c hapter 8

CChapter 8hapter 8Costs of Costs of

ProductionProduction

Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

The character of entrepreneurshipTotal cost, total fixed cost, and total variable costThe law of diminishing returns

Economic PrinciplesEconomic PrinciplesAverage total cost, average variable cost, average fixed cost, and marginal costEconomies of scale, constant returns to scale, and diseconomies of scale

Economic PrinciplesEconomic Principles

The relationship between short-run average total cost and long-run average total costDownsizing

Fixed CostFixed Cost

Fixed cost

• Cost to the firm that does not vary with the quantity of goods produced. The cost is incurred even when the firm does not produce.

Variable CostVariable Cost

Variable cost

• Cost that varies with the quantity of goods produced. Variable costs include such items as wages and raw materials.

EXHIBIT 1A TOTAL FIXED COST FOR THE MAXIBOAT

EXHIBIT 1B TOTAL FIXED COST FOR THE MAXIBOAT

Exhibit 1: Total Fixed Exhibit 1: Total Fixed Cost for the MaxiboatCost for the Maxiboat

When plotting total fixed cost on a diagram with dollars on the “y” axis and output on the “x” axis, which of the following correctly describes the shape of the total fixed cost curve?a. An upward-sloping line

b. A horizontal line

c. A downward-sloping line

Exhibit 1: Total Fixed Exhibit 1: Total Fixed Cost for the MaxiboatCost for the Maxiboat

When plotting total fixed cost on a diagram with dollars on the “y” axis and output on the “x” axis, which of the following correctly describes the shape of the total fixed cost curve?a. An upward-sloping line

b. A horizontal line

c. A downward-sloping line

Labor ProductivityLabor Productivity

Labor productivity

• The output per laborer per hour

EXHIBIT 2 TOTAL VARIABLE COSTS PER FISHING RUN

Exhibit 2: Total Exhibit 2: Total Variable Costs Per Variable Costs Per

Fishing RunFishing RunComplete the sentence:

When output is zero, total variable cost is _____.

Exhibit 2: Total Exhibit 2: Total Variable Costs Per Variable Costs Per

Fishing RunFishing RunComplete the sentence:

When output is zero, total variable cost is zero.

Marginal ProductMarginal Product

Marginal product

• The change in total product caused by a one-unit increase in a factor of production (such as labor).

The Law of The Law of Diminishing ReturnsDiminishing Returns

Under what circumstances does the law of diminishing returns hold?

• In the short run, when at least one factor of production is fixed.

Under what circumstances does the law of diminishing returns hold?• As more of a variable factor of production (such as labor) is added to the fixed factor, each will eventually run out of physical space and equipment to work effectively.

Under what circumstances does the law of diminishing returns hold?• With crowding, eventually the marginal product of each successive laborer will be less than the one previously added.

EXHIBIT 3 TOTAL VARIABLE COST

Exhibit 3: Total Exhibit 3: Total Variable CostVariable Cost

If total variable cost (TVC) is increasing at an increasing rate, then which of the following is true about the TVC curve:a. It is upward-sloping and becoming steeper.b. It is upward-sloping and becoming flatter.c. It cannot start at the origin.

Exhibit 3: Total Exhibit 3: Total Variable CostVariable Cost

If total variable cost (TVC) is increasing at an increasing rate, then which of the following is true about the TVC curve:a. It is upward-sloping and becoming steeper.b. It is upward-sloping and becoming flatter.c. It cannot start at the origin.

EXHIBIT 4A TOTAL COST CURVE

EXHIBIT 4B TOTAL COST CURVE

Exhibit 4: Total Cost Exhibit 4: Total Cost CurveCurve

1. How is total cost calculated?

• Total cost is the sum of the total fixed and total variable costs of production.

2. How is the shape of the total cost curve determined?• The shape of the total cost curve is principally determined by the shape of the total variable cost curve.

2. How is the shape of the total cost curve determined?• This is because the total fixed cost is always the same ($2,000), regardless of what quantity is produced.

Average Total CostAverage Total Cost

Average total cost (ATC)

• Total cost divided by the quantity of goods produced. ATC declines, reaches a minimum, then increases as more of a good is produced.

Average Fixed CostAverage Fixed Cost

Average fixed cost (AFC)

• Total fixed cost divided by the quantity of goods produced. AFC steadily declines as more of a good is produced.

Average variable cost (AVC)

• Total variable cost divided by the quantity of goods produced. AVC declines, reaches a minimum, then increases as more of a good is produced.

