# Short-Run Costs and Output Decisions

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1 Chapter 8 Short-Run Costs and Prepared by: Fernando & Yvonn Quijano 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

2 Short-Run Costs and 8 Chapter Outline Costs in the Short Run Fixed Costs Variable Costs Total Costs Short-Run Costs: A Review : Revenues, Costs, and Profit Maximization Total Revenue (TR) and Marginal Revenue (MR) Comparing Costs and Revenues to Maximize Profit The Short-Run Supply Curve Looking Ahead 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 31

3 SHORT-RUN COSTS AND OUTPUT DECISIONS You have seen that firms in perfectly competitive industries make three specific decisions. DECISIONS are based on INFORMATION 1. The quantity of output to supply 1. The price of output 2. How to produce that output (which technique to use) 3. The quantity of each input to demand 2. Techniques of production available* 3. The price of inputs* *Determines production costs FIGURE 8.1 Decisions Facing Firms 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 31

4 fixed cost Any cost that does not depend on the firm s level of output. These costs are incurred even if the firm is producing nothing. There are no fixed costs in the long run. variable cost A cost that depends on the level of production chosen. total cost (TC) Fixed costs plus variable costs Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 31

5 FIXED COSTS Total Fixed Cost (TFC) total fixed costs (TFC) or overhead The total of all costs that do not change with output, even if output is zero. TABLE 8.1 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm (1) Q (2) TFC \$1,000 \$1,000 \$1,000 \$1,000 \$1,000 \$1,000 (3) AFC (TFC/Q) \$ 1, Firms have no control over fixed costs in the short run. For this reason, fixed costs are sometimes called sunk costs Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 31

6 sunk costs Another name for fixed costs in the short run because firms have no choice but to pay them. Average Fixed Cost (AFC) average fixed cost (AFC) Total fixed cost divided by the number of units of output; a per-unit measure of fixed costs. AFC TFC q 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 31

7 FIGURE 8.2 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm spreading overhead The process of dividing total fixed costs by more units of output. Average fixed cost declines as quantity rises Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 31

8 VARIABLE COSTS Total Variable Cost (TVC) total variable cost (TVC) The total of all costs that vary with output in the short run. total variable cost curve A graph that shows the relationship between total variable cost and the level of a firm s output Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 31

9 TABLE 8.2 Derivation of Total Variable Cost Schedule from Technology and Factor Prices PRODUCE USING TECHNIQUE UNITS OF INPUT REQUIRED (PRODUCTION FUNCTION) K L TOTAL VARIABLE COST ASSUMING P K = \$2, P L = \$1 TVC = (K x P K ) + (L x P L ) 1 Unit of output A B (4 x \$2) + (4 x \$1) = \$12 (2 x \$2) + (6 x \$1) = \$10 2 Units of output A B (7 x \$2) + (6 x \$1) = \$20 (4 x \$2) + (10 x \$1) = \$18 3 Units of output A B (9 x \$2) + (6 x \$1) = \$24 (6 x \$2) + (14 x \$1) = \$ Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 31

10 FIGURE 8.3 Total Variable Cost Curve The total variable cost curve embodies information about both factor, or input, prices and technology. It shows the cost of production using the best available technique at each output level given current factor prices Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 31

11 Marginal Cost (MC) marginal cost (MC) The increase in total cost that results from producing one more unit of output. Marginal costs reflect changes in variable costs Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 31

12 TABLE 8.3 Derivation of Marginal Cost from Total Variable Cost UNITS OF OUTPUT TOTAL VARIABLE COSTS (\$) MARGINAL COSTS (\$) Although the easiest way to derive marginal cost is to look at total variable cost and subtract, do not lose sight of the fact that when a firm increases its output level, it hires or demands more inputs. Marginal cost measures the additional cost of inputs required to produce each successive unit of output Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 31

13 The Shape of the Marginal Cost Curve in the Short Run FIGURE 8.4 Declining Marginal Product Implies That Marginal Cost Will Eventually Rise with Output 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 31

14 When an independent accountant works until late at night, he faces diminishing returns. The marginal cost of his time increases. In the short run, every firm is constrained by some fixed input that (1) leads to diminishing returns to variable inputs and (2) limits its capacity to produce. As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output. Marginal costs ultimately increase with output in the short run Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 31

15 Graphing Total Variable Costs and Marginal Costs FIGURE 8.5 Total Variable Cost and Marginal Cost for a Typical Firm slopeof TVC TVC Δq TVC 1 TVC MC 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 31

16 Average Variable Cost (AVC) average variable cost (AVC) Total variable cost divided by the number of units of output. AVC TVC q 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 31

17 TABLE 8.4 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) 0 \$ 0 \$ \$ \$ 1,000 \$ 1,000 \$ \$ (8) ATC (TC/q or AFC + AVC) ,000 1,010 1,000 1, ,000 1, ,000 1, ,000 1, ,000 1, , ,000 9, Marginal cost is the cost of one additional unit. Average variable cost is the total variable cost divided by the total number of units produced Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 31

