Short-Run Costs and

Output Decisions

8
CHAPTER OUTLINE
Costs in the Short Run
Fixed Costs
Variable Costs
Total Costs
Short-Run Costs: A Review

Output Decisions: Revenues,

Costs, and Profit Maximization
Perfect Competition
Total Revenue and Marginal Revenue
Comparing Costs and Revenues to
Maximize Profit
The Short-Run Supply Curve

Looking Ahead

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Costs in the Short Run

fixed cost Any cost that does not depend on the firms
level of output. These costs are incurred even if the firm
is producing nothing. There are no fixed costs in the long
run.
variable cost A cost that depends on the level of
production chosen.
total cost (TC) Total fixed costs plus total variable costs.
TC = TFC + TVC

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Costs in the Short Run

Fixed Costs
Total Fixed Cost (TFC)
total fixed costs (TFC) or overhead The
total of all costs that do not change
with output even if output is zero.
TABLE 8.1 Short-Run Fixed Cost (Total and Average) of a Hypothetical
Firm
(1)
q
0
1
2
3
4
5

(2)
TFC
$1,000
1,000
1,000
1,000
1,000
1,000

(3)
AFC (TFC/q)
$

1,000
500
333
250
200

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Costs in the Short Run

Fixed Costs
Average Fixed Cost (AFC)
average fixed cost (AFC) Total fixed cost divided
by the number of units of output; a per-unit
measure of fixed costs.

TFC
AFC =
q
spreading overhead The process of dividing total
fixed costs by more units of output. Average fixed
cost declines as quantity rises.

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Costs in the Short Run

Average Fixed Cost (AFC)

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Costs in the Short Run

Variable Costs
Total Variable Cost (TVC)
total variable cost (TVC) The total of all costs
that vary with output in the short run.
total variable cost curve A graph that shows
the relationship between total variable cost and
the level of a firms output.

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Costs in the Short Run

Variable Costs
Total Variable Cost (TVC)

TABLE 8.2 Derivation of Total Variable Cost Schedule from Technology and Factor Prices

Produce
1 unit of
output
2 units of
output

3 units of
output

Using
Technique

Units of Input Required

(Production Function)
K
L

Total Variable Cost Assuming

PK = $2, PL = $1
TVC = (K x PK) + (L x PL)

(4 x $2) + (4 x $1)

= $12

(2 x $2) + (6 x $1)

= $10

(7 x $2) + (6 x $1)

= $20

10

14

(4 x $2) + (10 x $1) = $18

(9 x $2) + (6 x $1)

= $24

(6 x $2) + (14 x $1) = $26

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Costs in the Short Run

Variable Costs
Total Variable Cost (TVC)

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Costs in the Short Run

Variable Costs
Marginal Cost (MC)
marginal cost (MC) The increase in total cost
that results from producing 1 more unit of output.
Marginal costs reflect changes in variable costs.
TABLE 8.3 Derivation of Marginal Cost from Total Variable Cost
Units of Output

Total Variable Costs ($)

0
1
2
3

0
10
18
24

Marginal Costs ($)

10
8
6

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Costs in the Short Run

Variable Costs
The Shape of the Marginal Cost Curve in the Short Run

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Costs in the Short Run

Variable Costs
The Shape of the Marginal Cost Curve in the Short Run

In the short run, every firm is constrained by some

fixed input that (1) leads to diminishing returns to
variable inputs and (2) limits its capacity to
produce. As a firm approaches that capacity, it
becomes increasingly costly to produce
successively higher levels of output. Marginal costs
ultimately increase with output in the short run.

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Costs in the Short Run

Graphing Total Variable Costs and Marginal Costs

slope of TVC =

TVC TVC
=
= TVC = MC
q
1
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Costs in the Short Run

Variable Costs
Average Variable Cost (AVC)
average variable cost (AVC) Total variable
cost divided by the number of units of output.

