$25 is equal to the average
variable cost of $25 because
average variable cost is
minimized at this output.

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 7.2 COST IN THE SHORT RUN
Total Cost as a Flow
Note that the firm’s output is measured as a flow: The firm produces
a certain number of units per year. Thus its total cost is a flow.

TABLE 7.2 Production Costs for Aluminum Smelting

($/ton) (based on an output of 600 tons/day)
Per-ton costs that are constant Output ≤ 600 Output > 600
for all output levels tons/day tons/day
Electricity $316 $316
Chapter 7 The Cost of Production

Alumina 369 369

Other raw materials 125 125
Plant power and fuel 10 10
Subtotal $820 $820
Per-ton costs that increase when
output exceeds 600 tons/day
Labor $150 $225
Maintenance 120 180
Freight 50 75
Subtotal $320 $480
Total per-ton production costs $1140 $1300

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 7.2 COST IN THE SHORT RUN

Figure 7.2
The Short-Run Variable
Costs of Aluminum Smelting
Chapter 7 The Cost of Production

The short-run average

variable cost of smelting is
constant for output levels
using up to two labor shifts.
When a third shift is added,
marginal cost and average
variable cost increase until
maximum capacity is
reached.

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 7.3 COST IN THE LONG RUN

The User Cost of Capital

● user cost of capital Annual cost of
owning and using a capital asset, equal
to economic depreciation plus forgone
interest.

The user cost of capital is given by the sum of the economic

depreciation and the interest (i.e., the financial return) that could
Chapter 7 The Cost of Production

have been earned had the money been invested elsewhere.

Formally,

We can also express the user cost of capital as a rate per dollar of
capital:

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 7.3 COST IN THE LONG RUN

The Cost-Minimizing Input Choice

We now turn to a fundamental problem that all firms face: how to
select inputs to produce a given output at minimum cost.
For simplicity, we will work with two variable inputs: labor (measured in
hours of work per year) and capital (measured in hours of use of
machinery per year).

The Price of Capital

Chapter 7 The Cost of Production

The price of capital is its user cost, given by r = Depreciation rate + Interest rate.

The Rental Rate of Capital

● rental rate Cost per year of renting one unit of capital.

If the capital market is competitive, the rental rate should be equal to the user
cost, r. Why? Firms that own capital expect to earn a competitive return when
they rent it. This competitive return is the user cost of capital.
Capital that is purchased can be treated as though it were rented at a rental rate
equal to the user cost of capital.

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 7.3 COST IN THE LONG RUN

The Isocost Line

● isocost line Graph showing
all possible combinations of
labor and capital that can be
purchased for a given total cost.
To see what an isocost line looks like, recall that the total cost C of
producing any particular output is given by the sum of the firm’s labor
cost wL and its capital cost rK:
Chapter 7 The Cost of Production

(7.2)

If we rewrite the total cost equation as an equation for a straight line,

we get

It follows that the isocost line has a slope of ΔK/ΔL = −(w/r), which is
the ratio of the wage rate to the rental cost of capital.

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 7.3 COST IN THE LONG RUN

The Isocost Line

Figure 7.3

Producing a Given Output at

Minimum Cost

Isocost curves describe the

combination of inputs to
production that cost the
same amount to the firm.
Chapter 7 The Cost of Production

Isocost curve C1 is tangent

to isoquant q1 at A and
shows that output q1 can be
produced at minimum cost
with labor input L1 and
capital input K1.
Other input combinations–
L2, K2 and L3, K3–yield the
same output but at higher
cost.

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 7.3 COST IN THE LONG RUN

Choosing Inputs

Figure 7.4

Input Substitution When an

Input Price Changes

Facing an isocost curve

C1, the firm produces
output q1 at point A using
L1 units of labor and K1
units of capital.
Chapter 7 The Cost of Production

When the price of labor

increases, the isocost
curves become steeper.
Output q1 is now produced
at point B on isocost curve
C2 by using L2 units of
labor and K2 units of
capital.

