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CH. 11: OUTPUT AND COSTS
 Measure of relationship between output and cost
 Short run costs
 Fixed vs variable
 Cost curves
 Law of diminishing marginal returns
 Long run costs
 No fixed costs
 Cost curves
 Returns to scale
Short run vs. Long run
• The Short Run
 A time frame in which one or more resources used in
production is fixed.
 For most firms, capital is fixed in the short run.
 Other resources used by the firm (such as labor, raw
materials, and energy) are variable in the short run.
 Short-run decisions are easily reversed.
• The Long Run
 A time frame in which the quantities of all resources
can be varied.
 No fixed inputs in the long run.
Decision Time Frames
• Sunk Costs.
 A cost incurred by the firm that cannot be
changed.
 If a firm’s plant has no resale value, the amount
paid for it is a sunk cost.
 Sunk costs are irrelevant to a firm’s decisions .
 Examples:
• The price that a landlord paid for a piece of property
should have no effect on rent charged.
• The price that an airline paid for jets that it purchased
previously should have no effect on the price they
charge for airline tickets today.
SR Measures of Production
• Total product (TP)
• Units of output produced in a given period.
• Marginal product of labor (MPL)
 D TP resulting from one additional unit of L, ceteris
paribus.
 DTP/DL
• Average product of labor (APL)
• TP/L
Relationship between TP, MP and AP
• The Total Product Curve
Relationship between TP, MP and AP
• The Total Product Curve
Relationship between TP, MP and AP
Almost all production
processes are like the
one shown here
– Initially increasing
marginal returns
– Eventually diminishing
marginal returns
Relationship between TP, MP and AP
 Increasing marginal returns
• MP rises as use of input increases
• Results from increased specialization and division of
labor.
 Diminishing marginal returns
• MP falls as use of input increases
• Occurs because amount of capital per worker falls.
 The 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.
Short-Run Technology Constraint
• IF
MP>AP, what
happens to AP if L is
increased?
•If MP<AP, what
happens to AP if L is
increased?
•MP=AP when AP is
at a maximum.
Suppose that a firm has 10 workers
producing tables, APL is 5 and MPL of the
11th worker is 4. If the 11th worker is added,
we know that:
1. APL will decrease.
2. APL will increase.
3. MPL will increase.
...
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PL
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AP
L
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SR 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.
TC = TFC + TVC
SR Total Cost Curves
SR Costs
• Marginal Cost
 the increase in total cost that results from a oneunit increase in total product.
 DTC/DTP
 If labor is the only variable input, MC=W/ MPL
 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.
SR Costs
• Average Costs
– Average fixed cost (AFC) = TFC/TP
– Average variable cost (AVC) = TVC/TP
• If labor is the only variable input, AVC=W/APL
– Average total cost (ATC) is total cost per unit of
output.
ATC = TC/TP = AFC + AVC.
SR Costs
• Marginal vs. AVC and ATC
If MC<AVC, AVC decreases as TP increases
If MC>AVC, AVC increases as TP increases
If MC<ATC, ATC decreases as TP increases
If MC>ATC, ATC increases as TP increases
SR Cost Curves
• The ATC curve is Ushaped.
• If MC<AVC, AVC is falling.
• If MC>AVC, AVC is rising.
• MC always interesects
• ATC at min of ATC
• AVC at min of AVC
• AFC always decreases as
.
output increases
Relationship between production
and cost
Short-Run Cost
• Shifts in Cost Curves
– The position of a firm’s cost curves depend on two
factors:
 Technology
 Prices of productive resources
 What is effect on ATC, MC, AVC of
• Increase in price of labor.
• Increase in fixed costs
• Increase in productivity of labor.
Fill in the table below
TP
TC
0
100
1
150
2
190
3
240
4
300
5
400
TFC
TVC
ATC
AVC
MC
Long-Run Cost
• In the long run, all inputs are variable and all
costs are variable.
• The Production Function
– Shows the relationship between the maximum
output attainable and the quantities of both
capital and labor.
Long-Run Cost
– Marginal product of capital (MPk)
• the increase in TP from one more unit of capital, ceteris
paribus.
– A firm’s production function exhibits diminishing
marginal returns to labor as well as diminishing
marginal returns to capital (for a given quantity of
labor).
– For each plant size, diminishing marginal product
of labor creates a set of short run, U-shaped costs
curves for MC, AVC, and ATC.
LR Cost
The long-run average cost curve is the relationship between the
lowest attainable average total cost and output when both the plant
size and labor are varied.
K=1
K=2 K=3
K=4
What’s the low cost method for producing 5 sweaters? 13
sweaters? 25 sweaters?
LR Cost
The long-run average cost (LRAC) curve.
LR Cost
• Economies of scale
– falling long-run average cost as output increases.
• Diseconomies of scale
– rising long-run average cost as output increases.
• Constant returns to scale
– constant long-run average cost as output
increases.
Long-Run Cost
Long-Run Cost
– Minimum efficient scale is the smallest quantity
of output at which the long-run average cost
reaches its lowest level.
LRATC
MES
Market Structure and Minimum
Efficient Scale
• As MES rises relative to consumer demand,
the number of firms in the industry will fall.
• Cases to consider:

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Microsoft
Steel industry
Printing industry
Farming