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Principles of Economics Thirteenth Edition Chapter 8 Short-Run Costs and Output Decisions Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights...

Principles of Economics Thirteenth Edition Chapter 8 Short-Run Costs and Output Decisions Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Chapter 8 Short-Run Costs and Output Decisions (1 of 2) This chapter focuses on the costs of production. To calculate costs, a firm must know: – The quantity of inputs needed – How much those inputs cost Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Chapter 8 Short-Run Costs and Output Decisions (2 of 2) In their quest for profits, firms make three specific decisions involving their production. Figure 8.1 Decisions Facing Firms Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Costs in the Short Run fixed cost Any cost that does not depend on the firm’s level of output. These costs are incurred even if the firm is producing nothing. There are no fixed costs in the long run. variable cost A cost that depends on the level of production chosen. total cost (TC) Total fixed costs plus total variable costs. TC = TFC + TVC Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Fixed Costs (1 of 2) Total Fixed Cost (TFC) total fixed costs (TFC) or overhead The total of all costs that do not change with output even if output is zero. Table 8.1 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm (1) (2) (3) q TFC AFC (TFC / q) $ $ 0 100 — 1 100 100 2 100 50 3 100 33 4 100 25 5 100 20 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Fixed Costs (2 of 2) Average Fixed Cost (AFC) average fixed cost (AFC) Total fixed cost divided by the number of units of output; a per-unit measure of fixed costs. As output increases, average fixed cost declines because we are dividing a fixed number ($1,000) by a larger and larger quantity. spreading overhead The process of dividing total fixed costs by more units of output. Average fixed cost declines as quantity rises. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 8.2 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm TFC AFC = q Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Variable Costs (1 of 6) Total Variable Cost (TVC) total variable cost (TVC) The total of all costs that vary with output in the short run. total variable cost curve A graph that shows the relationship between total variable cost and the level of a firm’s output. A total variable cost curve expresses the relationship between TVC and total output. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Table 8.2 Derivation of Total Variable Cost Schedule from Technology and Factor Prices Produce Using Units of Input Units of Input Total Variable Cost Technique Required Required Assuming (Production (Production Pk = $2, PL = $1, P sub k P sub L Function) Function) TVC = (K × P ) + (L × PL ) k P sub K P sub L K L 1 unit of A 10 7 (10 × $2) + (7 × $1) = $27 output B 6 8 (6 × $2) + (8 × $1) = $20 2 units of A 16 8 (16 × $2) + (8 × $1) = $40 output B 11 16 (11 × $2) + (8 × $1) = $38 3 units of A 19 15 (19 × $2) + (15 × $1) = $53 output B 18 22 (18 × $2) + (22 × $1) = $58 In this table, total variable cost is derived from production requirements and input prices. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 8.3 Total Variable Cost Curve Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Variable Costs (2 of 6) Marginal Cost (MC) marginal cost (MC) The increase in total cost that results from producing 1 more unit of output. Marginal costs reflect changes in variable costs. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Table 8.3 Derivation of Marginal Cost from Total Variable Cost Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Variable Costs (3 of 6) The Shape of the Marginal Cost Curve in the Short Run In the short run, every firm is constrained by some fixed input that (1) leads to diminishing returns to variable inputs and (2) limits its capacity to produce. As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output. Marginal costs ultimately increase with output in the short run. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 8.4 Declining Marginal Product Implies That Marginal Cost Will Eventually Rise with Output In the short run, every firm is constrained by some fixed factor of production. A fixed factor implies diminishing returns (declining marginal product) and a limited capacity to produce. As that limit is approached, marginal costs rise. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Variable Costs (4 of 6) Graphing Total Variable Costs and Marginal Costs Total variable costs always increase with output. Marginal cost is the cost of producing each additional unit. Thus, the marginal cost curve shows how total variable cost changes with single-unit increases in total output. ΔTVC ΔTVC Slope of TVC = = = ΔTVC = MC Δq 1 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 8.5 Total Variable Cost and Marginal Cost for a Typical Firm Total variable costs always increase with output. Marginal cost is the cost of producing each additional unit. Thus, the marginal cost curve shows how total variable cost changes with single-unit increases in total output. