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Chapter 5 Costs (Short-Run). Copyright © Houghton Mifflin Company.All rights reserved. 5a - 2 Production An entrepreneur must put together resources --

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Presentation on theme: "Chapter 5 Costs (Short-Run). Copyright © Houghton Mifflin Company.All rights reserved. 5a - 2 Production An entrepreneur must put together resources --"— Presentation transcript:

1 Chapter 5 Costs (Short-Run)

2 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 2 Production An entrepreneur must put together resources -- land, labor, capital -- and produce a product people will be willing and able to purchase.

3 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 3 Combining Resources There are many combinations of resources that could be used. Consider the following table showing different quantities of mechanics and different quantities of airplanes that the hypothetical firm, PWA, might use:

4 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 4 Alternative Quantities of Output that Can Be Produced by Different Combinations of Resources

5 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 5 Production in the Short Run The short run is a period just short enough that at least one resource (input) cannot be changed -- is fixed, that is. Suppose that the company has leased 10 airplanes and this can’t be changed for a year or so.

6 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 6 Quantities of Output that Can Be Produced When One Resource Is Fixed

7 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 7 What can you say about marginal product ? As the quantity of a variable input (labor in the example) increases while all other inputs are fixed, output rises, initially rising more and more rapidly, but eventually at a slower rate and perhaps even declining. This is called the LAW OF DIMINISHING MARGINAL RETURNS.

8 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 8 Applications: Law of Diminishing Marginal Returns Air bags -- Explain the advantages of installing additional air bags per car.

9 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 9 Applications: Law of Diminishing Marginal Returns Explain the number of clerks in department stores and the number of servers at a restaurant.

10 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 10 Consider Diminishing Marginal Product Explain where the Law of DMR shows up on the following table:

11 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 11 Consider Diminishing Marginal Product

12 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 12 Where Is Diminishing Marginal Product? With the number of airplanes fixed at 20, what occurs? Output is: 340 450 570 640 710 760 So, average physical product is: So marginal physical product is:

13 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 13 Where Is Diminishing Marginal Product? Suppose we fix the number of mechanics at 5. Do diminishing marginal returns show up?

14

15 The Costs of Doing Business Short-Run Costs

16 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 16 Relationship between Output and Costs Now, let’s consider costs: For each additional 1 unit of output, how much additional costs are incurred? Since output rises rapidly initially as the variable resource is increased, then the costs of each additional output would at first decline.

17 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 17 Relationship between Output and Costs Then, as output rises more and more slowly as the variable resource increases, the cost of each additional output would rise more and more rapidly.

18 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 18 Relationship between Output and Costs So what does this mean for the shape of the cost curves? How would you describe the shape of the cost curves?

19 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 19 Plot the Average Cost and the Marginal Cost Schedules Average cost is the per-unit cost: total cost divided by quantity of output. Marginal cost is the change in total cost divided by the change in total output.

20 100 200 300 400 500 600 15 10 5 Costs Quantity of Output Marginal and Average Cost

21 100 200 300 400 500 600 15 10 5 Quantity of Output Marginal and Average Cost Costs

22 100 200 300 400 500 600 15 10 5 ATC Quantity of Output Marginal and Average Cost Costs

23 100 200 300 400 500 600 15 10 5 ATC Quantity of Output Marginal and Average Cost Costs

24 100 200 300 400 500 600 15 10 5 Quantity of Output Marginal and Average Cost ATC Costs

25 100 200 300 400 500 600 15 10 5 Quantity of Output Marginal and Average Cost ATC Costs

26 100 200 300 400 500 600 15 10 5 Quantity of Output Marginal and Average Cost ATC Costs

27 100 200 300 400 500 600 15 10 5 Quantity of Output MC Marginal and Average Cost ATC Costs

28 100 200 300 400 500 600 15 10 5 Quantity of Output MC |----------------| MC<ATC MC>ATC |------------------------- Marginal and Average Cost ATC Costs

29 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 29 Point of All This: Law of Diminishing Marginal Returns and Costs Every firm, no matter activity or size, faces the law of diminishing marginal returns. Every firm, has U-shaped short-run cost curves.

30 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 30 Let’s now make the hypothetical example more realistic: All we have considered to this point is the cost of the variable resource -- number of mechanics. Firms have costs for the fixed resources as well -- leases on airplanes and other costs -- these costs we call fixed costs.

31 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 31 Let’s now make the hypothetical example more realistic: Fixed costs do not vary as output varies. Variable costs vary as output rises.

32 AFC = TFC/Q AVC = TVC/Q ATC = TC/Q

33 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 33 The Average Cost Schedules

34 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 34 The Average Cost Schedules

35 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 35 Completing Calculations

36 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 36 What are average costs doing as output rises? Average variable cost: Declines initially and then rises. Average fixed cost: Declines. Average total cost: Declines initially and then rises.

37 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 37 Now for MC: MC=Change in TC/Change in Q

38 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 38 Completing Calculations

39 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 39 The Shape of Short-Run Cost Curves The short run cost curves are U- shaped-- except for the fixed costs. Fixed costs mean that the costs remain the same even as output changes. Average fixed costs decline as output rises -- not U-shaped.

40 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 40 100 200 300 400 500 600 30 20 10 MC ATC Costs Quantity of Output AVC What are the diamonds?

41 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 41 100 200 300 400 500 600 30 20 10 ATC Costs Quantity of Output AVC ATC -AVC = AFC

42 Copyright © Houghton Mifflin Company.All rights reserved. 5a - 42 Define each of the following: Fixed Variable Total Average Marginal Direct Overhead

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