Microeconomics: Output and Cost (Chapter 10 Study Notes)

Output and Cost

Introduction

This chapter explores how firms measure and manage their costs and output in both the short run and long run. Understanding these concepts is essential for analyzing firm behavior and market outcomes in microeconomics.

Economic Cost and Profit

Firm's Goal

• Definition of a Firm: An institution that hires factors of production, organizes them, and sells goods and services.

• Goal: The primary goal of a firm is to maximize profit. Firms that fail to do so may be eliminated or taken over by more efficient competitors.

Accounting Profit

• Definition: Accounting profit is total revenue minus total cost, as measured by accountants for tax and investor reporting.

• Calculation: Accountants use standardized rules (e.g., Revenue Canada) to determine costs and profits.

• Formula: $\text{Accounting Profit} = \text{Total Revenue} - \text{Explicit Costs}$

Economic Profit

• Definition: Economic profit is total revenue minus total cost, where total cost includes both explicit and implicit (opportunity) costs.

• Purpose: Used by economists to predict firm decisions and behavior.

• Formula: $\text{Economic Profit} = \text{Total Revenue} - \text{Total Opportunity Cost}$

Opportunity Cost of Production

• Definition: The value of the next best alternative use of resources used in production.

• Components:

  • Resources bought in the market

  • Resources owned by the firm

  • Resources supplied by the firm's owner

Resources Bought in the Market

• Opportunity Cost: The money spent could have been used to buy other resources for alternative production.

Resources Owned by the Firm

• Implicit Rental Rate: The opportunity cost of using owned capital, which includes:

  • Economic Depreciation: The decrease in market value of capital over time.

  • Interest Forgone: The return that could have been earned if the funds used to buy capital were invested elsewhere.

Resources Supplied by the Firm's Owner

• Entrepreneurship: The return to entrepreneurship is called normal profit, which is considered an opportunity cost.

• Owner's Labor: If the owner does not take a wage, the opportunity cost is the wage income forgone from the best alternative job.

Summary Table: Economic Accounting

Item	Amount
Total Revenue	$300,000
Cost of Resources Bought in Market	$230,000
Economic Depreciation	$25,000
Forgone Interest	$5,000
Normal Profit	$20,000
Forgone Wages	$5,000
Opportunity Cost of Production	$285,000
Economic Profit	$15,000

Additional info: Table values inferred and rounded for clarity.

Short-Run and Long-Run Decisions

Time Frames in Production

• Short Run: At least one input (usually capital/plant) is fixed; other inputs (labor, materials) can be varied. Decisions are easily reversed.

• Long Run: All inputs are variable, including plant size. Decisions are not easily reversed. Sunk costs (irrecoverable costs) are irrelevant to current decisions.

Short-Run Technology Constraint

Production Concepts

• Total Product (TP): Total output produced in a given period.

• Marginal Product (MP): Change in total product from a one-unit increase in labor, holding other inputs constant.

• Average Product (AP): Total product divided by quantity of labor employed.

• Formulas:

  • $MP = \frac{\Delta TP}{\Delta L}$

  • $AP = \frac{TP}{L}$

Law of Diminishing Returns

• Definition: As more of a variable input is added to a fixed input, the marginal product of the variable input eventually decreases.

• Reason: Additional workers have less capital and space to work with.

• Example: Hiring more workers in a fixed-size factory leads to crowding and lower productivity per worker.

Short-Run Cost Concepts

Types of Cost

• Total Cost (TC): Cost of all resources used.

• Total Fixed Cost (TFC): Cost of fixed inputs; does not change with output.

• Total Variable Cost (TVC): Cost of variable inputs; changes with output.

• Relationship: $TC = TFC + TVC$

Marginal and Average Costs

• Marginal Cost (MC): Increase in total cost from a one-unit increase in output.

  • $MC = \frac{\Delta TC}{\Delta Q}$

• Average Fixed Cost (AFC): $AFC = \frac{TFC}{Q}$

• Average Variable Cost (AVC): $AVC = \frac{TVC}{Q}$

• Average Total Cost (ATC): $ATC = \frac{TC}{Q} = AFC + AVC$

Shapes of Cost Curves

• AFC Curve: Slopes downward as output increases (spreading fixed cost).

• AVC and ATC Curves: U-shaped due to initially increasing returns (falling costs) and then diminishing returns (rising costs).

• MC Curve: Falls when marginal returns are increasing, rises when diminishing returns set in.

• Relationship: MC intersects AVC and ATC at their minimum points.

Determinants of Cost Curves

Technology

• Technological Change: Increases productivity, shifts product curves upward and cost curves downward.

• Capital-Labor Mix: More capital and less labor can increase fixed costs but decrease variable costs.

Prices of Factors of Production

• Increase in Fixed Cost: Shifts TC and ATC upward; MC unchanged.

• Increase in Variable Cost: Shifts TC, ATC, and MC upward.

Long-Run Cost

Production Function

• Definition: Relationship between maximum output attainable and quantities of capital and labor.

• Diminishing Marginal Product: Applies to both labor and capital in the long run.

Short-Run vs. Long-Run Cost

• Each plant size has its own short-run ATC curve.

• The long-run average cost (LRAC) curve is formed by the lowest ATC for each output level across all possible plant sizes.

Economies and Diseconomies of Scale

• Economies of Scale: Features that lead to falling LRAC as output increases.

• Diseconomies of Scale: Features that lead to rising LRAC as output increases.

• Constant Returns to Scale: LRAC remains constant as output increases.

Minimum Efficient Scale

• Definition: The smallest quantity of output at which LRAC reaches its lowest level.

• Significance: Identifies the output level where the firm is most efficient in the long run.

Summary Table: Cost Concepts and Formulas

Concept	Formula	Description
Total Cost (TC)	$TC = TFC + TVC$	Sum of fixed and variable costs
Marginal Cost (MC)	$MC = \frac{\Delta TC}{\Delta Q}$	Cost of producing one more unit
Average Fixed Cost (AFC)	$AFC = \frac{TFC}{Q}$	Fixed cost per unit
Average Variable Cost (AVC)	$AVC = \frac{TVC}{Q}$	Variable cost per unit
Average Total Cost (ATC)	$ATC = AFC + AVC$	Total cost per unit

Example Application

• If a firm wants to produce 13 sweaters per day, it should choose the plant size that yields the lowest ATC for that output level.

• Minimum efficient scale is reached when LRAC is at its lowest point.