1. 7 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Short-Run Costs and Output Decisions

2. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 25 Decisions Facing Firms DECISIONSINFORMATION are based on How much of each input to demand 3. Which production technology to use 2. How much output to supply 1. The prices of inputs 3. The market price of the output 1. The techniques of production that are available 2.

3. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 25 Costs in the Short Run The short run is a period of time for which two conditions hold: 1. The firm is operating under a fixed scale (fixed factor) of production, and 2. Firms can neither enter nor exit an industry.

4. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 25 Costs in the Short Run Fixed cost is any cost that does not depend on the firm’s 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 is a cost that depends on the level of output chosen. Total Cost = Total Fixed + Total Variable Cost Cost

5. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 25 Total Fixed Cost (TFC) Total fixed costs (TFC) or overhead refers to the total of all costs that do not change with output, even if output is zero. Another name for fixed costs in the short run is sunk costs is because firms have no choice but to pay for them.

6. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 25 Average Fixed Cost (AFC) Average fixed cost (AFC) is the total fixed cost (TFC) divided by the number of units of output (q): Average fixed cost declines as quantity rises, because the sanme total is divided by a larger number of units.

7. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 25 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm 2501,0004 2001,0005 3331,0003 (2) TFC (3) AFC (TFC/q) 5001,0002 1 $  $1,0000 (1) q As output increases, total fixed cost remains constant and average fixed cost declines.

8. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 25 Variable Costs The total variable cost curve is a graph that shows the relationship between total variable cost and the level of a firm’s output. At any given level of output, total variable cost depends on 1) the techniques of production that are available 2)the prices of inputs.

9. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 25 Derivation of Total Variable Cost Schedule from Technology and Factor Prices The total variable cost curve shows the cost of production using the best available technique at each output level, given current factor prices. (14 x $1) = (6 x $1) = (10 x $1) = (6 x $1) = (4 x $1) = (4 x $2) +104Boutput TOTAL VARIABLE COST ASSUMING P K = $2, P L = $1 TVC = (K x P K ) + (L x P L ) UNITS OF INPUT REQUIRED (PRODUCTION FUNCTION) USING TECHNIQUEPRODUCT (2 x $2) +62Boutput (6 x $2) + (9 x $2) + (7 x $2) + (4 x $2) + $26 $20 $12 14 6 6 4 L 6Boutput K 9AUnits of3 7A 2 4A1 $10 $18 $24

10. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 25 Marginal Cost (MC) Marginal cost (MC) is the increase in total cost that results from producing one more unit of output. Marginal cost reflects changes in variable costs. 6243 TOTAL VARIABLE COSTS ($) MARGINAL COSTS ($) 8182 10 1 0 0 0 UNITS OF OUTPUT

11. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 25 The Shape of the Marginal Cost Curve in the Short Run In the short run every firm is constrained by some fixed input that: Marginal cost eventually rises with output. Diminishing marginal returns implies increasing marginal cost.

12. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 25 Graphing Total Variable Costs and Marginal Costs Total variable cost always increases with output. The marginal cost curve shows how total variable cost changes.

13. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 25 Average Variable Cost (AVC) Average variable cost (AVC) is the total variable cost divided by the number of units of output. Marginal cost is the cost of one additional unit, while average variable cost is the variable cost per unit of all the units being produced.

14. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 25 Short-Run Costs of a Hypothetical Firm

15. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 25 Graphing Average Variable Costs and Marginal Costs When marginal cost is below average cost, average cost is declining. When marginal cost is above average cost, average cost is increasing. Marginal cost intersects average variable cost at the lowest, or minimum, point of AVC. At 200 units of output, AVC is minimum and equal to MC.

16. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 25 Total Costs Adding the same amount of total fixed cost to every level of total variable cost yields total cost. For this reason, the total cost curve has the same shape as the total variable cost curve; it is simply higher by an amount equal to TFC.

17. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 25 Average Total Cost Average total cost (ATC) is total cost divided by the number of units of output (q). Because AFC falls with output, an ever-declining amount is added to AVC.

18. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 25 The Relationship Between Average Total Cost and Marginal Cost If MC is below ATC, then ATC will decline toward marginal cost. If MC is above ATC, ATC will increase. MC intersects the ATC and AVC curves at their minimum points.

19. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 25 Output Decisions: Revenues, Costs, and Profit Maximization The perfectly competitive firm faces a perfectly elastic demand curve for its product.

20. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 25 Total Revenue (TR) and Marginal Revenue (MR) Total revenue (TR) is the total amount that a firm takes in from the sale of its output. Marginal revenue (MR) is the additional revenue that a firm takes in when it increases output by one additional unit. In perfect competition, P = MR.

21. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 25 Comparing Costs and Revenues to Maximize Profit The profit-maximizing level of output for all firms is the output level where MR = MC. In perfect competition, MR = P, therefore, the firm will produce up to the point where the price of its output is just equal to short- run marginal cost. The key idea here is that firms will produce as long as marginal revenue exceeds marginal cost.

22. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 25 Comparing Costs and Revenues to Maximize Profit The profit-maximizing output is q*, the point at which P* = MC.

23. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 25 Profit Analysis for a Simple Firm

24. C H A P T E R 7: Short-Run Costs and Output Decisions © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 25 The Short-Run Supply Curve At any market price, the marginal cost curve shows the output level that maximizes profit. Thus, the marginal cost curve of a perfectly competitive profit-maximizing firm is the firm’s short-run supply curve.