CHAPTER CHECKLIST 1. Explain How Economists Measure A Firm's Production .

CHAPTER CHECKLISTChapterProductionand Cost111. Explain how economists measure a firm’scost of production and profit.2. Explain the relationship between a firm’soutput and labor employed in the short run.3. Explain the relationship between a firm’soutput and costs in the short run.Copyright 2002 Addison WesleyLECTURE TOPICS Economic Cost and Profit Short-run Production4. Derive and explain a firm’s long-run averagecost curve.11.1 ECONOMIC COST AND PROFIT The Firm’s GoalTo maximize profit Accounting Cost and Profit Short-run Cost Long-run CostAn accountant measures cost and profit to ensure thatthe firm pays the correct amount of income tax and toshow the bank.Economists predict the decisions that a firm makes tomaximize its profit. These decisions respond toopportunity cost and economic profit.1

11.1 ECONOMIC COST AND PROFIT Opportunity CostThe highest-valued alternative forgone is theopportunity cost of a firm’s production.11.1 ECONOMIC COST AND PROFITExplicit Costs and Implicit CostsExplicit costA cost paid in money.Implicit costAn opportunity cost incurred by a firm when it uses afactor of production for which it does not make a directmoney payment.The two main implicit costs are economic depreciationand the cost of the firm owner’s resources.11.1 ECONOMIC COST AND PROFITEconomic depreciationThe opportunity cost of a firm using capital that itowns—measured as the change in the market value ofcapital over a given period.11.1 ECONOMIC COST AND PROFIT Economic ProfitA firm’s economic profit equals total revenue minustotal cost.Normal profitTotal cost is the sum of the explicit costs and implicitcosts and is the opportunity cost of production.The return to entrepreneurship. Normal profit is part of afirm’s opportunity cost because it is the cost of notrunning another firm.Because the firm’s opportunity cost of productionincludes normal profit, the return to the entrepreneurequals normal profit plus economic profit.If a firm incurs an economic loss, the entrepreneurreceives less than normal profit.2

11.1 ECONOMIC COST AND PROFIT11.1 ECONOMIC COST AND PROFITFigure 11.1shows two viewsof cost and profit.Economistsmeasure cost asthe sum of explicitcosts and implicitcosts, whichequals opportunitycost.11.1 ECONOMIC COST AND PROFITNormal profit is animplicit cost.Accountantsmeasure cost asexplicit costs andaccountingdepreciation.11.1 ECONOMIC COST AND PROFITEconomic profitequals totalrevenue minusopportunity cost.Accounting profitequals totalrevenue minusaccounting cost.3

SHORT RUN AND LONG RUNThe Short Run: Fixed PlantThe short run is a time frame in which the quantities ofsome resources are fixed.In the short run, a firm can usually change the quantityof labor it uses but not the quantity of capital11.2 SHORT-RUN PRODUCTIONTo increase output with a fixed plant, a firm mustincrease the quantity of labor it uses.We describe the relationship between output and thequantity of labor by using three related concepts: Total productThe Long Run: Variable Plant Marginal productThe long run is a time frame in which the quantities ofall resources can be changed. Average productA sunk cost is irrelevant to the firm’s decisions.11.2 SHORT-RUN PRODUCTION Total ProductTotal product (TP) is the total quantity of a goodproduced in a given period.Total product is an output rate—the number of unitsproduced per unit of time.Total product increases as the quantity of laboremployed increases.11.2 SHORT-RUN PRODUCTIONFigure 11.2 shows thetotal product and thetotal product curve.Points A through H onthe curve correspondto the columns of thetable.The TP curve is like thePPF: It separatesattainable points andunattainable points.4

11.2 SHORT-RUN PRODUCTION Marginal ProductMarginal product is the change in total product thatresults from a one-unit increase in the quantity of laboremployed.It tells us the contribution to total product of addingone more worker.When the quantity of labor increases by more (or less)than one worker, calculate marginal product as:MarginalChange inChange inproduct total product quantity of laborThe table calculatesmarginal productand the orange barsin part (b) illustrateit.Notice that thesteeper the slope ofthe TP curve, thegreater is marginalproduct.11.2 SHORT-RUN PRODUCTIONFigure 11.3 showstotal product andmarginal product.We can illustratemarginal productas the orange barsthat form stepsalong the totalproduct curve.The height of eachstep representsmarginal product.The total product andmarginal product curvesin this figure incorporatea feature of allproduction processes: Increasing marginalreturns initially Decreasingmarginal returnseventually Negative marginalreturns5

11.2 SHORT-RUN PRODUCTION11.2 SHORT-RUN PRODUCTIONIncreasing Marginal ReturnsDecreasing Marginal ReturnsIncreasing marginal returns occur when theDecreasing marginal returns occur when themarginal product of an additional worker exceeds themarginal product of the previous worker.marginal product of an additional worker is less than themarginal product of the previous worker.Increasing marginal returns occur when a small numberof workers are employed and arise from increasedspecialization and division of labor in the productionprocess.Decreasing marginal returns arise from the fact thatmore and more workers use the same equipment andwork space.11.2 SHORT-RUN PRODUCTIONDecreasing marginal returns are so pervasive that theyqualify for the status of a law:The law of decreasing returns states that:As a firm uses more of a variableinput, with a given quantity of fixedinputs, the marginal product of thevariable input eventually decreases.As more workers are employed, there is less and lessthat is productive for the additional worker to do.11.2 SHORT-RUN PRODUCTION Average ProductAverage product is the total product per workeremployed.It is calculated as:Average product Total product Quantity of laborAnother name for average product is productivity.6

