Download Producer Choice - The Costs of Production

Chapter 20
The Costs of Production
THE FIRM
IN THE CIRCULAR FLOW MODEL
$ COSTS
$ INCOMES
RESOURCE
MARKET
RESOURCES
INPUTS
BUSINESSES
/ FIRMS
HOUSEHOLDS
GOODS &
SERVICES
GOODS &
SERVICES
PRODUCT
MARKET
$ REVENUE
$ CONSUMPTION
WHAT ARE COSTS?
The Law of Supply states firms are willing
to produce and sell a greater quantity of a
good when the price of the good is high,
resulting in an upward sloping curve.
The economic goal of a firm is to maximize
profits
The firm must assess costs before it can
assess profit
ECONOMIC COSTS
Economic Costs are AKA
the Opportunity Costs
Definition: The value or worth
the resource would have in
its best alternative use.
TOTAL REVENUE, TOTAL
COST, and PROFIT
TOTAL REVENUE
The amount a firm receives for the sale of its
output.
TOTAL COST
The market value of the inputs a firm uses in
production
PROFIT
The firm’s total revenue minus its total cost
Profit = Total Revenue – Total Cost
COSTS AS OPPORTUNITY
COSTS
A firm’s cost of production includes all the
opportunity costs of making its output of goods
and services. They are known as Explicit and
Implicit Costs
Explicit costs are input costs that require a
direct outlay of money by the firm
Implicit costs are input costs that do not
require an outlay of money by the firm
ARE THEY EXPLICIT OR
IMPLICIT COSTS?
 Hiring a new worker
 Spending time with your significant other
instead of working
 Taking a client to lunch
 Going to college instead of getting a job
 Studying for a test instead of plowing
snow for money
 Buying new work clothes
E
I
E
I
I
E
ECONOMIC PROFIT VERSUS
ACCOUNTING PROFIT
Economists measure a firm’s economic profit
as Total Revenue – Total Cost, including
both explicit and implicit costs.
Accountants measure the accounting profit as
the firm’s Total Revenue – only the firm’s
Explicit Costs.
ECONOMIC PROFIT VERSUS
ACCOUNTING PROFIT
 When Total Revenue exceeds both
explicit and implicit costs, the firm earns
economic profit.
 Economic profit is smaller than
accounting profit.
ECONOMIC COSTS
Economic (opportunity) Costs
How an
Economist
Views a Firm
Economic
Profit
Implicit costs
(including a
normal profit)
Explicit
Costs
How an
Accountant
Views a Firm
T
O
T
A
L
R
E
V
E
N
U
E
Accounting
Profit
Accounting
costs (explicit
costs only)
TRY THIS PROBLEM
Gomez runs a small pottery firm. His costs are:
One helper at $12,000 per year
Annual Rent = $5000
Expenditures on materials = $20,000
His personal investment in the company = $40,000
(he could earn $4000 per year if his money is
alternatively invested)
He has been offered $15,000 per year to work as
a potter for a competitor.
He estimates his entrepreneurial talents are
worth $3000 per year.
Total Revenue from pottery sales is $72,000
Calculate the accounting profit and the economic
profit for Gomez’s pottery firm.
ANSWER to the PROBLEM
EXPLICIT COSTS = $37,000
$12,000 for the helper
$5,000 for rent
$20,000 for materials
IMPLICIT COSTS = $22,000
$4000 of forgone interest
$15,000 of forgone salary
$3,000 of entrepreneurship
ACCOUNTING PROFIT = $35,000 ($72,000 of revenue - $37,000 of
explicit costs)
ECONOMIC PROFIT = $13,000 ($72,000 - $37,000 of explicit costs $22,000 of implicit costs)
Short-Run versus LongRun Costs
 The Economic Short Run vs the Long Run
 The Short Run is:
 A period too brief for a firm to alter its plant capacity,
yet long enough to permit a change in the degree to
which the fixed plant is used.
 The firm can alter the intensity with which it uses its
resources.
