Short-Run Costs and Output Decisions

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1 Lecture 7 Short-Run Costs and Outut Decisions Eric Doviak Princiles of Microeconomics Decisions Facing Firms decisions 1. uantity of outut to suly 2. How to roduce that outut (which technique to use) 3. uantity of each inut to demand are based on information 1. The rice of outut 2. Techniques of roduction available* 3. The rice of inuts* * Determines roduction costs Costs in the Short Run The short run is a eriod of time for which two conditions hold: 1. Firm is oerating under a fixed scale (fixed factor) of roduction and 2. Firms can neither enter nor exit an industry. In the short run, all firms have costs that they must bear regardless of their outut. These kinds of costs are called fixed costs. Page 104

2 Costs in the Short Run Fixed cost: any cost that does not deend on the firm s level of outut. (The firm incurs these costs even if it doesn t roduce any outut). firms have no control over fixed costs in the short run. (For this reason, fixed costs are sometimes called sunk costs). o o obvious examles: roerty taxes, loan ayments, etc. not-so-obvious examle: firm must ay rent to hired caital. If that level of caital cannot be adjusted immediately ( fixed factor ), then rental ayments are a fixed cost in the short-run Variable cost: deends on the level of roduction derived from roduction requirements and inut rices o variable cost rises as outut rises because firm has to hire more inuts (kaital and labor) to roduce larger quantities of outut Costs Total vs. Average TC,, FC TC=+FC AC, A, AFC AC=A+AFC A FC AFC Total Cost (TC) Fixed Cost (FC) Variable Cost () Avg. Cost (AC) Avg. Fixed Cost (AFC) Avg. Variable Cost (A) TC FC TC FC AC AFC A Page 105

3 Marginal Cost Marginal cost: increase in total cost from roducing one more unit of outut (the additional cost of inuts required to roduce each successive unit of outut) only reflects changes in variable costs o fixed cost does not increase as outut increases o marginal cost is the sloe of both total cost and variable cost Shae of the Marginal Cost Curve In the short run, the firm is constrained by a fixed inut, therefore: 1. the firm faces diminishing returns to variable inuts and 2. the firm has limited caacity to roduce outut As the firm aroaches that caacity it becomes increasingly costly to roduce successively higher levels of outut. Marginal costs ultimately increase with outut in the short run. Marginal Cost The thinner lines reresent the sloe of the curve. MPL Marginal Product of Labor (MPL) is the additional roduct roduced by each successive unit of labor. increases as increases because the returns to each successive unit of a variable factor (such as labor) eventually diminish when other factors (such as caital) are held fixed. L Sloe (change in er unit change in ) always ositive ( increasing), but over some ranges the sloe is greater than it is over other ranges. is simly the sloe of at each level of. Page 106

4 Marginal Cost is NOT Average Variable Cost Average Variable Cost the (Total) Variable Cost divided by total quantity roduced. (It s a simle fraction). Marginal Cost the increase in (Total) Variable Cost incurred by roducing one additional unit of outut. (It s a derivative). Marginal Cost curve intersects the Average (Total) Cost and Average Variable Cost curves at their minimum oints., AC, A AC A Short-Run Average and Marginal Cost If a firm s caital stock is fixed in the short-run, then the rental ayments that the firm makes on its caital stock is a fixed cost. We can use that assumtion to derive short-run average and marginal cost curves. So start by assuming that a firm s roduction function is given by: X=K 2/3 L 1/3 Since the firm s caital stock is fixed (by assumtion) we can solve the roduction function for labor to find the amount of labor needed to roduce various levels of outut: 3 L X K2 Its total costs are given by: TCrK wl TCrK w X K 3 2 Page 107

5 Short-Run Average and Marginal Cost To find Short-Run Average Cost simly divide by Total Cost by X: TC rk 2 AC AC w X K2 X X AC AFCA To find Short-Run Marginal Cost take the derivative of Total Cost with resect to X: d TC 2 3w X K2 d X So if the wage and rental rate are both equal to $1 and the caital stock is equal to 10 units, then: w = $1 r = $1 K =10 Outut: Revenues, Costs and Profit Maximization In the short run, a cometitive firm faces an infinitely elastic demand curve (which corresonds to the market equilibrium rice). (A monoolist faces the downward-sloing market demand curve). market-level view * S M com. firm s view S= D D M M F Each household has a downward sloing demand curve, but: o rice is determined by market suly and demand o so shifts of one firms s suly curve do not affect the market rice Each firm faces infinitely elastic (horizontal) demand Page 108

6 Total Revenue and Marginal Revenue Total Revenue total amount that firm receives from sale of its outut Marginal Revenue additional revenue that a firm takes in when it increases outut by one additional unit. If the market demand curve is given by: D M = 10 and if the cometitive industry equilibrium rice = $8 Com. Firm s MR = * qty. dem. TR MR Monoolist s MR qty. dem. TR MR Note that: TR therefore: MR d 10 2 d TR in the case of a monooly Profit-Maximization Profit-maximizing level of outut for all firms is the outut level where firms MR = Perfectly cometitive firm s MR = *, so it will roduce u to the oint where * =. Monoolist roduces u to the oint where MR =, but this occurs at a lower outut level than would occur if the industry were erfectly cometitive (and monoolist sells at a rice that that exceeds MR and ) The key idea here is that firms will roduce as long as marginal revenue exceeds marginal cost. com. firm monoolist M * D F =MR MR = MR D M F M Page 109

7 Short-Run Suly Curve At any market rice, the marginal cost curve shows the outut level that maximizes rofit. Thus, the marginal cost curve of a erfectly cometitive rofitmaximizing firm is the firm s short-run suly curve. market level S M cometitive firm =S 3 3 D 3 =MR D 2 =MR 2 1 D 1 1 D 2 D 3 D 1 =MR 1 M F Page 110

A Simple Model of Pricing, Markups and Market. Power Under Demand Fluctuations

A Simple Model of Pricing, Markups and Market. Power Under Demand Fluctuations A Simle Model of Pricing, Markus and Market Power Under Demand Fluctuations Stanley S. Reynolds Deartment of Economics; University of Arizona; Tucson, AZ 85721 Bart J. Wilson Economic Science Laboratory;