Ch07

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

Decisions Facing FirmsDecisions Facing Firms

DECISIONSDECISIONS are based onare based on INFORMATIONINFORMATION

1.1. The quantity of output to The quantity of output to supplysupply

1.1. The price of outputThe price of output

2.2. How to produce that How to produce that output (which technique output (which technique to use)to use)

2.2. Techniques of Techniques of production available*production available*

3.3. The quantity of each The quantity of each input to input to demanddemand

3.3. The price of inputs*The price of inputs*

*Determines production costs*Determines production costs


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.

• In the short run, all firms have In the short run, all firms have costs that they must bear costs that they must bear regardless of their output. These regardless of their output. These kinds of costs are called kinds of costs are called fixed fixed costscosts..


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.producing nothing.

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

TC TFC TVC Total Cost = Total Fixed + Total Variable

Cost Cost


Fixed CostsFixed Costs

• Firms have no control over fixed Firms have no control over fixed costs in the short run. For this costs in the short run. For this reason, fixed costs are sometimes reason, fixed costs are sometimes called called sunk costssunk costs..

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

AFCTFC

q


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

• AFC falls as output AFC falls as output rises; a phenomenon rises; a phenomenon sometimes called sometimes called spreading overheadspreading overhead..

(1)(1)qq

(2)(2)TFCTFC

(3)(3)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


Variable CostsVariable Costs

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

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


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

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

PRODUCTPRODUCTUSINGUSING

TECHNIQUETECHNIQUE

UNITS OFUNITS OFINPUT REQUIREDINPUT REQUIRED

(PRODUCTION FUNCTION)(PRODUCTION 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 ofUnits of AA 44 44 (4 x $2) +(4 x $2) + (4 x $1) =(4 x $1) = $12$12outputoutput BB 22 66 (2 x $2) +(2 x $2) + (6 x $1) =(6 x $1) =

22 Units ofUnits of AA 77 66 (7 x $2) +(7 x $2) + (6 x $1) =(6 x $1) = $20$20outputoutput BB 44 1010 (4 x $2) +(4 x $2) + (10 x $1) =(10 x $1) =

33 Units ofUnits of AA 99 66 (9 x $2) +(9 x $2) + (6 x $1) =(6 x $1) = outputoutput BB 66 1414 (6 x $2) +(6 x $2) + (14 x $1) =(14 x $1) = $26$26

$10

$18

$24


Marginal CostMarginal Cost

• Marginal cost (MC)Marginal cost (MC) is the increase is the increase in total cost that results from in total cost that results from producing one more unit of output.producing one more unit of output.

• Marginal cost reflects changes in Marginal cost reflects changes in variable costs.variable costs.

MCTC

Q

TFC

Q

TVC

Q


Derivation of Marginal Cost fromDerivation of Marginal Cost fromTotal Variable CostTotal Variable Cost

UNITS OF OUTPUTUNITS OF OUTPUTTOTAL VARIABLE COSTS TOTAL VARIABLE COSTS

($)($)MARGINAL COSTS MARGINAL COSTS

($)($)

00 00 00

11 1010 1010

22 1818 88

33 2424 66

• Marginal costMarginal cost measures the measures the additionaladditional cost of inputs required to produce each cost of inputs required to produce each successive unit of output.successive unit of output.


The Shape of the Marginal Cost Curve The Shape of the Marginal Cost Curve in the Short Runin the Short Run

• The fact that in the short run every firm is The fact that in the short run every firm is constrained by some fixed input means constrained by some fixed input means that:that:

1.1. The firm faces diminishing returns to variable The firm faces diminishing returns to variable inputs, andinputs, and

2.2. The firm has limited capacity to produce The firm has limited capacity to produce output.output.

• As a firm approaches that capacity, it As a firm approaches that capacity, it becomes increasingly costly to produce becomes increasingly costly to produce successively higher levels of output.successively higher levels of output.


The Shape of the Marginal Cost Curve The Shape of the Marginal Cost Curve in the Short Runin the Short Run

• Marginal costs ultimately increase with Marginal costs ultimately increase with output in the short run.output in the short run.


Graphing Total Variable Costs and Graphing Total Variable Costs and Marginal CostsMarginal Costs

• Total variable costs always Total variable costs always increase with output. The increase with output. The marginal cost curve shows marginal cost curve shows how total variable cost how total variable cost changes with single unit changes with single unit increases in total output.increases in total output.

• Below 100 units of output, Below 100 units of output, TVCTVC increases at a increases at a decreasing ratedecreasing rate. Beyond . Beyond 100 units of output, 100 units of output, TVCTVC increases at an increases at an increasing increasing rate.rate.


