1. Production and Cost in the Short Run
Chapter 7
Production and Cost in the Short Run
© 2006 Thomson/South-Western

2. Explicit and Implicit Costs
Explicit costs
Refer to the firm’s actual cash payments for resources  wages, rent, taxes, etc.
Implicit costs
The opportunity costs of using resources owned by the firm or provided by the firm’s owners
Require no cash payment and no entry in the firm’s accounting statement, which records its revenues, explicit costs, and accounting profits

3. Alternative Measures of Profit
Wanda Wheeler currently earns $50,000 in her current job
She decides to start her own business
She withdraws $20,000 from her savings account, hires and assistant and uses a spare bay in her garage that had been renting for $1,200 a year
Exhibit 1 shows the results after the first year

4. Exhibit 1: Accounts of Wheeler Dealer 2004

5. Normal Profit
Alternatively, the accounting profit just sufficient to ensure that all resources used by the firm earn their opportunity cost  normal profit
Recall that the accounting profit = $64,000
Normal profits = $50,000 + $1,200 + $1,000 = $52,200: normal profit
$11,800:economic profit

6. Fixed and Variable Resources
Variable resources can be varied quickly to change the output rate
Fixed resources are those resources which cannot be easily changed
This provides us the distinction between the short run and the long run
Short run: at least one resource is fixed
Long run: all resources are variable
Varies from industry to industry

7. Exhibit 2: Short-Run Relationship

8. Law of Diminishing Marginal Returns
As more of a variable resource is combined with a given amount of a fixed resource, marginal product eventually declines
This is the most important feature of production in the short run  dictates the shape of the production function and the cost curves

9. Exhibit 3: Total and Marginal Product of Labor
Because of increasing marginal returns, marginal product increases with each of the first three workers: total product is increasing at an increasing rate
Once diminishing returns sets in with the 4th worker, marginal product declines: total product increases at a decreasing rate
As long as marginal product is positive, total product increases, and when marginal product turns negative, total product starts to fall

10. Costs in the Short Run
Fixed costs pay for fixed resources and must be paid even if no output is produced – they do not vary when output varies
Variable cost is the cost of variable resources – labor in our example – and vary with the amount of labor employed in the production process: as more labor is employed, output and variable cost both increase
The firm can hire labor at $100 per worker day: variable cost equals $100 times the number of workers hired

11. Exhibit 4: Short-Run Cost Data
Tons Moved Fixed Variable Marginal
per Day cost Workers Cost Total Cost Cost
(q) (FC) per Day (VC) TC=FC+VC MC=TC/ q
(1) (2) (3) (4) (5) (6)
$ $ $ $
Since total cost is the opportunity cost of all resources employed by the firm, it includes a normal profit but not an economic profit.
Marginal cost is simply the change in total cost divided by the change in output  MC = ΔTC / Δq
Changes in MC reflect changes in marginal productivity of the variable resource employed

12. Marginal Cost and Marginal Productivity
When the firm experiences increasing marginal returns – marginal product is increasing – the marginal cost decreases
When the firm experiences diminishing marginal returns – marginal product begins to decline – the marginal cost of output increases
Exhibit 5 provides a graphical illustration of our cost curves

13. Exhibit 5: Total and Marginal Cost Curves

14. Exhibit 5: Total and Marginal Cost Curves(
Exhibit 5: Total and Marginal Cost Curves
Since total cost does not vary with output, the fixed cost curve is a horizontal line at $200
Variable cost is zero when output is zero – the variable cost curve starts at zero
The total cost curve sums the variable and fixed cost curves
Because a constant fixed cost is added to variable cost, the total cost curve is the variable cost curve shifted vertically by the amount of fixed cost
Marginal cost declines until the 9th unit of output and then increases
This reflects labor’s increasing, and then diminishing, marginal returns
$1,000
Total
cost
Total dollars
Variable
cost
500
Fixed
cost
Fixed
cost
200 3 6 9 12 15
Tons per day
$100
Cost per ton
Marginal
cost 50 25 3 6 9 12 15
Tons per day

15. Average Cost in the Short Run
The average cost per unit of output is another of the useful cost measures
There are average cost measures corresponding to variable cost, fixed cost and variable cost
Exhibit 6 provides a detailed listing of the variable costs for our example

16. Exhibit 6: Short Run Cost Data
Tons Moved Variable Marginal Average Average
per Day Cost Total Cost Cost Variable Cost Total Cost
(q) (VC) TC=FC+VC MC=∆TC/∆q AVC=VC/q ATC=TC /q
(1) (2) (3) (4) (5) =(2) / (1) (6)=(3) / (1)
$ $ $ 
$ $150.00
Average variable cost, AVC, equals variable cost divided by output  AVC = VC / q
Average total cost, ATC = TC / q
Both average variable cost and average total cost first decline as output expands, then increase

17. Marginal and Average Cost
The relationship between marginal and average cost is also important
When marginal cost is below or less than average cost it pulls average cost down
When marginal cost is above or higher than average cost it pulls average cost up
Exhibit 7 depicts this relationship

18. Exhibit 7: Average and Marginal Cost Curves
$150
The distance between the average variable and total cost gets smaller as output increases because average fixed costs decline as output increases
125
Marginal cost
100
Cost per ton 75
Average total cost 50
Average variable cost
Notice also that the rising marginal cost curve intersects both the average variable and total cost curves at their minimums. 25
Tons per day

19. Costs in the Long Run
All inputs that are under the firm’s control can be varied  there are no fixed costs
Long run is best thought of as a planning horizon
Choice of input combinations is flexible, but that flexibility is available only to firms that have not yet acted on their plans
Firms plan for the long run, but they produce in the short run

20. Long-Run Average Cost Curve
Suppose that, because of the special nature of technology in the industry, a firm must choose among only three possible sizes
Small
Medium
Large

21. Long-Run Average Cost Curve
Now suppose there are many possible plant sizes
Exhibit 9 presents a sample of short-run average total cost curves shown in purple
The long-run average cost curve, shown in red, is formed by connecting the points on the various short-run average cost curves that represent the lowest per-unit cost for each rate of output

22. Exhibit 8: Long-Run Planning Curve

23. Exhibit 9: Firm’s Long-Run Planning Curve

24. Economies of Scale
Notice that the long-run average curve is U-shaped, a result of economies and diseconomies of scale
Economies of scale imply that long-run average costs decline as output expands while diseconomies of scale imply that long-run average costs increase as output increases

25. Economies of Scale
A larger size often allows for larger, more efficient, machines and allows workers a greater degree of specialization  Production techniques such as the assembly line can be utilized only if the rate of output is large enough
Typically, as the scale of the firm increases, capital substitutes for labor and complex machines substitute for simpler machines

26. Diseconomies of Scale
As a firm expands, diseconomies of scale, eventually take over: long-run average cost increase as output expands
Additional layers of management are needed to monitor production
The more levels of management in an organization, the more difficult it is for top management to communicate with those that perform most of the production tasks

27. Exhibit 10: A Firm’s Long-Run Average Cost Curve