CHAPTER 8 - Study Guide for Whinston and Bernheim CHAPTER 8...

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Study Guide for Whinston and Bernheim 1 CHAPTER 8 Cost CHAPTER SUMMARY Technology and production, the topics of chapter 7, examined the physical relationship between inputs and outputs. Those were real flows of labor and machine time combining to produce real benches and apple cider and consulting services. We learned less about how actually to produce things than we learned about how consistently to represent those relationships and look for regularities like the Law of Diminishing Marginal Returns and returns to scale. Frankly, that chapter was not intended to teach us how to build benches or press apple cider, though we might have gained a little insight into those processes. Production theory’s real purpose was to show us where production costs come from. It was to lay the foundations for this chapter, where we take a close look at those production costs. We begin with some definitions: total cost is the expenditure (in the true economic sense) required to produce any given level of output. This is almost tautologically true; it’s really sort of self evident. It says, take everything you spend on labor and everything you spend on capital (and all the other inputs), add them up, and there you have your costs. If some of those costs vary as output changes, we call them variable cost and if some of those expenditures remain the same no matter how much output we produce, we call them fixed cost. We extend the definitions by looking more closely at fixed costs and ask the question, really fixed? Or are they just fixed as long as we are producing some positive level of output. For example, you might be reading the text in your college library. The fire insurance on the library is fixed whether or not you or anybody else is taking advantage of the library to study. That means when the last student leaves, that cost still prevails. That is unavoidable fixed cost, also known as sunk cost . But another fixed cost is the electricity bill to light the reading room. It doesn’t matter whether you are the only reader or there are dozens in the room, the light bill is fixed. But, as they say, “When the last person leaves, hit the light switch.” That part of fixed cost is avoidable . Now we have some vocabulary about costs, but we don’t yet have a cost function , which is the relationship between the flow of output and the total cost of producing that flow. It takes the form Total Cost = C (Output). It includes both fixed cost and variable cost. The fixed cost function is pretty simple; it’s just a number. Or in the case of avoidable fixed cost, it’s more of a toggle. If production is positive it is “on” at a constant level; if production is zero, so is avoidable fixed cost. By definition, variable cost changes as output changes, so that functional relationship is the variable cost function , Variable Cost = VC(Output). In the last chapter we learned about the production function, which answered the direct
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This note was uploaded on 06/09/2008 for the course BUAD 351 taught by Professor Eastin during the Spring '07 term at USC.

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CHAPTER 8 - Study Guide for Whinston and Bernheim CHAPTER 8...

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