Chapter 23
The Firm:
Cost and Output Determination
Introduction
Why do publishers print so many books
each year and then destroy them?
How does doing this affect their costs of
doing business?
By the time you have completed this
chapter, you will be able to analyze
these questions.
2
Learning Objectives
 Discuss the difference between the short run and the long
run from the perspective of a firm
 Understand why the marginal physical product of labor
eventually declines as more units of labor
are employed
 Explain the short-run cost curves a typical firm faces
 Describe the long-run cost curves a typical firm faces
 Identify situations of economies and diseconomies of scale
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Did You Know That...
Production technologies and the costs
producers face are related?
4
Short Run versus Long Run
Short Run
– A time period when at least one input, such as
plant size, cannot be changed
– Plant Size
• The physical size of the factories that a firm owns
and operates to produce its output
5
Short Run versus Long Run
Long Run
– The time period in which all factors of
production can be varied
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Short Run versus Long Run
Managers take account of both the short-run
and long-run consequences of their
behavior.
While making decisions about what
to do today, tomorrow, and next week—they
keep an eye on the long-run benefits.
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The Relationship Between
Output and Inputs
A firm takes numerous inputs, combines
them using a technological production
process and ends up
with output.
We classify production inputs in two broad
categories—labor and capital.
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The Relationship Between
Output and Inputs
Output / time period = Some function of capital and labor inputs
or
Q = ƒ(K,L)
Q = output/time period
K = capital
L = labor
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The Relationship Between
Output and Inputs
Production
– Any activity that results in the conversion of
resources into products that can be used in
consumption
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The Relationship Between
Output and Inputs
Production Function
– The relationship between maximum physical
output and the quantity of capital and labor
used in the production process
– The production function is a technological
relationship between inputs and output.
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E-Commerce Example:
Put Away the Clay and Turn on
the Holographic Camera
Once a company has integrated a
holographic camera system into its existing
computer network, creating holographic
designs takes less time.
Consequently, product developers using
holographic techniques can now create
more designs while utilizing fewer labor
resources.
12
E-Commerce Example:
Put Away the Clay and Turn on
the Holographic Camera
Why do technological improvements often
reduce labor requirements for specific tasks,
thereby allowing labor to be utilized for
other purposes?
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The Relationship Between
Output and Inputs
Average Physical Product
– Total product divided by the variable input
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The Relationship Between
Output and Inputs
Marginal Physical Product
– The physical output that is due to the addition
of one more unit of a variable factor of
production
– The change in total product occurring when a
variable input is increased and all other inputs
are held constant
– Also called marginal product
15
The Production
Function and
Marginal
Product:
A Hypothetical
Case, Panel (a)
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The Production
Function and Marginal Product:
A Hypothetical Case
17
The Production
Function and Marginal Product:
A Hypothetical Case
18
Diminishing Marginal Product
Measuring marginal product
Specialization and marginal product
Diminishing marginal product
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Diminishing Marginal
Product
Law of Diminishing Marginal Product
– The observation that after some point,
successive equal-sized increases in a variable
factor of production, such as labor, added to
fixed factors of production, will result in
smaller increases in output
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An Example of the Law of
Diminishing Marginal Product
Production of computer
printers example
– We have a fixed amount of factory space,
assembly equipment, and quality control
diagnostic software.
– So the addition of more workers
eventually yields successively smaller increases
in output.
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An Example of the Law of
Diminishing Marginal Product
 After a while, when all the assembly equipment
and quality-control diagnostic software are being
used, additional workers will have to start
assembling and troubleshooting quality problems
manually.
 The marginal physical product of an additional
worker, given a specified amount of capital, must
eventually be less than that for the previous
workers.
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Short-Run Costs to the Firm
 Total Costs
– The sum of total fixed costs and total
variable costs
 Fixed Costs
– Costs that do not vary with output
 Variable Costs
– Costs that vary with the rate of production
Total costs (TC) = TFC + TVC
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Short-Run Costs to the Firm
Average Total Costs (ATC)
Average total costs (ATC) =
Total costs (TC)
Output (Q)
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Short-Run Costs to the Firm
Average Variable Costs (AVC)
Average variable costs (AVC) =
Total variable costs (TVC)
Output (Q)
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Short-Run Costs to the Firm
Average Fixed Costs (AFC)
Average fixed costs (AFC) =
Total fixed costs (TFC)
Output (Q)
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Short-Run Costs to the Firm
Marginal Cost
– The change in total costs due to a one-unit
change in production rate
Marginal costs (MC) =
Change in total cost
Change in output
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Cost of Production: An Example
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Cost of Production: An Example
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Cost of Production: An Example
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Short-Run Costs to the Firm
Question
– What do you think—is there a predictable
relationship between the production function
and AVC, ATC, and MC?