Average Fixed CostAverage Fixed Cost

Average CostAverage Cost

• AFC is ($1 million/100,000) = $10

• AVC is ($2 million/100,000) = $20

• ATC is ($3 million/100,000) = $30—or

• ATC = AFC + AVC = $10 + $20 = $30

If total fixed cost is $1 million, total variable cost is $2 million, and output is 100,000, what is AFC, AVC, and ATC?

EXHIBIT 5A AVERAGE FIXED COST, AVERAGE VARIABLE COST, AND AVERAGE TOTAL COST CURVES

EXHIBIT 5B AVERAGE FIXED COST, AVERAGE VARIABLE COST, AND AVERAGE TOTAL COST CURVES

Exhibit 5: Average Fixed Exhibit 5: Average Fixed Cost, Average Variable Cost, Cost, Average Variable Cost,

and Average Total Cost and Average Total Cost CurvesCurves1. What is the difference between

the ATC and AVC curves?• The difference between the ATC and AVC curves is AFC.

1. What is the difference between the ATC and AVC curves?• The ATC curve is the vertical sum of the AFC and the AVC curves.

and Average Total Cost and Average Total Cost CurvesCurves

2. Why do the AVC and ATC curves become closer together as output increases?• Because (ATC - AVC) = AFC, and as output increases, AFC becomes smaller

and Average Total Cost and Average Total Cost CurvesCurves

Marginal CostMarginal Cost

Marginal cost

• The change in total cost generated by a change in the quantity of a good produced.

EXHIBIT 6A MARGINAL COST AND AVERAGE TOTAL COST CURVES

EXHIBIT 6B MARGINAL COST AND AVERAGE TOTAL COST CURVES

Exhibit 6: Marginal Cost Exhibit 6: Marginal Cost and Average Total Cost and Average Total Cost

CurvesCurves1. What are the shapes of the MC and ATC curves?• The ATC curve is U-shaped, and the MC curve is upward-sloping and intersects the ATC curve.

2. What is the relationship between the MC and the ATC curves in Exhibit 6?

• Within the output range 0 to 8,000, MC is below ATC, causing ATC to decrease.

CurvesCurves

2. What is the relationship between the MC and the ATC curves in Exhibit 6?

• Beyond an output of 8,000, MC is above ATC, causing ATC to increase.

CurvesCurves

2. What is the relationship between the MC and the ATC curves in Exhibit 6?• At 8,000, MC = ATC. At this point ATC is at its minimum.• The MC curve always cuts the ATC curve from below at the ATC curve’s minimum.

CurvesCurves

EXHIBIT 7 AVERAGE TOTAL COST CURVES FOR TWO FISHING FIRMS WITH DIFFERENT FIXED COSTS

Exhibit 7: Average Total Cost Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Curves for Two Fishing Firms with

Different Fixed CostsDifferent Fixed Costs1. In Exhibit 7, what is the average total cost for Strang and Burnett at an output of 2,000 fish?• At an output of 2,000 fish, Strang’s average total cost is $0.70.

• At the same output level, Burnett’s average total cost is $1.10.

2. What explains the difference in the average total cost for Strang and Burnett?• The difference is due to the fact that Strang and Burnett have different fixed costs associated with the different capacity boats that they use.

Different Fixed CostsDifferent Fixed Costs

3. How does efficiency change as output quantity increases?

• At an output less than 4,000, Strang’s operation is more efficient.

• When output increases above 4,000, Burnett’s operation becomes more efficient.

Different Fixed CostsDifferent Fixed Costs

Economies of ScaleEconomies of Scale

Economies of scale

• Decreases in the firm’s average total cost brought about by increased specialization and efficiencies in production realized through increases in the scale of the firm’s operations.

Constant Returns to Constant Returns to ScaleScale

Constant returns to scale

• Costs per unit of production are the same for any level of production. Changes in plant size do not affect the firm’s average total cost.

Diseconomies of ScaleDiseconomies of Scale

Diseconomies of scale

• Increases in the firm’s average total cost brought about by the disadvantages associated with bureaucracy and the inefficiencies that eventually emerge with increases in the firm’s operations.

EXHIBIT 8 ECONOMIES OF SCALE, DISECONOMIES OF SCALE, AND CONSTANT RETURNS TO SCALE

Exhibit 8: Economies of Exhibit 8: Economies of Scale, Diseconomies of Scale, Diseconomies of

Scale, and Constant Returns Scale, and Constant Returns to Scaleto Scale1. What happens to ATC as output

increases from 0 to 50,000?

• As output increases from 0 to 50,000, the minimum points on the short-run ATCs decline.

1. What happens to ATC as output increases from 0 to 50,000?

• This range of output features economies of scale in production.

Scale, and Constant Scale, and Constant Returns to ScaleReturns to Scale

2. What happens to ATC as output increases from 50,000 to 70,000?

• Between 50,000 and 70,000 units of output there are approximately constant returns to scale.