 In the short run, output can change but production
processes are fixed.
Short-Run versus LongRun Costs
 The Economic Short Run vs the Long Run
 The Long Run is:
 a period of time long enough for the firm to adjust the
quantities of all the resources that it employs
including plant capacity.
 In the long run, all inputs can be varied and
production processes can be changed.
Short-Run versus LongRun Costs
 Fixed Costs and Variable Costs
 Fixed costs = costs that cannot be changed
 Variable costs = costs that can be changed
In the Short Run, some costs are fixed.
In the Long Run, all costs are variable.
WHICH ARE SHORT-RUN AND
WHICH ARE LONG-RUN?
LR
*Wendy’s builds a new restaurant
*Harley-Davidson hires 200 more
SR
production workers
SR
*A farmer increases the amount of
fertilizer used on his corn crop
*An Alcoa aluminum plant adds a third SR
shift of workers
*A farmer switched from growing corn to LR
growing asparagus
Section 2 - SHORT-RUN PRODUCTION
RELATIONSHIPS
 A firm’s costs of production depend on
the prices of the resources needed and
the quantities of resources needed to
produce their output
 Firm’s will analyze the cost relationships
between their inputs and output
Section 2 - SHORT-RUN PRODUCTION
RELATIONSHIPS
Total Product (TP) – AKA Total Physical Product
(TPP) - The total quantity, or total output, of a
particular good or service produced.
Marginal Product (MP) – the extra
output or added product associated with adding a unit of
a variable resource, usually labor, to the production
process.
Change in Total Product
Marginal Product =
Change in Labor Input
Section 2 - SHORT-RUN PRODUCTION
RELATIONSHIPS
 Average Product (AP) is output per unit of
labor input
Average Product =
Total Product
Units of Labor
TPP for
Al’s
Building
Company
How many
employees
is too many?
TPP with Different
Quantities of Carpenters
40
F
Garages per Year
Total Output in
35
32
30
E
G
TPP
D
25
20
15
C
10
B
5
A
0
1
2
3
4
5
Quantity of Carpenters
per Year
6
7
Al’s
Product
Schedule
Al’s Marginal Physical
(MPP) Curve
Product
14
Increasing
marginal
returns
12
10
Diminishing
marginal
returns
Negative
marginal
returns
How
many
carpen
ters
should
Al
hire?
MPP in
Garages per Year
8
6
4
2
0
–2
–4
–6
MPP
0
1
2
3
4
5
Number of Carpenters
6
7
Complete the table by calculating marginal
product and average product from the data
given
Inputs of
Total Product Marginal
Average
Labor
Complete
the table by
calculating
marginal
product and
average
product
from the
data given
Product
0
0
1
15
2
34
3
51
4
65
5
74
6
80
7
83
8
82
Product
Complete the table by calculating
marginal product and average product
from the data given
Complete
the table by
calculating
marginal
product and
average
product
from the
data given
Graph TP,
MP
and AP
Inputs of
Labor
Total Product Marginal
Product
0
0
1
15
2
34
3
51
4
65
5
74
6
80
7
83
8
82
Average
Product
x
15
19
x
15
17
17
14
9
6
17
16.25
14.8
13.33
3
-1
11.86
10.25
The “Law” of Diminishing
Marginal Returns
Diminishing Marginal Returns – definition: Is
the property whereby the marginal product of
an input declines as a quantity of input
increases.
Example: As more workers are hired at a firm,
each additional worker contributes less and
less to the production because the firm has a
limited amount of equipment.
 It explains the shape of the marginal
physical product curve
The Flower Pot Example
A farmer plants 80 acres of corn but does
not weed his fields. His yield is 40 bushels
per acre. If he weeds once his yield rises to
50 bushels per acre. Two weedings yield
57 bushels per acre. Three weedings yield
61 bushels per acre. Each weeding adds
less and less yield per acre – Diminishing
Marginal Returns
The Flower Pot Example
 If diminishing marginal
returns didn’t occur more
weedings, seeds, and
fertilizer would continue to
yield more and more corn
per acre. The world could
be fed out of a flowerpot.
