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Learning Objectives

Learning Objectives

- Distinguish between the short-run and the long-run
- Explain the relationship between a firm’s output and labor employed in the short-run
- Explain the relationship between a firm’s output and costs in the short-run
- Derive and explain a firm’s short-run cost curves

Learning Objectives (cont.)

- Explain the relationship between a firm’s output and costs in the long-run
- Derive and explain a firm’s long-run average cost curve

Learning Objectives

- Distinguish between the short-run and the long-run
- Explain the relationship between a firm’s output and labor employed in the short-run
- Explain the relationship between a firm’s output and costs in the short-run
- Derive and explain a firm’s short-run cost curves

Sidney’s Sweaters Inc.

Throughout the chapter we are going to refer to Sidney’s Sweaters Inc., a producer of knitted sweaters. The firm is owned and operated by Sidney.

Decision Time Frames

The Objective: Profit Maximization

- All of the firm’s decisions are aimed at one overriding objective: maximum attainable profit.
To study the relationship between a firm’s output decision and its costs, we distinguish two decision time frames:

- The short-run
- The long-run

Decision Time Frames

The Short-Run and the Long-Run

The short-run is a time frame in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.

The long-run is a time frame in which the quantities of all inputs can be varied.

A sunk cost is irrelevant to the firm’s decisions.

Decision Time Frames

To increase output in the short-run, a firm must increase the quantity of labor employed.

Total product is the total output produced.

Marginal product is the increase in total product that result from a one-unit increase in an input.

Average product is the total product divided by the quantity of inputs.

Learning Objectives

- Distinguish between the short-run and the long-run
- Explain the relationship between a firm’s output and labor employed in the short-run
- Explain the relationship between a firm’s output and costs in the short-run
- Derive and explain a firm’s short-run cost curves

Total Product, Marginal Product, and Average Product

Total Marginal Average

Labor product product product

(workers (sweaters (sweaters per (sweaters

per day) per day) additional worker) per worker)

a 0 0

b 1 4

c 2 10

d 3 13

e 4 15

f 5 16

Total Product, Marginal Product, and Average Product

Total Marginal Average

Labor product product product

(workers (sweaters (sweaters per (sweaters

per day) per day) additional worker) per worker)

a 0 0

b 1 4

c 2 10

d 3 13

e 4 15

f 5 16

4

6

3

2

1

Total Product, Marginal Product, and Average Product

Total Marginal Average

Labor product product product

(workers (sweaters (sweaters per (sweaters

per day) per day) additional worker) per worker)

a 0 0

b 1 4 4.00

c 2 10 5.00

d 3 13 4.33

e 4 15 3.75

f 5 16 3.20

4

6

3

2

1

f

e

d

c

b

a

Total Product Curve15

Unattainable

Output (sweaters per day)

10

Attainable

5

0 1 2 3 4 5

Labor (workers per day)

Marginal Product Curve

Marginal product is also measured by the slope of the total product curve.

Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker.

Marginal Product Curve

Diminishing marginal returns

Occur when the marginal product of an additional worker is less than the marginal product of the previous worker

Law of diminishing returns

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

Marginal Product

TP

15

6

d

13

Output (sweaters per day)

Marginal product

(sweaters per day per worker)

4

10

c

3

5

2

4

MP

0 1 23 4 5

0 1 23 4 5

Labor (workers per day)

Labor (workers per day)

Average Product Curve

What does the average product curve look like?

average

product

c

c

d

e

b

f

AP

MP

Average Product6

Average product & Marginal product

(sweaters per day per worker)

4.33

4

3

2

0 1 2 3 4 5

Labor (workers per day)

- Distinguish between the short-run and the long-run
- Explain the relationship between a firm’s output and labor employed in the short-run
- Explain the relationship between a firm’s output and costs in the short-run
- Derive and explain a firm’s short-run cost curves

Short-Run Cost

Total cost (TC) is the cost of all productive resources used by a firm.

Total fixed cost (TFC) is the cost of all the firm’s fixed inputs.

Total variable cost (TVC) is the cost of all the firm’s variable inputs.

Short-Run Cost

Total cost (TC) is the cost of all productive resources used by a firm.

TC = TFC + TVC

Total Cost Curves

Total Total

fixed variable Total

cost cost cost

Labor Output (TFC) (TVC) (TC)

(workers (sweaters

per day) per day) (dollars per day)

a 0 0

b 1 4

c 2 10

d 3 13

e 4 15

f 5 16

Total Cost Curves

Total Total

fixed variable Total

cost cost cost

Labor Output (TFC) (TVC) (TC)

(workers (sweaters

per day) per day) (dollars per day)

a 0 0 25

b 1 4 25

c 2 10 25

d 3 13 25

e 4 15 25

f 5 16 25

Total Cost Curves

Total Total

fixed variable Total

cost cost cost

Labor Output (TFC) (TVC) (TC)

(workers (sweaters

per day) per day) (dollars per day)

a 0 0 25 0

b 1 4 25 25

c 2 10 25 50

d 3 13 25 75

e 4 15 25 100

f 5 16 25 125

Total Cost Curves

Total Total

fixed variable Total

cost cost cost

Labor Output (TFC) (TVC) (TC)

(workers (sweaters

per day) per day) (dollars per day)

a 0 0 25 0 25

b 1 4 25 25 50

c 2 10 25 50 75

d 3 13 25 75 100

e 4 15 25 100 125

f 5 16 25 125 150

TVC

TFC

Total Cost CurvesTC = TFC + TVC

150

Cost (dollars per day)

100

50

0 5 10 15

Output (sweaters per day)

Marginal Cost

Marginal cost is the increase in total cost that results from a one-unit increase in output.

