Principles of Economics, Case and Fair,8E

Chapter 8

Short-Run Costs and Output Decisions

Prepared by: Fernando & Yvonn Quijano

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair CHAPTER 8: Short-Run Costs and Output Decisions © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair and Output Decisions Short - Run Costs

Looking Ahead The Short Comparing Costs and Revenues Total Revenue ( Output Decisions: Revenues, Short Total Costs Variable Costs Fixed Costs Costs in the Short Run to to Maximize Profit Revenue ( Costs, and Profit Maximization - Run Costs: A Review Chapter OutlineChapter - Run Supply Curve

MR 8

) TR

) and Marginal

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CHAPTER 8: Short-Run Costs and Output Decisions SHORT 3. 2. 1. inputto The quantityof each to use) output (whichtechnique Howto thatproduce supply The quantityof to output © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair make make three specific decisions. You have seen that firms in perfectly competitive industries DECISIONS

RUN COSTS RUN DECISIONS OUTPUTAND demand

FIGURE 8.1 are based on

Decisions Facing Firms

*Determinesproduction costs 3. The of inputs*price 2. 1. The of outputprice available* Techniques ofproduction

INFORMATION

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair costs. total cost( levelof productionchosen. variable cost long run. nothing. There nofixedthe costs in are if are eventheisincurred firm producing on the firm’sof output. level These costs fixed cost

TC Any cost that not doesdepend ) A that cost on the depends Fixedcosts plusvariable

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE sometimes called sunk costs. Firms have no control over fixed costs in the short run. For this reason, fixed costs are FIXED COSTS Total Fixed Cost ( © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair output, even ifoutputiszero. total of allcosts thatdowith notchange total fixed costs ( TABLE 8.1 (1) Q 5 4 3 2 1 0

Average)of a HypotheticalFirm Short TFC - $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 Run Fixed Cost (Total and TFC (2) TFC

)

) or overhead AFC $

1,000

( (3) 200 250 333 500 TFC/Q

)

The

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE Average Fixed Cost( © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair per by of unitsdividedthe number ofoutput;a average fixedcost ( choiceto pay but them. in the short run becausefirms have no sunk costs - unit measure of fixedunitcosts. measure Another name for Anotherfixedcosts name AFC AFC AFC TFC

q )

) Total fixedcost

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair FIGURE 8.2 quantity rises. output. Averageas fixedcost declines fixedtotal costs by dividing unitsof more spreading overhead

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

Theof process

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE VARIABLECOSTS Total Variable Cost( © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair output. of athe variablecost and firm’slevel total betweenshows the relationship total variable cost curve costs that with vary outputinthe short run. total variable cost(

TVC TVC )

) The total of all A that graph

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE 3 Units of 2 Units of 1 Unit of TABLE 8.2 PRODUCE output output output © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair

Derivation of Total Variable Cost Schedule from Technologyand Factor Prices

TECHNIQUE USING B A B A B A

(PRODUCTION FUNCTION) UNITS OF INPUT 6 9 4 7 2 4 K L

REQUIRED

14 10 6 6 6 4

ASSUMING (6 x$2) + (14 x$1) = $26 (9 x$2) + (6 x$1) = $24 (4 x$2) + (10 x$1) = $18 (7 x$2) + (6 x$1) = $20 (2 x$2) + (6 x$1) = $10 (4 x$2) + (4 x$1) = $12 TOTALVARIABLE COST TVC

= ( K

x P P K

= $2, ) + (

L P

x L

P = $1 L )

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE level given current factor prices. technology. It shows the cost of production using the best available technique at each output The total variable cost curve embodies information about both factor, or input, prices and © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair FIGURE 8.3

Total Variable Cost Curve

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE Marginal Marginal Cost( © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair changes in variable costs. changesvariable in unit of costs reflect output. Marginal cost one that more results from producing marginal cost ( MC MC )

) Thein increase total

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE successive unit of output. more inputs. do not lose sight of the fact that when a firm increases its output level, it hires or demands Althoughthe easiest way to derive marginal cost is to look at total variable cost and subtract, TABLE 8.3 UNITS OF OUTPUT © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair Marginal cost 2 1 0 3 Derivation of Marginal Cost from Total Variable Cost

measures the TOTALVARIABLE COSTS($)

additional 24 18 10 0

cost of inputs required to produce each

MARGINALCOSTS($)

