Chapter

Short-Run Costs
and Output Decisions 8

Prepared by:

Fernando & Yvonn Quijano

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 1
 Decisions Facing Firms

You have seen that firms in perfectly competitive industries

make three specific decisions:

DECISIONS are based on INFORMATION

1. The quantity of output to 1. The price of output
supply

2. How to produce that output 2. Techniques of production

(which technique to use) available*

3. The quantity of each input 3. The price of inputs*

to demand

*Determines production costs

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 2
 Costs in the Short Run

• The short run is a period of time

for which two conditions hold:
1. The firm is operating under a fixed
scale (fixed factor) of production, and
2. Firms can neither enter nor exit an
industry.
• In the short run, all firms have
costs that they must bear
regardless of their output. These
kinds of costs are called fixed
costs.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 3
 Costs in the Short Run

• Fixed cost is any cost that does not

depend on the firm’s level of output. These
costs are incurred even if the firm is
producing nothing.
• Variable cost is a cost that depends on the
level of production chosen.

TC  TFC  TVC
Total Cost = Total Fixed + Total Variable
Cost Cost

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 4
 Fixed Costs

• Firms have no control over fixed

costs in the short run. For this
reason, fixed costs are sometimes
called sunk costs.
• Average fixed cost (AFC) is the
total fixed cost (TFC) divided by the
number of units of output (q):

TFC
AFC 
q

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 5
 Short-Run Fixed Cost
(Total and Average) of a Hypothetical Firm

(1) (2) (3)

q TFC AFC (TFC/q)
0 $1,000 $ --
1 1,000 1,000
2 1,000 500
3 1,000 333
4 1,000 250
5 1,000 200

• AFC falls as output rises; a

phenomenon sometimes
called spreading overhead.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 6
 Variable Costs

• The total variable cost curve is a graph that

shows the relationship between total variable
cost and the level of a firm’s output.

• The total variable cost is

derived from production
requirements and input
prices.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 7
 Derivation of Total Variable Cost Schedule
from Technology and Factor Prices

UNITS OF
INPUT REQUIRED
(PRODUCTION FUNCTION)
TOTAL VARIABLE
COST ASSUMING
USING PK = $2, PL = $1
PRODUCT TECHNIQUE K L TVC = (K x PK) + (L x $10
PL)

1 Units of A 4 4 (4 x $2) + (4 x $1) = $12

output B 2 6 (2 x $2) + (6 x $1) = $18

2 Units of A 7 6 $24
(7 x $2) + (6 x $1) = $20
output B 4 10 (4 x $2) + (10 x $1) =

3 Units of A 9 6 (9 x $2) + (6 x $1) =

•output
The total variable
B cost
6 curve14shows the cost
(6 x $2) ofx $1) = $26
+ (14

production using the best available technique at

each output level, given current factor prices.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 8
 Marginal Cost

• Marginal cost (MC) is the increase

in total cost that results from
producing one more unit of output.
• Marginal cost reflects changes in
variable costs.

TC TFC TVC

MC   
Q Q Q

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 9
 Derivation of Marginal Cost from
Total Variable Cost
TOTAL VARIABLE COSTS MARGINAL COSTS
UNITS OF OUTPUT ($) ($)
0 0 0
1 10 10
2 18 8
3 24 6

• Marginal cost measures the additional

cost of inputs required to produce each
successive unit of output.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 10
 The Shape of the Marginal Cost Curve
in the Short Run
• The fact that in the short run every firm is
constrained by some fixed input means
that:
1. The firm faces diminishing returns to variable
inputs, and
2. The firm has limited capacity to produce
output.
• As a firm approaches that capacity, it
becomes increasingly costly to produce
successively higher levels of output.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 11
 The Shape of the Marginal Cost Curve
in the Short Run
• Marginal costs ultimately increase with
output in the short run.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 12
 Graphing Total Variable Costs and
Marginal Costs
• Total variable costs always
increase with output. The
marginal cost curve shows
how total variable cost
changes with single unit
increases in total output.
• Below 100 units of output,
TVC increases at a
decreasing rate. Beyond
100 units of output, TVC
increases at an increasing
rate.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 13
 Average Variable Cost

