COECA1-B22

Chapter 11: Outputs and Cost

By Joshua van Houten

 Learning Outcomes:

1. Distinguish between the economic short and long run.

2. Explain the relationship between a firm’s output and labour employed in the
short run.

3. Explain the relationship between a firm’s output and its costs in the short run
and derive the firm’s short-run cost curves.

4. Explain the relationship between a firm’s output and its costs in the long run
and derive the firm’s long-run cost curve.
 Decision Timeframes
To study the relationship between a firm’s output decision and its costs, we distinguish between
two decision time frames:
• The short run
• The long run

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 Decision Timeframes
The Short-Run
• The short-run is a time frame in which the quantity of at least one factor of production is fixed.

• For most firms their capital, land and entrepreneurship are fixed factors of production and labour
is the variable factor of production.
• We call the fixed factors of production the firm’s factory. Therefore, in the short-run a firm’s
factory is fixed.
• To increase output in the short run, a firm must increase the quantity of a variable factor of
production, which is usually labour.
• Short-run decisions are easily reversed. The firm can increase or decrease its output in the short-
run by increasing or decreasing the amount of labour it hires. 2
 Decision Timeframes

The Long-Run

• The long-run is a time frame in which the quantities of all factors of production can be varied.

• The long-run is a period in which the firm can change its factory.

• To increase output in the long-run, a firm can change its factory as well as the quantity of
labour it hires.

• Long-run decisions are not easily reversed. (Past expenditure on a plant that has no resale value
and is called a sunk cost.

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 Short-run Technology Constraints

Product Concepts:

• Total product - is the maximum output that a given quantity of labour can produce.

• Marginal product of labour - is the increase in total product that results from a one-unit
increase in the quantity of labour employed, with all other inputs remaining the same
(ceteris paribus).

• Average product - tells how productive workers are on average.

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 Short-run Technology Constraints

To increase output in the short run, a firm must increase the quantity of labour employed. We

describe the relationship between output and the quantity of labour employed by using three related

concepts:

1. Total product

2. Marginal product

3. Average product

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 Total Product Curves
• The product curves are graphs of the relationships between
employment and the three product concepts.

• The total product curve is similar to the production possibilities

frontier. It separates the attainable output levels from those that
are unattainable.

• All the points that lie above the curve are unattainable. Points that
lie below the curve are attainable, but they are inefficient. (As
they use more labour than is necessary)

• Only the points on the total product curve are technologically

efficient
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 Increasing Marginal Returns

• Most production processes experience increasing marginal returns

initially.

• Increasing marginal returns - occur when the marginal product of

an additional worker exceeds the marginal product of the previous
worker.

• Increasing marginal returns arise from increased specialization and

division of labour in the production process.

• Marginal product increases to a maximum (in this example when 1.5

workers a day are employed)
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 Diminishing Marginal Returns

• All production processes eventually reach a point of diminishing

marginal returns.

• Diminishing marginal returns - occurs when the marginal product of an

additional worker is less than the marginal product of the previous worker.

• The law of diminishing returns - as a firm uses more of a variable factor

of production with a given quantity of the fixed factors of production, the
marginal product of the variable factor eventually diminishes.

• When more than 1.5 workers a day are employed marginal product
declines – diminishing marginal product.

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 Average Product

• Average product increases from 1 to 2 workers (its maximum value

is at point C) but then decreases as yet more workers are employed.

• Average product is largest when average product and marginal

product are equal.

• For the number of workers at which marginal product exceeds

average product, average product is increasing. For the number of
workers at which marginal product is less than average product,
average product is decreasing.

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Short-run Costs

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 Short-run Costs

To produce more output in the short run, a firm must employ more labour, which increases costs.

Short-run Costs:

• A firm’s total cost (TC) is the cost of all the factors of production it uses.

• Total cost is total fixed cost (TFC) plus total variable cost (TVC).

• TFC is the cost of the firm’s fixed factors. I.E rent

• TVC is the cost of the firm’s variable factors. I.E labour

• TC is the sum of total fixed cost and total variable cost. TC = TFC + TVC

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 Short-run Costs

Total cost Curve

• Total variable cost increases as

output increases, so the TVC curve
and the TC curve increase as output
increases.

