Dr. Mohammed Alwosabi Econ 140 – Ch.

10

Notes on Chapter 10
OUTPUT AND COSTS

PRODUCTION TIMEFRAME
— There are many decisions made by the firm. Some decisions are major
decisions that are hard to reverse without a big loss while other decisions are
small ones that could be easily changed. All decisions are aimed to achieve
the main goal of the firm: maximizing economic profit.
— The use of resources implies cost of production. In order to lower the cost of
production the firm must know how many resources are needed to produce a
given level of output. The challenge to the managers is to choose the right
level of output and cost that maximize economic profit.
— To study the relationship between a firm output decisions and its cost, we
must distinguish between two decisions time frames.

The short-run (SR)

— The SR is time frame in which some inputs are fixed while others are
variable. Fixed inputs are such as building, capital, plant and organization and
variable inputs are such as labor, raw materials and energy.
— To increase the output in the SR, a firm must increase the quantity of the
variable input.
— SR decisions can easily be reversed. The firm for example can increase or
decrease its output in the SR by increasing or decreasing the amount of labor
to employ.

The long-run (LR)

— The LR is a time frame in which all its resources are variable.
— To increase the output in the LR, a firm is able to change its technology,
capital, plant as well as its labor.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

— LR decisions are not easily reversed. Once a decision is made the firm usually
must live with it for some time.
— A sunk cost is a cost that is incurred by the firm and cannot be changed. If a
firm’s plant has no resale value, the amount paid for it is a sunk cost. Sunk
costs are irrelevant to a firm’s decisions.

THE SHORT RUN PRODUCTION FUNCTION

— The total amount of output produced by a firm is a function of the levels
of input used by the firm.
— Production function refers to a technological relationship between
different combinations of inputs (factors of production) and the maximum
amount of output that can be produced within a given period of time,
assuming a fixed level of technology.
— The production function illustrates the relationship between output (Q)
and inputs of labor (L), capital (K), land (N), and the entrepreneurship (E):
Q = f (L, K, N, E)
— To simplify the production function, let us assume the production process
requires only two inputs – labor and capital. Since we are in the short-run,
at least one input must be fixed. We will assume that the capital is fixed
while the firm can change the amount of labor. Thus, the production
function becomes:
Q = f (L, K)
— The production function in this simple form, where labor is the only input
that can be changed, is sometimes referred to as the total product of labor
(TPL). To increase the quantity in the SR, a firm must increase labor.
— We describe the relationship between Q and L by using the following
related concepts:
1. Total product (TPL)
2. Marginal product (MPL)
3. Average product (APL)

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

Total Product (TPL):

— Total product is the total output produced in a given period. It shows the
output capacity of the firm.
— Total product captures the relationship that exists between the maximum
level of output that can be produced by a firm and the quantity of labor
used in production, holding other inputs and technology constant.
— TP is similar to the production possibilities frontier (PPF):
o It separates the attainable output level from the unattainable level of
output. All points that lies above the curve are unattainable, while
points that lie on the curve or below it are attainable.
o Points on TP curve are technologically efficient. Technological
efficiency is producing the maximum output attainable from any
combination of inputs.
o Points below the curve are inefficient. They produce less output
from a given input
o In other words, inefficiency is the use of more inputs than necessary
to produce a given output. Inefficiency leads to higher cost.

L TPL MPL APL AP, MP

0 0 -- --
1 5 5 5
2 14 9 7
3 30 16 10 TP
4 44 14 11
5 50 6 10
6 50 0 8.33
7 48 -2 6.86
8 43 -5 5.38
9 36 -7 4 L
MP

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

— TP curve shows how output changes as the quantity of labor changes. A

careful inspection of the table and the figure above indicates that output
initially increases more rapidly as the quantity of labor increases (the
shape of the TP curve starts steep), but this increase gets smaller and
smaller as L increases (the curve become less steep). The steeper the slope
of the TP curve, the greater is the MP.

Marginal Product:
— Marginal product (MP) is a short-run production function that shows
how much each additional worker contributes to output.
— MP is defined as the change in total output that results from the use of one
additional unit of a variable input, holding other inputs constant
Change in total output ∆TP ∆Q
MPL = = =
Change in the quantity of labor ∆L ∆L
— MP is the slope of the TP curve
— We plot MPL at the mid points between labor input to emphasize that it is
the result of changing input.
— MPL increases until reaches maximum then start to decrease until reaches
zero and after that starts to become negative.
— Almost every production process has two features: initially, (1) increasing
marginal returns (IMR), and then (2) Diminishing marginal returns
(DMR), eventually.