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 7.3 COST IN THE LONG RUN

Choosing Inputs

Recall that in our analysis of production technology, we showed

that the marginal rate of technical substitution of labor for
capital (MRTS) is the negative of the slope of the isoquant and
is equal to the ratio of the marginal products of labor and
capital:
(7.3)
Chapter 7 The Cost of Production

It follows that when a firm minimizes the cost of producing a particular

output, the following condition holds:

We can rewrite this condition slightly as follows:

(7.4)

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 7.3 COST IN THE LONG RUN

Figure 7.5
The Cost-Minimizing
Response to an Effluent Fee

When the firm is not

charged for dumping its
wastewater in a river, it
chooses to produce a
given output using 10,000
Chapter 7 The Cost of Production

gallons of wastewater and

2000 machine-hours of
capital at A.
However, an effluent fee
raises the cost of
wastewater, shifts the
isocost curve from FC to
DE, and causes the firm
to produce at B—a
process that results in
much less effluent.

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 7.3 COST IN THE LONG RUN

Cost Minimization with Varying Output Levels

● expansion path Curve passing
through points of tangency
between a firm’s isocost lines
and its isoquants.

The Expansion Path and Long-Run Costs

To move from the expansion path to the cost curve, we follow three
Chapter 7 The Cost of Production

steps:
1. Choose an output level represented by an isoquant. Then find
the point of tangency of that isoquant with an isocost line.
2. From the chosen isocost line determine the minimum cost of
producing the output level that has been selected.
3. Graph the output-cost combination.

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 7.3 COST IN THE LONG RUN

Cost Minimization with Varying Output Levels

Figure 7.6

A Firm’s Expansion Path and

Long-Run Total Cost Curve

In (a), the expansion path

(from the origin through points
A, B, and C) illustrates the
lowest-cost combinations of
labor and capital that can be
used to produce each level of
Chapter 7 The Cost of Production

output in the long run— i.e.,

when both inputs to
production can be varied.
In (b), the corresponding long-
run total cost curve (from the
origin through points D, E, and
F) measures the least cost of
producing each level of
output.

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 7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

The Inflexibility of Short-Run Production

Figure 7.7

The Inflexibility of Short-Run

Production

When a firm operates in the

short run, its cost of
production may not be
minimized because of
inflexibility in the use of capital
Chapter 7 The Cost of Production

inputs.
Output is initially at level q1.
In the short run, output q2 can
be produced only by
increasing labor from L1 to L3
because capital is fixed at K1.
In the long run, the same
output can be produced more
cheaply by increasing labor
from L1 to L2 and capital from
K1 to K2.

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 7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Long-Run Average Cost

Figure 7.8

Long-Run Average and

Marginal Cost

When a firm is producing at

an output at which the long-
run average cost LAC is
falling, the long-run marginal
Chapter 7 The Cost of Production

cost LMC is less than LAC.

Conversely, when LAC is
increasing, LMC is greater
than LAC.
The two curves intersect at
A, where the LAC curve
achieves its minimum.

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 7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Long-Run Average Cost

● long-run average cost curve (LAC) Curve

relating average cost of production to output
when all inputs, including capital, are variable.

● short-run average cost curve (SAC) Curve

relating average cost of production to output when
Chapter 7 The Cost of Production

level of capital is fixed.

● long-run marginal cost curve (LMC) Curve

showing the change in long-run total cost as
output is increased incrementally by 1 unit.

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 7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Economies and Diseconomies of Scale

As output increases, the firm’s average cost of producing that output

is likely to decline, at least to a point.
This can happen for the following reasons:
1. If the firm operates on a larger scale, workers can specialize
in the activities at which they are most productive.
Chapter 7 The Cost of Production

2. Scale can provide flexibility. By varying the combination of

inputs utilized to produce the firm’s output, managers can
organize the production process more effectively.
3. The firm may be able to acquire some production inputs at
lower cost because it is buying them in large quantities and
can therefore negotiate better prices. The mix of inputs
might change with the scale of the firm’s operation if
managers take advantage of lower-cost inputs.

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 7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Economies and Diseconomies of Scale

At some point, however, it is likely that the average cost of

production will begin to increase with output.
There are three reasons for this shift:
1. At least in the short run, factory space and machinery may
make it more difficult for workers to do their jobs effectively.
Chapter 7 The Cost of Production

2. Managing a larger firm may become more complex and

inefficient as the number of tasks increases.
3. The advantages of buying in bulk may have disappeared
once certain quantities are reached. At some point,
available supplies of key inputs may be limited, pushing
their costs up.

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 7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Economies and Diseconomies of Scale

● economies of scale Situation

in which output can be doubled
for less than a doubling of cost.

● diseconomies of scale
Situation in which a doubling of
output requires more than a
Chapter 7 The Cost of Production

doubling of cost.

Increasing Returns to Scale: Output more than doubles when

the quantities of all inputs are
doubled.
Economies of Scale: A doubling of output requires less
than a doubling of cost.

