Principles of Microeconomics

ECON 101 - SS 20-21

KFUPM - Spring-23
Dr. Muhammad Imran Chaudhry, CFA
 Firms’ Decision Time Frames
• Firms make many decisions to maximize profits. All decisions
of firms can be categorized into two time frames:
– Short-run: Time frame in which quantity of at least one resource used
in production is fixed.
• For most firms, capital, called the firm’s plant, is fixed in the short run.
• Other resources used by firms such as labor, raw materials, and energy)
can be varied in the short run. Short-run decisions are easily reversed.
– Long run: Time frame in which the quantities of all resources can be
varied i.e., no fixed level of any factor of production.
• Duration of the long-run depends on nature of business e.g., a few weeks
for a restaurant to several years for oil producing firms.
• Long-run decisions are not easily reversed.
• Sunk cost are costs incurred by firms that cannot be changed. Sunk costs
are irrelevant to a firm’s current decisions.
 Short-Run Technology Constraint
• To increase output in the short run, a firm must increase
the amount of labor employed. Three concepts describe
the relationship between output and the quantity of labor
employed:
– Total product: Total product is the total output produced in
a given period.
– Marginal product: Marginal product of labor is the change
in total product that results from a one-unit increase in the
quantity of labor employed, with all other inputs remaining
the same.
– Average product: Average product of labor is equal to total
product divided by the quantity of labor employed.
 Short-Run Technology Constraint
• Table shows a firm’s product
schedule.
• Note that as quantity of labor
employed increases:
– Total product increases.
– Marginal product rises, initially
and than eventually decreases.
– Average product decreases.
• Let’s see a graphical illustration
of this firm’s product schedule.
 Short-Run Technology Constraint
• Product curves show how the
firm’s total product, marginal
product, and average product
change as the firm varies the
quantity of labor employed.
– Total product curve is similar to
PPF, it separates attainable output
from unattainable output levels in
the short run.
– Profit maximizing firms will always
want to get the maximum possible
output from its inputs.
 Short-Run Technology Constraint
• Let’s now try to derive firm’s
Marginal Product Curve
– The first worker hired produces
4 units of output.
– Second worker hired produces 6
units of output. Total product
becomes 10 units.
– Third worker hired produces 3
units of output. Total product
becomes 13 units.
– And so on….
 Short-Run Technology Constraint
• The height of each bar
measures the marginal
product of labor.
• For example, when labor
increases from 2 to 3,
total product increases
from 10 to 13
• So the marginal product
of the third worker is 3
units of output.
 Short-Run Technology Constraint
• To graph marginal product of
labor, we stack the bars in the
previous graph side by side.
• Almost all production
processes are like the one
shown here and have
• Increasing marginal returns
initially, and diminishing
marginal returns eventually
– Increasing marginal returns
arise from increased
specialization and division of
labor.
– Diminishing marginal returns
arises because each additional
worker has less access to
capital and less space in which
to work.
 Short-Run Technology Constraint
• Now lets see Average product
curve and its relationship
with the marginal product
curve.
– When marginal product exceeds
average product, average
product increases.
– When marginal product is below
average product, average
product decreases.
– When marginal product equals
average product, average
product is at its maximum.
– Example: Think about your
semester GPA and cumulative
GPA.
• The firm’s cost curves are
linked to its product curves.
 Modelling Costs of Production
• To produce more output in the short run, the firm must employ
more labor, which means that it must increase its costs.
• Three cost concepts and three types of cost curves are
– Total cost
– Marginal cost
– Average cost
• We classify firms’ costs of production according to behavior vis-
à-vis (short-run) production levels:
– Variables Costs: Cost associated with the variable factors of production
changes with production levels e.g., seed/fertilizer linked to production
of each additional unit of potatoes.
• What does the idea of specialization say about relationship between total
variable costs and production levels (output)?
 Modelling Costs of Production
• How does the law of diminishing marginal product affect the relationship
between total variable costs and production levels (output)?
– Fixed Costs: Costs associated with fixed factors of production do not
change with production levels e.g., machinery lease/head-office rent
not linked to production of each additional unit of potatoes.
• What does the concept of thinking at the margin reveal about relevance of
fixed costs in short-run production decisions?
• Total Cost is simply the sum of variable and fixed cost:
TC = TVC + TFC
• Now let’s try to leverage our understanding of the behavior of
firm’s production technology to model productions costs of a
firm i.e., how to illustrate TVC, TFC and TC on a graph with total
costs on the Y-axis and output on the X-axis?
 TC
Total
Costs ($)