• The vertical distance between the

TC curve and the TVC curve equals
total fixed cost, as illustrated by the
two arrows.

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 Short-run Costs
Average Costs

Three average costs of production are:

1. Average fixed cost (AFC) - is total fixed cost per unit of output

2. Average variable cost (AVC) - is total variable cost per unit of output.

3. Average total cost (ATC) - is total cost per unit of output

The average cost concepts are calculated from the total cost concepts as follows:

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 Short-run Costs
Marginal Cost

• A firm’s marginal cost - is the increase in total cost that results

from a one-unit increase in output.

• We calculate marginal cost as the increase in total cost divided

by the increase in output:

• At small outputs, marginal cost decreases as output increases

because of greater specialisation and the division of labour.

• As output increases further, marginal cost eventually increases

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 Diminishing Returns

The law of diminishing returns - means that the output produced by each additional worker is
successively smaller. To produce an additional unit of output, ever more workers are required, and
the cost of producing the additional unit of output – marginal cost – must eventually increase.

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Short-run Costs – Practical

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Short-run Costs – Practical Answers

7.1 0
0 7.2 20 000
7.3 50 000
7.4 30
7.5 20 000
7.6 10
7.7 25
7.8 85 000
7.9 28.33
7.10 85 000
7.11 5
7.12 110 000
7.13 130 000
7.14 3.33
7.15 30

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 Marginal Cost and Average Costs
• The marginal cost curve (MC) intersects the average variable cost
curve and the average total cost curve at their minimum points.
• When marginal cost is less than average cost, average cost is
decreasing, and when marginal cost exceeds average cost, average
cost is increasing.
• ATC is the sum of AFC and AVC, so the shape of the ATC curve
combines the shapes of the AFC and AVC curves.
• The U shape of the ATC curve arises from the influence of two
opposing forces:
1. Spreading total fixed cost over a larger output
2. Eventually diminishing returns
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Marginal Cost & Average Costs

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 Cost Curves and Product Curves

• The technology that a firm uses determines its costs.

• At the point of maximum average product, average variable cost is at a
minimum.
• As labour increases up to 1.5 workers a day , output increases to 6.5
sweaters a day
• Marginal product and average product rise and marginal costs and average
variable costs fall.
• At the point of maximum marginal product, marginal cost is at a minimum.
• Average product diminishes and average variable cost increases.

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 Cost Curves and Product Curves

• As labour increases from 1.5 workers to 2 workers a day, output increases

from 6.5 sweaters to 9 sweaters a day.
• Marginal product falls and marginal cost rises, but average product
continues to rise and average variable cost continues to fall.
• At the point of maximum average product, average variable cost is at a
minimum.
• Average product diminishes and average variable cost increases.

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 Shifts in the Cost Curves

The position of a firm’s short-run cost curves depends on two factors:

• Technology
• Prices of factors of production.
Technology
• A technological change that increases productivity increases the marginal product and average
product of labour.
Prices of Factors of Production
• An increase in the price of a factor of production increases the firm’s costs and shifts its cost
curves.
• How the curves shift depends on which factor price changes.
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 Long-run Costs

• In the long run, a firm can vary both the quantity of labour and the quantity of capital, so in
the long run all the firm’s costs are variable.

• The behaviour of long-run cost depends on the firm’s production function, which is the
relationship between the maximum output attainable and the quantities of both labour and
capital.

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 Long-run Costs
The Production Function
• The table shows the total product data for four quantities of capital (factory sizes)

• The greater the factory size, the larger is the output produced by any given quantity of labour.

• For a given factory size, the marginal product of labour diminishes as more labour is employed.

• For a given quantity of labour, the marginal product of capital diminishes as the quantity of capital used
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 Long-run Costs - Diminishing Returns

Diminishing returns occur with each of the four factory sizes

as the quantity of labour increases. You can check that fact by
calculating the marginal product of labour in each of the
factories with 2, 3 and 4 machines. With each factory size, as
the firm increases the quantity of labour employed, the
marginal product of labour (eventually) diminishes.

