Ch07

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
CHAPTERCHAPTER 77
Prepared by: FernandoPrepared by: Fernando
Quijano and Yvonn QuijanoQuijano and Yvonn Quijano
Short-Run CostsShort-Run Costs
and Output Decisionsand Output Decisions

Decisions Facing FirmsDecisions Facing Firms
DECISIONSDECISIONS are based onare based on INFORMATIONINFORMATION
1.1. The quantity of output toThe quantity of output to
supplysupply
1.1. The price of outputThe price of output
2.2. How to produce thatHow to produce that
output (which techniqueoutput (which technique
to use)to use)
2.2. Techniques ofTechniques of
production available*production available*
3.3. The quantity of eachThe quantity of each
input toinput to demanddemand
3.3. The price of inputs*The price of inputs*
*Determines production costs*Determines production costs

Costs in the Short RunCosts in the Short Run
• TheThe short runshort run is a period of timeis a period of time
for which two conditions hold:for which two conditions hold:
1.1. The firm is operating under a fixedThe firm is operating under a fixed
scale (fixed factor) of production, andscale (fixed factor) of production, and
2.2. Firms can neither enter nor exit anFirms can neither enter nor exit an
industry.industry.
• In the short run, all firms haveIn the short run, all firms have
costs that they must bearcosts that they must bear
regardless of their output. Theseregardless of their output. These
kinds of costs are calledkinds of costs are called fixedfixed
costscosts..

Costs in the Short RunCosts in the Short Run
• Fixed costFixed cost is any cost that does notis any cost that does not
depend on the firm’s level of output. Thesedepend on the firm’s level of output. These
costs are incurred even if the firm iscosts are incurred even if the firm is
producing nothing.producing nothing.
• Variable costVariable cost is a cost that depends onis a cost that depends on
the level of production chosen.the level of production chosen.
T C T F C T V C= +
Total Cost = Total Fixed + Total Variable
Cost Cost

Fixed CostsFixed Costs
• Firms have no control over fixedFirms have no control over fixed
costs in the short run. For thiscosts in the short run. For this
reason, fixed costs are sometimesreason, fixed costs are sometimes
calledcalled sunk costssunk costs..
• Average fixed cost (Average fixed cost (AFCAFC)) is theis the
total fixed cost (total fixed cost (TFCTFC) divided by the) divided by the
number of units of output (number of units of output (qq):):
A F C
T F C
q
=

Short-Run Fixed Cost (Total andShort-Run Fixed Cost (Total and
Average) of a Hypothetical FirmAverage) of a Hypothetical Firm
• AFC falls as outputAFC falls as output
rises; a phenomenonrises; a phenomenon
sometimes calledsometimes called
spreading overheadspreading overhead..
(1)(1)
qq
(2)(2)
TFCTFC
(3)(3)
AFC (TFC/q)AFC (TFC/q)
00 $1,000$1,000 $$ −−−−
11 1,0001,000 1,0001,000
22 1,0001,000 500500
33 1,0001,000 333333
44 1,0001,000 250250
55 1,0001,000 200200

Variable CostsVariable Costs
• TheThe total variable cost curvetotal variable cost curve is a graphis a graph
that shows the relationship between totalthat shows the relationship between total
variable cost and the level of a firm’s output.variable cost and the level of a firm’s output.
• The total variableThe total variable
cost is derived fromcost is derived from
productionproduction
requirements andrequirements and
input prices.input prices.

Derivation of Total Variable Cost ScheduleDerivation of Total Variable Cost Schedule
from Technology and Factor Pricesfrom Technology and Factor Prices
• The total variable cost curve shows the cost ofThe total variable cost curve shows the cost of
production using the best available technique atproduction using the best available technique at
each output level, given current factor prices.each output level, given current factor prices.
PRODUCTPRODUCT
USINGUSING
TECHNIQUETECHNIQUE
UNITS OFUNITS OF
INPUT REQUIREDINPUT REQUIRED
(PRODUCTION FUNCTION)(PRODUCTION FUNCTION)
TOTAL VARIABLETOTAL VARIABLE
COST ASSUMINGCOST ASSUMING
PPKK = $2,= $2, PPLL = $1= $1
TVCTVC = (= (KK xx PPKK) + () + (LL xx PPLL))KK LL
11 Units ofUnits of AA 44 44 (4 x $2) +(4 x $2) + (4 x $1) =(4 x $1) = $12$12
outputoutput BB 22 66 (2 x $2) +(2 x $2) + (6 x $1) =(6 x $1) =
22 Units ofUnits of AA 77 66 (7 x $2) +(7 x $2) + (6 x $1) =(6 x $1) = $20$20
outputoutput BB 44 1010 (4 x $2) +(4 x $2) + (10 x $1) =(10 x $1) =
33 Units ofUnits of AA 99 66 (9 x $2) +(9 x $2) + (6 x $1) =(6 x $1) =
outputoutput BB 66 1414 (6 x $2) +(6 x $2) + (14 x $1) =(14 x $1) = $26$26
$10
$18
$24

