Micro Chapter 8
Costs and the Supply of Goods
7 Learning Goals:
1) Bring out the role costs play in making
economic decisions
2) Define and differentiate between a short-run
time period and a long-run time period
3) Define and calculate costs used to make
decisions
4) Relate costs to output decisions in the short run
5) Relate costs to output decisions in the long run
6) Explore the factors that cause shifts in the cost
curves
7) Explain how past, present, and future costs
influence production decisions
“From the standpoint of society
as a whole, the “cost” of
anything is the value that it has
in alternative uses.”
Thomas Sowell
The Economic Role of
Costs
The demand for a product represents
the voice of consumers instructing
firms to produce the good. On the
other hand, a firm’s costs represent
the desire of consumers not to
sacrifice goods that could be produced
if the same resources were employed
elsewhere.
Economic profit ≠ Accounting
profit
Accounting profit = total revenue – total
out-of-pocket costs
Economic profit = total revenue – total outof-pocket costs – opportunity costs
Zero economic profit referred to as normal
profit rate
Q8.1 The costs of a firm indicate the desire of
consumers for
1. the product produced by the firm.
2. other goods that might have been produced
with the same resources.
3. goods that can be easily substituted for the
good produced by the firm.
4. goods that are complementary with the good
produced by the firm.
Q8.2 (MA) When a firm is earning economic profit,
which of the following are necessarily false?
1.
2.
3.
4.
The firm is increasing the value of the resources that it is
using.
The firm is reducing the value of the resources that it is
using.
The firm is supplying the market with a low quality product.
The firm is creating less value for consumers than another
firm that is currently earning losses.
Short Run and Long Run
Time Periods
You must know these 2
definitions:
Short Run (SR) – a period of time in which
at least one input is fixed
Long Run (LR) – a period of time in which
all inputs are variable; i.e. none of the
inputs are fixed
Q8.3 The short run is a time period such that
1.
2.
3.
4.
the existing firms in the market do not have sufficient time
to change the amounts of any of the inputs that they
employ.
the existing firms in the market do not have sufficient time
to either increase or decrease their current rate of output.
the existing firms in the market do not have sufficient time
to increase the size of their existing plant or build a new
factory.
new firms may build plants and enter the industry.
Q8.4 The long run is a period of
1.
2.
3.
4.
at least one year.
sufficient length to allow a firm to expand output by
hiring additional workers.
sufficient length to allow a firm to alter its plant size and
capacity and all other factors of production.
sufficient length to allow a firm to transform economic
losses into economic profits by hiring better workers.
Categories of Costs
Some costs are fixed – they don’t vary
with quantity
Some costs are variable – they vary with
quantity
Average costs are per unit costs
Marginal cost is the change in total cost
Output and Costs In the
Short Run
Watch video: Modern Times- Charlie
Chaplin productivity
Read and reread this section
carefully.
The ability of a firm to make stuff (its
production) is intimately tied to costs
You must understand why the cost curves
look like they do, AND
How they are related to production
Here is the graph you need to
know:
Watch content video: Micro Chapter 08short run costs
Why does MC first fall and then
rise rapidly?
MC initially falls for two reasons:
(1) Increasing marginal returns- each
additional input adds more to total output
than the previous input
(2) learning by doing
Watch video: Groundhog Day-learning by
doing
Why does MC first fall and then
rise rapidly?
MC rises because of diminishing marginal
returns
At some point, each additional input adds
less to total output than the previous input
Since more and more input is required,
marginal cost rises rapidly
I left a stack of handouts containing a problem set by the door
to the classroom today. Each student was supposed to pick
one up. The problem was that, in the last three minutes
before class started, the line of students waiting to pick up the
handouts and walk through the entryway to the classroom
was getting longer and longer. I had a brilliant idea- make
two piles- and I did that. More students per minute were able
to pick up the handout and walk into the classroom. With the
addition of more of the variable input (piles of handouts), the
output (students walking into class) increased. But despite
my doubling the number of stacks, the number of students
walking into class each minute didn’t double. The reason is
that there was a fixed input- the size of the entryway into the
room. If I had added a third pile, the output might have
increased further, but not by very much. Even in distributing
handouts before class, the principle of diminishing marginal
productivity seems to work.
Q: This story is similar to you leaving class. How could we
increase the marginal return of getting students out of class?
That is, how could we get more students out the doors in the
same amount of time?
What’s the relationship between MC
and ATC?
Just before class, my economics major students were
laughing at a conversation they overheard between the
instructor of the previous class and her student. The student
said, “I really need a good grade in this class ‘cause my GPA
has to be high for me to get into grad school.” My students
were laughing because the grade in that particular class could
not have had much of an effect on the senior’s GPA. The
student (it wasn’t an economics class, thank goodness) did
not distinguish marginal from average. The same thing
happens among my intro students at least once a year.