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 7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Economies and Diseconomies of Scale

Economies of scale are often measured in terms of a cost-output

elasticity, EC. EC is the percentage change in the cost of production
resulting from a 1-percent increase in output:

(7.5)

To see how EC relates to our traditional measures of cost, rewrite the

Chapter 7 The Cost of Production

equation as follows:
(7.6)

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 7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

The Relationship Between Short-Run and Long-Run Cost

Figure 7.9

Long-Run Cost with Economies

and Diseconomies of Scale

The long-run average cost

curve LAC is the envelope
of the short-run average
cost curves SAC1, SAC2,
Chapter 7 The Cost of Production

and SAC3.
With economies and
diseconomies of scale, the
minimum points of the short-
run average cost curves do
not lie on the long-run
average cost curve.

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 7.5 PRODUCTION WITH TWO OUTPUTS—
ECONOMIES OF SCOPE

Product Transformation Curves

Figure 7.10

Product Transformation Curve

The product transformation

curve describes the different
combinations of two outputs
that can be produced with a
fixed amount of production
inputs.
Chapter 7 The Cost of Production

The product transformation

curves O1 and O2 are bowed
out (or concave) because
there are economies of
scope in production.

● product transformation curve Curve showing the

various combinations of two different outputs (products)
that can be produced with a given set of inputs.
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 7.5 PRODUCTION WITH TWO OUTPUTS—
ECONOMIES OF SCOPE

Economies and Diseconomies of Scope

● economies of scope Situation in

which joint output of a single firm is
greater than output that could be
achieved by two different firms when
each produces a single product.
Chapter 7 The Cost of Production

● diseconomies of scope Situation

in which joint output of a single firm
is less than could be achieved by
separate firms when each produces
a single product.

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 7.5 PRODUCTION WITH TWO OUTPUTS—
ECONOMIES OF SCOPE

The Degree of Economies of Scope

To measure the degree to which there are economies of scope, we

should ask what percentage of the cost of production is saved when
two (or more) products are produced jointly rather than individually.

(7.7)
Chapter 7 The Cost of Production

● degree of economies of scope (SC)

Percentage of cost savings resulting
when two or more products are
produced jointly rather than
Individually.

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 7.5 PRODUCTION WITH TWO OUTPUTS—
ECONOMIES OF SCOPE

In the trucking business, several related products can be

offered, depending on the size of the load and the length of the
haul. The range of possibilities raises questions about both
economies of scale and economies of scope.
In the trucking business, several related products can be offered, depending on the size
of the load and the length of the haul. The range of possibilities raises questions about
both economies of scale and economies of scope.
Chapter 7 The Cost of Production

The scale question asks whether large-scale, direct hauls are more profitable than
individual hauls by small truckers. The scope question asks whether a large trucking firm
enjoys cost advantages in operating both direct quick hauls and indirect, slower hauls.
Because large firms carry sufficiently large truckloads, there is usually no advantage to
stopping at an intermediate terminal to fill a partial load.
Because other disadvantages are associated with the management of very large firms,
the economies of scope get smaller as the firm gets bigger.
The study suggests, therefore, that to compete in the trucking industry, a firm must be
large enough to be able to combine loads at intermediate stopping points.

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 *7.6 DYNAMIC CHANGES IN COSTS—
THE LEARNING CURVE

As management and labor gain experience with production, the firm’s

marginal and average costs of producing a given level of output fall for four
reasons:
1. Workers often take longer to accomplish a given task the first few
times they do it. As they become more adept, their speed increases.
2. Managers learn to schedule the production process more effectively,
Chapter 7 The Cost of Production

from the flow of materials to the organization of the manufacturing

itself.
3. Engineers who are initially cautious in their product designs may
gain enough experience to be able to allow for tolerances in design
that save costs without increasing defects. Better and more
specialized tools and plant organization may also lower cost.
4. Suppliers may learn how to process required materials more
effectively and pass on some of this advantage in the form of lower
costs.
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 *7.6 DYNAMIC CHANGES IN COSTS—
THE LEARNING CURVE

Figure 7.11

The Learning Curve

A firm’s production cost may

fall over time as managers and
workers become more
experienced and more
effective at using the available
plant and equipment.
The learning curve shows the
Chapter 7 The Cost of Production

extent to which hours of labor

needed per unit of output fall
as the cumulative output
increases.

