Micro
McEachern
ECON
7
2010-2011
CHAPTER
Production and
Cost in the Firm
Designed by
Amy McGuire, B-books, Ltd.
Chapter 7
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
1
Cost and Profit
 Producers: Maximize profit
 Opportunity cost
– All resources have an opportunity cost
 Explicit costs
– Payments for resources
 Implicit costs
– Opportunity cost of resources owned
by the firm / firm owners
– No cash payment
1
LO
Chapter 7
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2
Alternative Measures of Profit
 Accounting profit
– Total revenue minus explicit costs
 Economic profit
– Total revenue minus all costs (implicit and
explicit)
• Opportunity cost of all resources
 Normal profit
– “Accounting profit in excess of normal profit”
• Accounting profit = Economic + Normal profit
LO1
Chapter 7
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3
Wheeler Dealer Accounts,
2010
Exhibit 1
LO1
Chapter 7
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4
Production in the Short Run
 Variable resources
– Can be varied quickly
 Fixed resources
– Cannot be altered easily
 Short run
– At least one resource is fixed
 Long run
– No resource is fixed
LO2
Chapter 7
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5
Law of Diminishing
Marginal Returns
 Total product
 Production function
– Relationship between amount of
resources employed and total
product
 Marginal product
– Change in total product from an
additional unit of resource
LO2
Chapter 7
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6
Law of Diminishing
Marginal Returns
 Increasing marginal returns
– Marginal product
increases
 Diminishing marginal
returns
– Marginal product
decreases
 Law of diminishing
marginal returns
LO2
Chapter 7
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7
LO2
Exhibit 2
The Short-Run Relationship Between Units of
Labor and Tons of Furniture Moved
Marginal product increases as the firm hires each of the first three workers, reflecting
increasing marginal returns. Then marginal product declines, reflecting diminishing
marginal returns. Adding more workers may, at some point, actually reduce total product
(as occurs here with an eighth worker) because workers start getting in each other’s way.
Chapter 7
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8
Effects of an Increase in Demand
Total product
(tons/day)
(a) Total product
15
Total
product
10
5
0
Marginal product
(tons/day)
Exhibit 3
LO2
5
4
3
2
1
0
5
Increasing
marginal
returns
Diminishing but
positive
marginal returns
Marginal
product
5
Chapter 7
10
Workers per day
(b) Marginal product
Negative
marginal
returns
10
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Workers per day
9
LO3
Costs in the Short Run
 Fixed cost FC
 For fixed resources
 Variable cost VC
 For variable resources
 Total cost TC = FC + VC
 Marginal cost MC = ∆TC/∆q
 Change in TC to produce
one more unit of output
Chapter 7
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10
LO3
Costs in the Short Run
 Changes in MC
 Reflect changes in
marginal productivity
 Increasing marginal returns
 MC falls
 Diminishing marginal
returns
 MC increases
Chapter 7
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11
LO3
Exhibit 4
Short-Run Total and Marginal Cost
Data for Smoother Mover
First 3 workers: increasing marginal returns: MC declines
With the 4th worker: diminishing marginal returns: MC increases
Chapter 7
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12
LO3
Exhibit 5
TC is the vertical
sum of FC and VC
VC starts from
origin; increases
slowly at first; with
diminishing returns,
VC increases rapidly
Total and
Marginal
Cost Curves
for Smoother
Mover
FC = $200 at all
levels of output
MC first declines: increasing
marginal returns; then increases:
diminishing marginal returns
Chapter 7
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13
LO3
Average Cost in the
Short Run
 Average variable cost AVC = VC/q
 Average total cost ATC = TC/q
 When MC < average cost
 The marginal pulls down the average
 When MC > average cost
 The marginal pulls up the average
 U-shape of average cost curves
 Law of diminishing marginal returns
Chapter 7
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14
LO3
Exhibit 6
Short-Run Total, Marginal, and Average
Cost Data for Smoother Mover
MC first falls then increases (increasing then diminishing marginal returns)
As long as MC < AC, average cost declines
Once MC > AC, average cost increases
Chapter 7
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15
LO3
Exhibit 7
Average and Marginal Cost Curves
for Smoother Mover
When MC is above AVC (ATC),
AVC (ATC) is increasing.
ATC and AVC: decline,
reach low points, then rise.
When MC is below AVC
(ATC), AVC (ATC) is falling
When MC = AVC (ATC),
AVC (ATC) is at its
minimum.
