Short-run Cost

and the firm’s budget constraint.Although largely the domain of accountants,the concept of cost to an economist carries a somewhat different connotation.As already discussed in Chapter 1,economists generally are concerned with any and all costs that are relevant to the production process. These costs are referred to as total economic costs. Relevant costs are all costs that pertain to the decision by management to produce a particular good or service.

Total economic costs include the explicit costs associated with the dayto-day operations of a firm,but also implicit (indirect) costs.All costs,both explicit and implicit,are opportunity costs.They are the value of the next best alternative use of a resource.What distinguishes explicit costs from implicit costs is their “visibility”to the manager.Explicit costs are sometimes referred to as “out-of-pocket”costs.Explicit costs are visible expenditures associated with the procurement of the services of a factor of production.Wages paid to workers are an example of an explicit cost.

By contrast,implicit costs are,in a sense,invisible:the manager will not receive an invoice for resources supplied or for services rendered.To understand the distinction,consider the situation of a programmer who is weighing the potential monetary gains from leaving a job at a computer software company to start a consulting business.The programmer must consider not only the potential revenues and out-of-pocket expenses (explicit costs) but also the salary forgone by leaving the computer company.The programmer will receive no bill for the services he or she brings to the consulting company,but the forgone salary is just as real a cost of running a consulting business as the rent paid for office space.As with any opportunity cost, implicit costs represent the value of the factor’s next best alternative use and must therefore be taken into account.As a practical matter,implicit costs are easily made explicit.In the scenario just outlines,the programmer can make the forgone salary explicit by putting himself or herself “on the books”as a salaried employee of the consulting firm.

SHORT-RUN COST

The theory of cost is closely related to the underlying production technology.We will begin by assuming that the firm’s short-run total cost (TC) of production is given by the expression

(6.1) As we discussed in Chapter 5,the short run in production is defined as that period of time during which at least one factor of production is held at some fixed level.Assuming only two factors of production,capital (K) and labor (L),and assuming that capital is the fixed factor (K0),then Equation (6.1) may be written TC fQ = ( )

TC fgK L = ( ) [ ] 0 , (6.2) Equation (6.2) simply says that the short-run total cost of production is a function of output,which is itself a function of the level of capital and labor usage.In other words,total cost is a function of output,which is a function of the production technology and factors of production,and factors of production cost money.

Equation (6.2) is a general statement that relates the total cost of production to the usage of the factors of production,fixed capital and variable labor.Equation (6.2) also makes clear that total cost is intimately related to the characteristics of the underlying production technology.As we will see,concepts such as total cost (TC),average total cost (ATC),average variable cost (AVC),and marginal cost (MC) are defined by their production counterparts,total physical product,average physical product,and marginal physical product of both labor and capital.

To begin with,let us assume that the prices of labor and capital are determined in perfectly competitive factor markets.The short-run total economic cost of production is given as (6.3) where PK is the rental price of capital, PL is the rental price of labor, K0 is a fixed amount of capital,and L is variable labor input.The most common example of the rental price of labor is the wage rate.An example of the rental price of capital might be what a construction company must pay to lease heavy equipment,such as a bulldozer or a backhoe.If the construction company already owns the heavy equipment,the rental price of capital may be viewed as the forgone income that could have been earned by leasing its own equipment to someone else.In either case,both PK and PL are assumed to be market determined and are thus parametric to the output decisions of the firm’s management.Thus,Equation (6.3) may be written TCQ TFC TVCQ ( ) = + ( ) (6.4) where TFC and TVC represent total fixed cost and total variable cost, respectively.

Total fixed cost is a short-run production concept.Fixed costs of production are associated with acquiring and maintaining fixed factors of production.Fixed costs are incurred by the firm regardless of the level of production.Fixed costs are incurred by the firm even if no production takes place at all.Examples often include continuing expenses incurred under a binding contract,such as rental payments on office space,certain insurance payments,and some legal retainers.

Total variable costs of production are associated with acquiring and maintaining variable factors of production.In stages I and II of production,

TC PK PL K L= + 0