11

C h a p t e r
OUTPUT AND
COSTS

The Big Picture

Where we have been:
This chapter has explained how the firm’s output decision affects its costs when the firm
allocates its factors of production efficiently in the short run and in the long run. The
student sees how establishing short-run productivity and cost measures and
understanding how they are related reveals how a firm can predict how its costs will
change with the level of output. This relationship helps firm managers make profitable
output decisions in the short run and make commitments to efficient plant size in the
long run.

Where we are going:

Chapters 12, 13, 14, and 15 use the productivity and cost relationships developed in this
chapter to explain how firms make decisions in competition, monopoly, and other market
structures. Chapter 18 uses these same ideas to explain how firms decide how much labor
and capital to use.

New in the Thirteenth Edition

Some of the examples and applications have been updated. The introduction connects to a
new Economics in the News case that discusses Ikea’s decision to open a new store in
Nashville, TN. The example using costs of check out stations at retail stores now is prefaced
with Target’s decision to spend millions to remodel stores.

© 2019 Pearson Education Ltd.

Lecture Notes
Output and Costs
 In the short run, a firm needs to increase the quantity of labor employed in order to increase its
production.
 In the long run, a firm can increase the quantity of any or all of the factors of production it employs
to increase its production.
 Firms must pay for the factors they use, so when a firm changes its production, its costs change.
I. Decision Time Frames
 A firm owner’s decisions can be categorized as short run decisions and long run decisions.
 The short run is a time frame in which the quantities of some factors of production are fixed.
The fixed factors include the firm’s management organization structure, level of technology,
buildings and large equipment. These factors are called the firm’s plant.
 The long run is a time frame in which the quantities of all factors of production can be varied.
Long-run decisions are not easily reversed so usually a firm must live with the plant size that it
has created for some time. The past cost of buying a plant that has no resale value is called a
sunk cost.
Help the students to understand that the difference between the long run and short run is not related to
calendar time. Compare the street vendor, who is a firm owner operating out of a food truck, to the giant
automaker firm, Honda. Ask them how long it would take for the food vendor to double the size of his or her
plant (truck, oven, etc.) versus Honda to double its plant size (factory buildings covering multiple blocks,
computerized assembly lines and robotics, etc.). They will realize that the length of time covered by the long
run differs among firms.

II. Short-Run Technology Constraint

To increase its output in the short run, a firm must increase the quantity of labor employed. There are three
relationships between the quantity of labor and the firm’s output.
Product Schedules
 Total product is the maximum output that a Total Marginal Average
given quantity of labor can produce. The Labor product product product
marginal product of labor is the increase in 0 0
total product that results from a one-unit 10
increase in the quantity of labor employed with 1 10 10
all other inputs remaining the same. The 20
average product of labor is equal to the total 2 30 15
product of labor divided by the quantity of 6
labor. The table to the right has examples of 3 36 12
these product schedules.
Product Curves
 The total product curve illustrates the total product schedule. The slope of the total product curve
equals the marginal product of labor at that quantity of labor.
 The marginal product curve shows the additional output generated by each additional unit of labor.
The marginal product of labor curve (MP) has an upside-down U shape. Increasing marginal returns
occurs when the marginal product of an additional worker is greater than the marginal product of the
previous worker. At low levels of employment, increasing marginal returns is likely because hiring
an additional worker allows large gains from specialization. Eventually these gains become small or
nonexistent and diminishing marginal returns set in. Diminishing marginal returns occur when the
marginal product of an additional worker is less than the marginal product of the previous worker.
The law of diminishing returns states that as a firm uses more of a variable factor of production,
120 CHAPTER 11

with a given quantity of the fixed factor of production, the marginal product of the variable factor
eventually diminishes.
 The average product curve shows the average
product that is generated by labor at each level of
labor. As the figure shows, the average product of
labor curve (AP) has an upside-down U shape.
 As the figure shows, the marginal product curve and
the average product curve are related: when the
marginal product of labor exceeds the average
product of labor, the average product of labor
increases; when the marginal product of labor is less
than the average product of labor, the average
product of labor decreases; and the marginal
product of labor equals the average product of labor
when the average product of labor is at its
maximum.

