ch 07 production and cost in the firm micro econ4
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Chapter 7 ECON4 William A. McEachern
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Production
and Cost
in the Firm
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2
2
Cost and Profit
• Producers: Maximize profit
• Opportunity cost
– All resources have an opportunity cost
• Explicit costs
– Opportunity cost of resources employed
by a firm
– Cash payments
– On the accounting statement
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3
3
Cost and Profit
• Implicit costs
– A firm’s opportunity cost of using its own
resources or those provided by its
owners
– Without a corresponding cash payment
– Not on the accounting statement
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Alternative Measures of Profit
• Accounting profit
– Total revenue minus explicit costs
• Economic profit
– Total revenue minus all costs (implicit and
explicit)
• Opportunity cost of all resources
• Normal profit
– Accounting profit earned when all resources
earn their opportunity cost
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Exhibit 1
5
Wheeler Dealer Accounts, 2012
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Production in the Short Run
• Variable resources
– Can be varied in the short run to increase
or decrease production
• Fixed resources
– Cannot be varied in the short run
• Short run
– At least one resource is fixed
• Long run
– No resource is fixed6© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Diminishing Marginal Returns
• Total product
– A firm’s total output
• Production function
– Relationship between amount of
resources employed and total product
• Marginal product
– Change in total product from an
additional unit of resource
– Other things constant
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Diminishing Marginal Returns
• Increasing marginal returns
– Marginal product increases
• Diminishing marginal returns
– Marginal product decreases
• Law of diminishing marginal returns
– As more of a variable resource is added
to a given amount of another resource
– Marginal product eventually declines
• Could become negative
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Exhibit 2
9
The Short-Run Relationship Between Units of Labor and
Tons of Furniture Moved
Marginal product increases as the firm hires each of the first three workers, reflecting
increasing marginal returns. Then marginal product declines, reflecting diminishing
marginal returns. Adding more workers may, at some point, actually reduce total
product (as occurs here with an eighth worker) because workers start getting in each
other’s way.
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Exhibit 3
10
The Total and Marginal Product of Labor
5
10
15
To
tal p
rod
uct
(tons/d
ay)
5 10 Workers per day0
5 10 Workers per day
1
3
5
Ma
rgin
al p
rod
uct
(tons/d
ay)
0
2
4
Total
product
Marginal product
Negative
marginal
returns
Diminishing but
positive
marginal returns
Increasing
Marginal
returns
(a) Total product
(b) Marginal product
When marginal product
is rising, total product
increases by increasing
amounts. When
marginal product is
falling but still positive,
total product increases
by decreasing amounts.
When marginal product
equals 0, total product is
at a maximum. When
marginal product is
negative, total product is
falling.
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Costs in the Short Run
• Fixed cost, FC
– Any production cost that is independent
of the firm’s rate of output
• Variable cost, VC
– Any production cost that changes as the
rate of output changes
• Total cost, TC = FC + VC
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Costs in the Short Run
• Marginal cost, MC = ∆TC/∆q
– Change in total cost resulting from a one-
unit change in output
• Changes in MC
– Reflect changes in marginal productivity
• Increasing marginal returns
– MC falls
• Diminishing marginal returns
– MC increases12© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Exhibit 4
13
Short-Run Total and Marginal Cost Data for Smoother Mover
Because of increasing marginal returns from the first three workers, marginal cost
declines at first, as shown in column (6). Because of diminishing marginal returns
beginning with the fourth worker, marginal cost starts increasing.
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Costs in the Short Run
• Fixed cost curve
– Straight horizontal line
• Variable cost curve
– Starts at the origin
• Total cost curve
– Fixed cost curve + variable cost curve
• Slope of total cost curve
– Marginal cost
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Exhibit 5
15
Total and Marginal Cost Curves for Smoother Mover
200
$500
To
tal d
olla
rs
25
Cost per
ton
$50Marginal cost
9 15 Tons per day0 63 12
Fixed cost
Total cost
Tons per day0 9 1563 12
Variable costFixed
cost
In panel (a), fixed cost is $200
at all levels of output. Variable
cost starts from the origin and
increases slowly at first as
output increases. When the
variable resource generates
diminishing marginal returns,
variable cost begins to
increase more rapidly. Total
cost is the vertical sum of fixed
cost and variable cost. In panel
(b), marginal cost first
declines, reflecting increasing
marginal returns from the
variable resource (labor in this
example) and then increases,
reflecting diminishing marginal
returns.