• Average variable cost (AVC) is the

total variable cost divided by the
number of units of output.
• Marginal cost is the cost of one
additional unit. Average variable
cost is the average variable cost per
unit of all the units being produced.
• Average variable cost follows
marginal cost, but lags behind.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 14
 Relationship Between Average Variable
Cost and Marginal Cost
• 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
• At 200 units of output, AVC is cost at the minimum point
minimum, and MC = AVC. of AVC.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 15
 Short-Run Costs of a Hypothetical Firm

(3) (4) (6) (7) (8)

(1) (2) MC AVC (5) TC AFC ATC
q TVC (D TVC) (TVC/q) TFC (TVC + TFC) (TFC/q) (TC/q or AFC + AVC)

0 $ 0 $ - $ - $1,000 $ 1,000 $ - $ -
1 10 10 10 1,000 1,010 1,000 1,010
2 18 8 9 1,000 1,018 500 509

3 24 6 8 1,000 1,024 333 341

4 32 8 8 1,000 1,032 250 258

5 42 10 8.4 1,000 1,042 200 208.4

- - - - - - - -

- - - - - - - -

- - - - - - - -
500 8,000 20 16 1,000 9,000 2 18

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 16
 Total Costs

• Adding TFC to TVC means

adding the same amount of
total fixed cost to every
level of total variable cost.

• Thus, the total cost curve

has the same shape as the
total variable cost curve; it
is simply higher by an
amount equal to TFC.
TC  TFC  TVC

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 17
 Average Total Cost

• Average total cost (ATC) is

total cost divided by the
number of units of output
(q).

A T C  A FC  A VC
TC TFC TVC
ATC   
q q q
• Because AFC falls with
output, an ever-declining
amount is added to AVC.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 18
 Relationship Between Average Total
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.
• Marginal cost intersects
average total cost and
average variable cost
curves at their minimum
points.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 19
 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
Output Decisions

them. Sometimes referred to as explicit costs.

CHAPTER 8: Short-Run Costs

Economic costs Costs that include the full opportunity costs of all inputs.
These include what are often called implicit costs.

Total fixed costs Costs that do not depend on the quantity of output produced. TFC
These must be paid even if output is zero.

Total variable costs Costs that vary with the level of output. TVC

Total cost The total economic cost of all the inputs used by a TC = TFC + TVC
firm in production.

Average fixed costs Fixed costs per unit of output. AFC = TFC/q

Average variable costs Variable costs per unit of output. AVC = TVC/q

Average total costs Total costs per unit of output. ATC = TC/q ATC = AFC +
AVC
and

Marginal costs The increase in total cost that results from MC = TC/ q
producing one additional unit of output.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 20
 Output Decisions: Revenues, Costs,
and Profit Maximization
• In the short run, a competitive firm faces a
demand curve that is simply a horizontal line at
the market equilibrium price.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 21
 Total Revenue (TR) and
Marginal Revenue (MR)
• Total revenue (TR) is the total amount that a firm
takes in from the sale of its output.

TR  P  q
• Marginal revenue (MR) is the additional revenue
that a firm takes in when it increases output by
one additional unit.
• In perfect competition, P = MR.

TR P ( q )
MR    P
q q
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 22
 Comparing Costs and Revenues to
Maximize Profit
• The profit-maximizing level of output for all
firms is the output level where MR = MC.
• In perfect competition, MR = P, therefore,
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 cost.
• The key idea here is that firms will produce
as long as marginal revenue exceeds
marginal cost.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 23
 COMPARING COSTS AND REVENUES TO
MAXIMIZE PROFIT
The Profit-Maximizing Level of Output
Output Decisions
CHAPTER 8: Short-Run Costs
and

FIGURE 8.10 The Profit-Maximizing Level of Output for a Perfectly Competitive Firm
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 24
 Profit Analysis for a Simple Firm

(6) (7) (8)

(1) (2) (3) (4) (5) TR TC PROFIT
q TFC TVC MC P = MR (P x q) (TFC + TVC) (TR - TC)
0 $ 10 $ 0 $ - $ 15 $ 0 $ 10 $ -10
1 10 10 10 15 15 20 -5
2 10 15 5 15 30 25 5
3 10 20 5 15 45 30 15
4 10 30 10 15 60 40 20
5 10 50 20 15 75 60 15
6 10 80 30 15 90 90 0

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 25
 The Short-Run Supply Curve

• At any market price, the marginal cost curve shows the output level
that maximizes profit. Thus, the marginal cost curve of a perfectly
competitive profit-maximizing firm is the firm’s short-run supply curve.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 26