Ch06-Perfect competition

8/13/2019 Ch06-Perfect competition

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6

CHAPTER

Output and

Costs


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Pearson Education 2012

After studying this chapter you will be able to:

Distinguish between the short run and the long run

Explain the relationship between a firms output and

labour employed in the short run

Explain the relationship between a firms output andcosts in the short run and derive a firms short-run costcurves

Explain the relationship between a firms output and

costs in the long run and derive a firms long-runaverage cost curve


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What does one of the largest European airlines and a small

scale jumper maker have in common?Each firm must decide how much to produce, how manypeople to employ and how much capital to use.

Is being bigger always better for a firm?

Why do some firms, such as car makers, have plenty ofslack and wish they could sell more whereas othersoperate flat out all the time?

We answer these questions by looking at the types ofdecisions firms make and their impact on costs.


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Decision Time Frames

The firm makes many decisions to achieve its mainobjective:profit maximization.

Some decisions are critical to the survival of the firm.

Some decisions are irreversible (or very costly to reverse).

Other decisions are easily reversed and are less critical tothe survival of the firm, but still influence profit.

All decisions can be placed in two time frames:

The short run

The long run


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Decision Time Frames

The Long Run

The long runis a time frame in which the quantities of allresources including the plant size can be varied.

Long-run decisions are not easily reversed.

A sunk costis a cost incurred by the firm and cannot bechanged.

If a firms plant has no resale value, the amount paid for itis a sunk cost.

Sunk costs are irrelevant to a firms decisions.


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Short-run Technology Constraint

To increase output in the short run, a firm must increasethe amount of labour employed.

Three concepts describe the relationship between output

and the quantity of labour employed:1 Total product

2 Marginal product

3 Average product


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Product Schedules

Total productis the total output produced in a givenperiod.

Themarginal productof labour is the change in totalproduct that results from a one-unit increase in thequantity of labour employed, with all other inputsremaining the same.

Theaverage productof labour isequal to total productdivided by the quantity of labour employed.

Table 6.1on page 131 shows a firms product schedules.


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Product Curves

Product curves are graphs of the three product conceptsthat show how total product, marginal product, and

average product change as the quantity of labouremployed changes.


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Total Product Curve

Figure 6.1 shows a totalproduct curve.

The total product curveshows how total productchanges with the quantity

of labour employed.


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The total product curve issimilar to the PPF.

It separates attainableoutput levels fromunattainable output levelsin the short run.


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Marginal Product Curve

Figure 6.2 shows themarginal product of labourcurve and how themarginal product curverelates to the total productcurve.

The first worker hiredproduces 4 units of output.


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The second worker hiredproduces 6 units of outputand total product becomes10 units.

The third worker hiredproduces 3 units of outputand total product becomes13 units.

And so on.


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The height of each barmeasures the marginalproduct of labour.

For example, when labourincreases from 2 to 3, totalproduct increases from 10to 13,

so the marginal product ofthe third worker is 3 unitsof output.


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To make a graph of themarginal product of labour,we can stack the bars inthe previous graph side byside.

The marginal product oflabour curve passes

through the mid-points ofthese bars.


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Almost all productionprocesses are like theone shown here and

have:

Increasing marginalreturns initially

Diminishing marginalreturns eventually


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Increasing Marginal

Returns Initially

When the marginal product

of a worker exceedsthemarginal product of theprevious worker, themarginal product of labour

increasesand the firmexperiences increasingmarginal returns.


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Diminishing Marginal

Returns Eventually

When the marginal product

of a worker is lessthan themarginal product of theprevious worker, themarginal product of labour

decreases.The firm experiencesdiminishing marginal

returns.



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Increasing marginal returns arise from increasedspecialization and division of labour.

Diminishing marginal returns arises from the fact that

employing additional units of labour means each workerhas less access to capital and less space in which to work.

Diminishing marginal returns are so pervasive that they areelevated to the status of a law.

The law of diminishing returnsstates that as a firm usesmore of a variable input with a given quantity of fixedinputs, the marginal product of the variable input eventuallydiminishes.


