© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of...
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Ch07

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Ch07

  1. 1. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair CHAPTERCHAPTER 77 Prepared by: FernandoPrepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano Short-Run CostsShort-Run Costs and Output Decisionsand Output Decisions
  2. 2. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Decisions Facing FirmsDecisions Facing Firms DECISIONSDECISIONS are based onare based on INFORMATIONINFORMATION 1.1. The quantity of output toThe quantity of output to supplysupply 1.1. The price of outputThe price of output 2.2. How to produce thatHow to produce that output (which techniqueoutput (which technique to use)to use) 2.2. Techniques ofTechniques of production available*production available* 3.3. The quantity of eachThe quantity of each input toinput to demanddemand 3.3. The price of inputs*The price of inputs* *Determines production costs*Determines production costs
  3. 3. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Costs in the Short RunCosts in the Short Run • TheThe short runshort run is a period of timeis a period of time for which two conditions hold:for which two conditions hold: 1.1. The firm is operating under a fixedThe firm is operating under a fixed scale (fixed factor) of production, andscale (fixed factor) of production, and 2.2. Firms can neither enter nor exit anFirms can neither enter nor exit an industry.industry. • In the short run, all firms haveIn the short run, all firms have costs that they must bearcosts that they must bear regardless of their output. Theseregardless of their output. These kinds of costs are calledkinds of costs are called fixedfixed costscosts..
  4. 4. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Costs in the Short RunCosts in the Short Run • Fixed costFixed cost is any cost that does notis any cost that does not depend on the firm’s level of output. Thesedepend on the firm’s level of output. These costs are incurred even if the firm iscosts are incurred even if the firm is producing nothing.producing nothing. • Variable costVariable cost is a cost that depends onis a cost that depends on the level of production chosen.the level of production chosen. T C T F C T V C= + Total Cost = Total Fixed + Total Variable Cost Cost
  5. 5. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Fixed CostsFixed Costs • Firms have no control over fixedFirms have no control over fixed costs in the short run. For thiscosts in the short run. For this reason, fixed costs are sometimesreason, fixed costs are sometimes calledcalled sunk costssunk costs.. • Average fixed cost (Average fixed cost (AFCAFC)) is theis the total fixed cost (total fixed cost (TFCTFC) divided by the) divided by the number of units of output (number of units of output (qq):): A F C T F C q =
  6. 6. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Short-Run Fixed Cost (Total andShort-Run Fixed Cost (Total and Average) of a Hypothetical FirmAverage) of a Hypothetical Firm • AFC falls as outputAFC falls as output rises; a phenomenonrises; a phenomenon sometimes calledsometimes called spreading overheadspreading overhead.. (1)(1) qq (2)(2) TFCTFC (3)(3) AFC (TFC/q)AFC (TFC/q) 00 $1,000$1,000 $$ −−−− 11 1,0001,000 1,0001,000 22 1,0001,000 500500 33 1,0001,000 333333 44 1,0001,000 250250 55 1,0001,000 200200
  7. 7. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Variable CostsVariable Costs • TheThe total variable cost curvetotal variable cost curve is a graphis a graph that shows the relationship between totalthat shows the relationship between total variable cost and the level of a firm’s output.variable cost and the level of a firm’s output. • The total variableThe total variable cost is derived fromcost is derived from productionproduction requirements andrequirements and input prices.input prices.
  8. 8. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Derivation of Total Variable Cost ScheduleDerivation of Total Variable Cost Schedule from Technology and Factor Pricesfrom Technology and Factor Prices • The total variable cost curve shows the cost ofThe total variable cost curve shows the cost of production using the best available technique atproduction using the best available technique at each output level, given current factor prices.each output level, given current factor prices. PRODUCTPRODUCT USINGUSING TECHNIQUETECHNIQUE UNITS OFUNITS OF INPUT REQUIREDINPUT REQUIRED (PRODUCTION FUNCTION)(PRODUCTION FUNCTION) TOTAL VARIABLETOTAL VARIABLE COST ASSUMINGCOST ASSUMING PPKK = $2,= $2, PPLL = $1= $1 TVCTVC = (= (KK xx PPKK) + () + (LL xx PPLL))KK LL 11 Units ofUnits of AA 44 44 (4 x $2) +(4 x $2) + (4 x $1) =(4 x $1) = $12$12 outputoutput BB 22 66 (2 x $2) +(2 x $2) + (6 x $1) =(6 x $1) = 22 Units ofUnits of AA 77 66 (7 x $2) +(7 x $2) + (6 x $1) =(6 x $1) = $20$20 outputoutput BB 44 1010 (4 x $2) +(4 x $2) + (10 x $1) =(10 x $1) = 33 Units ofUnits of AA 99 66 (9 x $2) +(9 x $2) + (6 x $1) =(6 x $1) = outputoutput BB 66 1414 (6 x $2) +(6 x $2) + (14 x $1) =(14 x $1) = $26$26 $10 $18 $24
  9. 9. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Marginal CostMarginal Cost • Marginal cost (MC)Marginal cost (MC) is the increaseis the increase in total cost that results fromin total cost that results from producing one more unit of output.producing one more unit of output. • Marginal cost reflects changes inMarginal cost reflects changes in variable costs.variable costs. M C T C Q T F C Q T V C Q = = + ∆ ∆ ∆ ∆ ∆ ∆
  10. 10. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Derivation of Marginal Cost fromDerivation of Marginal Cost from Total Variable CostTotal Variable Cost UNITS OF OUTPUTUNITS OF OUTPUT TOTAL VARIABLE COSTSTOTAL VARIABLE COSTS ($)($) MARGINAL COSTSMARGINAL COSTS ($)($) 00 00 00 11 1010 1010 22 1818 88 33 2424 66 • Marginal costMarginal cost measures themeasures the additionaladditional cost of inputs required to produce eachcost of inputs required to produce each successive unit of output.successive unit of output.
