# Learning Objectives. Essential Concepts

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1 Learning Objectives After reading Chapter 8 and working the problems for Chapter 8 in the textbook and in this Student Workbook, you should be able to: Essential Concepts Understand the information given by a production function. Explain two efficiency concepts: technical efficiency and economic efficiency. Define and give examples of three types of inputs used in production: variable inputs, fixed inputs, and quasi-fixed inputs. Explain the difference between long-run and short-run production time periods. Explain why sunk costs in production differ from avoidable costs. Distinguish between variable proportions production and fixed proportions production. Compute average product (AP) and marginal product (MP) and explain the relation among total, average, and marginal products. Define and explain the law of diminishing marginal product. Define and draw graphs of total fixed cost (TFC), total variable cost (TVC), total cost (TC), and short-run marginal cost (SMC). Define and draw graphs of average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC). Relate short-run costs to the production function using the relations between (i) average variable cost and average product, and (ii) short-run marginal cost and marginal product. 1. A production function shows the maximum amount of output that can be produced from any specified set of inputs, given the existing technology. 2. Technical efficiency is achieved when the maximum possible amount of output is being produced with a given combination of inputs. Economic efficiency is achieved when the firm is producing a given amount of output at the lowest possible total cost. 163

2 3. Production inputs can be either variable or fixed: (a) (b) (c) variable input: an input for which the level of usage may be readily varied in order to change the level output. Payments for variable inputs are called variable costs. Examples of variable inputs are labor, raw materials, and energy. fixed input: an input for which the level of usage cannot be readily changed and which must be paid even if no output is produced. Payments for fixed inputs are called fixed costs. Examples of fixed inputs are buildings and other inputs that a firm leases and capital equipment that cannot be readily varied with changes in output. quasi-fixed input: A lumpy or indivisible input for which a fixed amount must be employed for any positive level of output, and none of the input must be purchased when output is zero. Payments for quasi-fixed inputs are called quasi-fixed costs. Fixed and quasi-fixed inputs are both used in constant amounts as output varies, but fixed inputs must be paid for even if output is zero while quasi-fixed inputs need not be purchased when output is zero. Examples of quasi-fixed inputs are railroad tracks, antenna towers for radio stations, and electricity for lighting an office. 5. The short run refers to a time span during which the firm employs at least one fixed input, which, by definition, must be paid even when output is zero in the short run. In the short run, quasi-fixed inputs may or may not be employed; quasifixed inputs have no bearing on the short-run nature of production. 6. The long run, also called the firm s planning horizon, refers to the time period just far enough in the future to allow all fixed inputs to become variable inputs. For any quasi-fixed inputs that might be needed, their levels are fixed in the long run at whatever lump amount is required. 7. A sunk cost of production is a payment for an input that, once made, cannot be recovered should the manager no longer wish to employ the input. Sunk input costs should be ignored for decision making purposes because sunk costs are not part of the economic cost of production. Once the sunk payment is made, the economic (opportunity) cost of using the input thereafter is zero. 8. In contrast to a sunk cost of production, an avoidable cost of production is a payment for an input that a firm can recover or avoid paying should the manager no longer wish to employ the input. Avoidable costs do matter in decision making and should not be ignored. Avoidable costs reflect the opportunity costs of resource use. 9. Average product of labor ( AP = Q / L ) and marginal product of labor ( MP = ΔQ / Δ L ) are related in the following way: When AP is rising (falling), MP is greater (less) than AP. When AP reaches its maximum value, AP = MP. 10. The law of diminishing marginal product states that as the usage of a variable input increases, a point is reached beyond which its marginal product decreases. 164

3 11. Panel A in the preceding figure shows the typical total product curve (TP) when production occurs with only one variable input. The total product curve reflects the following relations: a. No output can be produced with zero workers. b. Output increases at an increasing rate until L 0 workers are employed producing Q 0 units of output. Over this range marginal product is increasing. c. Total product then increases but at a decreasing rate when the firm hires between L 0 and L 2 workers. Over this range MP is decreasing. d. Average product reaches its maximum value at L 1, where AP equals MP. e. Finally a point will be reached beyond which output will decline, indicating a negative marginal product. In Panel A, this occurs for employment levels greater than L 2. The maximum possible total product is thus Q

