Chapter 11

Output and
Costs
 Decision Time Frames
Decision Time Frames
To study the relationship between a firm’s output
decision and its costs, we distinguish between
two decision time frames:
The short run
The long run
 The Short Run
The Short Run
The short run is a time frame in which the quantity
of at least one factor of production is fixed.

 For most firms, capital, land, and entrepreneurship

are fixed factors of production and labor is the
variable factor of production.
 We call the fixed factors of production the firm’s
plant. In the short run, a firm’s plant is fixed.
 The Short Run
To increase output in the short run, a firm must
increase the quantity of a variable factor of
production, which is usually labor.

Short-run decisions are easily reversed. The firm

can increase or decrease its output in the short
run by increasing or decreasing the amount of
labor it hires.
 The Long Run
The Long Run
The long run is a time frame in which the
quantities of all factors of production can be
varied. That is, the long run is a period in which
the firm can change its plant.
 The Long Run

To increase output in the long run, a firm can

change its plant as well as the quantity of labor
it hires.

Long-run decisions are not easily reversed.

 The Long Run
Sunk cost
The past expenditure on a plant that has no resale
value a sunk cost.

The only costs that influence its current

decisions are the short-run cost of changing its
labor inputs and the long-run cost of changing
its plant.
Short-Run Technology constraint

Short-Run Technology constraint

To increase output in the short run, a firm must
increase the quantity of labor employed.
Short-Run Technology constraint
The relationship between output and the quantity of
labor employed described by using three related
concepts:
 Total Product
 Marginal Product
 Average Product

These product concepts can be illustrated either by

product schedules or by product curves.
 Product Schedules
Total product
Total product is the maximum output that a given
quantity of labor can produce.

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

Average product
Average product tells how productive workers
are on average. The average product of labor is
equal to total product divided by the quantity of
labor employed.
Product Schedules
Total Product Curves
 Total Product Curves
All the points that lie above the curve are
unattainable.

Points that lie below the curve, are attainable,

but they are inefficient—they use more labor
than is necessary to produce a given output.

Only the points on the total product curve are

technologically efficient.
Marginal product
 Marginal product
The total product and marginal product curves
differ across firms and types of goods. But the
shapes of the product curves are similar because
almost every production process has two
features:
Increasing marginal returns initially
Diminishing marginal returns eventually
 Increasing Marginal Returns
Increasing Marginal Returns
Increasing marginal returns occur when the
marginal product of an additional worker
exceeds the marginal product of the previous
worker.

Increasing marginal returns arise from increased

specialization and division of labor in the
production process.
 Diminishing Marginal Returns
Diminishing Marginal Returns
Diminishing marginal returns occur when the
marginal product of an additional worker is less
than the marginal product of the previous
worker.

Diminishing marginal returns arise from the fact

that more and more workers are using the same
capital and working in the same space.
 law of diminishing returns
law of diminishing returns
The law of diminishing returns states that
“As a firm uses more of a variable factor of
production with a given quantity of the fixed
factor of production, the marginal product of the
variable factor eventually diminishes”.
Average Product Curve
 Average Product Curve

Average product is largest when average

product and marginal product are equal. That
is, the marginal product curve cuts the average
product curve at the point of maximum
average product.
 Short-run Cost
Short-run Cost
To produce more output in the short run, a firm must
employ more labor, which means that it must
increase its costs. The relationship between output
and cost described by using three cost concepts:
 Total cost
 Marginal cost
 Average cost
 Total Cost
Total Cost
A firm’s total cost (TC) is the cost of all the
factors of production it uses. We separate total
cost into total fixed cost and total variable cost.

Total fixed cost

Total fixed cost (TFC) is the cost of the firm’s
fixed factors.
 Total Cost
Total variable cost
Total variable cost (TVC) is the cost of the firm’s
variable factors.

Total cost is the sum of total fixed cost and total

variable cost. That is,
TC = TFC + TVC
Total Cost
Total Cost Curves
 Marginal Cost
Marginal Cost
A firm’s marginal cost is the increase in total cost
that results from a one-unit increase in output.

Marginal cost is calculated as the increase in

total cost divided by the increase in output.
 Average Cost
Average Cost
Three average costs of production are
1. Average fixed cost
2. Average variable cost
3. Average total cost
 Average Cost
Average fixed cost
Average fixed cost (AFC) is total fixed cost per
unit of output.

Average variable cost

Average variable cost (AVC) is total variable
cost per unit of output
 Average Cost
Average total cost
Average total cost (ATC) is total cost per unit of
output.
Marginal Cost and Average Cost
The marginal cost curve (MC) intersects the
average variable cost curve and the average
total cost curve at their minimum points.

