Ch 07 production and cost in the firm micro econ4

Chapter 7 ECON4 William A. McEachern

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Production

and Cost

in the Firm

2

2

Cost and Profit

• Producers: Maximize profit

• Opportunity cost

– All resources have an opportunity cost

• Explicit costs

– Opportunity cost of resources employed

by a firm

– Cash payments

– On the accounting statement

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


3

3

Cost and Profit

• Implicit costs

– A firm’s opportunity cost of using its own

resources or those provided by its

owners

– Without a corresponding cash payment

– Not on the accounting statement



Alternative Measures of Profit

• Accounting profit

– Total revenue minus explicit costs

• Economic profit

– Total revenue minus all costs (implicit and

explicit)

• Opportunity cost of all resources

• Normal profit

– Accounting profit earned when all resources

earn their opportunity cost



Exhibit 1

5

Wheeler Dealer Accounts, 2012



Production in the Short Run

• Variable resources

– Can be varied in the short run to increase

or decrease production

• Fixed resources

– Cannot be varied in the short run

• Short run

– At least one resource is fixed

• Long run

– No resource is fixed6© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Diminishing Marginal Returns

• Total product

– A firm’s total output

• Production function

– Relationship between amount of

resources employed and total product

• Marginal product

– Change in total product from an

additional unit of resource

– Other things constant



Diminishing Marginal Returns

• Increasing marginal returns

– Marginal product increases

• Diminishing marginal returns

– Marginal product decreases

• Law of diminishing marginal returns

– As more of a variable resource is added

to a given amount of another resource

– Marginal product eventually declines

• Could become negative



Exhibit 2

9

The Short-Run Relationship Between Units of Labor and

Tons of Furniture Moved

Marginal product increases as the firm hires each of the first three workers, reflecting

increasing marginal returns. Then marginal product declines, reflecting diminishing

marginal returns. Adding more workers may, at some point, actually reduce total

product (as occurs here with an eighth worker) because workers start getting in each

other’s way.



Exhibit 3

10

The Total and Marginal Product of Labor

5

10

15

To

tal p

rod

uct

(tons/d

ay)

5 10 Workers per day0

5 10 Workers per day

1

3

5

Ma

rgin

al p

rod

uct

(tons/d

ay)

0

2

4

Total

product

Marginal product

Negative

marginal

returns

Diminishing but

positive

marginal returns

Increasing

Marginal

returns

(a) Total product

(b) Marginal product

When marginal product

is rising, total product

increases by increasing

amounts. When

marginal product is

falling but still positive,

total product increases

by decreasing amounts.

When marginal product

equals 0, total product is

at a maximum. When

marginal product is

negative, total product is

falling.



Costs in the Short Run

• Fixed cost, FC

– Any production cost that is independent

of the firm’s rate of output

• Variable cost, VC

– Any production cost that changes as the

rate of output changes

• Total cost, TC = FC + VC




• Marginal cost, MC = ∆TC/∆q

– Change in total cost resulting from a one-

unit change in output

• Changes in MC

– Reflect changes in marginal productivity

• Increasing marginal returns

– MC falls

• Diminishing marginal returns

– MC increases12© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Exhibit 4

13

Short-Run Total and Marginal Cost Data for Smoother Mover

Because of increasing marginal returns from the first three workers, marginal cost

declines at first, as shown in column (6). Because of diminishing marginal returns

beginning with the fourth worker, marginal cost starts increasing.




• Fixed cost curve

– Straight horizontal line

• Variable cost curve

– Starts at the origin

• Total cost curve

– Fixed cost curve + variable cost curve

• Slope of total cost curve

– Marginal cost



Exhibit 5

15

Total and Marginal Cost Curves for Smoother Mover

200

$500

To

tal d

olla

rs

25

Cost per

ton

$50Marginal cost

9 15 Tons per day0 63 12

Fixed cost

Total cost

Tons per day0 9 1563 12

Variable costFixed

cost

In panel (a), fixed cost is $200

at all levels of output. Variable

cost starts from the origin and

increases slowly at first as

output increases. When the

variable resource generates

diminishing marginal returns,

variable cost begins to

increase more rapidly. Total

cost is the vertical sum of fixed

cost and variable cost. In panel

(b), marginal cost first

declines, reflecting increasing

marginal returns from the

variable resource (labor in this

example) and then increases,

reflecting diminishing marginal

returns.



