CHAPTER 7

Short-Run Costs
and Output Decisions

Prepared by: Fernando

Quijano and Yvonn Quijano

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Decisions Facing Firms

DECISIONS are based on INFORMATION

1. The quantity of output to 1. The price of output
supply

2. How to produce that 2. Techniques of production

output (which technique available*
to use)

3. The quantity of each 3. The price of inputs*

input to demand

*Determines production costs

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Costs in the Short Run

The short run is a period of time

for which two conditions hold:
1. The firm is operating under a fixed
scale (fixed factor) of production, and
2. Firms can neither enter nor exit an
industry.
In the short run, all firms have
costs that they must bear
regardless of their output. These
kinds of costs are called fixed
costs.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Costs in the Short Run

Fixed cost is any cost that does not

depend on the firms level of output. These
costs are incurred even if the firm is
producing nothing.

Variable cost is a cost that depends on the

level of production chosen.

TC TFC TVC
Total Cost = Total Fixed + Total Variable
Cost Cost

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Fixed Costs

Firms have no control over fixed

costs in the short run. For this
reason, fixed costs are sometimes
called sunk costs.
Average fixed cost (AFC) is the
total fixed cost (TFC) divided by the
number of units of output (q):

TFC
AFC
q

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Short-Run Fixed Cost (Total and
Average) of a Hypothetical Firm
(1) (2) (3)
q TFC AFC (TFC/q)
0 $1,000 $
1 1,000 1,000
2 1,000 500
3 1,000 333
4 1,000 250
5 1,000 200

AFC falls as output

rises; a phenomenon
sometimes called
spreading overhead.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Variable Costs

The total variable cost curve is a graph

that shows the relationship between total
variable cost and the level of a firms output.

The total variable

cost is derived from
production
requirements and
input prices.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Derivation of Total Variable Cost Schedule
from Technology and Factor Prices

UNITS OF
INPUT REQUIRED
(PRODUCTION FUNCTION)
TOTAL VARIABLE
COST ASSUMING
USING PK = $2, PL = $1
PRODUCT TECHNIQUE K L TVC = (K x PK) + (L x P L)
$10
1 Units of A 4 4 (4 x $2) + (4 x $1) = $12
output B 2 6 (2 x $2) + (6 x $1) =
$18
2 Units of A 7 6 (7 x $2) + (6 x $1) = $20
$24
output B 4 10 (4 x $2) + (10 x $1) =

3 Units of A 9 6 (9 x $2) + (6 x $1) =

output
The B 6 curve14shows the
The total variable cost curve shows the cost of
variable cost (6 x $2) + (14ofx $1) = $26
cost
production using the best available technique at
each output level, given current factor prices.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Marginal Cost

Marginal cost (MC) is the increase

in total cost that results from
producing one more unit of output.
Marginal cost reflects changes in
variable costs.

TC TFC TVC
M C
Q Q Q

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Derivation of Marginal Cost from
Total Variable Cost
TOTAL VARIABLE COSTS MARGINAL COSTS
UNITS OF OUTPUT ($) ($)
0 0 0
1 10 10
2 18 8
3 24 6

Marginal cost measures the additional

cost of inputs required to produce each
successive unit of output.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Shape of the Marginal Cost Curve
in the Short Run
The fact that in the short run every firm is
constrained by some fixed input means
that:
1. The firm faces diminishing returns to variable
inputs, and
2. The firm has limited capacity to produce
output.
As a firm approaches that capacity, it
becomes increasingly costly to produce
successively higher levels of output.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Shape of the Marginal Cost Curve
in the Short Run
Marginal costs ultimately increase with
output in the short run.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Graphing Total Variable Costs and
Marginal Costs
2002 Prentice Hall Business Publishing
Total variable costs always
increase with output. The
marginal cost curve shows
how total variable cost
changes with single unit
increases in total output.
Below 100 units of output,
TVC increases at a
decreasing rate. Beyond
100 units of output, TVC
increases at an increasing
rate.
Principles of Economics, 6/e Karl Case, Ray Fair
 Average Variable Cost

Average variable cost (AVC) is the

total variable cost divided by the
number of units of output.

Marginal cost is the cost of one

additional unit. Average variable
cost is the average variable cost per
unit of all the units being produced.

Average variable cost follows

marginal cost, but lags behind.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Relationship Between Average Variable
Cost and Marginal Cost
At 200 units of output, AVC is
minimum, and MC = AVC.
2002 Prentice Hall Business Publishing
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.
Principles of Economics, 6/e Karl Case, Ray Fair
 Short-Run Costs of a Hypothetical Firm

(3) (4) (6) (7) (8)

(1) (2) MC AVC (5) TC AFC ATC
q TVC ( TVC) (TVC/q) TFC (TVC + TFC) (TFC/q) (TC/q or AFC + AVC)

0 $ 0 $ $ $ 1,000 $ 1,000 $ $
1 10 10 10 1,000 1,010 1,000 1,010
2 18 8 9 1,000 1,018 500 509

3 24 6 8 1,000 1,024 333 341

4 32 8 8 1,000 1,032 250 258

5 42 10 8.4 1,000 1,042 200 208.4

500 8,000 20 16 1,000 9,000 2 18

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Total Costs

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.
TC TFC TVC

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Average Total Cost

Average total cost (ATC) is

total cost divided by the
number of units of output
(q).

ATC AFC AVC

TC TFC TVC
ATC
q q q
Because AFC falls with
output, an ever-declining
amount is added to AVC.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Relationship Between Average Total
Cost and Marginal Cost
If marginal cost is below
average total cost, average
total cost will decline
toward marginal cost.
If marginal cost is above
average total cost, average
total cost will increase.
Marginal cost intersects
average total cost and
average variable cost
curves at their minimum
points.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Output Decisions: Revenues, Costs,
and Profit Maximization
In the short run, a competitive firm faces a
demand curve that is simply a horizontal line at
the market equilibrium price.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Total Revenue (TR) and
Marginal Revenue (MR)
Total revenue (TR) is the total amount that a firm
takes in from the sale of its output.

TR P q
Marginal revenue (MR) is the additional revenue
that a firm takes in when it increases output by
one additional unit.
In perfect competition, P = MR.

TR P (q )
M R P
q q
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Comparing Costs and Revenues to
Maximize Profit
The profit-maximizing level of output for all
firms is the output level where MR = MC.
In perfect competition, MR = P, therefore,
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 key idea here is that firms will produce
as long as marginal revenue exceeds
marginal cost.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Profit Analysis for a Simple Firm

(6) (7) (8)

(1) (2) (3) (4) (5) TR TC PROFIT
q TFC TVC MC P = MR (P x q) (TFC + TVC) (TR 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

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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 firms short-run supply curve.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair