10
OUTPUT AND
COSTS
Outline
The ATM is Everywhere!
A. Why are banks closing teller windows and replacing them with
ATMs?
B. Why do auto-makers have unused production capacity while
electric utilities sometimes can’t produce enough to meet
demand?
C. This chapter studies a firm’s production possibilities and costs
of production.
I.
Decision Time Frames
A. The firm makes many decisions in order to achieve its main
objective: profit maximization. Some decisions are relatively
critical to the survival of the firm, or are irreversible (or
very costly to reverse). Other decisions are easily reversible
or are much less critical to the survival of the firm (but still
influence profitability).
B. The Short Run
1. The short run is a time frame in which the quantity of one or
more resources used in production is fixed.
2. Some resources used by the firm are fixed in quantity (such
as technology, buildings, capital) regardless of output. This
is called the firm’s plant. In the short run, a firm’s plant
is fixed.
3. Other resources used by the firm do vary with output (such as
labor, raw materials, energy). In the short run, only the
level of these variable resources can change.
4. Short-run decisions over variable resource use are easily
reversed.
C. The Long Run
1. The long run is a time frame in which the quantities of all
resources can be varied. This means that the firm can change
its plant size, as well as the level of all other variable
resources, in the long run.
2. Long-run decisions are not easily reversed.
3. Sunk costs are costs incurred by the firm and cannot be
changed.
a) The firm’s investment in plant size is a sunk cost.
b) Sunk costs are irrelevant to a firm’s decisions.
II. Short-Run Technology Constraint
A. To increase output in the short run, a firm must increase the
amount of labor employed. Three concepts describe the
relationship between output and the quantity of labor employed.
B. Product Schedules
1. Total product, which is the total amount produced.
2. Marginal product, which is the increase in total product that
results from a one-unit increase in the quantity of labor
employed, with all other inputs remaining the same.
3. Average product, which is equals total product divided by the
quantity of labor employed.
4. Table 10.1 (page 215) shows an example of total product,
marginal product, and average product for a firm that
produces sweaters.
C. Product Curves
1. Product curves are graphs of the three product concepts that
show how total product, marginal product, and average product
change as the quantity of labor employed changes.
D. The Total Product Curve
1. The total product curve shows how the total product increases
with the level of labor employed.
2. It is similar to the PPF in that is separates attainable
output levels from unattainable output levels in the short
run.
3. Figure 10.1 (page 216) shows a total product curve.
E. The Marginal Product Curve
1. The marginal product curve for labor shows the change in
total product for each unit of labor employed.
2. The total and marginal product curves are directly related.
a) The height of the marginal product curve is the slope of
the total product curve.
b) Figure 10.2 (page 217) shows the relationship between the
marginal product of labor curve and the total product
curve.
3. When the marginal product of an additional worker exceeds
the marginal product of the previous worker, the marginal
product of labor curve rises with labor, and the firm
experiences increasing marginal returns.
4. When the marginal product of an additional worker is less
than the marginal product of the previous worker, the
marginal product of labor curve falls with labor and the
firm experiences diminishing marginal returns.
a) Diminishing marginal returns arises from the fact that
employing additional units of labor means each worker has
less access to capital and less space in which to work.
b) The additional output gained by the last unit of labor
employed falls.
5. The law of diminishing returns states that as a firm uses more of
a variable input with a given quantity of fixed inputs, the
marginal product of the variable input eventually
diminishes.
F. Average Product Curve
The marginal product of labor curve and the average product
curve have the following relationship shown in Figure 10.3 (page
218):
1. The average product curve increases with labor whenever the
marginal product of labor exceeds the average product.
2. The average product curve falls with labor whenever the
marginal product of labor is less than the average product.
3. The average product curve is at its maximum value when the
marginal product of labor equals the average product.
4. The relationship between a student’s marginal class grade and
her or his grade point average (GPA) is similar to that
between marginal product and average product.
a) If a student’s next class grade is higher (lower) than the
student’s GPA, this marginal grade will pull the student’s
GPA (average grade) up (down).
b) If the next class grade is the same as the GPA, the GPA
will remain unchanged.
III. Short-Run Cost
A. To produce more output in the short run, the firm must employ
more labor, which means that it must increase its costs. These
costs can be described in a way that relates cost with output.
B. Total Cost
1. A firm’s total cost (TC) is the cost of all resources used.
2. Total fixed cost (TFC) is the cost of the firm’s fixed inputs.
Fixed costs do not change with output.
3. Total variable cost (TVC) is the cost of the firm’s variable
inputs. Variable costs do change with output.
4. Total cost equals total fixed cost plus total variable cost,
or TC = TFC + TVC.
5. Figure 10.4 (page 219) shows the TFC, TVC and TC curves.
B. Marginal Cost
1. Marginal cost (MC) is the increase in total cost that results
from a one-unit increase in total product.
1. Over the output range with increasing marginal returns,
marginal cost falls as output increases.
2. Over the output range with diminishing marginal returns,
marginal cost rises as output increases.
C. Average Cost
Average cost measures can be derived from each of the total
cost measures:
1. Average total cost (ATC) is total cost per unit of output.
2. Average fixed cost (AFC) is total fixed cost per unit of output.
3. Average variable cost (AVC) is total variable cost per unit of
output.
4. Average total cost equals average fixed cost plus average
variable cost, or
ATC = AFC + AVC.
5. Table 10.2 (page 223) provides a complete glossary of cost
terms.