TVC
AVC =
q

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Costs in the Short Run

Variable Costs
Average Variable Cost (AVC)
TABLE 8.4 Short-Run Costs of a Hypothetical Firm
(1)
q

(2)
TVC

(3)
MC
( TVC)

(4)
AVC
(TVC/q)

(5)
TFC

(6)
TC
(TVC + TFC)

$1,000

$ 1,000

(7)
AFC
(TFC/q)

10

10

10

1,000

1,010

1,000

1,010

18

1,000

1,018

500

509

24

1,000

1,024

333

341

32

1,000

1,032

250

258

42

10

8.4

1,000

1,042

200

208.4

500

8,000

20

16

1,000

9,000

(8)
ATC
(TC/q or AFC + AVC)
$

18
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Costs in the Short Run

Variable Costs
Graphing Average Variable Costs and Marginal Costs
FIGURE 8.6 More Short-Run Costs

When marginal cost is below

average cost, average cost is
declining.
When marginal cost is above
average cost, average cost is
increasing.
Rising marginal cost intersects
average variable cost at the
minimum point of AVC.

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Costs in the Short Run

Total Costs

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Costs in the Short Run

Total Costs
Average Total Cost (ATC)
average total cost (ATC) Total cost
divided by the number of units of output.

TC
ATC =
q
ATC = AFC + AVC

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Costs in the Short Run

Total Costs
Average Total Cost (ATC)
FIGURE 8.8 Average Total Cost =
Average Variable Cost + Average Fixed Cost

To get average total cost, we add

average fixed and average variable
costs at all levels of output.
Because average fixed cost falls with
output, an ever-declining amount is
added to AVC.
Thus, AVC and ATC get closer
together as output increases, but the
two lines never meet.

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Costs in the Short Run

Total Costs
The Relationship Between Average Total Cost and Marginal Cost
The relationship between average total cost
and marginal cost is exactly the same as the
relationship between average variable cost
and marginal cost.
If marginal cost is below average total cost,
average total cost will decline toward marginal
cost. If marginal cost is above average total
cost, average total cost will increase. As a
result, marginal cost intersects average total
cost at ATCs minimum point for the same
reason that it intersects the average variable
cost curve at its minimum point.
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Costs in the Short Run

Short-Run Costs: A Review
TABLE 8.5 A Summary of Cost Concepts
Term

Definition

Equation

Accounting costs

Out-of-pocket costs or costs as an accountant would

define them. Sometimes referred to as explicit costs.

Economic costs

Costs that include the full opportunity costs of all inputs.

These include what are often called implicit costs.

Total fixed costs (TFC)

Costs that do not depend on the quantity of output

produced. These must be paid even if output is zero.

Total variable costs (TVC)

Costs that vary with the level of output.

Total cost (TC)

The total economic cost of all the inputs used

by a firm in production.

Average fixed costs (AFC)

Fixed costs per unit of output.

AFC = TFC/q

Average variable costs

(AVC)

Variable costs per unit of output.

AVC = TVC/q

Average total costs (ATC)

Total costs per unit of output.

Marginal costs (MC)

The increase in total cost that results from

producing 1 additional unit of output.

TC = TFC + TVC

ATC = TC/q ATC = AFC + AVC

MC = DTC/Dq
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EC ON OMIC S IN PRACTIC E
Average and Marginal Costs at a College
Students

Costs in Dollars
Total Fixed Cost Total Variable Cost Total Cost

Average Total Cost

500

$60 million

$ 20 million

$ 80 million

$160,000

1,000

60 million

40 million

100 million

100,000

1,500

60 million

60 million

120 million

80.000

2,000

60 million

80 million

140 million

70,000

2,500

60 million

100 million

160 million

64,000

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Output Decisions: Revenues, Costs, and Profit Maximization

Perfect Competition

perfect competition An industry structure in

which there are many firms, each small relative to
the industry, producing identical products and in
which no firm is large enough to have any control
over prices. In perfectly competitive industries, new
competitors can freely enter and exit the market.
homogeneous products Undifferentiated
products; products that are identical to, or
indistinguishable from, one another.

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Output Decisions: Revenues, Costs, and Profit Maximization

Perfect Competition

FIGURE 8.9 Demand Facing a Single Firm in a Perfectly Competitive Market

If a representative firm in a perfectly competitive market raises the price of its output above $6.00,
the quantity demanded of that firms output will drop to zero.
Each firm faces a perfectly elastic demand curve, d.
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Output Decisions: Revenues, Costs, and Profit Maximization

Total Revenue and Marginal Revenue
total revenue (TR) The total amount that a firm takes in
from the sale of its product: the price per unit times the
quantity of output the firm decides to produce (P x q).

total revenue = price quantity

TR = P q
marginal revenue (MR) The additional revenue that a
firm takes in when it increases output by one additional
unit. In perfect competition, P = MR.

