© 2005 Thomson C hapter 8 Costs of Production

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles The character of entrepreneurship Total cost, total fixed cost, and total variable cost The law of diminishing returns

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles Average total cost, average variable cost, average fixed cost, and marginal cost Economies of scale, constant returns to scale, and diseconomies of scale

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e Economic Principles The relationship between short- run average total cost and long- run average total cost Downsizing

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e Fixed Cost Fixed cost Cost to the firm that does not vary with the quantity of goods produced. The cost is incurred even when the firm does not produce.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e Variable Cost Variable cost Cost that varies with the quantity of goods produced. Variable costs include such items as wages and raw materials.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e EXHIBIT 1ATOTAL FIXED COST FOR THE MAXIBOAT

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e EXHIBIT 1BTOTAL FIXED COST FOR THE MAXIBOAT

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e Exhibit 1: Total Fixed Cost for the Maxiboat When plotting total fixed cost on a diagram with dollars on the “y” axis and output on the “x” axis, which of the following correctly describes the shape of the total fixed cost curve? a.An upward-sloping line b.A horizontal line c.A downward-sloping line

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e Exhibit 1: Total Fixed Cost for the Maxiboat When plotting total fixed cost on a diagram with dollars on the “y” axis and output on the “x” axis, which of the following correctly describes the shape of the total fixed cost curve? a. An upward-sloping line b. A horizontal line c. A downward-sloping line

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e Labor Productivity Labor productivity The output per laborer per hour

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e EXHIBIT 2TOTAL VARIABLE COSTS PER FISHING RUN

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e Exhibit 2: Total Variable Costs Per Fishing Run Complete the sentence: When output is zero, total variable cost is _____.

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e Exhibit 2: Total Variable Costs Per Fishing Run Complete the sentence: When output is zero, total variable cost is zero.

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e Marginal Product Marginal product The change in total product caused by a one-unit increase in a factor of production (such as labor).

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e The Law of Diminishing Returns Under what circumstances does the law of diminishing returns hold? In the short run, when at least one factor of production is fixed.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e The Law of Diminishing Returns Under what circumstances does the law of diminishing returns hold? As more of a variable factor of production (such as labor) is added to the fixed factor, each will eventually run out of physical space and equipment to work effectively.

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e The Law of Diminishing Returns Under what circumstances does the law of diminishing returns hold? With crowding, eventually the marginal product of each successive laborer will be less than the one previously added.

© 2005 Thomson 19 EXHIBIT 3TOTAL VARIABLE COST

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e Exhibit 3: Total Variable Cost If total variable cost (TVC) is increasing at an increasing rate, then which of the following is true about the TVC curve: a. It is upward-sloping and becoming steeper. b. It is upward-sloping and becoming flatter. c. It cannot start at the origin.

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e Exhibit 3: Total Variable Cost If total variable cost (TVC) is increasing at an increasing rate, then which of the following is true about the TVC curve: a. It is upward-sloping and becoming steeper. b. It is upward-sloping and becoming flatter. c. It cannot start at the origin.

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e EXHIBIT 4ATOTAL COST CURVE

© 2005 Thomson 23 EXHIBIT 4BTOTAL COST CURVE

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Exhibit 4: Total Cost Curve 1. How is total cost calculated? Total cost is the sum of the total fixed and total variable costs of production.

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e Exhibit 4: Total Cost Curve 2. How is the shape of the total cost curve determined? The shape of the total cost curve is principally determined by the shape of the total variable cost curve.

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e Exhibit 4: Total Cost Curve 2. How is the shape of the total cost curve determined? This is because the total fixed cost is always the same ($2,000), regardless of what quantity is produced.

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Average Total Cost Average total cost (ATC) Total cost divided by the quantity of goods produced. ATC declines, reaches a minimum, then increases as more of a good is produced.

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e Average Fixed Cost Average fixed cost (AFC) Total fixed cost divided by the quantity of goods produced. AFC steadily declines as more of a good is produced.

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e Average variable cost (AVC) Total variable cost divided by the quantity of goods produced. AVC declines, reaches a minimum, then increases as more of a good is produced. Average Fixed Cost

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e Average Cost AFC is ($1 million/100,000) = $10 AVC is ($2 million/100,000) = $20 ATC is ($3 million/100,000) = $30—or ATC = AFC + AVC = $10 + $20 = $30 If total fixed cost is $1 million, total variable cost is $2 million, and output is 100,000, what is AFC, AVC, and ATC?

