short run costs and output decisions

© 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 Costsand Output Decisions


Decisions Facing Firms

DECISIONSare based

on INFORMATION1. The quantity of output

to supply1. The price of output

2. How to produce that output (which technique to use)

2. Techniques of production available*

3. The quantity of each input to demand

3. The price of inputs*

*Determines production costs


Costs in the Short Run

• The short run is a period of time for which two conditions hold:1. The firm is operating under a fixed

scale (fixed factor) of production, and

2. Firms can neither enter nor exit an industry.

• In the short run, all firms have costs that they must bear regardless of their output. These kinds of costs are called fixed costs.


Costs in the Short Run

• Fixed cost is any cost that does not depend on the firm’s level of output. These costs are incurred even if the firm is producing nothing.

• Variable cost is a cost that depends on the level of production chosen.

TC TFC TVC Total Cost = Total Fixed + Total Variable

Cost Cost


Fixed Costs

• Firms have no control over fixed costs in the short run. For this reason, fixed costs are sometimes called sunk costs.

• Average fixed cost (AFC) is the total fixed cost (TFC) divided by the number of units of output (q):

AFCTFC

q


Short-Run Fixed Cost (Total and Average) of a Hypothetical

Firm

• AFC falls as output rises; a phenomenon sometimes called spreading overhead.

(1)q

(2)TFC

(3)AFC (TFC/q)

0 $1,000 $

1 1,000 1,000

2 1,000 500

3 1,000 333

4 1,000 250

5 1,000 200


Variable Costs

• The total variable cost curve is a graph that shows the relationship between total 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.


Derivation of Total Variable Cost Schedule from Technology and

Factor Prices

• The total variable cost curve shows the cost of production using the best available technique at each output level, given current factor prices.

PRODUCT

USINGTECHNIQU

E

UNITS OFINPUT REQUIRED

(PRODUCTION FUNCTION)

TOTAL VARIABLECOST ASSUMING

PK = $2, PL = $1TVC = (K x PK) + (L x

PL)K L

1 Units of

A 4 4 (4 x $2) +

(4 x $1) =$12

output B 2 6 (2 x $2) +

(6 x $1) =

2 Units of

A 7 6 (7 x $2) +

(6 x $1) =$20

output B 4 10 (4 x $2) +

(10 x $1) =

3 Units of

A 9 6 (9 x $2) +

(6 x $1) =

output B 6 14 (6 x $2) +

(14 x $1) =

$26

$10

$18

$24


Marginal Cost

• Marginal cost (MC) is the increase in total cost that results from producing one more unit of output.

• Marginal cost reflects changes in variable costs.MC

TC

Q

TFC

Q

TVC

Q


Derivation of Marginal Cost fromTotal Variable Cost

UNITS OF OUTPUT

TOTAL VARIABLE COSTS ($)

MARGINAL COSTS ($)

0 0 01 10 10

2 18 8

3 24 6

• Marginal cost measures the additional cost of inputs required to produce each successive unit of output.


The Shape of the Marginal Cost Curve in the Short Run

• The fact that in the short run every firm is constrained by some fixed input means that:1. The firm faces diminishing returns to

variable inputs, and

2. The firm has limited capacity to produce output.

• As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output.


The Shape of the Marginal Cost Curve in the Short Run

• Marginal costs ultimately increase with output in the short run.


Graphing Total Variable Costs and Marginal Costs

• Total variable costs always increase with output. The marginal cost curve shows how total variable cost changes with single unit 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.


Average Variable Cost

• Average variable cost (AVC) is the total variable cost divided by the number of units of output.

• Marginal cost is the cost of one additional unit. Average variable cost is the average variable cost per unit of all the units being produced.

• Average variable cost follows marginal cost, but lags behind.


Relationship Between Average Variable Cost and Marginal

Cost• When marginal cost is

below average cost, 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..


Short-Run Costs of a Hypothetical Firm

(1)q

(2)TVC

(3)MC(

TVC)

(4)AVC

(TVC/q)(5)

TFC

(6)TC

(TVC + TFC)

(7)AFC

(TFC/q)

(8)ATC

(TC/q or AFC + AVC)

0 $ 0 $ $ $ 1,000

$1,000 $ $

1 10 10 10 1,000

1,010 1,000

1,010

2 18 8 9 1,000

1,018 500 509

3 24 6 8 1,000

1,024 333 341

4 32 8 8 1,000

1,032 250 258

5 42 10 8.4 1,000

1,042 200 208.4

500 8,000

20 16 1,000

9,000 2 18


Total Costs

• Adding TFC to TVC means adding the same amount of total fixed cost to every 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..

TC TFC TVC


Average Total Cost

• Average total cost (ATC) is total cost divided by the number of units of output (q).

ATC AFC AVC

ATCTC

q

TFC

q

TVC

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..


Relationship Between Average Total Cost and Marginal Cost

• If marginal cost is below average total cost, average total cost will decline toward marginal cost.

• If marginal cost is above average total cost, average total cost will increase.

• Marginal cost intersects average total cost and average variable cost curves at their minimum points.


Output Decisions: Revenues, Costs, and Profit Maximization• In the short run, a competitive firm faces a

demand curve that is simply a horizontal line at the market equilibrium price.


Total Revenue (TR) andMarginal Revenue (MR)

• Total revenue (TR) is the total amount that a firm takes in from the sale of its output.

TR P q

MRTR

q

P q

q

( )

• 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


Comparing Costs and Revenues to Maximize Profit

• The profit-maximizing level of output for all firms is the output level where MR = MC.

• In perfect competition, MR = P, therefore, the profit-maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to short-run marginal cost.

• The key idea here is that firms will produce as long as marginal revenue exceeds marginal cost.


Profit Analysis for a Simple Firm

(1)q

(2)TFC

(3)TVC

(4)MC

(5)P = MR

(6)TR

(P x q)

(7)TC

(TFC + TVC)

(8)PROFIT(TR TC)

0 $ 10 $ 0 $ $ 15 $ 0 $ 10 $ -10

1 10 10 10 15 15 20 -5

2 10 15 5 15 30 25 5

3 10 20 5 15 45 30 15

4 10 30 10 15 60 40 20

5 10 50 20 15 75 60 15

6 10 80 30 15 90 90 0


The Short-Run Supply Curve

• At any market price, the marginal cost curve shows the output level that maximizes profit. Thus, the marginal cost curve of a perfectly competitive profit-maximizing firm is the firm’s short-run supply curve.

short run costs and output decisions

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