  11. 11. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair The Shape of the Marginal Cost CurveThe Shape of the Marginal Cost Curve in the Short Runin the Short Run • The fact that in the short run every firm isThe fact that in the short run every firm is constrained by some fixed input meansconstrained by some fixed input means that:that: 1.1. The firm faces diminishing returns to variableThe firm faces diminishing returns to variable inputs, andinputs, and 2.2. The firm has limited capacity to produceThe firm has limited capacity to produce output.output. • As a firm approaches that capacity, itAs a firm approaches that capacity, it becomes increasingly costly to producebecomes increasingly costly to produce successively higher levels of output.successively higher levels of output.
  12. 12. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair The Shape of the Marginal Cost CurveThe Shape of the Marginal Cost Curve in the Short Runin the Short Run • Marginal costs ultimately increase withMarginal costs ultimately increase with output in the short run.output in the short run.
  13. 13. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Graphing Total Variable Costs andGraphing Total Variable Costs and Marginal CostsMarginal Costs • Total variable costs alwaysTotal variable costs always increase with output. Theincrease with output. The marginal cost curve showsmarginal cost curve shows how total variable costhow total variable cost changes with single unitchanges with single unit increases in total output.increases in total output. • Below 100 units of output,Below 100 units of output, TVCTVC increases at aincreases at a decreasing ratedecreasing rate. Beyond. Beyond 100 units of output,100 units of output, TVCTVC increases at anincreases at an increasingincreasing rate.rate.
  14. 14. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Average Variable CostAverage Variable Cost • Average variable cost (AVC)Average variable cost (AVC) is theis the total variable cost divided by thetotal variable cost divided by the number of units of output.number of units of output. • Marginal cost is the cost ofMarginal cost is the cost of oneone additional unitadditional unit. Average variable. Average variable cost is the average variable cost percost is the average variable cost per unit ofunit of all the unitsall the units being produced.being produced. • Average variable costAverage variable cost followsfollows marginal cost, but lags behind.marginal cost, but lags behind.
  15. 15. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Relationship Between AverageRelationship Between Average Variable Cost and Marginal CostVariable Cost and Marginal Cost • When marginal cost isWhen marginal cost is below average cost,below average cost, average cost is declining.average cost is declining. • When marginal cost isWhen marginal cost is above average cost,above average cost, average cost is increasing.average cost is increasing. • Rising marginal costRising marginal cost intersects average variableintersects average variable cost at the minimum pointcost at the minimum point ofof AVCAVC.. • At 200 units of output, AVC isAt 200 units of output, AVC is minimum, andminimum, and MCMC == AVCAVC..