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e EXHIBIT 5AAVERAGE FIXED COST, AVERAGE VARIABLE COST, AND AVERAGE TOTAL COST CURVES

© 2005 Thomson 32 EXHIBIT 5BAVERAGE FIXED COST, AVERAGE VARIABLE COST, AND AVERAGE TOTAL COST CURVES

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Total Cost Curves 1. What is the difference between the ATC and AVC curves? The difference between the ATC and AVC curves is AFC.

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e 1. What is the difference between the ATC and AVC curves? The ATC curve is the vertical sum of the AFC and the AVC curves. Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Total Cost Curves

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e 2. Why do the AVC and ATC curves become closer together as output increases? Because (ATC - AVC) = AFC, and as output increases, AFC becomes smaller Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Total Cost Curves

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e Marginal Cost Marginal cost The change in total cost generated by a change in the quantity of a good produced.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e EXHIBIT 6AMARGINAL COST AND AVERAGE TOTAL COST CURVES

© 2005 Thomson 38 EXHIBIT 6BMARGINAL COST AND AVERAGE TOTAL COST CURVES

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e Exhibit 6: Marginal Cost and Average Total Cost Curves 1. What are the shapes of the MC and ATC curves? The ATC curve is U-shaped, and the MC curve is upward-sloping and intersects the ATC curve.

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e 2. What is the relationship between the MC and the ATC curves in Exhibit 6? Within the output range 0 to 8,000, MC is below ATC, causing ATC to decrease. Exhibit 6: Marginal Cost and Average Total Cost Curves

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e 2. What is the relationship between the MC and the ATC curves in Exhibit 6? Beyond an output of 8,000, MC is above ATC, causing ATC to increase. Exhibit 6: Marginal Cost and Average Total Cost Curves

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e 2. What is the relationship between the MC and the ATC curves in Exhibit 6? At 8,000, MC = ATC. At this point ATC is at its minimum. The MC curve always cuts the ATC curve from below at the ATC curve’s minimum. Exhibit 6: Marginal Cost and Average Total Cost Curves

© 2005 Thomson 43 EXHIBIT 7AVERAGE TOTAL COST CURVES FOR TWO FISHING FIRMS WITH DIFFERENT FIXED COSTS

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Different Fixed Costs 1. In Exhibit 7, what is the average total cost for Strang and Burnett at an output of 2,000 fish? At an output of 2,000 fish, Strang’s average total cost is $0.70. At the same output level, Burnett’s average total cost is $1.10.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e 2. What explains the difference in the average total cost for Strang and Burnett? The difference is due to the fact that Strang and Burnett have different fixed costs associated with the different capacity boats that they use. Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Different Fixed Costs

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e 3. How does efficiency change as output quantity increases? At an output less than 4,000, Strang’s operation is more efficient. When output increases above 4,000, Burnett’s operation becomes more efficient. Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Different Fixed Costs

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e Economies of Scale Economies of scale Decreases in the firm’s average total cost brought about by increased specialization and efficiencies in production realized through increases in the scale of the firm’s operations.

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Constant Returns to Scale Constant returns to scale Costs per unit of production are the same for any level of production. Changes in plant size do not affect the firm’s average total cost.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e Diseconomies of Scale Diseconomies of scale Increases in the firm’s average total cost brought about by the disadvantages associated with bureaucracy and the inefficiencies that eventually emerge with increases in the firm’s operations.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e EXHIBIT 8ECONOMIES OF SCALE, DISECONOMIES OF SCALE, AND CONSTANT RETURNS TO SCALE

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e Exhibit 8: Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale 1. What happens to ATC as output increases from 0 to 50,000? As output increases from 0 to 50,000, the minimum points on the short-run ATCs decline.

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e 1. What happens to ATC as output increases from 0 to 50,000? This range of output features economies of scale in production. Exhibit 8: Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e 2. What happens to ATC as output increases from 50,000 to 70,000? Between 50,000 and 70,000 units of output there are approximately constant returns to scale. Exhibit 8: Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e 3. What happens to ATC as output increases beyond 70,000? The minimum points on the short-run ATCs rise beyond 70,000 units of output. There are diseconomies of scale in this range of output. Exhibit 8: Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e Short Run Short run The time interval during which producers are able to change the quantity of some but not all the resources they use to produce goods and services.

