output and costs 229
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
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.
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) 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.
4. 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 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.
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.
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.
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.
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.
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.
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 long-run 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. 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.