The marginal pulls (but cannot not push) the average. Don’t let the students fall into the trap of thinking
that if the marginal measure rises (falls) with the level of an activity, then the average measure must also rise
(fall). This is a sloppy statement of the relationship between marginal and average measures. Use the tried-
and-true grade point average (GPA) example used in the text. Explain that if a student’s GPA is a 3.5 and the
next marginal class grade is a C (2.0), followed by a B (3.0), this increasing marginal grade will not be
pushing their GPA up at all. Conceptually, the students should understand that the marginal value can’t
“push” the average measure higher when it is, itself, lower than the average measure. The marginal measure
must be higher (lower) than the average value if the average value is to rise (fall) with the level of activity,
thereby “pulling” the average up (down).

Understanding marginal returns: Ask students to picture a typical fast food restaurant. This is a “plant” and
equipment with which they are familiar as customers if not also as workers. Fixed inputs include the building
and the equipment. Ask them to imagine one worker trying to cook the food, take the orders and run the
drive through. Add a second worker and specialization can begin to occur, so the MP initially rises. But keep
adding workers and marginal product will inevitably fall. Diminishing returns is not the same as negative
returns; students might need help understanding that total product is still rising, but at a decreasing rate.

III. Short-Run Cost

Fixed Variable Total Average Average Average Marginal
cost cost cost fixed cost variable cost total cost cost
Labo Output (dollars (dollars) (dollars) (dollars) (dollars) (dollars) (dollars)
r )
0 0 50 0 50
10.00
1 10 50 100 150 5.00 10.00 15.00
5.00
2 30 50 200 250 1.66 6.67 8.33
16.67
3 36 50 300 350 1.39 8.33 9.72
The table above continues the previous product schedule table and shows different costs.

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 OUTPUT AND COSTS 121

Total Cost
 Total cost (TC) is the cost of all the factors of production a firm uses. Total fixed cost (TFC) is the
cost of the firm’s fixed factors. Total variable cost (TVC) is the cost of the firm’s variable factors.
Total cost is the sum of total fixed cost plus total variable cost so TC = TFC + TVC.

Relation between TP and TVC. Make a graph of a TP curve on a transparency. Label the x-axis labor and
the y-axis output. Put some actual numbers on the labor axis (use 1, 2, 3, 4, and 5 labor units) and tell the
students that the price of a unit of labor $10. Next, change the label on the x-axis to TVC and ask the
students to tell you the numbers to put on the x-axis now that it measures TVC (the numbers will now be $10,
$20, $30, $40 and $50). Once the students are really clear about what you have done, pick up the
transparency, turn it over, and replace it on the display base with what was previously the x-axis (TVC)
running vertically. Point out that the students are now looking at a TVC curve. Emphasize that all the
product curves can be derived from the TP curve and all the cost curves can be derived from the TVC curve.

Marginal Cost
 Marginal cost (MC) is the increase in total cost that results from a one-unit increase in output. The
MC curve is U-shaped. Initially greater specialization makes additional units cost less than those that
have come before, but eventually diminishing returns sets in and marginal costs rise.
Average Cost
 Average fixed cost (AFC) is total fixed cost per unit of output. The value of AFC falls as output
increases.
 Average variable cost (AVC) is total variable costs per unit of output. At low levels of output, AVC
falls as output increases but at higher levels of output, AVC rises as output increases.
 Average total cost (ATC) is the total cost per unit of output. ATC = AFC + AVC. At low levels of
output, ATC falls as output increases but at higher levels of output, ATC rises as output increases.
Marginal Cost and Average Cost
 The figure illustrates typical MC, AFC, AVC, and
ATC curves. As the figure shows, the MC curve, the
AVC curve, and the ATC curve are all U-shaped.
There are other additional important points about
this figure:
 The vertical distance between the AVC curve
and the ATC curve is the AFC. Because the
AFC decreases as output increases, these curves
become vertically closer to each other as output
increases.
 The MC curve intersects the AVC curve and
ATC curve at their minimums
Why the Average Total Cost Curve is U-shaped
 The ATC curve combines the shapes of the AFC and
AVC curves. The AFC curve constantly falls as
output expands, pulling down ATC curve. The AVC curve first falls but then rises because of
diminishing returns. Eventually AVC curve starts to rise more rapidly than the AFC falls, so at that
point the ATC rises.
An Economics in the News case describes a new cost curve application inspired by Target’s decision to
spend millions to remodel its stores. The case derives and analyzes the cost curves for both traditional clerks
and for checkout assistants for shoppers using self scan technologies.