Average Product, AP, and
Marginal Product, MP
Total Product, TP
SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product
Quantity of Labor
Quantity of Labor
Increasing
Marginal
Returns
Average
Product
Marginal
Product
Average Product, AP, and
Marginal Product, MP
Total Product, TP
SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product
Quantity of Labor
Quantity of Labor
Diminishing
Marginal
Returns
Average
Product
Marginal
Product
Average Product, AP, and
Marginal Product, MP
Total Product, TP
SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product
Quantity of Labor
Quantity of Labor
Negative
Marginal
Returns
Average
Product
Marginal
Product
Short-Run Production
Costs
 Production information must be coupled
with resource prices to determine the
total and per-unit costs of producing
various levels of output.
 In the short-run some resources, those
associated with the firm’s plant, are fixed.
Other resources are variable. Therefore,
short-run costs are either fixed or
variable.
SHORT-RUN PRODUCTION COSTS
Fixed Costs – Examples:
rent, interest on
Debts, insurance premiums
Total Fixed Costs
Total Fixed Costs
Average Fixed Costs = Quantity of output
Variable Costs – Examples: materials, fuels,
Utilities, transportation, and labor
Total Variable Costs
Average Variable Costs =
Total Variable Costs
Quantity of
output
SHORT-RUN PRODUCTION COSTS
Total Cost
TC = Total Fixed + Variable Costs
Average Total Cost =
Total Costs
Quantity of output
Marginal Cost – the extra, or additional, cost
of producing one more unit of output
Total Variable Costs
Marginal Cost =
Change in Total Costs
Change in Quantity
of output
SHORT-RUN PRODUCTION COSTS
Summary of Definitions
Total Fixed Costs =
Total Variable Costs =
Total Costs =
Average Fixed Costs =
Average Variable Costs =
Average Total Costs =
Marginal Cost =
TFC
TVC
TC
AFC
AVC
ATC
MC
COST CURVES AND THEIR SHAPES
Marginal Cost Curve rises with the amount of output
produced reflecting the property of diminishing marginal
product.
COST CURVES AND THEIR SHAPES
The Average Total Cost Curve is U-shaped. At low levels of
output ATC is high because fixed cost is spread over only a few
units. ATC declines as output increases. ATC starts rising
because AVC rises substantially.
COST CURVES AND THEIR SHAPES
The Relationship between MC and ATC
When MC is less than ATC, ATC is falling.
When MC is greater than ATC, ATC is rising.
The MC curve crosses the ATC curve at the efficient scale (the
quantity that minimizes ATC
SHORT-RUN COSTS GRAPHICALLYAVERAGE AND MARGINAL
MC
COSTS
Costs (dollars)
ATC
AVC
AFC
Quantity
Costs (dollars)
SHORT-RUN COSTS GRAPHICALLY
Combining TVC
With TFC to get
Total Cost
Total
Cost
TC
TVC
Fixed Cost
Variable Cost
TFC
Quantity
Average Product and
Marginal Product
PRODUCTIVITY AND COST CURVES
AP
MP
Costs (dollars)
Quantity of labor
MC
AVC
Quantity of output
Al’s (Variable) Cost
Schedules
Total Variable Cost per Year
(thousands $)
Al’s Total Variable Cost
Curve
200
180
160
140
120
100
80
60
40
20
0
TC
2
4
6
Quantity of Garages
(a)
8
10
30
Garage (thousands $)
Average Variable Cost per
Al’s Average Variable Cost
Curve
C
25
20
AVC
15
D
10
5
0
2
4
6
Quantity of Garages
(b)
8
10
Marginal Variable Cost per Added
Garage (thousands $)
Al’s Marginal Variable
Cost Curve
50
45
40
35
30
25
20
15
10
5
0
MVC
2
4
6
Quantity of Garages
(c)
8
10
Fixed Costs: Total
14
Total Fixed Cost per Year
(thousands of $)
TFC
12
10
8
6
4
2
0
1
2
3
4
5
6
Output
(a)
7
8
9
10
Al’s Fixed Costs
Average Fixed Cost per Garage
(thousands $)
Fixed Costs: Average
14
12
10
8
6
4
AFC
2
0
1
2
3
4
5
6
Output
(b)
7
8
9
10
Section 3 – Long-Run
Production Costs
 A typical average cost curve declines at
first because average fixed costs decline.