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Average Product Curve

Figure 6.3 shows theaverage product curveand its relationship withthe marginal productcurve.

When marginal product

exceedsaverage product,average productincreases.


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When marginal product isbelowaverage product,average product

decreases.When marginal productequals average product,average product is at its

maximum.


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Marginal Mark and Average Mark

The relationship between a students marginal mark and

her or his average mark is similar to that between marginal

product and average product.If a students next mark is higher (lower) than the students

average mark, this marginal mark will pull the students

average up (down).

If the next mark is the same as the average mark, theaverage remains unchanged.


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Short-run Cost

To produce more output in the short run, the firm mustemploy more labour, which means that it must increase itscosts.

We describe the way a firms costs change as totalproduct changes by using three cost concepts and threetypes of cost curve:

Total cost

Marginal cost

Average cost


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Short-run Cost

Total Cost

A firms total cost(TC)is the cost of allresources used.

Total fixed cost(TFC)is the cost of the firms fixed

inputs. Fixed costs do not change with output.

Total variable cost(TVC)is the cost of the firms variableinputs. Variable costs do change with output.

Total cost equals total fixed cost plus total variable cost.That is:

TC= TFC+ TVC


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Short-run Cost

Figure 6.4 shows a firms

total cost curves.

Total fixed cost is the same

at each output level.

Total variable costincreases as outputincreases.

Total cost, which is the sumof TFCand TVCalsoincreases as outputincreases.


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Short-run Cost

The total variable costcurve gets its shape fromthe total product curve.

Notice that the TPcurvebecomes steeper at lowoutput levels and then lesssteep at high output levels.

In contrast, the TVCcurvebecomes less steep at lowoutput levels and steeperat high output levels.


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Short-run Cost

To see the relationshipbetween the TVCcurveand the TPcurve, lets lookagain at the TPcurve.

But let us add a secondx-axis to measure totalvariable cost.

1 worker costs $25; 2workers cost $50: and soon, so the twox-axes lineup.


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Short-run Cost

Redraw the graph withcost on the y-axis andoutput on thex-axis, andyouve got the TVCcurve

drawn the usual way.

Put the TFCcurve back inthe figure,

and add TFCto TVC, andyouve got the TCcurve.


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Short-run Cost

Marginal Cost

Marginal cost(MC)is the increase in total cost thatresults from a one-unit increase in total product.

Over the output range withincreasing marginal returns,marginal cost falls as output increases.

Over the output range withdiminishing marginal returns,marginal cost rises as output increases.


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Short-run Cost

Average Cost

Average cost measures can be derived from each of thetotal cost measures:

Average fixed cost(AFC)is total fixed cost per unit ofoutput.

Average variable cost(AVC)is total variable cost per unitof output.

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

ATC = AFC + AVC.


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Short-run Cost

Figure 6.5 shows the MC,AFC,AVCandATCcurves.

TheAFCcurve shows that

average fixed cost falls asoutput increases.

TheAVCcurve is U-shaped.As output increases,

average variable cost falls toa minimum and thenincreases.


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TheATCcurve is alsoU-shaped.

ATC = AFC + AVC

AFC is downward sloping.

AVC is U-shaped.

SoATC is also U-shaped.

Short-run Cost


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Short-run Cost

The MCcurve is veryspecial.

WhereAVCis falling, MCisbelowAVC.

WhereAVCis rising, MCis

aboveAVC.At the minimumAVC, MCequalsAVC.


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Short-run Cost


Similarly, whereATCisfalling, MCis belowATC.

WhereATCis rising, MCisaboveATC.

At the minimumATC, MCequalsATC.


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Short-run Cost

Why the Average Total Cost Curve Is U-Shaped

TheAVCcurve is U-shaped because:

Initially, marginal product exceeds average product, which

brings rising average product and fallingAVC.

Eventually, marginal product falls below average product,which brings falling average product and risingAVC.

TheATC curve is U-shaped for the same reasons. Inaddition,ATCfalls at low output levels becauseAFCisfalling steeply.