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Output Decisions: Revenues, Costs, and Profit Maximization

Comparing Costs and Revenues to Maximize Profit
The Profit-Maximizing Level of Output

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Output Decisions: Revenues, Costs, and Profit Maximization

Comparing Costs and Revenues to Maximize Profit
The Profit-Maximizing Level of Output
As long as marginal revenue is greater than marginal cost, even
though the difference between the two is getting smaller,
added output means added profit. Whenever marginal revenue
exceeds marginal cost, the revenue gained by increasing output
by 1 unit per period exceeds the cost incurred by doing so.
The profit-maximizing perfectly competitive firm will produce
up to the point where the price of its output is just equal to
short-run marginal costthe level of output at which P* = MC.
The profit-maximizing output level for all firms is the output
level where MR = MC.

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Output Decisions: Revenues, Costs, and Profit Maximization

Comparing Costs and Revenues to Maximize Profit
A Numerical Example
TABLE 8.6 Profit Analysis for a Simple Firm
(1)

(2)

(3)

(4)

(5)

TFC

TVC

MC

P = MR

(6)
TR
(P x q)

(7)
TC
(TFC + TVC)

(8)
Profit
(TR TC)

10

$ 10

15

20

15

30

25

15

45

30

15

30

10

15

60

40

20

10

50

20

15

75

60

15

10

80

30

15

90

90

$ 10

15

10

10

10

15

10

15

10

20

10

5
6

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EC ON OMIC S IN PRACTIC E
Case Study in Marginal Analysis: An Ice Cream Parlor
An analysis of fixed
costs; variable
costs; marginal
costs; revenues;
marginal revenues;
and profits were
used by this ice
cream parlor to
determine whether
to stay in business.

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Output Decisions: Revenues, Costs, and Profit Maximization

The Short-Run Supply Curve

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Annex: Firms in Perfect

Competition
Based on Mankiw Ch. 12

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Characteristics of Perfect Competition

1. Many buyers and many sellers.
2. The goods offered for sale are largely the same.
3. Firms can freely enter or exit the market.
Because of 1 & 2, each buyer and seller is a price
taker takes the price as given.
Because of 3, economic profit is zero.
>0 will cause entry
< 0 will cause exit
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The Revenue of a Competitive Firm

Total revenue (TR)

TR = P x Q
TR
Q

Average revenue (AR)

AR =

Marginal revenue (MR):

The change in TR from
selling one more unit.

TR
MR =
Q

=P

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Profit Maximization
What Q maximizes the firms profit?
To find the answer, think at the margin.
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
If MR > MC, then increase Q to raise profit.
If MR < MC, then reduce Q to raise profit.

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MR = P for a Competitive Firm

A competitive firm can keep increasing its output
without affecting the market price.
So, each one-unit increase in Q causes revenue to
rise by P, i.e., MR = P.

MR = P is only true for

firms in perfectly competitive
markets.

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Profit Maximization

At any Q with
MR > MC,
increasing Q
raises profit.
At any Q with
MR < MC,
reducing Q
raises profit.

TR

TC

Profit MR MC

$0

$5

$5

10

20

15

30

23

40

33

50

45

Profit =
MR MC

$10

$4

$6

10

10

10

10

10

12

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For any firm (whether PC or not),

MR = MC
determines profit maximization.
For the PC firm, the key
difference is that
P = MR
And therefore P = MR = MC
36
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MC and the Firms Supply Decision

Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.

Costs

So, increase Q
to raise profit.

MC

At Qb, MC > MR.

So, reduce Q
to raise profit.

MR

P1

At Q1, MC = MR.
Changing Q
would lower profit.

Qa Q 1 Qb

Q
37
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MC and the Firms Supply Decision

If price rises to P2,
then the profitmaximizing quantity
rises to Q2.
The MC curve
determines the
firms Q at any price.
Hence,
the MC curve is the
firms supply curve.

Costs
MC
P2

MR2

P1

MR

Q1

Q2

Q
38
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Shutdown vs. Exit

Shutdown:
A short-run decision not to produce anything
because of market conditions.
Exit:
A long-run decision to leave the market.
A key difference:
If shut down in SR, must still pay FC.
If exit in LR, zero costs.

