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The Firm:
Cost and Output Determination
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Learning Objectives
Discuss the difference between the short run and the long
run from the perspective of a firm
Understand why the marginal physical product of laboreventually declines as more units of labor are employed
Explain the short-run cost curves a typical firm faces
Describe the long-run cost curves a typical firm faces
Identify situations of economies and diseconomies of scale
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Did You Know That...
Production technologies and the costsproducers face are related?
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Short Run
A time period when at least one input, such as
plant size, cannot be changed
Plant Size
The physical size of the factories that a firm owns
and operates to produce its output
Short Run versus Long Run
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Short Run versus Long Run
Long Run
The time period in which all factors of
production can be varied
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Short Run versus Long Run
Managers take account of both the short-run
and long-run consequences of their
behavior.
While making decisions about what
to do today, tomorrow, and next week
they keep an eye on the long-run benefits.
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The Relationship Between
Output and InputsA firm takes numerous inputs, combines
them using a technological production
process and ends up with output.
We classify production inputs in two broad
categorieslabor and capital.
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The Relationship Between
Output and Inputs
Q = output/time periodK= capital
L = labor
Q =(K,L)
or
Output / time period = Some function of capital and labor inputs
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The Relationship Between
Output and InputsProduction
Any activity that results in the conversion of
resources into products that can be used in
consumption
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The Relationship Between
Output and InputsProduction Function
The relationship between maximum physical
output and the quantity of capital and labor
used in the production process
The production function is a technological
relationship between inputs and output.
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E-Commerce Example:
Put Away the Clay and Turn on
the Holographic Camera
Once a company has integrated aholographic camera system into its existing
computer network, creating holographicdesigns takes less time.
Consequently, product developers using
holographic techniques can now createmore designs while utilizing fewer laborresources.
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E-Commerce Example:
Put Away the Clay and Turn on
the Holographic Camera
Why do technological improvements often
reduce labor requirements for specific tasks,thereby allowing labor to be utilized for
other purposes?
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The Relationship Between
Output and InputsAverage Physical Product
Total product divided by the variable input
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The Relationship Between
Output and InputsMarginal Physical Product
The physical output that is due to the addition
of one more unit of a variable factor ofproduction
The change in total product occurring when a
variable input is increased and all other inputsare held constant
Also called marginal product
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The Production
Function and
MarginalProduct:
A Hypothetical
Case, Panel (a)
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The Production
Function and Marginal Product:
A Hypothetical Case
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The Production
Function and Marginal Product:
A Hypothetical Case
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Diminishing Marginal Product
Measuring marginal product
Specialization and marginal product
Diminishing marginal product
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Law of Diminishing Marginal Product
The observation that after some point,
successive equal-sized increases in a variable
factor of production, such as labor, added to
fixed factors of production, will result in
smaller increases in output
Diminishing Marginal
Product
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An Example of the Law of
Diminishing Marginal ProductProduction of computer
printers example
We have a fixed amount of factory space,assembly equipment, and quality controldiagnostic software.
So the addition of more workerseventually yields successively smaller increasesin output.
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An Example of the Law of
Diminishing Marginal ProductAfter a while, when all the assembly equipment
and quality-control diagnostic software are being
used, additional workers will have to start
assembling and troubleshooting quality problems
manually.
The marginal physical product of an additional
worker, given a specified amount of capital, musteventually be less than that for the previous
workers.
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Total costs (TC) = TFC + TVC
Short-Run Costs to the Firm
Total Costs
The sum of total fixed costs and totalvariable costs
Fixed Costs
Costs that do not vary with output
Variable Costs
Costs that vary with the rate of production
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Average Total Costs (ATC)
Short-Run Costs to the Firm
Average total costs (ATC) = Total costs (TC)Output (Q)
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Average Variable Costs (AVC)
Short-Run Costs to the Firm
Average variable costs (AVC) =Total variable costs (TVC)
Output (Q)
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Average Fixed Costs (AFC)
Short-Run Costs to the Firm
Average fixed costs (AFC) = Total fixed costs (TFC)Output (Q)
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Marginal Cost
The change in total costs due to a one-unit
change in production rate
Short-Run Costs to the Firm
Marginal costs (MC) =Change in total cost
Change in output
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Cost of Production: An Example
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Cost of Production: An Example
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Cost of Production: An Example
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Short-Run Costs to the Firm
Question
What do you thinkis there a predictable
relationship between the production function
and AVC, ATC, and MC?