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Variable Costs (5 of 6) Average Variable Cost (AVC) average variable cost (AVC) Total variable cost divided by the number of units of output; a per-unit measure of variable costs. TVC AVC = q Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Table 8.4 Short-Run Costs of a Hypothetical Firm (1) (2) (3) (4) (5) (6) (7) (8) q TVC MC AVC TFC TC AFC ATC (ΔTVC ) (TVC/q) (TVC + TFC) (TFC/q) Left parenthesis delta T V C right parenthesis $ $ (TC/q or AFC $ $ $ + AVC) $ 0 0.00 $— — 100.00 100.00 — — 1 20.00 $20.00 20.00 100.00 120.00 100.00 120.00 2 38.00 $18.00 19.00 100.00 138.00 50.00 69.00 3 53.00 $15.00 17.66 100.00 153.00 33.33 51.00 4 65.00 $12.00 16.25 100.00 165.00 25.00 41.25 5 75.00 $10.00 15.00 100.00 175.00 20.00 35.00 6 83.00 $8.00 13.83 100.00 183.50 16.67 30.50 7 94.50 $11.50 13.50 100.00 194.50 14.28 27.78 8 108.00 $13.50 13.50 100.00 208.00 12.50 26.00 9 128.50 $20.50 14.28 100.00 228.50 11.11 25.39 10 168.50 $40.00 16.85 100.00 268.50 10.00 26.85 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Variable Costs (6 of 6) Graphing Average Variable Costs and Marginal Costs When marginal cost is below average cost, average cost is declining. When marginal cost is above average cost, average cost is increasing. Rising marginal cost intersects average variable cost at the minimum point of AVC. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 8.6 More Short-Run Costs Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Total Costs (1 of 4) Figure 8.7 Total Cost = Total Fixed Cost + Total Variable Cost Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Total Costs (2 of 4) Adding TFC to TVC means adding the same amount of total fixed cost to every level of total variable cost. Thus, the total cost curve has the same shape as the total variable cost curve; it is simply higher by an amount equal to TFC. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Total Costs (3 of 4) Average Total Cost (ATC) average total cost (ATC) Total cost divided by the number of units of output; a per-unit measure of total costs. TC ATC = q Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 8.8 Average Total Cost = Average Variable Cost + Average Fixed Cost To get ATC, we add average fixed and average variable costs at all levels of output. Because average fixed cost falls with output, an ever- declining amount is added to AVC. Thus, AVC and ATC get closer together as output increases, but the two lines never meet. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Total Costs (4 of 4) The Relationship between Average Total Cost and Marginal Cost This relationship is the same as the relationship between A VC and MC. If MC is below ATC, ATC will decline toward MC. If MC is above ATC, ATC will increase. As a result, MC intersects ATC at ATC’s minimum point for the same reason that it intersects the AVC curve at its minimum point. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Short-Run Costs: A Review Table 8.5 A Summary of Cost Concepts Term Definition Equation Accounting costs Out-of-pocket costs, or costs as an accountant would — define them. Sometimes referred to as explicit costs. Economic costs Costs that include the full opportunity costs of all inputs. — These include what are often called implicit costs. Total fixed costs Costs that do not depend on the quantity of output — (TFC) produced. These must be paid even if output is zero. Total variable costs Costs that vary with the level of output. — (TVC) Total cost (TC) The total economic cost of all the inputs used by a firm in TC = TFC + TVC production. Average fixed costs Fixed costs per unit of output. AFC = TFC / q (AFC) Average variable Variable costs per unit of output. AVC = TVC / q costs (AVC) Average total costs Total costs per unit of output. ATC = TC / q (ATC) ATC = AFC + AVC Marginal costs (MC) The increase in total cost that results from producing one MC = ΔTC / Δq M C equals delta T C divided by delta q additional unit of output. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Output Decisions: Revenues, Costs, and Profit Maximization (1 of 2) Perfect Competition perfect competition An industry structure in which there are many firms, each small relative to the industry, producing identical products and in which no firm is large enough to have any control over prices. In perfectly competitive industries, new competitors can freely enter the market, and old firms can exit. homogeneous products Undifferentiated products; products that are identical to, or indistinguishable from, one another. