8 Short-Run Costs and Output Decisions CHAPTER OUTLINE Costs in the Short Run Fixed Costs Variable Costs Total Costs Short-Run Costs: A Review Output Decisions: Revenues, Costs, and Profit Maximization Perfect Competition Total Revenue and Marginal Revenue Comparing Costs and Revenues to Maximize Profit The Short-Run Supply Curve Looking Ahead

In their quest for profits, firms make three specific decisions involving their production.  FIGURE 8.1 Decisions Facing Firms

fixed cost Any cost that does not depend on the firms’ level of output. These costs are incurred even if the firm is producing nothing. There are no fixed costs in the long run. variable cost A cost that depends on the level of production chosen. total cost (TC) Total fixed costs plus total variable costs. TC = TFC + TVC Costs in the Short Run

A production function and Fixed Costs 1 4 Number of workers Output (quantity of cookies produced per hour) Marginal product of labor Cost of factory Cost of workers Total cost of inputs (cost of factory + cost of workers) $ $ $

total fixed costs (TFC) or overhead The total of all costs that do not change with output even if output is zero. (Typically Capital) TABLE 8.1 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm (1) q (2) TFC (3) AFC (TFC/q) $ $  Fixed Costs Total Fixed Cost (TFC)

 FIGURE 8.2 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm Average fixed cost is simply total fixed cost divided by the quantity of output. As output increases, average fixed cost declines because we are dividing a fixed number ($1,000) by a larger and larger quantity. Average Fixed Cost (AFC) average fixed cost (AFC) Total fixed cost divided by the number of units of output; a per-unit measure of fixed costs. spreading overhead The process of dividing total fixed costs by more units of output. Average fixed cost declines as quantity rises.

A production function and variable costs 1 7 Number of workers Output (quantity of cookies produced per hour) Marginal product of labor Cost of factory Cost of workers Total cost of inputs (cost of factory + cost of workers) $ $ $

Total Cost $90 Quantity of Output (cookies per hour) Caroline’s production function and total-cost curve 2 8 (a) Production function The production function in panel (a) shows the relationship between the number of workers hired and the quantity of output produced. Here the number of workers hired (on the horizontal axis) is from the first column in Table 1, and the quantity of output produced (on the vertical axis) is from the second column. The production function gets flatter as the number of workers increases, which reflects diminishing marginal product. The total-cost curve in panel (b) shows the relationship between the quantity of output produced and total cost of production. Here the quantity of output produced (on the horizontal axis) is from the second column in Table 1, and the total cost (on the vertical axis) is from the sixth column. The total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product. (b) Total-cost curve Number of Workers Hired Production function Total-cost curve Quantity of Output (cookies per hour)

marginal cost (MC) The increase in total cost that results from producing 1 more unit of output. Marginal costs reflect changes in variable costs. TABLE 8.3 Derivation of Marginal Cost from Total Variable Cost Units of OutputTotal Variable Costs ($)Marginal Costs ($) Marginal Cost (MC)

 FIGURE 8.4 Declining Marginal Product Implies That Marginal Cost Will Eventually Rise with Output In the short run, every firm is constrained by some fixed factor of production. A fixed factor implies diminishing returns (declining marginal product) and a limited capacity to produce. As that limit is approached, marginal costs rise. The Shape of the Marginal Cost Curve in the Short Run In the short run, every firm is constrained by some fixed input that (1) leads to diminishing returns to variable inputs and (2) limits its capacity to produce. As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output. Marginal costs ultimately increase with output in the short run.

 FIGURE 8.5 Total Variable Cost and Marginal Cost for a Typical Firm Total variable costs always increase with output. Marginal cost is the cost of producing each additional unit. Thus, the marginal cost curve shows how total variable cost changes with single-unit increases in total output. Graphing Total Variable Costs and Marginal Costs

 FIGURE 8.6 More Short-Run Costs When marginal cost is below average cost, average cost is declining. When marginal cost is above average cost, average cost is increasing. Rising marginal cost intersects average variable cost at the minimum point of AVC. Graphing Average Variable Costs and Marginal Costs

 FIGURE 8.7 Total Cost = Total Fixed Cost + Total Variable Cost Adding TFC to TVC means adding the same amount of total fixed cost to every level of total variable cost. Thus, the total cost curve has the same shape as the total variable cost curve; it is simply higher by an amount equal to TFC. Total Costs

average total cost (ATC) Total cost divided by the number of units of output. Average Total Cost (ATC)  FIGURE 8.8 Average Total Cost = Average Variable Cost + Average Fixed Cost To get average total cost, we add average fixed and average variable costs at all levels of output. Because average fixed cost falls with output, an ever-declining amount is added to AVC. Thus, AVC and ATC get closer together as output increases, but the two lines never meet.

If marginal cost is below average total cost, average total cost will decline toward marginal cost. If marginal cost is above average total cost, average total cost will increase. As a result, marginal cost intersects average total cost at ATC’s minimum point for the same reason that it intersects the average variable cost curve at its minimum point. The relationship between average total cost and marginal cost is exactly the same as the relationship between average variable cost and marginal cost. The Relationship Between Average Total Cost and Marginal Cost

What Does a Firm Do? Firm’s Objective – Firms seek to maximize profits Profits = Total Revenues minus Total Costs Choose Q such that Max {TR(Q*) –TC{Q*} Total revenue – Revenue received from sale of its output Total cost – Market value of the inputs a firm uses in production 16

2-17 Total revenue = P*Q – Revenue received from sale of its output – Market price for the good – Perfect Comp -> P-taker – Firm’s output decision does not affect price: P does not depend on Q – Revenues only affected then by quantity supplied/produced – What can be produced profitably at the given market price?

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