18 Graphing Average Variable Costs and Marginal Costs FIGURE 8.6 More Short-Run Costs Marginal cost intersects average variable cost at the lowest, or minimum, point of AVC Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 31

19 TOTAL COSTS FIGURE 8.7 Total Cost = Total Fixed Cost + Total Variable Cost 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 31

20 Average Total Cost (ATC) average total cost (ATC) Total cost divided by the number of units of output. ATC TC q ATC AFC AVC 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 31

21 FIGURE 8.8 Average Total Cost = Average Variable Cost + Average Fixed Cost 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 31

22 The Relationship Between Average Total Cost and Marginal Cost The relationship between average total cost and marginal cost is exactly the same as the relationship between average variable 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. As a result, marginal cost intersects average total cost at ATC s minimum point, for the same reason that it intersects the average variable cost curve at its minimum point Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 31

23 SHORT-RUN COSTS: A REVIEW TABLE 8.5 A Summary of Cost Concepts Accounting costs Economic costs TERM DEFINITION EQUATION Out-of-pocket costs or costs as an accountant would define them. Sometimes referred to as explicit costs. Costs that include the full opportunity costs of all inputs. These include what are often called implicit costs. Total fixed costs Costs that do not depend on the quantity of output produced. These must be paid even if output is zero. TFC Total variable costs Costs that vary with the level of output. TVC Total cost The total economic cost of all the inputs used by a firm in production. TC = TFC + TVC Average fixed costs Fixed costs per unit of output. AFC = TFC/q Average variable costs Variable costs per unit of output. AVC = TVC/q Average total costs Total costs per unit of output. ATC = TC/q ATC = AFC + AVC Marginal costs The increase in total cost that results from producing one additional unit of output. MC = TC/ q 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 31

24 OUTPUT DECISIONS: REVENUES, COSTS, AND PROFIT MAXIMIZATION FIGURE 8.9 Demand Facing a Typical Firm in a Perfectly Competitive Market In the short run, a competitive firm faces a demand curve that is simply a horizontal line at the market equilibrium price. In other words, competitive firms face perfectly elastic demand in the short run Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 31

25 OUTPUT DECISIONS: REVENUES, COSTS, AND PROFIT MAXIMIZATION TOTAL REVENUE (TR) AND MARGINAL REVENUE (MR) total revenue (TR) The total amount that a firm takes in from the sale of its product: the price per unit times the quantity of output the firm decides to produce (P x q). total revenue TR price x quantity P x q marginal revenue (MR) The additional revenue that a firm takes in when it increases output by one additional unit. In perfect competition, P = MR Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 31

26 OUTPUT DECISIONS: REVENUES, COSTS, AND PROFIT MAXIMIZATION COMPARING COSTS AND REVENUES TO MAXIMIZE PROFIT The Profit-Maximizing Level of Output FIGURE 8.10 The Profit-Maximizing Level of Output for a Perfectly Competitive Firm 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 31

27 OUTPUT DECISIONS: REVENUES, COSTS, AND PROFIT MAXIMIZATION As long as marginal revenue is greater than marginal cost, even though the difference between the two is getting smaller, added output means added profit. Whenever marginal revenue exceeds marginal cost, the revenue gained by increasing output by one unit per period exceeds the cost incurred by doing so. 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 level of output at which P* = MC. The profit-maximizing output level for all firms is the output level where MR = MC Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 31

28 OUTPUT DECISIONS: REVENUES, COSTS, AND PROFIT MAXIMIZATION A Numerical Example TABLE 8.6 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 \$ Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 31

29 OUTPUT DECISIONS: REVENUES, COSTS, AND PROFIT MAXIMIZATION THE SHORT-RUN SUPPLY CURVE FIGURE 8.11 Marginal Cost Is the Supply Curve of a Perfectly Competitive Firm The marginal cost curve of a competitive firm is the firm s short-run supply curve Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 31

30 LOOKING AHEAD Keep in mind that the marginal cost curve carries information about both input prices and technology. In the next chapter, we turn to the long run Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 31

31 REVIEW TERMS AND CONCEPTS average fixed cost (AFC) average total cost (ATC) average variable cost (AVC) fixed cost marginal cost (MC) marginal revenue (MR) spreading overhead sunk costs total cost (TC) total fixed costs (TFC), or overhead total revenue (TR) total variable cost (TVC) total variable cost curve variable cost 1. TC = TFC + TVC 2. AFC = TFC/q 3. Slope of TVC = MC 4. AVC = TVC/q 5. ATC = TC/q = AFC + AVC 6. TR = P x q 7. Profit-maximizing level of output for all firms: MR = MC 8. Profit-maximizing level of output for perfectly competitive firms: P = MC 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 31

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