Micro Chapter 8
Costs and the Supply of Goods
7 Learning Goals:
1) Bring out the role costs play in making
economic decisions
2) Define and differentiate between a short-run
time period and a long-run time period
3) Define and calculate costs used to make
decisions
4) Relate costs to output decisions in the short run
5) Relate costs to output decisions in the long run
6) Explore the factors that cause shifts in the cost
curves
7) Explain how past, present, and future costs
influence production decisions
“From the standpoint of society
as a whole, the “cost” of
anything is the value that it has
in alternative uses.”
Thomas Sowell
You may skip the following 2 sections:
The Organization of the Business Firm
How Well Does the Corporate Structure
Work? (15th edition), or
Costs, Competition, and the Corporation
(14th edition)
The Economic Role of
Costs
The demand for a product represents the
voice of consumers instructing firms to
produce the good. On the other hand, a
firm’s costs represent the desire of
consumers not to sacrifice goods that
could be produced if the same resources
were employed elsewhere.
Economic profit ≠ Accounting
profit
Accounting profit = total revenue – total
out-of-pocket costs
Economic profit = total revenue – total outof-pocket costs – opportunity costs
Economic profit = total revenue – explicit
costs – implicit costs
Zero economic profit referred to as normal
profit rate
Two Clicker questions next
Q8.1 Which of the following is most likely to
be true of economic and accounting profits?
a) Economic profits are less than accounting
profits.
b) Accounting profits are less than economic
profits.
c) Economic profits plus accounting profits
equal zero.
d) Accounting profits minus economic profits
equal zero.
Q8.2 If most businesses in an industry are
earning a 23 percent rate of return on their
assets, but your firm is earning 13 percent,
your rate of economic profit is
a)
b)
c)
d)
3 percent.
10 percent.
23 percent.
36 percent.
Short Run and Long Run
Time Periods
Two Clicker questions next
Q8.3 The short run is a time period such
that
a) the existing firms in the market do not have
sufficient time to change the amounts of any of the
inputs that they employ.
b) the existing firms in the market do not have
sufficient time to either increase or decrease their
current rate of output.
c) the existing firms in the market do not have
sufficient time to increase the size of their existing
plant or build a new factory.
d) new firms may build plants and enter the industry.
Q8.4 The long run is a period of
a) at least one year.
b) sufficient length to allow a firm to expand
output by hiring additional workers.
c) sufficient length to allow a firm to alter its
plant size and capacity and all other
factors of production.
d) sufficient length to allow a firm to
transform economic losses into economic
profits by hiring better workers.
You must know these 2
definitions:
Short Run (SR) – a period of time in which
at least one input is fixed
Long Run (LR) – a period of time in which
all inputs are variable; i.e. none of the
inputs are fixed
Categories of Costs
Class Activity: Let’s plan a birthday
party!
Let’s plan a birthday party!
Class Activity: Write down some items we
need for a party
Some costs are fixed – they don’t vary
with quantity
Some costs are variable – they vary with
quantity
Circle the fixed costs
Average costs are per unit costs
Marginal cost is the change in total cost
Now for alphabet soup!
Clicker question next
Q8.5 If average fixed costs equal $60 and
average total costs equal $120 when output
is 100, the total variable cost must be
Q8.5 If average fixed costs equal $60 and
average total costs equal $120 when output
is 100, the total variable cost must be
a)
b)
c)
d)
$40.
$60.
$6,000.
$8,000.
Video:
Class Activity:
Identify at least two variable costs for
SPAM
Video:
Class Activity:
Identify at least two fixed costs for Wilson
footballs
Video:
Class Activity:
Which marginal cost do you think rises the
fastest: Spam, Wilson, or Harley
Davidson? Why?
Output and Costs In the
Short Run
Video:
Clicker question next
Q8.6 There appears to be two functions on this
part of the assembly line- tightening the bolt then
stamping it. How many more people do you think
could be added to this part of the assembly line
before they started bumping into each other and
slowing the progress down?
a)
b)
c)
d)
e)
f)
g)
4
6
8
10
12
14
16
Read and reread this section
carefully.
The ability of a firm to make stuff (its
production) is intimately tied to costs
You must understand why the cost curves
look like they do, AND
How they are related to production
Here is the graph you need to
know:
Why does MC fall first?
MC initially falls for two reasons:
(1) Increasing marginal returns- each
additional input adds more to total output
than the previous input
(2) learning by doing
Video:
Why does MC rise later?
MC rises because of diminishing marginal
returns
At some point, each additional input adds
less to total output than the previous input
Since more and more input is required,
marginal cost rises rapidly
Clicker question next
Q8.7 Which of the following about costs is always
true?
a) When marginal costs are less than average
total costs, average total costs will be
decreasing.
b) When average fixed costs are falling, marginal
costs must be less than average fixed costs.
c) When average fixed costs are rising, marginal
costs must be greater than average total costs.
d) When marginal costs are greater than average
total costs, average total costs will be
decreasing.
Diminishing Marginal Returns
Demonstration:
10 volunteers needed
Class Activity: Write down the production
from each round
Class Activity: Economics is Everywhere
7.5
I left a stack of handouts containing a problem set by the door
to the classroom today. Each student was supposed to pick
one up. The problem was that, in the last three minutes
before class started, the line of students waiting to pick up the
handouts and walk through the entryway to the classroom
was getting longer and longer. I had a brilliant idea- make
two piles- and I did that. More students per minute were able
to pick up the handout and walk into the classroom. With the
addition of more of the variable input (piles of handouts), the
output (students walking into class) increased. But despite
my doubling the number of stacks, the number of students
walking into class each minute didn’t double. The reason is
that there was a fixed input- the size of the entryway into the
room. If I had added a third pile, the output might have
increased further, but not by very much. Even in distributing
handouts before class, the principle of diminishing marginal
productivity seems to work.
