1. ECON 101: Introduction to Economics - I
Lecture 7 – Costs and Supply

2. Decision Time Frames
The firm makes many decisions to achieve its main objective: profit maximization.
Some decisions are critical to the survival of the firm.
Some decisions are irreversible (or very costly to reverse).
Other decisions are easily reversed and are less critical to the survival of the firm, but still influence profit.
All decisions can be placed in two time frames:
The short run
The long run
The big picture
Stand back from the details of this chapter and be sure that your students learn two big ideas:
A firm’s production costs depend on the freedom to choose all inputs.
1. Long-run flexibility enables firms to produce at a lower cost than is possible in the short run when some inputs are fixed.
2, In the short run, with one or more fixed inputs, production costs vary with output in a predictable way because they are directly linked to input productivity.
Also, preview where we are heading. We want to be able to predict firm’s decisions. To do so, we need to know about the influences on their costs and revenues.
1. Cost conditions are similar for all firms. That’s what we study here.
2. Revenue conditions depend on the market constraints. That’s what we study in the three chapters that follow.
Emphasize that what the student learns hear about cost is a vital prerequisite for understanding firms in perfect competition, monopoly, monopolistic competition, and oligopoly.

3. Decision Time Frames The 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 firm’s 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.

4. Decision Time Frames The Long Run
The long run is a time frame in which the quantities of all resources—including the plant size—can 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 firm’s plant has no resale value, the amount paid for it is a sunk cost.
Sunk costs are irrelevant to a firm’s current decisions.

5. The complete theory of supply (1)
Short-run and long-run cost curves and output decisions need to be carefully distinguished when we study the determinants of supply.
The profit-maximizing firm will choose the lowest cost way of producing any given level output, given the technology available and factor input costs.
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6. The complete theory of supply (2)
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7. The production function
The amount of output produced depends upon the inputs used in the production process.
A factor of production (“input”) is any good or service used to produce output.
e.g. labour, capital (machinery, buildings), raw materials, energy.
The production function specifies the maximum output which can be produced given inputs.
It summarizes technically efficient ways to combine inputs to produce output.
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Short run vs long run
The short run is the period in which a firm can make only partial adjustment of inputs, e.g. the firm may be able to vary the amount of labour, but cannot change capital.
The firm cannot fully adjust to a change in conditions.
The quantity of at least one input of production is fixed.
The long run is the period in which a firm can adjust all inputs to changed conditions.
The long run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels.
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The short run
Fixed factor of production
a factor whose input level cannot be varied
Fixed costs
costs that do not vary with output levels
Variable costs
costs that do vary with output levels
Short-run total cost (STC) = short-run fixed cost (SFC) + short-run variable cost (SVC)
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10. 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
Lots of definitions and terminology can cloud the primary message
Make good use of the glossary of productivity and cost terms provided in Table 11.2 (page 223) but don’t get mired down in reciting productivity and cost measure definitions!
Emphasize to the students that they must learn these definitions. But don’t spend a lot of class time on them.
Focus on why productivity measures and cost measures are vital for decision making.
Managers must frequently make quick decisions with little information. If managers have knowledge of a useful relationship between input measures (which are relatively easy to get) and production cost measures (which are much more difficult to get—especially marginal cost figures) they can use their understanding of this link to make inferences about how production costs will change when the firm’s output changes.

11. Short-Run Technology Constraint
Product Schedules
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.

12. Short-Run Technology Constraint
The total product curve is similar to the PPF.
It separates attainable output levels from unattainable output levels in the short run.

13. The marginal product of labour
The marginal product of labour is the increase in output obtained by adding 1 unit of the variable factor but holding constant the inputs of all other factors.
Labour is often assumed to be the variable factor, with capital fixed.
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14. (total product per week)
The marginal product of labour (cont.)
Labour Input
(workers)
Output
(total product per week)
Marginal Product
of Labour 1 2 6 3 14 4 24 5 32 7 40 9 38 2 4 8 10
4 = 8/2
-1 = -2/2
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15. The law of diminishing marginal returns
Holding all factors constant except one, the law of diminishing marginal returns implies that beyond some value of the variable input further increases in the variable input lead to steadily decreasing marginal product of that input.
For example, trying to increase labour input without also increasing capital will bring diminishing marginal returns.
The law of diminishing marginal returns of a variable input is a short-run phenomenon.
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16. The law of diminishing marginal returns (cont.)
The efficiency of the workers starts to decrease because, in the short run, the level of capital (the other input of production) is fixed and cannot be changed.
e.g. the factory has 4 machines and there are 4 workers
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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.
Three cost concepts and three types of cost curves are
Total cost
Marginal cost
Average cost
Explain the intuition behind each cost measure. For example, explain why the relationship between marginal product and marginal cost is worth understanding.
Point out that although separating fixed and variable components of cost help us understand why unit cost of production is U-shaped in the short run and why fixed costs don’t matter in a firm’s output decision.

18. Short-run total, fixed and variable cost curves
A firm’s short-run total cost (STC) is the cost of all resources used.
Short-run fixed cost (SFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output.
Short-run variable cost (SVC) is the cost of the firm’s variable inputs. Variable costs do change with output.
STC = SFC + SVC
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19. Short-Run Cost 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.

