Ch 10 OUTPUT AND COSTS
I.
Decision Time Frames
A. The firm makes many decisions in order to achieve its main objective: profit maximization.
1.
Some decisions are relatively critical to the survival of the firm, or are irreversible (or
very costly to reverse).
2.
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 quantities of some resources are fixed.
2. Some resources used by the firm are fixed in quantity (such as technology, buildings,
capital) in the short run. This set of resources is called the firm’s plant. In the short run, a
firm’s plant is fixed.
3. Other resources used by the firm vary with output (such as labor, raw materials, energy).
In the short run, to increase output the firm must increase the quantity of variable inputs
it uses.
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 quantity of all its other
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. The firm’s
investment in its plant is a sunk cost. 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 quantity of labor employed.
B. Product Schedules
Three concepts describe the relationship between output and the quantity of labor employed.
1.
Total product, which is the maximum output that a given quantity of labor can
produce.
2.
Marginal product of labor, 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 of labor, which
equals total product divided by the
quantity of labor employed.
4.
Table 10.1 shows an example of
total product, marginal product, and
average product for a firm that
produces sweaters.
C. Product Curves
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Produce 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. Total Product Curve
The total product curve shows how the total product increases with the level of labor
employed.
1.
The total product curve is similar to the PPF because it separates attainable output levels
from unattainable output levels in the short run.
2.
Figure 10.1 shows a total product curve.
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E. Marginal Product Curve
The marginal product of labor curve shows the change in total product for each unit of labor
employed.
1.
The total and marginal product curves are related.
a)
The height of the marginal
product curve is the slope of the
total product curve.
b) Figure 10.2 shows the
relationship between the marginal
product of labor curve and the
total product curve.
2.
When the marginal product of an
additional worker exceeds the
marginal product of the previous
worker, the marginal product of labor
curve rises as the quantity of labor
increases. The firm experiences
increasing marginal returns.
3.
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 as the quantity of labor
increases. The firm experiences
diminishing marginal returns,
which occurs when the marginal
product of an additional worker is less
than the marginal product of the
previous worker.
a)
4.
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.
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.
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F. Average Product Curve
The marginal product of labor curve and
the average product curve have the
relationship shown in Figure 10.3:
1.
When the marginal product of labor
exceeds the average product of labor,
the average product increases when
the quantity of labor increases.
2.
When the marginal product of labor is
less than the average product of labor,
the average product decreases when
the quantity of labor increases.
3.
The marginal product curve intersects
the average product curve at the point
of maximum average product.
4.
The relationship between a student’s marginal class grade and the student’s grade point
average (GPA) is similar to that between marginal product and average product.
a)
If the grade in another class is higher than the student’s GPA, this marginal grade
will pull the student’s GPA up.
b) If the grade in another class is less than the student’s GPA, this marginal grade will
pull the student’s GPA down.
c)
If the grade in another class is the same as the student’s GPA, the GPA will be
unchanged.
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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 the factors of
production it uses.
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 change with output.
4.
Total cost equals total fixed cost
plus total variable cost, or TC =
TFC + TVC.
5.
Figure 10.4 shows 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 output.
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C. Average Cost
There are three average 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 provides a complete glossary of cost terms.
6.
The value of MC, ATC, and AVC cost measures are related:
a)
When MC is below AVC, AVC falls as output increases. When MC is above AVC,
AVC rises as output increases. And the MC curve intersects the AVC curve at its
lowest point.
b) When MC is below ATC, ATC falls as output increases. When MC is above ATC,
ATC rises as output increases. And the MC curve intersects the ATC curve at its
lowest point.
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c)
Figure 10.5 shows the MC, AFC, AVC, and ATC curves.
D. Why the Average Total Cost Curve is U-Shaped
1. ATC is the sum of AFC and AVC. Initially the ATC curve slopes downward because both
the AFC and AVC curves slope downward. Eventually at some level of output,
diminishing returns mean that as output increases, AVC increases. When AVC slopes
upward enough, it offsets the downward slope of the AFC curve so that the ATC curve
slopes upward.
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E. Cost Curves and Product Curves
The shapes of a firm’s cost curves are determined by the technology it uses.
1. Figure 10.6 shows the relationships
between MC and the marginal
product of labor and also the
relationship between AVC and the
average product of labor.
2. When the marginal product curve is
at its maximum, the marginal cost is
at its minimum. So when the
marginal product curve is rising, the
MC curve is falling and when the
marginal product curve is falling,
the MC curve is rising.
3. When the average product of labor
is at its maximum, the AVC is at its
minimum. So then the average
product of labor curve is rising, the
AVC curve is falling and when the
average product of labor curve is
falling, the AVC curve is rising.
F.
Shifts in Cost Curves
1.
Technological change influences
both the productivity curves and the
cost curves.
a) A technological change that
increases productivity shifts the
average and marginal product
curves upward and the average
and marginal cost curves
downward.
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) curve and the average total cost
(ATC) curve upward but does not shift the marginal cost (MC) curve.
b) An increase in a variable cost shifts the total cost (TC) curve, the average total cost
(ATC) curve, and the marginal cost (MC) curve upward.
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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 shows a production
function.
3.
The marginal product of capital is
the change in total product divided
by the change in capital when the
quantity of labor is constant.
a) The amount of capital a firm
employs determines its plant
size.
b) Typically, a firm’s production
function exhibits diminishing
marginal product of labor (for
a given plant size) as well as
diminishing marginal product of capital (for a given quantity of labor).
c) For each plant size, the diminishing marginal product of labor creates a set of short
run, U-shaped costs curves for MC, AVC, and ATC.
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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
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 the plant size and labor are varied.
a) The LRAC curve is a planning curve; it shows the minimum possible ATC the firm
can attain for any given level of output. So for any level of output the firm may
choose to produce, the LRAC tells the plant size and quantity of labor that will
minimize cost.
c) Once the firm has chosen its plant size, the firm will incur costs corresponding the
ATC curve associated with that plant size.
E. Economies and Diseconomies of Scale
1.
The long-run average cost curve is influenced by the firm’s technology.
a)
Economies of scale are features of a firm’s technology that lead to falling longrun average cost as output increases. As plant size increases, the minimum attainable
ATC falls and the LRAC curve slopes downward. Economies of scale occur when 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, the minimum
attainable ATC rises and the LRAC curve slopes upward. Diseconomies of scale
occur when 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, the
minimum attainable ATC remains constant and the LRAC curve is horizontal.
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Constant returns to scale occur if 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 has constant returns to scale which is then followed by 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.