What is Economics?1
Chapter
10 / output and costs1
output and costs1
Chapter Key Ideas
The ATM is Everywhere!
A.Why are banks replacing teller windows with ATMs?
B.Why do auto-makers have unused production capacity while electric utilities can’t always produce enough to meet demand?
C.This chapter studies a firm’s production possibilities and the costs of production.
Outline
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 10.1shows 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 10.2shows 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 10.4shows 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 10.5shows 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 10.3shows 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 ATCfalls 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 ATCrises 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 ATCremains 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.
Reading Between the Lines
A news article reveals that banks are closing human teller windows and replacing them with ATMs. An analysis of the short-run and long-run average total cost curves is explored for the two different technologies for supplying teller services.
New in the Seventh Edition
There are no significant changes to this chapter.
Teaching Suggestions
1.The big picture. Stand back from the details of this chapter and be sure that your students learn two big ideas:
A firm’s lowest production costs depend on the manager’s flexibility to choose the level of all inputs. This flexibility enables firm managers to produce at a lower cost than is possible in the short run when some inputs are fixed.
In the short run, with one or more fixed inputs, production costs vary with output in a predictable way because they are directly linked to measures of input productivity.
2.Lots of definitions and terminology can cloud the primary message. Make good use of the glossary of productivity and cost terms provided in Table 10.2 but don’t get mired down in reciting productivity and cost measure definitions! Students must learn the definitions, but they are secondary to the concepts they define and the insights they bring.
3.Focus on why productivity measures and cost measures are useful for decision making: Firm managers must frequently make quick decisions with little information. If managers have knowledge of a useful relationship between input measures (which are relatively easy to get) and production cost measures (which are more difficult to get—especially marginal cost figures) they can use their understanding of this link to make inferences about how production costs might behave when the firm’s output must change to accommodate market changes.
4.The marginal pulls (but cannot not push) the average. Don’t let the students fall into the trap of thinking that if the marginal measure rises (falls) with the level of an activity, then the average measure must also rise (fall). This is a sloppy statement of the relationship between marginal and average measures. Use the tried-and-true grade point average (GPA) example used in the text. Explain that if a student’s GPA is a 3.5 and their next marginal class grade is a C (2.0), followed by a B (3.0), this increasing marginal grade will not be pushing their GPA up at all. Conceptually, the students should understand that the marginal value can’t “push” the average measure higher when it is, itself, lower than the average measure. The marginal measure must be higher (lower) than the average value if the average value is to rise (fall) with the level of activity, thereby “pulling” the average from its position of higher (or lower) than the average.
4.Learn about production by producing. This chapter is one more place where an in-class experiment has a huge payoff in student comprehension. This 30 minute experiment teaches students about product curves and production cost measures. It motivates the students to go beyond memorizing the cost and productivity definitions by getting them directly involved with generating their own data as well as productivity and cost measures. This fun exercise will illustrate the concept of diminishing returns to labor as well as how short-run productivity measures and production cost measures are related.
Inputs:Capital: A medium sized table (the class must have an unobstructed view of it), tear-off scratch pads with about 500 sheets of paper, a fully loaded stapler, a back-up stapler (also fully loaded), a spreadsheet (that you can download from your Parkin Instructor’s Web site). Labor: Provided by your students.
The Task: To produce “widgets.” A widget is a piece of paper, torn from a pad, folded twice very carefully so that the corners of the paper align, and stapled. (The first fold bisects the paper along its long side and the second fold is at right angles to the first.) Once folded, it is stapled to hold the folds in place. A widget is fragile and breaks if it falls off the table.
The Pre-Experiment Stage: Hire a manager from your class and appoint an auditor. (Have some jokes about Enron and Andersen.) Get the manager to hire a quality controller, an accountant, and some workers. Tell the manager that he must produce widgets as efficiently as possible and that he can discuss the process with his workers and with the class.
The Experiment: A “work day” lasts for 1 minute. Get the class to keep time. On day 1, have one worker produce widgets. On day 2, have two workers produce widgets, and so on. You’ll probably run for 10 to 12 days before you get to almost zero marginal product. Record the inputs and outputs in a spreadsheet. Have some fun with quality control, shirking, and cheating. The auditor must ensure that old widgets and partly made widgets don’t get used in a subsequent day. Each day must start clean.