Microeconomics [Chapter 10] Output and costs

Prepared by Dr. L. Al-Khalifa

1. What is a firm? - A firm is an organization that hires factors of productions and organizes them to produce and sell goods and services. - A firms goal is to maximize profit. Profit = total revenues total opportunity costs 2. How Economists calculate economic profit? - The decisions firms make are based on opportunity cost and economic profit. - Economic profit = Total revenues all opportunity costs of production - Opportunity costs are divided into explicit and implicit costs. - Explicit costs are paid directly with money (rents and wages for examples) - Implicit costs are not paid directly with money. They result from the uses of the capital, the financial resources or the time of the owners of the firm. - Implicit costs include: 1. Depreciation (the change in the capital value) 2. Interests forgone (when owners take their money out of the bank) 3. Normal profit (profit or income the owners gave up to run their business) Sunk costs are irrelevant to a firm's decisions. An example of a sunk cost is the past cost of buying new plant. 3. The short-run technology constraints: - To increase output in the short-run, the firm must increase variable inputs (labor). - An increase in labor increases total product (TP). - Average Product of labor (AP) increases in the beginning and decreases later. - Average Product = Total Product (output) divided by the amount of labor. AP = TP Number of labor - Marginal Product of labor (MP) increases in the beginning and decreases later. Marginal Product is the increase in Total Product (output) resulting from one-unit increase in the amount of labor employed. MP = Change in TP Change in the number of labor 4. The law of diminishing marginal return: The law of diminishing marginal return states that as a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes. AP increases when MP exceeds AP AP decreases when MP is smaller than AP AP is at a maximum when MP = AP

Output (TP)

TP
TP increase slowly later due to decreasing marginal returns

Output(TP) AP when MP> AP AP when MP< AP AP at a maximum when AP=MP

100 50
TP increase fast first due to Increasing marginal returns

100 50
MP

AP Labor
12 3 4 5 6 7 8

0
1234567

Labor

Microeconomics [Chapter 10] Output and costs

Prepared by Dr. L. Al-Khalifa

5. What are the short-run costs? A. Total cost (TC), is the cost of all productive resources used by the firm. It can be divided into: 1. Total Fixed Cost (TFC), is the cost of the firms fixed inputs (capital). 2. Total Variable Cost (TVC), is the cost of the firms variable input (labor) 3. Total Cost equals Total Fixed Cost plus Total Variable Cost.

Total Costs 500 300 200 100 0 2 4 6 8 10 12

TC TVC

TC = TFC + TVC TVC = TC - TFC

The vertical distance = TFC TC and TVC increase slowly at the beginning and fast later due to the diminishing marginal return TFC TFC = TC - TVC 14 16 18 Total Product (output) Thousands of units per day

B. Average Costs can be divided into: 1. Average Total Cost (ATC), is total cost per unit of output; TC Output 2. Average Variable Cost (AVC), is variable cost per unit of output; TVC Output 3. Average Fixed Cost (AFC), is Fixed cost per unit of output; TFC Output C. Marginal Cost Marginal Cost (MC) is the increase in total cost resulting from one unit increase in output; TC Output

Average and Marginal Costs ($ per output) 3 2 1

MC Cuts AVC and ATC at their lowest point ATC = AVC +AFC AVC = ATC - AFC The vertical distance between ATC and AVC = AFC. It decreases as output increases because TFC decreases.

AFC = ATC AVC, AFC as output 0 100

-

200

300

400

500

Output (quantity per day)

As output increases Average fixed cost decreases.

Microeconomics [Chapter 10] Output and costs

Prepared by Dr. L. Al-Khalifa

ATC and AVC are U shapes. They decrease first and increase later due to diminishing marginal return. MC curve cuts AVC and ATC curves at their lowest points.

6. What is the relationship between cost curves and product curves? Average product & marginal product

AP MP Labor Marginal cost $ Average variable cost MC AVC

Output The shapes of a firms cost curve are determined by the technology it uses: - Marginal cost at its minimum at the same output for which marginal product is at its maximum. - The output range over which marginal cost is declining is the same range over which the marginal product increases; and the output range over which marginal cost increases is the same range over which the marginal product declines. - Average variable cost at its minimum at the same output for which average product is at its maximum. - The output range over which AVC is declining is the same range over which the AP increases; and the output range over which AVC increases is the same range over which the AP declines. 7. What are the factors that shift the costs curves? A. A technology advance that increases productivity shifts the product curves upward and the cost curves downward. B. Change in the prices of resources shift the cost curves as the following: - An increase in a fixed cost shifts the total fixed cost (TFC), total cost (TC), and average total cost (ATC) and Average fixed cost (AFC) upwards. It does not affect MC and AVC - An increase in a variable cost shifts the total cost (TC), total variable cost (TVC), average total cost (ATC), Average variable cost (AVC) and marginal cost (MC) curves upward. 8. The long-run cost - In the long run, a firm can vary both the quantity of labor and the quantity of capital. So in the long-run all the firm costs are variable. - Long run cost is the cost of production when a firm used the economically efficient quantities of labor and capital. 9. What is the production function?