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Short-Run Costs to the Firm
Answer
As long as marginal physical product rises,
marginal cost will fall, and when marginal
physical product starts to fall (after reaching the
point of diminishing marginal product),
marginal cost will begin to rise.
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The Relationship Between
Average and Marginal CostsWhen marginal costs are less than average
variable costs, the latter must fall.
When marginal costs are greater than
average variable costs, the latter must rise.
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The Relationship Between
Average and Marginal CostsThere is also a relationship between
marginal costs and average total costs.
Average total cost is equal to total cost divided
by the number of units produced.
Marginal cost is the change in total
cost due to a one-unit change in the production
rate.
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The Relationship Between Diminishing
Marginal Product and Cost Curves
Firms short-run cost curves are a reflection
of the law of diminishing marginal product.
Given any constant price of the variable
input, marginal costs decline as long as the
marginal product of the variable resource is
rising.
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At the point at which diminishing marginal
product begins, marginal costs begin to rise
as the marginal product of the variable inputbegins to decline.
The Relationship Between Diminishing
Marginal Product and Cost Curves
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The Relationship Between Diminishing
Marginal Product and Cost Curves
If the wage rate is constant, then the labor
cost associated with each additional unit of
output will decline as long as the marginalphysical product of labor increases.
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The Relationship Between Output
and Costs
/ / /
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The Relationship Between Output
and Costs
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The Relationship Between Output
and Costs
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The Relationship Between Output
and Costs
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Long-Run Cost Curves
Planning Horizon
The long run, during which all inputs
are variable
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Preferable Plant Size and the
Long-Run Average Cost Curve
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Long-Run Cost Curves
Long-Run Average Cost Curve
The locus of points representing the minimum
unit cost of producing any given rate of output,
given current technology and resource prices
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Long-Run Cost Curves
Observation
Only at minimum long-run average cost curve
is short-run average cost curve tangent to long-run average cost curve.
Question
Why do you think the long-run average cost
curve is U-shaped?
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Why the Long-Run Average
Cost Curve is U-Shaped
Economies of scale
Constant returns to scale
Diseconomies of scale
Economies of Scale Constant Returns
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Economies of Scale, Constant Returns
to Scale, and Diseconomies of Scale
Shown with Long-Run Average CostCurve
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Why the Long-Run Average
Cost Curve is U-Shaped
Economies of Scale
Decreases in long-run average costs resulting
from increases in output
These economies of scale do not persist indefinitely,
however.
Once long-run average costs rise, the curve begins
to slope upwards.
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Reasons for economies of scale
Specialization
Division of tasks or operations
Dimensional factor
Improved productive equipment
Why the Long-Run Average
Cost Curve is U-Shaped
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Why the Long-Run Average
Cost Curve is U-Shaped
Explaining diseconomies of scale
Limits to the efficient functioning
of management
Coordination and communication is more of a
challenge as firm size increases
S Di i
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Summary Discussion
of Learning Objectives
The short run versus the long run from a
firms perspective
Short runa period in which at least one input
is fixed
Long runa period in which all inputs
are variable
S Di i
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Summary Discussion
of Learning Objectives
The law of diminishing marginal product
As more units of a variable input are employed with a
fixed input, marginal physical product eventuallybegins to decline.
A firms short-run cost curves
Fixed and average fixed cost
Variable and average variable cost
Total and average total cost
Marginal cost
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Summary Discussion
of Learning Objectives
A firms long-run cost curve
Planning horizonAll inputs are variable including plant size