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Short-Run Costs to the Firm
Answer
– As long as marginal physical product rises,
marginal cost will fall, and when marginal
physical product starts to fall (after reaching the
point of diminishing marginal product),
marginal cost will begin to rise.
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Example: Reducing the Marginal Cost
of Air Transport with “Winglets”
 After years of experimentation, engineers created
winglets by making jetliners’ wings slightly longer
and curving them up at the ends.
 Since the early 2000s, most new planes ordered by
airliners have included winglets, which provide
fuel savings for every mile that a plane is in the
air.
 Some airlines are in the process of adding winglets
to their existing fleet of planes too.
33
Example: Reducing the Marginal Cost
of Air Transport with “Winglets”
How has airlines’ use of winglets affected
their total cost curves?
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The Relationship Between
Average and Marginal Costs
When marginal costs are less than average
variable costs, the latter must fall.
When marginal costs are greater than
average variable costs, the latter must rise.
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The Relationship Between
Average and Marginal Costs
There is also a relationship between
marginal costs and average total costs.
– Average total cost is equal to total cost divided
by the number of units produced.
– Marginal cost is the change in total
cost due to a one-unit change in the production
rate.
36
The Relationship Between Diminishing
Marginal Product and Cost Curves
Firms’ short-run cost curves are a reflection
of the law of diminishing marginal product.
Given any constant price of the variable
input, marginal costs decline as long as the
marginal product of the variable resource is
rising.
37
The Relationship Between Diminishing
Marginal Product and Cost Curves
At the point at which diminishing marginal
product begins, marginal costs begin to rise
as the marginal product of the variable input
begins to decline.
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The Relationship Between Diminishing
Marginal Product and Cost Curves
If the wage rate is constant, then the labor
cost associated with each additional unit of
output will decline as long as the marginal
physical product of labor increases.
39
The Relationship Between Output
and Costs
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The Relationship Between Output
and Costs
41
The Relationship Between Output
and Costs
42
The Relationship Between Output
and Costs
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Long-Run Cost Curves
Planning Horizon
– The long run, during which all inputs
are variable
44
Preferable Plant Size and the
Long-Run Average Cost Curve
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Long-Run Cost Curves
Long-Run Average Cost Curve
– The locus of points representing the minimum
unit cost of producing any given rate of output,
given current technology and resource prices
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Long-Run Cost Curves
Observation
– Only at minimum long-run average cost curve
is short-run average cost curve tangent to longrun average cost curve.
Question
– Why do you think the long-run average cost
curve is U-shaped?
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Why the Long-Run Average
Cost Curve is U-Shaped
Economies of scale
Constant returns to scale
Diseconomies of scale
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Economies of Scale, Constant Returns
to Scale, and Diseconomies of Scale
Shown with Long-Run Average Cost
Curve
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Why the Long-Run Average
Cost Curve is U-Shaped
Economies of Scale
– Decreases in long-run average costs resulting
from increases in output
• These economies of scale do not persist indefinitely,
however.
• Once long-run average costs rise, the curve begins
to slope upwards.
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Why the Long-Run Average
Cost Curve is U-Shaped
Reasons for economies of scale
– Specialization
• Division of tasks or operations
– Dimensional factor
– Improved productive equipment
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Why the Long-Run Average
Cost Curve is U-Shaped
Explaining diseconomies of scale
– Limits to the efficient functioning
of management
– Coordination and communication is more of a
challenge as firm size increases
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Issues and Applications: Book Publishers
Search for a Lower-Cost Business Model
 In publishing, destruction is part
of production:
– There is a 34% chance that any book from the “happy”
warehouse finds its way back to the
“sad” one.
 The costs of production:
– Once a publisher has incurred the fixed costs
of printing a book, the marginal cost is
relatively small.
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Summary Discussion
of Learning Objectives
The short run versus the long run from a
firm’s perspective
– Short run—a period in which at least one input
is fixed
– Long run—a period in which all inputs
are variable
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Summary Discussion
of Learning Objectives
 The law of diminishing marginal product
– As more units of a variable input are employed with a
fixed input, marginal physical product eventually
begins to decline.
 A firm’s short-run cost curves
– Fixed and average fixed cost
– Variable and average variable cost
– Total and average total cost
– Marginal cost
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Summary Discussion
of Learning Objectives
A firm’s long-run cost curve
– Planning horizon
– All inputs are variable including plant size
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