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122 CHAPTER 11

Cost Curves and Product Curves

 The shape of the AVC curve is determined by the shape of the AP curve. Over the range of output for
which the AP curve is rising, the AVC curve is falling and over the range of output for which the AP
curve is falling, the AVC curve is rising.
 The shape of the MC curve is determined by the shape of the MP curve. Over the range of output for
which the MP curve is rising, the MC curve is falling and over the range of output for which the MP
curve is falling, the MC curve is rising.
Making Decisions Using the Relationships Between Productivity and Cost. Explain to the students the
usefulness of understanding the intuition behind the relationship between productivity measures and cost
measures. For example:
If a firm manager knows that average productivity of labor has been falling with the last additional quantity
of labor hired, then the manager knows that the average variable cost (AVC) of production has necessarily
been rising as the output from that additional labor has increased.
If the manager knows that AVC is rising as output increases, then the manager also knows that the marginal
cost (MC) of the additional output has been higher than the AVC (which has been pulling AVC up).
If the manager has sold the previous units of output at a small profit, the manager might be faced with a
time-sensitive contractual opportunity that arises within the same short run time period. The manager might
be asked to sell a little more output at the same market price as the previous sales. The manager can quickly
infer that the profitability of this potential new contract will not be as high because the marginal cost of
producing the extra output will be higher than the last units of output produced. The manager can infer this
result through productivity-cost relationships rather than knowing marginal costs directly.
Firm managers must frequently make quick decisions with little information. If managers have knowledge of
a useful relationship between input measures (which are relatively easy to get) and production cost measures
(which are more difficult to get—especially marginal cost figures) they can use their understanding of this
link to make inferences about how production costs might behave when the firm’s output must change to
accommodate market changes.

Shifts in the Cost Curves

 The cost curves shift with changes in technology or changes in prices of factors of production.
 An increase in technology that allows more output to be produced from the same resources shifts
the cost curves downward. If the technology requires more capital, a fixed input, then the
average total cost curve shifts upward at low levels of output and downward at higher levels of
output.
 A fall in the price of the fixed factor shifts the AFC and ATC curves downward but leaves the AVC
and MC curves unchanged. A fall in the price of a variable factor shifts the AVC, ATC, and MC
curves downward but leaves the AFC curve unchanged.
IV. Long-Run Cost
In the long run, a firm can vary the level of all resources so both labor and capital are variable factors. As a
result, in the long run all costs are variable costs.
The Production Function
The production function determines the behavior of long run costs.
 A firm’s production function typically exhibits diminishing returns to capital as well as diminishing
returns to labor. The marginal product of capital is the change in total product divided by the change
in capital when the quantity of labor is held
constant. Holding constant the quantity of
employment, after some level of output the firm
will have diminishing returns to capital—the
marginal product of capital decreases as more
capital is used.

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 OUTPUT AND COSTS 123

Short-Run Cost and Long-Run Cost

 In the long run, a firm can use different plant sizes. Each plant size has a different short-run ATC
curve. Each short-run ATC curve is U-shaped and the larger the plant size, the greater is the output at
which the average total cost is a minimum.
 The figure illustrates three average total cost curves for three plant sizes. ATC1 pertains to the
smallest plant size and ATC3 to the largest.
The Long-Run Average Cost Curve
 The long-run average cost curve, LRAC, is the relationship between the lowest attainable average
total cost and output when both the plant size and labor are varied. This curve is derived from the
short-run average total cost curves. It shows the lowest average total cost to produce a given level of
output. In the figure, the LRAC curve is the darkened parts of the three short-run ATC curves.
 The LRAC curve is a planning curve. Once the firm chooses a plant size, then it operates on the
short-run costs curves associated with that plant size.
An Economics in Action case describes why a firm in the auto industry might have capital equipment that is
not fully used. The firm is producing at a point on its short-run average total cost curve that is not the
minimum of the short-run average cost curve, so the firm has under-utilized capital. But the production point
is on the long-run average cost, so the quantity being manufactured is produced at the minimum average
total cost.

