Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Chapter 11. Technology, Production, and Costs
Instructor: JINKOOK LEE
Department of Economics / Texas A&M University
ECON 202 504
Principles of Microeconomics
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Short Run and Long Run in Economics
Short run: The period of time during which at least one of a firms inputs is
fixed.
fixed input: firm’s technology and the size of physical plant.
variable input: the number of workers.
Long run: The period of time in which a firm can vary all its inputs (adopt
new technology and increase or decrease the size of its physical plant).
all inputs are variable.
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Fixed Costs and Variable Costs
Variable costs (VC): Costs that change as output changes.
labor costs, raw material costs.
Fixed costs (FC): Costs that remain constant as output changes.
lease payments, payments for fire insurance.
Total cost (TC): The cost of all the inputs a firm uses in production.
in the short run: TC = FC + VC
in the long run: TC = VC
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Implicit Costs and Explicit Costs
Economists always measure costs as opportunity costs.
Opportunity cost: The highest-valued alternative that must be given up to
engage in an activity.
Explicit cost: A cost that involves spending money (accounting costs).
Implicit cost: A non-monetary opportunity cost.
Sunk cost: A cost that has already been paid and cannot be recovered.
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Implicit Costs and Explicit Costs
Calculate Noel’s opportunity cost.
Noel has just graduated from medical college.
He has been offered a job at one of the most prestigious hospitals in
town. The job would pay him $45,000 a year.
However, his uncle, who runs a health care and fitness center, has also
offered him a position for $35,000 a year.
However, Noel wishes to enroll for a medical research program at a
foreign university, which would cost him $38,000, and eventually does
so.
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Implicit Costs and Explicit Costs
Calculate Sally’s opportunity cost.
Sally quit her job as an auto mechanic earning $50,000 per year to
start her own business.
To save money she operates her business out of a small building she
owns. Until she started her own business, she had rented out for
$10,000 per year.
She also invested her $20,000 savings (which earned a market interest
rate of 5% per year) in her business.
Cost of labor: $40,000
Cost of materials: $15,000
Equipment rental: $5,000
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Implicit Costs and Explicit Costs
How do we calculate the opportunity cost?
Opportunity cost = Explicit cost + Implicit cost
Be careful!! Explicit cost should not include Sunk cost.
Jill owns a pizza restaurant.
What is Jill’s explicit, implicit, and opportunity cost?
Costs in the Long Run
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Production Function
Production function: The relationship between the inputs employed by a
firm and the maximum output it can produce with those inputs.
Assume that in the short run, Jill uses one variable input (labor) and one fixed
input (pizza oven) to produce a single good (pizza).
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Total Cost and Average Total Cost Function
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
The Law of Diminishing Returns
Marginal product of labor (MPL): The additional output a firm produces
as a result of hiring one more worker.
MPL at Jill Johnsons Restaurant
workers (1→ 2): MPL increases (division of labor and specialization).
workers (3→ 6): MPL declines (workers get in each other’s way).
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
The Law of Diminishing Returns
Law of diminishing returns: at some point, adding more of a variable
input will cause the marginal product of the variable input to decline.
Output increases as more workers are hired
Second worker causes production to increase by a greater amount than did the
hiring of the previous worker
After the third worker, hiring more workers results in diminishing returns.
When the point of diminishing returns is reached, production increases at a
decreasing rate.
The marginal product of labor rises initially because of the effects of specialization
and division of labor, and then it falls due to the effects of diminishing returns.
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Marginal Cost
Now, we partly understand why average total cost (ATC) curves are
U-shaped from the relationship between ATC and MPL.
To completely understand, however, we should know the relationship
between marginal cost (MC) curve and MPL.
Marginal cost (MC): The change in a firms total cost from producing one
more unit of a good or service (MC = ∆TC
∆Q ).
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
MPL and MC
Relationship between MPL and MC
When MPL is rising, MC is falling.
When MPL is falling, MC is rising.
Since MPL rises and then falls, MC falls and then rises (U shape)
Jill pays each new worker the same $650 per week, thus MC (=
depends on that worker’s additional output.
∆TC
∆Q )
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
MC and ATC
Relationship between MC and ATC
As long as MC is below ATC, ATC will be falling.
When MC is above ATC, ATC will be rising.
The relationship between MC and ATC explains why ATC curve also has a U
shape.
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Summary on Cost Curves
Recall that average total cost is the sum of average fixed cost plus average
variable cost (ATC = AFC + AVC ).
Average total cost: ATC =
Average fixed cost: AFC =
TC
Q
FC
Q
Average variable cost: AVC =
VC
Q
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Summary on Cost Curves
Key facts about cost curves
The marginal cost (MC),
average total cost (ATC), and
average variable cost (AVC)
curves are all U shaped.
MC curve intersects both AVC
curve and ATC curve at their
minimum points.
As output increases, average
fixed cost (AFC) gets smaller
and smaller.
As output increases, the
difference between ATC and
AVC decreases.
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
The Long Run Costs
In the long run, the cost of purchasing more pizza ovens becomes variable
Jill can choose whether to expand her business by buying more ovens.
In the long run, all costs are variable.
There are no fixed costs in the long run.
Total cost = variable cost
Average total cost (ATC) = Average variable cost (AVC)
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Long-Run Average Cost Curve
Long-run average cost curve: A curve that shows the lowest cost at
which a firm is able to produce a given quantity of output in the long run,
when no inputs are fixed.
Economies of scale: when a firm’s long-run average costs fall as it
increases the quantity of output it produces.
Constant returns to scale: a firm’s long-run average costs remain
unchanged as it increases output.
Minimum efficient scale: the level of output at which all economies of
scale are exhausted.
Diseconomies of scale: a firm’s long-run average costs rise as the firm
increases output.
Cost and Production
MPL and APL
Short-Run Production/Short-Run Cost
Costs in the Long Run
Long-Run Average Cost Curve for Bookstores
If a small bookstore expects to sell
only 1,000 books, it will be able to sell
that quantity at the lowest average
cost of $22 per book.
A larger bookstore will be able to sell
20,000 books at a lower cost of $18
per book (economies of scale).
A bookstore selling 20,000 books and a
bookstore selling 40,000 books per
month will have the same average cost
(constant returns to scale).
The bookstore selling 20,000 books will
have reached minimum efficient scale.
For very large bookstores, their average
costs will rise as sales increase beyond
40,000 books (diseconomies of scale).