Someone tells me that unless he or she gets a B in my class,
his or her GPA will be so low that he or she will be thrown out
of the university. These students also don’t seem to know
marginal from average. Their average is low because of their
previous bad grades. The marginal grade- what they get in
my class- is not going to affect their GPAs very much.
What’s the relationship between MC and
ATC?
Illustration: your GPA
Let’s say you’re a sophomore with a 3.0
cumulative GPA (analogous to ATC)
Suppose this semester’s GPA (analogous to
MC) is 3.5
–
Your new cumulative would be higher (ATC rises)
Now suppose this semester’s GPA (MC) is 2.0
–
Your new cumulative would be lower (ATC falls)
Then, next semester’s GPA (MC) is 2.5
–
Your new cumulative would still be lower (ATC still
falls)
Catch phrase: “the average chases the
margin”
Q8.5 As output is expanded, if MC is more than
ATC,
1.
2.
3.
4.
ATC must be at its minimum.
ATC must be at its maximum.
ATC must be increasing.
the firm must be earning economic profit.
Q8.6 The short run average total cost (ATC) curve
of a firm will tend to be U-shaped because
1.
2.
3.
4.
larger firms always have lower per unit costs than
smaller firms.
at small output rates, AFC will be high while at large
output rates MC will be high as the result of diminishing
returns.
diminishing returns will be present when output is small
while high AFC will push per unit cost to high levels when
output is large.
increasing marginal returns will be present at both small
and large output rates.
Output and Costs In the
Long Run
Graph of LR Costs:
Watch content video: Micro Chapter 08long run costs
Why does LR ATC look like
this?
Because in order to produce larger
quantities, the firm will need to “get
bigger.” That is, they will need to increase
their capital.
These are typically expensive so capital
costs become large which drives up
LRATC.
Economies of scale is the benefit to
the firm from becoming larger.
Economies of scale means the benefit is getting
bigger (ATC is falling)
– Also referred to as Increasing Returns to Scale
Diseconomies of scale means the benefit is
negative (ATC is rising)
– Also referred to as Decreasing Returns to Scale
What’s an efficient size for a church or synagogue? If there
were economies of scale throughout, with all the Baptists in a
big Texas city such as Austin, we’d see just one giant Baptist
church. With 10,000 Jews in Austin, we’d see just one big
synagogue. We don’t: There are many churches in each
denomination, as well as many synagogues. As the city has
expanded, more and more different kinds of Baptist churches,
Jewish synagogues, and other churches have been organized.
It’s not just that each one serves a local area. People drive a
long way to the church or synagogue of their choice even
when another one is closer. They like the peculiarities of a
leader’s ministry, the type of service, and even the particular
social interactions of a congregation. With one big house of
worship, these choices would be lost. Statistical studies of the
long-run average cost curves of churches suggest that this is
true: There are economies of scale up to some size, but as
the church or synagogue begins growing beyond a certain
size, diseconomies of scale set in- it becomes less efficient.
Q: List some of the cost and production factors that would
create economies of scale then some factors that would create
diseconomies of scale.
Q 8.7 A downward-sloping portion of a longrun average total cost curve is the result of
1.
2.
3.
4.
economies of scale.
diseconomies of scale.
diminishing returns.
the existence of fixed resources.
Q8.8 In the long run, a firm might experience
rising per unit costs due to
1.
2.
3.
4.
economies of scale.
diseconomies of scale.
the law of supply.
the law of diminishing marginal returns.
Summary:
In the SR, diminishing returns determine
the shape of the cost curves
In the LR, economies of scale determine
the shape of the cost curves
What Factors Cause Cost
Curves to Shift?
Cost curves shift up and down
Higher costs shift curves up:
1) Resources become more expensive
2) Higher taxes
3) More, or stricter, regulations
4) Older technology
Lower costs shift curves down:
1) Resources become less expensive
2) Lower taxes
3) Less regulation
4) Newer technology
Cost curves impact supply
curves
When cost curves shift up, supply shifts
left
When cost curves shift down, supply shifts
right
The Economic Way of
Thinking about Costs
Some costs should be ignored
Sunk costs cannot be reversed or
recovered
Therefore they should be ignored (but not
forgotten) when making decisions about
the future
Keep thinking on the margin:
Continue to engage in an activity as long
as the marginal benefit is greater than the
marginal cost
Question Answers:
8.1 = 2
8.2 = 2 & 4
8.3 = 3
8.4 = 3
8.5 = 3
8.6 = 2
8.7 = 1
8.8 = 2