Principles of Economics

Twelfth Edition

Chapter 8
Short-Run Costs
and Output
Decisions

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Costs in the Short Run

fixed cost Any cost that does not depend on the firm’s 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.

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Fixed Costs (1 of 2)
total fixed costs (TFC) The total of all costs that do not change with output even
if output is zero.

q TFC ($)
0 100
1 100
2 100
3 100
4 100
5 100

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Fixed Costs

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

As output increases, average fixed cost declines because we are dividing a fixed
number by a larger and larger quantity.

q TFC ($) AFC ($)

0 100 —
1 100 100
2 100 50
3 100 33
4 100 25
5 100 20

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Variable Costs (1 of 6)

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 firm’s output.

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 Derivation of Total Variable Cost Schedule from Technology and Factor Prices

Produce Using Units of Input Required Total Variable Cost

Technique (𝑷𝑲 = $𝟐, 𝑷𝑳 = $𝟏)
K L

1 unit of output A 10 7 (10 2) + (7×1) = 27

B 6 8 (6×2) + (8×1) = 20
2 units of output A 16 8 40
B 11 16 38
3 units of output A 19 15 53

B 18 22 58

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Variable Costs (2 of 6)

marginal cost (MC) The increase in total cost that results from producing one
more unit of output. Marginal costs reflect changes in variable costs.

Units of Output Total Variable Costs Marginal Costs ($)

($)
0 0 —
1 20 20
2 38 18
3 53 15

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Variable Costs (3 of 6)

The shape of the marginal cost curve in the short-run

In the short run, every firm is constrained by some fixed input that
• leads to diminishing returns to variable inputs and
• 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.

When MP increases MC will decrease and MC will increase as MP decreases

for the variable input.

MP and MC are negatively related.

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 A fixed factor implies diminishing returns (declining marginal product) and a
limited capacity to produce. As that limit is approached, marginal costs rise.

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Variable Costs (4 of 6)

Graphing Total Variable Costs and Marginal Costs

Total variable costs always increase with output.

Marginal cost is the cost of producing each additional unit.

Thus, the marginal cost curve shows how total variable cost changes with single-
unit increases in total output.

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Variable Costs (5 of 6)

average variable cost (AVC) Total variable cost divided by the number of units
of output; a per-unit measure of variable costs.

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Variable Costs (6 of 6)

Average Variable Costs vs. Marginal Costs

falls

is at its
minimum

rises

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Total Costs (1 of 4)

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.

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Total Costs (3 of 4)

average total cost (ATC) Total cost divided by the number of units of output; a
per-unit measure of total costs.

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 To get ATC, 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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Total Costs (4 of 4)

Average Total Costs vs. Marginal Costs

This relationship is the same as the relationship between AVC and MC.

falls If MC is below ATC, ATC will decline toward MC.

is at its
minimum

rises If MC is above ATC, ATC will increase.

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Short-run Costs 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 both explicit costs and
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 TC = TFC + TVC
firm in production.
Average fixed costs (AFC) Fixed costs per unit of output. AFC = TFC/q

Average variable costs Variable costs per unit of output. AVC = TVC/q
(AVC)
Average total costs (ATC) Total costs per unit of output. ATC = TC/q ;
ATC = AFC + AVC
Marginal costs (MC) The increase in total cost that results from MC = ΔTC/Δq ;
producing 1 additional unit of output. MC = ΔTVC/Δq

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Ex: Use the information in the graph to find the values for marginal cost, total
variable cost, total cost, and total fixed cost at an output level of 500.

At

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Ex. Complete the table.

P Q ATC AVC AFC TFC TVC TC TR Profit

6 50 5 3 2 100 150 250 300 50

4 30 3 2 1 30 60 90 120 30

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Output Decisions: Revenues, Costs, and Profit Maximization (1 of 2)

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 the market, and old firms can exit.

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 (2 of 2)

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

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Total Revenue and Marginal Revenue

marginal revenue (MR) The additional revenue that a firm takes in when it
increases output by one additional unit.

 In perfect competition, price is determined through the market equilibrium.

