Chapter 11: Outputs and Costs

why is the Average Total Cost curve U-shaped?

The ATC curve combines the shapes of the AFC and AVC curves. The AFC curve constantly falls as output expands, pulling down ATC curve. The AVC curve first falls but then rises because of diminishing returns. Eventually AVC curve starts to rise more rapidly than the AFC falls, so at that point the ATC rises.The U shape of the ATC curve arises from the influence of two opposing forces: spreading total fixed cost over a larger output and eventually diminishing returns.

MC Curve

The MC curve intersects the AVC curve and ATC curve at their minimums. At small outputs, marginal cost decreases as output increases because of greater specialization and the division of labor. But as output increases further, marginal cost eventually increases because of the law of diminishing returns. When marginal cost is less than average cost, average cost is decreasing, and when marginal cost exceeds average cost, average cost is increasing. This relationship holds for both the ATC curve and the AVC curve.

average product curve

The average product curve shows the average product that is generated by labor at each level of labor. As the figure shows, the average product of labor curve (AP) has an upside-down U shape.

what influences/shifts the position of a firm's short-run cost curves?

The cost curves shift with changes in technology or changes in prices of factors of production.

the minimum efficient scale

a firm's minimum efficient scale is the smallest output at which long-run average cost reaches its lowest level. The minimum efficient scale plays a role in determining market structure. In a market in which the minimum efficient scale is small relative to market demand, the market has room for many firms, and the market is competitive. In a market in which the minimum efficient scale is large relative to market demand, only a small number of firms, and possibly only one firm, can make a profit and the market is either an oligopoly or monopoly.

normal profit

normal profit means earning zero economic profits. A firm may still be earning accounting profits even if its economic profit is zero. Normal profit occurs when a firm's total revenue is equal to its explicit and implicit costs. normal profit occurs when a firm is neither earning money nor losing money, so if economic profits are negative it is not earning a normal economic profit.

Fragmented market

when minimum efficient scale is a small fraction of the total market, that is going to lead to fragmentation. A fragmented market means that there are lots of competitors splitting the market. When minimum efficient scale is close to the market size, there are less competitors and it is considered to be a far more concentrated market.

natural monopoly

when minimum efficient scale is greater than market - whoever can produce the market value is going to produce most efficiently. the closer you can get to the market value, you are going to have the lowest ATC of production in the long run. This makes it very hard for anyone to compete with you especially if you take up most of the market. When the market dynamics make it so that it is only efficient for one player, it is called natural monopoly

what are the three concepts we use to describe the relationship between the quantity of labor and the firm's output?

total product, average product, and marginal product

ATC, AFC, AND AVC Curves

The vertical distance between the AVC curve and the ATC curve is the AFC. Because the AFC decreases as output increases, these curves become vertically closer to each other as output increases.

where do economies of scale occur?

Along the LRAC curve, economies of scale occur if average cost falls as output increases; diseconomies of scale occur if average cost rises as output increases.

how does technology change the cost curves?

An increase in technology that allows more output to be produced from the same resources shifts the cost curves downward. If the technology requires more capital, a fixed input, then the average total cost curve shifts upward at low levels of output and downward at higher levels of output.

how does the prices of factors of production change the cost curves?

An increase in the price of a factor of production increases the firm's costs and shifts its cost curves. An increase in rent or some other component of fixed cost shifts the TFC and AFC curves upward and shifts the TC curve upward but leaves the AVC and TVC curves and the MC curve unchanged. An increase in wages, gasoline, or another component of variable cost shifts the TVC and AVC curves upward and shifts the MC curve upward but leaves the AFC and TFC curves unchanged.

breakeven point

As long as MR is higher than MC it is rational for the firm to keep producing. A firm breaks even at the point where MR = MC. After this point, it does not make sense for the firm to keep producing. A rational firm that is trying to maximize its profit will produce the quantity where MR = MC.

