CHAPTER 11 Output and Costs

CHAPTER 11 Output and Costs

The Firm’s Objectives and Constraints
The firm’s main objective is to maximize economic profits. This means they are making the best (most efficient) use of scarce resources. Firms that try to maximize economic profits will have the best chance of surviving in a competitive environment. Capital markets force publicly owned firms to maximize long-run profits. Those that do not will have lower stock prices and higher costs of financial capital. In the long run, they will not survive.

The Firm’s Objective and Constraints
The Short Run and the Long Run The short run is a period of time in which the quantity of capital is fixed and the quantities of the other inputs (mainly labor) can be varied. The long run is a period of time in which the quantities of all inputs can be varied.

How Long Is the Long Run? In some industries — consulting or photocopying services — the short run may last only a month or two. In other industries, the short run can be several years. Electric power generating and railroads are two industries that take years to build new capital. Ask students how long it takes to change the quantity of capital used by a consultant. “Capital” usually means an office, a telephone and a computer; the quantity of capital used by a consultant can be changed in a few days. Then ask them about hydroelectric power generating. A dam and all the associated hardware must be designed and built. It can take up to ten years from start to finish.

Short-Run Technology Constraint
In order to increase output in the short-run (holding the capital stock constant), firms must increase the quantity of labor.

Short-Run Technology Constraint
The effect of a change in the quantity of labor, holding the capital stock constant, can be described using three related concepts: Total product is the total output produced. Marginal product is the increase in total product that result from a one-unit increase in an input. Average product is the total product divided by the quantity of inputs.

Total Product Total product (TP) is the total quantity of output produced with a given quantity of a fixed input. The total product curve shows the maximum quantity of output that can be produced with a given amount of capital as the amount of labor employed is varied.

The Total Product Curve
The total product curve is similar to the production possibilities frontier. Both separate attainable output levels from those that are unattainable. Only points on the total product curve are technologically efficient.

Total Product Schedule
Labor Output a b c d e f

Total Product Curve 15 10 5 0 1 2 3 4 5 Output (sweaters per day)
Labor (workers per day)

Total Product Curve 15 f e d 10 c 5 b a 0 1 2 3 4 5
Output (sweaters per day) 10 c 5 b a Labor (workers per day)

Total Product Curve TP 15 f e d 10 c 5 b a 0 1 2 3 4 5
Output (sweaters per day) 10 c 5 b a Labor (workers per day)

Total Product Curve TP 15 f e Unattainable d 10 c Attainable 5 b a
Output (sweaters per day) 10 c Attainable 5 b a Labor (workers per day)

Marginal Product The marginal product of an input is the increase in total product divided by the increase in the quantity of the input employed, when the quantity of all other inputs is constant. You may want to mention that adding one worker to production may affect the output produced by the other workers. Therefore, marginal product may not just be the additional output produced by the new worker.

Marginal Product of Labor
The marginal product of labor (MP) is the increase in total product divided by the increase in the quantity of labor employed, when the quantity of capital is constant. MP= TP/ L

Marginal Product of Labor Schedule
Labor Total Product Marginal product of Labor a b c d e f

Marginal Product Curve
Marginal product is also measured by the slope of the total product curve. Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker.

Diminishing marginal returns Occur when the marginal product of an additional worker is less than the marginal product of the previous worker 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

15 TP 6 d Output (sweaters per day) 13 Marginal product (sweaters per day per worker) 10 4 c 3 5 2 4 Labor (workers per day) Labor (workers per day)

The red highlights the point of diminishing returns 15 TP 6 d Output (sweaters per day) 13 Marginal product (sweaters per day per worker) 10 4 c 3 5 2 4 Labor (workers per day) Labor (workers per day)

The red highlights the point of diminishing returns 15 TP 6 d Output (sweaters per day) 13 Marginal product (sweaters per day per worker) 10 4 c 3 5 2 4 MP Labor (workers per day) Labor (workers per day)

Average Product The average product of an input is equal to total product divided by the quantity of the input employed. Average product tells us how productive, on average, a factor of production is.