Increasing marginal returns (IMR)

— IMR occurs when every additional worker adds more to the total
product than the previous one. Thus, the MP of an additional
worker exceeds the MP of the previous worker.
— IMR arise from the increase in specialization, teamwork and
division of labor in the production process.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

Diminishing marginal returns (DMR)

— DMR occurs when the MP of an additional worker is less than the
MP of the previous worker. DMR is observed in SR because we
add more and more of the variable input to the fixed input. As
more workers are added to a fixed machine, for example, there is
less and less for the additional worker to do and the gains from
specialization and the division of labor is getting less and less.
Because DMR exists eventually in every production process in the
SR it is called the law of diminishing returns
— Law of diminishing returns: As a firm uses more and more of a variable
input with a given quantity of a fixed input, the MP of the variable input
eventually diminishes (decline).

The Relationship between MPL and TPL

— Because of IMR, TP increases initially at increasing rate. Then, because of
DMR, TP increases at decreasing rate.
— The point that TP change its increase from increasing at increasing rate to
increasing at decreasing rate (i.e., the point where DMR start its course) is
called the turning point. When TPL is at its turning point MPL is at its
maximum,
o If MPL > 0, TPL is increasing
o If MPL = 0, TPL is at its maximum
o If MPL < 0, TPL is decreasing
— Exercise:
(True or False): TP decreases when MP decreases.
— Exercise:
Why the law of diminishing returns does not apply in long run?
In long run, firm can increase the availability of space and capital to keep
up with the increase in the variable input.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

— Exercise:
How many workers a firm should hire if it can hire all workers it wanted
at zero wage (i.e., the workers are volunteers)?
The firm should hire enough workers to produce where MP = 0
— Exercise:
Find the MPL from the labor and output data in the following table:

Total and Marginal Product

from Hiring Labor
Labor TPL MPL
0 0
2 200
4 500
6 700
8 800

Notice that even though output rises from zero to 200, marginal product is
only 100. This is because the firm hired two more workers and we want to
know how much output would rise if they only hired one additional
worker.
— Exercise:
Could the law of diminishing returns be applied to the marginal product of
capital (MPK)?
The answer is yes. If the capital is the variable input, marginal product of
capital (MPK) is the change in the firm’s output as a result of one unit
change in capital, keeping labor and other inputs fixed.
Law of DMR also hold for capital that means if firm uses more capital
with fixed input, MP of capital eventually declines.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

Average Product (AP)

— The relationship between the quantity of input and total output can also be
represented through the average product of labor (APL).
— The average product is defined as the ratio of total product to the quantity
of labor. AP is the total product per unit of labor
TP Q
APL = =
L L
— Economists expect that the AP may initially rises but will ultimately
decline as a result of the law of diminishing returns. The average product
of labor shows labor productivity.
— Productivity refers to the output produced per unit of input. For example,
output per hour of labor. Productivity of any input depends on the amount
of other resources available to it. It increases when the ratio of output per
unit of input increases
— Greater labor productivity means higher output per worker. Labor
productivity will increase if capital per worker increases.

AP,
The Relationship between MPL and APL MP

— Usually, MPL reaches the max before APL

— As more labor is employed APL increases until
It reaches the maximum then starts to decline
— MP curve cuts the AP curve at the point AP
of its maximum. MP

— If MP > AP, AP is increasing Ö an additional L

L*
worker adds more to output than the average
worker is producing. In this case, the average has to increase.
— If MP = AP, AP is at maximum Ö an additional worker adds the same
amount of output as the average worker is producing. In this case, the
average stays the same and it is at maximum.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

— If MP < AP, AP is decreasing Ö an additional worker adds less to output

than the average worker is producing. In this case, the average has to
decrease.

