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Chapter 8. Costs of Production. Economic Principles. The character of entrepreneurship Total cost, total fixed cost, and total variable cost The law of diminishing returns. Economic Principles. Average total cost, average variable cost, average fixed cost, and marginal cost

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chapter 8

Chapter 8

Costs of Production

Gottheil — Principles of Economics, 7e

economic principles
Economic Principles
  • The character of entrepreneurship
  • Total cost, total fixed cost, and total variable cost
  • The law of diminishing returns

Gottheil — Principles of Economics, 7e

economic principles1
Economic Principles
  • Average total cost, average variable cost, average fixed cost, and marginal cost
  • Economies of scale, constant returns to scale, and diseconomies of scale

Gottheil — Principles of Economics, 7e

economic principles2
Economic Principles
  • The relationship between short-run average total cost and long-run average total cost
  • Downsizing

Gottheil — Principles of Economics, 7e

fixed cost
Fixed Cost

Fixed cost

  • Cost to the firm that does not vary with the quantity of goods produced. The cost is incurred even when the firm does not produce.

Gottheil — Principles of Economics, 7e

variable cost
Variable Cost

Variable cost

  • Cost that varies with the quantity of goods produced. Variable costs include such items as wages and raw materials.

Gottheil — Principles of Economics, 7e

slide7

EXHIBIT 1A TOTAL FIXED COST FOR THE MAXIBOAT

Gottheil — Principles of Economics, 7e

slide8

EXHIBIT 1B TOTAL FIXED COST FOR THE MAXIBOAT

Gottheil — Principles of Economics, 7e

exhibit 1 total fixed cost for the maxiboat
Exhibit 1: Total Fixed Cost for the Maxiboat

a. An upward-sloping line

b. A horizontal line

c. A downward-sloping line

Gottheil — Principles of Economics, 7e

When plotting total fixed cost on a diagram with dollars on the “y” axis and output on the “x” axis, which of the following correctly describes the shape of the total fixed cost curve?

exhibit 1 total fixed cost for the maxiboat1
Exhibit 1: Total Fixed Cost for the Maxiboat

When plotting total fixed cost on a diagram with dollars on the “y” axis and output on the “x” axis, which of the following correctly describes the shape of the total fixed cost curve?

a. An upward-sloping line

b. A horizontal line

c. A downward-sloping line

Gottheil — Principles of Economics, 7e

slide11

EXHIBIT 2 TOTAL VARIABLE COSTS PER FISHING RUN

Gottheil — Principles of Economics, 7e

exhibit 2 total variable costs per fishing run
Exhibit 2: Total Variable Costs per Fishing Run

Complete the sentence:

When output is zero, total variable cost is _____.

Gottheil — Principles of Economics, 7e

exhibit 2 total variable costs per fishing run1
Exhibit 2: Total Variable Costs per Fishing Run

Complete the sentence:

When output is zero, total variable cost iszero.

Gottheil — Principles of Economics, 7e

labor productivity
Labor Productivity

Labor productivity

  • The output per laborer per hour.

Gottheil — Principles of Economics, 7e

marginal product
Marginal Product

Marginal product

  • The change in total product caused by a one-unit increase in a factor of production (such as labor).

Gottheil — Principles of Economics, 7e

the law of diminishing returns
The Law of Diminishing Returns

Under what circumstances does the law of diminishing returns hold?

  • In the short run, when at least one factor of production is fixed.

Gottheil — Principles of Economics, 7e

the law of diminishing returns1
The Law of Diminishing Returns

Under what circumstances does the law of diminishing returns hold?

  • As more of a variable factor of production (such as labor) is added to the fixed factor, each will eventually run out of physical space and equipment to work effectively.

Gottheil — Principles of Economics, 7e

the law of diminishing returns2
The Law of Diminishing Returns

Under what circumstances does the law of diminishing returns hold?

  • With crowding, eventually the marginal product of each successive laborer will be less than the one previously added.

Gottheil — Principles of Economics, 7e

slide19

EXHIBIT 3 TOTAL VARIABLE COST

Gottheil — Principles of Economics, 7e

exhibit 3 total variable cost
Exhibit 3: Total Variable Cost

If total variable cost (TVC) is increasing at an increasing rate, then which of the following is true about the TVC curve:

a. It is upward-sloping and becoming steeper.

b. It is upward-sloping and becoming flatter.

c. It cannot start at the origin.

Gottheil — Principles of Economics, 7e

exhibit 3 total variable cost1
Exhibit 3: Total Variable Cost

If total variable cost (TVC) is increasing at an increasing rate, then which of the following is true about the TVC curve:

a. It is upward-sloping and becoming steeper.

b. It is upward-sloping and becoming flatter.

c. It cannot start at the origin.