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e Long Run Long run The time interval during which producers are able to change the quantity of all the resources they use to produce goods and services. In the long run, all costs are variable.

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e Short Run and Long Run Can a firm always be in the long run, and therefore avoid the short run? Usually not, since most of the time a firm must make some commitment to capital.

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e Short Run and Long Run Can a firm always be in the long run, and therefore avoid the short run? Once a production facility is bought or leased, it would take time for the firm to switch to a new facility, or for the facility to depreciate. That time period is the short run.

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e EXHIBIT 9SHORT- AND LONG-RUN COST CURVES FOR A FISHING FIRM

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm 1. What is the relationship between the short-run ATC (SRATC) curves and the long-run ATC curve (LRATC)? The LRATC curve is tangent to lowest points on each of the various possible SRATC curves. The LRATC curve is also called an envelope curve.

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e 2. Why are there multiple SRATC curves, but only one LRATC curve? Recall that in the short-run, firms can change the quantity of some, but not all of the resources they use to produce goods and services. Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e Each SRATC curve represents a commitment to a different size of production facility. 2. Why are there multiple SRATC curves, but only one LRATC curve? Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e Once a firm has chosen a short-run cost curve, the firm is committed to it until the fixed cost items associated with the chosen ATC depreciate. 2. Why are there multiple SRATC curves, but only one LRATC curve? Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e The long-run is the time interval during which producers can change the quantity of all of the resources they use to produce goods and services. 2. Why are there multiple SRATC curves, but only one LRATC curve? Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e The single LRATC curve represents the cost options open to the firm before any specific commitment is made. 2. Why are there multiple SRATC curves, but only one LRATC curve? Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e Long-Run Average Total Cost Curve 1. In what portion of the long-run average total cost curve are there economies of scale in production? Along the initial downward-sloping portion of the long-run average total cost curve, where average total cost falls as output increases.

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e 2. In what portion of the long-run average total cost curve are there diseconomies of scale in production? Along the upward-sloping portion of the long-run average total cost curve, where average total cost rises as output increases. Long-Run Average Total Cost Curve

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e Rightsizing Rightsizing Implementing a firm’s decision to adjust its plant size to produce current output in the most efficient manner possible.

© 2005 Thomson 69 Gottheil - Principles of Economics, 4e Rightsizing Suppose that a firm is currently producing high up on the steeply downward-sloping portion of its average cost curve. Is this evidence that the firm has recently undergone rightsizing? No. The firm’s output is too small for its current production facility.

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e Rightsizing Suppose that a firm is currently producing high up on the steeply downward-sloping portion of its average cost curve. Is this evidence that the firm has recently undergone rightsizing? By switching to a smaller production facility the firm may be able to reduce its average costs.

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e Downsizing Downsizing Implementing a firm’s decision to decrease its plant size to produce current output in the most efficient manner possible.

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e Downsizing Suppose that a firm is currently producing high up on the steeply upward-sloping portion of its average cost curve. Is this evidence that the firm can produce current output more efficiently by downsizing? No. The firm’s output is too large for its current production facility.

© 2005 Thomson 73 Gottheil - Principles of Economics, 4e Downsizing Suppose that a firm is currently producing high up on the steeply upward-sloping portion of its average cost curve. Is this evidence that the firm can produce current output more efficiently by downsizing? No. The firm’s output is too large for its current production facility.

© 2005 Thomson 74 Gottheil - Principles of Economics, 4e EXHIBIT 10AVERAGE COST CURVES FOR IRRIGATED COTTON FARMS, TEXAS HIGH PLAINS Source: J. Patrick Madden, Economies of Size in Farming, U.S. Department of Agriculture, AER No. 107, Washington, D.C., February 1967, p. 44.

© 2005 Thomson 75 Gottheil - Principles of Economics, 4e Exhibit 10: Average Cost Curves for Irrigated Cotton Farms, Texas High Plains If a Texas high plains cotton farmer had a one-person farm and used six- row equipment, are his average costs always going to be higher than for farms with more people working? No. At a $60,000 income, cost per dollar of gross income is as low or lower than for farms with more people working.