Average Cost in the Short Run

• Average variable cost, AVC = VC/q

– Variable cost divided by output

• Average fixed cost, AFC = FC/q

– Fixed cost divided by quantity

• Average total cost, ATC = TC/q

– Total cost divided by output

– ATC = AFC + AVC



Average Cost in the Short Run

• When MC < average cost

– The marginal pulls down the average

• When MC > average cost

– The marginal pulls up the average

• U-shape of average cost curves

– Law of diminishing marginal returns



Exhibit 6

18

Short-Run Total, Marginal, and Average Cost

Data for Smoother Mover

Marginal cost first falls then increases because of increasing then diminishing marginal

returns from labor. As long as marginal cost is below average cost, average cost

declines. Once marginal cost exceeds average cost, average cost increases. Columns

(4), (5), and (6) show the relation between marginal and average costs.



Exhibit 7

19

Average and Marginal Cost Curves for Smoother Mover

0 5 10 15 Tons per day

$150

125

100

75

50

25

Cost

per

ton

ATC

AVC

MC

Average variable cost and

average total cost curves first

decline, reach low points, and

then rise. Overall, they have U

shapes. When marginal cost

is below average variable

cost, average variable cost is

falling. When marginal cost

equals average variable cost,

average variable cost is at its

minimum. When marginal cost

is above average variable

cost, average variable cost is

increasing. The same

relationship holds between

marginal cost and average

total cost.



Costs in the Long Run

• Long run

– Planning horizon

– All resources can be varied

• Firms plan for the long run

• Firms produce in the short run




• Economies of scale

– Forces that reduce a firm’s average cost

– As the scale of operation increases in the

long run

• Diseconomies of scale

– Forces that may eventually increase a

firm’s average cost

– As the scale of operation increases in the

long run




• Long-run average cost curve

– Indicates the lowest average cost of

production

• At each rate of output when the scale of the

firm varies

– Planning curve

– U-shaped

• Economies of scale

• Diseconomies of scale



Exhibit 8

23

Short-Run Average Total Cost Curves Form the Long-Run

Average Cost Curve, or Planning CurveC

ost

per

unit

0 q qa q’ Output per periodqb

S

S’

M M’

L

L’

Curves SS’, MM’, and LL’ show short-run average total costs for small, medium, and large

plants, respectively. For output less than qa, average cost is lowest when the plant is small.

Between qa and qb, average cost is lowest with a medium-size plant. If output exceeds qb,

the large plant offers the lowest average cost. The long-run average-cost curve connects

these low cost segments of each curve and is identified as SabL’.

a b



Exhibit 9

24

Many Short-Run Average Total Cost Curves Form a Firm’s

Long-Run Average Cost Curve, or Planning Curve

ATC1

ATC2

0 q q’ Output per period

Cost

per

unit

$11

10

9

b

ATC3

ATC4

ATC5

ATC6

ATC7

ATC8

ATC9

ATC10

Long-run

average cost

c

a

With many possible plant sizes, the long-run average cost curve is the envelope of portions of the

short-run average cost curves. Each short-run curve is tangent to the long-run average cost

curve. Each point of tangency represents the least-cost way of producing that rate of output.




• Constant long-run average cost

– Over some range of output

– Long-run average cost neither increases

nor decreases with changes in firm size

– No economies of scale

– No diseconomies of scale



Exhibit 10

26

A Firm’s Long-Run Average Cost CurveC

ost

per

unit

0 A Output per periodB

Economies

of scale

Long-run

average cost

Diseconomies

of scale

Constant

average cost

Up to output level A, long-run average cost falls as the firm experiences economies of

scale. Output level A is the minimum efficient scale—the lowest rate of output at which the

firm takes full advantage of economies of scale. Between A and B, the average cost is

constant. Beyond output level B, long-run average cost increases as the firm experiences

diseconomies of scale.© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as


Economies & Diseconomies of Scale

• Plant level

– Particular location

• Firm level

– Collection of plants



Economy & Finance

Ch 07 production and cost in the firm micro econ4