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Short-run Cost

Cost Curves and Product Curves

The shapes of a firms cost curves are determined by the

technology it uses:

MCis at its minimum at the same output level at whichmarginal product is at its maximum.

When marginal product is rising, marginal cost is falling.

AVCis at its minimum at the same output level at whichaverage product is at its maximum.

When average product is rising, average variable cost isfalling.


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Short-run Cost

Figure 6.6 shows theserelationships.


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Short-run Cost

Shifts in Cost Curves

The position of a firms cost curves depend on two factors:

Technology

Prices of factors of production


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Short-run Cost

Technology

Technological change influences both the productivitycurves and the cost curves.

An increase in productivity shifts the average and marginalproduct curves upward and the average and marginal costcurves downward.

If a technological advance brings more capital and lesslabour into use, fixed costs increase and variable costsdecrease.

In this case, average total cost increases at low outputlevels and decreases at high output levels.


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Short-run Cost

Prices of Factors of Production

An increase in the price of a factor of production increasescosts and shifts the cost curves.

An increase in a fixedcost shifts the total cost (TC ) andaverage total cost (ATC ) curves upward but does notshiftthe marginal cost (MC ) curve.

An increase in a variablecost shifts the total cost (TC ),

average total cost (ATC ), and marginal cost (MC ) curvesupward.


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Long-run Cost

Diminishing Marginal Product of CapitalThe marginal product of capitalis the increase in outputresulting from a one-unit increase in the amount of capitalemployed, holding constant the amount of labour

employed.

A firms production function exhibits diminishing marginal

returns to labour (for a given plant size) as well asdiminishing marginal returns to capital (for a quantity of

labour).

For eachplant size, diminishing marginal product of labourcreates a set of short run, U-shaped costs curves for MC,AVC,andATC.


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Long-run Cost

Short-Run Cost and Long-Run Cost

The average cost of producing a given output varies anddepends on the firms plant size.

The larger the plant size, the greater is the output at whichATCis at a minimum.

Neat Knits has 4 different plant sizes: 1, 2, 3, or 4 knittingmachines.

Each plant has a short-runATCcurve.The firm can compare theATCfor each given output atdifferent plant sizes.


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Long-run Cost

ATC1is theATCcurve for a plant with 1 knittingmachine.


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Long-run Cost

ATC2is theATCcurve for a plant with 2 knittingmachines.


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Long-run Cost

ATC3is theATCcurve for a plant with 3 knittingmachines.


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Long-run Cost

The long-run average cost curve is made up from thelowestATCfor each output level.

So, we want to decide which plant has the lowest cost for

producing each output level.Lets find the least-cost way of producing a given outputlevel.

Suppose that Neat Knits wants to produce 13 jumpers a

day.


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Long-run Cost

13 jumpers a day cost $7.69 each onATC1.


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Long-run Cost



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Long-run Cost



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Long-run Cost

13 jumpers a day cost $6.80 each onATC2.The least-cost way of producing 13 jumpers a day.


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Long-run Cost

Long-run Average Cost Curve

The long-run average cost curveis the relationshipbetween the lowest attainable average total cost andoutput when both the plant size and labour are varied.

The long-run average cost curve is a planning curve thattells the firm the plant size that minimizes the cost ofproducing a given output range.

Once the firm has chosen that plant size, it incurs thecosts that correspond to theATCcurve for that plant.


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Long-run Cost

Figure 6.8 illustrates the long-run average cost (LRAC) curve.


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Long-run Cost

Figure 6.8 illustrates economies and diseconomies of scale.


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Long-run Cost

Minimum Efficient Scale

A firm experiences economies of scale up to some outputlevel.

Beyond that output level, it moves into constant returns toscale or diseconomies of scale.

Minimum efficient scaleis the smallest quantity of outputat which the long-run average cost reaches its lowestlevel.

If the long-run average cost curve is U-shaped, theminimum point identifies the minimum efficient scaleoutput level.

Ch06-Perfect competition

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