10 0 6 8

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE Short Run The Shapeof the Marginal in CostCurve the © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair FIGURE 8.4

Marginal Cost Will Eventually Rise with Output Declining Marginal Product Implies That

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE Marginal costs ultimately increase with output in the short run. capacity, it becomes increasingly costlyto produce successively higher levels of output. returns to variable inputs and (2) limits its capacityto produce. As a firm approaches that In the short run, every firm is constrained bysome fixed input that (1) leads to diminishing © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair his time increases. returns. The marginalcost of night, faceshe diminishing accountantworkslate until at When independentan

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE slope FIGURE 8.5

TVC

Cost for a TypicalFirm Total Variable Cost and Marginal

TVC Δ q TVC 1

TVC MC

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE Average Variable Cost( © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair cost divided by cost ofunitsthe numberofoutput. divided average variable cost ( AVC

TVC AVC AVC q )

)

Total variable

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE cost divided bythe total number of units produced. Marginal cost is the cost of 500 TABLE 8.4 (1) 5 4 3 2 1 0 q

42 32 24 18 10

0 Short

( - Run Costs of a Hypothetical Firm $

MC (3) TVC

20 10 10 8 6 8

)

one additional unit ( $ TVC/q AVC

(4) 16 10 8 8 9 8.4

)

$ TFC

1,000 1,000 1,000 1,000 1,000 1,000 1,000 (5)

. . Averagevariable cost is the total variable

(

TVC

1,042 1,032 1,024 1,018 1,010 1,000

TC (6)

9,000 + TFC

)

$ ( TFC

AFC 1,000 (7) 200 250 333 500 /

q 2

)

(TC/q

or $

1,010 ATC

AFC+ AVC) (8) 208.4 258 341 509 18

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE Marginal cost intersects average variable cost at the lowest, or minimum, point of AVC. Costs Graphing AverageVariable Costs andMarginal © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair

FIGURE 8.6

More More Short - Run Costs

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Total Cost = Total Fixed Cost + Total Variable Cost

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE Average Total Cost ( © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair divided by of unitsdividedthe numberofoutput. average totalcost ( ATC

ATC

AFC ATC

ATC

TC )

q ) Total cost AVC

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Fixed Cost Variable Cost + Average AverageTotal Cost = Average

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE reason that it intersects the average variable cost curve at its minimum point. result, marginal cost intersects average total cost at ATC’sminimum point, for the same cost. If marginal cost is If marginal cost is and Marginal Cost The Relationship Between AverageTotal Cost © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair between between average variable cost and marginal cost. marginal cost is exactly the same as the relationship The relationship between average total cost and below

above average total cost, average total cost will

average total cost, average total cost will

decline increase

toward toward marginal

. . Asa

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CHAPTER 8: Short-Run Costs and Output Decisions COSTSRUN SHORTIN THE Marginal costs Average total costs Average variable costs Average fixed costs Total cost Total variable costs Total fixed costs Economic costs Accounting costs TABLE 8.5 SHORT

ASummaryof Cost Concepts

RUNCOSTS: A REVIEW

Costs Costs do that not depend on the quantity of output Costs include that the opportunity full costs of all inputs. Out The The increase in that total cost results from Total costs per unit of output. Variable per unit costs output. of Fixed costs per unit of output. The total economic all cost of the inputs used by a Costs with varythat level the of output. produced. produced. These be paid must even output if is zero. These include what are often called producing one additional unit of output. firm in production. - define define them. Sometimes referred to as of - pocket or as costs an costs accountant would DEFINITION

implicit costs

explicit explicit costs .