Assume equilibrium price is ∗

, then if 1 unit is sold:
∗
∗ ∗
if 2 units are sold: ∗

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Total Revenue and Marginal Revenue

Hence, in perfect competition, the marginal revenue is equal to the price.

The marginal revenue curve and the demand curve facing a competitive firm
are identical.

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If a representative firm in a perfectly competitive market raises the price of its
output above $5.00, the quantity demanded of that firm’s output will drop to
zero.

Each firm faces a perfectly elastic demand curve, d.

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Comparing Costs and Revenues to Maximize Profit (1 of 2)

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 output level for all firms (for all market types) is
the output level where

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Comparing Costs and Revenues to Maximize Profit (1 of 2)

The Profit-Maximizing Level of Output

 In perfect competition, however, MR = P.

 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
level of output at which

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Comparing Costs and Revenues to Maximize Profit (2 of 2)

In perfect competition:

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If price is above marginal cost, as it is at every quantity less than 300 units of
output, profits can be increased by raising output; each additional unit
increases revenues by more than it costs to produce the additional output
because P > MC. Beyond q* = 300, however, added output will reduce profits.

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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.

This is true except when price is so low that it pays a firm to shut down—a
point that will be discussed in Chapter 9.

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Ex. A producer of hard-disk drives for notebook computers currently has
factory with two disk-pressing machines, which it cannot change in the short
run. Each of the machines costs $100 per day. Each hired worker costs $50 per
day. The relationship between output and the number of workers is given in
the table. a. Fill in the columns.

Q L TFC TVC TC AFC AVC ATC MC

0 0 200 0 200 ─ ─ ─ ─
1 10 200 500 700 200 500 700 500
2 15 200 750 950 100 375 475 250
3 18 200 900 1100 66.67 300 366.67 150
4 22 200 1100 1300 50 275 325 200
5 28 200 1400 1600 40 280 320 300
6 36 200 1800 2000 33.33 300 333.33 400
7 48 200 2400 2600 28.57 342.86 371.43 600

Machines are fixed →

Variable cost → Cost of L

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b. Over what range of output are there decreasing marginal costs, increasing
marginal costs, increasing returns to labor, and diminishing returns to labor?

MC decreases when
Q L MC
0 0 ─
1 10 500
2 15 250 MC increases when
3 18 150
4 22 200
5 28 300
6 36 400 When MC decreases, MP rises: increasing
7 48 returns to L when
600

When MC increases, MP falls: diminishing

returns to L when

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c. Suppose the firm operates in a perfectly competitive output market and can
sell as many disk drives as it wants for $510 each. In the short run, what is the
profit-maximizing level of output for this firm?

Compare with MC values to

Q P MC determine profit-maximizing level of output.
0 ─
1 510 500
2 510 250 for so profit will increase.
3 510 150
4 510 200 For , so profit will decrease
5 510 300
6 510 400 Then, profit-maximizing output level ∗

7 510 600

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Study Questions

Q1. A firm’s cost curves are given by the following table:

Q TC TFC TVC AVC ATC MC
0 $100
1 130
2 150
3 160
4 172
5 185
6 210
7 240
8 280
9 330
10 390
a. Complete the table.
b. Suppose the market price is $30. How much will the firm produce in the
short run? How much are total profits?
c. Suppose the market price is $50. How much will the firm produce in the
short run? How much are total profits?
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Q2. The following curve is a production function for a firm that uses just
one variable factor of production, labor. It shows total output for every
level of inputs:

a. Derive and graph the marginal product curve.

b. Suppose that the wage rate is $4. Derive and graph the firm’s marginal cost
curve.
c. If output sells for $6, what is the profit-maximizing level of output? How
much labor will the firm hire?

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REVIEW TERMS AND CONCEPTS

average fixed cost (AFC) total variable cost curve

average total cost (ATC) variable cost
average variable cost (AVC)
fixed cost
homogeneous products
marginal cost (MC)
marginal revenue (MR)
perfect competition
total cost (TC)
total fixed costs (TFC) or overhead
total revenue (TR)
total variable cost (TVC)

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