Economies and Diseconomies of Scale

 Economies of scale are features of a firm’s technology that lead to falling long-run average cost as
output increases. With given factor prices, economies of scale occur if the percentage increase in
output exceeds the percentage increase in all factors of production. The long-run average cost curve
slopes downward in this range of output. The main source of economies of scale is greater
specialization of both labor and capital.
 Constant returns to scale are features of a firm’s technology that lead to constant long-run average
cost as output increases. With given factor prices, economies of scale occur if the percentage
increase in output equals the percentage increase in all factors of production. The long run average
cost curve is horizontal in this range of output.
 Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as
output increases. With given factor prices, economies of scale occur if the percentage increase in
output is less than the percentage increase in all factors of production. The long run average cost
curve slopes upward in this range of output.
 The minimum efficient scale is the smallest quantity of output at which the long-run average cost
curve reaches its lowest level.

Concepts are important, not just the formulas. Make good use of the glossary of productivity and cost
terms provided in Table 11.2 in the text, but don’t get mired down in reciting productivity and cost measure
definitions! Students must learn the definitions, but they are secondary to the concepts they define and the
insights they bring. Stand back from the details of this chapter and be sure that your students learn two big
ideas.
 A firm’s lowest production costs depend on the manager’s flexibility to choose the level of all factors.
This flexibility enables firm managers to produce at a lower cost in the long run than in the short run
when some factors are fixed.
 In the short run, with one or more fixed factors, production costs vary with output in a predictable way
because they are directly linked to measures of factor productivity.

When does the firm actually reach the “long run”? Think of the long run as a window of opportunity in
which firms get to re-make decisions. If things are going well, firms may be re-making decisions regularly

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124 CHAPTER 11

and extending fixed inputs on a regular basis. But if things are going poorly, the window in which a lease
can be broken or a contract not renewed will be pressing. Point out to the students that the long-run average
cost curve yields the lowest average cost of production possible when plant size is free to change. Once a
firm commits to a specific plant size, it is locked into a specific short run cost curve configuration. Any
significant departure from the range of output per period that best suits that configuration means the firm
will incur higher short-run average total costs than it would have had it chosen a more appropriate plant size.
If faulty market analysis or unexpected changes in market conditions cause a firm to commit to a plant that
is too small (or too large) when the required range of production is actually relatively high (or relatively
low), then the firm will suddenly be locked into a much less competitive production cost situation with
potentially dire economic consequences. If the firm’s competitors chose their plant size more wisely, the
firm might have a tough time surviving! Who is successful in the long run may depend on decisions to get
bigger or smaller that wound up being correct as market conditions changed.