 It then reaches a minimum and begins to
rise because of decreasing marginal
returns.
Section 3 – Long-Run
Production Costs
• Costs differ in the short and long runs,
because in the long run, more
adjustments can be made. For example:
A firm increases the size of its plant
* Because many costs are fixed in the
short-run but variable in the long run, a
firm’s long-run cost curves differ from its
short-run cost curves.
Section 3 – Long-Run
Production Costs
 The long-run average total cost curve
(ATC) shows the lowest possible shortrun average cost corresponding to each
output level.
 ATC makes no distinction between fixed
and variable costs (all resource costs are
variable in the long run)
LONG-RUN PRODUCTION COSTS
For every plant capacity size...
there is a short-run ATC curve.
All such plant capacities can
be plotted on the same graph.
Unit Costs
LONG-RUN PRODUCTION COSTS
Output
Unit Costs
LONG-RUN PRODUCTION COSTS
Output
Unit Costs
LONG-RUN PRODUCTION COSTS
The long-run ATC just “envelopes”
all of the short-run ATC curves.
Output
Unit Costs
LONG-RUN PRODUCTION COSTS
long-run ATC
Output
Average Cost per Pound of Chicken
Short-Run and Long-Run
Average Cost Curves
S
$0.40
0.35
0
U B
V
T
40
L
G
W
100
Output in Pounds of Chicken
ECONOMIES OF SCALE
Economies of Scale refers to the property
whereby long-run average total cost falls as the
quantity of output increases.
It explains the downsloping part of the longrun ATC curve.
ECONOMIES OF SCALE
As plant size increases, a number of factors
will for a time lead to lower average costs of
production.
1. Labor Specialization – hiring more workers
means jobs can be divided and subdivided.
Workers can work full-time on the tasks for
which they have special skills.
ECONOMIES OF SCALE
2. Managerial Specialization – means the better and
more efficient use of management. Instead of an executive performing
many functions he/she can focus on his area of expertise.
3. Efficient Capital – As a firm grows it can afford more efficient and
Modern equipment.
4. Other Factors – start-up costs, advertising costs,
depreciation costs, and many others
Economies of Scale becomes
Constant Returns to Scale
 In some industries a wide range of output
may exist between the output at which
economies of scale end and the output at
which Diseconomies of Scale begin.
 That range, where long-run average
costs remains stable is called
Constant Returns to Scale.
Diseconomies of Scale
 In time the expansion of a firm may lead
to higher average total costs, causing
Diseconomies of Scale.
 When a firm becomes bigger it is more
difficult to be efficient with managerial
practices as bureaucratic interference
evolves.
 Employees might feel alienated and more
likely to be less attentive to their work
AC
Quantity of Output
(a)
Constant returns
to scale
AC
Quantity of Output
(b)
Long-Run Average Cost
Increasing returns
to scale
Long-Run Average Cost
Long-Run Average Cost
Possible Shapes for the
Long-Run AC Curve
Decreasing returns
to scale
Quantity of Output
(c)
AC
ECONOMIES AND
DISECONOMIES OF SCALE
Unit Costs
Economies
of scale
long-run ATC
Output
ECONOMIES AND
DISECONOMIES OF SCALE
Constant returns
to scale
Unit Costs
Economies
of scale
long-run ATC
Output
ECONOMIES AND
DISECONOMIES OF SCALE
Constant returns
to scale
Diseconomies
of scale
Unit Costs
Economies
of scale
long-run ATC
Output
Unit Costs
ECONOMIES AND
DISECONOMIES OF SCALE
Where extensive
economies of
scale exist
long-run ATC
Output
Unit Costs
ECONOMIES AND
DISECONOMIES OF SCALE
Where economies
of scale are
quickly exhausted
long-run ATC
Output
CHAPTER SUMMARY
 The goal of firms is to maximize profit,
which equals total revenue minus total
cost.
