# Analysis of Costs

A. Economic Analysis of Costs

1. Total cost (TC) can be broken down into fixed cost (FC) and variable cost (VC). Fixed costs are unaffected by any production decisions, while variable costs are incurred on items like labor or materials which increase as production levels rise.

2. Marginal cost (MC) is the extra total cost resulting from 1 extra unit of output. Average total cost (AC) is the sum of ever-declining average fixed cost (AFC) and average variable cost (AVC). Short-run average cost is generally represented by a U-shaped curve that is always intersected at its minimum point by the rising MC curve.

3. Useful rules to remember are

TC = FC + VC AC = TC/q AC = AFC + AVC

At the bottom of U-shaped AC, MC = AC = minimum AC.

4. Costs and productivity are like mirror images. When the law of diminishing returns holds, the marginal product falls and the MC curve rises. When there is an initial stage of increasing returns, MC initially falls.

5. We can apply cost and production concepts to a firm’s choice of the best combination of factors of production. Firms that desire to maximize profits will want to minimize the cost of producing a given level of output. In this case, the firm will follow the least-cost rule: different factors will be chosen so that the marginal product per dollar of input is equalized for all inputs. This implies that

MPL/PL = MPA/PA = …

B. Economic Costs and Business Accounting

6. To understand accounting, the most important relationships are:

1. The character of the income statement (or profit-and-loss statement); the residual nature of profits; depreciation on fixed assets

2. The fundamental balance sheet relationship between assets, liabilities, and net worth; the breakdown of each of these into financial and fixed assets; and the residual nature of net worth

C. Opportunity Costs

7. The economist’s definition of costs is broader than the accountant’s. Economic cost includes not only the obvious out-of-pocket purchases or monetary transactions but also more subtle opportunity costs, such as the return to labor supplied by the owner of a firm. These opportunity costs are tightly constrained by the bids and offers in competitive markets, so price is close to opportunity cost for marketed goods and services.

8. The most important application of opportunity cost arises for nonmarket goods–those like clean air or health or recreation–which may be highly valuable even though they are not bought and sold in markets.

1. A production-function table lists the output that can be produced for each labor column and each land row. Diminishing returns to one variable factor, when other factors are held fixed or constant, can be shown by calculating the decline of marginal products in any row or column.

2. An equal-product curve or isoquant depicts the alternative input combinations that produce the same level of output. The slope, or substitution ratio, along such an equal-product curve equals relative marginal products (e.g., MPL/MPA). Curves of equal total cost are parallel lines with slopes equal to factor-price ratios PL/PA. Least-cost equilibrium comes at the tangency point, where an equal-product curve touches but does not cross the lowest TC curve. In least-cost equilibrium, marginal products are proportional to factor prices, with equalized marginal product per dollar spent on all factors (i.e., equalized MPi/Pi

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