Experiment: Learn about production by producing. This chapter is one more place where an in-class
experiment has a huge payoff in student comprehension. This 30 minute experiment teaches students about
product curves and production cost measures. It motivates the students to go beyond memorizing the cost
and productivity definitions by getting them directly involved with generating their own data as well as
productivity and cost measures. This fun exercise will illustrate the concept of diminishing returns to labor
as well as how short-run productivity measures and production cost measures are related.
 Factors: Capital: A medium-sized table (the class must have an unobstructed view of it), tear-off
scratch pads with about 500 sheets of paper, a fully loaded stapler, and a back-up stapler (also fully
loaded). Labor: Provided by your students.
 The Task: To produce “widgets.” A widget is a piece of paper, torn from a pad, folded twice very
carefully so that the corners of the paper align, and stapled. (The first fold bisects the paper along its
long side and the second fold is at right angles to the first.) Once folded, it is stapled to hold the folds in
place. A widget is fragile and breaks if it falls off the table.
 The Pre-Experiment Stage: Hire a manager from your class and appoint an auditor. Get the manager to
hire a quality controller, an accountant, and some workers. Tell the manager that he must produce
widgets as efficiently as possible and that he can discuss the process with his workers and with the class.
 The Experiment: A “work day” lasts for 1 minute. Get the class to keep time. On day 1, have one
worker produce widgets. On day 2, have two workers produce widgets, and so on. You’ll probably run
for 10 to 12 days before you get to almost zero marginal product. Record the inputs and outputs. Have
some fun with quality control, shirking, and cheating. The auditor must ensure that old widgets and
partly made widgets don’t get used in a subsequent day. Each day must start clean.
 The Assignment (Stage 1): Have the students to calculate marginal product and average product from
the total product numbers that you’re recorded. Get them to make graphs of the total product, marginal
product, and average product curves. Get them to describe the curves and to explain their similarities
with and differences to the curves for sweater production in the textbook.
 The Assignment (Stage 2). Use the data from your widget production experiment and give the students
figures for the cost of the capital and the wage rate of a worker. (Make up the numbers—any will do.)
Tell the students to calculate total cost, marginal cost, and average cost. Get them to make graphs of the
total cost, marginal cost, and average cost curves. Get them to describe the curves and to explain their
similarities with and differences to the curves for sweaters in the textbook. (This assignment and the
previous one make an outstanding assignment for credit.)
 The Experiment Extended. If you have the time, duplicate the capital of the first experiment and repeat
all its steps. You should generate a horizontal LRAC. Get the class to think about what would have to
happen in the context of this experiment to get economies of scale and diseconomies of scale.

Economics in the News discusses Ikea’s decision to open a new store in Nashville, TN.

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 OUTPUT AND COSTS 125

Additional Problems
1. Charlie’s Chocolates total product schedule is in the
Labor Output
table.
(workers per (boxes per
a. Draw the total product curve. day) day)
b. Calculate the average product of labor and draw the 1 12
average product curve. 2 24
c. Calculate the marginal product of labor and draw the 3 48
marginal product curve. 4 84
d. What is the relationship between the average product 5 121
and marginal product when Charlie’s Chocolates 6 192
produces (i) less than 276 boxes a day and (ii) more 7 240
than 276 boxes a day? 8 276
9 300
2. In problem 1, the price of labor is $50 per day, and 10 312
total fixed costs are $50 per day.
a. Calculate total cost, total variable cost, and total fixed costs for each level of output and draw
the short-run total cost curves.
b. Calculate average total cost, average fixed cost, average variable cost, and marginal cost at
each level of output and draw the short-run average and marginal cost curves.

3. In problem 2, suppose that the price of labor increases to $70 per day. Explain what changes
occur to the short-run average and marginal cost curves?
4. In problem 2, Charlie’s Chocolates buys a second plant and now the total product of each
quantity of labor doubles. The total fixed cost of operating each plant is $50 a day. The wage
rate is $50 a day.
a. Set out the average total cost curve when Charlie’s operates two plants.
b. Draw the long-run average cost curve.
c. Over what output range is it efficient to operate one plant and two plants?

5. The table shows the

Labor Output
production function of
(workers (pizzas per day)
Mario’s Pizza-to-Go.
per day) Plant 1 Plant 2 Plant 3 Plant 4
Mario must pay $100
a day for each oven he 1 4 8 11 13
rents and $75 a day 2 8 12 15 17
for each kitchen hand 3 11 15 18 20
he hires 4 13 17 20 22
a. Find and graph the Ovens 1 2 3 4
average total cost curve for each plant size.
b. Draw Mario’s long-run average cost curve.
c. Over what output range does Mario experience economies of scale?
d. Explain how Mario uses his long-run average cost curve to decide how many ovens to rent.