ATC = TC/q ATC = +AFC AVC

TC TC = + TFC TVC MC = EQUATION AVC = TVC/q AFC AFC TFC/q = TVC

TFC

TC/

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CHAPTER 8: Short-Run Costs and Output Decisions AND PROFIT MAXIMIZATIONAND PROFIT REVENUES,DECISIONS:COSTS,OUTPUT elastic demand in the short run. line at the market equilibrium price. In other words, competitive firms face perfectly In the short run, a competitive firm faces a demand curve that is simplya horizontal FIGURE 8.9 © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair

Demand Facing a Typical Firm in a PerfectlyCompetitive Market

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CHAPTER 8: Short-Run Costs and Output Decisions AND PROFIT MAXIMIZATIONAND PROFIT REVENUES,DECISIONS:COSTS,OUTPUT REVENUE ( REVENUE TOTAL REVENUE( © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair perfect perfect competition, unit. In increasesby oneadditional output revenue that a takesit firm whenin marginal revenue ( output ( to producethe firm decides the per unittimes the quantityof price a firm takes infrom the saleofitsproduct: total revenue( total MR

revenue )

TR TR TR ) MARGINALAND ) price P x q MR P The total amount that = ) x MR The additional quantity .

P x q ).

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CHAPTER 8: Short-Run Costs and Output Decisions AND PROFIT MAXIMIZATIONAND PROFIT REVENUES,DECISIONS:COSTS,OUTPUT MAXIMIZE PROFIT COMPARING COSTS ANDREVENUESTO FIGURE 8.10 The Profit © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair The Profit - Maximizing Levelof Output - Maximizing Level of Output for a PerfectlyCompetitive Firm

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CHAPTER 8: Short-Run Costs and Output Decisions AND PROFIT MAXIMIZATIONAND PROFIT REVENUES,DECISIONS:COSTS,OUTPUT The profit which the price of its output is just equal to short The profit period exceeds the cost incurred bydoing so. revenue exceeds marginal cost, the revenue gained byincreasing output byone unit per between the two is getting smaller, added output means added profit. Whenever marginal Aslong as marginal revenue is greater than marginal cost, even though the difference P*

© 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair = - - maximizing perfectly competitive will firm produce up to the point where maximizing output level for all firms is the output level where MC .

- run marginal cost

— the level of output at MR

= MC

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CHAPTER 8: Short-Run Costs and Output Decisions AND PROFIT MAXIMIZATIONAND PROFIT REVENUES,DECISIONS:COSTS,OUTPUT TABLE 8.6 (1) 4 3 2 1 0 6 5 q

TFC 10 10 10 10 10 10 10 (2)

Profit Profit Analysisfor a Simple Firm

TVC (3) 80 50 30 20 15 10

MC (4) 30 20 10 10

5 5

P $

= (5)

15 15 15 15 15 15 15 MR

( $ P

TR (6)

x 90 75 60 45 30 15

)

( TFC $

TC (7) +

90 60 40 30 25 20 10 TVC

)

( TR PROFIT $

(8) -

15 20 15 10 TC

- 0 5 5 28

)

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CHAPTER 8: Short-Run Costs and Output Decisions AND PROFIT MAXIMIZATIONAND PROFIT REVENUES,DECISIONS:COSTS,OUTPUT The marginal cost curve of a competitive is firm the firm’s short THE SHORT FIGURE 8.11 © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair Marginal Cost Is the SupplyCurveof a PerfectlyCompetitive Firm - RUN SUPPLYRUN CURVE

- run supplycurve.

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CHAPTER 8: Short-Run Costs and Output Decisions LOOKING AHEAD © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair In the next chapter, we turn to the long run. information about both Keep in mind that the

marginal cost curve input prices

and technology

carries carries

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CHAPTER 8: Short-Run Costs and Output Decisions REVIEW TERMS CONCEPTSAND total fixed costs ( total cost ( sunk costs spreading overhead marginal revenue ( marginal cost ( fixed cost average variable cost ( average total cost ( average fixed cost ( total variable cost ( total revenue ( overhead © 2007 © 2007 Prentice Hall Business Publishing Principles Economics of 8e by Case and Fair

)

TR MC TFC )

) MR TVC

ATC AFC

), or ) AVC

) ) )

)

8. Profit 7. Profit 6. 5. 4. 3. Slope of 2. 1. variable cost total variable cost curve

AVC TR ATC AFC TC P for perfectly competitive firms: for all firms:

= = MC

= = = - - P x q TFC maximizing level of output maximizing level of output TC/q TVC/q TFC/q

TVC

MR = TVC

= AFC

MC =

AVC

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