Chapter 23: The Firm - Cost and Output Determination ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 23: The Firm - Cost and Output Determination Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Short Run versus Long Run A time period when at least one input, such as plant size, cannot be changed Plant Size The physical size of the factories that a firm owns and operates to produce its output Long Run The time period in which all factors of production can be varied

Short Run versus Long Run Short run and long run are terms that apply to planning decisions made by managers. The firm always operates in the short run in the sense that decisions can only be made in the present. But some of these decisions result in a long-term commitment of resources.

The Relationship Between Output and Inputs (Short Run) Production Any activity that results in the conversion of resources into products that can be used in consumption or inputs to further production Production Function The relationship between inputs and output A technological, not an economic, relationship The relationship between inputs and maximum physical output

Diminishing Marginal Returns Law of Diminishing (Marginal) Returns The observation that after some point, successive equal-sized increases in a variable factor of production, such as labor, added to fixed factors of production, will result in smaller increases in output

The Relationship Between Output and Inputs Average Physical Product Total product divided by the variable input Marginal Physical Product The physical output that is due to the addition of one more unit of a variable factor of production The change in total product occurring when a variable input is increased and all other inputs are held constant Also called marginal product or marginal return

Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 23-1, Panel (a)

Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Graphical relationship between marginal physical product and total output

A B A – Point of Diminishing Marginal Returns B – Point of Diminishing Total Returns

Short-Run Costs to the Firm Total Costs The sum of total fixed costs and total variable costs Fixed Costs Costs that do not vary with output Variable Costs Costs that vary with the rate of production Total costs (TC) = TFC + TVC

Short-Run Costs to the Firm Average Total Costs (ATC) Average total costs (ATC) = total costs (TC) output (Q)

Short-Run Costs to the Firm Average total costs (ATC) = total costs (TC) output (Q) Average variable costs (AVC) = total variable costs (TVC) output (Q) Average fixed costs (AFC) = total fixed costs (TFC) output (Q) Marginal costs (MC) = change in total cost change in output

Cost of Production: An Example Figure 23-2, Panel (a)

Total Cost of Production: An Example Panel (b) 60 Total costs 50 Total variable costs 40 Total costs (dollars per day) 30 20 10 Total fixed costs 1 2 3 4 5 6 7 8 9 10 11 Output (recordable DVDs per day) Figure 23-2, Panel (b)

Average and Marginal Costs of Production: An Example Figure 23-2, Panel (c)

Short-Run Costs to the Firm As long as marginal physical product rises, marginal cost will fall, and when marginal physical product starts to fall (after reaching the point of diminishing marginal returns), marginal cost will begin to rise. Inefficient to Efficient to Inefficient

The Relationship Between Returns and Average and Marginal Costs If the wage rate is constant, then the marginal labor cost associated with each additional unit of output will decline as long as the marginal physical product of labor increases. When marginal cost is less than average variable cost, then average variable cost will decline. When marginal cost exceeds average variable cost, then average variable cost will increase. It is also true that the direction of change in average total cost will be determined by whether marginal cost exceeds the current average.

The Relationship Between Diminishing Marginal Returns and Cost Curves

The Marginal and Average Cost Curves Adding the average fixed cost curve to the graph.. Then, ATC = AVC + AFC ATC (SAC) AFC

Long-Run Cost Curves Planning Horizon The long run, during which all inputs are variable

Preferable Plant Size and the Long-Run Average Cost Curve Panel (a) Panel (b) SAC 8 1 SAC SAC 7 1 SAC 2 SAC 6 SAC C 2 SAC 2 3 SAC C 5 SAC 4 C SAC 3 4 SAC 1 Average Cost (dollars per unit of output) Average Cost (dollars per unit of output) LAC C 3 Q 1 Q 2 Output per Time Period Output per Time Period Figure 23-4, Panels (a) and (b)

Long-Run Cost Curves Long-Run Average Cost Curve Observation The locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices Observation Only at the minimum of the long-run average cost curve is the minimum of the short-run average cost curve tangent to it.

Why the Long-Run Average Cost Curve is U-Shaped Economies of Scale Decreases in long-run average costs resulting from increases in output These economies of scale do not persist indefinitely, however. Once long-run average costs rise, the curve begins to slope upwards.

Why the Long-Run Average Cost Curve is U-Shaped Reasons for economies of scale Specialization Dimensional factor Improved productive equipment

Why the Long-Run Average Cost Curve is U-Shaped Explaining Diseconomies of Scale Limits to the efficient functioning of management Coordination and communication is more of a challenge as firm size increases

Minimum Efficient Scale Minimum Efficient Scale (MES) The lowest rate of output per unit time at which long-run average costs for a particular firm are at a minimum

Minimum Efficient Scale LAC Long-Run Average Costs (dollars per unit) A 10 B 1,000 Output per Time Period Figure 23-6

Minimum Efficient Scale Small MES relative to industry demand: There is room for many efficient firms High degree of competition Large MES relative to industry demand: Room for only a small number of efficient firms Small degree of competition

Chapter 23: The Firm - Cost and Output Determination ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 23: The Firm - Cost and Output Determination Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.