Principles of Microeconomics, Econ 1021A, Lecture 9

Principles of Microeconomics, Economics 1021A, Lecture 9: Output and Cost

• The lecture covers output and cost, time frames (short-run and long-run), and firm behaviour.
• Key topics include distinguishing economic and accounting definitions of costs and profits, explaining and differentiating short- and long-run cost schedules, and discussing the economic significance of understanding production costs.
• Firms are institutions that hire factors of production to produce and sell goods/services.
• The goal is to predict firm behaviour, based on the assumption that firms maximize profit and minimize costs.

Profit

• Profit is revenue minus cost.
• Two types of profit are:
  • Accounting profit: Total revenue minus accounting cost.
  • Economic profit: Total revenue minus total economic cost.
• Accounting profit ignores opportunity cost.
• Economic profit includes opportunity cost.

Firm Opportunity Costs

• Opportunity cost of production is the value of the best alternative use of resources.
• It is the total economic cost of using resources, whether:
  • Bought in the market (includes raw materials, employee wages, leased capital, financing costs).
  • Supplied by the firm's owner (entrepreneurship, labor).
  • Owned by the firm (capital - economic depreciation, interest forgone, implicit rental rate).

Short-run and Long-run

• Short-run and long-run are not precise measures of time.
• The key distinction in decisions is what is fixed versus what's flexible.
• What's fixed does not change during that time period.
• What's flexible can be adjusted.
• Persistence of decision's consequences.

Short-run

• The quantity of one or more resources used in production (e.g., capital stock) is fixed in the short run.
• Variable inputs (e.g., labor, raw materials, energy) are adjustable in the short run.
• The quantity of capital is not adjustable in the short run.
• Short-run decisions don't affect future options.
• A firm cannot immediately sell, buy, or exit/enter a market in the short run.

Long-run

• All quantities of resources, including capital stock and plant size, are adjustable in the long run.
• Long-run decisions affect future options and can be sunk costs.
• Sunk costs are costs incurred in the past that cannot be recovered.
• Sunk costs are irrelevant to current decisions.

Short-run Output

• Total Product (TP): total output produced in a given period.
• Marginal Product (MP) of labor: change in total product from a 1-unit increase in the quantity of labor employed, with all other inputs remaining the same.
• Average Product (AP) of labor: output per unit of labor employed (total output divided by the quantity of labor).

Short-run Cost

• Total cost (TC) = economic cost of all inputs used to produce a given amount of output.
• Marginal cost (MC) is the increase in total cost from a one-unit increase in output.
• Average cost (AC) is cost per unit of output (total cost divided by total product).

Short-run Total cost: Breakdown

• Total cost (TC) is the sum of total fixed cost (TFC) and total variable cost (TVC).
• Total fixed cost (TFC) does not change with output.
• Total variable cost (TVC) increases with output.

Cost Curves Reflect Output Curves

• Total product is steeper at low output and flatter at high output because of diminishing marginal product.
• Variable cost is the wage multiplied by the quantity of labor.
• Variable cost increases as labor requirements grow.

Short-run Cost Curves

• Cost curves plot costs against output quantities.
• To get cost on the y-axis, flip the last slide's TVC graph and reinsert the total fixed cost.
• Add up the curves to find a convex total cost curve.

Marginal Cost

• Marginal cost (MC): increase in total cost resulting from a one-unit increase in total product.
• Over the increasing marginal product range, marginal cost falls as output increases.
• Over the diminishing marginal product range, marginal cost rises as output increases.

Average Cost

• Average cost measures costs per unit of output produced.
• Types of average cost:
  • Average fixed cost (AFC).
  • Average variable cost (AVC).
  • Average total cost (ATC).
• ATC = AFC + AVC = (TFC + TVC)/Q

Average Cost Curve Shapes

• As output increases, average fixed cost (AFC) decreases.
• But average variable cost (AVC) initially falls and then increases.

U-shaped Average Variable Cost

• AVC curve is U-shaped because marginal product declines.
• Initially, marginal worker is more productive than average.
• The incremental cost of output is lower than average variable cost, and AVC falls.
• Eventually, marginal worker is less productive than average.
• The incremental cost of output is higher than average variable cost, and AVC rises.

U-shaped Average Total Cost

• The ATC curve is U-shaped for two reasons:
  • Diminishing marginal product and U-shaped average variable cost.
  • Spreading fixed costs across larger output (so AFC falls as output grows).

Cost Curve Shifts

• Technology shifts both product and cost curves. Increased productivity shifts cost curves downward.
• Prices of factors of production shift cost curves: higher fixed costs shift the total and ATC curves upward; higher variable costs shift all three cost curves upward.

Long-run Cost

• In the long run, all inputs are variable.
• The production function is very important for understanding long-run cost behavior.
• A firm's production function (e.g. for sweaters) relates capital inputs and labor inputs to output.
• A firm can choose among different plants/amounts of capital with distinct short-run cost curves.
• LRATC: long-run average total cost; the lowest average cost across all different levels of capital.

Scale Economies

• Economies and diseconomies of scale affect production decisions, the market structure, and supply curves.
• Economies of scale: long-run average costs drop as output increases.
• Diseconomies of scale: long-run average costs rise as output increases.
• Constant returns to scale: long-run average costs remain constant as output increases. (This occurs where the effect of economies and diseconomies balance out).

Minimum Efficient Scale

• The minimum efficient scale is the smallest quantity of output that minimizes long-run average costs.