chapter 5 costs (short-run). copyright © houghton mifflin company.all rights reserved. 5a - 2...

Chapter 5

Costs (Short-Run)

Copyright © Houghton Mifflin Company.All rights reserved. 5a - 2

Production

• An entrepreneur must put together resources -- land, labor, capital -- and produce a product people will be willing and able to purchase.


Combining Resources

• There are many combinations of resources that could be used.

• Consider the following table showing different quantities of mechanics and different quantities of airplanes that the hypothetical firm, PWA, might use:


Number Capital -- Number of Airplanesof Mechanics 5 10 15 20 25 30 35 40

0 0 0 0 0 0 0 0 0

1 30 100 250 340 410 400 400 3902 60 250 360 450 520 530 520 5003 100 360 480 570 610 620 620 6104 130 440 580 640 690 700 700 6905 130 500 650 710 760 770 780 7706 110 540 700 760 800 820 830 8407 100 550 720 790 820 850 870 8908 80 540 680 800 830 860 880 900

Alternative Quantities of Output that Can Be Produced by Different Combinations of Resources


Production in the Short Run

• The short run is a period just short enough that at least one resource (input) cannot be changed -- is fixed, that is.

• Suppose that the company has leased 10 airplanes and this can’t be changed for a year or so.



0 0 0 0 0 0 0 0 0

1 30 100 250 340 410 400 400 3902 60 250 360 450 520 530 520 5003 100 360 480 570 610 620 620 6104 130 440 580 640 690 700 700 6905 130 500 650 710 760 770 780 7706 110 540 700 760 800 820 830 8407 100 550 720 790 820 850 870 8908 80 540 680 800 830 860 880 900

Quantities of Output that Can Be Produced When One Resource Is

Fixed


What can you say about marginal product ?

• As the quantity of a variable input (labor in the example) increases while all other inputs are fixed, output rises, initially rising more and more rapidly, but eventually at a slower rate and perhaps even declining.

• This is called the LAW OF DIMINISHING MARGINAL RETURNS.


Applications: Law of Diminishing Marginal Returns

• Air bags -- Explain the advantages of installing additional air bags per car.


Applications: Law of Diminishing Marginal Returns

• Explain the number of clerks in department stores and the number of servers at a restaurant.


Consider Diminishing Marginal Product

• Explain where the Law of DMR shows up on the following table:


0 0 0 0 0 0 0 0 0

1 30 100 250 340 410 400 400 3902 60 250 360 450 520 530 520 5003 100 360 480 570 610 620 620 6104 130 440 580 640 690 700 700 6905 130 500 650 710 760 770 780 7706 110 540 700 760 800 820 830 8407 100 550 720 790 820 850 870 8908 80 540 680 800 830 860 880 900



0 0 0 0 0 0 0 0 0

1 30 100 250 340 410 400 400 3902 60 250 360 450 520 530 520 5003 100 360 480 570 610 620 620 6104 130 440 580 640 690 700 700 6905 130 500 650 710 760 770 780 7706 110 540 700 760 800 820 830 8407 100 550 720 790 820 850 870 8908 80 540 680 800 830 860 880 900

Consider Diminishing Marginal Product


Where Is Diminishing Marginal Product?

• With the number of airplanes fixed at 20,

• what occurs? Output is:

• 340 450 570 640 710 760

• So, average physical product is:

• So marginal physical product is:


Where Is Diminishing Marginal Product?

• Suppose we fix the number of mechanics at 5.

• Do diminishing marginal returns show up?


0 0 0 0 0 0 0 0 0

1 30 100 250 340 410 400 400 3902 60 250 360 450 520 530 520 5003 100 360 480 570 610 620 620 6104 130 440 580 640 690 700 700 6905 130 500 650 710 760 770 780 7706 110 540 700 760 800 820 830 8407 100 550 720 790 820 850 870 8908 80 540 680 800 830 860 880 900

The Costs of Doing Business

Short-Run Costs


Relationship between Output and Costs

• Now, let’s consider costs:

• For each additional 1 unit of output, how much additional costs are incurred?

• Since output rises rapidly initially as the variable resource is increased, then the costs of each additional output would at first decline.



• Then, as output rises more and more slowly as the variable resource increases, the cost of each additional output would rise more and more rapidly.



• So what does this mean for the shape of the cost curves?

• How would you describe the shape of the cost curves?


Plot the Average Cost and the Marginal Cost Schedules

• Average cost is the per-unit cost: total cost divided by quantity of output.

• Marginal cost is the change in total cost divided by the change in total output.