TVC

TFC

Total
Output
 Modelling Costs of Production-Short-run
• We can gain more insights, if we divide both sides of total cost
equation by output:
Total cost/Q = Variable cost/Q + Fixed cost/Q
Avg Total Cost = Avg Variable Cost + Avg Fixed Cost
– ATC: Total cost divided by total output. AVC: Total variable cost divided
by total output. AFC total fixed cost divided by the total output.
• Marginal cost: change in total cost associated with producing
one additional unit of output.
ΔTC
MC =
Δq
– We know the graphical representations of TC, VC and FC. Now, let us
try to derive the graphical representation of AFC, AVC, ATC and MC
but cost per unit on the Y-axis and output on the X-axis.
 Modelling Costs of Production-
Short-run
• Average fixed cost (AFC) fall as output increases?:
– AFC asymptotes towards the X-axis and Y-axis.
• The average variable cost (AVC) curve is expected to have a U-
shape?
– As output increases, average variable cost falls to a minimum and then
eventually increases due to diminishing marginal product.
• The average total curve (ATC) is also U-shaped?
• Marginal cost curve’s behavior is akin to the marginal product
curve.
– Over the output range with increasing marginal product (AVC falling),
marginal cost falls as output increases.
– Over the output range with diminishing marginal product (AVC rising),
marginal cost rises as output increases.
– As a result, MC intersects the AVC and ATC at their minimum point!
 MC
Cost per Output
Unit ($)
ATC AVC

AFC

Output
Marginal cost and marginal product are inversely related to one another. As one
increases the other automatically decreases.
When MC is below ATC and AVC, then they (ATC and AVC) must be falling and
when MC is above ATC and AVC, then they (ATC and AVC) must be rising.
Thus, MC intersects AVC and ATC at their minimum points.
Analyzing Costs of Production-Short-run
• Average total cost is U-shaped.
– The ATC curve is the vertical sum of the AFC curve and the AVC curve.
The U-shape of the ATC curve arises from the influence of two opposing
forces:
• Spreading total fixed cost over a larger output—AFC curve slopes
downward as output increases.
• Eventually diminishing returns—the AVC curve slopes upward and AVC
increases more quickly than AFC is decreasing.
• Marginal cost eventually increases as output increases, due to
the diminishing marginal product of labor.
– Recall marginal product of labor falls with output, hence marginal cost
rises with output.
• Marginal cost curve intersects average total cost curve and
average variable cost curve at their minimum points.
– ATC and AVC are averages. If the average is falling, then last unit has cost
below the average. If the average is rising, then the last unit has a cost
above the average.
Two Sides of the Same Coin?
Analyzing Costs of Production-Short-run
• The position of a firm’s cost curves depends on two factors:
– Technological change influences both the product curves and the cost
curves. An increase in productivity shifts the product curves upward
and the cost curves downward.
• If technological advances result in firms using more capital and less labor,
fixed costs increase and variable costs decline. In this case, average total
cost increases at low output levels and decreases at high output levels.
– An increase in the price of a factor of production increases
costs and shifts the cost curves.
• An increase in a fixed cost shifts the total cost (TC ) and average total cost
(ATC ) curves upward but does not shift the marginal cost (MC ) curve.
• An increase in a variable cost shifts the total cost (TC ), average total cost
(ATC ), and marginal cost (MC ) curves upward.
Modelling Costs of Production-Long-run
• In long run, all inputs are variable, and all costs are variable.
– A firm’s (long-run) production function is the relationship between the
maximum output attainable and quantities of capital and labor. Long-
run cost behavior is determined by long-run production function.
• Long-run average cost curve: relationship between the lowest
attainable average total cost and output when both plant and
labor can be varied.
– The LRAC curve is also a planning curve that tells a firm about the plant
size that minimizes the cost of producing a given output.
• For each plant, diminishing marginal product of labor creates a set of short
run, U-shaped cost curves for MC, AVC, and ATC.
– Firms decide which plant has the lowest cost for producing each output
level. Once a firm has chosen a plant size, this firm incurs the costs that
correspond to the ATC curve for that plant.
– The long-run average cost curve (LRAC) is made up from the lowest ATC
for each output level.
Modelling Costs of Production-Long-run
 Optimal Size and Long Run Cost Curves
• What is the optimal size for a factory?
– In the long-run firms choose the optimal plant size that minimizes AC
at a given level of output (i.e., scale).
– Due to this flexibility in the long run, all the short run ATC curves lie on
or above the long run ATC curve.
• At what quantity does a short run ATC curve touch the long
run ATC curve?
– In the short run factory size is fixed at exactly the optimal size required
for producing that quantity of output.
• Long-run cost function is the lower envelope of short-run cost
function:
– If plant size chosen optimally in the short-run, then short-run and
long-run cost are equal at the profit-maximizing output (i.e., optimal
scale).
– In the short-run, plant-size is fixed so costs to produce a given output
greater than the long-run cost of production.
Optimal Size and Long Run Cost Curves

