Chapter Microeconomics 8 Outline 10/31/07
CHAPTER #8 - Costs and the Changes at Firms over Time Total costs The sum of variable costs and fixed costs Fixed costs Costs of production that do not depend on the quantity of production. Variable costs Costs of production that vary with the quantity of production Fixed costs are the part of total costs that do not vary with the amount produced in the short run, which include the cost of factories, land, machines, and all other things that do not change when production changes in the short-run. Variable costs include wage payments for workers, gasoline for trucks, and other things that change when the amount produced changes.
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Remember, TC = FC + VC The Short Run and the Long Run Short run The period of time during which it is not possible to change all inputs to production; only some inputs, such as labor, can be changed. Long run Long enough that all inputs, including capital can be changed. The minimum period of time during which all inputs to production can be changed. Costs Variable costs increase with output Variable costs are shown by the distance between the total costs curve and the fixed costs curve. Marginal Cost Marginal cost The change in total costs due to a one-unit change in quantity produced. Average Cost Average total cost (ATC) Total costs of production divided by the quantity produced (also called cost per unit). Cost/unit Average variable cost (AVC) Variable costs divided by the quantity produced Average fixed cost (AFC) Fixed costs divided by the quantity produced. We use the average total cost most frequently o The other two are important for knowing whether to shut down a firm or keep it open when it is losing money
Costs Depend on the Firm's Production Function Cost information is determined by how much input of labor and capital it takes to produce output and by the price of capital and labor. The Production Function Production function A relationship that shows the quantity of output for any given amount of input. Marginal product of labor Change in production that can be obtained with an additional unit of labor. o Decreasing marginal product of labor is called diminishing returns to labor. Increasing marginal product of labor is called increasing returns to labor. For low levels of labor input, the marginal product of labor increases: Output increases by more from a given change in labor input as labor increases o At low levels of production, increasing marginal product of labor is a possibility because the firm's capital can be better utilized. Marginal product of labor Increasing Decreasing Marginal cost Decreasing Increasing
Average product of labor The quantity produced divided by the amount of labor input o Quantity produced Total product o Average product of labor = (Q / L); where Q is total product and L is labor input Review Costs depend on the firm's production function. When marginal product of labor is decreasing, marginal cost is increasing.
AVERAGE COST CURVES Information about average cost can be turned into an informative graph. o Cost curves: Marginal cost Average total cost Average variable cost The marginal product of each additional worker increases at lower levels of production and then decreases at higher levels of production Average total cost curve U-shaped
When marginal cost is less than average total cost, then average total cost is declining; when marginal cost is greater than average total cost, then average total cost is increasing. MARGINAL VERSUS AVERAGE IN THE CLASSROOM A below-average contribution causes the average to fall; on the other hand, an aboveaverage contribution causes the average to rise. o The relationships between marginal cost and average total cost or average variable cost say nothing more than this
GENERIC COST CURVES Generic cost curve The general properties of this curve characterize virtually all firms, not just one firm in one specific industry o There isn't a scale (for the axes) on this graph, because the chart describes all firms The gap between average total cost and average variable cost is average fixed cost, or fixed costs divided by quantity, (FC / Q). o Since fixed costs do not change, the ratio FC / Q declines as Q increases. It's helpful to use the following checklist when you draw this graph: 1. Make sure the marginal cost curve cuts through the average total cost curve and the average variable cost curve at their minimum points and understand the reason for this 2. Make sure the distance between average total cost and average variable cost gets smaller as you increase the amount of production 3. Put a small dip on the left-hand side of the marginal cost curve before the upward slope begins. This makes your curve look more interesting and allows for the possibility of decreasing marginal cost at very low levels of production. Review The marginal cost curve and the average cost curves are closely related. The marginal cost curve cuts through both the average total cost (ATC) curve and the average variable cost (AVC) curve at their lowest points. Another important property of a cost curve diagram is that the gap between average total cost and average variable cost gets smaller as more is produced. The relationships between marginal cost and the two average cost curves are represented by the following general rule: When marginal cost is less than average total cost (or average variable cost), then average total cost (or average variable cost) is declining; when marginal cost is greater than average total cost (or average variable cost), then average total cost (or average variable cost) is increasing.