4 12. Panel B in the figure shows the AP and MP curves that correspond to TP in Panel A. Notice that a. both curves first rise, reach a maximum, then decline. b. marginal product attains a maximum (at L 0 ) at a lower input level than the level at which average product attains its maximum (at L 1 ). c. while AP is always positive, MP is zero at L 2 units of labor and is negative thereafter. 13. Short-run total cost (TC) is the sum of total variable cost (TVC) and total fixed cost (TFC): TC = TVC + TFC 14. Average fixed cost (AFC) is equal to total fixed cost divided by output: TFC AFC = Q 15. Average variable cost (AVC) is equal to total variable cost divided by output: TVC AVC = Q 16. Average total cost is equal to total cost divided by output or the sum of average variable and average fixed cost: TC ATC = = AVC + AFC Q 17. Short-run marginal cost (SMC) measures the rate of change in TC as output varies: ΔTC ΔTVC SMC = = ΔQ ΔQ 18. The following figure shows the typical set of short-run average and marginal cost curves. Note the following relations: a. AFC decreases continuously as output increases (AFC is not shown in the figure above, but it is equal to vertical distance between ATC and AVC). b. AVC is -shaped and AVC equals SMC at AVC s minimum. c. ATC is -shaped and ATC equals SMC at ATC s minimum. d. SMC is -shaped and intersects AVC and ATC at their minimum points. SMC lies below (above) ATC and AVC when ATC and AVC are falling (rising). 166

5 19. In the case of a single variable input, short-run costs are related to the production function by the two relations: w AVC = and AP w SMC = MP where w is the price of the variable input. Since AP and MP first increase, reach a peak and then decrease, AVC and SMC first fall, reach a minimum value and then rise. 167

6 Matching Definitions average fixed cost average product of labor average total cost average variable cost avoidable cost of production economic efficiency fixed input fixed proportions production law of diminishing marginal product long run marginal product of labor production production function quasi-fixed input short run short-run marginal cost sunk cost of production technical efficiency total cost total fixed cost total variable cost variable input variable proportions production 1. The creation of goods and services from inputs or resources. 2. A table or mathematical equation showing the maximum amount of output that can be produced from any specified set of inputs, given the existing technology. 3. Production of the maximum level of output that can be obtained from a given combination of inputs. 4. Production of a given amount of output at the lowest possible total cost. 5. An input for which the level of usage cannot readily be changed. 6. An input for which the level of usage may be changed quite readily. 7. An input that must be used in a lump amount for any positive amount of output produced. 8. That period of time in which the level of usage of one or more inputs is fixed. 9. That period of time in which all inputs are variable, which is sometimes called the planning horizon. 10. Production in which a given level of output can be produced with more than one combination of inputs. 11. Production in which one, and only one, ratio or mix of inputs can be used to produce a good. 12. Total product divided by the number of units of labor employed. 13. An input payment firms can recover or avoid paying should the manager no longer wish to employ the input. 14. Additional output attributable to using one more worker holding the use of all other inputs constant. 168

7 15. As the level of usage of the variable input increases, other inputs held constant, a point will be reached beyond which the marginal product decreases. 16. Total amount paid for fixed inputs. 17. Total amount paid for variable inputs. 18. The sum of total fixed and total variable costs. 19. Fixed cost per unit of output (i.e., total fixed cost divided by output). 20. Variable cost per unit of output (i.e., total variable cost divided by output). 21. Total cost per unit of output (i.e., total cost divided by output). 22. A nonrecoverable input payment that should be ignored in managerial decision making. 23. The change in either total cost or total variable cost per unit change in output. Study Problems 1. For each of the firm s decisions, determine whether the manager is making a decision in the short run or the long run. a. Eckerd s decides to stay open 24 hours a day rather than 16 hours a day. b. Harley Davidson builds another production facility. c. American Airlines restructures its flight schedules to increase the percentage of seats filled on each of its flights. d. Dell Computer adds more workers in its shipping department to speed delivery of new PC orders. 2. Fill in the blanks in the following table: Usage of Variable Input Total Product Marginal Product Average Product The wage rate is \$12 per unit of labor. After completing the table, answer the following questions: 169

