1. Economics 10 1 2017 September Lecture 12 Chapter 11 Output and Costs
2017 Economics 101 CCC

2. How much to produce?
How many people to employ?
Equipment to buy and use?
Size of Store and machine numbers?

3. Content Time frames: short run and the long run Short Run:
relationship between a firm’s output and labour employed in the short run
what do the firm’s short-run cost curves look like?
Long Run:
What is economies of scale?
Why are these important?

4. Time Frame
Text book pages 248

5. Decision Time Frames
Firms make 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 .

6. Decision Time Frames Short Run
time frame in which the quantity of one or more resources used in production is fixed.
capital, called the firm’s plant, is fixed in the short run.
resources used by the firm (such as labour, raw materials, and energy) can be changed in the short run.
short-run decisions are easily reversed.

7. Decision Time Frames
Long Run
time frame in which the quantities of all resources—including the plant size—can be varied.
Long-run decisions are NOT easily reversed.
Costs that Influence
NOT Sunk cost - irrelevant to a firm’s current decisions. Why?
cannot be changed by any current decision. It is already incurred and so must be paid.
Short run cost of changing labour inputs and the long-run cost of changing plant.

8. Terms to Know

9. Terms & Concepts Profit
The total revenue the firm receives from the sale of its products minus all costs incurred in their production
Profit-maximizing firm
A firm whose primary goal is to maximize profits
Factors of production:
Input to the production of a good e.g. labour, machines, land, buildings, energy

10. Terms & Concepts Capital durable good used in production Entrepreneur
an individual organizes factors of production- risk and return trade off

11. Some of firm’s decisions can take longer to implement
Terms & Concepts
Short Run (SR)
A period of time sufficiently short that at least one of the firm’s factors of production cannot be changed
Ex labour versus machine investment
Long Run (LR)
A period of time of sufficient length that all the firm’s factors of production can be changed
Viewed in terms of cost and ease to make changes or implement changes by the firm
Some of firm’s decisions can take longer to implement

12. Terms & Concepts Fixed factor of production
An input whose quantity cannot be altered in the short run
Ex: manufacturing equipment, suitable factory space,
Variable factor of production
An input whose quantity can be altered in the short run
Ex: Labour

13. Terms & Concepts Marginal product
Increase in total output caused by an increase in one unit in the variable factor of production – holding all other factors of production & technology fixed.
Ex: Increase one employee – how much increase in output occurs
Average product
Total output divided by variable factor of production.

14. Terms & Concepts Production Function
technological relationship between input and output
determine how many inputs to use when they are trying max profit.
basis for developing the cost curve and why they have those shapes
Related to technical and economic efficiency 8

15. Short Run Technology Constraints – Product curves

16. Short-Run Technology Constraint
To increase output in the short run, a firm must increase the amount of labour employed.
Relationship between output and the quantity of labour employed defined by these concepts:
1. Total product
2. Marginal product
3. Average product

17. Short-Run Technology Constraint
Product Schedules
Total product - total output produced in a given period.
Marginal product of labour - change in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same.
Ex: Increase one employee – how much increase in output occurs
Average product of labour - total product divided by the quantity of labour employed.

18. Short-Run Technology Constraint
What do you notice here as the quantity of labour employed increases:
Total product increases.
Marginal product increases initially …
but eventually decreases.
Average product decreases.

19. Short-Run Technology Constraint
Total Product Curve
total product curve shows how total product changes with the quantity of labour employed.
Note Axis

20. Short-Run Technology Constraint
Total Product Curve
first worker hired produces 4 units of output total = 4
second worker hired produces 6 units of output total = 10
third worker hired produces 3 units of output total = 13
etc

21. Short-Run Technology Constraint
Marginal Product Curve
The first worker hired produces 4 units of output.

22. Total no. of employees /day
Total number of bottle per day
Marginal product 1 90 2
200
110 3
260 60 4
300 40 5
338 38 6
371 33 7
400 29 11
500 16
600 22
700
Adding one employee does not get the same effect each time .. Decreasing each time

23. Another way to look at it ….
Total no. of employees /day
Total number of bottle per day
Marginal product 1 90 2
200
110 3
260 60 4
300 40 5
338 38 6
371 33 7
400 29 11
500 16
600 22
700
Another way to look at it ….
To get an extra bottles ..how many employees needed
200 to 300
400 to 500
600 to 700..

24. Short-Run Technology Constraint
Marginal product of labour curve
Diminishing marginal returns occurs

25. Short-Run Technology Constraint
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.
Why does it increases at first?
increased specialization and division of labour.
Why does it decrease eventually?
Additional worker has less access to capital and less space in which to work.
Why important to firms to know this law?