 When analyzing a firm’s behavior, it is
important to include all the opportunity
costs of production
 Some opportunity costs are explicit
while other opportunity costs are
implicit.
CHAPTER SUMMARY
 A firm’s costs reflect its production
process.
 * A typical firm’s production function gets
flatter as the quantity of input increases,
displaying the property of diminishing
marginal product
 *A firms total costs are divided between fixed
and variable costs. Fixed costs do not
change when the firm alters the quantity of
output. Variable costs do change with
output
CHAPTER SUMMARY
 Average total cost is total cost divided by
the quantity of output.
 Marginal cost is the amount by which
total cost would rise if output were
increased by one unit.
 The marginal cost always rises with the
quantity of output.
 Average cost first falls as output
increases and then rises.
CHAPTER SUMMARY
 The average-total-cost curve is U-shaped
 The marginal-cost curve always
crosses the average-total-cost curve
at the minimum of ATC
 A firm’s costs often depend on the time
horizon being considered
 In particular, many costs are fixed in
the short-run but variable in the longrun.
Historical Costs versus
Analytical Costs Curves
 All points on the analytical cost curve
(used in economic analysis) refer to the
same period of time.
 An historical cost curve, showing the
actual relationship between cost and
output at different periods of time, is
probably not a good indicator of the
analytical cost curve.
Cost per Unit
Declining HCC w/declining
Analytical ACC
$100
75
A
1942 analytical
cost curve
50
25
Historical
cost curve
2005 analytical
cost curve
B
0
Quantity of Output
Declining HCC with Ushaped Analytical ACC
Cost per Unit
$100
1942 analytical
cost curve
75
50
25
0
Historical
cost curve
2005 analytical
cost curve
A
Quantity of Output
B
Cost Minimization in
Theory and Practice
 Real business situations are more
complex than those outlined in this
chapter, and the quality of the available
information is less precise.
 Yet when managers are doing their jobs
well and the market is functioning
smoothly, these models are a good
approximation to the real world.
Character of the
Production Indifference
Curves
 Each production indifference curve
shows all combinations of input quantities
capable of producing a given quantity of
output.
 Higher curves correspond to higher
outputs on a production indifference map.
Quantity of Land in Acres
A Production Indifference
Map
B
600
D
400
200
260,000 bushels
A
C
E
0
3
5
7
240,000 bushels
220,000 bushels
10
Quantity of Labor in Years
Character of the
Production Indifference
Curves
 Budget line: a curve that shows all the
combinations of inputs that keep total
costs constant.
 Slope of the budget line: the trade-off
between one input and another, which
keeps total costs constant.
 Constant input prices  constant slope
of a budget line
Cost Minim., Expansion
Path, and Cost Curves
 The least costly way to produce any
given level of output is shown by the
point of tangency between a budget line
and the production indifference curve
corresponding to that level of output.
 The combination of these points shows
the firm’s expansion path.
Quantity of Land in Acres
A Budget Line
360 J
K
40
Number of Workers
Cost Minimization
Quantity of Land in Acres
450
360
J
$450,000
270 A
T
225
$360,000
240,000
bushels
$270,000
15
B
30
K
40
50
Number of Workers
Effects of Changes in
Input Prices
  input prices   slope of the budget
line
 Optimal input proportions then change.
 Point at which the budget line is tangent
to an indifference curve also changes.