8 a. After units of labor usage, the firm experiences diminishing returns. b. At units of labor, SMC = AVC. c. The level of output at which SMC = AVC is units of output. d. Minimum average variable cost = \$. e. At the level of labor usage and associated output for which SMC = AVC, marginal cost = \$. 3. Consider a firm using a single variable input and a single fixed input, capital. When the amount of capital is increased: a. the total product curve will. b. the average product curve will. c. the marginal product curve will. 4. Assume labor the only variable input of a firm has average and marginal product curves shown in the following figure. The price of labor is \$1,000 per unit (i.e., w = \$1,000). a. At minimum average variable cost, the firm employs units of labor. b. Minimum average variable cost is reached at units of output. c. At its minimum value, average variable cost is \$. d. Marginal cost reaches its minimum value at units of labor usage, 170

9 which corresponds to units of output. e. At its minimum value, marginal cost is \$. f. The average variable cost when 550 units of labor are employed is \$. g. The marginal cost when 550 units of labor are employed is \$. 5. Use the figure below to answer these questions: At 200 units of output, find the following costs: a. AFC = e. TVC = b. AVC = f. TC = c. ATC = g. SMC = d. TFC = At 600 units of output, find the following costs: h. AFC = l. TVC = i. AVC = m. TC = j. ATC = n. SMC = k. TFC = 171

10 6. Total fixed cost is \$150 per week and the price per week of labor is \$500 per worker. Fill in the blanks in the table below: Product Total Cost Average Cost Labor Total Average Marginal Fixed Variable Total Fixed Variable Total 0 0 xx xx xx xx xx xx Marginal Cost Multiple Choice / True-False 1. Marginal product equals average product a. when marginal product equals zero. b. when average product equals zero. c. at the inflection point of the total product curve. d. at the maximum value of marginal product. e. at the maximum value of average product. 2. The economically efficient input combination for producing a given level of output a. minimizes the average cost of producing the given level of output. b. occurs at the maximum value of the total product curve. c. can produce that level of output at the lowest possible total cost. d. is determined entirely by the production function. 3. Which of the following could NOT be an example of a quasi-fixed cost: a. raw material costs b. lights and security guards in the parking lots c. local phone service for administrative operations d. railroad track for CSX, a rail freight company 4. If average product is rising, then marginal product a. cannot be falling. b. can be either rising or falling, but it must lie above average product. c. must lie below average product. d. must be rising. 172

11 In questions 5 8, suppose that the short-run production function is given by: Labor Quantity The average product of labor when 3 units of labor are employed is a. 3. b. 5. c. 7. d. 11. e The marginal product of the 6 th laborer is a. 3. b. 5. c. 7. d. 11. e Diminishing marginal returns begin with the a. 2 nd unit of labor. b. 4 th unit of labor. c. 5 th unit of labor. d. 6 th unit of labor. 8. Marginal product is negative when more than a. 3 units of labor are employed. b. 4 units of labor are employed. c. 5 units of labor are employed. d. 6 units of labor are employed. 9. Fixed costs a. must be considered in any decision-making process. b. do not exist in the long run. c. decrease as output rises. d. a and b. e. b and c. 173

12 Fill in the missing values and answer questions Q Total Cost Fixed Cost Variable Cost Fixed Cost Average Variable Cost Total Cost Marginal Cost xx xx xx xx What is total fixed cost? a. 10 b. 15 c. 20 d. cannot be determined e. none of the above 11. What is total cost when Q = 1? a. 30 b. 35 c. 40 d. 20 e. none of the above 12. What is average total cost when Q = 2? a. 10 b. 20 c. 30 d. 40 e. none of the above 13. What is marginal cost when Q = 3? a. 7 b. 8 c. 9 d What is marginal cost when Q = 4? a. 5 b. 10 c. 11 d. 15 e

