Outline
The ATM is Everywhere!
A. Why are banks closing teller windows and replacing them with ATMs?
B. Why do auto-makers have unused production capacity while electric utilities sometimes can’t produce enough to meet demand?
C. This chapter studies a firm’s production possibilities and costs of production.
I. Decision Time Frames
A. The firm makes many decisions in order to achieve its main objective: profit maximization. Some decisions are relatively critical to the survival of the firm, or are irreversible (or very costly to reverse). 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 quantity of one or more resources used in production is fixed.
2. Some resources used by the firm are fixed in quantity (such as technology, buildings, capital) regardless of output. This is called the firm’s plant. In the short run, a firm’s plant is fixed.
3. Other resources used by the firm do vary with output (such as labor, raw materials, energy). In the short run, only the level of these variable resources can change.
4. Short-run decisions over variable resource use are easily reversed.
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 level of all other variable 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.
a) The firm’s investment in plant size is a sunk cost.
b) 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 amount of labor employed. Three concepts describe the relationship between output and the quantity of labor employed.
B. Product Schedules
1. Total product, which is the total amount produced.
2. Marginal product, 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, which is equals total product divided by the quantity of labor employed.
4. Table 10.1 (page 215) shows an example of total product, marginal product, and average product for a firm that produces sweaters.
C. Product Curves
1. Product 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. The Total Product Curve
1. The total product curve shows how the total product increases with the level of labor employed.
2. It is similar to the PPF in that is separates attainable output levels from unattainable output levels in the short run.
3. Figure 10.1 (page 216) shows a total product curve.
E. The Marginal Product Curve
1. The marginal product curve for labor shows the change in total product for each unit of labor employed.
2. The total and marginal product curves are directly related.
a) The height of the marginal product curve is the slope of the total product curve.
b) Figure 10.2 (page 217) shows the relationship between the marginal product of labor curve and the total product curve.
3. When the marginal product of an additional worker exceeds the marginal product of the previous worker, the marginal product of labor curve rises with labor, and the firm experiences increasing marginal returns.
4. 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 with labor and the firm experiences diminishing marginal returns.
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.
b) The additional output gained by the last unit of labor employed falls.
5. 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 following relationship shown in Figure 10.3 (page 218):
1. The average product curve increases with labor whenever the marginal product of labor exceeds the average product.
2. The average product curve falls with labor whenever the marginal product of labor is less than the average product.
3. The average product curve is at its maximum value when the marginal product of labor equals the average product.
4. The relationship between a student’s marginal class grade and her or his grade point average (GPA) is similar to that between marginal product and average product.
a) If a student’s next class grade is higher (lower) than the student’s GPA, this marginal grade will pull the student’s GPA (average grade) up (down).
b) If the next class grade is the same as the GPA, the GPA will remain 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 resources used.
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 do change with output.
4. Total cost equals total fixed cost plus total variable cost, or TC = TFC + TVC.
5. Figure 10.4 (page 219) shows the 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 total product.
1. Over the output range with increasing marginal returns, marginal cost falls as output increases.
2. Over the output range with diminishing marginal returns, marginal cost rises as output increases.
C. Average Cost
Average cost measures can be derived from each of the total 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 (page 223) provides a complete glossary of cost terms.
6. The value of MC, ATC, and AVC cost measures are related:
a) When MC is below (above) AVC, AVC falls (rises) as output increases. When MC equals AVC, AVC is constant at its minimum value—the MC curve intersects the AVC curve at its lowest point.
b) When MC is below (above) ATC, ATC falls (rises) as output increases. When MC equals ATC, ATC is constant at its minimum value—the MC curve intersects the ATC curve at its lowest point.
c) Figure 10.5 (page 221) shows the MC, AFC, AVC, and ATC curves.
D. Why the Average Total Cost Curve Is U-Shaped
The MC, AVC, and ATC curves are all U-shaped because:
1. Initially, increasing marginal returns bring falling MC and a downward-sloping MC curve. Eventually, diminishing marginal returns bring rising MC and an upward-sloping MC curve. The MC curve reaches a minimum when these two influences offset each other.
2. When MC is below AVC, AVC is falling and the AVC curve slopes downward. Diminishing marginal returns, which eventually bring rising MC, mean that MC eventually exceeds AVC. At this point, AVC rises and the AVC curve slopes upward. The AVC curve reaches a minimum when these two influences offset each other.
3. ATC is the sum of AFC and AVC. Initially the ATC curve slopes downward because the AFC slopes downward—total fixed costs are spread over greater levels of output, and because the AVC curve slopes downward. Eventually, diminishing returns, which bring rising AVC also bring rising ATC and an upward-sloping ATC curve.
E. Cost Curves and Product Curves
The shapes of a firm’s cost curves are determined by the technology it uses:
1. MC is at its minimum at the same level of output created by the level of labor that maximizes marginal product. This means that when the marginal product curve rises (falls) with labor, the MC curve falls (rises) with output.
2. AVC is at its minimum when the average product of labor is at its maximum. This means that when the average product rises (falls) with labor, the AVC falls (rises) with output.
3. Figure 10.6 (page 222) shows the relationships between MC and the marginal product of labor, as well as the relationship between AVC and the average product of labor.
F. Shifts in Cost Curves
1. Technological change influences both the productivity curves and the cost curves.
a) Changes that increase (decrease) productivity will shift the average and marginal product curves upward (downward) and the average and marginal cost curves downward (upward).
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 ) and average total cost (ATC ) curves upward but does not shift the marginal cost (MC ) curve.
b) An increase in a variable cost shifts the total cost (TC ), average total cost (ATC ), and marginal cost (MC ) curves 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 (page 224) shows a production function.
3. The marginal product of capital is the increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labor employed.
a) The level of capital a firm employs determines its plant size.
b) Typically, a firm’s production function will exhibit diminishing marginal returns to labor (for a given plant size) as well as diminishing marginal returns to capital (for a quantity of labor).
c) For each plant size, diminishing marginal productivity 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 (page 225) 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 plant size and labor are varied.
a) The LRAC curve reflects the minimum possible ATC the firm can attain for any given level of output.
b) For any level of output the firm may choose to produce, the LRAC reflects the lowest possible ATC taken from an ATC curve that corresponds to a particular plant size.
c) Once the firm has chosen that plant size, it will incur production costs corresponding the ATC curve associated with that plant size.
E. Economies and Diseconomies of Scale
1. The long-run cost curve is influenced by the available 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, minimum attainable ATC for each plant size falls with output. 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, minimum attainable ATC for each plant size rises with output. 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, minimum attainable ATC for each plant size remains constant with output. 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 moves into constant returns to scale or 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.