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Principles of Microeconomics
Economics 1021A
Lecture 9: Output and cost

Fall 2023

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Output and cost

This lecture develops deeper producer theory underlying supply

• Distinguish economic and accounting definitions of costs and
profits
• Explain, derive, and differentiate short- and long-run cost
schedules
• Discuss broader economic significance of understanding
production costs

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Firms
First things first...

Firm: institution that hires factors of production and organizes

them to produce and sell goods and services
• Our goal is to predict firm behaviour
Critical assumption: firms maximize profit and minimize costs
• Otherwise they would be eliminated or taken over by more
profitable entrepreneur

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Profit

Profit always equals revenue minus cost

Two types of cost =⇒ two types of profit:

1 Accounting profit: total revenue net of accounting cost

• Ignores opportunity cost
2 Economic profit: total revenue net of total economic cost
• Includes opportunity cost
Key difference: accounting profit ignores opportunity cost
(constrained to measured costs like wages, materials, etc.)

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Firm opportunity costs

Opportunity cost of production is the value of the best

alternative use of the resources that a firm uses.

It is the total economic cost of using resources that are:

• Bought in the market
• Supplied by the firm’s owner
• Owned by the firm

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Opp cost of purchased inputs

Opportunity cost of production includes cost of using resources

bought in the market:
• Firm could have bought different resources
• Includes raw materials, employees’ wages, leased capital,
financing costs, ...

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Opp cost of inputs supplied by owner

Opportunity cost of inputs supplied by firm’s owner includes their

entrepreneurship and labour:
• Average return to entrepreneurship is called normal profit and
is the opportunity cost of entrepreneurship
• Wage in next best alternative job is the opportunity cost of
owner’s labour

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Opp cost of inputs owned by firm

Opportunity cost of using capital the firm owns includes:

• Economic depreciation (degrades in quality)
• Measurable as change in the market value of capital during use
• Interest forgone (could have loaned it out)
• Measurable as funds used to acquire capital
Often called capital’s implicit rental rate
• Capital-owning firm implicitly rents the capital from itself
• Could sell or rent out capital, so forgone rents on owned
capital are an opportunity cost

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Economic cost and profit

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Short-run and long-run

Important to separate short-run and long-run decisions

Key distinction: what (not when) we’re choosing:

• What’s fixed
• What’s flexible
• Persistence of a decision’s consequences

Short-run and long-run are not precise measures of time.

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Short run

Short run: time span when the quantity of one or more resources
used in production (i.e. capital stock) is fixed

• Variable inputs (i.e. labour, raw materials, energy, ...) are

adjustable in the short run
• Short-run decisions don’t affect future options, so cannot
sell/buy capital or exit/enter market in the short run

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Long run

Long run: time span when the quantities of all resources

(including capital stock/plant size) are adjustable
• Long-run decisions are not easily reversed, affect future
options, and can become sunk costs
Sunk cost: a cost incurred in the past that cannot be undone
• Example: amount paid for a computer with no resale value
• Sunk costs you have incurred in the past are irrelevant to
current decisions

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Sunk cost fallacy

Sunk cost fallacy: believing that sunk investments justify further

expenditures
• Finish a book that’s still boring half way through, go to a
baseball game in the rain because you already paid for the
tickets, ...
• Concorde fallacy: British and French governments continued
funding the (insane) supersonic passenger jet even after it
became apparent there was no longer an economic case for it

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Short-run constraint

Short-run output decisions compare variable costs (wages, energy

prices, ...) and benefits (revenue)
• Focus on a simplified model with two-inputs: labour
(adjustable in short-run) and capital (adjustable in long-run)
• Then, increasing output in short-run requires employing more
labour and short-run decisions compare labour’s costs
(additional wages) and benefits (additional output and
revenue)

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Short-run output

Three important output concepts:

1 Total product (TP): total output produced in a given period
2 Marginal product (MP) of labour: change in total product
from a one-unit increase in the quantity of labour employed,
with all other inputs remaining the same
3 Average product (AP) of labour: output per unit of labour
employed (total output divided by quantity of labour)

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Short-run output

As the quantity of labour em-

ployed increases:
• Total product increases
• Marginal and average
product increase initially
. . . but eventually decrease

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Total product curve

• Like the PPF, the total

product curve separates
attainable and unattainable
output levels
• We can also use total
product to determine
marginal and average
product

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From the total product to the marginal product curve

