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CHAPTER

7
AnalysisofCosts
CHAPTEROVERVIEWANDTEACHINGTIPS
Thischapterbringsintofocusthewiderangeofcostmeasuresusedbyeconomists:totalcost,fixedcost,variablecost,averagetotalcost,averagefixedcost,averagevariablecost,andmarginalcost.Minimumproductioncostsforafirmarerepresentedalongatotalcostschedule,whichisafunctionofthelevelofoutput.Inputsusedintheirleast-costcombinationlinktheproductionfunctionwiththecostcurves,anditistheabilitytoadjusttheemploymentofinputsthatprovidesthedistinctionbetweenthetwocomponentsofshort-runtotalcost:variablecostandfixedcost.Themajorobjectivehereisforstudentstoobtainasolidunderstandingofaneconomist’sperspectiveofcostaccounting,sothatsubsequentdescriptionsofmarketstructurewillmakesense.Thestudentisexpectedtousetablesanddiagramstodevelopanunderstandingofbothspecificexamplesandmoregeneralrepresenta-tionsofcostconcepts.Chapter7alsoprovidesabriefintroductiontoaccountingpractices.Theintroductionhereisshort,coveringonlytwobasictools—thebalancesheetandtheincomestatement.Thebalancesheetisasnapshotoffinancialhealth;itreflectstheeconomicconditionofaneconomicentityatsomeprescribedpointintime.Theincomestatement,bywayofcontrast,isamotionpicture,reflectinggrowthoveragivenperiodoftime;itdescribesthepathafirmtakesbetweentwodifferentbalancesheets.
LEARNINGOBJECTIVES

1.Defineanddescribetotalcost,fixedcost,variablecost,marginalcost,andaveragecost,explaining
whatthesemeasuresofcostaredesignedtoreflectandhowtheyarerelatedtooneanother.2.Derivetheassociatedaverageandmarginalcoststatisticsfromtotal,fixed,andvariablecost.3.Explainthelinkbetweenproductivityandcost.4.DemonstratepreciselywhymarginalcostalwaysintersectsaveragecostattheminimumofanyU-shapedaveragecostcurve.5.Demonstratewhyproductioncostsareminimizedwheninputsarehiredincombinationssuchthattheratiosoftheirmarginalproductstotheirpricesareallequal.6.Explaincarefullytheinformationthatabalancesheetisintendedtoconvey.
Listthemajorcategoriesappearingonthetwosidesofabalancesheet,andindicatethemeaning(ordefinitionofeachofthosecategories.7.Listthemajoritemsappearingonanincomestatement.Indicatetheinformationthatanincome
statementisintendedtoconvey.8.Explaintheroleofdepreciationandopportunitycostinthecorrectandaccurateconstructionof
anincomestatement.9.Definethetermopportunitycostandapplyittomanagementdecisionsmadebyfirmsandindividuals
SUGGESTEDANSWERSTOQUESTIONSINTHETEXT

1.a..344b.Attheendof1959hisaveragewas.346.Hisaveragefor1960was.316.Sincehisaveragein1960wasbelowhislifetimeaveragethe1960averagepulledhislifetimeaveragedown.2.MCandAVCdonotchange;TC,AC,andAFCshiftup.MinimumoccurswhereMC=AC=$60at5units.
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30CHAPTER7:ANALYSISOFCOSTS

3.ACabove(belowMCmeansthatthenextincrementlowers(increasestheaverage;i.e.,ACisfalling(climbing.OnlywhenMC=ACisACneitherrisingnorfalling;i.e.,itisatitsminimum.4.Withavolunteerarmythegovernmentmustbeconcernedaboutattractingsoldiers.Peoplewillagreetoenlistonlywhenthewagestheyarepaidcovertheiropportunitycosts.Ifserviceiscompulsory,thegovernmenthasnosuchconstraintsonitswagescheme.5.a.Fixedcostequals15$12=$180.MCisthecostofthelaborrequiredforeachunitincreaseinoutput:
$30,$25,$20,$30,$50,$70,$90.Variablecostistotallabortimesthewage:$30,$55,$65,$l05,$l55,$225,$315.b.DoublingthewageincreasesACandMC(doubles,infact,MCbutnotAC.
c.DoublingproductivitycutsMCandACinhalf.(Factorpricesandproductivitybothinfluencecostcurves.6.a.Averagecostsareminimizedwhenmarginalcostequalsaveragecost;ACisfallingwhereMCisminimized.b.AFC=FC/output;FCisfixedsoasoutputincreasesAFCfalls.
c.ACisrisingwheneverMC>AC,butACisfallingwhenMCevenifMCisrising.d.Theabsenceofamarketdoesnotimplytheabsenceofvalue.
e.Theleast-costrulecollapsestothisonlyinveryspecialcircumstances.Thefirmminimizescostswhenthe
ratiosofmarginalproducttoinputpriceareequalforallinputs.7.Theincomestatementwouldlooksomethinglike:Netsales$10millionLess:costs$9millionNetincome$1millionLess:dividends$08.Assets