 When marginal cost is less than average cost,

average cost is decreasing, and when marginal
cost exceeds average cost, average cost is
increasing.
Marginal Cost and Average Cost
Marginal Cost and Average Cost
Cost Curves and Product Curves
 Shifts in the Cost Curves

The position of a firm’s short-run cost curves

depends on two factors:
Technology
Prices of factors of production
 Shifts in the Cost Curves
Technology
A technological change that increases
productivity increases the marginal product and
average product of labor. With a better
technology, the same factors of production can
produce more output, so the technological
advance lowers the costs of production and shifts
the cost curves downward.
 Shifts in the Cost Curves
Prices of Factors of Production
An increase in the price of a factor of production
increases the firm’s costs and shifts its cost
curves. How the curves shift depends on which
factor price changes.
 Shifts in the Cost Curves
Prices of Factors of Production
An increase in rent or some other component of
fixed cost shifts the TFC and AFC curves
upward and shifts the TC curve upward but
leaves the AVC and TVC curves and the MC
curve unchanged.
 Shifts in the Cost Curves
Prices of Factors of Production
An increase in wages, gasoline, or another
component of variable cost shifts the TVC and
AVC curves upward and shifts the MC curve
upward but leaves the AFC and TFC curves
unchanged.
 Long-Run Cost
Long-Run Cost
In the long run, a firm can vary both the quantity
of labor and the quantity of capital, so in the long
run, all the firm’s costs are variable.

The behavior of long-run cost depends on the

firm’s production function.
 The Production Function

The Production Function

The firm’s production function, which is the
relationship between the maximum output
attainable and the quantities of both labor and
capital.
The Production Function
 Diminishing Returns
Diminishing Returns
Diminishing returns occur with each of the four
plant sizes as the quantity of labor increases.

With each plant size, as the firm increases the

quantity of labor employed, the marginal product
of labor (eventually) diminishes.
 Diminishing Marginal Product of
Capital
Diminishing Marginal Product of Capital
Diminishing returns also occur with each
quantity of labor as the quantity of capital
increases.

We calculate the diminishing return by using

marginal product of capital.
 Diminishing Marginal Product of
Capital

The marginal product of capital

The marginal product of capital is the change in
total product divided by the change in capital
when the quantity of labor is constant—
equivalently, the change in output resulting from
a one-unit increase in the quantity of capital.
Short-Run Cost and Long-Run Cost

Short-Run Cost and Long-Run Cost

Campus Sweaters can hire workers for $25 a day
and rent knitting machines for $25 a day. Using
these factor prices and the data in Table 11.3, we
can calculate the average total cost and graph the
ATC curves for factories with 1, 2, 3, and 4
knitting machines.
Short-Run cost of four different
plants
 Short-Run cost of four different
plants
In Fig. 11.7, two things stand out:
Each short-run ATC curve is U-shaped.
For each short-run ATC curve, the larger the
plant, the greater is the output at which
average total cost is at a minimum.

Each short-run ATC curve is U-shaped because,

as the quantity of labor increases, its marginal
product initially increases and then diminishes.
Short-Run Cost and Long-Run Cost

In short-run ATC curve a firm operates on

depends on the plant it has. In the long run, the
firm can choose its plant and the plant it chooses
is the one that enables it to produce its planned
output at the lowest average total cost.
Short-Run Cost and Long-Run Cost

In the long run, Firm chooses the plant that

minimizes average total cost. When a firm is
producing a given output at the least possible
cost, it is operating on its long-run average cost
curve.
 long-run average cost curve
long-run average cost curve
The long-run average cost curve is the
relationship between the lowest attainable
average total cost and output when the firm can
change both the plant it uses and the quantity of
labor it employs.
 long-run average cost curve
long-run average cost curve
The long-run average cost curve is a planning
curve. It tells the firm the plant and the quantity
of labor to use at each output to minimize
average cost.
The Long-Run Average Cost Curve
 The Long-Run Average Cost Curve
The Long-Run Average Cost Curve
The long-run average cost curve LRAC consists
of pieces of the four short-run ATC curves.

The piece of each ATC curve with the lowest

average total cost is highlighted in dark blue in
Fig. 11.8. This dark blue scallop-shaped curve
made up of the pieces of the four ATC curves is
the LRAC curve.
 Economies and Diseconomies of
Scale
Economies of scale
Economies of scale are features of a firm’s
technology that make average total cost fall as
output increases.

Diseconomies of scale
Diseconomies of scale are features of a firm’s
technology that make average total cost rise as
output increases.
 Economies and Diseconomies of
Scale

Constant returns to scale

Constant returns to scale are features of a firm’s
technology that keep average total cost constant
as output increases. When constant returns to
scale are present, the LRAC curve is horizontal.
 Minimum Efficient Scale
Minimum Efficient Scale
A firm’s minimum efficient scale is the smallest
output at which long-run average cost reaches its
lowest level. At Campus Sweaters, the minimum
efficient scale is 15 sweaters a day.