20. Short-run marginal cost curve
The shape of the short-run marginal cost (SMC) curve is almost the mirror image of the marginal product curve.
There is a close relationship between these two curves.
SMC is falling as long as the marginal product of labour is rising.
Once diminishing returns to labour set in, the marginal product of labour falls and SMC starts to rise again.
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21. Short-run average cost curves
The average cost is defined as the total cost divided by the quantity produced.
The average cost measures the total cost per unit of output.
Short-run average total cost (SATC) is total cost per unit of output.
SATC = short-run total cost (STC)/Quantity of output
Short-run average variable cost (SAVC) is total variable cost per unit of output.
Short-run average fixed cost (SAFC) is total fixed cost per unit of output.
SATC = SAFC + SAVC
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22. Short-run average cost curves
Short-run average variable cost (SAVC) = short-run variable cost (SVC)/Quantity of output
Short-run average fixed cost (SAFC) = short-run fixed cost (SFC)/Quantity of output
SATC = SAFC + SAVC
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23. Short-run marginal and average cost curves
SATC is falling when SMC is less than SATC, while it is rising when SMC is greater than SATC
The same applies for the relationship between SMC and SAVC
SATC is at a minimum at the output at which the SMC curve and the SATC curve cross (point A)
SAVC is at its minimum at the output at which the SMC curve and the SAVC curve cross (point B)
MC < AC
MC = AC
MC > AC
AC is:
Falling
Minimum
Rising
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24. Short-Run Cost Cost Curves and Product Curves
The shapes of a firm’s cost curves are determined by the technology it uses:
MC is at its minimum at the same output level at which MP is at its maximum.
When MP is rising, MC is falling.
AVC is at its minimum at the same output level at which AP is at its maximum.
When AP is rising, AVC is falling.

25. Short-Run Cost
Figure shows these relationships.

26. The firm’s short-run output decision
Firm sets output at Q1, where SMC=MR
subject to checking the average condition:
if price is above SATC1 firm produces Q1 at a profit
if price is between SATC1 and SAVC1 firm produces Q1 at a loss
if price is below SAVC1 firm produces zero output.
SMC
SATC
SATC1
SAVC
SAVC1
SMC = MR MR Q1
Output
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27. Production in the long run
In the long run all factors of production are variable.
Costs and the choice of technique
Technique B is the economically efficient (lowest-cost) production method at the rental and wage rates in Table 7.7
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28. Factor prices and the choice of technique
Factor intensity
A technique using a lot of capital and little labour is ‘capital intensive’.
One using a lot of labour but relatively little capital is ‘labour intensive’.
Factor prices and the choice of technique
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29. Costs in the long run: Average cost
The average cost of production is total cost divided by the level of output.
Long-run average cost (LAC) is often assumed to be U-shaped:
LAC
Average cost
Output
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30. Costs in the long run: Economies of scale
Economies of scale – or increasing returns to scale – occur when long-run average costs decline as output rises:
LAC
Average cost
Output
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31. Costs in the long run: Decreasing returns to scale
Diseconomies of scale – or decreasing returns to scale – occur when long-run average costs rise as output rises:
LAC
Average cost
Output
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32. Costs in the long run: Constant returns to scale
Constant returns to scale occur when long-run average costs are constant as output rises:
LAC
Average cost
Output
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33. The firm’s long-run output decision
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34. The long-run average cost curve (LAC)
SATC1
Each plant size
is designed for
a given output level.
Output
Average cost
LAC
In the long-run, plant size itself is variable, and the long-run average cost curve LAC is found to be the ‘envelope’ of the SATCs.
The firm can choose the plant size that minimizes the costs.
SATC2
SATC3
SATC4
So there is a
sequence of SATC curves, each corresponding to
a different plant size.
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35. The long-run average cost curve (LAC) (cont.)
By definition, the LAC curve shows the least-cost way to make each output when all factors can be varied.
A (B) is the least-cost way to make output Q1 (Q2) in the short run.
To construct the LAC curve we select at each output the plant size which gives the lowest SATC at this output.
The LAC curve shows the minimum average cost way to produce a given output when all factors can be varied, not the minimum average cost at which a given plant can produce.
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36. The firm’s output decisions – a summary
Marginal condition
Check whether to produce
Short-run decision
Choose the output at which MR=SMC
Produce this output unless price lower than SAVC, in which case produce zero
Long-run decision
Choose the output at which MR=LMC
Produce this output unless price is lower than LAC, in which case produce zero.
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Some maths
An example of a short-run total cost function:
Where SFC=F and SVC = cQ+ Dq2
and
Thus the short-run average fixed cost decreases steadily as Q increases.
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Some maths (2)
Short run average variable cost is:
And short run average total cost:
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39. Concluding comments (1)
In the long run, a firm can fully adjust all its inputs.
In the short run, some inputs are fixed.
The production function shows the maximum output that can be produced using given quantities of inputs.
The total cost curve is derived from the production function, for given wages and rental rates of factors of production.
The short-run marginal cost curve (SMC) reflects the marginal product of the variable factor, holding other factors fixed.
The SMC curve cuts both the SATC and SAVC curves at their minimum points.
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40. Concluding comments (2)
The long-run total cost curve is obtained by finding, for each output, the least-cost method of production when all inputs can be varied.
Average cost is total cost divided by output.
LAC is typically U-shaped.
Much of manufacturing has economies of scale.
When marginal cost is below average cost, average cost is falling.
In the long run, the firm supplies the output at which long-run marginal cost (LMC) equals MR provided price is not less than the level of long-run average cost at that level of output.
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