26. Short-Run Technology Constraint
What does the law of diminishing returns imply for the shape of the marginal cost curve?
As a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production,
marginal product of the variable factor eventually diminishes. And thus law of diminishing returns occurs
each additional worker produces a successively smaller addition to output
Implies that to get an additional unit of output, ever more workers are required.
cost of an additional unit of output—marginal cost—is increasing, so the marginal cost curve eventually slopes upward.

27. Short-Run Technology Constraint
What does the law of diminishing returns imply for the shape of the marginal cost curve?

28. Short-Run Technology Constraint
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.

29. Short Run Costs

30. Short-Run Cost
To produce more output in the short run, the firm must employ more labour, which means that it must increase its costs.
Three cost concepts and three types of cost curves are
Total cost
Marginal cost
Average cost

31. Short-Run Cost
Total cost (TC) is the cost of all resources used. Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output. Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output. Total cost equals total fixed cost plus total variable cost. TC = TFC + TVC

32. Short-Run Cost
What is the relationship between the TVC curve and the TP curve?
add a second x-axis to measure total variable cost.
1 worker costs $25; 2 workers cost $50: and so on, so the two x-axes line up.
Essentially changing from labour in workers per day to cost of labour per day

33. Short-Run Cost ATC = AFC + AVC. Average Cost
Average cost measures can be derived from each of the total cost measures:
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.
ATC = AFC + AVC.

34. Short-Run Cost
AFC curve shows that average fixed cost falls as output increases.
FC/Q ?
AVC curve is U-shaped. As output increases, average variable cost falls to a minimum and then increases.
ATC curve is also U-shaped
Consider the logic! WHY these shapes?

35. Short-Run Cost Why is the Average Total Cost Curve U-Shaped?
influence of two opposing forces:
Spreading total fixed cost over a larger output—AFC curve slopes downward as output increases.
Diminishing Marginal Returns—the AVC curve slopes upward and AVC increases more quickly than AFC is decreasing.

36. Short-Run Cost Effect One: Average Fixed Cost
If Average Fixed Cost = Total fixed cost/Q
Then as Q increases that same fixed cost gets spread out over more and more Q so the AFC decreases.

37. Short-Run Cost
Effect Two: Diminishing Marginal Returns and Average Variable Cost
When diminishing marginal returns kicks in...
need more and more employees to produce same change of output

38. Short-Run Cost So ATC is pulled in two directions
First falls, then rises, as output increases:
AVC eventually goes up as output increases
Law of Diminishing Returns implies that marginal costs rise
As marginal costs increase, eventually they pull up AVC
Average Fixed Cost (AFC)
Decreases with increasing output
AFC/Q will decline as Q increases
“Spreading the overhead” over more units

39. What items shift the Cost Curves?

40. What items shift the Cost Curves?
Technology
Prices of factors of production

41. What items shift the Cost Curves?
Technology
Technological change influences both the product curves and the cost curves.
An increase in productivity shifts the product curves upward and the cost curves downward.
If a technological advance results in the firm using more capital and less labour, fixed costs increase and variable costs decrease.

42. What items shift the Cost Curves?
Prices of Factors of Production
fixed cost increase shifts the total cost (TC ) and average total cost (ATC ) curves upward but does not shift the marginal cost (MC ) curve.
variable cost increase shifts the total cost (TC ), average total cost (ATC ), and marginal cost (MC ) curves upward.

43. Long Run

44. Long-Run Cost
Long run, all inputs are variable and all costs are variable.
Long-run cost depends upon the firm’s production function.
relationship between the maximum output attainable and the quantities of both capital and labour.
Ex bigger plant and so need more labour

45. Long-Run Cost LRAC = TC/Q
Total Cost is resulting from increasing all factors of production (fixed or variable) such as labour and capital.
You are not just increasing Q here you are increasing scale or size of plant and all capital and labour inputs.
So TC and Q are both increasing .. With different results over the curve

46. Long-Run Cost
As the size of the plant increases, the output that a given quantity of labour can produce increases.
But for each plant size increase,
As quantity of labour increases, diminishing marginal returns occur.
As size of capital increases, diminishing marginal product of capital occurs

47. Long-Run Cost What is Diminishing Marginal Product of Capital?
increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labour employed.
A firm experiences diminishing marginal returns to capital (for a set quantity of labour).
For each plant, diminishing marginal product of labour creates a set of short run, U-shaped costs curves for MC, AVC, and ATC.

48. Long-Run Cost Short-Run Cost and Long-Run Cost
A firm has 4 different plants: 1, 2, 3, or 4 knitting machines.
Each plant has a short-run ATC curve.
The firm can compare the ATC for each output at different plants.