13 15. When the average product of the variable input is equal to the marginal product, a. marginal cost reaches its minimum value. b. average variable cost reaches its minimum value. c. marginal cost is rising. d. both a and c. e. both b and c. 16. If a firm is producing 5 units of output and the marginal cost for the fifth unit is \$7 and the average variable cost for the fifth unit is \$3, then the average variable cost for the fourth unit is. a. 1 b. 2 c. 4 d. 8 e. none of the above 17. If short-run marginal cost is -shaped, then a. total cost increases at an increasing rate, then increases at a decreasing rate. b. total variable cost increases at a decreasing rate then increases at an increasing rate. c. total variable cost must be S-shaped. d. all of the above. e. both b and c. 18. Average total cost a. increases as output increases. b. decreases as output increases. c. increases if marginal cost is increasing. d. increases if marginal cost is greater than average total cost. e. both c and d. 19. Average fixed cost a. increases as output increases. b. decreases as output increases. c. increases if marginal cost is increasing. d. increases if marginal cost is greater than average fixed cost. 20. Quasi-fixed costs DIFFER from fixed costs because a. only fixed costs can be avoided if output is zero. b. only quasi-fixed costs can be avoided if output is zero. c. quasi-fixed cost vary directly with the level of output while fixed costs do not vary with the level of output. d. only fixed costs are sunk costs. 21. A fixed cost is a. the cost of any input with a fixed price per unit. b. a cost which increases in a fixed proportion as output increases. c. a cost the firm must pay even if output is zero. d. a cost that does not vary with the amount of good or service produced. e. both c and d 175

14 22. T F A firm that operates in an economically efficient way is also operating in a technically efficient way. 23. T F Average fixed cost is not usually graphed with the other average cost curves because average fixed cost can be obtained from average total cost and average variable cost. 24. T F If average variable cost is rising, marginal cost must be rising. 25. T F Marginal cost measures the change in total variable cost as output changes. 26. T F The payments to quasi-fixed inputs should be ignored in decision making since they are not opportunity costs. 27. T F The long run period of production can be thought of as the set of all possible short run situations. 28. T F Two reasons for input fixity are (1) the costs of adjusting the level of an input is prohibitively high, and (2) a required input can only be purchased in lumpy, indivisible amounts. Answers MATCHING DEFINITIONS 1. production 2. production function 3. technical efficiency 4. economic efficiency 5. fixed input 6. variable input 7. quasi-fixed input 8. short run 9. long run 10. variable proportions production 11. fixed proportions production 12. average product of labor 13. avoidable cost 14. marginal product of labor 15. law of diminishing marginal product 16. total fixed cost 17. total variable cost 18. total cost 19. average fixed cost 20. average variable cost 21. average total cost 22. sunk cost 23. short-run marginal cost 176

15 STUDY PROBLEMS 1. a. short run; This decision involves increasing the usage of a fixed input, the store. b. long run; A new plant allows increased usage of capital inputs that are fixed in the short run. c. short run; American Airlines is still using the same number of planes (presumably a fixed input in the short run), but using the planes more intensively. d. short run; Dell did not increase the capital resources employed by the shipping department; it is just using more of the variable input labor. 2. The table should look like this: Usage of Variable Input Total Product Marginal Product Average Product a. 2; MP begins to fall after 2 units of labor are employed. b. 3; SMC will equal AVC when MP = AP. c. 18; TP is 18 at L = 3 d. \$2; AVC = w/ap = 12/6 e. \$2; SMC = w/mp = 12/6 3. a. increase (shift upward) b. increase (shift upward) c. increase (shift upward) 4. a. 450; AVC is minimized when AP is maximized. b. 911,250; Since AP = Q/L, 2,025 = Q/450 Q = 911,250. c. \$0.49; AVC = w/ap \$1,000/2,025. d. 300; 540,000; SMC is minimized at the level of labor usage where MP is maximized. Since AP = Q/L and AP = 1,800 at L = 300, then 1,800 = Q/300 Q = 540,000. e. \$0.37; SMC = w/mp = \$1,000/2,700 f. \$0.52; AVC = w/ap = \$1,000/1,925 g. \$1.21; SMC = w/mp = \$1,000/ a. \$15; the vertical distance between ATC and AVC at Q = 200. b. \$10; read this off the AVC curve at Q = 200 c. \$25; read this off the ATC curve at Q = 200 d. \$3,000; TFC = AFC Q = e. \$2,000; TVC = AVC Q = f. \$5,000; TC = ATC Q = or TC = TVC + TFC = 3, ,000 g. about \$4; read this off the SMC curve at Q = 200 h. \$5; the vertical distance between ATC and AVC at Q =