Average Cost

Average fixed Cost (AFC) is total fixed cost per unit of output. The value of AFC falls as output increases. Average variable cost (AVC) is total variable cost per unit of output. At low levels of output, AVC falls as output increases but at higher levels of output, AVC rises as output increases. Average total cost (ATC) is total cost per unit of output. ATC = AFC + AVC. At low levels of output, ATC falls as output increases but at higher levels of output, ATC rises as output increases. Each average cost concept is calculated by dividing the related total cost by output.

average product

Average product tells how productive workers are on average. The average product of labor is equal to the total product divided by the quantity of labor employed. For example, the average product of 3 workers is 4.33 sweaters per worker—13 sweaters a day divided by 3 workers. As firms hire more labor, average product increases initially and then begins to decrease.

constant returns to scale

Constant returns to scale are features of a firm's technology that lead to constant long- run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output equals the percentage increase in all factors of production. The long run average cost curve is horizontal in this range of output. A producer experiences constant returns to scale if it increases its use of inputs and, as a result, the increase in output is equal to the increase in inputs

diseconomies of scale

Diseconomies of scale are features of a firm's technology that lead to rising long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output is less than the percentage increase in all factors of production. The long run average cost curve slopes upward in this range of output.

Short Run ATC Curve

Each short-run ATC curve is U-shaped. Each short-run ATC curve is U-shaped because, as the quantity of labor increases, its marginal product initially increases and then diminishes. For each short-run ATC curve, the larger the plant, the greater is the output at which average total cost is at a minimum. The minimum average total cost for a larger plant occurs at a greater output than it does for a smaller plant because the larger plant has a higher total fixed cost and therefore, for any given output, a higher average fixed cost.

economies of scale

Economies of scale are features of a firm's technology that lead to falling long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output exceeds the percentage increase in all factors of production. The long-run average cost curve slopes downward in this range of output. The main source of economies of scale is greater specialization of both labor and capital.

what is the relationship between the average product and marginal product curve?

For the number of workers at which marginal product exceeds average product, average product is increasing. For the number of workers at which marginal product is less than average product, average product is decreasing and the marginal product of labor equals the average product of labor when the average product of labor is at its maximum. That is, the marginal product curve cuts the average product curve at the point of maximum average product.

long run cost

In the long run, a firm can vary both the quantity of labor and the quantity of capital, so in the long run, all the firm's costs are variable. The behavior of long-run cost depends on the firm's production function, which is the relationship between the maximum output attainable and the quantities of both labor and capital.

Increasing marginal returns

Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker. Increasing marginal returns arise from increased specialization and division of labor in the production process. At low levels of employment, increasing marginal returns is likely because hiring an additional worker allows large gains from specialization. Eventually these gains become small or nonexistent and diminishing marginal returns set in

Marginal Cost

Marginal cost (MC) is the increase in total cost that results from a one-unit increase in output. We calculate marginal cost as the increase in total cost divided by the increase in output. The MC curve is U-shaped. Initially greater specialization makes additional units cost less than those that have come before, but eventually diminishing returns sets in and marginal costs rise.

diminishing marginal returns

Most production processes experience increasing marginal returns initially, but all production processes eventually reach a point of diminishing marginal returns. Diminishing marginal returns occur when the marginal product of an additional worker is less than the marginal product of the previous worker. As more workers are added, there is less and less for the additional workers to do that is productive. Hiring more and more workers continues to increase output but by successively smaller amounts. The law of diminishing returns states that as a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes.

long run

The long run is a time frame in which the quantities of all factors of production can be varied. Long-run decisions are not easily reversed so usually a firm must live with the plant size that it has created for some time. The past cost of buying a plant that has no resale value is called a sunk cost.

