CHAPTER 13
Costs
CHAPTER SUMMARY AND TEACHING OBJECTIVES
In this chapter economic costs are discussed. Much like a standard microeconomics course, the costs
are presented in order of short run and then long run. The emphasis is on what costs mean to a manager
and how they are measured. How are costs measured? What is the relationship between output and
costs in the short run? What is the relationship between output and costs in the long run?
1. The crucial element in this material is to emphasize to students that all firms can be analyzed
using essentially the same framework because, at least in the short run, all firms have cost-output
relationships that are the same. This is the role of the Law of Diminishing Marginal Returns.
It is important to show that knowledge about production is a large determinant of the behavior of
costs.
IMPORTANT TERMS
short run period of time just short enough that at least one resource cannot be changed
long run period of time just long enough that all resources are variable
law of diminishing marginal returns adding another unit of the variable resource to the fixed
resources will increases output but at a declining rate
average total costs (ATC) per unit costs
marginal costs (MC) additional cost per additional unit of output
total fixed costs (TFC) cost of fixed resources
Chapter 13: Costs 59
TOPICS AND TEACHING SUGGESTIONS
1. Output and Productivity
The law of diminishing marginal returns is the foundation of short-run costs.
2. The Planning Horizon: The Long Run
The discussion in this section emphasizes economies and diseconomies of scale but attempts to
focus on the idea of the long run as a planning period.
ANSWERS TO EXERCISES
1. Use the following information to list the total fixed costs, total variable costs, average fixed costs,
average variable costs, average total costs, and marginal costs.
Output
TC
TFC
TVC
AFC
AVC
ATC
MC
0
$100
1
150
2
225
3
230
Output
TVC
AFC
ATC
0
$100
1
150
2
225
3
230
2. Use the following table to answer the questions listed below.
Output
Cost
TFC
TVC
AFC
AVC
ATC
MC
0
$20
10
40
20
60
30
90
40
120
60
280
60 Chapter 13: Costs
a. List the total fixed costs, total variable costs, average fixed costs, average variable costs,
average total costs, and marginal costs.
b. Plot each of the cost curves.
c. At what quantity of output does marginal cost equal average total cost and average variable
cost?
Output
Cost
TFC
TVC
AFC
AVC
ATC
MC
0
$20
20
10
40
20
20
2
2
4
2
20
60
20
40
1
2
3
2
30
90
20
70
2/3
7/3
3
3
40
120
20
100
1/2
2.5
3
3
50
180
20
160
2/5
16/5
3.6
6
60
280
20
260
1/3
13/3
3.67
10
3. Describe some conditions that might cause larger firms to experience inefficiencies that small
firms would not experience.
4. Why would different industries have different degrees of economies or diseconomies of scale?
5. Describe the relation between marginal and average cost. Describe the relation between marginal
and average fixed costs and between marginal and average variable costs.
6. Consider a firm with a given sized production facility as described by its existing cost curves.
a. Explain what would happen to those cost curves if a mandatory health insurance program is
imposed on all firms.
The cost curves would shift up if everything else remained the same.
b. Suppose the plan requires a firm to provide a health insurance program for each employee
worth 10 percent of the employee’s salary.
c. How would that plan compare to one that requires each firm to provide a $100,000 group
program that would cover all employees in the firm no matter the number of employees?
7. Explain the statement “We had to increase our volume to spread the overhead.”
8. Express Mail offers overnight delivery to customers. It is attempting to come to some conclusion
whether to expand its facilities. Currently its fixed costs are $2 million per month and its variable
costs are $2 per package. It charges $12 per package and has a monthly volume of 2 million
packages. If it expands, its fixed costs will rise by $1 million and its variable costs will fall to
$1.50 per package. Should it expand?
9. Explain outsourcing and what it means for the costs of a firm.
10. “The thing a lot of people don’t understand about e-commerce is the degree to which it is a scale
business,” says Jeff Bezos, CEO of Amazon.com. Where a conventional retailer might have to
double its capital spending to double sales, Amazon’s costs are largely fixed. “Once our software
11. Suppose the costs (in cents) per passenger-mile of operating a jumbo jet on flights of 1200 and
2,500 miles with 250, 300, and 350 passengers aboard is
1
:
Number of
Passengers
Number of Miles
1,200
2,500
250
4.3
3.4
300
3.8
3.0
350
3.5
2.7
a. What is the marginal cost of one more passenger on a 1,200 mile flight if there are between
250 and 300 passengers.
b. If the number of passengers is 300 and the flight is between 1,200 and 2,500 miles, what is the
marginal cost of flying an additional mile?
c. What would the fare on a 2,500 mile flight have to be for a company to cover the operating
costs?
62 Chapter 13: Costs
a. If 250 passengers were carried total operating costs would be 1200
250
4.3cents or
12. What is the economist’s interpretation of costs? What does the following statement mean: “the
concept of cost is far richer (pardon the pun) than the dollars and cents you hand over at the cash
register.”?
a. Costs are opportunity cost plus sunk costs.
b. Costs are what must be given up to gain something.
c. Costs are the value of the opportunity costs of employees.
d. Costs are direct and overhead.
e. Costs are direct, overhead, and sunk.
13. Why might a large firm be more efficient than a small firm?
a. Large firms enable more specialization and trading according to comparative advantage.
b. Large firms experience economies of scale.
c. Large firms may be less efficient than small firms if there are diseconomies of scale.
d. A large firm is able to purchase at quantity discounts.
e. All of the above are correct.
14. What best accounts for the saying “Too many cooks spoil the broth.”?
a. Economies of scale
b. Diseconomies of scale
c. Diminishing marginal returns
d. Increasing marginal returns
e. The law of demand
15. If average fixed costs equal $40 and average total costs equal $100 when output is 10, then total
variable costs when output is 10 must be:
a. $40
b. $60
c. $600
d. $6,000
16. What would it mean if experience results in lower costs per unit but that this result eventually
confronts diminishing marginal product?
17. Could a first mover gain a sustainable advantage from gaining experience? Explain.