CH. 11: OUTPUT AND COSTS

Measure of relationship between output and cost Production function

Shows relationship between inputs and output Law of diminishing marginal returns

Cost function Shows relationship between output and cost Short run vs long run cost

Economies of Scale and Scope

Short run vs. Long run• The Short Run

A time frame in which one or more resources used in production is fixed.

For most firms, capital is fixed in the short run. Other resources used by the firm (such as labor, raw

materials, and energy) are variable in the short run. Short-run decisions are easily reversed.

• The Long Run A time frame in which the quantities of all resources

can be varied. No fixed inputs in the long run.

Decision Time Frames

• Sunk Costs. A cost incurred by the firm that cannot be

escaped after it is incurred If a firm’s plant has no resale value, the amount paid

for it is a sunk cost. If a firm pays for research and development, the cost is

sunk after incurred – regardless of whether the R&D had a successful outcome

Sunk costs are irrelevant to a firm’s decisions since the firm cannot escape sunk costs after they have been incurred.

SR Measures of Production

• Total product (TP)• Units of output produced in a given period.

• Marginal product of labor (MPL) D TP resulting from one additional unit of L, ceteris

paribus. DTP/DL

• Average product of labor (APL)

• TP/L

Relationship between TP, MP and AP

• The Total Product Curve

Relationship between TP, MP and AP• The Total Product Curve

Relationship between TP, MP and APAlmost all production

processes are like the one shown here

– Initially increasing marginal returns

–Eventually diminishing marginal returns

Relationship between TP, MP and AP

Increasing marginal returns • MP rises as use of input increases• Results from increased specialization and division of

labor. Diminishing marginal returns

• MP falls as use of input increases• Occurs because amount of capital per worker falls.

The law of diminishing returns • 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

• IF MP>AP, what happens to AP if L is increased?

• If MP<AP, what happens to AP if L is increased?

• MP=AP when AP is at a maximum.

SR Cost

• 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.

TC = TFC + TVC

SR Total Cost Curves

SR Costs

• Marginal Cost the increase in total cost that results from a one-

unit increase in total product. DTC/DTP If labor is the only variable input, MC=W/ MPL

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.

SR Costs

• Average Costs– Average fixed cost (AFC) = TFC/TP– Average variable cost (AVC) = TVC/TP

• If labor is the only variable input, AVC=W/APL

– Average total cost (ATC) is total cost per unit of output.

ATC = TC/TP = AFC + AVC.

SR Costs

• Marginal vs. AVC and ATCIf MC<AVC, AVC decreases as TP increasesIf MC>AVC, AVC increases as TP increases

If MC<ATC, ATC decreases as TP increasesIf MC>ATC, ATC increases as TP increases

SR Cost Curves

• The ATC curve is U-shaped.

• If MC<AVC, AVC is falling.• If MC>AVC, AVC is rising.• MC always interesects

• ATC at min of ATC• AVC at min of AVC

• AFC always decreases as output increases.

Relationship between production and cost

Short-Run Cost

• Shifts in Cost Curves– The position of a firm’s cost curves depend on two

factors: Technology Prices of productive resources What is effect on ATC, MC, AVC of

• Increase in price of labor.• Increase in fixed costs • Increase in productivity of labor.

Fill in the table belowTP TC TFC TVC ATC AVC MC

0 100

1 150

2 190

3 240

4 300

5 400

Fill in the table belowTP TC TFC TVC ATC AVC MC

0 100 100 0 -- -- --

1 150 100 50 150 50 50

2 190 100 90 95 45 40

3 240 100 140 80 46.66 50

4 300 100 200 75 50 60

5 400 100 300 80 60 100

Long-Run Cost

• In the long run, all inputs are variable and all costs are variable.

• The Production Function– Shows the relationship between the maximum

output attainable and the quantities of both capital and labor.

Long-Run Cost

– Marginal product of capital (MPk)• the increase in TP from one more unit of capital, ceteris

paribus. – A firm’s production function exhibits diminishing

marginal returns to labor as well as diminishing marginal returns to capital (for a given quantity of labor).

– For each plant size, diminishing marginal product of labor creates a set of short run, U-shaped costs curves for MC, AVC, and ATC.

LR Cost

What’s the low cost method for producing 5 sweaters? 13 sweaters? 25 sweaters?

The long-run average cost curve is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied.

K=1 K=2 K=3 K=4

LR CostThe long-run average cost (LRAC) curve.

LR Cost

• Economies of scale – falling long-run average cost as output

increases.• Diseconomies of scale

– rising long-run average cost as output increases.

• Constant returns to scale – constant long-run average cost as output

increases.

Long-Run Cost

Long-Run Cost– Minimum efficient scale is the smallest quantity

of output at which the long-run average cost reaches its lowest level.

LRATC

MES

Market Structure and Minimum Efficient Scale

• As MES rises relative to consumer demand, the number of firms in the industry will fall.

• Cases to consider: Microsoft Steel industry Printing industry Farming