Marginal Grade and GPA

— To see the relationship between AP and MP think about your "marginal
grade" of any additional course and your GPA:
o GPA ↑ when marginal grade > GPA
o GPA ↓ when marginal grade < GPA
o GPA is constant when marginal grade equals GPA

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

SHORT RUN COST FUNCTIONS

— The production decision has to be based not only on the capacity to
produce (the production function) but also on the costs of production (the
cost function).
— The most desirable rate of output to produce is the one that maximizes
total profit.
— To produce more output in the SR, a firm must employ more of its
variable input (the labor), which means that it must increase its cost.
— We describe the relationship between output and cost by using three cost
concepts:
1. Total cost (TC)
2. Marginal cost (MC)
3. Average cost (AC)

Total costs (TC)

— Total cost (TC) is the market value of all factors of production used to
produce goods or services. This cost may be explicit, paid for directly, or
implicit, not paid for directly but estimated via opportunity costs including
the cost of entrepreneurship, which is the normal profit.
— Even in the short-run, total costs remain the sum of explicit and implicit
costs. However, in the short-run it is actually more useful to divide total
costs into two other types of costs because there are two different types of
inputs in the short run: variable inputs that the firm can change and fixed
inputs that the firm cannot change. Thus, total cost contains both total
fixed cost and total variable cost.
— TC = TFC + TVC

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

Total Fixed Cost (TFC)

— TFC is the cost of the fixed inputs that the firm uses in production. It does
not vary with the changes in the output, even when output equals zero.
— Examples of such fixed costs include rent, annual license fees, mortgage
payments, interest payments on loans, the cost of basic plant and
equipment.
— There is no way to avoid fixed costs in the short run.
TFC > 0 even if Q = 0

Total Variable Cost (TVC)

— TVC is the cost of the variable inputs that the firm uses in production. It
varies when the rate of output changes. Labor costs, raw material costs
and energy costs are examples of variable costs.
— TVC is equal to zero when no output is produced and increases with the
level of output.
— Since TC = TFC + TVC, in the short run,
when Q =0, TVC = 0 ⇒ TC = TFC
— In short run, changes in TC will result only from changes in the TVC.
TVC gives TC its shape.
Costs
TC
Total Costs Graphically
TVC
— The diagram contains a graph of a
total fixed cost curve. Since total
fixed costs are the same at all levels
of output, a graph of the total fixed
cost curve is a horizontal line. TFC
— The total variable cost curve
Q
increases as output increases. Initially, it is expected to increase at an
increasing rate (since marginal productivity increases initially,

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

the cost of additional units of output decline). As the level of output rises,
however, variable costs are expected to increase at a decreasing rate (as a
result of the law of diminishing marginal returns).
— Since total cost equals the sum of total variable and total fixed costs, the
total cost curve is just the vertical summation of the TFC and TVC curves.

Marginal Cost
— Marginal cost (MC) is the increase in total costs associated with a one-unit
increase in output.
∆TC ∆TC ∆TVC
MC = = =
∆TP ∆Q ∆Q
— Since the TC consist of the sum of TFC and TVC, TC can only change if
either of these two changes. But we know that TFC does not change.
Thus, the only possible source for a change in TC is a change in TVC.
— Diminishing returns in production cause MC to increase as the rate of
output increases. The shape of MC curves reflects the law of diminishing
returns. Diminishing returns exist because in the short run some resources
are fixed.

Average (per-unit) Costs

— One of the most common costs is average, or per-unit, cost. Average cost
can be divided into:
TC = TFC + TVC
TC TFC TVC
= +
Q Q Q
ATC = AFC + AVC

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

— The following table and diagram present all of the cost functions
Q TFC TVC TC MC AFC AVC ATC
0 10 0 10 0 0 0 0
1 10 8 18 8 10 8 18
2 10 14 24 6 5 7 12
3 10 18 28 4 3.33 6 9.33
4 10 21 31 3 2.5 5.25 7.75
5 10 25 35 4 2 5 7
6 10 31 41 6 1.67 5.17 6.83
7 10 40 50 8 1.43 5.71 7.14
8 10 50 60 10 1.25 6.25 7.5
9 10 65 75 15 1.11 7.22 8.33
10 10 90 100 25 1 9 10

AFC, AVC, ATC

MC
ATC

AVC

AFC
Q

Falling AFC:
— To understand why average fixed costs always decline one must simply
recall two important facts. First, total fixed costs are always constant
regardless of the level of output. Second, to calculate average fixed costs
we simply divide total fixed costs by output. Hence, as the firm’s output
rises we are dividing the same number – total fixed costs – by an
increasing output. The result, average fixed cost, must fall as output rises
and as the fixed cost is spread over more output.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

— Note that AFC decreases at a decreasing rate. It approaches the horizontal

axis but never equal to zero.
— Note that the vertical distance between the ATC and the AVC curve is
equal to AFC (since AFC+AVC = ATC). Because the difference between
ATC and AVC equals AFC and because as output rises AFC is getting
closer and closer to zero, then the vertical distance between ATC curve
and AVC curve is getting smaller and smaller as total output increases.

