11

Short-Run CostsShort-Run Costsand Output Decisionsand Output Decisions

22

Decisions Facing FirmsDecisions Facing Firms

DECISIONSDECISIONS

are are based based

onon INFORMATIONINFORMATION

How much of each input to demand

3.

Which production technology

to use

2.How much output to supply

1.

The prices of inputs

3.

The market price of

the output

1.

The techniques of production

that are available

2.

33

Costs in the Short RunCosts in the Short Run

The The short runshort run is a period of time is a period of time for which two conditions hold:for which two conditions hold:1.1. The firm is operating under a fixed The firm is operating under a fixed

scale (fixed factor) of production, andscale (fixed factor) of production, and

2.2. Firms can neither enter nor exit an Firms can neither enter nor exit an industry.industry.

44

Costs in the Short RunCosts in the Short Run

Fixed costFixed cost is any cost that does not is any cost that does not depend on the firm’s level of output. These depend on the firm’s level of output. These costs are incurred even if the firm is costs are incurred even if the firm is producing nothing. There are no fixed producing nothing. There are no fixed costs in the long run.costs in the long run.

Variable costVariable cost is a cost that depends on the is a cost that depends on the level of production chosen.level of production chosen.

55

Costs in the Short RunCosts in the Short Run

TC TFC TVC Total Cost = Total Fixed + Total Variable

Cost Cost

66

Total Fixed Cost (Total Fixed Cost (TFCTFC))

Total fixed costs (TFC)Total fixed costs (TFC) or or overheadoverhead refers to the total of all refers to the total of all costs that do not change with output, costs that do not change with output, even if output is zero.even if output is zero.

Another name for fixed costs in the Another name for fixed costs in the short run is short run is sunk costssunk costs is because is because firms have no choice but to pay for firms have no choice but to pay for them. them.

77

Average Fixed Cost (Average Fixed Cost (AFCAFC))

Average fixed cost (AFC)Average fixed cost (AFC) is the total fixed cost is the total fixed cost ((TFCTFC) divided by the number of units of output ) divided by the number of units of output ((qq):):

AFCTFC

q

88

Average Fixed Cost (Average Fixed Cost (AFCAFC))

• Spreading overhead is the process of dividing total fixed costs by more units of output. Average fixed cost declines as quantity rises.

99

Short-Run Fixed CostShort-Run Fixed Cost(Total and Average) of a (Total and Average) of a Hypothetical FirmHypothetical Firm

((11))qq

((22))TFCTFC

((33))AFC (TFC/q)AFC (TFC/q)

00 $1,000$1,000 $ $

11 1,0001,000 1,0001,000

22 1,0001,000 500500

33 1,0001,000 333333

44 1,0001,000 250250

55 1,0001,000 200200

1010

1111

Short-Run Fixed CostShort-Run Fixed Cost(Total and Average) of a (Total and Average) of a Hypothetical FirmHypothetical Firm

As output increases, total fixed cost As output increases, total fixed cost remains constant and average fixed cost remains constant and average fixed cost declinesdeclines..

1212

Variable CostsVariable Costs

The The total variable cost curvetotal variable cost curve is is a graph that shows the a graph that shows the relationship between total variable relationship between total variable cost and the level of a firm’s cost and the level of a firm’s output.output.

The total variable cost is derived from production requirements and input prices.

1313

Variable CostsVariable Costs

1414

Derivation of Total Derivation of Total Variable Cost Schedule Variable Cost Schedule from Technology and from Technology and Factor PricesFactor Prices

The total variable cost curve shows the The total variable cost curve shows the cost of production using the best available cost of production using the best available technique at each output level, given technique at each output level, given current factor prices.current factor prices.

1515

PRODUCTPRODUCT

USINGUSINGTECHNIQUTECHNIQU

EE

UNITS OFUNITS OFINPUT REQUIREDINPUT REQUIRED

)PRODUCTION )PRODUCTION FUNCTION(FUNCTION(

TOTAL VARIABLETOTAL VARIABLECOST ASSUMINGCOST ASSUMING

PPKK = $2, = $2, PPLL = $1 = $1

TVCTVC = ) = )KK x x PPKK( + )( + )LL x x

PPLL((KK LL

11 Units Units ofof

AA 44 44 ))44 x $2x $2 ( (++

))44 x $1x $1= (= ( $12$12

outputoutput BB 22 66 ))22 x $2x $2 ( (++

))66 x $1x $1= (= (

22 Units Units ofof

AA 77 66 ))77 x $2x $2 ( (++

))66 x $1x $1= (= ( $20$20

outputoutput BB 44 1010 ))44 x $2x $2 ( (++

))1010 x $1x $1 ( (==

33 Units Units ofof

AA 99 66 ))99 x $2x $2 ( (++

))66 x $1x $1= (= (

outputoutput BB 66 1414 ))66 x $2x $2 ( (++

))1414 x $1x $1 ( (==

$26$26

$10

$18

$24

1616

Marginal Cost (Marginal Cost (MCMC))