ATC1 ATC2 ATC4

ATC3 LRAC

q2 output
 Analyzing Long-Run Production Technology
• Returns to Scale is a concept related to long-run production
function, whereby, all the inputs are increased proportionally.
– In the long-run, all factors of production are variable!
• Increasing Returns to Scale (IRS):
– f(2L,2K) > 2f(L,K) i.e., doubling all inputs leads to more than the
doubled output. What would happen to long run average total costs
in this case?
• Average costs decline. Increase in output is more than increase in costs!
• Constant Returns to Scale (CRS):
– f(2L,2K) = 2f(K,L) i.e. doubling all inputs leads to doubling output.
• No change in long-run average costs as both costs and output are doubled.
• Decreasing Returns to Scale (DRS):
– f(2L,2K) < 2f(L,K) i.e., doubling all inputs results in less than doubled
output. What would happen to long run average total costs in this
case?
• Average costs rise as cost increases by more than the increase in output.
 Analyzing Long-Run Cost Functions
• Firms’ long-run production technologies often exhibit regions
of IRS, CRS and DRS:
– Behavior of long-run production technology provides insights into the
long-run cost function.
• Long-run average cost (LRAC) curve has an apparent U-shape:
– Economies of scale: LRAC decreases as scale of output increases due
to a greater specialization of labor and capital.
• As firms get bigger, workers have opportunities to specialize in tasks they
excel at or firms employ more workers who specialize in specific tasks.
– Constant returns to scale: LRAC does not change with scale of output.
– Diseconomies of scale: LRAC increases as scale of output increases
due to coordination problems i.e., difficulty of managing large
enterprises.
• Average costs increases since managerial resources begin to get spread
too thin in the firm and/or duplication of tasks starts to occur e.g.,
departments have their own software programs etc.
Long Run Average Cost Curve

LRAC
ATC3

Coordi nation/Communication Problems

Specialization

qMES output

EOS: double the inputs, output more than doubles ➔ LRAC falls

DOS: double the inputs, output less than doubles ➔ LRAC rises
 Analyzing Long-Run Cost Functions
• As the LRAC curve is U-shaped, the minimum point identifies
the minimum efficient scale output level.
• Minimum efficient scale is the smallest quantity of output at
which the long-run average cost reaches its lowest level.
• Shape of industries’ LRAC has an important influence on the
competitive structure of an industry.
– An industry in which the minimum efficient scale is small relative to
the market demand, that market has room for many firms.
– An industry in which the minimum efficient scale is large relative to
the market demand, that market has room for few firms, or maybe
even one firm only!