16 i. \$10; read this off the AVC curve at Q = 600 j. \$15; read this off the ATC curve at Q = 600 k. \$3,000; TFC = AFC Q = l. \$6,000; TVC = AVC Q = m. \$9,000; TC = ATC Q = or TC = TVC + TFC = 3, ,000 n. \$25; read this off the SMC curve at Q = Your table should look like this: Product Total Cost Average Cost Labor Total Average Marginal Fixed Variable Total Fixed Variable Total Marginal Cost xx xx xx xx xx ,000 1, ,500 1, ,000 2, ,500 2, ,000 3, ,500 3, ,000 4, ,500 4, ,000 5, MULTIPLE CHOICE / TRUE-FALSE 1. e MP = AP at AP s maximum point. Note that answer c is wrong because the inflection point on TP is where MP (not AP) reaches its maximum. 2. c The efficient input combination is the one that minimizes total, not average, cost. 3. a Raw material costs vary directly with the amount of output, and therefore cannot be a quasi-fixed input. The other three choices are all inputs for which the usage could be constant as output rises and the firm could avoid paying for the input if output is zero. 4. b MP both rises and falls over the range of labor usage for which AP is rising. 5. c AP 3 = 21/3 = 7 6. e TP 5 = 25 and TP 6 = 24 TP falls by one unit. MP for the sixth unit of labor is b MP is smaller for the fourth unit of labor than it is for the third unit of labor. 8. c MP < 0 after 5 units of labor are employed. 9. b Fixed costs are the payment to the fixed inputs. Since all inputs are variable in the long run, there are no fixed costs in the long run. 178

17 10. c You can see that fixed cost is \$20 by noting that when Q = 0, TC = \$ c Since SMC for unit 1 is \$20, TC for the first unit must be \$20 greater than TC when Q = 0. Therefore, TC = = e Since AVC = \$15, TVC = \$30 (= 2 15). TC = TVC + TFC = = 50. Therefore, ATC = TC/Q = 50/2 = \$ a ATC = \$19 and TC = \$57 (= 3 19). Since TC is \$50 for 2 units, and TC is \$57 for 3 units, the marginal cost of the 3 rd unit must be \$ c TC Q=4 = TVC + TFC = = 68. Since TC Q=3 = \$57, the marginal cost of the 4 th unit must be \$ e When AP = MP, AP is at its maximum value. MP is falling when AP = MP, and thus SMC (= w/mp) is rising. 16. b Since AVC 5 = \$3, TVC 5 = \$15. Given marginal cost of the 5 th unit is \$7, the total variable cost of 4 units must be \$8. Thus AVC 4 = \$8/4 = \$ e If SMC is -shaped, then the slope of TVC first falls, then rises. The only way this can occur is if TVC is S-shaped (i.e., TVC first increases at a decreasing rate, then increases at an increasing rate). 18. d If marginal exceeds average, then average rises. 19. b While TFC is constant, AFC declines as Q gets larger. 20. b Quasi-fixed costs can be avoided in the event the manager decides to cease production, while fixed costs must continue to be paid. 21. e Both c and d are correct. 22. T All economically efficient firms are technically efficient. The converse is not true. 23. T AFC = ATC AVC 24. T When AVC is rising, SMC exceeds AVC and is rising. 25. T SMC = ΔTC / ΔQ. Since ΔTC = ΔTVC (only TVC varies as Q changes), SMC = ΔTVC / ΔQ. 26. F Quasi-fixed input payments are avoidable costs, and thus represent part of the economic cost of production. 27. T The long run is sometimes referred to as the planning horizon. 28. T These are indeed the two reason for input fixity. When the first one holds, the input is a fixed input, and when the second one holds, the input is a quasi-fixed input. 179

18 Homework Exercises 1. The following figure shows a firm s marginal and average product curves for labor, the only variable input employed by the firm. The wage rate of labor is \$200 and the fixed cost is \$6,000. When average variable cost reaches its minimum: a. Output is units. b. AVC is \$ and SMC is \$. c. ATC is \$. When 36 workers are hired: d. Output is units. e. AVC is \$ and SMC is \$ at this output. f. At the level of output associated with 36 workers, AVC is (increasing, decreasing) and SMC is (increasing, decreasing). 180

19 2. Fill in the blanks in the table below: Output TC TFC TVC AFC AVC ATC SMC 0 0 xx xx xx xx Use the figure below to answer the questions on the next page. 181

20 At 100 units of output, find the following costs: a. AFC = e. TVC = b. AVC = f. TC = c. ATC = g. SMC = d. TFC = At 300 units of output, find the following costs: h. AFC = l. TVC = i. AVC = m. TC = j. ATC = n. SMC = k. TFC = 182

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