Microeconomics [Chapter 10] Output and costs

Prepared by Dr. L. Al-Khalifa

It is a table that shows the relationship between different amounts of capital and labor the firm can use and the maximum amount of output that it can be produced. Example: Labor Output (Sweaters per day) (workers per day) Plant 1 Plant 2 Plant 3 Plant 4 1 4 10 13 15 2 10 15 18 20 3 13 18 22 24 4 15 20 24 26 5 16 21 25 27 Knitting machines 1 2 3 4 Suppose that the wage of labor is $25 per day and the rent of machine is $25 per day. The Following table gives you the average total cost (total cost divided by output): Labor Output (Sweaters per day) (workers per day) Plant 1 Plant 2 Plant 3 Plant 4 1 $50 =12.5 $75 = 7.5 $100 =7.7 $125 =8.3 4 10 13 15 2 75 = 7.5 100 =6.6 125 =6.9 150 =7.5 10 15 18 20 3 100 =7.7 125 =6.9 150 =6.8 175 =7.2 13 18 22 24 4 125 = 8.3 150 =7.5 175 =7.2 200 =7.6 15 20 24 26 5 150 =9.4 175 =8.3 200 =8 225 =8.3 16 21 25 27 Knitting machines 1 2 3 4 - The economically plant size for producing a given output is the one that has the lowest average total cost. - For example the economically efficient method to use to produce 15 sweaters a day is plant 2, according to the above table. 10. What is the long-run average cost curve LRAC? - LRAC is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied. - LRAC is derived from the lowest points of the short-run average total cost curves - LRAC is a U shape. It is a planning curve that tells the firm the best plant size to choose to produce a given output. Example: Average total cost Plant 3 Plant 2 Plant 1 2

LRAC
1

To produce 5 units, the firm should choose plant size 1 To produce 10 units, the firm should choose plant size 2 To produce 15 units, the firm should choose plant size 3

Economies of scale Diseconomies of scale

10

15

Output

11. What is the difference between economies and diseconomies of scale?

Microeconomics [Chapter 10] Output and costs

Prepared by Dr. L. Al-Khalifa

Economies of scale occur at the range of output over which LRAC falls. Diseconomies of scale occur at the range of output over which LRAC rises.

12. What are the returns to scale? - Returns to scale are the changes in output resulting from changing all inputs by the same percentage The three possibilities for returns to scale are: 1. Increasing returns to scale: the percentage change in the firm's output is greater than the percentage change in inputs. In this case there are economies of scale. 2. Constant returns to scale: the percentage change in the firm's output equals the percentage change in inputs. In this case there are no economies of scale and no diseconomies of scale. 3. Decreasing returns to scale: the percentage change in the firm's output is less than the percentage change in inputs. In this case there are diseconomies of scale. Chapter 10 Exercise 1. Average product of labor is the output produced per unit of_______, and marginal product of labor is the increase in output that one unit increase in ___________. a. all inputs, all inputs. b. variable input, variable input c. fixed input, all inputs d. variable input, the fixed input 2. The law of diminishing marginal returns says that as the firm uses more of ______, with a given quantity of ______, _______ product eventually decreases. a. a fixed input, variable inputs, marginal b. all inputs, capital, average c. a variable input, fixed inputs, marginal d. a variable input, fixed inputs, average 3. The marginal product of labor equals the average product of labor when__________________________. a. the average product of labor is at its maximum b. the average product of labor is at its minimum c. the marginal product of labor is at its maximum d. None of the above answer are correct because marginal product of labor never equals the average product of labor 4. In the short run,_____________________________. a. there is at least one fixed input and the other inputs can be varied. b. all inputs are variable c. all inputs are fixed d. one year or less elapses 5. In the long run,_____________________________. a. some inputs are variable and some inputs are fixed c. all inputs are fixed b. all inputs are variable d. technology is constant

6. Which of the following statement is true? a. When average product exceeds marginal product, marginal product is rising. b. When average product is rising, marginal product is rising. c. When marginal product exceeds average product, average product is rising. d. When marginal product is falling, average product is falling. 7. Average fixed cost ___________________________________________. a. initially declines and then rises with increasing output b. continually rises with increasing output. c. continually declines with increasing output.

Microeconomics [Chapter 10] Output and costs

Prepared by Dr. L. Al-Khalifa

d. remains unchanged with increasing output. 8. Marginal cost is the increase in total _________that results from one unit increase in ________. a. cost, output b. fixed cost, the fixed input c. fixed cost, output d. variable cost, the variable input 9. The marginal cost curve passes through the a. minimum points of the average total cost curve and the average variable cost curve. b. minimum points of the average total cost curve and the average fixed cost curve. c. minimum points of the average variable cost curve and the average fixed cost. d. maximum points of the total cost curve and the total variable cost curve. 10. Pats Catering finds that when it caters 10 meals a week, its total cost is $3,000. If, at this level of output , Pat has a total varalbe cost of $2,500, what is Pats fixed cost? a. $250 b. $300 c. $500 d. $3,000 Use table 1 for the next three questions Output Total variable Total cost cost 3 $15 $21 4 18 24 11. The average variable cost of producing the third unit is ________. a. $6 b. $5 c. $3 d. $2 12. The marginal cost of producing the fourth unit is ________. a. $6 b. $5 c. $3 d. $2 13. The average fixed cost of the third unit is_______. a. $6 b. $5 c. $3 d. $2 14. If the company produces no output, it must pay __________. a. no costs b. a small amount of variable cost c. its fixed cost d. its owners a normal profit 15. A farmer discover that the total cost of growing 50 acres of eggplant is $50,000 and the total cost of growing 51 acres of eggplant is $52,000. the marginal cost of the 51th acre of eggplant is _______________. a. $52,000 b. $50,000 c. $2,000 d. $1,000 16. When a firm experiences increasing returns to scale, its________________________. a. long-run average cost curve slopes downward b. short-run marginal cost curve slopes downward c. short-run average total cost curve slopes downward d. long-run average cost curve slopes upward 17. Features of a firm's technology that lead to falling long-run average cost as output increases are_________________________. a. constant returns to scale b. economies of scale c. diminishing returns d. diseconomies of scale. 18. If all inputs are increased by 5 percent and output increases by 8 percent, then all the following are true except___________________________. a. the long run average cost curve slopes upwards b. the firm experiences economies of scale c. the long run average cost curve slopes downwards d. the firm experiences increasing returns to scale