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Microeconomics ECO001
Lecture 7- Output and Costs
Topics to be discussed:
Objective and Profit of Firm
Short Run and Long Run
Total, Average and Marginal Products
Law of Diminishing Marginal Returns
Total, Average and Marginal Costs
Returns to Scale and Long Run Costs
Ref: Parkin, Chapter 11
1
Learning Outcomes
Measuring Profit
Profit is defined as Total Revenue (TR) minus
Total Cost (TC)
Total Revenue is obtained by Price of
product Multiply by Quantity sold
If TR > TC, the firm is earning an economic
profit
If TR < TC, the firm is incurring a loss
If TR = TC, the firm is making zero
economic profit or normal profit
Firms need to make decision on price and
output in order to maximize profit
4
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 firms
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.
5
Long Run
The long run is a time frame in which the
quantities of all resourcesincluding the
plant sizecan 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 firms plant has no resale value, the
amount paid for it is a sunk cost.
Sunk costs are irrelevant to a firms
decisions.
6
Labor
Total
Product
Marginal
Product
Average
Product
4.00
10
5.00
13
4.33
15
3.75
16
3.20
15
17
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.
We describe the way a firms costs change
as total product changes by using three
cost concepts and three types of cost
curve:
Total cost
Marginal cost
Average cost
18
Short-Run Cost
A firms total cost (TC) is the cost of all
resources used.
Total fixed cost (TFC) is the cost of the
firms fixed inputs. Fixed costs do not
change with output.
Total variable cost (TVC) is the cost of the
firms variable inputs. Variable costs do
change with output.
Total cost equals total fixed cost plus total
variable cost. That is:
TC = TFC + TVC
19
20
21
22
Marginal 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.
23
TVC
TC
MC
120
120
120
100
220
100
120
150
270
50
120
240
360
90
120
380
500
140
120
560
680
180
24
Average Costs
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.
TFC
TVC
TC
AFC
AVC
ATC
120
120
120
100
220
120
100
220
120
150
270
60
75
135
120
240
360
40
80
120
120
380
500
30
95
125
120
560
680
24
112
136
26
28
29
Long-Run Cost
Short-Run Cost and Long-Run Cost
The average cost of producing a given
output varies and depends on the firms
plant size.
The larger the plant size, the greater is the
output at which ATC is at a minimum.
Cindy has 4 different plant sizes: 1, 2, 3, or
4 knitting machines.
Each plant has a short-run ATC curve.
The firm can compare the ATC for each
given output at different plant sizes.
33
Long-Run Cost
ATC1, ATC2, ATC3 and ATC4 are the ATC curve for a plant with
1, 2, 3 and 4 knitting machines respectively.
34
Long-Run Cost
The long-run average cost curve is made
up from the lowest ATC for each output
level.
So, we want to decide which plant has the
lowest cost for producing each output level.
Lets find the least-cost way of producing a
given output level.
Suppose that a firm wants to produce 13
sweaters a day.
35
Long-Run Cost
13 sweaters a day cost $9.50 each on ATC4, $7.69 on ATC1 and
ATC3 and $6.80 on ATC2
The least-cost way of producing 13 sweaters a day is on ATC 2.
36
Long-Run Cost
Long-Run Average Cost Curve
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.
The long-run average cost curve is a
planning curve that tells the firm the plant
size that minimizes the cost of producing a
given output range.
Once the firm has chosen that plant size, it
incurs the costs that correspond to the ATC
curve for that plant.
37
Long-Run Cost
The figure below illustrates the long-run average cost (LRAC) curve.
38
Long-Run Cost
Economies and Diseconomies of Scale
Economies of scale are features of a
firms technology that lead to falling longrun average cost as output increases.
Diseconomies of scale are features of a
firms technology that lead to rising longrun average cost as output increases.
Constant returns to scale are features of
a firms technology that lead to constant
long-run average cost as output increases.
39
Long-Run Cost
The figure below illustrates economies and diseconomies of scale.
40
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 long-run average cost curve is Ushaped, the minimum point identifies the
minimum efficient scale output level.
41
Exercise 7.1
Suppose 40 employee-hours can produce 80
units of output. Assuming the law of diminishing
marginal returns is present, to produce 160 units
of output will require
A)
an additional 40 employee-hours.
B)
a total of 80 or less employee-hours.
C)
less than 40 additional employeehours.
D)
a total of 81 or more employee-hours.
E)
a total of 80 employee-hours.
42
Exercise 7.2
If the firm spends $200 to produce 17 units of
output and spends $455 to produce 34 units,
then the marginal cost of increasing production
from 17 to 34 units is
(A) $13.38.
(B) $15.
(C) $7.50.
(D) $11.76.
Exercise 7.3
Economies of scale exist when
Exercise 7.4
Suppose, a firm has $1500 of variable
costs and $500 of fixed cost when it
produces 500 units of output and sells
them for $5 per unit.
(1) Calculate the average fixed cost,
average variable cost and average total
cost at this output level.
(2) Is this firm making a profit or incurring a
loss at this output?
48
Exercise 7.5
TVC
TC
MC
AFC
AVC
ATC
60
80
120
140
200
300
500
50
TVC
TC
MC
AFC
AVC
ATC
60
80
140
80
60
80
140
120
180
40
30
60
90
140
200
20
20
46.67 66.67
200
260
60
15
50
65
ATC
AVC
Output