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Output Decisions: Revenues, Costs, and Profit Maximization (2 of 2) Total Revenue and Marginal Revenue total revenue (TR) The total amount that a firm takes in from the sale of its product: the price per unit times the quantity of output the firm decides to produce (P × q). total revenue = price× quantity TR = P × q Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 8.9 Demand Facing a Single Firm in a Perfectly Competitive Market If a representative firm in a perfectly competitive market raises the price of its output above $5.00, the quantity demanded of that firm’s output will drop to zero. Each firm faces a perfectly elastic demand curve, d. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Total Revenue and Marginal Revenue marginal revenue (MR) The additional revenue that a firm takes in when it increases output by one additional unit. In perfect competition, the marginal revenue is equal to the price. The marginal revenue curve and the demand curve facing a competitive firm are identical. The horizontal line in Figure 8.9(b) can be thought of as both the demand curve facing the firm and its marginal revenue curve: P * = d = MR Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Comparing Costs and Revenues to Maximize Profit (1 of 2) The Profit-Maximizing Level of Output As long as marginal revenue is greater than marginal cost, even though the difference between the two is getting smaller, added output means added profit. Whenever marginal revenue exceeds marginal cost, the revenue gained by increasing output by 1 unit per period exceeds the cost incurred by doing so. The profit-maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to short-run marginal cost—the level of output at which P * = MC. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Comparing Costs and Revenues to Maximize Profit (2 of 2) The Profit-Maximizing Level of Output The profit-maximizing output level for all firms is the output level where MR = MC. In perfect competition, however, MR = P, as shown earlier. Hence, for perfectly competitive firms, we can rewrite our profit-maximizing condition as P = MC. Important note: The key idea here is that firms will produce as long as marginal revenue exceeds marginal cost. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 8.10 The Profit-Maximizing Level of Output for a Perfectly Competitive Firm If price is above marginal cost, as it is at every quantity less than 300 units of output, profits can be increased by raising output; each additional unit increases revenues by more than it costs to produce the additional output because P > MC. Beyond q * = 300, however, added output will reduce profits. At 340 units of output, an additional unit of output costs more to produce than it will bring in * revenue when sold on the market. Profit-maximizing output is thus q , the point at which P = MC. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved A Numerical Example (1 of 2) Table 8.6 Profit Analysis for a Simple Firm (1) (2) (3) (4) (5) (6) (7) (8) TR TC Profit q TFC TVC MC P = MR (P × q) (TFC + (TR − $ $ $ $ $ TVC) TC) $ $ 0 10 0 — 15 0 10 −10 1 10 10 10 15 15 20 −5 2 10 15 5 15 30 25 5 3 10 20 5 15 45 30. 15 4 10 30 10 15 60 40 20 5 10 50 20 15 75 60 15 6 10 80 30 15 90 90 0 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved A Numerical Example (2 of 2) If firms can produce fractional units, it is optimal to produce between 4 and 5 units. The profit-maximizing level of output is thus between 4 and 5 units. The firm continues to increase output as long as price (marginal revenue) is greater than marginal cost. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Short-Run Supply Curve At any market price, the marginal cost curve shows the output level that maximizes profit. Thus, the marginal cost curve of a perfectly competitive profit-maximizing firm is the firm’s short-run supply curve. This is true except when price is so low that it pays a firm to shut down—a point that will be discussed in Chapter 9. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 8.11 Marginal Cost Is the Supply Curve of a Perfectly Competitive Firm Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Review Terms and Concepts average fixed cost (A F C) total variable cost (T V C) average total cost (A T C) total variable cost curve average variable cost (A V C) variable cost fixed cost Equations: homogeneous products TC =TFC +TVC marginal cost (M C) AFC =TFC ÷ q Slope of TVC = MC marginal revenue (M R) AVC =TVC ÷ q perfect competition ATC =TC ÷ q = AFC + AVC spreading overhead TR = P× q total cost (T C) profit-maximizing level of output for total fixed costs (T F C) or overhead all firms: MR = MC total revenue (T R) profit-maximizing level of output for perfectly competitive firms: P = MC Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved