Chapter 8 Costs McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2 Learning Objectives What are different types of costs? What is diminishing marginal returns? Why do marginal costs increase? Why is the average total costs curve U-shaped? What is the relationship between the average total costs curve and marginal costs curve? What is the difference between short run and long run? What are economies and diseconomies of scale? 8-2

3 Costs: Economic Terms Output = number of goods produced. Variable inputs = inputs that can be changed with output. Fixed inputs = inputs that can not be changed with output. Fixed costs = costs that are the same regardless of output. Variable costs = costs that vary with output Total costs = fixed costs + variable costs Marginal costs = the extra cost of making one more good. 8-3

4 Average Costs Total Costs = Fixed Costs + Variable Costs 8-4

5 Average Costs Average Total Costs = Average Fixed Costs + Average Variable Costs 8-5

6 Rocket Ship vs. Space Elevator Fixed CostsVariable Costs Total Costs Rocket Ship$1 billionOutput X $10 million $1 billion + (Output X $10 million) Space Elevator $50 billionOutput X $1,000 $50 billion + (Output X $1,000) 8-6

7 Costs For Rocket Ship OutputAverage Fixed Costs = Average Variable Costs = Average Total Costs = Average Fixed Costs + Average Variable Costs 1$1 billion$10 million$1.01 billion 10$100 million$10 million$110,000,000 1,000$1 million$10 million$11,000,000 4,900$0.2 million$10 million$10,200,000 1,000,000$1,000$10 million$10,001,000 1 billion$1$10 million$10,000,

8 Costs For Space Elevator OutputAverage Fixed Costs = Average Variable Costs = Average Total Costs = Average Fixed Costs + Average Variable Costs 1$50 billion$1,000$50 billion + $1,000 10$5 billion$1,000$5 billion + $1,000 1,000$50 million$1,000$50,001,000 4,900$10.2 million$1,000$10,201,000 1,000,000$50,000$1,000$51,000 1 billion$50$1,000$1,

9 Break Even Price The break even price represents the minimum a firm can charge without losing money. A firm breaks even when Price = Average Total Costs. 8-9

10 Firms With Constant Marginal Costs Average fixed costs always decrease as output increases. When marginal costs are constant, average total costs continually decrease as output increases. Firms with constant marginal costs or high fixed costs benefit from having many customers. 8-10

11 Firms With High Fixed Costs Firms producing goods with high fixed costs and low marginal costs can benefit tremendously from international trade. Pharmaceuticals: International pharmaceutical needs are usually the same. Movies: To attract international audience firms have to produce common denominator movies. Jet fighters: Political dilemma of whether to allow foreign sales to lower price. 8-11

12 A Fictional Story In Ixion, Land is a fixed input. Food is grown with both labor and land. Villich increases only the workforce hoping to increase output and reduce costs. As a result, average total costs increase because output increases by less than expected. Average fixed costs decrease but average variable costs increase. 8-12

13 U-shaped Average Total Costs Curve A fixed input causes diminishing marginal returns. Diminishing marginal returns cause increasing marginal costs. Increasing marginal costs cause increasing average variable costs. Increasing average variable costs cause the average total costs curve to be U- shaped. 8-13

14 Diminishing Marginal Returns With one input fixed, diminishing marginal returns to the other input occurs when one receives lower and lower benefits from increasing the amount of that input used. When the amount of land is fixed, workers are subject to diminishing marginal returns. Number of workers Bushels of wheat production per year Marginal benefits of last worker hired ,7901, =890 32,5002,500-1,790=710 43,1003,100-2,500=600 53,4003,400-3,100=300 63,5003,500-3,400=100 73,5103,510-3,500=10 83,5113,511-3,510=1 8-14

15 Increasing Marginal Costs When production is subject to diminishing marginal returns, each additional increase in output requires more and more input. Hence, each additional output increases additional cost of production. If marginal costs are increasing then the cost of each new good is higher than the last, so average variable costs increase as well. 8-15

