Summary

  1. Economic cost includes accounting cost plus the opportunity cost of inputs. Opportunity cost is the value of the input’s next-best use. Decisions should be made taking opportunity costs into account—that is, on the basis of economic cost, not accounting cost. [Section 7.1]

  2. Sunk costs are costs that can never be recovered even if the firm shuts down completely. Costs that are already sunk should not affect decisions going forward, because they have already been paid regardless of what choice is made in the present. [Section 7.2]

  3. A firm’s total cost can be split into fixed and variable components. Fixed cost does not change when the firm’s output does and must be paid even if output is zero. It can only be avoided by the firm completely shutting down and disposing of the inputs (an action that can be undertaken only in the long run). Variable costs are costs that change with the output level. [Section 7.3]

  4. Cost curves relate a firm’s cost to its output quantity. Because fixed cost doesn’t change as output changes, fixed cost curves are horizontal, and total cost curves are parallel to variable cost curves (separated by the amount of fixed cost). [Section 7.3]

  5. Two additional important cost concepts are average and marginal costs. Average cost at a given output quantity equals the ratio of cost to output. Average fixed cost falls continuously as output increases. Average variable cost and average total cost tend to be U-shaped, falling initially, but then rising as output increases. Marginal cost is the additional cost of making one more unit of output. [Section 7.4]

  6. In the short run, the firm’s capital inputs are held constant along its expansion path, and all changes in output come from changing labor inputs. This means that, for all quantities except that quantity at which the fixed capital level is cost-minimizing, short-run total and average total costs must be higher than their long-run values. Every fixed capital level has its own short-run cost curves. The long-run average total cost curve is an “envelope” of all the short-run average total cost curves. Long-run marginal cost equals the short-run marginal costs at the quantities at which the fixed capital level is cost-minimizing. [Section 7.5]

  7. Economies of scale describe the relative rate at which a firm’s cost changes when its output changes. When cost increases at a slower rate than output, the firm has economies of scale. Average cost is falling and the long-run average total cost curve is downward-sloping when there are economies of scale. If cost increases at a faster rate than output, diseconomies of scale occur. Average total cost is rising and the long-run average total cost curve is upward-sloping in this case. If cost increases at the same rate as output, there are neither scale economies nor diseconomies, and long-run average total cost is constant. [Section 7.6]

  8. Economies of scope describe how a firm’s total cost changes with its product specialization. If producing two outputs jointly is cheaper than producing the same amount of the two outputs separately, then there are economies of scope. There are diseconomies of scope if it is instead more expensive. [Section 7.6]