The Long Run Average Cost Curve

The long-run average cost curve LRAC consists of pieces of the four short-run ATC curves. LRAC, is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied. This curve is derived from the short-run average total cost curves. It shows the lowest average total cost to produce a given level of output. In the figure, the LRAC curve is the darkened parts of the three short-run ATC curves. The LRAC curve is a planning curve. Once the firm chooses a plant size, then it operates on the short-run costs curves associated with that plant size.

marginal product curve

The marginal product curve shows the additional output generated by each additional unit of labor. The marginal product of labor curve (MP) has an upside-down U shape. Marginal product is also measured by the slope of the total product curve.

marginal product of capital

The marginal product of capital is the change in total product divided by the change in capital when the quantity of labor is constant—equivalently, the change in output resulting from a one-unit increase in the quantity of capital. For example, if Campus Sweaters has 3 workers and increases its capital from 1 machine to 2 machines, output increases from 13 to 18 sweaters a day. The marginal product of the second machine is 5 sweaters a day.

production function

The production function determines the behavior of long run costs. A firm's production function typically exhibits diminishing returns to capital as well as diminishing returns to labor. Holding constant the quantity of employment, after some level of output the firm will have diminishing returns to capital— the marginal product of capital decreases as more capital is used. As the plant size increases, the output produced by any given quantity of labor increases. For a given plant size, the marginal product of labor diminishes as more labor is employed. For a given quantity of labor, the marginal product of capital diminishes as the quantity of capital used increases.

what is the relationship between the AVC curve and the AP curve?

The shape of the AVC curve is determined by the shape of the AP curve. Over the range of output for which the AP curve is rising, the AVC curve is falling and over the range of output for which the AP curve is falling, the AVC curve is rising.

what is the relationship between the MC curve and the MP curve?

The shape of the MC curve is determined by the shape of the MP curve. Over the range of output for which the MP curve is rising, the MC curve is falling and over the range of output for which the MP curve is falling, the MC curve is rising.

what does the slope of the total product curve tell us?

The slope of the total product curve equals the marginal product of labor at that quantity of labor.

total product curve

The total product curve shows how the quantity of sweaters produced changes as the quantity of labor employed changes. Points below the TP curve are attainable but inefficient. All the points that lie above the curve are unattainable. Only the points on the total product curve are technologically efficient. Notice the shape of the total product curve. As employment increases, the curve gets less steep.

total product

Total Product is the maximum output that a given quantity of labor can produce. As a firm employs more labor, total product increases. For example, when 1 worker is employed, total product is 4 sweaters a day, and when 2 workers are employed, total product is 10 sweaters a day. Each increase in employment increases the total product.

Total Cost

Total cost (TC) is the cost of all the factors of production a firm uses. Total fixed cost (TFC) is the cost of the firm's fixed factors. Total variable cost (TVC) is the cost of the firm's variable factors. Total cost is the sum of total fixed cost plus total variable cost so TC = TFC + TVC.

Total cost curve

Total fixed cost is constant—the TFC curve is a horizontal line. Total variable cost increases as output increases, so the TVC curve and the TC curve slope upward as output increases. The vertical distance between the TC curve and the TVC curve equals total fixed cost

economic profit

calculated as total revenue - explicit costs - implicit costs. Economic profits are positive when total revenue is greater than its explicit and implicit costs. A firm earns zero economic profit when price (P) = ATC (Q)

accounting profit

calculated as total revenue minus total explicit cost. Accounting profit gives you the amount you profit from the business and get to keep for yourself. If a firm has negative accounting profits then its economic profits are negative.

marginal product

the marginal product of labor is the increase in total product that results from a one-unit increase in the quantity of labor employed, with all other inputs remaining the same. For example, when a firm increases employment from 2 to 3 workers and does not change its capital, the marginal product of the third worker is 3 sweaters—total product increases from 10 to 13 sweaters. As firms hire more labor, marginal product increases initially and then begins to decrease.

Short Run

the short run is a time frame in which the quantity of at least one factor of production is fixed. For most firms, capital, land, and entrepreneurship are fixed factors of production and labor is the variable factor of production. We call the fixed factors of production the firm's plant: In the short run, a firm's plant is fixed. To increase output in the short run, a firm must increase the quantity of a variable factor of production, which is usually labor. Short-run decisions are easily reversed. The firm can increase or decrease its output in the short run by increasing or decreasing the amount of labor it hires.