Marginal cost (MC)Marginal cost (MC) is the increase in total cost that is the increase in total cost that results from producing one more unit of output. results from producing one more unit of output. Marginal cost reflects changes in variable costsMarginal cost reflects changes in variable costs..

UNITS OF UNITS OF OUTPUTOUTPUT

TOTAL VARIABLE TOTAL VARIABLE COSTSCOSTS)$( )$(

MARGINAL MARGINAL COSTSCOSTS)$( )$(

00 00 00

11 1010 1010

22 1818 88

33 2424 66

1717

The Shape of theThe Shape of theMarginal Cost Curve in Marginal Cost Curve in the Short Runthe Short Run

In the short run every firm is constrained by In the short run every firm is constrained by some fixed input that:some fixed input that:

1.1. leads to diminishing returns to variable leads to diminishing returns to variable inputs, andinputs, and

2.2. limits its capacity to produce.limits its capacity to produce.

1818

1919

Graphing Total VariableGraphing Total VariableCosts and Marginal CostsCosts and Marginal Costs

Total variable cost always increases Total variable cost always increases with output.with output.

The marginal cost curve shows how The marginal cost curve shows how total variable cost changes. total variable cost changes.

2020

2121

Average Variable Cost Average Variable Cost ((AVCAVC))

Average variable cost (AVC)Average variable cost (AVC) is the total variable is the total variable cost divided by the number of units of outputcost divided by the number of units of output..

AVCTVC

q

2222

Average Variable Cost Average Variable Cost ((AVCAVC))

• Marginal cost is the cost of one additional unit, while average variable cost is the variable cost per unit of all the units being produced.

2323

Short-Run CostsShort-Run Costsof a Hypothetical Firmof a Hypothetical Firm

2424

))11((qq

))22((TVCTVC

))33((MCMC((

TVCTVC))

))44((AVCAVC

((TVC/qTVC/q))))55((

TFCTFC

))66((TCTC

((TVCTVC + + TFCTFC))

))77((AFCAFC

((TFCTFC//qq))

))88((ATCATC

(TC/q (TC/q oror AFC + AFC + AVC)AVC)

00 $$ 00 $$ $$ $$ 1,001,0000

$$1,0001,000 $$ $$

11 1010 1010 1010 1,001,0000

1,0101,010 1,0001,000 1,0101,010

22 1818 88 99 1,001,0000

1,0181,018 500500 509509

33 2424 66 88 1,001,0000

1,0241,024 333333 341341

44 3232 88 88 1,001,0000

1,0321,032 250250 258258

55 4242 1010 8.48.4 1,001,0000

1,0421,042 200200 208.4208.4

500500 8,008,0000

2020 1616 1,001,0000

9,0009,000 22 1818

2525

Graphing Average Graphing Average VariableVariableCosts and Marginal CostsCosts and Marginal Costs

When marginal cost is below average cost, When marginal cost is below average cost, average cost is declining.average cost is declining.

• When marginal cost is above average cost, average cost is increasing.

• Marginal cost intersects average variable cost at the lowest , or minimum, point of AVC.

2626

•At 200 units of output, AVC is minimum and equal to MC.

2727

Total CostsTotal Costs

Adding the same amount Adding the same amount of total fixed cost to every of total fixed cost to every level of total variable cost level of total variable cost

yields total costyields total cost..

• For this reason, the total cost curve has the same shape as the total variable cost curve; it is simply higher by an amount equal to TFC.

TC TFC TVC

2828

Average Total CostAverage Total Cost

Average total cost (ATCAverage total cost (ATC) is total cost divided ) is total cost divided by the number of units of output (by the number of units of output (qq).).

ATC AFC AVC

ATCTC

q

TFC

q

TVC

q

• Because AFC falls with output, an ever-declining amount is added to AVC.