● learning curve Graph relating amount of inputs

needed by a firm to produce each unit of output to
its cumulative output.

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 *7.6 DYNAMIC CHANGES IN COSTS—
THE LEARNING CURVE

Graphing the Learning Curve

The learning curve is based on the relationship

(7.8)

Learning versus Economies of Scale

Figure 7.12
Chapter 7 The Cost of Production

Economies of Scale versus Learning

A firm’s average cost of production

can decline over time because of
growth of sales when increasing
returns are present (a move from A
to B on curve AC1),
or it can decline because there is a
learning curve (a move from A on
curve AC1 to C on curve AC2).

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 *7.6 DYNAMIC CHANGES IN COSTS—
THE LEARNING CURVE

Learning versus Economies of Scale

TABLE 7.3 Predicting the Labor Requirements of Producing

a Given Output

Cumulative Output Per-Unit Labor Requirement Total Labor

(N) for Each 10 Units of Output (L)* Requirement
10 1.00 10.0
20 .80 18.0(10.0 + 8.0)
Chapter 7 The Cost of Production

30 .70 25.0(18.0 + 7.0)

40 .64 31.4(25.0 + 6.4)
50 .60 37.4(31.4 + 6.0)
60 .56 43.0(37.4 + 5.6)
70 .53 48.3(43.0 + 5.3)
80 .51 53.4(48.3 + 5.1)
*The numbers in this column were calculated from the equation log(L) = −0.322 log(N/10), where L is the
unit labor input and N is cumulative output.

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 *7.6 DYNAMIC CHANGES IN COSTS—
THE LEARNING CURVE

Figure 7.13

Learning Curve for Airbus

Industrie

The learning curve relates

the labor requirement per
aircraft to the cumulative
Chapter 7 The Cost of Production

number of aircraft
produced.
As the production process
becomes better organized
and workers gain
familiarity with their jobs,
labor requirements fall
dramatically.

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 7.7 ESTIMATING AND PREDICTING COST

● cost function Function relating cost of

production to level of output and other
variables that the firm can control.

Figure 7.14
Variable Cost Curve for the
Automobile Industry

An empirical estimate of the

variable cost curve can be
Chapter 7 The Cost of Production

obtained by using data for

individual firms in an industry.
The variable cost curve for
automobile production is
obtained by determining
statistically the curve that best
fits the points that relate the
output of each firm to the firm’s
variable cost of production.

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 7.7 ESTIMATING AND PREDICTING COST

To predict cost accurately, we must determine the underlying

relationship between variable cost and output. The curve
provides a reasonably close fit to the cost data.
But what shape is the most appropriate, and how do we
represent that shape algebraically?
Here is one cost function that we might choose:
(7.9)
Chapter 7 The Cost of Production

If we wish to allow for a U-shaped average cost curve and a marginal

cost that is not constant, we must use a more complex cost function.
One possibility is the quadratic cost function, which relates variable cost
to output and output squared:
(7.10)

If the marginal cost curve is not linear, we might use a cubic cost function:
(7.11)

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 7.7 ESTIMATING AND PREDICTING COST

Figure 7.15

Cubic Cost Function

A cubic cost function

implies that the average
and the marginal cost
curves are U-shaped.
Chapter 7 The Cost of Production

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 7.7 ESTIMATING AND PREDICTING COST

Cost Functions and the Measurement of Scale Economies

The scale economies index (SCI) provides an index of whether or not

there are scale economies.
SCI is defined as follows:

(7.12)
Chapter 7 The Cost of Production

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 7.7 ESTIMATING AND PREDICTING COST

In 1955, consumers bought 369 billion

kilowatt- hours (kwh) of electricity; in
1970 they bought 1083 billion.
Was this increase due to economies of
scale or to other factors?
If it was the result of economies of scale,
Chapter 7 The Cost of Production

it would be economically inefficient for

regulators to “break up” electric utility
monopolies.

TABLE 7.4 Scale Economies in the Electric Power Industry

Output (million kwh) 43 338 1109 2226 5819
Value of SCI, 1955 .41 .26 .16 .10 .04

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 7.7 ESTIMATING AND PREDICTING COST
Chapter 7 The Cost of Production

Figure 7.16

Average Cost of Production in the Electric Power Industry

The average cost of electric power in 1955 achieved a minimum

at approximately 20 billion kilowatt-hours.
By 1970 the average cost of production had fallen sharply and
achieved a minimum at an output of more than 33 billion kilowatt-
hours.

© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e. 49 of 49