Chapter Eight Costs and the Changes at Firms over Time

Chapter EightCosts and the

Changes at Firms over Time

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Intro

• Purpose of chapter is to develop a model for analyzing when a firm decides to maintain, shut down, or expand their production process.

• Costs determine how large firms should be.– Economists can capture the whole essence of a firm with

a graph of its costs.• Can determine the profitability of a firm and whether it should

shut down or expand.


Finding Average Cost at an Individual Firm

• Total Costs: Sum of variable costs and fixed costs– The more that is produced, the larger total costs will be.

• Fixed Costs: The part of total costs that do not vary with the amount produced in the short run– Examples include land, factories, and machines

• Variable Costs: The costs of production that vary with the quantity produced– Examples include wages and gasoline for trucks

TC = FC + VC


Short Run and the Long Run

• Short Run: Period of time during which it is not possible to change all inputs to production. Only some inputs, like labor, can be changed.– Can’t build factory in the short run

• Long Run: The minimum period of time during which all inputs to production can be changed

• Frequent examples of short run and long run– Capital can NOT change in the short run– Labor CAN change in the short run


Average and Marginal Cost

Q TC FC VC ATC AFC AVC MC

0 300 300 0 -- -- -- --

1 450 300 150 450 300 150 150

2 570 300 270 285 150 135 120

3 670 300 370 223 100 123 100

4 780 300 480 195 75 120 110

5 900 300 600 180 60 120 120


Figure 8.1: Fixed Costs versus Variable Costs


Figure 8.2: Total Costs Minus Fixed Costs Equal Variable Costs (For On-The-Move)


Marginal Cost

• The change in total costs due to a one-unit change in quantity produced.– In other words, how much does cost go up when you

produce one more unit

• Marginal cost declines in very low levels of production, but then increases as production increases


Average Cost

• Average Total Cost (ATC): Total costs of production divided by the quantity produced – Also referred to as Cost Per Unit– ATC = TC/Q

• Average Variable Cost (AVC): Variable costs divided by the Quantity– AVC = VC/Q

• ATC decreases at first, then increases as production rises

• AVC decreases at first, then increases as production rises


Costs Depend on the Firm’s Production Function

• Production Function: Relationship that shows the quantity of output for any given amount of input

• Marginal Product of Labor: Change in production that can be obtained with an additional unit of labor– Decreasing marginal product of labor = Diminishing

Returns to Labor– Increasing marginal product of labor = Increasing

Returns to Labor


Figure 8.3: On-the-Move's Production Function


Production Function

• Increasing marginal product of labor = Decreasing marginal cost

• Decreasing marginal product of labor = Increasing marginal cost

• Average Product of Labor = The quantity produced divided by the amount of labor input– APL = Q/L– Marginal Product of Labor = ΔQ/ΔL


Figure 8.4: Average Cost and Marginal Cost from a Numerical Example


Average Cost Curves

• Average Cost Curves (ATC, AVC) are both U-shaped

• Lowest point of ATC and AVC are where they intersect the MC curve


Figure 8.5: Generic Sketch of Average Cost and Marginal Cost


Costs and Production: The Short Run

• If a firm is maximizing profits, it will choose to produce a quantity where price = marginal cost


Figure 8.6: Price Equals Marginal Cost


Figure 8.7: Showing Profits on the Cost Curve Diagram


Figure 8.8: Showing a Loss on the Cost Curve Diagram


The Breakeven Point

• The Breakeven Point is where price equals the minimum of average total cost (ATC)


Figure 8.9: The Breakeven Point


The Shutdown Point

• A firm should shut down when the price falls below the minimum point of the average variable cost curve and is not expected to rise again.

• Two Important Points:– Shutdown point: P = Minimum AVC– Breakeven point: P = Minimum ATC


Figure 8.10: The Shutdown Point


Costs and Production: The Long Run

• All costs can be adjusted in the long run• If a firm increases its capital (factories, for example)

– Fixed costs will rise– Variable costs decline

• What happens to Total Cost?– New total cost will be higher at low levels of output

(fixed costs dominate)• ATC will also be higher at low levels

– New total cost will be lower at high levels of output (variable costs dominate)

• ATC will be lower at high levels


Figure 8.11: Shifts in Total Costs as a Firm Increases Its Capital


Figure 8.12: Shifts in Average Total Cost Curves When a Firm Expands Its Capital


Long-run ATC Curve

• The Long-Run Average Total Cost Curve is the curve that connects the short-run ATC curves at the lowest ATC for each quantity produced as the firm expands in the long run

• Remember: A firm will always act to maximize profits


Figure 8.13: Long-Run versus Short-Run Average Total Cost


Economies of Scale

• When all inputs to production increase, we say that the SCALE of the firm increases.– Long run ATC describes what happens to a firm’s ATC when its

scale increases

• Economies of Scale (Increasing Returns to Scale): Situation in which long run ATC decreases as output increases

• Diseconomies of Scale (Decreasing Returns to Scale): Situation in which long run ATC increases as output increases

• Constant Returns to Scale: Situation in which long run ATC is constant as the output changes


Economies of Scale

• The long run ATC for most firms declines at low levels of output, then remains flat, and finally increases at high levels of output– As a firm gets very large, administrative expenses,

coordination, and incentive problems, will begin to raise ATC.

• Minimum efficient scale: The smallest scale of production for which long-run ATC is at a minimum.


Figure 8.14: Economies and Diseconomies of Scale


Figure 8.15: Typical Shape of the Long-Run Average Total Cost Curve


Mergers and Economies of Scope

• If product lines of 2 firms are similar, then such mergers may be a way to reduce costs. – Example: Exxon and Mobil– Also merge to combine different skills or resources to

develop new products

• Combining different types of firms to reduce costs or create new products is called ECONOMIES OF SCOPE.

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Chapter Eight Costs and the Changes at Firms over Time