Marginal CostMarginal Cost
• Marginal cost (MC)Marginal cost (MC) is the increaseis the increase
in total cost that results fromin total cost that results from
producing one more unit of output.producing one more unit of output.
• Marginal cost reflects changes inMarginal cost reflects changes in
variable costs.variable costs.
M C
T C
Q
T F C
Q
T V C
Q
= = +
∆
∆
∆
∆
∆
∆

Derivation of Marginal Cost fromDerivation of Marginal Cost from
Total Variable CostTotal Variable Cost
UNITS OF OUTPUTUNITS OF OUTPUT
TOTAL VARIABLE COSTSTOTAL VARIABLE COSTS
($)($)
MARGINAL COSTSMARGINAL COSTS
($)($)
00 00 00
11 1010 1010
22 1818 88
33 2424 66
• Marginal costMarginal cost measures themeasures the additionaladditional
cost of inputs required to produce eachcost of inputs required to produce each
successive unit of output.successive unit of output.

The Shape of the Marginal Cost CurveThe Shape of the Marginal Cost Curve
in the Short Runin the Short Run
• The fact that in the short run every firm isThe fact that in the short run every firm is
constrained by some fixed input meansconstrained by some fixed input means
that:that:
1.1. The firm faces diminishing returns to variableThe firm faces diminishing returns to variable
inputs, andinputs, and
2.2. The firm has limited capacity to produceThe firm has limited capacity to produce
output.output.
• As a firm approaches that capacity, itAs a firm approaches that capacity, it
becomes increasingly costly to producebecomes increasingly costly to produce
successively higher levels of output.successively higher levels of output.

The Shape of the Marginal Cost CurveThe Shape of the Marginal Cost Curve
in the Short Runin the Short Run
• Marginal costs ultimately increase withMarginal costs ultimately increase with
output in the short run.output in the short run.

Graphing Total Variable Costs andGraphing Total Variable Costs and
Marginal CostsMarginal Costs
• Total variable costs alwaysTotal variable costs always
increase with output. Theincrease with output. The
marginal cost curve showsmarginal cost curve shows
how total variable costhow total variable cost
changes with single unitchanges with single unit
increases in total output.increases in total output.
• Below 100 units of output,Below 100 units of output,
TVCTVC increases at aincreases at a
decreasing ratedecreasing rate. Beyond. Beyond
100 units of output,100 units of output, TVCTVC
increases at anincreases at an increasingincreasing
rate.rate.

Average Variable CostAverage Variable Cost
• Average variable cost (AVC)Average variable cost (AVC) is theis the
total variable cost divided by thetotal variable cost divided by the
number of units of output.number of units of output.
• Marginal cost is the cost ofMarginal cost is the cost of oneone
additional unitadditional unit. Average variable. Average variable
cost is the average variable cost percost is the average variable cost per
unit ofunit of all the unitsall the units being produced.being produced.
• Average variable costAverage variable cost followsfollows
marginal cost, but lags behind.marginal cost, but lags behind.

Relationship Between AverageRelationship Between Average
Variable Cost and Marginal CostVariable Cost and Marginal Cost
• When marginal cost isWhen marginal cost is
below average cost,below average cost,
average cost is declining.average cost is declining.
• When marginal cost isWhen marginal cost is
above average cost,above average cost,
average cost is increasing.average cost is increasing.
• Rising marginal costRising marginal cost
intersects average variableintersects average variable
cost at the minimum pointcost at the minimum point
ofof AVCAVC..
• At 200 units of output, AVC isAt 200 units of output, AVC is
minimum, andminimum, and MCMC == AVCAVC..

Short-Run Costs of a Hypothetical FirmShort-Run Costs of a Hypothetical Firm
(1)(1)
qq
(2)(2)
TVCTVC
(3)(3)
MCMC
((∆∆ TVCTVC))
(4)(4)
AVCAVC
((TVC/qTVC/q))
(5)(5)
TFCTFC
(6)(6)
TCTC
((TVCTVC ++ TFCTFC))
(7)(7)
AFCAFC
((TFCTFC//qq))
(8)(8)
ATCATC
(TC/q(TC/q oror AFC + AVC)AFC + AVC)
00 $$ 00 $$ −− $$ −− $$1,0001,000 $$ 1,0001,000 $$ −− $$ −−
11 1010 1010 1010 1,0001,000 1,0101,010 1,0001,000 1,0101,010
22 1818 88 99 1,0001,000 1,0181,018 500500 509509
33 2424 66 88 1,0001,000 1,0241,024 333333 341341
44 3232 88 88 1,0001,000 1,0321,032 250250 258258
55 4242 1010 8.48.4 1,0001,000 1,0421,042 200200 208.4208.4
−− −− −− −− −− −− −− −−
−− −− −− −− −− −− −− −−
−− −− −− −− −− −− −− −−
500500 8,0008,000 2020 1616 1,0001,000 9,0009,000 22 1818

