Short-Run Cost

                                                                                                                                               

Labor	Output	Fixed cost  (dollars)	Variable cost  (dollars)	Total cost  (dollars)	Average fixed cost  (dollars)	Average  variable cost  (dollars)	Average total cost  (dollars)	Marginal cost  (dollars)
0	0	50	0	50
								10.00
1	10	50	100	150	5.00	10.00	15.00
								5.00
2	30	50	200	250	1.66	6.67	8.33
								16.67
3	36	50	300	350	1.39	8.33	9.72

Thetable above continues the previous product schedule table and shows differentcosts.

Total Cost

·        Totalcost (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 of production—the cost ofland, capital, and entrepreneurship. Totalvariable cost (TVC) is the cost of thefirm’s variable inputs—the cost of labor. Total cost is the sum of total fixedcost plus total variable cost:

TC = TFC + TVC.

Marginal Costand Average Costs

·        Marginalcost (MC) is the increase in total cost thatresults from a one-unit increase in output.

·        Averagefixed cost (AFC) is total fixed cost perunit of output. The value of AFC falls as output increases.

·        Averagevariable cost (AVC) is total variable costsper unit of output. At low levels of output, AVC falls as output increasesbut at higher levels of output, AVC rises as output increases.

·        Averagetotal cost (ATC)is the total cost per unit of output. ATC = AFC + AVC. At low levels ofoutput, ATC falls as output increases but at higher levels of output, ATCrises as output increases.

·        The figureillustrates typical MC, AFC, AVC, and ATC curves. As the figureshows, the MC curve, the AVC curve, and the ATC curve areall U-shaped. There are other additional important points about this figure:

·        The verticaldistance between the AVC curve and the ATC curve is the AFC.Because the AFC decreases as output increases, these curves becomecloser to each other as output increases.

·        The MCcurve intersects the AVC curve and ATC curve at their minimums.

This chapter has a plethora of definitions.Students must learn the definitions, but they are secondary to the conceptsthey define and the insights they bring. Focus on why productivity measures andcost measures are useful for decision making. Managers must frequently makequick decisions with little information. If managers have knowledge of a usefulrelationship between input measures and production cost measures they can usetheir understanding of this link to make inferences about how production costsmight behave when the firm’s output must change to accommodate market changes.

qLandMine: The grade point average versus marginal gradeexample in the text is outstanding to use in class to describe how the marginalproduct and marginal cost curves relate to the average product and average costcurves. Once students can tell a story using the same intuition, they finddrawing those curves much easier. While you have the curves drawn on the boardor overhead, physically pull the average cost curves down (while marginal costis below) or pull them up (when the marginal cost curve rises above). Usetheatrics: raise your hands over your head and “pull down the curves.” If youhave a more sports-oriented class, you can try using a batting averagepercentage and at-bat outcome example (if you had a .300 batting average andyou struck out at your next at-bat [the marginal factor], your batting averageis pulled down).

Cost Curvesand Product Curves

·        The shape of the cost curves is related to the shape of theproductivity curves.

·        The shape ofthe AVC curve is determined by the shape of the AP curve. Overthe range of output for which the AP curve is rising, the AVCcurve is falling and over the range of output for which the AP curve isfalling, the AVC curve is rising.

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

Shifts in theCost Curves

·        The cost curves shift with changes in technology or changesin resource prices.

·        An increase in technology that allowsmore output to be produced from the same resources shifts the cost curvesdownward. If the technology requires more capital, a fixed input, then theaverage total cost curve shifts upward at low levels of output and downward athigher levels of output.

·        Afall in the price of the fixed factor of production shifts the AFC and ATCcurves downward but leaves the AVC and MC curves unchanged. Afall in the price of a variable factor of production shifts the AVC, ATC,and MC curves downward but leaves the AFC curve unchanged.

qLandMine: Students are introduced to more graphs inthis chapter. When summing up the day’s lecture, the clearest way to show thedifferences (especially with respect to the variables on the axes) is to grapheach of the curves on the board at the same time. Suggest that studentspractice graphing each of the curves many times noting the maximum points, minimumpoints, and intersections. Tell your students that it is important to draw the ATC curve and MC curve correctly, that is, so that the MC curve intersects the ATCcurve when the ATC is at its minimum.

n 14.4    Long-Run Cost

Inthe long run, a firm can vary the quantity of both labor and capital, so in thelong run all costs are variable costs.

Plant Sizeand Cost

·        In the long run, when a firm changesits plant size, its average total cost might rise, fall, or not change

·        Economiesof scale are features of a firm’s technologythat make average total cost fall as output increases. The main source ofeconomies of scale is greater specialization of both labor and capital.

·        Diseconomiesof scale are features of a firm’s technologythat make average total cost rise as output increases. Diseconomies of scale arise from the difficulty of coordinating andcontrolling a large business.

qLandMine: Distinguish between decreasing marginalproduct in the short run versus diseconomies of scale in the long run.Decreasing returns occur when additional units of labor are combined with afixed amount of capital. Diseconomies of scale do not occur for the samereason, because in the long run both labor and capital can change. Diseconomiesof scale occur because of chaos, organizational overloads, etc.

·        Constantreturns to scalearefeatures of a firm’s technology that keep average total cost constant as outputincreases. Constant returns to scale occur when a firm is able to replicate itsexisting production facility including its management system.

The Long-Run Average Cost Curve

·        Inthe long run, a firm can use different plant sizes. Each plant size has a differentshort-run ATC curve. Each short-run ATC curve is U-shaped and thelarger the plant size, the greater is the output at which the average totalcost is a minimum.

·        The figure illustrates three average totalcost curves for three plant sizes. ATC₁pertains to the smallest plant size and ATC₃to the largest.

·        The long-runaverage cost curve, LRAC,is the curve that shows the lowest average total cost at which it is possibleto produce each output when the firm has sufficient time to change both itsplant size and labor employed. This curve is derived from the short-run averagetotal cost curves. It shows the lowest average total cost to produce a givenlevel of output. In the figure, the LRAC curve is the darkened parts ofthe three short-run ATC curves.

·        The LRAC slopes downward when the firm has economies of scale, ishorizontal when the firm has constant returns to scale, and slopes upward whenthe firm has diseconomies of scale.

Point out to the students that the long-runaverage cost curve yields the lowest average cost of production possible whenplant size is free to change. Once a firm commits to a specific plant size, itis locked into a specific short run cost curve configuration. Any significant departurefrom the range of output per period that best suits that configuration meansthe firm will incur higher short-run average total costs than it would have hadit chosen a more appropriate plant size. If the firm’s competitors chose theirplant size more wisely, the firm might have a tough time surviving! Thisobservation explains why successful firms often spend much money on long runmarket analysis.

qLand Mine:Before moving on to the next chapter, be sure that your students see the big picture.There are two big ideas:

·        First, a firm’s long-runproduction costs depend on the freedom to choose all inputs. Long-runflexibility enables firms to produce at a lower cost than is possible in theshort run when some inputs are fixed.

·        Second, in the short run, withone or more fixed inputs, production costs vary with output in a predictableway because they are directly linked to input productivity.

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