Chapter 7
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16
Costs in the Long Run




All resources can be varied
Planning horizon
Firms plan in the long run
Firms produce in short run
LO4
Chapter 7
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17
Costs in the Long Run
 U-shaped long-run average cost curve
 Economies of scale
– LRAC falls as output expands
 Diseconomies of scale
– LRAC increases as output expands
 Constant lung-run average cost
LO4
Chapter 7
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18
LO4 Short-Run Average Total Cost Curves Form
S
Cost per unit
Exhibit 8
the Long-Run Average Cost Curve, or
Planning Curve
L’
M’
M
S’
a
L
b
Long run ATC curve: SabL’
0
Chapter 7
SS’, MM’, LL’ are short run ATC curves
q qa
q’
qb
Output per period
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19
LO4
Exhibit 9
Many Short-Run ATC Curves Form a Firm’s
LRAC Curve, or Planning Curve
ATC10
Cost per unit
ATC1
$11
10
9
a
ATC9
ATC2
b
ATC8
ATC3
c
Long-run
average cost
ATC7
ATC4
ATC5
ATC6
Many possible plant sizes
Each short-run curve is
tangent to the long run
average cost curve
Output per period
0
q q’
Each point of tangency represents the least cost way of producing that level of output
Chapter 7
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20
A Firm’s Long-Run Average
Cost Curve
Long-run
average cost
Cost per unit
Exhibit 10
LO4
0
A
Economies
of scale
Chapter 7
B
Constant
average cost
Output per period
Diseconomies
of scale
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21
Case Study
LO4 Scale Economies and Diseconomies at the Movies
Chapter 7
 Movie theaters
 Economies of scale
 Decrease in LRAC as the number
of screens initially increases
 Diseconomies of scale
 Adding even more screens
 Problems arise
 LRAC starts to increase
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22
Economies and
Diseconomies of Scale
 Plant level
– Particular location
 Firm level
– Collection of plants
LO4
Chapter 7
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23
Case Study
LO4 Scale Economies and Diseconomies at McDonald's
Chapter 7
 Economies of scale
 At plant level
 Specialization
 At firm level
 Sharing: information; technology
 Diseconomies
of scale
 At firm level
 Uniform
menu
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24
Appendix
A Closer Look at
Production and Cost
Chapter 7
 Production function
 Technologically efficient production
 Isoquant
– All technologically efficient combinations
of 2 resources
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25
Exhibit A
A Firm’s Production Function Using Labor
and Capital: Production per Month
Chapter 7
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26
Appendix
A Closer Look at
Production and Cost
Chapter 7
 Isoquants
– Farther from origin: greater output rates
– Negative slope
– Don’t intersect
– Convex to the origin
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27
Appendix
A Closer Look at
Production and Cost
Chapter 7
 Marginal rate of technical substitution
– MRTS
– Slope of isoquant
– MRTS = MPL/MPC
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28
Exhibit B
Units of capital per month
A Firm’s Isoquants
10
Isoquants:
- negative slope
- convex to the origin
h
a
f
g
5
b
c
0
Q3 (475) Q3: 475 units of output
e
d
Q2 (415)
Q2: 415 units of output
Q1 (290)
5
10
Units of labor per month
Q1: all technologically efficient combinations of labor and capital
that can be used to produce 290 units of output
Chapter 7
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29
Appendix
A Closer Look at
Production and Cost
Chapter 7
 Isocost line
 All combinations of capital and labor
 Can be hired for a given total cost
 Are parallel
 Slope of isocost line
– Negative
– Price of labor divided by price of capital
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30
Exhibit C
A Firm’s Isocost Lines
Units of capital per month
Slope = -w/r = -$1,500/$2,500 = -0.6
Each isocost line
– Combinations of labor and
capital that can be purchased
for a given amount of total cost
– Slope is negative wage
divided by the rental cost of
capital
10
5
0
5
10
15
Units of labor per month
Higher costs: isocost lines farther from origin
Chapter 7
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31
Appendix
A Closer Look at
Production and Cost
Chapter 7
 Profit maximization
 Cost minimization
 Minimum cost to produce a given output
– Tangency between isocost line and
isoquant
• Slope = MRTS = w/r
 Expansion path
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32
TC = $19,000
Units of capital per month
Exhibit D
A Firm’s Optimal Combination
of Inputs
e: isoquant Q2 is tangent
to the isocost line
10
a
f
5
Q3 (475)
e
Q2 (415)
Q1 (290)
0
5
10
Units of labor per month
Chapter 7
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33
Units of capital per month
Exhibit E
A Firm’s Expansion Path
Expansion path
- Slopes up to the right
- More of both
resources is needed
to increase output
Expansion path
d
c
h
b
C
a
Q1
0
L
Q2
Q4
Q3
L’
Units of labor per month
Chapter 7
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34