Short-Run Costs and Output Decisions

1. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair


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Prepared by: Fe rnand o Prepared by: Fe rnand o
Q uijano and Yvonn Q uijanoQ uijano and Yvonn Q uijano
Short-Run CostsShort-Run Costs
and Output Decisionsand Output Decisions

2. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Decisions Facing FirmsDecisions Facing Firms
3.
2.
1.
3.
2.
1.
*Determines production costs
The price of inputs*
Techniques of
production available*
The price of output
INFORMATION
The quantity of each
input to demand
How to produce that
output (which technique
to use)
The quantity of output to
supply
are based on DECISIONS

3. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Costs in the Short RunCosts in the Short Run
•The The short runshort run is a period of time is a period of time
for which two conditions hold:for which two conditions hold:
1.1.The firm is operating under a fixed The firm is operating under a fixed
scale (fixed factor) of production, andscale (fixed factor) of production, and
2.2.Firms can neither enter nor exit an Firms can neither enter nor exit an
industry.industry.
•In the short run, all firms have In the short run, all firms have
costs that they must bear costs that they must bear
regardless of their output. These regardless of their output. These
kinds of costs are called kinds of costs are called fixed fixed
costscosts..

4. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Costs in the Short RunCosts in the Short Run
•Fixed costFixed cost is any cost that does not is any cost that does not
depend on the firm’s level of output. These depend on the firm’s level of output. These
costs are incurred even if the firm is costs are incurred even if the firm is
producing nothing.producing nothing.
•Variable costVariable cost is a cost that depends on is a cost that depends on
the level of production chosen.the level of production chosen.
T C T F C T V C= +
Total Cost = Total Fixed + Total Variable
Cost Cost

5. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Fixed CostsFixed Costs
•Firms have no control over fixed Firms have no control over fixed
costs in the short run. For this costs in the short run. For this
reason, fixed costs are sometimes reason, fixed costs are sometimes
called called sunk costssunk costs..
•Average fixed cost (Average fixed cost (AFCAFC)) is the is the
total fixed cost (total fixed cost (TFCTFC) divided by the ) divided by the
number of units of output (number of units of output (qq):):
A F C
T F C
q
=

6. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Short-Run Fixed Cost (Total and Short-Run Fixed Cost (Total and
Average) of a Hypothetical FirmAverage) of a Hypothetical Firm
•AFC falls as output AFC falls as output
rises; a phenomenon rises; a phenomenon
sometimes called sometimes called
spreading overheadspreading overhead..
2501,0004
2001,0005
3331,0003
(2)
TFC
(3)
AFC (TFC/q)
5001,0002
1,0001,0001
$ --$1,0000
(1)
q

7. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Variable CostsVariable Costs
•The The total variable cost curvetotal variable cost curve is a graph is a graph
that shows the relationship between total that shows the relationship between total
variable cost and the level of a firm’s output.variable cost and the level of a firm’s output.
•The total variable The total variable
cost is derived from cost is derived from
production production
requirements and requirements and
input prices.input prices.

8. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Derivation of Total Variable Cost Schedule Derivation of Total Variable Cost Schedule
from Technology and Factor Pricesfrom Technology and Factor Prices
•The total variable cost curve shows the cost of The total variable cost curve shows the cost of
production using the best available technique at production using the best available technique at
each output level, given current factor prices.each output level, given current factor prices.
(14 x $1) =
(6 x $1) =
(10 x $1) =
(6 x $1) =
(6 x $1) =
(4 x $1) =
(4 x $2) +104Boutput
TOTAL VARIABLE
COST ASSUMING
P
K
= $2, P
L
= $1
TVC = (K x P
K
) + (L x P
L
)
UNITS OF
INPUT REQUIRED
(PRODUCTION FUNCTION)
USING
TECHNIQUE PRODUCT
(2 x $2) +62Boutput
(6 x $2) +
(9 x $2) +
(7 x $2) +
(4 x $2) +
$26