Average Product of Labor
The average product of labor is total product divided by the quantity of labor employed, when the quantity of capital is constant. AP = TP/L

Average Product of Labor Schedule
Labor Total Product Marginal Average Product Product of Labor of Labor a b c d e f

What does the average product
Average Product Curve What does the average product curve look like?

Average Product Curve 6 4.33 4 3 2 0 1 2 3 4 5 Labor (workers per day)
Average product & Marginal product (sweaters per day per worker) 4.33 4 3 2 Labor (workers per day)

Average Product Curve 6 c d 4.33 4 e b f 3 2 0 1 2 3 4 5
Average product & Marginal product (sweaters per day per worker) d 4.33 4 b e f 3 2 Labor (workers per day)

Average Product Curve AP 6 d 4.33 4 e b f 3 2 0 1 2 3 4 5
Average product & Marginal product (sweaters per day per worker) d 4.33 4 b e f 3 AP 2 Labor (workers per day)

Average Product Curve AP MP Maximum average product 6 c d 4.33 4 e b f
Average product & Marginal product (sweaters per day per worker) d 4.33 4 b e f 3 AP 2 MP Labor (workers per day)

The Relationship Between Marginal and Average
When marginal product is above average product, average is rising — marginal is pulling average up. When marginal product is below average product, average is falling — marginal is pulling average down. Marginal product intersects average where average is at its maximum.

Marginal and Average Grade
The marginal grade is the grade you receive in this class. Your average grade is your G.P.A. (grade point average). If the grade you get in this class is higher than your G.P.A., it will pull your G.P.A. up. If, on the other hand, ...

The Shapes of the Product Curves
Total, marginal, and average product curves for different goods will still have similar shapes because almost every production process incorporates two features: Increasing marginal returns initially Diminishing marginal returns eventually

Increasing Marginal Returns
Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker. Increasing marginal returns will usually be the rule when the quantity of labor employed is low.

Diminishing Marginal Returns
Diminishing marginal returns occur when the marginal product of an additional worker is less than the marginal product of the previous worker. All production processes eventually reach a point of diminishing marginal returns.

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. Because marginal product eventually diminishes, so does average product.

Short-Run Cost To produce more output in the short run, a firm must employ more labor. This will also increase its cost. To produce more output, a firm must increase its costs.

Short-Run Cost Total cost (TC) is the cost of all productive resources used by a firm. Total fixed cost (TFC) is the cost of all the firm’s fixed inputs. Total variable cost (TVC) is the cost of all the firm’s variable inputs.

Total Cost A firm’s total cost is the sum of the costs of all the inputs it uses in production. Total cost includes the cost of renting land, buildings and equipment; wages paid to the work force; and normal profit.

Total Fixed Cost and Total Variable Cost
Total cost (TC) is divided into two categories: Total fixed cost (TFC) Total variable cost (TVC) TC = TFC + TVC

Total Fixed Cost A fixed cost is the cost of a fixed input.
Fixed cost doesn’t change when output changes. Total fixed cost is the total cost of the fixed inputs.

Total Variable Cost A variable cost is a cost of a variable input.
Variable costs change when the level of output changes. Total variable cost is the total cost of the variable inputs.

Total Cost Schedule Total Total fixed variable Total cost cost cost
Labor Output (TFC) (TVC) (TC) (workers (sweaters per day) per day) (dollars per day) a b c d e f

Total Cost Schedules Total Total fixed variable Total cost cost cost
Labor Output (TFC) (TVC) (TC) (workers (sweaters per day) per day) (dollars per day) a b c d e f

Total Cost Curves 0 5 10 15 150 Cost (dollars per day) 100 50
Output (sweaters per day)