Build marginal product curve

from changes in total product:
• First worker’s marginal
product is 4 units
• Second worker’s marginal
product is 10 - 4 = 6 units
• ...
Bar height = marginal product

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Marginal product curve

Marginal product curve repre-

sents changes in total product
between quantities of inputs by
arranging bars from last slide
side-by-side

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Marginal product curve: increasing at first

Expect increasing marginal re-

turns to labour at low levels
• At first, the marginal
product of next worker
exceeds that of last worker
• Think of this as synergies
from teamwork and
benefits of specialization
kicking in

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Marginal product curve: diminishing eventually

Expect diminishing marginal re-

turns to labour at high levels
• Eventually, marginal
product of next worker less
than that of last worker
• We’re in the short-run, so
the amount of capital is
fixed and more workers are
sharing a fixed amount of
tools

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Average product curve

Average product is total product

divided by quantity of labour

Important relationship between

average and marginal product:
• MP > AP, AP is growing
• MP < AP, AP is falling
• MP = AP, average product
at maximum

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Short-run cost

Now that we have a model of short-run output, we can build

important notions of short-run costs of production:
1 Total cost (TC): economic cost of all inputs used to produce
a given amount of output
2 Marginal cost (MC): increase in total cost from a one-unit
increase in output
3 Average cost (AC): cost per unit output (total cost divided
by total product)

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Short-run total cost: breakdown

Total cost is the sum of:

• Total fixed cost (TFC):
cost fixed inputs and does
not change with output
• Total variable cost (TVC):
cost of variable inputs and
increases with output

Total cost = Total variable cost + Total fixed cost

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Cost curves reflect output curves

• Total product steeper at low

output and flatter at high
output because of labour’s
diminishing marginal
product
• And variable cost is the
wage times the quantity of
labour
• So variable cost will grow as
labour requirements grow

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Cost curves reflect output curves

• Total product steeper at low

output and flatter at high
output because of labour’s
diminishing marginal
product
• And variable cost is the
wage times the quantity of
labour
• So variable cost will grow as
labour requirements grow

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Short-run cost curves

Cost curves plot costs against

output quantities:
• To get cost on y-axis, flip
last slide’s TVC graph
• Then, re-insert total fixed
cost
• Add up curves to find a
convex total cost curve

Diminishing marginal product of labour and constant wage mean

total cost curve gets steeper as output grows
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Marginal cost

Marginal cost (MC): increase in total cost that results from a

one-unit increase in total product
• Incremental cost of increasing output quantity
• Over the output range with increasing marginal product,
marginal cost falls as output increases
• Over the output range with diminishing marginal product,
marginal cost rises as output increases

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Average cost

Average cost measures costs per-unit of output produced and can

be derived from total cost measures:
• Average fixed cost (AFC): total fixed cost per unit of output
• Average variable cost (AVC): total variable cost per unit of
output
• Average total cost (ATC): total cost per unit of output
TFC TVC
Bringing everything together: ATC = AFC + AVC = Q + Q

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Average cost curve shapes

Average cost curve’s shapes will be important for studying profit

and competition:
• As output increases,
average fixed cost (AFC =
TFC/Q) decreases
• But average variable cost
(AVC = TVC/Q) falls to a
minimum and then
increases

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U-shaped average variable cost

AVC curve is U-shaped because marginal product declines

Remember that increasing short-run output means hiring labour:
• Initially, marginal worker more productive than average
• And MC of output is lower than AVC
• Small TVC increase is offset by output increase and AVC falls

• Eventually, marginal worker less productive than average

• And MC of output is greater than AVC
• Large TVC increase offsets output increase and AVC grows

AVC reaches minimum when MC equals AVC

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U-shaped average total cost

The ATC curve is U-shaped for two reasons:

1 Diminishing marginal product and U-shaped AVC
2 Spread fixed costs across larger output so AFC falls as output
grows
When output is big, fixed costs per unit are small so reason 2
eventually becomes less important and ATC starts increasing

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Cost curve shifts

Movement of cost curves is just as important for movement along

cost curves. Factors that shift cost curves include:
• Technology, which affects both the product curves and the
cost curves
• Prices of factors of production, which only affect cost curves

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Cost curve shifts: input prices

Prices of factors of production shift cost curves but not

product curves:
• Price increase of fixed input shifts the total cost (TC) and
average total cost (ATC) curves upward but does not shift the
marginal cost (MC) curve
• Price increase of variable input shifts the total cost (TC),
average total cost (ATC), and marginal cost (MC) curves
upward