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Average Cost in the Short Run
• Average variable cost, AVC = VC/q
– Variable cost divided by output
• Average fixed cost, AFC = FC/q
– Fixed cost divided by quantity
• Average total cost, ATC = TC/q
– Total cost divided by output
– ATC = AFC + AVC
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Average Cost in the Short Run
• When MC < average cost
– The marginal pulls down the average
• When MC > average cost
– The marginal pulls up the average
• U-shape of average cost curves
– Law of diminishing marginal returns
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Exhibit 6
18
Short-Run Total, Marginal, and Average Cost
Data for Smoother Mover
Marginal cost first falls then increases because of increasing then diminishing marginal
returns from labor. As long as marginal cost is below average cost, average cost
declines. Once marginal cost exceeds average cost, average cost increases. Columns
(4), (5), and (6) show the relation between marginal and average costs.
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Exhibit 7
19
Average and Marginal Cost Curves for Smoother Mover
0 5 10 15 Tons per day
$150
125
100
75
50
25
Cost
per
ton
ATC
AVC
MC
Average variable cost and
average total cost curves first
decline, reach low points, and
then rise. Overall, they have U
shapes. When marginal cost
is below average variable
cost, average variable cost is
falling. When marginal cost
equals average variable cost,
average variable cost is at its
minimum. When marginal cost
is above average variable
cost, average variable cost is
increasing. The same
relationship holds between
marginal cost and average
total cost.
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Costs in the Long Run
• Long run
– Planning horizon
– All resources can be varied
• Firms plan for the long run
• Firms produce in the short run
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Costs in the Long Run
• Economies of scale
– Forces that reduce a firm’s average cost
– As the scale of operation increases in the
long run
• Diseconomies of scale
– Forces that may eventually increase a
firm’s average cost
– As the scale of operation increases in the
long run
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Costs in the Long Run
• Long-run average cost curve
– Indicates the lowest average cost of
production
• At each rate of output when the scale of the
firm varies
– Planning curve
– U-shaped
• Economies of scale
• Diseconomies of scale
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Exhibit 8
23
Short-Run Average Total Cost Curves Form the Long-Run
Average Cost Curve, or Planning CurveC
ost
per
unit
0 q qa q’ Output per periodqb
S
S’
M M’
L
L’
Curves SS’, MM’, and LL’ show short-run average total costs for small, medium, and large
plants, respectively. For output less than qa, average cost is lowest when the plant is small.
Between qa and qb, average cost is lowest with a medium-size plant. If output exceeds qb,
the large plant offers the lowest average cost. The long-run average-cost curve connects
these low cost segments of each curve and is identified as SabL’.
a b
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Exhibit 9
24
Many Short-Run Average Total Cost Curves Form a Firm’s
Long-Run Average Cost Curve, or Planning Curve
ATC1
ATC2
0 q q’ Output per period
Cost
per
unit
$11
10
9
b
ATC3
ATC4
ATC5
ATC6
ATC7
ATC8
ATC9
ATC10
Long-run
average cost
c
a
With many possible plant sizes, the long-run average cost curve is the envelope of portions of the
short-run average cost curves. Each short-run curve is tangent to the long-run average cost
curve. Each point of tangency represents the least-cost way of producing that rate of output.
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Costs in the Long Run
• Constant long-run average cost
– Over some range of output
– Long-run average cost neither increases
nor decreases with changes in firm size
– No economies of scale
– No diseconomies of scale
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Exhibit 10
26
A Firm’s Long-Run Average Cost CurveC
ost
per
unit
0 A Output per periodB
Economies
of scale
Long-run
average cost
Diseconomies
of scale
Constant
average cost
Up to output level A, long-run average cost falls as the firm experiences economies of
scale. Output level A is the minimum efficient scale—the lowest rate of output at which the
firm takes full advantage of economies of scale. Between A and B, the average cost is
constant. Beyond output level B, long-run average cost increases as the firm experiences
diseconomies of scale.© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Economies & Diseconomies of Scale
• Plant level
– Particular location
• Firm level
– Collection of plants
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