16 U-shaped Average Total Costs Curve Increase in marginal costs cause increase in average variable costs. At some point, increase in average variable costs is greater than the decrease in average fixed cost. With increasing output, average total costs first go down but then go up. Too few workers Too many workers Average total costs B A Costs Output Per Month 8-16

17 Relationship Between Marginal Cost and Average Total Cost When marginal costs are below average total costs, then average total costs must be falling. When marginal costs are above average total costs, then average total costs must be increasing. Marginal costs curve always goes through the lowest point on the average total cost curve. Marginal costs > Average Total Costs Marginal costs < Average Total Costs Output Per Month Marginal costs Average total costs Costs 8-17

18 Diminishing Marginal Returns and Starvation Thomas Malthus predicted that the human population would increase at a faster rate than the food supply, making starvation almost inevitable. Malthus believed in diminishing marginal returns to agriculture because land is a fixed input. Malthus proved to be wrong because of innovations in agriculture. The gains from agricultural innovations have more than outweighed the harm of diminishing marginal returns. 8-18

19 Diminishing Marginal Returns and Innovation Neo-Malthusians predict disaster. With the fixed inputs of the earth, if the human population increases and nothing else changes, human economic activity will become subject to diminishing marginal returns. In the long run, innovations can effectively multiply the existing supply of fixed inputs. The “invisible hand” of the market can overcome problems caused by fixed inputs. 8-19

20 Short Run vs. Long Run The short run is the time period when firms cannot change fixed inputs. Only variable inputs can be changed, e.g. number of workers. The long run is the time period when firms can change fixed as well as variable inputs and innovate. In the long run, firms can move to another short run average total cost curve. The length of the long run is different for different firms. 8-20

21 Long Run Analysis In the long run, for any given level of output, a firm will choose its fixed input to minimize its average total costs. For any given level of output, the long run average total costs are the lowest short run average total costs for that level of output. A firm’s long run average total costs curve consists of the low points on its short run average total costs curves. 8-21

22 Constant Returns to Scale = When long run average total costs are constant as output increases. If in the long run, all inputs increase by 10% then output increases by exactly 10%. 8-22

23 Economies of Scale = When long run average total costs decrease as output increases. If in the long run, all inputs increase by 10% then output increases by more than 10%. Costs that don’t increase, even in the long run as output expands, can cause economies of scale. 8-23

24 Diseconomies of Scale = When long run average total costs increase as output increases. If in the long run, all inputs increase by 10% then output increases by less than 10%. Diseconomies of scale can arise when a firm must use inferior inputs to expand or government regulations regarding large firms. 8-24

25 Do You Know? Why can fixed inputs cause diminishing marginal returns? A fixed input cannot be changed in the short run. When the quantity used of a variable input with the fixed input is increased, there is overcrowding and benefits of increasing the variable input keep falling. Why do diminishing marginal returns cause increasing marginal costs? When production is subject to diminishing marginal returns, each additional increase in output requires more and more input. Hence, marginal cost keeps increasing. 8-25

26 Do You Know? Why was Malthus wrong? Malthus proved to be wrong in predicting mass- starvation because he did not expect agricultural innovations to outweigh the harm of diminishing marginal returns. Why do we expect sometime to observe economies of scale? Increase in all inputs allows division of labor and specialization. Specialization leads to increase in production. As a result, long run average total costs exhibit economies of scale. 8-26

27 Summary Fixed costs = costs that are the same regardless of output Variable costs = costs that vary with output. Marginal costs = the extra cost of increasing output by one. Total costs = fixed costs + variable costs. Average fixed costs = Average variable costs = Average total costs = average fixed costs + average total costs. 8-27

28 Summary Average fixed costs always decrease as output increases. Average variable costs increase with output if marginal costs increase. Fixed inputs cause diminishing marginal returns to variable inputs. Typical average total costs curve is U-shaped. Marginal costs curve goes through the low point on the average total costs curve. In the short run firms cannot innovate or change fixed inputs; in the long run they can. The long run average total costs curve consists of the low points on all the short run average total costs curves. 8-28

29 Coming Up How do firms produce in perfect competition? 8-29