COSTS AND PRODUCTION: THE SHORT RUN If it is maximizing profits, a firm will choose a quantity to produce in the short run such that its marginal cost equals the market price (P = MC). o When the firm produces this quantity, are its profits positive or negative? o We need to use cost curves to find the firm's profits THE PROFIT OR LOSS RECTANGLE Profits = TR TC The Total Revenue Area Total Revenue = P * Q o Total revenue can be represented by the area of a rectangle with width Q and height P (hence, P * Q = Area) The Total Costs Area (Average Total Cost) * (Q) = TC The quantity produced (Q) is the width of the rectangle, and average cost total (ATC) is the height of the rectangle. Total costs are given by the area of the rectangle with the hash marks. Profits or Losses Look at the difference between two rectangles The market price is at a point where the intersection of the marginal cost curve and the market price line gives a quantity of production for which average total cost is above the price. The firm will produce the quantity that equates price and marginal cost, as shown by the intersection of the price line and the marginal cost curve Total costs = (average total cost) * (Q) The difference between total revenue and total costs is profit, but in this case profits are negative, or there is a loss. THE BREAKEVEN POINT Breakeven point The point at which price equals the minimum of average total cost. o P = ATC o Firm earns positive profits if the price is greater than the breakeven point (P > ATC) o Firm has negative profits if the price is lower than the breakeven point (P < ATC)
THE SHUTDOWN POINT The firm should shut down if the price falls below the minimum point of the average variable cost curve and is not expected to rise again. o In this case, the market price equals marginal cost at a quantity where total revenue (P * Q) is smaller than the variable costs (AVC * Q) of producing at that point. When total revenue is less than variable costs, it makes sense to stop producing If P > AVC, because total revenue is greater than variables costs, shutting down would eliminate this extra revenue keep producing in the short run. A sunk cost is a cost that you have committed to pay and that you cannot recover The shutdown point is the point at which price equals the minimum of average variable cost. o P = AVC If profits are negative and the price is greater than average variable cost, keep producing in the short run
REVIEW Profits can be represented as a rectangle on the cost curve diagram. So can losses. The profit or loss rectangle is the difference between the revenue rectangle and the loss rectangle At the breakeven point, profits are zero. When P < AVC, profits are maximized by shutting down.
COSTS AND PRODUCTION: THE LONG RUN
THE EFFECT OF CAPITAL EXPANSION ON TOTAL COSTS After expansion, total costs will be higher at very low levels of output, where fixed costs dominate, but will be lower at high levels of output, where variable costs dominate. EFFECTS OF A CAPITAL EXPANSION ON AVERAGE TOTAL COST Average total cost (ATC) is total costs (TC) divided by the quantity (Q). If total costs increase at a given quantity of output, so will average total cost. If total costs decrease at a given level of output, so will average total cost.
THE LONG-RUN ATC CURVE Long-run average total cost curve The curve that traces out the short-run average total cost curves, showing the lowest average total cost for each quantity produced as the firm expands in the long run. o The other average total cost is called the short-run average total cost curve or simply the average total cost curve. CAPITAL EXPANSION AND PRODUCTION IN THE LONG RUN If the firm can increase its profits by expanding its capital and its output, then we predict that it will do so. Likewise, if the firm can increase profits by reducing capital and its output, it will do so. The firm adjust the amount of capital to maximize profits (long-run) THE MIX OF CAPITAL AND LABOR Long-run Can adjust capital and labor The firm will use more capital relative to labor if the cost of capital declines relative to that of labor. o Converesely, the firm will use less capital relative to labor if the cost of capital rises relative to that of labor REVIEW In the long run, the firm can expand by increasing its capital. Fixed costs increase and variable costs decline at each level of production as the firm expands its capital. Thus, total costs, and average total cost, are higher at low levels of production and lower at high levels of production. The long-run average total cost curve traces out the points on the lowest short-run average total cost curve for each level of production
ECONOMIES OF SCALE When all inputs (capital and labor) increase, we say that the scale of the firm increases. Economies of scale A situation in which long-run average total cost declines as the output of a firm increases o We say that there are economies of scale, or increasing returns to scale, if longrun average total cost falls as the scale of the firm increases Diseconomies of scale A situation in which long-run average total cost increases as the output of a firm decreases. In other words, decreasing returns to scale happens if longrun average total cost rises as the scale of the firm increases. Constant returns to scale A situation in which long-run average total cost is constant as the output of a firm changes. The situation where long-run average total cost neither rises nor falls.
DETERMINING WHETHER A FIRM HAS ECONOMIES OR DISECONOMIES OF SCALE As the scale of a firm increases, the work can be divided into different tasks and some members of the labor force can specialize in each task. If the long-run average total cost curve slopes downward, we say there are economies of scale. If the long-run average total cost curve slopes upward, we say there are diseconomies of scale. If the long-run average total cost curve is flat, we say there are constant returns to scale. Minimum efficient scale The smallest scale of production for which long-run average total cost is at a minimum. MERGERS AND ECONOMIES OF SCOPE Firms can grow through mergers between one firm and another firm If product lines are similar, then mergers may be a way to reduce costs Mergers are also a common way for firms to combine different skills or resources to develop new products. Combining different types of firms to reduce costs or create new products is sometimes called economies of scope REVIEW Economies of scale are nothing more than a downward-sloping long-run average total cost curve. Economies of scale may occur because of the specialization that the division of labor in larger firms permits Although economies of scale probably exist over some regions of production, the evidence indicates that as firms grow very large, diseconomies of scale set in Firms sometimes expand by merging with other firms.