Output and Costs

Decision Time Frames

The firm makes many decisions to achieve its main objective:

profit maximization

Some decisions are critical to the survival of the firm.

Some decisions are irreversible (or very costly to reverse).
Other decisions are easily reversed and are less critical to the survival of the
firm, but still influence profit.
All decisions can be placed in two time frames:
• The short run
• The long run
Decision Time Frames

The Short Run

The short run is a time frame in which the quantity of one or more resources
used in production is fixed.
For most firms, the capital, called the firm’s plant, is fixed in the short run.
Other resources used by the firm (such as labor, raw materials, and energy)
can be changed in the short run.
Short-run decisions are easily reversed.
Decision Time Frames

The Long Run

The long run is a time frame in which the quantities of all resources—
including the plant size—can be varied.
• Long-run decisions are not easily reversed.

A sunk cost is a cost incurred by the firm and cannot be changed.

• If a firm’s plant has no resale value, the amount paid for it is a sunk cost.
• Sunk costs are irrelevant to a firm’s current decisions.
Short-Run Technology Constraint

To increase output in the short run, a firm must increase the amount of labor.
Three concepts describe the relationship between output and the quantity of
labor employed:
1. Total product
2. Marginal product
3. Average product
Short-Run Technology Constraint

Product Schedules
Total product is the total output produced in a given period.
The marginal product of labor is the change in total product that results
from a one-unit increase in the quantity of labor employed, with all other
inputs remaining the same.
The average product of labor is equal to total product divided by the
quantity of labor employed.
Short-Run Technology Constraint

The table shows a firm’s product

schedules.
As the quantity of labor employed
increases:
• Total product increases.
• Marginal product increases initially …
but eventually decreases.
• Average product increases initially and
eventually decreases as well.
Short-Run Technology Constraint

Product curves show how the firm’s

total product, marginal product, and
average product change as the firm
varies the quantity of labor
employed.

The figure shows a total product

curve: how total product changes
with the quantity of labor employed.
Short-Run Technology Constraint

The total product curve is similar to

the PPF.
It separates attainable output levels
from unattainable output levels in the
short run.
Short-Run Technology Constraint

The first worker hired produces 4

units of output.
The second worker hired produces 6
units of output and total product
becomes 10 units.
The third worker hired produces 3
units of output and total product
becomes 13 units. …
And so on.
The height of each bar measures the
marginal product of labor.
Short-Run Technology Constraint

Marginal Product Curve

To make a graph of the marginal
product of labor, we can stack the bars
in the previous graph side by side.
The marginal product of labor curve
passes through the mid-points of these
bars.
• Increasing marginal returns initially
• Diminishing marginal returns eventually
Short-Run Technology Constraint

Increasing marginal returns arises from increased specialization and division

of labor.
Diminishing marginal returns arises because each additional worker has less
access to capital and less space in which to work.
Diminishing marginal returns are so pervasive that they are elevated to the
status of a “law.”
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.
Short-Run Technology Constraint

The figure shows the average

product curve and its relationship
with the marginal product curve.
When marginal product exceeds
average product, average product
increases.
When marginal product is below
average product, average product
decreases.
When marginal product equals
average product, average product is
at its maximum.
Short-Run Cost

To produce more output in the short run, the firm must employ more labor,
which means that it must increase its costs.
Three cost concepts and three types of cost curves are
• Total cost
• Marginal cost
• Average cost
Short-Run Cost

A firm’s total cost (TC) is the cost of all resources used.

Total fixed cost (TFC) is the cost of the firm’s fixed inputs.
• Fixed costs do not change with output.
Total variable cost (TVC) is the cost of the firm’s variable inputs.
• Variable costs do change with output.
Total cost equals total fixed cost plus total variable cost. That is:
TC = TFC + TVC
Short-Run Cost

The figure shows a firm’s total cost

curves.
Total fixed cost is the same at each
output level.
Total variable cost increases as
output increases.
Total cost, which is the sum of TFC
and TVC also increases as output
increases.
Short-Run Cost

The TVC curve gets its shape from

the TP curve.
Notice that the TP curve becomes
steeper at low output levels and then
less steep at high output levels.
In contrast, the TVC curve becomes
less steep at low output levels and
steeper at high output levels.
Short-Run Cost

To see the relationship between the

TVC curve and the TP curve, lets look
again at the TP curve.
But let us add a second
x-axis to measure total variable cost.
1 worker costs $25; 2 workers cost
$50; and so on, so the two x-axes line
up.
Short-Run Cost

We can replace the quantity of labor

on the x-axis with total variable cost.
When we do that, we must change
the name of the curve. It is now the
TVC curve.
But it is graphed with cost on the x-
axis and output on the y-axis.
Short-Run Cost

Redraw the graph with cost on the y-

axis and output on the x-axis, and
you’ve got the TVC curve drawn the
usual way.
Put the TFC curve back in the figure.
Add TFC to TVC, and you’ve got the
TC curve.
Short-Run Cost

Marginal cost (MC) is the increase in total cost that results from a one-unit
increase in total product.
Over the output range with increasing marginal returns, marginal cost falls as
output increases.
Over the output range with diminishing marginal returns, marginal cost rises
as output increases.
Short-Run Cost

Average cost measures can be derived from each of the total cost measures:
Average fixed cost (AFC) is total fixed cost per unit of output.
Average variable cost (AVC) is total variable cost per unit of output.
Average total cost (ATC) is total cost per unit of output.
ATC = AFC + AVC.
Short-Run Cost

The figure shows the MC, AFC, AVC,

and ATC curves.
The AFC curve shows that average
fixed cost falls as output increases.
The AVC curve is U-shaped.
As output increases, average variable
cost falls to a minimum and then
increases.
Short-Run Cost

The ATC curve is also U-shaped.

The MC curve is very special.
• For outputs over which AVC is falling,
MC is below AVC.
• For outputs over which AVC is rising,
MC is above AVC.
• For the output at minimum AVC, MC
equals AVC.
Short-Run Cost

Similarly…
• For the outputs over which ATC is
falling, MC is below ATC.
• For the outputs over which ATC is
rising, MC is above ATC.
• For the output at minimum ATC, MC
equals ATC.
Short-Run Cost

Why the Average Variable Cost Curve Is U-Shaped

The AVC curve is U-shaped because:
• Initially, MP exceeds AP, which brings rising AP and falling AVC.
• Eventually, MP falls below AP, which brings falling AP and rising AVC.

The ATC curve is U-shaped for the same reasons.

• In addition, ATC falls at low output levels because AFC is falling quickly.
Short-Run Cost

Why the Average Total Cost Curve Is U-Shaped

The ATC curve is the vertical sum of the AFC curve and the AVC curve.
The U-shape of the ATC curve arises from the influence of two opposing forces:
• Spreading total fixed cost over a larger output—AFC curve slopes downward as output
increases.
• Eventually diminishing returns—the AVC curve slopes upward and AVC increases
more quickly than AFC is decreasing.
Short-Run Cost

Average and Marginal Product and Cost

The firm’s cost curves are linked to its product
curves.
• MC is at its minimum at the same output level at which
MP is at its maximum.
• When MP is rising, MC is falling.
• AVC is at its minimum at the same output level at which
AP is at its maximum.
• When AP is rising, AVC is falling.
Short-Run Cost

Shifts in the Cost Curves

The position of a firm’s cost curves depends on two factors:
• Technology
• Prices of factors of production
Short-Run Cost

Technology
Technological change influences both the product curves and the cost curves.
An increase in productivity shifts the product curves upward and the cost
curves downward.

Capital-augmenting technical change

If a technological advance results in the firm using more capital and less labor,
fixed costs increase and variable costs decrease.
In this case, average total cost increases at low output levels and decreases at
high output levels.
Short-Run Cost

Prices of Factors of Production

An increase in the price of a factor of production increases costs and shifts
the cost curves.
• 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.
• An increase in a variable cost shifts the total cost (TC), average total cost (ATC), and
marginal cost (MC) curves upward.
Long-Run Cost

The table shows a firm’s production

function.
As the size of the plant increases, the
output that a given quantity of labor
can produce increases.
But for each plant, as the quantity of
labor increases, diminishing returns
occur.
Long-Run Cost

Diminishing Marginal Product of Capital

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 firm’s production function exhibits:
• Diminishing marginal returns to labor (for a given plant)
• Diminishing marginal returns to capital (for a quantity of labor).
For each plant, diminishing marginal product of labor creates a set of short
run, U-shaped cost curves for MC, AVC, and ATC.
Long-Run Cost

Short-Run Cost and Long-Run Cost

The average cost of producing a given output varies and depends on the
firm’s plant.
The larger the plant, the greater is the output at which ATC is at a minimum.
The firm has 4 different plants: 1, 2, 3, or 4 knitting machines.
Each plant has a short-run ATC curve.
The firm can compare the ATC for each output at different plants.
Long-Run Cost

• 𝐴𝑇𝐶1 is the ATC curve for a plant with 1

knitting machine.
• 𝐴𝑇𝐶2 is the ATC curve for a plant with 2
knitting machine.
• 𝐴𝑇𝐶3 is the ATC curve for a plant with 3
knitting machine.
• 𝐴𝑇𝐶4 is the ATC curve for a plant with 4
knitting machine.
…
Long-Run Cost

The long-run average cost curve is made up from the lowest ATC for each
output level.
We need to decide which plant has the lowest cost for producing each
output level.
Suppose that the firm wants to produce 13 sweaters a day.
What is the least-cost way of producing 13 sweaters a day?
Long-Run Cost

• Using Plant 1, 13 sweaters a day cost

$7.69 each on 𝐴𝑇𝐶1 .
• Using Plant 2, 13 sweaters a day cost
$6.80 each on 𝐴𝑇𝐶2 .
• Using Plant 3, 13 sweaters a day cost
$7.69 each on 𝐴𝑇𝐶3 .
• Using Plant 4, 13 sweaters a day cost
$9.50 each on 𝐴𝑇𝐶4 .
The least-cost way of producing 13
sweaters a day is to use 2 knitting
machines.
Long-Run Cost

The long-run average cost curve is

the relationship between the lowest
attainable average total cost and
output when both the plant and labor
are varied.
• The LRAC curve is a planning curve
that tells the firm the plant that
minimizes the cost of producing a given
output.
• Once the firm has chosen its plant, the
firm incurs the costs that correspond to
the ATC curve for that plant.
Long-Run Cost

Economies and Diseconomies of

Scale
• Economies of scale are features of a
firm’s technology that lead to falling
long-run average cost as output
increases.
• Diseconomies of scale are features of a
firm’s technology that lead to rising
long-run average cost as output
increases.
• Constant returns to scale are features of
a firm’s technology that lead to constant
long-run average cost as output
increases.
Long-Run Cost

Minimum Efficient Scale

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.
Minimum efficient scale is the
smallest quantity of output at which
the long-run average cost reaches its
lowest level.
• If the LRAC curve is U-shaped, the
minimum point identifies the minimum
efficient scale output level.