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Solutions to Additional Problems

1. a. To draw the total product curve measure labor on the x-axis and output on the y-axis. The total
product curve is upward sloping.
b. The average product of labor is equal to total product divided by the quantity of labor employed. For
example, when 3 workers are employed, they produce 48 boxes a day, so average product is 16
boxes per worker. The average product curve is upward sloping when the number of workers is
between 1 and 8, but it becomes downward sloping when 9 and 10 workers are employed.
c. The marginal product of labor is equal to the increase in total product when an additional worker is
employed. For example, when 3 workers are employed, total product is 48 boxes a day. When a
fourth worker is employed, total product increases to 84 boxes a day. The marginal product of going
from 3 to 4 workers is 36 boxes. The marginal product curve is upward sloping when the number of
workers is between 1 and 6, but it becomes downward sloping when 7 or more workers are
employed.
d. (i) When Charlie’s Chocolates produces fewer than 276 boxes a day, it employs fewer than 8
workers a day. With fewer than 8 workers a day, marginal product exceeds average product and
average product is increasing. Up to an output of 276 boxes a day, each additional worker adds
more to output than the average. Average product increases.
(ii) When Charlie’s Chocolates produces more than 276 boxes a day, it employs more than 8
workers a day. With more than 8 workers a day, average product exceeds marginal product and
average product is decreasing. For outputs greater than 276 boxes a day, each additional worker
adds less to output than average. Average product decreases.
2. a. Total cost is the sum of the costs of all the inputs that Charlie’s Chocolates uses in production. Total
variable cost is the total cost of the variable inputs. Total fixed cost is the total cost of the fixed
inputs.
For example, the total variable cost of producing 48 boxes a day is the total cost of the workers
employed, which is 3 workers at $50 a day, which equals $150. Total fixed cost is $50, so the total
cost of producing 48 boxes a day is $200.
To draw the short-run total cost curves, plot output on the x-axis and the total cost on the y-axis. The
total fixed cost curve is a horizontal line at $50. The total variable cost curve and the total cost curve
have shapes similar to those in Fig. 11.4, but the vertical distance between the total variable cost
curve and the total cost curve is $50.
b. Average fixed cost is total fixed cost per unit of output. Average variable cost is total variable cost
per unit of output. Average total cost is the total cost per unit of output.
For example, when the firm makes 48 boxes a day: Total fixed cost is $50, so average fixed cost is
$1.04 per box; total variable cost is $150, so average variable cost is $3.13 per box; and total cost is
$200, so average total cost is $4.17 per box.
Marginal cost is the increase in total cost divided by the increase in output. For example, when
output increases from 24 to 48 boxes a day, total cost increases from $150 to $200, an increase of
$50. That is, the increase in output of 24 boxes increases total cost by $50. Marginal cost is equal to
$50 divided by 24 boxes, which is $2.08 a box.
The short-run average and marginal cost curves are similar to those in Fig. 11.5.
3. The increase in the price of labor increases total variable cost and total cost but does not change total
fixed cost. Average variable cost is total variable cost per unit of output. The average variable cost
curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve
shifts upward. The marginal cost curve shifts upward. Average fixed cost does not change.

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 OUTPUT AND COSTS 127

4. a. Total cost is the cost of all the factors of production. For example, when 3 workers are employed
they now produce 96 boxes a day. With 3 workers, the total variable cost is $150 a day and the total
fixed cost is $100 a day. The total cost is $250 a day. The average total cost of producing 96 boxes is
$2.60.
b. The long-run average cost curve is made up of the lowest parts of the firm’s short-run average total
cost curves when the firm operates one plant and two plants. The long-run average cost curve is
similar to Fig. 11.8.
c. It is efficient to operate the number of plants that has the lower average total cost of a box of
chocolates. It is efficient to operate one plant when output is less than 48 boxes a day, and it is
efficient to operate two plants when the output is more than 48 boxes a day. Over the output range 1
to 48 boxes a week, average total cost is less with one plant than with two, but if output exceeds 48
boxes a day, average total cost is less with two plants than with one.
5. a. For example, the average total cost of producing a pizza when Mario rents 2 ovens and employs 4
workers equals the total cost ($200 rent for the ovens plus $300 for the workers) divided by the 17
pizzas produced. The average total cost equals $500÷17, which is $29.41 a pizza. The average total
cost curve is U-shaped, as in Fig. 11.5.
b. The long-run average cost curve is similar to that in Fig. 11.8.
c. Mario experiences economies of scale at output levels of 4 to 15 pizzas a day. When economies of
scale are present, the LRAC curve slopes downward. Mario’s LRAC curve slopes downward between
the output levels of 4 to 15 pizzas a day.
d. Mario will choose the plant (number of ovens to rent) that gives him minimum average total cost for
the normal or average number of pizzas that people buy.