$20
$12
14
6
6
4
L
6Boutput
K
9AUnits of3
7AUnits of2
Units of 4A1
$10
$18
$24

9. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Marginal CostMarginal Cost
•Marginal cost (MC)Marginal cost (MC) is the increase is the increase
in total cost that results from in total cost that results from
producing one more unit of output.producing one more unit of output.
•Marginal cost reflects changes in Marginal cost reflects changes in
variable costs.variable costs.
M C
T C
Q
T F C
Q
T V C
Q
= = +
D
D
D
D
D
D

10. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Derivation of Marginal Cost fromDerivation of Marginal Cost from
Total Variable CostTotal Variable Cost
6243
TOTAL VARIABLE COSTS
($)
MARGINAL COSTS
($)
8182
10101
000
UNITS OF OUTPUT
•Marginal costMarginal cost measures the measures the additionaladditional
cost of inputs required to produce each cost of inputs required to produce each
successive unit of output.successive unit of output.

11. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Shape of the Marginal Cost Curve The Shape of the Marginal Cost Curve
in the Short Runin the Short Run
•The fact that in the short run every firm is The fact that in the short run every firm is
constrained by some fixed input means constrained by some fixed input means
that:that:
1.1.The firm faces diminishing returns to variable The firm faces diminishing returns to variable
inputs, andinputs, and
2.2.The firm has limited capacity to produce The firm has limited capacity to produce
output.output.
•As a firm approaches that capacity, it As a firm approaches that capacity, it
becomes increasingly costly to produce becomes increasingly costly to produce
successively higher levels of output.successively higher levels of output.

12. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Shape of the Marginal Cost Curve The Shape of the Marginal Cost Curve
in the Short Runin the Short Run
•Marginal costs ultimately increase with Marginal costs ultimately increase with
output in the short run.output in the short run.

13. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Graphing Total Variable Costs and Graphing Total Variable Costs and
Marginal CostsMarginal Costs
•Total variable costs always Total variable costs always
increase with output. The increase with output. The
marginal cost curve shows marginal cost curve shows
how total variable cost how total variable cost
changes with single unit changes with single unit
increases in total output.increases in total output.
•Below 100 units of output, Below 100 units of output,
TVCTVC increases at a increases at a
decreasing ratedecreasing rate. Beyond . Beyond
100 units of output, 100 units of output, TVCTVC
increases at an increases at an increasing increasing
rate.rate.

14. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Average Variable CostAverage Variable Cost
•Average variable cost (AVC)Average variable cost (AVC) is the is the
total variable cost divided by the total variable cost divided by the
number of units of output.number of units of output.
•Marginal cost is the cost of Marginal cost is the cost of one one
additional unitadditional unit. Average variable . Average variable
cost is the average variable cost per cost is the average variable cost per
unit of unit of all the unitsall the units being produced. being produced.
•Average variable cost Average variable cost followsfollows
marginal cost, but lags behind.marginal cost, but lags behind.

15. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Relationship Between Average Relationship Between Average
Variable Cost and Marginal CostVariable Cost and Marginal Cost
•When marginal cost is When marginal cost is
below average cost, below average cost,
average cost is declining.average cost is declining.
•When marginal cost is When marginal cost is
above average cost, above average cost,
average cost is increasing.average cost is increasing.
•Rising marginal cost Rising marginal cost
intersects average variable intersects average variable
cost at the minimum point cost at the minimum point
of of AVCAVC..
•At 200 units of output, AVC is At 200 units of output, AVC is
minimum, and minimum, and MCMC = = AVCAVC..

16. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Short-Run Costs of a Hypothetical FirmShort-Run Costs of a Hypothetical Firm
1829,0001,000 16208,000500
--------
--------
--------
208.42001,0421,000 8.410425
2582501,0321,00088324
3413331,0241,00086243
5095001,0181,00098182
1,0101,0001,0101,000 1010101
-$-$1,000$1,000$-$-$0$0
(8)
ATC
(TC/q or AFC + AVC)
(7)
AFC
(TFC/q)
(6)
TC
(TVC + TFC)
(5)
TFC
(4)
AVC
(TVC/q)
(3)
MC
(D TVC)
(2)
TVC
(1)
q

17. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Total CostsTotal Costs
•Adding Adding TFCTFC to to TVCTVC means means
adding the same amount of adding the same amount of
total fixed cost to every total fixed cost to every
level of total variable cost.level of total variable cost.
•Thus, the total cost curve Thus, the total cost curve
has the same shape as the has the same shape as the
total variable cost curve; it total variable cost curve; it
is simply higher by an is simply higher by an
amount equal to amount equal to TFCTFC..
T C T F C T V C= +

18. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Average Total CostAverage Total Cost
•Average total cost (Average total cost (ATCATC) is ) is
total cost divided by the total cost divided by the
number of units of output number of units of output
((qq).).
A T C A F C A V C= +
A T C
T C
q
T F C
q
T V C
q
= = +
•Because Because AFCAFC falls with falls with
output, an ever-declining output, an ever-declining
amount is added to amount is added to AVCAVC..

19. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Relationship Between Average Total Relationship Between Average Total
Cost and Marginal CostCost and Marginal Cost
•If marginal cost is below If marginal cost is below
average total cost, average average total cost, average
total cost will decline total cost will decline
toward marginal cost.toward marginal cost.
•If marginal cost is above If marginal cost is above
average total cost, average average total cost, average
total cost will increase.total cost will increase.
•Marginal cost intersects Marginal cost intersects
average total cost and average total cost and
average variable cost average variable cost
curves at their minimum curves at their minimum
points.points.

20. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Output Decisions: Revenues, Costs, Output Decisions: Revenues, Costs,
and Profit Maximizationand Profit Maximization
•In the short run, a competitive firm faces a In the short run, a competitive firm faces a
demand curve that is simply a horizontal line at demand curve that is simply a horizontal line at
the market equilibrium price.the market equilibrium price.

21. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Total Revenue (Total Revenue (TRTR) and) and
Marginal Revenue (Marginal Revenue (MRMR))
•Total revenue (TR)Total revenue (TR) is the total amount that a firm is the total amount that a firm
takes in from the sale of its output.takes in from the sale of its output.
T R P q= ´
M R
T R
q
=
D
D
=
P q
q
( )D
D
•Marginal revenue (MR)Marginal revenue (MR) is the additional revenue is the additional revenue
that a firm takes in when it increases output by that a firm takes in when it increases output by
one additional unit.one additional unit.
•In perfect competition, In perfect competition, P = MRP = MR..
=P

22. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Comparing Costs and Revenues to Comparing Costs and Revenues to
Maximize ProfitMaximize Profit
•The profit-maximizing level of output for all The profit-maximizing level of output for all
firms is the output level where firms is the output level where MRMR = = MCMC..
•In perfect competition, In perfect competition, MRMR = = PP, therefore, , therefore,
the profit-maximizing perfectly competitive the profit-maximizing perfectly competitive
firm will produce up to the point where the firm will produce up to the point where the
price of its output is just equal to short-run price of its output is just equal to short-run
marginal cost.marginal cost.
•The key idea here is that firms will produce The key idea here is that firms will produce
as long as marginal revenue exceeds as long as marginal revenue exceeds
marginal cost.marginal cost.

23. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Profit Analysis for a Simple FirmProfit Analysis for a Simple Firm
09090153080106
156075152050105
204060151030104
15304515520103
5253015515102
-52015151010101
-10$10$0$15$-$0$10$0
(8)
PROFIT
(TR - TC)
(7)
TC
(TFC + TVC)
(6)
TR
(P x q)
(5)
P = MR
(4)
MC
(3)
TVC
(2)
TFC
(1)
q

24. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Short-Run Supply CurveThe Short-Run Supply Curve
•At any market price, the marginal cost curve shows the output level At any market price, the marginal cost curve shows the output level
that maximizes profit. Thus, the marginal cost curve of a perfectly that maximizes profit. Thus, the marginal cost curve of a perfectly
competitive profit-maximizing firm is the firm’s short-run supply curve.competitive profit-maximizing firm is the firm’s short-run supply curve.