Chapter Review

of scope,a merger of two firms could result in significant cost reductions. Moreover,a firm that divests itself of an unprofitable subsidiary might enjoy only modest cost reductions.Economies of scope make it difficult for firms to spread production costs across product lines.

CHAPTER REVIEW

The cost function of a profit-maximizing firm shows the minimum cost of producing various output levels given market-determined factor prices,and the firm’s budget constraint.Although cost is largely the domain of accountants,to an economist the concept carries a somewhat different connotation.Economists are concerned with any and all costs that are relevant to the managerial decision-making process. Relevant costs include not only direct, explicit,or out-of-pocket costs associated with the day-to-day operations of a firm,but also implicit (indirect) costs.

The relevant cost concept is economic cost,which includes all opportunity costs,including explicit and implicit costs.Opportunity cost is the value of a forgone opportunity (e.g.,the salary sacrificed by a computer programmer who leaves Microsoft to start a consulting business).Implicit costs may be made explicit,as occurs when the computer programmer pays himself or herself a salary equivalent to the forgone salary.In this case, implicit opportunity costs have been made explicit.

An analysis of the firm’s short-run cost function follows directly from an analysis of the firm’s short-run production function.Assuming constant factor prices,increasing marginal cost is a direct consequence of the law of diminishing returns,which in turn affects the pattern of behavior of the firm’s average total cost and average variable cost.Shortrun production functions assume that at least one factor of production is held fixed.The cost associated with these fixed inputs is called total fixed cost.

Long-run production functions assume that all inputs are variable,which implies that there are no fixed costs.Moreover,the law of diminishing returns is no longer operable.The long-run cost concept of economies of scale follows directly from the long-run production concept of increasing returns to scale.Economies of scale occur when long-run average total costs fall as the firm increases its capacity,and the concept itself is related to the production concept of increasing returns to scale.

Diseconomies of scale occur when long-run average total cost increases, as when the firm increases its capacity;the long-run production concept of decreasing returns to scale is related to the notion of diseconomies of scale. It can be argued that the firm’s optimal scale of operation occurs when longrun average total cost is minimized (i.e.,when the firm experiences constant returns to scale).