ECO 240 - 6
Costs in the Short Run
Reading: SLO Chapter 5
Short run: run A period of time so short that some of the firm’s inputs are fixed in total supply.
Costs and Output Decisions There are several ways to categorize short-run costs...
Fixed Costs (FC) Any cost that a firm bears in the short run that does not depend on its level of output ...
Variable Costs (VC) Variable costs are any costs that a firm bears that depends on the level of production chosen.
Sometimes called sunk costs because firms have no control over fixed costs in the short run
Costs
The TFC, TVC, and TC Curves
Total Costs (TC)
TC TVC
Total Costs = Total Fixed Costs + Total Variable Costs TFC
TC = TFC + TVC
Units of output
1
Average Variable Costs
Average Fixed Costs AFC = Total Fixed Costs quantity of output
AVC = Total Variable Costs quantity of output
Average Costs
Average Total Costs
AFC = Total Fixed Costs quantity of output AVC = Total Variable Costs quantity of output
ATC = Total Costs quantity of output ATC = AFC + AVC
Marginal costs reflect changes in variable costs.
The marginal cost curve is closely related to the marginal product curve:
Marginal cost ($)
Marginal costs represent the increase in total cost that results from producing one more unit of output
Total Costs quantity of output ATC = AFC + AVC
Marginal product
Marginal Costs (MC)
ATC =
Units of labor
Units of output
2
When marginal product begins to fall, marginal cost begins to rise:
Units of labor
TVC
Total variable costs
Diminishing returns set in.
Marginal cost ($)
Marginal product
Diminishing returns set in.
Given the law of diminishing returns, the total variable cost curve has a distinctive shape:
Diminishing returns set in where TVC begins to increase at an increasing rate. Units of output
Units of output
Total fixed costs are constant at every level of output... Total variable costs
Given the law of diminishing returns, the total variable cost curve has a distinctive shape: Total variable costs
TVC Marginal costs are minimized at this level of output.
TVC
TFC
Units of output
Output TFC TVC (Q) (£) (£)
100
0 1 2 3 4 5 6 7
80
60
12 12 12 12 12 12 12 12
0 10 16 21 28 40 60 91
TC (£)
Units of output
Total costs for firm X TC
12 22 28 33 40 52 72 103
Total costs for firm X TC
100
TVC
TVC 80
Diminishing marginal returns set in here
60
40
40
20
20
TFC
TFC
0 0
1
2
3
4
5
6
7
8
0 0
1
2
3
4
5
6
7
8
3
Average and marginal physical product
But average fixed costs decline as output increases.
b
Output
Average fixed costs
c
AFC = Total Fixed Costs quantity of output
APP
MPP
AFC Units of output
Marginal cost
MC
Quantity of the variable factor
Total costs for firm X
100
TC TVC
Costs (£)
80
Diminishing marginal returns set in here
Bottom of the MC curve
60
40
20
x
TFC 0
Output (Q)
Short-Run Costs Marginal cost
– marginal cost (MC) and the law of diminishing returns – the relationship between the marginal and total cost curves
0
1
2
3
4
5
6
7
8
Average total and average variable costs are also affected by the law of diminishing returns. $$
MC
ATC
AVC
Average cost
– average fixed cost (AFC) – average variable cost (AVC) – average (total) cost (AC) – relationship between AC and MC
Units of output
4
Average and marginal costs MC
AC AVC
Some important points about cost curves: Average total cost equals marginal cost
Costs (£)
where average total cost is minimized. Average variable cost equals marginal cost
where average variable cost is minimized.
z
The slope of the total variable cost curve
y x AFC
Output (Q)
describes the change in TVC when output increases by one unit. The slope of the total variable cost curve is equal to marginal cost.
Consider this shortshort-run cost data for a hypothetical firm:
Consider this shortshort-run cost data for a hypothetical firm:
q TVC MC AVC TFC 0 $ 0 $1000 1 10 1000 2 18 1000 3 24 1000 4 32 1000 5 42 1000
q TVC MC AVC TFC TC 0 $ 0 $-$-- $1000 $1000 1 10 10 10 1000 1010 2 18 8 9 1000 1018 3 24 6 8 1000 1024 4 32 8 8 1000 1032 5 42 10 8.4 1000 1042
TC
AFC ATC
Can you fill in the missing columns?
