CChapter 8hapter 8

Costs of Production

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• The character of entrepreneurship

• Total cost, total fixed cost, and total variable cost

• The law of diminishing returns

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Economic PrinciplesEconomic Principles

• Average total cost, average variable cost, average fixed cost, and marginal cost

• Economies of scale, constant returns to scale, and diseconomies of scale

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Economic PrinciplesEconomic Principles

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

• Downsizing

• The socioeconomic environment

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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.

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Variable CostVariable Cost

Variable cost

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

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EXHIBIT 1A TOTAL FIXED COST FOR THE MAXIBOAT

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EXHIBIT 1B TOTAL FIXED COST FOR THE MAXIBOAT

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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

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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?

b. A horizontal line

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Labor ProductivityLabor Productivity

Labor productivity

The output per laborer per hour

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EXHIBIT 2 TOTAL VARIABLE COSTS PER FISHING RUN

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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 _____.

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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.

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Marginal ProductMarginal Product

Marginal product

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

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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.

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The Law of The Law of Diminishing ReturnsDiminishing Returns

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.

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The Law of The Law of Diminishing ReturnsDiminishing Returns

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.

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EXHIBIT 3 TOTAL VARIABLE COST

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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.

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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.

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EXHIBIT 4A TOTAL COST CURVE

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EXHIBIT 4B TOTAL COST CURVE

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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.

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Exhibit 4: Total Cost Exhibit 4: Total Cost CurveCurve

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.

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Exhibit 4: Total Cost Exhibit 4: Total Cost CurveCurve

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.

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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.

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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.

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Average Variable CostAverage Variable Cost

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.

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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?

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

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

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Exhibit 5: Average Fixed Cost, Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Variable Cost, and Average Total Cost CurvesAverage Total Cost Curves

1. What is the difference between the ATC and AVC curves?

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

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Exhibit 5: Average Fixed Cost, Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Variable Cost, and Average Total Cost CurvesAverage Total Cost Curves

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.

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Exhibit 5: Average Fixed Cost, Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Variable Cost, and Average Total Cost CurvesAverage Total Cost Curves

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

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Marginal CostMarginal Cost

Marginal cost

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

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EXHIBIT 6A MARGINAL COST AND AVERAGE TOTAL COST CURVES

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EXHIBIT 6B MARGINAL COST AND AVERAGE TOTAL COST CURVES

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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.

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

CurvesCurves2. 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.

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

CurvesCurves2. 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.

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

CurvesCurves2. 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.

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

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

with Different Fixed Costswith Different Fixed Costs

1. 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.

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

with Different Fixed Costswith Different Fixed Costs

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.

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

with Different Fixed Costswith Different 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.

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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.

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Constant Returns to ScaleConstant Returns to Scale

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.

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Diseconomies of ScaleDiseconomies of Scale

Diseconomies of scaleIncreases 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.

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

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Exhibit 8: Economies of Scale, Exhibit 8: Economies of Scale, Diseconomies of Scale, and Diseconomies of Scale, and Constant Returns to ScaleConstant Returns to Scale

1. 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.

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Exhibit 8: Economies of Scale, Exhibit 8: Economies of Scale, Diseconomies of Scale, and Diseconomies of Scale, and Constant Returns to ScaleConstant Returns to Scale

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

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

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Exhibit 8: Economies of Scale, Exhibit 8: Economies of Scale, Diseconomies of Scale, and Diseconomies of Scale, and Constant Returns to ScaleConstant Returns 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.

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Exhibit 8: Economies of Scale, Exhibit 8: Economies of Scale, Diseconomies of Scale, and Diseconomies of Scale, and Constant Returns to ScaleConstant Returns to 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.

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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.

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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.

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Short Run and Long RunShort Run and Long Run

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.

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Short Run and Long RunShort Run and Long Run

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.

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

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

1. 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.

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

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.

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

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

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

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

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

• 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.

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

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

• 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.

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

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

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

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Long-Run Average Total Cost Long-Run Average Total Cost CurveCurve

1. 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.

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Long-Run Average Total Cost Long-Run Average Total Cost CurveCurve

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.

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RightsizingRightsizing

Rightsizing

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

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RightsizingRightsizing

Suppose 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.

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RightsizingRightsizing

Suppose 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.

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DownsizingDownsizing

Downsizing

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

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DownsizingDownsizing

Suppose 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.

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DownsizingDownsizing

Suppose 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.

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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.

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Exhibit 10: Average Cost Exhibit 10: Average Cost Curves for Irrigated Cotton Curves for Irrigated Cotton Farms, Texas High PlainsFarms, Texas High Plains

If 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.

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EXHIBIT 12 THE AVERAGE TOTAL COST (ATC) CURVES IDENTIFIED BY BUSINESSPEOPLE AS REPRESENTING THEIR PRODUCTS’ COST STRUCTURE

Source: Wilford J. Eiteman and Glenn E. Guthrie, “The Shape of the Average Cost Curve,” American Economic Review 42, no. 5 (December 1952), pp. 832–838.