Lecture08 - Lecture 08 Costs Perlo Chapter 7 Vladimir...

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Lecture 08: Costs Perlo/ Chapter 7 Vladimir Petkov VUW 26 March 2010 Vladimir Petkov (VUW) Lecture 08: Costs 26 March 2010 1 / 25
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Economic Costs The economic cost or the opportunity cost is the value of the best alternative use of a resource. In other words, cost is the value of sacri°ced opportunities. Explicit costs are those which have to be paid for directly. Implicit costs are those which accrue in the form of foregone alternatives but are not actually charged for in cash terms. Accounting costs are the sums of money paid by a °rm as shown in the transaction records of the °rm±s °nancial report. Economic costs often di/er from accounting costs! Economic costs may be higher or lower. Vladimir Petkov (VUW) Lecture 08: Costs 26 March 2010 2 / 25
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Economic Costs (Continued) These di/erences are especially drastic for durable assets (e.g. capital or land). Economists take into account the implicit cost of these assets. In contrast, accountants use arbitrary amortization rules. Also economists do not worry about sunk costs. Sunk costs are expenditures that cannot be recovered. They are irrelevant for economic decisions. Usually °xed costs are sunk, but there are exceptions! We will distinguish between short-run and long-run costs: short-run costs : production costs when one or more inputs are °xed; long-run costs : production costs when all inputs are variable. Vladimir Petkov (VUW) Lecture 08: Costs 26 March 2010 3 / 25
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Long-Run Input Choice We °rst analyze input choice in the long run. Suppose that the °rm±s production function is q = f ( K , L ) . Let the price of labor be w and the price of capital be r . Thus, the cost of inputs is C = wL + rK . The °rm±s objective it to choose L and K to minimize its production cost subject to attaining a given level of output ¯ q . That is, the °rm±s problem is min L , K C = wL + rK s. t. ¯ q = f ( K , L ) . Vladimir Petkov (VUW) Lecture 08: Costs 26 March 2010 4 / 25
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The Isocost Line The combinations of labor and capital that cost a given amount are summarized by the isocost line . Fixing the input cost at ¯ C , the equation of the isocost line is ¯ C = wL + rK . The isocost line is downward sloping. If we increase the amount of labor, we must reduce capital to keep the cost unchanged. Isocost lines that are farther from the origin correspond to a higher cost. We are using more inputs, so they cost more. Solving the isocost equation for K , we get K = ¯ C r ° w r L . So the slope of the isocost line is dK dL = ° w r . Vladimir Petkov (VUW) Lecture 08: Costs 26 March 2010 5 / 25
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The Isocost Line (Continued) Slope of isocost is L K r w - w C / r C / Vladimir Petkov (VUW) Lecture 08: Costs 26 March 2010 6 / 25
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