AFC $-1000 500 333 250 200
ATC $-1010 509 341 258 208
Were you correct?
Long-run Average Cost
LRAC
Inputs are variable, therefore all costs
LRAC is U-shaped / basin-shaped. Each
are variable. Assumptions: 1. Factor prices are given 2. The state of technology and factor quality are given 3. Firms choose the least-cost combination of factors for each output
SRAC sits on it or is tangent to it. The LRAC consists a series of alternative SRAC. The firm can build in the LR any one of the different sized plants. It can also alter the size of plant
5
Relationship: LRAC & SRAC
LRAC
LR a firm can build more factories, thus
LRAC can take various shapes:
experiencing economies of scale, the expansion enables / allows firm to produce with a new lower SRAC curve. Each SRAC corresponds to a particular amount of the factor that is fixed in the short-run. Given time, the several expansions at various time period, enable a series of SRACs – From these curves an envelope curve is developed.
1. Economies of scale – LRAC will fall as the
scale of production increases 2. Diseconomies of scale – LRAC will rise as output increases 3. Constant returns to scale /constant cost – LRAC will be horizontal
A typical long-run average cost curve
Costs
Technical Optimum
O
Economies of scale
Constant costs
Diseconomies of scale
It is the point where AC for the plant size LRAC
equals the MC of producing an extra unit. It is the least cost point. Where a firm’s MC < AC, increase in output will lower AC. Where a firm’s MC > AC, increase in output will make AC higher I.e. each extra unit of production is costing more
Output
Economies of large scale production
Economies of large scale production i.e.
A firm can enjoy economies of large scale
More specialization of labour and
production when an increase in the size of the operations reduces the cost per unit i.e. increasing returns to scale flowing from internal economies of scale. The firm uses input more efficiently and is considered as a cost advantage Factors that bring about internal economies of scale are as follows: (next slide please)
management Better capital equipment Improved management Better use of raw materials Greater use of by product and recycling The introduction of new technology
Internal Economies of scale
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Internal Economies of Scale (cont’d)
External Economies of Scale -a cost advantage
Large scale production can also bring
It is caused by factors outside the direct control of the
firm.When services provided by other firms or the government lead to an increase in the firm’s output that is more than proportional to the inputs. Factors:
increase efficiencies in marketing, advertising, the distribution of the finished product and the bulk purchase of inputs because the costs are spread over a much larger output. The cost per unit is less.
1. Increase in the size of the market
2. Access to more infrastructure such as roads and railways 3. Development of similar industries to give advantages offered by the localization of industries 4. More research and development by industries
Long-run average and marginal costs
Diseconomies of large scale production This is an increase in output causing a firm’s cost to ruse more than proportionately with revenue. Average costs increase. Factors caused
1. Removal of management from the productive process 2. Loss of personal contact with staff 3. Loss contact with the market & changes in the market 4. An imbalance between the fixed and variable inputs in the short run caused by rapid expansion 5. Inflexible decision-making
Deriving long-run average cost curves: factories of fixed size SRAC1 SRAC 2
SRAC3
Initial economies of scale, then diseconomies of scale
LRMC
LRAC
Costs
O
Output
Deriving long-run average cost curves: factories of fixed size
SRAC5 SRAC4
SRAC1 SRAC 2
SRAC3
SRAC5 SRAC4
O
Output
5 factories
Costs
Costs
LRAC 1 factory 2 factories 3 factories4 factories
O
Output
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Output Decisions, Revenues, Costs, and Profit Maximization
Revenue
Remember: Firms operate in perfectly competitive output markets. In perfectly competitive industries, prices are determined in the market and firms are price takers. The demand curve for the firm is perfectly elastic.