Gottheil — Principles of Economics, 7e

slide22

EXHIBIT 4A TOTAL COST CURVE

Gottheil — Principles of Economics, 7e

slide23

EXHIBIT 4B TOTAL COST CURVE

Gottheil — Principles of Economics, 7e

exhibit 4 total cost curve
Exhibit 4: Total Cost Curve

1. How is total cost calculated?

  • Total cost is the sum of the total fixed and total variable costs of production.

Gottheil — Principles of Economics, 7e

exhibit 4 total cost curve1
Exhibit 4: Total Cost Curve

2. How is the shape of the total cost curve determined?

  • The shape of the total cost curve is principally determined by the shape of the total variable cost curve.

Gottheil — Principles of Economics, 7e

exhibit 4 total cost curve2
Exhibit 4: Total Cost Curve

2. How is the shape of the total cost curve determined?

  • This is because the total fixed cost is always the same ($2,000), regardless of what quantity is produced.

Gottheil — Principles of Economics, 7e

exhibit 4 total cost curve3
Exhibit 4: Total Cost Curve

Average total cost (ATC)

  • Total cost divided by the quantity of goods produced. ATC declines, reaches a minimum, then increases as more of a good is produced.

Gottheil — Principles of Economics, 7e

exhibit 4 total cost curve4
Exhibit 4: Total Cost Curve

Average fixed cost (AFC)

  • Total fixed cost divided by the quantity of goods produced. AFC steadily declines as more of a good is produced.

Gottheil — Principles of Economics, 7e

exhibit 4 total cost curve5
Exhibit 4: Total Cost Curve

Average variable cost (AVC)

  • Total variable cost divided by the quantity of goods produced. AVC declines, reaches a minimum, then increases as more of a good is produced.

Gottheil — Principles of Economics, 7e

average cost
Average Cost

If total fixed cost is $1 million, total variable cost is $2 million, and output is 100,000, what is AFC, AVC, and ATC?

  • AFC is ($1 million/100,000) = $10
  • AVC is ($2 million/100,000) = $20
  • ATC is ($3 million/100,000) = $30 or
  • ATC = AFC + AVC = $10 + $20 = $30

Gottheil — Principles of Economics, 7e

slide31

EXHIBIT 5A AVERAGE FIXED COST, AVERAGE VARIABLE COST, AND AVERAGE TOTAL- COST CURVES

Gottheil — Principles of Economics, 7e

slide32

EXHIBIT 5B AVERAGE FIXED COST, AVERAGE VARIABLE COST, AND AVERAGE TOTAL COST CURVES

Gottheil — Principles of Economics, 7e

exhibit 5 average fixed cost average variable cost and average total cost curves
Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Total Cost Curves

1. What is the difference between the ATC and AVC curves?

  • The difference between the ATC and AVC curves is AFC.

Gottheil — Principles of Economics, 7e

exhibit 5 average fixed cost average variable cost and average total cost curves1
Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Total Cost Curves

1. What is the difference between the ATC and AVC curves?

  • The ATC curve is the vertical sum of the AFC and the AVC curves.

Gottheil — Principles of Economics, 7e

exhibit 5 average fixed cost average variable cost and average total cost curves2
Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Total Cost Curves

2. Why do the AVC and ATC curves become closer together as output increases?

  • Because (ATC - AVC) = AFC, and as output increases, AFC becomes smaller

Gottheil — Principles of Economics, 7e

marginal cost
Marginal Cost

Marginal cost

  • The change in total cost generated by a change in the quantity of a good produced.

Gottheil — Principles of Economics, 7e

slide37

EXHIBIT 6A MARGINAL COST AND AVERAGE TOTAL COST CURVES

Gottheil — Principles of Economics, 7e

slide38

EXHIBIT 6B MARGINAL COST AND AVERAGE TOTAL COST CURVES

Gottheil — Principles of Economics, 7e

exhibit 6 marginal cost and average total cost curves
Exhibit 6: Marginal Cost and Average Total Cost Curves

1. What are the shapes of the MC and ATC curves?

  • The ATC curve is U-shaped, and the MC curve is upward-sloping and intersects the ATC curve.

Gottheil — Principles of Economics, 7e

exhibit 6 marginal cost and average total cost curves1
Exhibit 6: Marginal Cost and Average Total Cost Curves

2. What is the relationship between the MC and the ATC curves in Exhibit 6?

  • Within the output range 0 to 8,000, MC is below ATC, causing ATC to decrease.

Gottheil — Principles of Economics, 7e

exhibit 6 marginal cost and average total cost curves2
Exhibit 6: Marginal Cost and Average Total Cost Curves

2. What is the relationship between the MC and the ATC curves in Exhibit 6?

  • Beyond an output of 8,000, MC is above ATC, causing ATC to increase.