Average Variable CostAverage Variable Cost

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

• Marginal cost is the cost of Marginal cost is the cost of one one additional unitadditional unit. Average variable . Average variable cost is the average variable cost per cost is the average variable cost per unit of unit of all the unitsall the units being produced. being produced.

• Average variable cost Average variable cost followsfollows marginal cost, but lags behind.marginal cost, but lags behind.


Relationship Between Average Relationship Between Average Variable Cost and Marginal CostVariable Cost and Marginal Cost

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

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

• Rising marginal cost Rising marginal cost intersects average variable intersects average variable cost at the minimum point cost at the minimum point of of AVCAVC..

• At 200 units of output, AVC is At 200 units of output, AVC is minimum, and minimum, and MCMC = = AVCAVC..


Short-Run Costs of a Hypothetical FirmShort-Run Costs of a Hypothetical Firm

(1)(1)qq

(2)(2)TVCTVC

(3)(3)MCMC

(( TVCTVC))

(4)(4)AVCAVC

((TVC/qTVC/q))(5)(5)

TFCTFC

(6)(6)TCTC

((TVCTVC + + TFCTFC))

(7)(7)AFCAFC

((TFCTFC//qq))

(8)(8)ATCATC

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

00 $$ 00 $$ $$ $$1,0001,000 $$ 1,0001,000 $$ $$

11 1010 1010 1010 1,0001,000 1,0101,010 1,0001,000 1,0101,010

22 1818 88 99 1,0001,000 1,0181,018 500500 509509

33 2424 66 88 1,0001,000 1,0241,024 333333 341341

44 3232 88 88 1,0001,000 1,0321,032 250250 258258

55 4242 1010 8.48.4 1,0001,000 1,0421,042 200200 208.4208.4

500500 8,0008,000 2020 1616 1,0001,000 9,0009,000 22 1818


Total CostsTotal Costs

• Adding Adding TFCTFC to to TVCTVC means means adding the same amount of adding the same amount of total fixed cost to every total fixed cost to every level of total variable cost.level of total variable cost.

• Thus, the total cost curve Thus, the total cost curve has the same shape as the has the same shape as the total variable cost curve; it total variable cost curve; it is simply higher by an is simply higher by an amount equal to amount equal to TFCTFC..

TC TFC TVC


Average Total CostAverage Total Cost

• Average total cost (Average total cost (ATCATC) is ) is total cost divided by the total cost divided by the number of units of output number of units of output ((qq).).

ATC AFC AVC

ATCTC

q

TFC

q

TVC

q

• Because Because AFCAFC falls with falls with output, an ever-declining output, an ever-declining amount is added to amount is added to AVCAVC..


Relationship Between Average Total Relationship Between Average Total Cost and Marginal CostCost and Marginal Cost

• If marginal cost is below If marginal cost is below average total cost, average average total cost, average total cost will decline total cost will decline toward marginal cost.toward marginal cost.

• If marginal cost is above If marginal cost is above average total cost, average average total cost, average total cost will increase.total cost will increase.

• Marginal cost intersects Marginal cost intersects average total cost and average total cost and average variable cost average variable cost curves at their minimum curves at their minimum points.points.


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

• In the short run, a competitive firm faces a In the short run, a competitive firm faces a demand curve that is simply a horizontal line at demand curve that is simply a horizontal line at the market equilibrium price.the market equilibrium price.


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

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

TR P q

MRTR

q

P q

q

( )

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

• In perfect competition, In perfect competition, P = MRP = MR..

P


Comparing Costs and Revenues to Comparing Costs and Revenues to Maximize ProfitMaximize 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, , therefore, the profit-maximizing perfectly competitive the profit-maximizing perfectly competitive firm will produce up to the point where the firm will produce up to the point where the price of its output is just equal to short-run price of its output is just equal to short-run marginal cost.marginal cost.

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


Profit Analysis for a Simple FirmProfit Analysis for a Simple Firm

(1)(1)qq

(2)(2)TFCTFC

(3)(3)TVCTVC

(4)(4)MCMC

(5)(5)P P == MR MR

(6)(6)TRTR

((PP x x qq))

(7)(7)TCTC

((TFC TFC ++ TVC TVC))

(8)(8)PROFITPROFIT((TR TR TC TC))

00 $$ 1010 $$ 00 $$ $$ 1515 $$ 00 $$ 1010 $$ -10-10

11 1010 1010 1010 1515 1515 2020 -5-5

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


The Short-Run Supply CurveThe Short-Run Supply Curve

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

Ch07

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