100 200 300 400 500 600

15

10

5

Costs

Quantity of Output

Marginal andAverage Cost

100 200 300 400 500 600

15

10

5

Quantity of Output


Costs

100 200 300 400 500 600

15

10

5

ATC

Quantity of Output


Costs

100 200 300 400 500 600

15

10

5

Quantity of Output


ATC

Costs

100 200 300 400 500 600

15

10

5

Quantity of Output

MCMarginal andAverage Cost

ATC

Costs

100 200 300 400 500 600

15

10

5

Quantity of Output

MC

|----------------|MC<ATC

MC>ATC|-------------------------


ATC

Costs


Point of All This: Law of Diminishing Marginal Returns and Costs

• Every firm, no matter activity or size, faces the law of diminishing marginal returns.

• Every firm, has U-shaped short-run cost curves.


Let’s now make the hypothetical example more realistic:

• All we have considered to this point is the cost of the variable resource -- number of mechanics.

• Firms have costs for the fixed resources as well -- leases on airplanes and other costs -- these costs we call fixed costs.


Let’s now make the hypothetical example more realistic:

• Fixed costs do not vary as output varies.

• Variable costs vary as output rises.

Q TC TFC TVC AFC AVC ATC MC

100 $2,000 $2,000 $0250 3000 $2,000 1000360 4000 $2,000 2000440 5000 $2,000 3000500 6000 $2,000 4000540 7000 $2,000 5000550 8000 $2,000 6000

AFC = TFC/Q AVC = TVC/Q

ATC = TC/Q


The Average Cost Schedules


100 $2,000 $2,000 $0250 3000 $2,000 1000 $20 10 30360 4000 $2,000 2000440 5000 $2,000 3000500 6000 $2,000 4000540 7000 $2,000 5000550 8000 $2,000 6000


The Average Cost Schedules


0 $2,000 $2,000 $0100 3000 $2,000 1000 $20 10 30250 4000 $2,000 2000 8 8 16360 5000 $2,000 3000440 6000 $2,000 4000500 7000 $2,000 5000540 8000 $2,000 6000


Completing Calculations


0 $2,000 $2,000 $0100 3000 $2,000 1000 $20 10 30250 4000 $2,000 2000 8 8 16360 5000 $2,000 3000 5.6 8.3 13.9440 6000 $2,000 4000 4.5 9.1 13.66500 7000 $2,000 5000 4 10 14540 8000 $2,000 6000 3.7 11.1 14.8550 9000 $2,000 7000 3.6 12.7 16.4


What are average costs doing as output rises?

• Average variable cost:

• Declines initially and then rises.

• Average fixed cost:

• Declines.

• Average total cost:

• Declines initially and then rises.



0 $2,000 $2,000 $0100 3000 $2,000 1000 $20 10 30 10250 4000 $2,000 2000 8 8 16360 5000 $2,000 3000 5.6 8.3 13.9440 6000 $2,000 4000 4.5 9.1 13.66500 7000 $2,000 5000 4 10 14540 8000 $2,000 6000 3.7 11.1 14.8550 9000 $2,000 7000 3.6 12.7 16.4

Now for MC: MC=Change in TC/Change in Q


Completing Calculations


0 $2,000 $2,000 $0100 3000 $2,000 1000 $20 10 30 10250 4000 $2,000 2000 8 8 16 7360 5000 $2,000 3000 5.6 8.3 13.9 9.1440 6000 $2,000 4000 4.5 9.1 13.66 12.5500 7000 $2,000 5000 4 10 14 16.7540 8000 $2,000 6000 3.7 11.1 14.8 25550 9000 $2,000 7000 3.6 12.7 16.4 100


The Shape of Short-Run Cost Curves

• The short run cost curves are U-shaped--

• except for the fixed costs.

• Fixed costs mean that the costs remain the same even as output changes.

• Average fixed costs decline as output rises -- not U-shaped.


100 200 300 400 500 600

30

20

10

MC

ATC

Costs

Quantity of Output

AVC

What are the diamonds?


100 200 300 400 500 600

30

20

10

ATC

Costs

Quantity of Output

AVC

ATC -AVC = AFC

ATC - AVC = AFC


Define each of the following:

• Fixed

• Variable

• Total

• Average

• Marginal• Direct

• Overhead

chapter 5 costs (short-run). copyright © houghton mifflin company.all rights reserved. 5a - 2...

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additional output

total output

output rises

unit of output

marginal productwhere

marginal productexplain

marginal physical product

total cost