MC and the U-shape of ATC (and AVC) Curves:

— AFC always declines as output rises. It does not matter whether MC is
rising or falling, AFC is always falling. Thus, MC and AFC are simply not
related. The one has no impact on the other.
— However, MC is related to ATC and AVC. These relationships exist
because MC is calculated from either TC or TVC as discussed earlier. We
calculate MC by taking the change in either TC or TVC and dividing that
change by the change in output.
— The MC curve starts below ATC curve and AVC curve, but rises faster
than both of them.
— MC always intersects both ATC and AVC curves from below at their
minimum points.
— MC curve gives ATC and AVC their U-shape
o If MC < ATC, ATC is decreasing,
o If MC > ATC, ATC is increasing.
o If MC = ATC, ATC at minimum
— Same thing is applied to AVC
o If MC < AVC, AVC is decreasing.
o If MC > AVC, AVC is increasing,
o If MC = AVC, AVC at minimum
— Looking at it from the production side, the AVC curve is U-shaped
because:

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

1. Initially, marginal product exceeds average product, which brings

rising average product and falling AVC.
2. Eventually, marginal product falls below average product, which
brings falling average product and rising AVC.
— The ATC curve is U-shaped for the same reasons. In addition, ATC falls at
low output levels because AFC is falling steeply.

Relating Costs to Production AP, MP

— Recall that the cost curves are U-shaped

because they are related to productivity;
when productivity rises initially due to the AP
returns to specialization (IMR), costs fall
MP
and when productivity eventually falls due
to diminishing returns (DMR), costs must L
AVC, MC
rise.
MC
— The relationship between costs and
AVC
Productivity is an inverse one; increases
in productivity cause costs to fall while
decreases in productivity cause costs to rise.
— MC and AC are mirror image of MP and AP. Q

— Initially MC and AC decrease because MP and AP increase, but

eventually MC and AVC increase because of DMR.
— MP reaches the max before AP and MC reaches the min before AVC
o When MP is increasing , MC is decreasing
o When MP is decreasing, MC is increasing
o When MP is at its maximum, MC is at its minimum
— We can say the same thing with regard to AP and AVC
o When AP is increasing , AVC is decreasing
o When AP is decreasing, AVC is increasing
o When AP is at its maximum, AVC is at its minimum

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

— When MP intersects AP at its maximum, MC intersects AVC at its

minimum.

Shifts in the Cost Curves

— The position of a firm's SR cost curves depends on two factors:
1. Technology
2. Prices of productive resources.

1. Technology
— A technological change that increases productivity shifts the TP, MP and
AP curves upward. With better technology, the same inputs can produce
more output. Therefore, technological change lowers costs and shifts the
cost curves downward.
— The relationship between product curves and cost curves have not change
with changes in technology.
— Often, a technological advance results in a firm using more capital (a fixed
input) and less labor (a variable input).Therefore, fixed costs increase and
variable costs decrease. This change in the mix of costs means ATC may
increase at low output levels and decrease at high output levels.

2. Prices of Resources
— The increase of price of fixed input shifts the fixed and total cost curves
(TFC, TC, AFC and ATC) upward.
— The increase in the price of variable inputs shift TVC, TC, AVC, ATC and
MC upward but leaves TFC and AFC unchanged.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

LONG-RUN COSTS
— The short-run is characterized by fixed inputs and fixed costs as well as
variable inputs and variable costs.
— Long run is a period of time long enough for the firm to change all of its
resources or to choose the production capacity that suite market demand
for its product. Because there are no fixed inputs in the LR, there are no
fixed costs. All inputs and all costs of production are variables in the long
run.
— Long-run average variable costs equal long-run average total costs. There
is no fixed cost in the long run
— The behavior of long-run cost depends upon the firm’s production
function, which is the relationship between the maximum output attainable
and the quantities of both capital and labor.
— The average cost of producing a given output varies and depends on the
firm’s plant size.
— The larger the plant size, the greater is the output at which ATC is at a
minimum.