Gottheil — Principles of Economics, 7e

exhibit 6 marginal cost and average total cost curves3
Exhibit 6: Marginal Cost and Average Total Cost Curves

2. What is the relationship between the MC and the ATC curves in Exhibit 6?

  • At 8,000, MC = ATC. At this point ATC is at its minimum.
  • The MC curve always cuts the ATC curve from below at the ATC curve’s minimum.

Gottheil — Principles of Economics, 7e

slide43

EXHIBIT 7 AVERAGE TOTAL COST CURVES FOR TWO FISHING FIRMS WITH DIFFERENT FIXED COSTS

Gottheil — Principles of Economics, 7e

exhibit 7 average total cost curves for two fishing firms with different fixed costs
Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Different Fixed Costs

1. In Exhibit 7, what is the average total cost for Strang and Burnett at an output of 2,000 fish?

  • At an output of 2,000 fish, Strang’s average total cost is $0.70.
  • At the same output level, Burnett’s average total cost is $1.10.

Gottheil — Principles of Economics, 7e

exhibit 7 average total cost curves for two fishing firms with different fixed costs1
Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Different Fixed Costs

2. What explains the difference in the average total cost for Strang and Burnett?

  • The difference is due to the fact that Strang and Burnett have different fixed costs associated with the different capacity boats that they use.

Gottheil — Principles of Economics, 7e

exhibit 7 average total cost curves for two fishing firms with different fixed costs2
Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Different Fixed Costs

3. How does efficiency change as output quantity increases?

  • At an output less than 4,000, Strang’s operation is more efficient.
  • When output increases above 4,000, Burnett’s operation becomes more efficient.

Gottheil — Principles of Economics, 7e

economies of scale
Economies of Scale

Economies of scale

  • Decreases in the firm’s average total cost brought about by increased specialization and efficiencies in production realized through increases in the scale of the firm’s operations.

Gottheil — Principles of Economics, 7e

constant returns to scale
Constant Returns to Scale

Constant returns to scale

  • Costs per unit of production are the same for any level of production. Changes in plant size do not affect the firm’s average total cost.

Gottheil — Principles of Economics, 7e

diseconomies of scale
Diseconomies of Scale

Diseconomies of scale

  • Increases in the firm’s average total cost brought about by the disadvantages associated with bureaucracy and the inefficiencies that eventually emerge with increases in the firm’s operations.

Gottheil — Principles of Economics, 7e

slide50

EXHIBIT 8 ECONOMIES OF SCALE, DISECONOMIES OF SCALE, AND CONSTANT RETURNS TO SCALE

Gottheil — Principles of Economics, 7e

exhibit 8 economies of scale diseconomies of scale and constant returns to scale
Exhibit 8: Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale

1. What happens to ATC as output increases from 0 to 50,000?

  • As output increases from 0 to 50,000, the minimum points on the short-run ATCs decline.

Gottheil — Principles of Economics, 7e

exhibit 8 economies of scale diseconomies of scale and constant returns to scale1
Exhibit 8: Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale

1. What happens to ATC as output increases from 0 to 50,000?

  • This range of output features economies of scale in production.

Gottheil — Principles of Economics, 7e

exhibit 8 economies of scale diseconomies of scale and constant returns to scale2
Exhibit 8: Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale

2. What happens to ATC as output increases from 50,000 to 70,000?

  • Between 50,000 and 70,000 units of output there are approximately constant returns to scale.

Gottheil — Principles of Economics, 7e

exhibit 8 economies of scale diseconomies of scale and constant returns to scale3
Exhibit 8: Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale

3. What happens to ATC as output increases beyond 70,000?

  • The minimum points on the short-run ATCs rise beyond 70,000 units of output. There are diseconomies of scale in this range of output.

Gottheil — Principles of Economics, 7e

short run
Short Run

Short run

  • The time interval during which producers are able to change the quantity of some but not all the resources they use to produce goods and services.

Gottheil — Principles of Economics, 7e

long run
Long Run

Long run

  • The time interval during which producers are able to change the quantity of all the resources they use to produce goods and services. In the long run, all costs are variable.

Gottheil — Principles of Economics, 7e

short run and long run
Short Run and Long Run

Can a firm always be in the long run, and therefore avoid the short run?

  • Usually not, since most of the time a firm must make some commitment to capital.

Gottheil — Principles of Economics, 7e

short run and long run1
Short Run and Long Run

Can a firm always be in the long run, and therefore avoid the short run?

  • Once a production facility is bought or leased, it would take time for the firm to switch to a new facility, or for the facility to depreciate. That time period is the short run.

Gottheil — Principles of Economics, 7e

slide59

EXHIBIT 9 SHORT- AND LONG-RUN COST CURVES FOR A FISHING FIRM

Gottheil — Principles of Economics, 7e

exhibit 9 short and long run cost curves for a fishing firm
Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

1. What is the relationship between the short-run ATC (SRATC) curves and the long-run ATC curve (LRATC)?

  • The LRATC curve is tangent to lowest points on each of the various possible SRATC curves.
  • The LRATC curve is also called an envelope curve.

