econ 101: introduction to economics - i lecture 7 – costs and supply

ECON 101: Introduction to Economics - I

Lecture 7 – Costs and Supply

© 2012 Pearson Education

The firm makes many decisions to achieve its main objective: profit maximization.

Some decisions are critical to the survival of the firm.

Some decisions are irreversible (or very costly to reverse).

Other decisions are easily reversed and are less critical to the survival of the firm, but still influence profit.

All decisions can be placed in two time frames:

The short run

The long run

Decision Time Frames


The Short Run

The short run is a time frame in which the quantity of one or more resources used in production is fixed.

For most firms, the capital, called the firm’s plant, is fixed in the short run.

Other resources used by the firm (such as labor, raw materials, and energy) can be changed in the short run.

Short-run decisions are easily reversed.



The Long Run

The long run is a time frame in which the quantities of all resources—including the plant size—can be varied.

Long-run decisions are not easily reversed.

A sunk cost is a cost incurred by the firm and 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 current decisions.


The complete theory of supply (1)

• Short-run and long-run cost curves and output decisions need to be carefully distinguished when we study the determinants of supply.

• The profit-maximizing firm will choose the lowest cost way of producing any given level output, given the technology available and factor input costs.

©McGraw-Hill Education, 2014

The complete theory of supply (2)


The production function• The amount of output produced depends

upon the inputs used in the production process.

• A factor of production (“input”) is any good or service used to produce output.– e.g. labour, capital (machinery, buildings),

raw materials, energy.

• The production function specifies the maximum output which can be produced given inputs.– It summarizes technically efficient ways to

combine inputs to produce output.©McGraw-Hill Education, 2014

Short run vs long run• The short run is the period in which a firm can

make only partial adjustment of inputs, e.g. the firm may be able to vary the amount of labour, but cannot change capital.– The firm cannot fully adjust to a change in conditions.– The quantity of at least one input of production is fixed.

• The long run is the period in which a firm can adjust all inputs to changed conditions.

• The long run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels.


The short run

• Fixed factor of production

– a factor whose input level cannot be varied

• Fixed costs

– costs that do not vary with output levels

• Variable costs

– costs that do vary with output levels

• Short-run total cost (STC) = short-run fixed cost (SFC) + short-run variable cost (SVC)



Short-Run Technology Constraint

To increase output in the short run, a firm must increase the amount of labor employed.

Three concepts describe the relationship between output and the quantity of labor employed:

1. Total product

2. Marginal product

3. Average product


Product Schedules

Total product is the total output produced in a given period.

The marginal product of labor is the change in total product that results from a one-unit increase in the quantity of labor employed, with all other inputs remaining the same.

The average product of labor is equal to total product divided by the quantity of labor employed.



The total product curve is similar to the PPF.

It separates attainable output levels from unattainable output levels in the short run.


The marginal product of labour

• The marginal product of labour is the increase in output obtained by adding 1 unit of the variable factor but holding constant the inputs of all other factors.

• Labour is often assumed to be the variable factor, with capital fixed.



Labour Input

(workers)

Output(total product per

week)

Marginal Product of Labour

0 0

1 2

2 6

3 14

4 24

5 32

7 40

9 38

2

4

8

10

8

The marginal product of labour (cont.)

4 = 8/2

-1 = -2/2

The law of diminishing marginal returns

• Holding all factors constant except one, the law of diminishing marginal returns implies that beyond some value of the variable input further increases in the variable input lead to steadily decreasing marginal product of that input.

• For example, trying to increase labour input without also increasing capital will bring diminishing marginal returns.

• The law of diminishing marginal returns of a variable input is a short-run phenomenon.


The law of diminishing

marginal returns (cont.)


• The efficiency of the workers starts to decrease because, in the short run, the level of capital (the other input of production) is fixed and cannot be changed.

• e.g. the factory has 4 machines and there are 4 workers


Short-Run Cost

To produce more output in the short run, the firm must employ more labor, which means that it must increase its costs.

Three cost concepts and three types of cost curves are

Total cost

Marginal cost

Average cost

Short-run total, fixed and variable cost curves

• A firm’s short-run total cost (STC) is the cost of all resources used.

• Short-run fixed cost (SFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output.

• Short-run variable cost (SVC) is the cost of the firm’s variable inputs. Variable costs do change with output.

• STC = SFC + SVC ©McGraw-Hill Education, 2014


Marginal Cost

Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product.

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.

Short-Run Cost

Short-run marginal cost curve

• The shape of the short-run marginal cost (SMC) curve is almost the mirror image of the marginal product curve.

• There is a close relationship between these two curves.

• SMC is falling as long as the marginal product of labour is rising.

• Once diminishing returns to labour set in, the marginal product of labour falls and SMC starts to rise again. ©McGraw-Hill Education, 2014

Short-run average cost curves


• The average cost is defined as the total cost divided by the quantity produced.– The average cost measures the total cost per unit of

output.

• Short-run average total cost (SATC) is total cost per unit of output.– SATC = short-run total cost (STC)/Quantity of output

• Short-run average variable cost (SAVC) is total variable cost per unit of output.

• Short-run average fixed cost (SAFC) is total fixed cost per unit of output.