Total CostsTotal Costs
• AddingAdding TFCTFC toto TVCTVC meansmeans
adding the same amount ofadding the same amount of
total fixed cost to everytotal fixed cost to every
level of total variable cost.level of total variable cost.
• Thus, the total cost curveThus, the total cost curve
has the same shape as thehas the same shape as the
total variable cost curve; ittotal variable cost curve; it
is simply higher by anis simply higher by an
amount equal toamount equal to TFCTFC..
T C T F C T V C= +

Average Total CostAverage Total Cost
• Average total cost (Average total cost (ATCATC) is) is
total cost divided by thetotal cost divided by the
number of units of outputnumber of units of output
((qq).).
A T C A F C A V C= +
A T C
T C
q
T F C
q
T V C
q
= = +
• BecauseBecause AFCAFC falls withfalls with
output, an ever-decliningoutput, an ever-declining
amount is added toamount is added to AVCAVC..

Relationship Between Average TotalRelationship Between Average Total
Cost and Marginal CostCost and Marginal Cost
• If marginal cost is belowIf marginal cost is below
average total cost, averageaverage total cost, average
total cost will declinetotal cost will decline
toward marginal cost.toward marginal cost.
• If marginal cost is aboveIf marginal cost is above
average total cost, averageaverage total cost, average
total cost will increase.total cost will increase.
• Marginal cost intersectsMarginal cost intersects
average total cost andaverage total cost and
average variable costaverage variable cost
curves at their minimumcurves at their minimum
points.points.

Output Decisions: Revenues, Costs,Output Decisions: Revenues, Costs,
and Profit Maximizationand Profit Maximization
• In the short run, a competitive firm faces aIn the short run, a competitive firm faces a
demand curve that is simply a horizontal line atdemand curve that is simply a horizontal line at
the market equilibrium price.the market equilibrium price.

Total Revenue (Total Revenue (TRTR) and) and
Marginal Revenue (Marginal Revenue (MRMR))
• Total revenue (TR)Total revenue (TR) is the total amount that a firmis the total amount that a firm
takes in from the sale of its output.takes in from the sale of its output.
T R P q= ×
M R
T R
q
=
∆
∆
=
P q
q
( )∆
∆
• Marginal revenue (MR)Marginal revenue (MR) is the additional revenueis the additional revenue
that a firm takes in when it increases output bythat a firm takes in when it increases output by
one additional unit.one additional unit.
• In perfect competition,In perfect competition, P = MRP = MR..
= P

Comparing Costs and Revenues toComparing Costs and Revenues to
Maximize ProfitMaximize Profit
• The profit-maximizing level of output for allThe profit-maximizing level of output for all
firms is the output level wherefirms is the output level where MRMR == MCMC..
• In perfect competition,In perfect competition, MRMR == PP, therefore,, therefore,
the profit-maximizing perfectly competitivethe profit-maximizing perfectly competitive
firm will produce up to the point where thefirm will produce up to the point where the
price of its output is just equal to short-runprice of its output is just equal to short-run
marginal cost.marginal cost.
• The key idea here is that firms will produceThe key idea here is that firms will produce
as long as marginal revenue exceedsas long as marginal revenue exceeds
marginal cost.marginal cost.

Profit Analysis for a Simple FirmProfit Analysis for a Simple Firm
(1)(1)
qq
(2)(2)
TFCTFC
(3)(3)
TVCTVC
(4)(4)
MCMC
(5)(5)
PP == MRMR
(6)(6)
TRTR
((PP xx qq))
(7)(7)
TCTC
((TFCTFC ++ TVCTVC))
(8)(8)
PROFITPROFIT
((TRTR −− TCTC))
00 $$ 1010 $$ 00 $$ −− $$ 1515 $$ 00 $$ 1010 $$ -10-10
11 1010 1010 1010 1515 1515 2020 -5-5
22 1010 1515 55 1515 3030 2525 55
33 1010 2020 55 1515 4545 3030 1515
44 1010 3030 1010 1515 6060 4040 2020
55 1010 5050 2020 1515 7575 6060 1515
66 1010 8080 3030 1515 9090 9090 00

The Short-Run Supply CurveThe Short-Run Supply Curve
• At any market price, the marginal cost curve shows the output levelAt any market price, the marginal cost curve shows the output level
that maximizes profit. Thus, the marginal cost curve of a perfectlythat maximizes profit. Thus, the marginal cost curve of a perfectly
competitive profit-maximizing firm is the firm’s short-run supply curve.competitive profit-maximizing firm is the firm’s short-run supply curve.

Ch07

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