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A Firms Short-run Decision to Shut Down

Cost of shutting down: revenue loss = TR
Benefit of shutting down: cost savings = VC
(firm must still pay FC)
So, shut down if TR < VC
Divide both sides by Q:

TR/Q < VC/Q

So, firms decision rule is:

Shut down if P < AVC

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A Competitive Firms SR Supply Curve

The firms SR
supply curve is
the portion of
its MC curve
P > AVC, then
aboveIf AVC.
firm produces Q
where P = MC.
If P < AVC, then
firm shuts down
(produces Q = 0).

Costs
MC
ATC
AVC

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A Firms Long-Run Decision to Exit

Cost of exiting the market: revenue loss = TR
Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
So, firm exits if TR < TC
Divide both sides by Q to write the firms decision
rule as:
Exit if P < ATC

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A New Firms Decision to Enter Market

In the long run, a new firm will enter the
market if it is profitable to do so: if TR > TC.
Divide both sides by Q to express the firms
entry decision as:

Enter if P > ATC

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The Competitive Firms Supply Curve

The firms
LR supply curve is
the portion of
its MC curve
above LRATC.

Costs
MC
LRATC

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A Firm With Profits

Costs, P
MC
revenue per unit = P
profit per unit = P ATC

MR
ATC

profit

cost per unit = ATC

profit-maximizing quantity
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A Firm With Losses

Costs, P
MC
ATC
cost per unit = ATC
revenue per unit = P

loss

loss per unit

MR
Q

loss-minimizing quantity
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Market Supply: Assumptions

1) All existing firms and potential entrants have
identical costs.
2) Each firms costs do not change as other firms enter
or exit the market.
3) The number of firms in the market is
fixed in the short run
(due to fixed costs)

variable in the long run

(due to free entry and exit)
48
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The SR Market Supply Curve

As long as P AVC, each firm will produce its profit-maximizing quantity, where MR = MC.
Recall from Chapter 4:
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.

49
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The SR Market Supply Curve

Example: 1000 identical firms
At each P, market Qs = 1000 x (one firms Qs)
P

One firm
MC

P3

P3

P2

P2

AVC

P1

Market
S

P1
10 20 30

Q
(firm)
10,000

Q
(market
)
20,000 30,000
50
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Entry & Exit in the Long Run

In the LR, the number of firms can change due to entry & exit.
If existing firms earn positive economic profit,

new firms enter, SR market supply shifts right.

P falls, reducing profits and slowing entry.

If existing firms incur losses,

some firms exit, SR market supply shifts left.

P rises, reducing remaining firms losses.

51
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The Zero-Profit Condition

Long-run equilibrium:
The process of entry or exit is complete
remaining firms earn zero economic profit.

Zero economic profit occurs when P = ATC.

Since firms produce where P = MR = MC,

the zero-profit condition is P = MC = ATC.

Recall that MC intersects ATC at minimum ATC.

Hence, in the long run, P = minimum ATC.

Recall significance of minimum ATC

52
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SR & LR Effects of an Increase in Demand

but then an increase
A firm begins in
profits
to zero
leadingeqm
to driving
SR
Over time,
profits
induce
entry,
in demand
raises
P,
long-run
and
restoring
long-run
eqm.
profits for the
firm.
shifting
S to the
right, reducing P
P

One firm
MC
Profit

Market

S1
S2

ATC
P2

P2
P1

P1

Q
(firm)

B
A

long-run
supply
D1

Q1 Q2

Q3

D2

Q
(market)
54
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CONCLUSION:
The Efficiency of a Competitive Market
Profit-maximization:

MC = MR

Perfect competition:

P = MR

So, in the competitive eqm:

P = MC
Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
So, the competitive eqm is efficient, maximizes total
surplus.
In the next chapter, monopoly: pricing & production
decisions, deadweight loss, regulation.
58
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A Firm With Profits

Costs, P
MC
revenue per unit P
profit per unit = P=
cost per unitATC
ATC
=

MR
ATC

profi
t

Q
FIRMS IN COMPETITIVE MARKETS

profit-maximizing
quantity

59
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A Firm With Losses

Costs, P
MC
ATC
cost per unit ATC
=
revenue per unit P
=

loss

loss per
unit

Q
loss-minimizing
quantity
FIRMS IN COMPETITIVE MARKETS

MR
Q

60
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