SATC = SAFC + SAVC

Short-run average cost curves• Short-run average

variable cost (SAVC) = short-run variable cost (SVC)/Quantity of output

• Short-run average fixed cost (SAFC) = short-run fixed cost (SFC)/Quantity of outputSATC = SAFC + SAVC


Short-run marginal and average cost curves

• SATC is falling when SMC is less than SATC, while it is rising when SMC is greater than SATC

– The same applies for the relationship between SMC and SAVC

• SATC is at a minimum at the output at which the SMC curve and the SATC curve cross (point A)

• SAVC is at its minimum at the output at which the SMC curve and the SAVC curve cross (point B)©McGraw-Hill Education, 2014

MC < AC MC = AC MC > AC

AC is:

Falling Minimum

Rising


Cost Curves and Product Curves

The shapes of a firm’s cost curves are determined by the technology it uses:

MC is at its minimum at the same output level at which MP is at its maximum.

When MP is rising, MC is falling.

AVC is at its minimum at the same output level at which AP is at its maximum.

When AP is rising, AVC is falling.

Short-Run Cost


Figure shows these relationships.

Short-Run Cost

The firm’s short-run output decision

• Firm sets output at Q1, where SMC=MR

• subject to checking the average condition:

– if price is above SATC1 firm produces Q1 at a profit

– if price is between SATC1 and SAVC1 firm produces Q1 at a loss

– if price is below SAVC1 firm produces zero output.

SAVC1

£

Output

MR

Q1

SATC1

SMC = MR


Production in the long run• In the long run all factors of production are variable.

Costs and the choice of technique

• Technique B is the economically efficient (lowest-cost) production method at the rental and wage rates in Table 7.7 ©McGraw-Hill Education, 2014

Factor intensity


• A technique using a lot of capital and little labour is ‘capital intensive’.

• One using a lot of labour but relatively little capital is ‘labour intensive’.

Factor prices and the choice of technique

Costs in the long run: Average cost

The average cost of production is total cost divided by the level of output.

Long-run average cost (LAC) is often assumed to be U-shaped:

Avera

ge c

ost

Output©McGraw-Hill Education, 2014

Costs in the long run: Economies of scale

Economies of scale – or increasing returns to scale – occur when long-run average costs decline as output rises:

Avera

ge c

ost

Output


Costs in the long run: Decreasing returns to scale

Diseconomies of scale – or decreasing returns to scale – occur when long-run average costs rise as output rises:

Avera

ge c

ost

Output


Costs in the long run: Constant returns to scale

Constant returns to scale occur when long-run average costs are constant as output rises:

Avera

ge c

ost

Output


The firm’s long-run output decision


The long-run average cost curve (LAC)

Output

Ave

rage

cos

t

SATC1

Each plant sizeis designed fora given output level.

SATC2

SATC3

SATC4

So there is a sequence of SATC curves, each corresponding toa different plant size.

In the long-run, plant size itself is variable, and the long-run average cost curve LAC is found to be the ‘envelope’ of the SATCs.•The firm can choose the plant size that minimizes the costs. ©McGraw-Hill Education, 2014

The long-run average cost curve (LAC) (cont.)


By definition, the LAC curve shows the least-cost way to make each output when all factors can be varied.

A (B) is the least-cost way to make output Q1 (Q2) in the short run.

To construct the LAC curve we select at each output the plant size which gives the lowest SATC at this output.

The LAC curve shows the minimum average cost way to produce a given output when all factors can be varied, not the minimum average cost at which a given plant can produce.

The firm’s output decisions – a summary

Marginal condition

Check whether to produce

Short-run decision

Choose the output at which MR=SMC

Produce this output unless price lower than SAVC, in which case produce zero

Long-run decision

Choose the output at which MR=LMC

Produce this output unless price is lower than LAC, in which case produce zero.


Some maths

• An example of a short-run total cost function:

• Where SFC=F and SVC = cQ+ Dq2

• and

• Thus the short-run average fixed cost decreases steadily as Q increases.

2dQcQFSTC

dQc

dQ

dSTCSMC 2

Q

F

Q

SFCSAFC


Some maths (2)

• Short run average variable cost is:

• And short run average total cost:

dQc

Q

SVCSAVC

dQc

Q

F

Q

STCSATC


Concluding comments (1)• In the long run, a firm can fully adjust all its

inputs. • In the short run, some inputs are fixed.• The production function shows the maximum

output that can be produced using given quantities of inputs.

• The total cost curve is derived from the production function, for given wages and rental rates of factors of production.

• The short-run marginal cost curve (SMC) reflects the marginal product of the variable factor, holding other factors fixed.

• The SMC curve cuts both the SATC and SAVC curves at their minimum points.©McGraw-Hill Education, 2014

Concluding comments (2)• The long-run total cost curve is obtained

by finding, for each output, the least-cost method of production when all inputs can be varied.

• Average cost is total cost divided by output.• LAC is typically U-shaped.• Much of manufacturing has economies of

scale.• When marginal cost is below average cost,

average cost is falling.• In the long run, the firm supplies the output

at which long-run marginal cost (LMC) equals MR provided price is not less than the level of long-run average cost at that level of output.


econ 101: introduction to economics - i lecture 7 – costs and supply

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