Q: This story is similar to you leaving class. How could we
increase the marginal return of getting students out of class?
That is, how could we get more students out the doors in the
same amount of time?
Another example: making the bed
What’s the relationship between MC
and ATC?
Story from Economics is Everywhere 7.7
Just before class, my economics major students were
laughing at a conversation they overheard between the
instructor of the previous class and her student. The student
said, “I really need a good grade in this class ‘cause my GPA
has to be high for me to get into grad school.” My students
were laughing because the grade in that particular class could
not have had much of an effect on the senior’s GPA. The
student (it wasn’t an economics class, thank goodness) did
not distinguish marginal from average. The same thing
happens among my intro students at least once a year.
Someone tells me that unless he or she gets a B in my class,
his or her GPA will be so low that he or she will be thrown out
of the university. These students also don’t seem to know
marginal from average. Their average is low because of their
previous bad grades. The marginal grade- what they get in
my class- is not going to affect their GPAs very much.
What’s the relationship between MC and
ATC?
Illustration: your GPA
Let’s say you’re a sophomore with a 3.0
cumulative GPA (analogous to ATC)
Suppose this semester’s GPA (analogous to
MC) is 3.5
–
Your new cumulative would be higher (ATC rises)
Now suppose this semester’s GPA (MC) is 2.0
–
Your new cumulative would be lower (ATC falls)
Then, next semester’s GPA (MC) is 2.5
–
Your new cumulative would still be lower (ATC still
falls)
Catch phrase: “the average chases the
margin”
Two Clicker questions next
Q8.8 As output is expanded, if MC is greater
than ATC,
a)
b)
c)
d)
ATC must be at its minimum.
ATC must be at its maximum.
ATC must be increasing.
the firm must be earning economic
profit.
Q8.9 The short run average total cost (ATC)
curve of a firm will tend to be U-shaped
because
a) larger firms always have lower per unit costs
than smaller firms.
b) at small output rates, AFC will be high while at
large output rates MC will be high as the result of
diminishing returns.
c) diminishing returns will be present when output
is small while high AFC will push per unit cost to
high levels when output is large.
d) increasing marginal returns will be present at
both small and large output rates.
Output and Costs In the
Long Run
Graph of LR Costs:
Why does LR ATC look like
this?
Because in order to produce larger
quantities, the firm will need to “get
bigger.” That is, they will need to increase
their capital.
These are typically expensive so capital
costs become large which drives up
LRATC.
Economies of scale is the benefit to
the firm from becoming larger.
Economies of scale means the benefit is getting
bigger (ATC is falling)
– Also referred to as Increasing Returns to Scale
Diseconomies of scale means the benefit is
negative (ATC is rising)
– Also referred to as Decreasing Returns to Scale
Class Activity: Economics is Everywhere 9.13
What’s an efficient size for a church or synagogue? If there
were economies of scale throughout, with all the Baptists in a
big Texas city such as Austin, we’d see just one giant Baptist
church. With 10,000 Jews in Austin, we’d see just one big
synagogue. We don’t: There are many churches in each
denomination, as well as many synagogues. As the city has
expanded, more and more different kinds of Baptist churches,
Jewish synagogues, and other churches have been organized.
It’s not just that each one serves a local area. People drive a
long way to the church or synagogue of their choice even
when another one is closer. They like the peculiarities of a
leader’s ministry, the type of service, and even the particular
social interactions of a congregation. With one big house of
worship, these choices would be lost. Statistical studies of the
long-run average cost curves of churches suggest that this is
true: There are economies of scale up to some size, but as
the church or synagogue begins growing beyond a certain
size, diseconomies of scale set in- it becomes less efficient.
Q: List some of the cost and production factors that would
create economies of scale then some factors that would create
diseconomies of scale.
Two Clicker questions next
Q8.10 A downward-sloping portion of a longrun average total cost curve is the result of
a)
b)
c)
d)
economies of scale.
diseconomies of scale.
diminishing returns.
the existence of fixed resources.
Q8.11 In the long run, a firm might
experience rising per unit costs due to
a)
b)
c)
d)
economies of scale.
diseconomies of scale.
the law of supply.
the law of diminishing marginal returns.
Summary:
In the SR, diminishing returns determine
the shape of the cost curves
In the LR, economies of scale determine
the shape of the cost curves
What Factors Cause Cost
Curves to Shift?
Cost curves shift up and down
Higher costs shift curves up:
1) Resources become more expensive
2) Higher taxes
3) More, or stricter, regulations
4) Older technology
Lower costs shift curves down:
1) Resources become less expensive
2) Lower taxes
3) Less regulation
4) Newer technology
Cost curves impact supply
curves
When cost curves shift up, supply shifts
left
When cost curves shift down, supply shifts
right
The Economic Way of
Thinking about Costs
Some costs should be ignored
Sunk costs cannot be reversed or
recovered
Therefore they should be ignored (but not
forgotten) when making decisions about
the future
Keep thinking on the margin:
Continue to engage in an activity as long
as the expected marginal benefit is greater
than the expected marginal cost
7 Learning Goals:
1) Bring out the role costs play in making
economic decisions
2) Define and differentiate between a short-run
time period and a long-run time period
3) Define and calculate costs used to make
decisions
4) Relate costs to output decisions in the short run
5) Relate costs to output decisions in the long run
6) Explore the factors that cause shifts in the cost
curves
7) Explain how past, present, and future costs
influence production decisions