2929

Average Total CostAverage Total Cost

3030

The Relationship BetweenThe Relationship BetweenAverage Total Cost and Average Total Cost and Marginal CostMarginal Cost

If If MCMC is below is below ATCATC, then , then ATCATC will decline will decline toward marginal cost.toward marginal cost.

If If MCMC is above is above ATCATC, , ATCATC will increase. will increase. MCMC intersects the intersects the ATCATC and and AVCAVC curves at curves at

their minimum points.their minimum points.

3131

The Relationship Between The Relationship Between Average Total Cost and Marginal CostAverage Total Cost and Marginal Cost

3232

Output Decisions: Revenues,Output Decisions: Revenues,Costs, and Profit MaximizationCosts, and Profit Maximization

The perfectly competitive firm faces a The perfectly competitive firm faces a perfectly perfectly

elastic demandelastic demand curve for its product curve for its product..

3333

Total Revenue (Total Revenue (TRTR) and) andMarginal Revenue (Marginal Revenue (MRMR))

Total revenue (TR)Total revenue (TR) is the total amount is the total amount that a firm takes in from the sale of its that a firm takes in from the sale of its output.output.

TR P q

3434

Total Revenue (Total Revenue (TRTR) and) andMarginal Revenue (Marginal Revenue (MRMR))

• Marginal revenue (MR) is the additional revenue that a firm takes in when it increases output by one additional unit.

• In perfect competition, P = MR.

3535

Comparing Costs andComparing Costs andRevenues to Maximize ProfitRevenues to Maximize Profit

The profit-maximizing level of output for all The profit-maximizing level of output for all firms is the output level where firms is the output level where MRMR = = MCMC..

In perfect competition, In perfect competition, MRMR = = PP, therefore, the , therefore, the firm will produce up to the point where the price firm will produce up to the point where the price of its output is just equal to short-run marginal of its output is just equal to short-run marginal cost.cost.

The key idea here is that firms will produce as The key idea here is that firms will produce as long as marginal revenue exceeds marginal long as marginal revenue exceeds marginal cost.cost.

3636

Comparing Costs andComparing Costs andRevenues to Maximize ProfitRevenues to Maximize Profit

3737

Comparing Costs andComparing Costs andRevenues to Maximize ProfitRevenues to Maximize Profit

The profit-maximizing output is The profit-maximizing output is q*,q*, the point at the point at which which P*P* = MC. = MC.

3838

Profit Analysis for a Profit Analysis for a Simple FirmSimple Firm

((11))qq

((22))TFCTFC

((33))TVCTVC

((44))MCMC

((55))P P == MR MR

((66))TRTR

))PP x x qq((

((77))TCTC

))TFC TFC ++ TVC TVC((

((88))PROFITPROFIT

))TR TR TC TC((

00 $$ 1010 $$ 00 $$ $$ 1515 $$ 00 $$ 1010 $$ --1010

11 1010 1010 1010 1515 1515 2020 --55

22 1010 1515 55 1515 3030 2525 55

33 1010 2020 55 1515 4545 3030 1515

44 1010 3030 1010 1515 6060 4040 2020

55 1010 5050 2020 1515 7575 6060 1515

66 1010 8080 3030 1515 9090 9090 00

3939

The Short-Run Supply CurveThe Short-Run Supply Curve

4040

The Short-Run Supply CurveThe Short-Run Supply Curve

At any market price, the marginal cost At any market price, the marginal cost curve shows the output level that curve shows the output level that maximizes profit. Thus, the marginal cost maximizes profit. Thus, the marginal cost curve of a perfectly competitive profit-curve of a perfectly competitive profit-maximizing firm is the firm’s short-run maximizing firm is the firm’s short-run supply curve.supply curve.

4141

Review Terms and ConceptsReview Terms and Concepts

average fixed cost (average fixed cost (AFCAFC))

average total cost (ATaverage total cost (ATC)C)

average variable cost (average variable cost (AVCAVC))

fixed costfixed cost

marginal cost (marginal cost (MCMC))

marginal revenue (marginal revenue (MRMR))

spreading overheadspreading overhead

sunk costs sunk costs

(total cost (total cost TCTC)) (total fixed cost (total fixed cost TFCTFC))

(total revenue (total revenue TRTR)) (total variable cost (total variable cost

TVCTVC)) total variable cost cur total variable cost cur

veve

variable cost variable cost