6. The value of MC, ATC, and AVC cost measures are related:
a) When MC is below (above) AVC, AVC falls (rises) as output
increases. When MC equals AVC, AVC is constant at its
minimum value—the MC curve intersects the AVC curve at its
lowest point.
b) When MC is below (above) ATC, ATC falls (rises) as output
increases. When MC equals ATC, ATC is constant at its
minimum value—the MC curve intersects the ATC curve at its
lowest point.
c) Figure 10.5 (page 221) shows the MC, AFC, AVC, and ATC
curves.
D. Why the Average Total Cost Curve Is U-Shaped
The MC, AVC, and ATC curves are all U-shaped because:
1.Initially, increasing marginal returns bring falling MC and a downward-sloping MC curve. Eventually, diminishing
marginal returns bring rising MC and an upward-sloping MC curve. The MC curve reaches a minimum when these
two influences offset each other.
2. When MC is below AVC, AVC is falling and the AVC curve
slopes downward. Diminishing marginal returns, which
eventually bring rising MC, mean that MC eventually exceeds
AVC. At this point, AVC rises and the AVC curve slopes
upward. The AVC curve reaches a minimum when these two
influences offset each other.
3. ATC is the sum of AFC and AVC. Initially the ATC curve
slopes downward because the AFC slopes downward—total fixed
costs are spread over greater levels of output, and because
the AVC curve slopes downward. Eventually, diminishing
returns, which bring rising AVC also bring rising ATC and an
upward-sloping ATC curve.
E. Cost Curves and Product Curves
The shapes of a firm’s cost curves are determined by the
technology it uses:
1. MC is at its minimum at the same level of output created by
the level of labor that maximizes marginal product. This
means that when the marginal product curve rises (falls) with
labor, the MC curve falls (rises) with output.
2. AVC is at its minimum when the average product of labor is at
its maximum. This means that when the average product rises
(falls) with labor, the AVC falls (rises) with output.
3. Figure 10.6 (page 222) shows the relationships between MC and
the marginal product of labor, as well as the relationship
between AVC and the average product of labor.
F. Shifts in Cost Curves
1. Technological change influences both the productivity curves
and the cost curves.
a) Changes that increase (decrease) productivity will shift
the average and marginal product curves upward (downward)
and the average and marginal cost curves downward
(upward).
b) If a technological advance requires more capital and less
labor to be used, fixed costs increase and variable costs
decrease. The average total cost increases at low levels
of output and decreases at high levels of output.
2. Changes in the prices of resources shift the cost curves.
a) An increase in a fixed cost shifts the total cost (TC )
and average total cost (ATC ) curves upward but does not
shift the marginal cost (MC ) curve.
b) An increase in a variable cost shifts the total cost (TC
), average total cost (ATC ), and marginal cost (MC )
curves upward.
IV. Long-Run Cost
A. In the long run, all inputs levels are variable, the firm incurs
no fixed cost to production, and all costs are variable.
B. The Production Function
1. The behavior of long-run cost depends upon the firm’s
production function, which is the relationship between the
maximum output attainable and the quantities of both capital
and labor.
2. Table 10.3 (page 224) shows a production function.
3. The marginal product of capital is the increase in output
resulting from a one-unit increase in the amount of capital
employed, holding constant the amount of labor employed.
a) The level of capital a firm employs determines its plant
size.
b) Typically, a firm’s production function will exhibit
diminishing marginal returns to labor (for a given plant
size) as well as diminishing marginal returns to capital
(for a quantity of labor).
c) For each plant size, diminishing marginal productivity of
labor creates a set of short run, U-shaped costs curves
for MC, AVC, and ATC.
C. Short-Run Cost and Long-Run Cost
1. The average cost of producing a given output varies and
depends on the firm’s plant size.
a) The larger the plant size, the greater is the output at
which ATC is at a minimum.
b) The firm can compare the ATC for each given output at
different plant sizes. Figure 10.7 (page 225) shows a set
of four ATC curves, each representing the four possible
plant sizes. Only one plant size delivers the minimum ATC
for each output.
2. The long-run average cost curve (LRAC) is the relationship
between the lowest attainable ATC and output when both plant
size and labor are varied.
a) The LRAC curve reflects the minimum possible ATC the firm
can attain for any given level of output.
b) For any level of output the firm may choose to produce,
the LRAC reflects the lowest possible ATC taken from an
ATC curve that corresponds to a particular plant size.
c) Once the firm has chosen that plant size, it will incur
production costs corresponding the ATC curve associated
with that plant size.
E. Economies and Diseconomies of Scale
1. The long-run cost curve is influenced by the available
technology.
a) Economies of scale are features of a firm’s technology that
lead to falling long-run average cost as output increases.
As plant size increases, minimum attainable ATC for each
plant size falls with output. The percentage increase in
output exceeds the percentage increase in inputs.
b) Diseconomies of scale are features of a firm’s technology
that lead to rising long-run average cost as output
increases. As plant size increases, minimum attainable ATC
for each plant size rises with output. The percentage
increase in output is less than the percentage increase in
inputs.
c) Constant returns to scale are features of a firm’s technology
that lead to constant long-run average cost as output
increases. As plant size increases, minimum attainable ATC
for each plant size remains constant with output. The
percentage increase in output equals the percentage
increase in inputs.
2. A firm experiences economies of scale up to some output
level. Beyond that output level, it moves into constant
returns to scale or diseconomies of scale.
a) Minimum efficient scale is the smallest quantity of output at
which the long-run average cost reaches its lowest level.
b) If the long-run average cost curve has the typical U
shape, the minimum point identifies the minimum efficient
scale output level.