11.2 SHORT-RUN PRODUCTIONFigure 11.4 shows averageproduct and its relationship tomarginal product.The table calculates averageproduct.For example, when thequantity of labor is 3 workers,total product is 6 gallons perhour, so average product is6 3 2 gallons per worker.11.2 SHORT-RUN PRODUCTIONWhen marginal product is lessthan average product, averageproduct is decreasing.When marginal product equalsaverage product, averageproduct is at its maximum.11.2 SHORT-RUN PRODUCTIONThe figure graphs the averageproduct against the quantity oflabor employed.The average product curve isAP.When marginal product exceedsaverage product, averageproduct is increasing.11.2 SHORT-RUN PRODUCTIONMarginal Grade and Grade Point AverageTo understand the relationship between averageproduct and marginal product, think about therelationship between a students marginal grade andgrade point average—average grade.7

11.2 SHORT-RUN PRODUCTIONFigure 11.5 showsmarginal grade andgrade point average.Sam’s first course isFrench, for which shegets a C (2). Hermarginal grade is 2,and her GPA is 2.She then gets a B (3)in calculus, whichpulls her average upto 2.5.11.3 SHORT-RUN COSTTo produce more output in the short run, a firm employmore labor, which means it must increase its costs.We describe the relationship between output and costusing three cost concepts:11.2 SHORT-RUN PRODUCTIONNext, she gets an A(4) in economics,which pulls her GPAup to 3.In her next course,history, she gets aB (3), whichmaintains her GPA.In her final course,English, she gets aD (1), which pullsher average down.11.3 SHORT-RUN COST Total CostA firm’s total cost (TC) is the cost of all the factors ofproduction the firm uses.Total cost divides into two parts: Total cost Marginal cost Average costTotal fixed cost (TFC) is the cost of a firm’s fixedfactors of production used by a firm —the cost of land,capital, and entrepreneurship.Total fixed cost doesn’t change as output changes.8

11.3 SHORT-RUN COST11.3 SHORT-RUN COSTTotal variable cost (TVC) is the cost of the variablefactor of production used by a firm —the cost of labor.To change its output in the short run, a firm mustchange the quantity of labor it employs, so total variablecost changes as output changes.Total cost is the sum of total fixed cost and total variablecost. That is,TC TFC TVCTable 11.2 on the next slide shows Sam’s Smoothies’costs.11.2 SHORT-RUN COSTFigure 11.6 shows Sam’sSmoothies’ total cost curves.Total fixed cost (TFC) isconstant—it graphs as ahorizontal line.11.2 SHORT-RUN COSTThe vertical distancebetween the total costcurve and the total variablecost curve is total fixedcost, as illustrated by thetwo arrows.Total variable cost (TVC)increases as outputincreases.Total cost (TC) alsoincreases as outputincreases.9

11.3 SHORT-RUN COST11.3 SHORT-RUN COST Marginal costA firm’s marginal cost is the change in total cost thatresults from a one-unit increase in total product.Marginal cost tells us how total cost changes as totalproduct changes.Table 11.3 on the next slide calculates marginal cost forSam’s Smoothies.11.3 SHORT-RUN COST Average CostThere are three average cost concepts:Average fixed cost (AFC) is total fixed cost per unitof output.11.3 SHORT-RUN COSTThe average cost concepts are calculated from the totalcost concepts as follows:TC TFC TVCDivide each total cost term by the quantity produced, Q, togiveAverage variable cost (AVC) is total variable costper unit of output.Average total cost (ATC) is total cost per unit ofoutput.TC TFC TVCQQQor,ATC AFC AVC10

11.3 SHORT-RUN COST11.2 SHORT-RUN COSTFigure 11.7 shows averagecost curves and marginal costcurve at Sam’s Smoothies.Average fixed cost (AFC)decreases as output increases.The average variablecost curve (AVC) is U-shaped.The average total cost curve(ATC) is also U-shaped.11.2 SHORT-RUN COSTThe vertical distance betweenthese two curves is equal toaverage fixed cost, asillustrated by the two arrows.The marginal cost curve (MC)is U-shaped and intersects theaverage variable cost curveand the average total costcurve at their minimum points.11.3 SHORT-RUN COST Why the Average Total Cost Curve IsU- ShapedAverage total cost, ATC, is the sum of average fixedcost, AFC, and average variable cost, AVC.The shape of the ATC curve combines the shapes ofthe AFC and AVC curves.The U shape of the average total cost curve arises fromthe influence of two opposing forces: Spreading total fixed cost over a larger output Decreasing marginal returns11

11.3 SHORT-RUN COST11.3 SHORT-RUN COST Cost Curves and Product CurvesThe technology that a firm uses determines its costs.At low levels of employment and output, as the firmhires more labor, marginal product and average productrise, and marginal cost and average variable cost fall.Then, at the point of maximum marginal product,marginal cost is a minimum.As the firm hires more labor, marginal productdecreases and marginal cost increases.11.3 SHORT-RUN COSTBut average product continues to rises, and averagevariable cost continues to fall.Then, at the point of maximum average product,average variable cost is a minimum.As the firm hires even more labor, average productdecreases and average variable cost increases.11.3 SHORT-RUN COSTFigure 11.8 illustrates the relationshipbetween the product curves and costcurves.A firm’s marginal cost curve is linkedto its marginal product curve.If marginal product rises, marginalcost falls.If marginal product is a maximum,marginal cost is a minimum.12