Output and Cost – Microeconomics Chapter 10 Study Notes

Output and Cost

Introduction

This chapter explores how firms measure and manage their costs and output, focusing on the distinction between economic and accounting costs, the behavior of costs in the short run and long run, and the technological constraints that affect production. Understanding these concepts is essential for analyzing firm decision-making and market outcomes in microeconomics.

Economic Cost and Profit

The Firm and Its Goal

• Firm: An institution that hires factors of production and organizes them to produce and sell goods and services.

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

Accounting Profit vs. Economic Profit

• Accounting Profit: Calculated as total revenue minus total cost, using standard accounting rules (e.g., Revenue Canada).

• Economic Profit: Calculated as total revenue minus total cost, where total cost includes opportunity costs (the value of the best alternative use of resources).

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

Opportunity Cost of Production

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

• Composed of resources:

  • Bought in the market

  • Owned by the firm

  • Supplied by the firm's owner

Resources Bought in the Market

• Expenditures on market resources are opportunity costs because the firm could have used them elsewhere.

Resources Owned by the Firm

• Using owned capital incurs an opportunity cost, as the firm could have sold or rented it.

• The implicit rental rate of capital is the opportunity cost of using owned capital.

• Components:

  • Economic depreciation: Change in market value of capital over time.

  • Interest forgone: Return on funds used to acquire the capital.

Resources Supplied by the Firm's Owner

• Owners may supply entrepreneurship and labor.

• Normal profit: The average profit an entrepreneur expects, considered an opportunity cost.

• Opportunity cost of owner's labor is the wage forgone from alternative employment.

Economic Accounting: A Summary

• Economic profit equals total revenue minus total opportunity cost.

Item	Amount
Total Revenue	$400,000
Cost of Resources Bought in Market	$230,000
Cost of Resources Owned by Firm	$40,000
Cost of Resources Supplied by Owner	$55,000 + $45,000 = $100,000
Opportunity Cost of Production	$370,000
Economic Profit	$30,000

Decision Time Frames

Short Run vs. Long Run

• 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 Cost: A cost that cannot be changed or recovered; 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:

  • $\text{MP} = \frac{\Delta \text{TP}}{\Delta \text{Labor}}$

  • $\text{AP} = \frac{\text{TP}}{\text{Labor}}$

Product Schedules and Curves

• As labor increases:

  • Total product increases.

  • Marginal product increases initially, then decreases.

  • Average product decreases.

Labour (workers/day)	Total Product (sweaters/day)	Marginal Product (sweaters/worker)	Average Product (sweaters/worker)
0	0	4	4.00
1	4	6	5.00
2	10	3	4.33
3	13	1	3.75
4	16	-	3.20

Total Product Curve

• Shows how total product changes with labor employed.

• Separates attainable from unattainable output levels in the short run.

Marginal Product Curve

• Shows the change in output from hiring additional workers.

• Typically, marginal product increases initially (due to specialization), then decreases (due to limited capital).

Diminishing Marginal Returns

• Occurs when each additional worker adds less to output than the previous one.

• Law of Diminishing Returns: As more of a variable input is used with a fixed input, the marginal product of the variable input eventually diminishes.

Average Product Curve

• When marginal product exceeds average product, average product rises.

• When marginal product is below average product, average product falls.

• When marginal product equals average product, average product is at its maximum.

Short-Run Cost

Cost Concepts

• 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.

• Formula: $\text{TC} = \text{TFC} + \text{TVC}$

Cost Curves

• AVC (Average Variable Cost): Gets its shape from the TP curve; falls then rises as output increases.

• ATC (Average Total Cost): U-shaped due to spreading fixed costs and diminishing returns.

• MC (Marginal Cost): The increase in total cost from producing one more unit of output.

• Formulas:

  • $\text{AFC} = \frac{\text{TFC}}{Q}$

  • $\text{AVC} = \frac{\text{TVC}}{Q}$

  • $\text{ATC} = \frac{\text{TC}}{Q} = \text{AFC} + \text{AVC}$

  • $\text{MC} = \frac{\Delta \text{TC}}{\Delta Q}$

Relationships Among Cost Curves

• When AVC is falling, MC is below AVC; when AVC is rising, MC is above AVC.

• MC equals AVC at AVC's minimum.

• Similar relationships hold for ATC and MC.

• U-shape of ATC arises from two forces:

  • Spreading fixed cost over more output (AFC falls).

  • Diminishing returns (AVC rises).

Shifts in Cost Curves

• Cost curves shift due to changes in technology or factor prices.

• Technological improvements shift product curves up and cost curves down.

• Increases in fixed costs shift TC and ATC up, but not MC.

• Increases in variable costs shift TC, ATC, and MC up.

Long-Run Cost

Production Function

• Relationship between maximum output and quantities of capital and labor.

• In the long run, all inputs are variable.

Diminishing Marginal Product of Capital

• Marginal product of capital: Increase in output from a one-unit increase in capital, holding labor constant.

• Production functions exhibit diminishing returns to both labor and capital.

Short-Run vs. Long-Run Cost

• Average cost of producing a given output depends on plant size.

• Each plant 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: LRAC falls as output increases.

• Diseconomies of scale: LRAC rises as output increases.

• Constant returns to scale: LRAC remains constant as output increases.

Minimum Efficient Scale

• The smallest output at which LRAC reaches its lowest level.

• If LRAC is U-shaped, the minimum point is the minimum efficient scale.

Example: Choosing Plant Size

• Suppose a firm wants to produce 13 sweaters per day. The cost per sweater varies by plant size:

  • 1 machine: $7.69

  • 2 machines: $6.80 (lowest cost)

  • 3 machines: $7.69

  • 4 machines: $9.50

• The least-cost option is to use 2 knitting machines.

Summary Table: Key Cost Concepts

Concept	Definition	Formula
Total Cost (TC)	Cost of all resources used	$TC = TFC + TVC$
Average Fixed Cost (AFC)	Fixed cost per unit of output	$AFC = \frac{TFC}{Q}$
Average Variable Cost (AVC)	Variable cost per unit of output	$AVC = \frac{TVC}{Q}$
Average Total Cost (ATC)	Total cost per unit of output	$ATC = AFC + AVC$
Marginal Cost (MC)	Increase in total cost from one more unit of output	$MC = \frac{\Delta TC}{\Delta Q}$
Marginal Product (MP)	Change in output from one more unit of labor	$MP = \frac{\Delta TP}{\Delta Labor}$
Average Product (AP)	Output per unit of labor	$AP = \frac{TP}{Labor}$

Additional info: These notes expand on the original slides by providing definitions, formulas, and examples for all major concepts, ensuring a self-contained study guide for exam preparation.