1. CH. 11: OUTPUT AND COSTS
Measure of relationship between output and cost
Production function
Shows relationship between inputs and output
Law of diminishing marginal returns
Cost function
Shows relationship between output and cost
Short run vs long run cost
Economies of Scale and Scope

2. Short run vs. Long run The Short Run
A time frame in which one or more resources used in production is fixed.
For most firms, capital is fixed in the short run.
Other resources used by the firm (such as labor, raw materials, and energy) are variable in the short run.
Short-run decisions are easily reversed.
The Long Run
A time frame in which the quantities of all resources can be varied.
No fixed inputs in the long run.

3. Decision Time Frames Sunk Costs.
A cost incurred by the firm that cannot be escaped after it is incurred
If a firm’s plant has no resale value, the amount paid for it is a sunk cost.
If a firm pays for research and development, the cost is sunk after incurred – regardless of whether the R&D had a successful outcome
Once incurred, sunk costs should be irrelevant to a firm’s decisions since the firm cannot escape sunk costs after they have been incurred.
Economic experiments suggest many people do NOT behave rationally when considering sunk costs.

4. SR Measures of Production
Total product (TP)
Units of output produced in a given period.
Marginal product of labor (MPL)
D TP resulting from one additional unit of L, ceteris paribus.
DTP/DL
Average product of labor (APL)
TP/L

5. Relationship between TP, MP and AP
The Total Product Curve

6. Relationship between TP, MP and AP
The Total Product Curve

7. Relationship between TP, MP and AP
Almost all production processes are like the one shown here
Initially increasing marginal returns
Eventually diminishing marginal returns

8. Relationship between TP, MP and AP
Increasing marginal returns
MP rises as use of input increases
Results from increased specialization and division of labor.
Diminishing marginal returns
MP falls as use of input increases
Occurs because amount of capital per worker falls.
The law of diminishing returns
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.

9. Short-Run Technology Constraint
IF MP>AP, what happens to AP if L is increased?
If MP<AP, what happens to AP if L is increased?
MP=AP when AP is at a maximum.

10. SR Cost
Total cost (TC) is the cost of all resources used.
Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output.
Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output.
TC = TFC + TVC
Start here 830

11. SR Total Cost Curves

12. SR Costs
Marginal Cost
the increase in total cost that results from a one-unit increase in total product.
ΔTC/ΔTP
If labor is the only variable input, MC=W/ MPL
Over the output range with increasing marginal returns, MC falls as output increases.
Over the output range with diminishing marginal returns, MC rises as output increases.

13. SR Costs Average Costs Average fixed cost (AFC) = TFC/TP
Average variable cost (AVC) = TVC/TP
If labor is the only variable input, AVC=W/APL
Average total cost (ATC) is total cost per unit of output.
ATC = TC/TP = AFC + AVC.

14. SR Costs Marginal vs. AVC and ATC
If MC<AVC, AVC decreases as TP increases
If MC>AVC, AVC increases as TP increases
If MC<ATC, ATC decreases as TP increases
If MC>ATC, ATC increases as TP increases

15. SR Cost Curves The ATC curve is U-shaped.
If MC<AVC, AVC is falling.
If MC>AVC, AVC is rising.
MC always interesects
ATC at min of ATC
AVC at min of AVC
AFC always decreases as output increases .

16. Relationship between production and cost

17. Short-Run Cost Shifts in Cost Curves
The position of a firm’s cost curves depend on two factors:
Technology
Prices of inputs
What is effect on ATC, MC, AVC of
Increase in price of labor
Increase in fixed costs
Increase in productivity of labor

18. Fill in the ** in the table belowTP TC
TFC
TVC
ATC
AVC MC
100 1
150 2
190 3
240 4
300 ** 5
400

19. Long-Run Cost
In the long run, all inputs are variable and all costs are variable.
The Production Function
Shows the relationship between the maximum output attainable and the quantities of both capital and labor.

20. Long-Run Cost Marginal product of capital (MPk)
the increase in TP from one more unit of capital, ceteris paribus.
A firm’s production function exhibits diminishing marginal returns to labor as well as diminishing marginal returns to capital (for a given 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.

21. LR Cost
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.
K=1
K=2
K=3
K=4
What’s the low cost method for producing 5 sweaters? 13 sweaters? 25 sweaters?

22. LR Cost
The long-run average cost (LRAC) curve.

23. LR Cost Economies of scale Diseconomies of scale
falling long-run average cost as output increases.
Diseconomies of scale
rising long-run average cost as output increases.
Constant returns to scale
constant long-run average cost as output increases.

24. Long-Run Cost

25. Long-Run Cost
Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its lowest level.
LRATC
MES

26. Market Structure and Minimum Efficient Scale
As MES rises relative to consumer demand, the number of firms in the industry will fall.
Cases to consider:
Microsoft
Steel industry
Printing industry
Farming