  16. 16. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Short-Run Costs of a Hypothetical FirmShort-Run Costs of a Hypothetical Firm (1)(1) qq (2)(2) TVCTVC (3)(3) MCMC ((∆∆ TVCTVC)) (4)(4) AVCAVC ((TVC/qTVC/q)) (5)(5) TFCTFC (6)(6) TCTC ((TVCTVC ++ TFCTFC)) (7)(7) AFCAFC ((TFCTFC//qq)) (8)(8) ATCATC (TC/q(TC/q oror AFC + AVC)AFC + AVC) 00 $$ 00 $$ −− $$ −− $$1,0001,000 $$ 1,0001,000 $$ −− $$ −− 11 1010 1010 1010 1,0001,000 1,0101,010 1,0001,000 1,0101,010 22 1818 88 99 1,0001,000 1,0181,018 500500 509509 33 2424 66 88 1,0001,000 1,0241,024 333333 341341 44 3232 88 88 1,0001,000 1,0321,032 250250 258258 55 4242 1010 8.48.4 1,0001,000 1,0421,042 200200 208.4208.4 −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− −− 500500 8,0008,000 2020 1616 1,0001,000 9,0009,000 22 1818
  17. 17. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Total CostsTotal Costs • AddingAdding TFCTFC toto TVCTVC meansmeans adding the same amount ofadding the same amount of total fixed cost to everytotal fixed cost to every level of total variable cost.level of total variable cost. • Thus, the total cost curveThus, the total cost curve has the same shape as thehas the same shape as the total variable cost curve; ittotal variable cost curve; it is simply higher by anis simply higher by an amount equal toamount equal to TFCTFC.. T C T F C T V C= +
  18. 18. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Average Total CostAverage Total Cost • Average total cost (Average total cost (ATCATC) is) is total cost divided by thetotal cost divided by the number of units of outputnumber of units of output ((qq).). A T C A F C A V C= + A T C T C q T F C q T V C q = = + • BecauseBecause AFCAFC falls withfalls with output, an ever-decliningoutput, an ever-declining amount is added toamount is added to AVCAVC..
  19. 19. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Relationship Between Average TotalRelationship Between Average Total Cost and Marginal CostCost and Marginal Cost • If marginal cost is belowIf marginal cost is below average total cost, averageaverage total cost, average total cost will declinetotal cost will decline toward marginal cost.toward marginal cost. • If marginal cost is aboveIf marginal cost is above average total cost, averageaverage total cost, average total cost will increase.total cost will increase. • Marginal cost intersectsMarginal cost intersects average total cost andaverage total cost and average variable costaverage variable cost curves at their minimumcurves at their minimum points.points.
  20. 20. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Output Decisions: Revenues, Costs,Output Decisions: Revenues, Costs, and Profit Maximizationand Profit Maximization • In the short run, a competitive firm faces aIn the short run, a competitive firm faces a demand curve that is simply a horizontal line atdemand curve that is simply a horizontal line at the market equilibrium price.the market equilibrium price.
  21. 21. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Total Revenue (Total Revenue (TRTR) and) and Marginal Revenue (Marginal Revenue (MRMR)) • Total revenue (TR)Total revenue (TR) is the total amount that a firmis the total amount that a firm takes in from the sale of its output.takes in from the sale of its output. T R P q= × M R T R q = ∆ ∆ = P q q ( )∆ ∆ • Marginal revenue (MR)Marginal revenue (MR) is the additional revenueis the additional revenue that a firm takes in when it increases output bythat a firm takes in when it increases output by one additional unit.one additional unit. • In perfect competition,In perfect competition, P = MRP = MR.. = P
  22. 22. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Comparing Costs and Revenues toComparing Costs and Revenues to Maximize ProfitMaximize Profit • The profit-maximizing level of output for allThe profit-maximizing level of output for all firms is the output level wherefirms is the output level where MRMR == MCMC.. • In perfect competition,In perfect competition, MRMR == PP, therefore,, therefore, the profit-maximizing perfectly competitivethe profit-maximizing perfectly competitive firm will produce up to the point where thefirm will produce up to the point where the price of its output is just equal to short-runprice of its output is just equal to short-run marginal cost.marginal cost. • The key idea here is that firms will produceThe key idea here is that firms will produce as long as marginal revenue exceedsas long as marginal revenue exceeds marginal cost.marginal cost.
  23. 23. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair Profit Analysis for a Simple FirmProfit Analysis for a Simple Firm (1)(1) qq (2)(2) TFCTFC (3)(3) TVCTVC (4)(4) MCMC (5)(5) PP == MRMR (6)(6) TRTR ((PP xx qq)) (7)(7) TCTC ((TFCTFC ++ TVCTVC)) (8)(8) PROFITPROFIT ((TRTR −− TCTC)) 00 $$ 1010 $$ 00 $$ −− $$ 1515 $$ 00 $$ 1010 $$ -10-10 11 1010 1010 1010 1515 1515 2020 -5-5 22 1010 1515 55 1515 3030 2525 55 33 1010 2020 55 1515 4545 3030 1515 44 1010 3030 1010 1515 6060 4040 2020 55 1010 5050 2020 1515 7575 6060 1515 66 1010 8080 3030 1515 9090 9090 00
  24. 24. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair The Short-Run Supply CurveThe Short-Run Supply Curve • At any market price, the marginal cost curve shows the output levelAt any market price, the marginal cost curve shows the output level that maximizes profit. Thus, the marginal cost curve of a perfectlythat maximizes profit. Thus, the marginal cost curve of a perfectly competitive profit-maximizing firm is the firm’s short-run supply curve.competitive profit-maximizing firm is the firm’s short-run supply curve.

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