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 Long-run Costs - Diminishing Marginal Product of
Capital
The marginal product of capital - is the change in total product divided by the change in
capital when the quantity of labour is constant – equivalently, the change in output resulting
from a one-unit increase in the quantity of capital.

 If Campus Sweaters has 3 workers and increases its capital from 1 machine to 2 machines,
output increases from 13 to 18 sweaters a day, the marginal product of the second machine is 5
sweaters a day.

 If Campus Sweaters continues to employ 3 workers and increases the number of machines
from 2 to 3, output increases from 18 to 20 sweaters a day. The marginal product of the third
machine is 2 sweaters a day.
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 Short-run Cost and Long-run cost

In Figure 11.6, two things stand out:

1. Each short-run ATC curve is U-shaped.

2. For each short-run ATC curve, the larger the

factory, the greater is the output at which
average total cost is at a minimum.

Each short-run ATC curve is U-shaped because, as the quantity of labour increases, its marginal
product initially increases and then diminishes.
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 Short-run Cost and Long-run cost

The minimum average total cost for a larger factory occurs at

a greater output than it does for a smaller factory because the
larger factory has a higher total fixed cost and therefore, for
any given output, a higher average fixed cost.

Which short-run ATC curve a firm operates on depends on the

factory it has. In the long run, the firm can choose its factory
and the factory it chooses is the one that enables it to produce
its planned output at the lowest average total cost.

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 Short-run Cost and Long-run cost
Campus Sweaters plans to produce 18 sweaters a day.
 With 1 machine, on ATC 1, average total cost is R33.33 a sweater.
 With 2 machines, on ATC 2 , average total cost is R27.78 a sweater.
 With 3 machines, on ATC 3, average total cost is R30.63 a sweater, the same as with 1 machine.
 With 4 machines, on ATC 4, average total cost is R35.00 a sweater.

 Cost per labourer per day =

R100
 Cost of the knitting machines
per day = R100
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 Short-run Cost and Long-run cost

Campus Sweaters plans to produce 18 sweaters a day.

With 1 machine, the average total cost curve is ATC1 And the
average total cost of 18 sweaters a day is R33.33 a sweater.

With 2 machines, on ATC 2 , average total cost is R27.78 a

sweater.

With 3 machines, on ATC 3, average total cost is R30.63 a

sweater, the same as with 1 machine.

With 4 machines, on ATC 4, average total cost is R35.00 a

sweater.
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 Short-run Cost and Long-run cost

The economically efficient factory for producing a given

output is the one that has the lowest average total cost. The
economically efficient factory to use to produce 18 sweaters a
day is the one with 2 machines, employing 3 workers.

When a firm is producing a given output at the least possible

cost, it is operating on its long-run average cost curve.

The long-run average cost curve (LRAC) - is the relationship

between the lowest attainable average total cost and output when
the firm can change both the factory it uses and the quantity of
labour it employs.
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 Long-run Average Cost Curve

The LRAC curve is a planning curve. It tells the firm the factory and the quantity of labour to use at each
output to minimise average cost.

Once the firm chooses a factory, the firm operates on the short-run cost curves that apply to that factory.

 For outputs up to 9 sweaters a day, average

total cost is the lowest on ATC 1.
 For outputs between 9 and 24 sweaters a
day, average total cost is the lowest on ATC
2.
 For outputs in excess of 24 sweaters a day,
average total cost is the lowest on ATC 4. 31
 Long-run Costs
• Economies of scale - are features of a firm’s technology that
make average total cost fall as output increases. Greater
specialisation of both labour and capital is the main source of
economies of scale.
• Campus Sweaters has economies of scale for outputs up to 18
sweaters a day.
• Diseconomies of scale - are features of a firm’s technology that
make average total cost rise as output increases. When
diseconomies of scale are present, the LRAC curve slopes
upward.
• In Figure 11.7, Campus Sweaters experiences diseconomies of
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 Long-run Costs

Minimum efficient scale - is the smallest output at which long-run

average cost reaches its lowest level. At Campus Sweaters, the
minimum efficient scale is 18 sweaters a day.

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 Thank you,
Class is Dismissed