ECON 152 – PRINCIPLES OF MICROECONOMICS
Chapter 23: The Firm Cost and Output Determination
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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
Long Run
 The
time period in which all factors of
production can be varied
2
Short Run versus Long Run
Short run and long run are terms that
apply to planning decisions made by
managers. The firm always operates in
the short run in the sense that decisions
can only be made in the present.
 But some of these decisions result in a
long-term commitment of resources.

3
The Relationship
Between Output and Inputs (Short Run)

Production
 Any
activity that results in the conversion of
resources into products that can be used in
consumption or inputs to further production

Production Function
 The
relationship between inputs and output
 A technological, not an economic, relationship
 The relationship between inputs and
maximum physical output
4
Diminishing Marginal Returns

Law of Diminishing (Marginal) Returns
 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
5
The Relationship
Between Output and Inputs

Average Physical Product
 Total

product divided by the variable input
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 or marginal return
6
Diminishing Returns,
the Production
Function,
and Marginal
Product: A
Hypothetical Case
Figure 23-1, Panel (a)
7
Diminishing Returns,
the Production
Function,
and Marginal
Product: A
Hypothetical Case
Graphical relationship
between marginal physical
product and total output
8
A
B
A – Point of
Diminishing Marginal
Returns
B – Point of
Diminishing Total
Returns
9
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
10
Short-Run Costs to the Firm

Average Total Costs (ATC)
total costs (TC)
Average total costs (ATC) =
output (Q)
11
Short-Run Costs to the Firm
Average total costs (ATC) =
total costs (TC)
output (Q)
total variable costs (TVC)
Average variable costs (AVC) =
output (Q)
Average fixed costs (AFC) =
Marginal costs (MC) =
total fixed costs (TFC)
output (Q)
change in total cost
change in output
Cost of Production: An Example
Figure 23-2, Panel (a)
13
Total Cost of Production: An Example
Panel (b)
Total costs (dollars per day)
60
Total costs
50
40
30
Total variable
costs
20
10
0
Figure 23-2, Panel (b)
Total fixed
costs
1
2 3 4 5 6 7 8 9 10
Output (recordable DVDs per day)
11
14
Average and Marginal Costs of
Production: An Example
Figure 23-2, Panel (c)
15
Short-Run Costs to the Firm

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
returns), marginal cost will begin to rise.
Inefficient to Efficient to Inefficient
16
The Relationship Between Returns and
Average and Marginal Costs



If the wage rate is constant, then the marginal labor cost
associated with each additional unit of output will decline
as long as the marginal physical product of labor
increases.
When marginal cost is less than average variable cost,
then average variable cost will decline. When marginal
cost exceeds average variable cost, then average
variable cost will increase.
It is also true that the direction of change in average total
cost will be determined by whether marginal cost
exceeds the current average.
17
The Relationship Between Diminishing
Marginal Returns and Cost Curves
18
19
The Marginal and Average Cost Curves
Adding the average
fixed cost curve to
the graph..
ATC (SAC)
Then,
ATC = AVC + AFC
AFC
20
Long-Run Cost Curves

Planning Horizon
 The
long run, during which all inputs are
variable
21
Preferable Plant Size
and the Long-Run Average Cost Curve
Panel (b)
SAC1
C2
C4
SAC2
C1
C3
SAC3
Q1
Q2
Output per Time Period
Figure 23-4, Panels (a) and (b)
Average Cost (dollars per unit of output)
Average Cost (dollars per unit of output)
Panel (a)
SAC8
SAC1
SAC7
SAC2
SAC6
SAC3
SAC5
SAC4
LAC
Output per Time Period
22
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

Observation
 Only
at the minimum of the long-run average
cost curve is the minimum of the short-run
average cost curve tangent to it.
23
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.

24
Why the Long-Run Average
Cost Curve is U-Shaped

Reasons for economies of scale
 Specialization
 Dimensional
factor
 Improved productive equipment
25
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
26
Minimum Efficient Scale

Minimum Efficient Scale (MES)
 The
lowest rate of output per unit time at
which long-run average costs for a particular
firm are at a minimum
27
(dollars per unit)
Long-Run Average Costs
Minimum Efficient Scale
LAC
B
A
0
10
1,000
Output per Time Period
Figure 23-6
28
Minimum Efficient Scale

Small MES relative to industry demand:
 There
is room for many efficient firms
 High degree of competition

Large MES relative to industry demand:
 Room
for only a small number of efficient firms
 Small degree of competition
29
ECON 152 – PRINCIPLES OF MICROECONOMICS
Chapter 23: The Firm Cost and Output Determination
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.