The Firm: Cost and 22 Output Determination Learning Objectives After you have studied this chapter, you should be able to 1. define short run, long run, production, production function, law of diminishing marginal product, average physical product, marginal physical product, total costs, fixed costs, variable costs, average fixed costs, average variable costs, average total costs, marginal costs, planning horizon, long-run average cost curve, planning curve, economies of scale, constant returns to scale, diseconomies of scale, and minimum efficient scale; 2. distinguish between the firm’s short run and its long run; 3. apply the law of diminishing marginal product to account for the shape of the firm’s short-run marginal cost curve, average total cost curve, and average variable cost curve; 4. classify firm costs as fixed or variable costs; 5. calculate average total costs, average fixed costs, average variable costs, and marginal costs, given sufficient information; 6. apply the concepts of economies of scale, diseconomies of scale, and constant returns to scale to predict the shape of a firm’s long-run average cost curve; 7. list reasons for economies of scale and for diseconomies of scale; and 8. understand the concept of minimum efficient scale (MES). Outline 1. The short run is defined as that time period in which a firm cannot alter its current size of plant. The long run is that time period in which all factors of production can be varied. ©2014 Pearson Education, Inc. 302 Miller • Economics Today, Seventeenth Edition 2. Total costs are identical to total fixed costs plus total variable costs. a. Total fixed costs do not vary with output. b. Total variable costs are the sum of all those costs that vary with output. c. There are several short-run average cost curves. i. Average total costs equal total costs divided by output. ii. Average variable costs equal total variable costs divided by output. iii. Average fixed costs equal total fixed costs divided by output. d. Marginal cost equals the change in total costs divided by the change in output. e. When marginal cost is above average cost, average cost rises. When marginal cost is below average cost, average cost falls. When marginal cost equals average cost, average cost remains constant. f. The marginal cost curve intersects the average total cost curve and the average variable cost curve at their respective minimum points. 3. The production function is a relationship between inputs and outputs. The production function is a technological, not an economic, relationship. a. The law of diminishing marginal product comes into play when the firm increases output in the short run. b. The marginal physical product is the change in total product that occurs when a variable input is increased and all other inputs are held constant. c. The law of diminishing marginal product implies that the marginal physical product of labor eventually falls. 4. Diminishing marginal product causes the marginal cost curve, the average total cost curve, and the average variable cost curve to rise. 5. In the long run, all inputs are variable, and long-run cost curves must take this into account. a. The long-run average cost curve is the locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices. b. Another name for the long-run average cost curve is the planning horizon. 6. The long-run average cost curve is U-shaped. a. Initially a firm experiences economies of scale due to specialization, a dimensional factor, or improved productive equipment. b. Eventually a firm might experience diseconomies of scale because a disproportionate increase in management and staff may be needed, and because the costs of information and communication also grow more than proportionally with output. 7. The minimum efficient scale is the lowest rate of output per unit time period at which average costs reach a minimum for a particular firm. ©2014 Pearson Education, Inc. Chapter 22 The Firm: Cost and Output Determination 303 Key Terms Average fixed costs Economies of scale Planning curve Average physical product Fixed costs Plant size Average total costs Long-run average cost curve Production Average variable costs Marginal costs Total costs Constant returns to scale Marginal physical product Variable costs Key Concepts Diseconomies of scale Planning horizon Law of diminishing marginal Production function product Short run Long run Minimum efficient scale Completion Questions Fill in the blank, or circle the correct term. 1. Our definition of the short run is the time during which _____________________ is fixed, but _______________________ is variable. 2. In the long run (no, all) factors are variable. 3. Fixed costs (do, do not) vary with output. Variable costs (do, do not) vary with output. 4. (Rent, Wages) and (mortgage interest payments, raw materials costs) are examples of fixed costs. (Rent, Wages) and (mortgage interest payments, raw materials costs) are examples of variable costs. 5. Short-run average cost curves eventually are upward sloping due to ______________. 6. If marginal cost exceeds average total cost, then average total cost will (fall, rise, remain constant). 7. At the minimum of the average total cost curve, marginal cost is (less than, greater than, equal to) average total cost. 8. If marginal cost is less than average total cost, then average total cost will (fall, rise, remain constant). 9. Because of the law of diminishing marginal product, in the (short, long) run the marginal product of labor will eventually (fall, rise, remain constant). ©2014 Pearson Education, Inc. 304 Miller • Economics Today, Seventeenth Edition 10. The long-run cost curve typically is U-shaped because initially, as a firm expands its scale of operations, it realizes _____________________ of scale. Then the firm may realize __________ returns to scale. Eventually, the firm realizes _________________ of scale. 11. Reasons for economies of scale include ____________________, ___________________, and ____________________. 12. A firm might experience diseconomies of scale due to ________________ and ________________. True-False Questions Circle the T if the statement is true, the F if it is false. Explain to yourself why a statement is false. T F 1. Short-run cost curves that include variable costs eventually reflect the influence of the law of diminishing marginal product. T F 2. Fixed costs vary with output. T F 3. Eventually, as output expands, the short-run marginal cost curve must rise. T F 4. When average total cost exceeds marginal cost, marginal cost must be rising. T F 5. When average variable cost is less than marginal cost, marginal cost must be falling. T F 6. At the minimum average total cost output level, marginal cost equals average total cost. T F 7. In the short run, the supply of labor to the firm is usually fixed. T F 8. Because of the law of diminishing marginal product, the marginal product of labor will rise. T F 9. Long-run cost curves are U-shaped due to the law of diminishing marginal product. T F 10. The minimum efficient scale is the lowest scale of output at which long-run average total cost is as low as possible. Multiple Choice Questions Circle the letter that corresponds to the best answer. 1. In the short run, for our purposes, a. all factors are variable. b. labor is variable. c. capital is variable. d. both capital and labor are variable. ©2014 Pearson Education, Inc. Chapter 22 The Firm: Cost and Output Determination 305 2. The long run a. permits the variation of all factors of production. b. is different for different firms. c. permits a firm to avoid the consequences of the law of diminishing marginal product. d. All of the above. 3. Fixed costs a. vary with output. b. do not vary with output. c. reflect the effect of diminishing marginal product. d. include labor and raw materials costs. 4. In the short run, which cost is not fixed? a. rent b. wages c. opportunity cost of capital d. interest payments on borrowed money 5. If marginal cost is above average total cost, then average total cost a. will rise. b. will fall. c. will remain constant. d. cannot be calculated. 6. At that output where average total cost is at a minimum, a. marginal cost equals average total cost. b. marginal cost equals average variable cost. c. average total cost is rising. d. total cost is constant. 7. Which short-run curve is not U-shaped? a. average total cost b. marginal cost c. average variable cost d. average fixed cost 8. The production function a. is a technological relationship. b. is not an economic relationship. c. relates output to inputs. d. All of the above. ©2014 Pearson Education, Inc. 306 Miller • Economics Today, Seventeenth Edition 9. Because of the law of diminishing marginal product, a. long-run average cost eventually rises. b. marginal cost falls. c. the marginal product of labor eventually falls. d. the average total cost curve falls. 10. Which is not due to the law of diminishing marginal product? a. rising short-run marginal cost b. rising long-run average total cost c. rising short-run average variable cost d. rising short-run average total cost 11. Analogy: Diminishing marginal product is to rising short-run average total costs as __________ is to rising long-run average total costs. a. economies of scale b. diseconomies of scale c. law of diminishing marginal product d. constant returns to scale 12. Which of the following helps to account for a U-shaped short-run average total cost curve? a. economies of scale b. diseconomies of scale c. law of diminishing marginal product d. constant returns to scale 13.