Scale, and Constant Returns Scale, and Constant Returns to Scaleto Scale

3. What happens to ATC as output increases beyond 70,000?

• The minimum points on the short-run ATCs rise beyond 70,000 units of output. There are diseconomies of scale in this range of output.

Scale, and Constant Scale, and Constant Returns to ScaleReturns to Scale

Short RunShort Run

Short run

• The time interval during which producers are able to change the quantity of some but not all the resources they use to produce goods and services.

Long RunLong Run

Long run

• The time interval during which producers are able to change the quantity of all the resources they use to produce goods and services. In the long run, all costs are variable.

Short Run and Long Short Run and Long RunRun

Can a firm always be in the long run, and therefore avoid the short run?

• Usually not, since most of the time a firm must make some commitment to capital.

Short Run and Long Short Run and Long RunRun

Can a firm always be in the long run, and therefore avoid the short run?• Once a production facility is bought or leased, it would take time for the firm to switch to a new facility, or for the facility to depreciate. That time period is the short run.

EXHIBIT 9 SHORT- AND LONG-RUN COST CURVES FOR A FISHING FIRM

Exhibit 9: Short- and Long-Exhibit 9: Short- and Long-Run Cost Curves for a Run Cost Curves for a

Fishing FirmFishing Firm1. What is the relationship between the short-run ATC (SRATC) curves and the long-run ATC curve (LRATC)?• The LRATC curve is tangent to lowest points on each of the various possible SRATC curves.

• The LRATC curve is also called an envelope curve.

2. Why are there multiple SRATC curves, but only one LRATC curve?

• Recall that in the short-run, firms can change the quantity of some, but not all of the resources they use to produce goods and services.

Exhibit 9: Short- and Exhibit 9: Short- and Long-Run Cost Curves for Long-Run Cost Curves for

a Fishing Firma Fishing Firm

• Each SRATC curve represents a commitment to a different size of production facility.

• Once a firm has chosen a short-run cost curve, the firm is committed to it until the fixed cost items associated with the chosen ATC depreciate.

• The long-run is the time interval during which producers can change the quantity of all of the resources they use to produce goods and services.

• The single LRATC curve represents the cost options open to the firm before any specific commitment is made.

Long-Run Average Long-Run Average Total Total

Cost CurveCost Curve1. In what portion of the long-run average total cost curve are there economies of scale in production?• Along the initial downward-sloping portion of the long-run average total cost curve, where average total cost falls as output increases.

2. In what portion of the long-run average total cost curve are there diseconomies of scale in production?• Along the upward-sloping portion of the long-run average total cost curve, where average total cost rises as output increases.

Long-Run Average Long-Run Average Total Total

Cost CurveCost Curve

RightsizingRightsizing

Rightsizing

• Implementing a firm’s decision to adjust its plant size to produce current output in the most efficient manner possible.

RightsizingRightsizingSuppose that a firm is currently producing high up on the steeply downward-sloping portion of its average cost curve. Is this evidence that the firm has recently undergone rightsizing? • No. The firm’s output is too small for its current production facility.

RightsizingRightsizingSuppose that a firm is currently producing high up on the steeply downward-sloping portion of its average cost curve. Is this evidence that the firm has recently undergone rightsizing? • By switching to a smaller production facility the firm may be able to reduce its average costs.

DownsizingDownsizing

Downsizing

• Implementing a firm’s decision to decrease its plant size to produce current output in the most efficient manner possible.

DownsizingDownsizingSuppose that a firm is currently producing high up on the steeply upward-sloping portion of its average cost curve. Is this evidence that the firm can produce current output more efficiently by downsizing?

• No. The firm’s output is too large for its current production facility.

DownsizingDownsizingSuppose that a firm is currently producing high up on the steeply upward-sloping portion of its average cost curve. Is this evidence that the firm can produce current output more efficiently by downsizing?

• No. The firm’s output is too large for its current production facility.

EXHIBIT 10 AVERAGE COST CURVES FOR IRRIGATED COTTON FARMS, TEXAS HIGH PLAINS

Source: J. Patrick Madden, Economies of Size in Farming, U.S. Department of Agriculture, AER No. 107, Washington, D.C., February 1967, p. 44.

Exhibit 10: Average Cost Exhibit 10: Average Cost Curves for Irrigated Cotton Curves for Irrigated Cotton Farms, Texas High PlainsFarms, Texas High PlainsIf a Texas high plains cotton farmer had a one-person farm and used six-row equipment, are his average costs always going to be higher than for farms with more people working?• No. At a $60,000 income, cost per dollar of gross income is as low or lower than for farms with more people working.

c hapter 8

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