LONG-RUN AVERAGE COST (LRAC)

— The long-run average cost curve is the relationship between the lowest
attainable average total cost and output when both the plant size and labor
are varied.
— The long-run average cost curve is a planning curve that tells the firm the
plant size that minimizes the cost of producing a given output range.
— LRAC shows the production efficiency at every level of output because it
shows the plant size and the quantity of resources to be used at each level
of output to minimize the cost.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

ACs SRATC4
SRATC1
LRAC
SRATC2
SRATC3

Q
a b c

— LR possibilities are determined by all possible SR options. In this case,

there are four options of varying size (ATC1, ATC2, ATC3, and ATC4).
— In the LR, we would choose that plant which yielded the lowest average
cost for any desired rate of output. The dark portion of the curve (LRAC)
represents these choices. At point a, the plant that results in SRATC1 is the
best choice while at b SRATC2 is the best. Same thing can be said about
point c where the best choice is SRATC4
— Therefore, LRAC is constructed from the lowest short run ATC at each
possible level of output.
— If plants of all sizes can be built, SR options are infinite. In this case, the
LRAC curve becomes a smooth U-shaped curve. Each point on the curve
represents the lowest production for a plant size best suited to one rate of
output.

ECONOMIES AND DISECONOMIES OF SCALE

— To increase its output in the long-run the firm can increase all of its inputs
which makes the firm becomes larger. This is referred to as increasing
scale of operations.
— Note that if a firm increased its output in the short-run it would not be
increasing its scale because the firm is not increasing all of its inputs.
Thus, scale is only a long-run concept.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

— In the short run, no firm experiences economies of scale.

— There are many options available in the long-run production. One option
is the decision to use one large plant. The other option is to use several
smaller plants to produce a given amount of output

Economies of Scale [or Increasing Returns to Scale (IRS)]

— Economies of scale refer to the reduction in the minimum average total
costs that result from increasing the size (scale) of plant and equipment.
If %↑ in output > %↑ input Ö increasing returns to scale.
— Economies of scale explain why ATC decreases as output increases in LR.
A larger scale of production might enable a firm to divide tasks into more
specialized activities, thereby increasing labor productivity. Furthermore,
a larger scale of operation might enables a company to justify the purchase
of more sophisticated (hence, more productive) machinery. These factors
help to explain why a firm can experience increasing returns to scale.

Constant Returns to Scale (CRS)

— In some cases, it is not "more efficient" to produce in large-scale plants
than in small plants. In such cases, the production process is characterized
by constant returns to scale.
— Constant Returns to Scale means the increase in plant size do not affect
minimum average costs. Minimum average (per-unit) costs are identical
for small plants and large plants.
(%↑ in Q = %↑ input Ö constant returns to scale)

Diseconomies of Scale [or Decreasing Returns to Scale (DRS)]

— Although large plants may be able to achieve greater efficiencies than
smaller plants, there is no assurance that they actually will, especially
when the plants becomes too large.

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

— Diseconomies of Scale occur when an increase in plant size results in

reducing operating efficiency. This happens because of the increased cost
of managing and coordinating a firm as the size of the firm rises
(%↑ in Q < %↑ input Ö decreasing returns to scale)
— A common source of diseconomies of scale is the growing complexity of
management and organizational structure.
— Efficiency and size do not necessarily go hand in hand. Operating on a
larger scale might create certain marginal inefficiency (e.g., management
difficulties, communication problems, bureaucratic red tape, rigid
corporate structure, anonymity) and hence cause decreasing returns to
scale.

LR Costs and Economies of Scale:

Cost

LRAC

Economies Diseconomies
of Scales Constant Returns of Scales
to Scales
Q

— If LRAC decrease as output increase, the firm experiences economies of

scale (IMS). The slope of its LRAC curve is negative and the slope of its
ATC curve is negative
— If LRAC increase as output increase, the firm experiences diseconomies
of scale (DRS)
— If LRAC remains constant as output increase, the firm experiences neither
economies nor diseconomies of scale (CRS)

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

EXERCISE

1. Fill out the blanks in the following two tables

L TP MP AP
0 0 --- ---
1 12
2 28
3 13
4 12
5 2
6 48
7 -6

Q TFC TVC TC MC AFC AVC ATC

0 50 --- --- --- ---
1 20
2 80
3 6
4 7.5
5 34
6 70

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Dr. Mohammed Alwosabi Econ 140 – Ch.10

2.

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Based on the above figure that shows ATC, AVC and MC, answer the following
questions
1. What is the MC of the 120th unit of output?
2. What is the ATC of the 120th unit of output?
3. What is the AVC of the 120th unit of output?
4. What is the AFC of the 120th unit of output?
5. At which level of output shown above will AFC be the lowest?
6. What is the TFC of the 100th unit of output?
7. Why does the ATC curve slope downward before the 120th units of output?
8. Why does the AVC curve start to slope upward after 100 units of output?
9. At which level of output does "increasing marginal returns" end?
10. At which level of output does "diminishing marginal returns" first occur?

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