Gottheil — Principles of Economics, 7e

exhibit 9 short and long run cost curves for a fishing firm1
Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

2. Why are there multiple SRATC curves, but only one LRATC curve?

  • Recall that in the short-run, firms can change the quantity of some, but not all of the resources they use to produce goods and services.

Gottheil — Principles of Economics, 7e

exhibit 9 short and long run cost curves for a fishing firm2
Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

2. Why are there multiple SRATC curves, but only one LRATC curve?

  • Each SRATC curve represents a commitment to a different size of production facility.

Gottheil — Principles of Economics, 7e

exhibit 9 short and long run cost curves for a fishing firm3
Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

2. Why are there multiple SRATC curves, but only one LRATC curve?

  • Once a firm has chosen a short-run cost curve, the firm is committed to it until the fixed cost items associated with the chosen ATC depreciate.

Gottheil — Principles of Economics, 7e

exhibit 9 short and long run cost curves for a fishing firm4
Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

2. Why are there multiple SRATC curves, but only one LRATC curve?

  • The long-run is the time interval during which producers can change the quantity of all of the resources they use to produce goods and services.

Gottheil — Principles of Economics, 7e

exhibit 9 short and long run cost curves for a fishing firm5
Exhibit 9: Short- and Long-Run Cost Curves for a Fishing Firm

2. Why are there multiple SRATC curves, but only one LRATC curve?

  • The single LRATC curve represents the cost options open to the firm before any specific commitment is made.

Gottheil — Principles of Economics, 7e

long run average total cost curve
Long-Run Average Total Cost Curve

1. In what portion of the long-run average total cost curve are there economies of scale in production?

  • Along the initial downward-sloping portion of the long-run average total cost curve, where average total cost falls as output increases.

Gottheil — Principles of Economics, 7e

long run average total cost curve1
Long-Run Average Total Cost Curve

2. In what portion of the long-run average total cost curve are there diseconomies of scale in production?

  • Along the upward-sloping portion of the long-run average total cost curve, where average total cost rises as output increases.

Gottheil — Principles of Economics, 7e

rightsizing
Rightsizing

Rightsizing

  • Implementing a firm’s decision to adjust its plant size to produce current output in the most efficient manner possible.

Gottheil — Principles of Economics, 7e

rightsizing1
Rightsizing

Suppose that a firm is currently producing high up on the steeply downward-sloping portion of its average cost curve. Is this evidence that the firm has recently undergone rightsizing?

  • No. The firm’s output is too small for its current production facility.

Gottheil — Principles of Economics, 7e

rightsizing2
Rightsizing

Suppose that a firm is currently producing high up on the steeply downward-sloping portion of its average cost curve. Is this evidence that the firm has recently undergone rightsizing?

  • By switching to a smaller production facility the firm may be able to reduce its average costs.

Gottheil — Principles of Economics, 7e

downsizing
Downsizing

Downsizing

  • Implementing a firm’s decision to decrease its plant size to produce current output in the most efficient manner possible.

Gottheil — Principles of Economics, 7e

downsizing1
Downsizing

Suppose that a firm is currently producing high up on the steeply upward-sloping portion of its average cost curve. Is this evidence that the firm can produce current output more efficiently by downsizing?

  • No. The firm’s output is too large for its current production facility.

Gottheil — Principles of Economics, 7e

downsizing2
Downsizing

Suppose that a firm is currently producing high up on the steeply upward-sloping portion of its average cost curve. Is this evidence that the firm can produce current output more efficiently by downsizing?

  • No. The firm’s output is too large for its current production facility.

Gottheil — Principles of Economics, 7e

outsourcing
Outsourcing

Outsourcing

  • The practice of a firm contracting out of delegating part or parts of its production process to external sources, often located in foreign countries.

Gottheil — Principles of Economics, 7e

slide75

EXHIBIT 10 AVERAGE COST CURVES FOR IRRIGATED COTTON FARMS, TEXAS HIGH PLAINS

Source: J. Patrick Madden, Economies of Size in Farming, U.S. Department of Agriculture, AER No. 107, Washington, D.C., February 1967, p. 44.

Gottheil — Principles of Economics, 7e

exhibit 10 average cost curves for irrigated cotton farms texas high plains
If a Texas high plains cotton farmer had a one-person farm and used six-row equipment, are his average costs always going to be higher than for farms with more people working?Exhibit 10: Average Cost Curves for Irrigated Cotton Farms, Texas High Plains
  • No. At a $60,000 income, cost per dollar of gross income is as low or lower than for farms with more people working.

Gottheil — Principles of Economics, 7e