Output and Cost

Introduction

This chapter explores how firms measure and manage their costs and output, focusing on the distinction between economic and accounting profit, the behavior of costs in the short run and long run, and the technological constraints that shape production decisions. Understanding these concepts is essential for analyzing firm behavior and market outcomes in microeconomics.

Economic Cost and Profit

The Firm and Its Goal

• Firm: An institution that hires factors of production and organizes them to produce and sell goods and services.

• Goal: The primary objective of a firm is to maximize profit. Firms that fail to do so may be eliminated or taken over by more efficient competitors.

Accounting Profit vs. Economic Profit

• Accounting Profit: Calculated as total revenue minus total cost, using rules set by accounting standards (e.g., Revenue Canada).

• Economic Profit: Calculated as total revenue minus total cost, where total cost includes opportunity costs (the value of the best alternative use of resources).

• Formula:

Opportunity Cost of Production

• The value of the best alternative use of resources used in production.

• Opportunity cost is the sum of costs for resources:

  • Bought in the market

  • Owned by the firm

  • Supplied by the firm's owner

Resources Bought in the Market

• The money spent on market resources is an opportunity cost, as the firm could have used those resources elsewhere.

Resources Owned by the Firm

• If the firm owns capital, using it incurs an opportunity cost (it could have been sold or rented out).

• The implicit rental rate of capital is the opportunity cost of using owned capital, consisting of:

  • Economic depreciation: Change in market value of capital over time.

  • Interest forgone: Return on funds used to acquire the capital.

Resources Supplied by the Firm's Owner

• Owners may supply entrepreneurship and labor.

• Normal profit: The average profit an entrepreneur expects, considered an opportunity cost.

• If the owner supplies labor without taking a wage, the opportunity cost is the wage income forgone from the best alternative job.

Economic Accounting Summary

• Economic profit equals total revenue minus total opportunity cost.

Decision Time Frames

• Decisions are made in two time frames:

  • Short run: At least one input is fixed (usually capital/plant).

  • Long run: All inputs, including plant size, can be varied.

• Sunk cost: A cost that cannot be changed or recovered (e.g., a plant with no resale value).

Short-Run Technology Constraint

Key Concepts

• Total product (TP): Total output produced in a given period.

• Marginal product (MP): Change in total product from a one-unit increase in labor, holding other inputs constant.

• Average product (AP): Total product divided by quantity of labor employed.

• Formulas:

Product Schedules and Curves

• As labor increases:

  • Total product increases.

  • Marginal product increases initially, then decreases.

  • Average product decreases.

Total Product Curve

• Shows how total product changes with labor employed.

• Separates attainable output levels from unattainable ones in the short run.

Marginal Product Curve

• Shows the change in output from hiring additional workers.

• Initially, marginal product increases due to specialization, then decreases due to limited capital and workspace.

Diminishing Marginal Returns

• Occurs when each additional worker adds less output than the previous one.

• Law of Diminishing Returns: As a firm uses more of a variable input with a fixed input, the marginal product of the variable input eventually diminishes.

Average Product Curve

• When marginal product exceeds average product, average product rises.

• When marginal product is below average product, average product falls.

• When marginal product equals average product, average product is at its maximum.

Short-Run Cost

Key Cost Concepts

• Total cost (TC): Cost of all resources used.

• Total fixed cost (TFC): Cost of fixed inputs (does not change with output).

• Total variable cost (TVC): Cost of variable inputs (changes with output).

• Formula:

Cost Curves

• Total fixed cost: Remains constant at all output levels.

• Total variable cost: Increases as output increases.

• Total cost: Increases as output increases, as it is the sum of TFC and TVC.

Marginal and Average Cost

• Marginal cost (MC): Increase in total cost from a one-unit increase in output.

• Average fixed cost (AFC): TFC per unit of output.

• Average variable cost (AVC): TVC per unit of output.

• Average total cost (ATC): TC per unit of output.

• Formula:

Shape of Cost Curves

• AFC falls as output increases.

• AVC and ATC are typically U-shaped due to initially increasing returns (falling costs) and eventually diminishing returns (rising costs).

• MC is below AVC/ATC when they are falling, and above when they are rising. MC equals AVC/ATC at their minimum points.

Why ATC Is U-Shaped

• ATC is the vertical sum of AFC and AVC.

• U-shape arises from two forces:

  • Spreading fixed cost over more output (AFC falls).

  • Diminishing returns (AVC rises faster than AFC falls at high output).

Shifts in Cost Curves

• Cost curves shift due to changes in technology or factor prices.

• Technological improvements shift product curves up and cost curves down.

• Higher fixed costs shift TC and ATC up, but not MC. Higher variable costs shift TC, ATC, and MC up.

Long-Run Cost

Production Function

• In the long run, all inputs and costs are variable.

• The production function shows the maximum output attainable for given quantities of capital and labor.

Diminishing Marginal Product of Capital

• Marginal product of capital: Increase in output from a one-unit increase in capital, holding labor constant.

• Production functions exhibit diminishing marginal returns to both labor and capital.

Short-Run vs. Long-Run Cost

• Average cost of producing a given output depends on plant size.

• Each plant size has its own short-run ATC curve.

• The long-run average cost (LRAC) curve is formed by the lowest ATC for each output level across all possible plant sizes.

Economies and Diseconomies of Scale

• Economies of scale: Features of technology that lead to falling LRAC as output increases.

• Diseconomies of scale: Features that lead to rising LRAC as output increases.

• Constant returns to scale: LRAC remains constant as output increases.

Minimum Efficient Scale

• The smallest output at which LRAC reaches its lowest level.

• If LRAC is U-shaped, the minimum point identifies the minimum efficient scale.

Summary Table: Short-Run and Long-Run Cost Concepts

Additional info: These notes expand on the textbook slides by providing definitions, formulas, and context for each concept, ensuring a self-contained study guide for exam preparation.