49. Each plant has a short-run ATC curve.
ATC1 is the ATC curve for a plant with 1 knitting machine.

50. Each plant has a short-run ATC curve.
ATC2 is the ATC curve for a plant with 2 knitting machines.

51. Each plant has a short-run ATC curve.
ATC3 is the ATC curve for a plant with 3 knitting machines.

52. Each plant has a short-run ATC curve.
ATC4 is the ATC curve for a plant with 4 knitting machines.

53. Long-Run Cost
Long-run average cost curve is made up from the lowest ATC for each output level.
So, we want to decide which plant has the lowest cost for producing each output level.
Let’s find the least-cost way of producing a given output level.
Suppose that the firm wants to produce 13 sweaters a day.

54. Long-Run Cost
13 sweaters a day cost $7.69 each on ATC1.

55. Long-Run Cost
13 sweaters a day cost $6.80 each on ATC2.

56. Long-Run Cost
13 sweaters a day cost $7.69 each on ATC3.

57. Long-Run Cost
13 sweaters a day cost $9.50 each on ATC4.

58. Long-Run Cost
The least-cost way of producing 13 sweaters a day is to use 2 knitting machines.

59. Long-Run Cost Long-Run Average Cost Curve
relationship between the lowest attainable average total cost and output when both the plant and labour are varied.
planning curve that tells the firm the plant that minimizes the cost of producing a given output range.
Once the firm has chosen its plant, the firm incurs the costs that correspond to the ATC curve for that plant.

60. Long-Run Cost
Figure 11.9 illustrates the long-run average cost (LRAC) curve.

61. Long-Run Average Cost Curve
The long-run average cost curve reflects 3 regions…
Economies of scale: LRAC falling. LRAC = TC/Q
Constant returns to scale: LRAC constant, LRAC = TC/Q
Diseconomies of scale: LRAC rising, LRAC = TC/Q
Kind of like a prediction ..
If increase output Q by 10% then total cost of inputs (TC) increases by 5% then what?
Value of TC/Q which is LRAC decreases

62. How to calculate economies of scale..
If we increase Q from 10 to 30 units by increasing capital and labour amounts and the resulting increase of cost is from 100 to 200 – what return to scale is occurring?
LRAC = TC/Q = 100/10 = 10 $ AC
LRAC = TC/Q = 200/30 = 6.67$AC
So LRAC is falling as Q increases .. and economies of scale is occurring or ..
Change in scale allows LRAC to decrease.
How to calculate economies of scale..

63. Economies of Scale
Economies of scale – when the LRAC curve slopes down as output increases
increasing all inputs results in a greater than proportionate increase in output How?
increased specialization of inputs
larger production runs allow use of more efficient capital equipment
Constant returns to scale – when the LRAC curve is horizontal as output increases
twice the inputs will give twice the output
the smallest output in this range is the minimum efficient quantity of production

64. Economies of Scale
Diseconomies of scale – when the LRAC curve slopes up as output increases
How?
Difficult to organize and coordinate all these factors of production over time and geographic areas
Harder to maintain smooth labour relations

65. Boundary of economies of scale
As a firm you want to take advantage of economies of scale to decrease LRAC … so if in section I.. You will increase scale to increase Q to get decrease LRAC.. What about at II and III ?
Boundary of economies of scale
and constant called min efficient
quantity = smallest Q that achieves min LRAC
I: Economies
of scale
II: Constant
returns to
scale
III: Diseconomies
of scale
LRAC
Minimum long-run average cost
Minimum efficient
quantity

66. Firm Decision re: scale dependent on LRAC..
If you are in an industry where economies of scale are possible, what will you do?
What if you find out your firm is operating in the diseconomies of scale section of the LRAC? What will you do?
What about if you are operating in the constant economies of scale part of the LRAC ? What will you do?

67. Long-Run Cost Minimum Efficient Scale
smallest quantity of output at which the long-run average cost reaches its lowest level.
firm experiences economies of scale up to some output level.
beyond that output level, it moves into constant returns to scale or diseconomies of scale.
If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale output level.

68. Questions
What are the main Costs curve and what are their shapes? Shy do they have these shapes?
What is diminished in diminishing returns?
Define long-run average cost (LRAC).
What does a firm’s LRAC curve show? How is it related to the firm’s short-run ATC curves?
What are economies of scale and diseconomies of scale? How do they arise? What do they imply for the shape of the LRAC curve?
Define scale, economies of scale, constant returns to scale, diseconomies of scale, and minimum efficient quantity.
What decisions are being made with these cost curves? Explain.

69. Questions
What is the difference between short run and long run? Why do we differentiate?
What is the use and important of sunk costs?
What is this concept and why are they important? Diminishing marginal return and return to capital ?
What items shift the Cost Curves?
What are the shapes of the AVC curve and the ATC curve and why do they have these shapes?

70. End of slides