Additional Discussion Questions

11. Is the law of diminishing returns a result of firms hiring the best workers first? Students
should understand that diminishing returns to labor occur under the assumption of a
homogenous work force. Emphasize that diminishing marginal returns occur due to labor’s
decreasing productivity given a fixed level of capital. The law of diminishing returns is
defined in the short run only. As the amount of capital increases, as technology changes, or as
the size of the plant increases, labor productivity can increase. If the variable input was a
herbicide or a fertilizer on a farm field, diminishing returns would still be observed.
2. Do increasing marginal costs result from the rising wages of workers? Students should
understand that rising marginal cost in the short run results from diminishing marginal
productivity of labor holding the wages for labor constant. Show the students the following
thought process:
 Employing another labor unit increases output, but the extra output is less than the added
output from the previous labor unit (diminishing marginal productivity).
 Each labor unit costs the same to employ, so the firm is getting less additional output for
the same additional cost (constant cost of labor).
 As a result, each additional unit of output is more expensive for the firm to make than the
previous units of output (rising marginal cost).
This chain of reasoning is very important because it clearly shows the linkage from the firm’s
production decisions and production constraints to its costs and the behavior of its cost
curves.

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3. Fixating on fixed costs. Students should be aware of how fixed costs affect pricing decisions
made by firms:
 Why are some consumer products cheaper to buy in bulk? The students should be aware
that if packaging costs comprise a significant proportion of the total cost of an item, then
an increase in the ratio of product to packaging lowers the cost per unit. The firm can be
more competitive and still retain profitability if it passes some of the savings on to the
customer through a lower unit price.
4. Do firms produce where the ATC (or MC) curve is at its minimum? Students frequently ask
a variation of this question. Students who ask this question should be praised because they are
clearly thinking ahead and trying to use what they are learning to better understand the real
world around them. However, you need to be clear to these students that costs are essentially
half of the picture. Firms are in business for one reason, to maximize their profit. Profit
equals revenue minus cost, so in order to maximize their profit, firms need also to be
concerned with their revenue. You can intuitively tell the students that the next chapters
“cover the revenue side of the picture” by looking at how the market structure in which a
firm competes affects the firm’s revenue and hence affects its decisions. Firms want to
minimize the cost of producing a given level of output, but the level of output that maximizes
profit may not be at the minimum of any cost function.
5. Discuss the following in terms of fixed costs, the short run and the long run: In agricultural
markets, firms hesitate to be early adopters of new technologies embodied in new capital
equipment, which can be quite expensive. But once they are proven to increase
productivity, firms rush to adopt them and firms that don’t (or can’t) will have difficulty
surviving. Equipment is a huge fixed cost for farmers. Committing to a particular piece of
equipment is a decision they will be stuck with for a while, and making the wrong choice
may make them a higher cost producer. A smart farmer could buy what turns out to be the
wrong piece of equipment because the new technology perhaps proved less durable than
expected. This farmer might be unable to reverse that choice in time to save the farm if
market conditions are overall poor.
6. Suppose you open a restaurant. Which inputs are fixed and variable in the short run?
When might you hit the long run and have to make new decisions? Labor, food, and other
raw materials, some portion of the utility bills, advertising all might be examples of variable
inputs. The building and the equipment, whether owned or leased, are typically fixed inputs.
When the lease is up, the firm gets to decide whether to renew, shut down, or go to a smaller
space or a bigger space. Ask students to describe what market conditions might lead to each
of the above. Why do they think so many restaurants fail?
7. Are firms that survive over long periods of time simply lucky or smarter than other firms?
Sometimes the capital choice a firm makes determines its survival and it can’t change the
choice easily once made. Unexpected changes in the economy or technology create winners
and losers based on past capital decisions.

© 2019 Pearson Education Ltd.

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© 2019 Pearson Education Ltd.