The Firm’s Expansion
Path
Quantity of Land in Acres
B'
J
E
S'
B
T
300,000
bushels
S
E
0
240,000
bushels
200,000
bushels
10 15
$270,000
B
K
Number of Workers
B'
Quantity of Land in Acres
Optimal Input at a
Different Set of Input
Prices
300
240
W
180
E
45
V
60
240,000 bushels
75
Quantity of Labor in Years
Chapter 8
Output, Price, and Profit
ECONOMIC COSTS
Economic (opportunity) Costs
Profits to an
Economist
Economic
Profit
Implicit costs
(including a
normal profit)
Explicit
Costs
Profits to an
Accountant
T
O
T
A
L
R
E
V
E
N
U
E
Accounting
Profit
Accounting
costs (explicit
costs only)
Price and Quantity: One
Decision, Not Two
 Firms face a demand curve on which
price and quantity are related.
 They can choose either price or quantity,
but not both.
Price per Garage (thousands $)
Demand Curve for Al’s
Garages
35
30
26
19
16
Da
b
c
d
25
22
20
e
Profit maximum
f
g
h
i
15
j
D
10
5
0
1
2
3
4
5
6
7
8
9
Output, Garages Marketed per Year
10
Total Profit: Keep Your
Eye on the Goal
 Simplifying assumption: maximum total
profit is the firm’s goal.
 Total profit = total revenue - total costs
 Economic profit  accounting profit
Total Profit: Keep Your
Eye on the Goal
 Total, Average, and Marginal Revenue
 Total Revenue = P  Q
 Average Revenue = TR/Q = (P  Q)/Q =
P
 Marginal Revenue =  total revenue from
one more unit of output.
Demand for Al’s Garages
Total Revenue per Year (thousands $)
Total Revenue Curve for
Al’s Garages
140
F
120
G
H
I
J
TR
E
D
100
C
80
B
60
40
A
20
0
1
2
3
4
5
6
Output, Garages Sold per Year
7
8
9
10
Total Profit: Keep Your
Eye on the Goal
 Total, Average, and Marginal Cost
 The shapes of the cost curves mean that
there is some size for the firm that is most
efficient.
 Firms that are smaller or larger than this
optimal size will have higher average costs.
Al’s Total, Average, and
Marginal Costs
Cost Curves for Al’s
Garages
200
TC
Total Cost per Year (thousands $)
180
160
140
120
100
80
60
40
20
0
1
2
3
4
5
6
7
8
Output, Garages per Year
(a) Total Cost
9
10
Cost Curves for Al’s
Garages
Average Cost per Garage (thousands $)
45
40
35
30
25
AC
20
15
10
5
0
1
2
3
4
5
6
7
Output, Garages per Year
(b) Average Cost
8
9
10
Marginal Cost per Added Garage (thousands $)
Cost Curves for Al’s
Garages
50
MC
45
40
35
30
25
20
15
10
5
0
1
2
3
4
5
6
7
8
Output, Garages per Year
(c) Marginal Cost
9
10
Marginal Analysis and
Profit
Marginal cost =  in TC /  in Q
Marginal Revenue =  total revenue (TRa –
TRb) from one more unit of output.
Marginals Analysis For The
Producer Firm
 Inputs  Costs
 How much does one more unit of input change
output?
 Input Costs  Output
 Will one more unit of output increase MR?
 Output  Profit
 Will one more unit of output increase or decrease
profit?
 If MR > MC,  production   profits
 If MR < MC,  production   profits
 Profit maximizing level output: MR = MC
TR – TC = Total Profit
Total Profit: Keep Your
Eye on the Goal
 Maximization of Total Profits
 Profits typically increase with output, then
fall.
 Some intermediate level of output, therefore,
generates the maximum profit.
TR, Costs, and Profit for
Al’s Garages
Marginal Analysis and
Maximization of Total
Profit
 Marginal profit is the slope of the total
profit curve.
 Profit is at a maximum when the marginal
profit is zero.