Defining total, average and marginal
revenue Revenue curves when firms are price takers
(horizontal demand curve) – average revenue (AR) – marginal revenue (MR)
Total revenue is the amount of revenue the firm takes in from the sale of its product. TR = price x quantity sold Marginal revenue is the additional revenue that a firm takes in when it increases output by one additional unit. MR = TR / q
Market
$ 5
S
$ 5
Firm
D=MR
Market
$ 5
Firm
D=MR
$ 5
Units of output
Units of output
The firm maximizes profits by producing where MR = MC : Market
$ 5
S
$ 5
D Units of output
S
D
Price per unit
Price per unit
Comparing Costs and Revenues to Maximize Profit :
In a perfectly competitive market, the firm’s demand curve is the firm’s marginal revenue curve: Price per unit
Total and Marginal Revenue
Firm
D=MR
D Units of output
Units of output
q* Units of output
8
Why is q=300 the profitprofit-maximizing level of output for the firm? Firm
$$
What will be the firm’s profit level at the profit--maximizing level of output? profit
MC
Firm
$$
MC
ATC $5
ATC $5
D=MR
D=MR
$3.50
0
100 250 300 340 Units of output
The firm’s profit at q=300 is $1.50 per unit, or $450. Firm
$$
MC ATC
$5
D=MR
$3.50
0
Consider the following data for a hypothetical firm: q TFC TVC MC 0 $10 $ 0 $-1 10 10 2 10 15 3 10 20 4 10 30 5 10 50 6
100 250 300 340 Units of output
10
TR
TC TR-TC
15
The Competitive Firm’s Short Run Supply Curve $$
TR $-15 30 45 60 75 90
80
P=MR $15 15 15 15 15 15
Can you fill in the missing columns?
What is the firm’s profit maximizing level of output? q TFC TVC MC P=MR 0 $10 $ 0 $-- $15 1 10 10 10 15 2 10 15 5 15 3 10 20 5 15 4 10 30 10 15 5 10 50 20 15 6 10 80 30 15
100 250 300 340 Units of output
0
TC TR-TC $10 $ -10 20 - 5 25 5 30 15 40 20 60 15 90 0
MC = S ATC P=MR and the firm produces where MC=P=MR. Thus the firm’s supply curve is its marginal cost curve - above AVC.
0
Units of output
9
TR curve for a firm facing a downward-sloping D curve
If price falls below AVC, the firm should produce no output. $$
Elasticity = -1 20
MC
16
TR
ATC
TR (£)
12
8
This will be explored more carefully in the
4
Why? 0
0
Units of output
0
1
2
3
4 Quantity
5
6
7
AR and MR curves for a firm facing a downward-sloping D curve
Profit
8
Elastic Elasticity = -1
AR, MR (£)
6
4
Profit
Inelastic
2
AR
Maximization
0 1
2
3
4
5
6
7
Quantity
-2
MR
-4
Finding maximum profit using total curves
d
12
16
TR
e
12 8
f
4 0
Costs and revenue (£)
TR, TC, TΠ (£)
20
8
4
Profit-maximising output
e
0
1
2
3
4
5
6
-4 -8
Finding the profit-maximising output using marginal curves 16 MC
TC
24
1
7
TΠ
2
3
4
5
6
7
Quantity
Quantity -4
MR
10
Measuring the maximum profit using average curves 16
MC
Profit Maximization
Total profit = £1.50 x 3 = £4.50 12
Costs and revenue (£)
Using total curves
– maximising difference between TR and TC – the total profit curve Using marginal and average curves
– stage 1: profit maximised where MR = MC
Profits maximised at the output where MC = MR
AC
8
a
6.00 TOTAL PROFIT b 4.50 4
AR 0
– stage 2: using AR and AC curves to measure maximum profit
1
3
4
The short-run shut-down point The firm will shut down in the short run if it cannot cover variable costs.
Costs and revenue (£)
AC
LOSS AR
If AVC is higher or AR lower than that shown, the firm will shut down.
P= AVC
O
Q
Quantity
Quantity
Loss Minimization What if a loss is made? – loss minimising: still produce where MR = MC
– short-run shut-down point: P = AVC
– long-run shut-down point: P = LRAC
AC AVC
AR
AR MR
7
MR
AC
Q
6
-4
MC
O
5
Quantity
Loss-minimising output
Costs and revenue (£)
2
Review Terms & Concepts Average fixed cost (AFC)
Total cost (TC)
Average total cost (ATC)
Total fixed cost (TFC)
Average variable cost
Total revenue (TR)
(AVC) Fixed cost Marginal cost (MC) Marginal revenue (MR) Spreading overhead Sunk costs
Total variable cost (TVC) Total variable cost curve Variable cost
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