It equals the increase in total cost divided by the increase in output.

Marginal costs decrease at low outputs because of the gains from specialization, but it eventually increases due to the law of diminishing returns.

Average Cost

Average fixed cost (AFC) is total fixed cost per unit of output.

Average variable cost (AVC) is total variable cost per unit of output.

Average total cost (ATC) is total cost per unit of output.

Marginal Cost and Average Costs

Total Total Average Average

fixed fixed Total Marginal fixed variable Total

cost cost cost cost cost cost cost

Labor Output (TFC) (TVC) (TC) (MC) (AFC) (AVC) (ATC)

(workers (sweaters (dollars per

per day) per day) (dollars per day) additional sweater) (dollars per sweater)

a 0 0 25 0 25

b 1 4 25 25 50

c 2 10 25 50 75

d 3 13 25 75 100

e 4 15 25 100 125

f 5 16 25 125 150

Marginal Cost and Average Costs

Total Total Average Average

fixed fixed Total Marginal fixed variable Total

cost cost cost cost cost cost cost

Labor Output (TFC) (TVC) (TC) (MC) (AFC) (AVC) (ATC)

(workers (sweaters (dollars per

per day) per day) (dollars per day) additional sweater) (dollars per sweater)

0

1

2

3

4

5

0

25

50

75

100

125

a

b

c

d

e

f

0

4

10

13

15

16

25

25

25

25

25

25

25

50

75

100

125

150

6.25

4.17

8.33

12.50

25.00

1

2

3

4

5

0

25

50

75

100

125

—

6.25

2.50

1.92

1.67

1.56

a

b

c

d

e

f

0

4

10

13

15

16

25

25

25

25

25

25

25

50

75

100

125

150

6.25

4.17

8.33

12.50

25.00

Marginal Cost and Average CostsTotal Total Average Average

fixed fixed Total Marginal fixed variable Total

cost cost cost cost cost cost cost

Labor Output (TFC) (TVC) (TC) (MC) (AFC) (AVC) (ATC)

(workers (sweaters (dollars per

per day) per day) (dollars per day) additional sweater) (dollars per sweater)

Marginal Cost and Average Costs

Total Total Average Average

fixed fixed Total Marginal fixed variable Total

cost cost cost cost cost cost cost

Labor Output (TFC) (TVC) (TC) (MC) (AFC) (AVC) (ATC)

(workers (sweaters (dollars per

per day) per day) (dollars per day) additional sweater) (dollars per sweater)

0

1

2

3

4

5

0

25

50

75

100

125

—

6.25

2.50

1.92

1.67

1.56

a

b

c

d

e

f

0

4

10

13

15

16

—

6.25

5.00

5.77

6.77

7.81

25

25

25

25

25

25

25

50

75

100

125

150

6.25

4.17

8.33

12.50

25.00

Marginal Cost and Average Costs

Total Total Average Average

fixed fixed Total Marginal fixed variable Total

cost cost cost cost cost cost cost

Labor Output (TFC) (TVC) (TC) (MC) (AFC) (AVC) (ATC)

(workers (sweaters (dollars per

per day) per day) (dollars per day) additional sweater) (dollars per sweater)

0

1

2

3

4

5

0

25

50

75

100

125

—

6.25

2.50

1.92

1.67

1.56

a

b

c

d

e

f

0

4

10

13

15

16

—

6.25

5.00

5.77

6.77

7.81

25

25

25

25

25

25

25

50

75

100

125

150

—

12.50

7.50

7.69

8.33

9.38

6.25

4.17

8.33

12.50

25.00

ATC

AVC

AFC

Marginal Cost and Average CostsATC = AFC + AVC

15

Cost (dollars per sweater)

10

5

0 5 10 15

Output (sweaters per day)

Cost Curves and Product Curve

How are the product curves related to the cost curves?

MP

Product Curvesand Cost Curves6

4

Average product and marginal product

2

2

Rising MP and

falling MC:

rising AP and

falling AVC

Falling MP and

rising MC:

rising AP and

falling AVC

Falling MP and

rising MC:

falling AP and

rising AVC

01.52.0

Labor

AVC

Maximum MP and

minimum MC

Maximum AP and

minimum AVC

Product Curvesand Cost Curves12

9

Average product and marginal product

6

3

0 6.5 10

Labor

Learning Objectives (cont.)

- Explain the relationship between a firm’s output and costs in the long run
- Derive and explain a firm’s long-run average cost curve

Long-Run Cost

Long-run cost

- The cost of production when a firm uses the economically efficient quantities of labor and capital.
Long-run costs are affected by the production function.

Production function

- The relationship between the maximum output attainable and the quantities of both labor an capital.

Learning Objectives (cont.)

- Explain the relationship between a firm’s output and costs in the long run
- Derive and explain a firm’s long-run average cost curve

The Production Function

Output (sweaters per day)

Labor Plant 1 Plant 2 Plant 3 Plant 4

1 4 10 13 15

2 10 15 18 21

3 13 18 22 24

4 15 20 24 26

5 16 21 25 27

Knitting machines (number) 1 2 3 4

The Long-Run Average Cost Curve

The long-run average total cost curve is derived from the short-run average total cost curves.

The segment of the short-run average total cost curves along which average total cost is the lowest make up the long-run average total cost curve.

Returns to Scale

Returns to scale are the increases in output that result from increasing all inputs by the same percentage.

Three possibilities:

- Constant returns to scale
- Increasing returns to scale
- Decreasing returns to scale

Returns to Scale

Constant returns to scale

Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by thesamepercentage

Returns to Scale

Increasing returns to scale

Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a larger percentage

Returns to Scale

Decreasing returns to scale

Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a smaller percentage

Minimum Efficient Scale

A firm’s minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level.

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