Total Revenue, Total Cost per Year (thousands $)
Profit Maximization
200
TC
180
160
140
TR
120
A
100
96
80
74
60
Profit
B
22,000
40
20
0
1
2
3
4
5
6
7
Output, Garages per Year
(a) Total Revenue. Total Cost
8
9
10
Total Profit per Year (thousands $)
Profit Maximization
40
34
20
Total profit
M
F
E
C
D
0
–20
1
2
3
4
5
6
–40
–60
–80
Output, Garages per Year
(b) Total Profit
7
8
9
10
Marginal Analysis and
Maximization of Total
Profit
 Optimum Marginal Revenue and
Marginal Cost
 If MR > MC,  production   profits
 If MR < MC,  production   profits
 Profit maximizing level output: MR = MC
Al’s Marginal Revenue and
Marginal Cost
Profit Maxim: Another
Graphical Interpretation
MR and MC per Garage per Year
(thousands $)
50
MC
40
30
20
E
10
0
1
2
3
4
5
6
7
8
9
10
MR
–10
Output, Garages per Year
(a) Marginal Revenue and Marginal Cost
Total Revenue, Total Cost per Year (thousands $)
Profit Maxim: Another
Graphical Interpretation
200
TC
180
160
140
TR
120
A
100
96
80
74
60
Profit
B
22,000
40
20
0
1
2
3
4
5
6
7
Output, Garages per Year
(a) Total Revenue. Total Cost
8
9
10
Total Profit per Year (thousands $)
Profit Maxim: Another
Graphical Interpretation
40
34
20
Total profit
M
F
E
C
D
0
–20
1
2
3
4
5
6
–40
–60
–80
Output, Garages per Year
(b) Total Profit
7
8
9
10
Marginal Analysis and
Maximization of Total
Profit
 Finding the Optimal Price from Optimal
Output
 MR = MC: rule for determining the level
of output
 Demand curve  price buyers will pay to
purchase that level of output
 Both output and price are now determined
for the profit maximizing firm.
Logic of Marginal Analysis
& Maximization
 If a decision is to be made about the
quantity of some variable, then maximize
net benefit.
 Net benefit = total benefit - total cost
 To maximize net benefit, select a value of
the variable at which marginal benefit =
marginal cost.
Logic of Marginal Analysis
& Maximization
 Application: Fixed Cost and Profit
Maximization
 An increase in fixed costs does not change
optimal output or price because it does not
affect marginal costs.
Rise in Fixed Cost: Total
Profits Before and After
Total Profit per Year
(thousands $)
Fixed Cost Does Not Affect
Profit-Maximizing Output
Profit with zero
fixed cost
40
M
Profit with
a fixed cost
N
20
0
1
2
3
4
5
6
7
8
Output in Garages per Year
9
10
The Role of Marginal
Analysis
 Marginal analysis can be used to
illuminate many everyday problems, in
business and elsewhere, sometimes with
surprising results.
 For example, a new activity will add to
profits if it more than covers its marginal
cost, not the fully allocated average cost.
The Role of Marginal
Analysis
 Any problem involving optimization can
be illuminated with marginal analysis.
 The logic of marginal analysis can be
applied to government, universities,
hospitals and other organizations as well
as businesses.
Theory and Reality
 Business people seldom use marginal
analysis in a literal sense.
 They often rely on intuition and hunches.
 But these theories can be used to
understand and predict behavior.
Relationships Among
Total, Average, and
Marginal Data
 Average = total  the number of units
 Total = average  the number of units
Relationships Among
Total, Average, and
Marginal Data
 Marginal value of the xth unit = total
value of x units - total value of (x - 1)
units.
 Total value of x units =  marginal
values of the first x units.
Relationships Among
Total, Average and
Marginal Data
 The marginal, average and total values
for the first unit are usually equal.
 If marginal < average, the average is
falling.
 If marginal > average, the average is rising.
 If marginal = average, the average is
constant; that is, the average is at a
maximum or minimum.
Marginal and Average Weight
(pounds)
Relationship Between
Marginal and Average Curves
B
150
100
E
C
A
D
F
Marginal
weight
50
0
Average
weight
1
2
3
4
Number of Persons
5
6