Diploma in Management Studies

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

After this lecture, students should be able to:

Explain the objective and profit of a firm
Distinguish between the short run and the long run
Explain the relationship between a firms output
and labor employed in the short run
Explain the relationship between a firms output
and costs in the short run and derive a firms shortrun cost curves
Explain the relationship between a firms output
and costs in the long run and derive a firms longrun average cost curve
2

The Firm and Its Economic

Problem
A firm is an institution that hires factors of
production and organizes them to produce and
sell goods and services.

The Firms Goal

A firms goal is to maximize profit.
If the firm fails to maximize profits it is either
eliminated or bought out by other firms seeking
to maximize profit.
3

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

Short-Run Technology Constraint

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

Total, Average and Marginal Product

BASIC TERMS

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.

Total, Marginal and Average Product Schedules

Label

Labor

Total
Product

Marginal
Product

Average
Product

4.00

10

5.00

13

4.33

15

3.75

16

3.20

Total Product Curve

The figure shows a total
product curve. It shows
how total product
changes with the
quantity of labor
employed.
It separates attainable
output levels from
unattainable output
levels in the short run.
10

Marginal Product Curve

The figure shows the marginal product of labor curve
and how the marginal product curve relates to the
total product curve.
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.
11

Marginal Product Curve

The height of each bar
measures the marginal
product of labor.
For example, when
labor increases from 2
to 3, total product
increases from 10 to 13,
so the marginal product
of the third worker is 3
units of output.
12

Short-Run Technology Constraint

The marginal product of labor curve passes
through the mid-points of these bars.
Almost all production
processes are like the
one shown here and
have:
Increasing marginal
returns initially
Diminishing marginal
returns eventually
13

Increasing Marginal Returns

Increasing Marginal
Returns Initially
When the marginal
product of a worker
exceeds the marginal
product of the
previous worker, the
marginal product of
labor increases and
the firm experiences
increasing marginal
returns.
14

Diminishing Marginal Returns

Diminishing Marginal
Returns Eventually
When the marginal
product of a worker is
less than the marginal
product of the previous
worker, the marginal
product of labor
decreases.
The firm experiences
diminishing marginal
returns.

15

Law of Diminishing Returns

Increasing marginal returns arise from increased

specialization and division of labor.
Diminishing marginal returns arises from the fact
that employing additional units of labor means
each 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.
16

Marginal Product and Average Product

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.

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

Short-Run Total Cost Curves

The figure shows a firms 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.

20

Short-Run Total Variable Cost Curve

The total variable cost curve gets its shape from
the total product 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.

21

Short-Run Total Cost Curves

Put the TFC curve
back in the figure,
and add TFC to
TVC, and youve
got the TC curve.

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

Numerical Example of Total and

Marginal Costs
Quantity TFC

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.

ATC = AFC + AVC.

25

Numerical Example of Average Costs

Q

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

Short-Run Average Cost Curves

The figure shows the MC, AFC, AVC, & ATC curves.
The AFC curve
shows that average
fixed cost falls as
output increases.
AVC curve is U
shaped. As output
increases, average
variable cost falls to
a minimum and
then increases.
27

Short-Run Average Cost Curves

The ATC curve is also U-shaped.
The MC curve is very
special.
Where AVC is
falling, MC is below
AVC.
Where AVC is rising,
MC is above AVC.
At the minimum AVC,
MC equals AVC.

28

Short-Run Average Cost Curves

Similarly, where ATC
is falling, MC is below
ATC.
Where ATC is rising,
MC is above ATC.
At the minimum ATC,
MC equals ATC.

29

Shape of AVC and ATC Curves

The AVC curve is U-shaped because:
Initially, marginal product exceeds average
product, which brings rising average product
and falling AVC.
Eventually, marginal product falls below
average product, which brings falling average
product 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 steeply.
30

Cost and Product

Curves

MC is at its minimum at the

same output level at which
marginal product is at its
maximum.
When marginal product is
rising, marginal cost is
falling.
AVC is at its minimum at
the same output level at
which average product is at
its maximum.
When average product is
rising, average variable cost
is falling.
31

Long-Run Cost - Diminishing Marginal

Product of Capital

In the long run, all inputs are variable and all

costs are variable.
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 firms production function exhibits diminishing
marginal returns to labor (for a given plant size)
as well as diminishing marginal returns to capital
(for a 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.
32

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

Answers to Exercise 7.1

The correct answer is (D).
Diminishing returns means the workers
are less productive due to insufficient
physical capital.
Since 40 hours is needed to produce
the first 80 units of output, it will take
more than 40 hours to produce another
80 units of output to reach 160 units.
43

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.

(E) impossible to calculate due to a lack of

information.
44

Answers to Exercise 7.2

The correct answer is (B).
Marginal cost is change in total cost
divided by change in output
Change in total cost is $455 - $200 =
$255
Change in output is 34 units 17 units
= 17 units
So MC = $255/17 = $15
45

Exercise 7.3
Economies of scale exist when

A) constant returns to scale are

present.

B) input prices are falling.

C) average costs fall as the scale of

production grows.

D) a 10% increase in all inputs causes

a 9% increase in output.

E) firms become extremely large.

46

Answers to Exercise 7.3

The correct answer is (c).
Economies of scale means when the
scale of production increases, total output
increases by more than total cost due to
efficiency in using resources
Thus the average total cost decreases
Cost

Long run ATC

Output

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

Answers to Exercise 7.4

Total fixed cost (TFC) = $500, Total
variable cost (TVC) = $1500, Total output
(Q) = 500 units
(1) AFC = TFC/Q = $500/500 = $1
AVC = TVC/Q = $1500/500 = $3
ATC = AFC + AVC = $4
(2) Total revenue = $5 X 500 = $2500
Total cost = $500 + $1500 = $2000
The firm is making a profit of $500
49

Exercise 7.5

Complete the following table and explain

the relationship between marginal cost and
average total cost.
Q

TVC

TC

MC

AFC

AVC

ATC

60

80

120

140

200

300

500
50

Answer to Exercise 7.5

The completed table is shown below:
Q

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

Answers to Exercise 7.5

The figures show that when MC is less

than ATC, ATC is decreasing.
Note that when MC is higher than ATC,
ATC is increasing.
When MC equals ATC, ATC is at its
minimum.
MC
Cost

ATC
AVC
Output