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Cost curve shifts: technology

Technological change affects both the product curves and

the cost curves:
• An increase in productivity shifts all the product curves
upward and all the cost curves downward
• But relationships between product and cost curves remain the
same
• If technological advances make a firm use more capital and
less labour, their fixed costs increase and variable costs
decrease

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Long-run Cost

Now we consider long-run costs, which differ from short-run costs

because all inputs are variable
• The production function is especially important for
behaviour of long-run cost
• Firm’s production function is a formula that gives the
maximum output they can produce from a bundle of inputs

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Production function

Example: a sweater manufacturer’s long-run production function

• The firm can choose from

many plant types, each with
different amounts of capital
• Plants can increase output
by hiring more workers, but
experience diminishing
marginal product of labour

Short-run decision minimizes cost at a given plant, long-run

minimizes cost by choosing a plant size
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Diminishing marginal product of capital

Production function exhibits diminishing marginal returns to

labour (for a given plant) as well as diminishing marginal
returns to capital (for a given quantity of labour)
• The marginal product of capital is the increase in output
resulting from a one-unit increase in the amount of capital
employed, holding constant the amount of labour employed
• Just like the marginal product of labour, we expect the firm to
have a diminishing marginal product of capital
This leads to an optimal mix of capital and labour in the long run

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Capital decisions and long-run cost: high-level

Long-run capital decisions affect short-run cost curves, use

this fact to consider capital investment decisions
• Average cost of producing a given output quantity at a plant
depends on capital installed
• Installing more capital means paying a higher fixed costs in
exchange for lower variable costs
• So big plants are only justified by high output, and this
trade-off guides capital decisions

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Capital decisions and long-run cost: high-level

In the long run, firm chooses level of capital to minimize

average total cost:
• For each level of capital, there is a set of short-run cost curves
• Long-run capital decision is a cost-minimizing production
plan that anticipates output quantity and chooses best
short-run cost curves
• Long-run average total cost (LRATC) traces minimum of
short-run average total cost (SRATC) curves across levels of
capital

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Capital decisions and long-run cost: example

Plants have different amounts of capital, and different cost curves

ATC1 is the ATC curve for a plant with 1 machine

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Capital decisions and long-run cost: example

Plants have different amounts of capital, and different cost curves

Plant 2 has more capital, meaning higher fixed costs in exchange

for lower variable costs at any given quantity
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Capital decisions and long-run cost: example

Plants have different amounts of capital, and different cost curves

ATC3 is the ATC curve for a plant with 3 machines, it has even
higher fixed costs and even lower variable costs at any given
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Capital decisions and long-run cost: example

Plants have different amounts of capital, and different cost curves

ATC4 is the ATC curve for a plant with 4 machines, it has the
highest fixed cost and the lowest variable cost
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Long-run average cost: example

In the long-run, choose plant with lowest average cost at required
output quantity:

How many machines gives the lowest possible cost of making

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Long-run average cost

In the long-run, the firm chooses the capital investment that leads
to the lowest average cost at the required output quantity:

LRAC curve is lower envelope of all possible short-run ATC curves.

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Long-run average cost

Long-run average cost curve: relationship between output

quantity and the lowest attainable average total cost when both
capital and labour are adjustable
• Planning curve that tells firm the capital investment that
minimizes the cost of producing a given output quantity
• Once the firm has chosen its capital, it is stuck with the
corresponding short-run cost curves and can change output by
adjusting labour in the short-run

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Scale economies

Economies and diseconomies of scale affect production

decisions, market structure, and supply curves:
• Economies of scale: falling long-run average cost as output
increases
• Diseconomies of scale: rising long-run average cost as
output increases
• Constant returns to scale: constant long-run average cost
as output increases.
Economies of scale depend on features of firm’s technology, input
markets, and production process.

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Scale economies
U-shaped average cost curve means economies of scale at low
output levels and diseconomies of scale as output grows:

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Minimum efficient scale

Minimum efficient scale: lowest quantity of output that

minimizes long-run average cost
• A firm with U-shaped LRATC curve experiences economies of
scale up to some output level, which we call the efficient scale
• Expanding output beyond efficient scale moves the firm into
the region of diseconomies of scale, where two smaller firms
might be able to produce at lower costs

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