Total Cost Curves TFC 0 5 10 15 150 Cost (dollars per day) 100 50

Total Cost Curves TVC TFC 0 5 10 15 150 Cost (dollars per day) 100 50

Total Cost Curves TC TVC TFC 0 5 10 15 150 Cost (dollars per day) 100

Marginal Cost Marginal cost (MC) is the increase in its total cost divided by the increase in its output. Marginal cost is the increase in total cost that results from a one unit increase in output. MC = TC/ Q

Marginal Cost Because fixed costs don’t change as output changes, marginal cost is also the increase in total variable cost divided by the increase in output. MC = TC/ Q MC = TVC/ Q TFC/ Q MC = TVC/ Q

Marginal Cost Marginal costs decrease at low outputs because of the gains from specialization, but it eventually increases due to the law of diminishing returns.

Average Cost Average cost is the cost per unit of output.
There are three average costs: Average fixed cost Average variable cost Average total cost

Average Cost Average fixed cost (AFC) is total fixed cost per unit of output. Average variable cost (AVC) is total variable cost per unit of output. Average total cost (ATC) is total cost per unit of output.

Average Cost Measures Average total cost (ATC) is total cost per unit of output. It is the sum of average fixed cost (AFC) and average variable cost (AVC).

Average Cost Total Cost = TC = TFC + TVC Average Total Cost = ATC
TC TFC TVC OR Q Q Q ATC = AFC+AVC = +

Marginal Cost and Average Costs
Total Total Average Average Average fixed variable Total Marginal fixed variable Total Labor Output cost cost cost cost cost cost cost L Q (TFC) (TVC) (TC) (MC) (AFC) (AVC) (ATC) (workers (sweaters per day) per day) $/day $/day $/day $/day $/day $/day $/day a b c d e f

15 Cost (dollars per sweater) 10 5 Output (sweaters per day)

15 Cost (dollars per sweater) 10 5 AFC Output (sweaters per day)

15 Cost (dollars per sweater) 10 AVC 5 AFC Output (sweaters per day)

15 ATC = AFC + AVC Cost (dollars per sweater) ATC 10 AVC 5 AFC Output (sweaters per day)

15 ATC = AFC + AVC MC Cost (dollars per sweater) ATC 10 AVC 5 AFC Output (sweaters per day)

15 ATC = AFC + AVC MC Cost (dollars per sweater) ATC 10 AVC 5 Minimum points AFC Output (sweaters per day)

Short-Run Cost Curves Total fixed cost is constant.
Total variable cost and total cost both increase with output. Average fixed cost slopes downward. The average total cost and average variable cost curves are U-shaped. The marginal cost curve is also U-shaped. The MC curve intersects the ATC and AVC at their respective minimums.

Why the Average Total Cost Curve is U-Shaped
There are two opposing forces that guarantee the short-run average total cost curve will be U-shaped: Decreasing average fixed cost Eventually increasing average variable cost caused by diminishing returns The shape of the ATC curve combines these two effects.

Cost Curves and Product Curves
There are two factors that determine a firm’s cost curves: Its technology Its product curves Marginal product and marginal cost move in opposite directions. Average product and average cost move in opposite directions, too.

Shifts in the Cost Curves
The position of a firm’s short-run cost curves depend on technology and the prices it pays for inputs. If technology changes or if factor prices change, the firm’s costs change and its cost curves shift.

Technological Change and Shifting Cost Curves
A technological change that increases productivity shifts the product curves upward and shifts the cost curves downward.

Changes in Factor Prices and Shifting Cost Curves
An increase in factor prices increases costs and shifts the cost curves upward. Changes in fixed cost only affect the fixed and total cost curves. Changes in variable cost shifts the variable, total, and marginal cost curves.

Cost Curves and Product Curves
How are the product curves related to the cost curves?

Cost and Product Curves
Average and Marginal Product and Cost The firm’s cost curves and product curves are linked: 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.

Cost and Product Curves
This figure (11.7 in the text) shows these relationships.

CHAPTER 11 Output and Costs

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