When economists examine firms over time they must define the

Short Run and Long Run• Short Run

– Only some inputs (e.g. labor) can be adjusted– Not enough time to adjust all inputs (such as

capital)

• Long Run– long enough time to adjust all inputs (capital as

well as labor)

Simple Illustration: Fixed and Variable Costs08_01

Variable costs: $600 per day

Fixed costs: $300 per day

Variable costs: $1,660 per day

Fixed costs: $300 per day

Total costs: $900 per day

Total costs: $1,960 per day

Five Moves per Day Ten Moves per Day

Costs at a Typical Firm (T8.1) 08_01T

Quantity(pianos moved Total Fixed Variable Average Average Average Marginal

per day) Costs Costs Costs Total Cost Fixed Cost Variable Cost(Q ) (TC ) (FC ) (VC ) (ATC ) (AFC ) Cost (AVC ) (MC )

0 300 300 01 450 300 150 450 300 150 1502 570 300 270 285 150 135 1203 670 300 370 223 100 123 1004 780 300 480 195 75 120 1105 900 300 600 180 60 120 1206 1,040 300 740 173 50 123 1407 1,200 300 900 171 43 128 1608 1,390 300 1,090 174 38 136 1909 1,640 300 1,340 182 33 149 250

10 1,960 300 1,660 196 30 166 32011 2,460 300 2,160 223 27 196 500

-- -- -- --

TC = FC + VC ATC = TCQ AFC =

FCQ

AVC = VCQ

Change in TC

Change in Q

Marginal Cost and the Marginal Product of Labor

• Note that marginal cost first declines and then increases for the example firm

• The explanation is that the marginal product of labor first increases before it decreases– in other words, diminishing returns to labor do

not set for a while

• A graph of the production function illustrates this very well

The production function and variable costs (T8.2)

08_02T

Labor Costs

Quantity Hours at $10 Wage

(pianos moved) of Work (variable costs)

0 0 0

1 15 150

2 27 270

3 37 370

4 48 480

5 60 600

6 74 740

7 90 900

8 109 1,090

9 134 1,340

10 166 1,660

11 216 2,160

and larger...

08_03

12

10

8

6

4

2

0 50 100 150 200 250HOURS OF WORK (L)

QUANTITY

Q is small here...

then gets larger...

but then starts to decline...

and continues to decline...

and so on.

Q L

Marginal product of labor =

Average Cost

• Average Total Cost – equals Total Cost/Quantity produced (TC/Q)– also called cost per unit

• Average variable cost (VC/Q)

• Average fixed cost (FC/Q)

08_04

3 4 5 6 7 8 9 10 11

100

200

300

400

500

DOLLARS

QUANTITY

0 1 2

Marginal cost (MC)

Average variable cost (AVC)

Average total cost (ATC)

Sketching cost curves

• MC curve should cut ATC and AVC curves at their lowest points

• ATC curve and AVC curve should get closer to each other as quantity increases

• for a flourish, add a little dip at the start of your marginal cost curve

Finding Total Costs, Total Revenue, and Profits

• Find profit maximizing level of production• Find total costs: TC = ATC times Q

– because ATC = TC/Q– ATC times Q is the area of a rectangle

• Find total revenue = P times Q– P times Q is also the area of a rectangle

• Profits (or loss) is the difference between in the two rectangles

08_07COST OR

PRICE

QUANTITY

MC

ATC

AVC

Quantity produced (Q)

This point tells us what the quantity produced is.

Market price (P)

Total revenue (P x Q)

Total costs (ATC x Q)

This point gives the average total costs for the quantity produced.

Profits

08_08 COST OR PRICE

QUANTITY

MC

ATC

AVC

Profit-maximizing quantity produced (Q)

Market price (P)

This point gives the average total costs for the quantity produced.

Total revenue (P x Q)

Total costs (ATC x Q)

This point tells us what the quantity produced is.

Loss

The Breakeven Point08_09

QUANTITY

MC

ATC

AVC

PRICE OR COST

QUANTITY

MC

ATC

AVC

PRICE OR COST

QUANTITY

MC

ATC

AVC

PRICE OR COST

P

P

QQ Q

P

Profits

Loss

Profits greater than zero (P > ATC)

Profits equal to zero, or breakeven (P = ATC)

Profits less than zero, or loss (P < ATC)

Shutdown Point08_10

QUANTITY

MC

ATC

AVC

PRICE OR COST

QUANTITY

MC

ATC

AVC

PRICE OR COST

QUANTITY

MC

ATC

AVC

PRICE OR COST

P

PP

Profits are negative but price is greater than average

variable costs: do not shut down. (P > AVC)

Shutdown Point (P = AVC)

Profits are negative and price is less than average variable costs: shut down.

(P < AVC)

Q Q Q

The Long Run

• Now the firm can adjust its capital

• What happens to the ATC curve?

08_11

3 4 5 6 7 8 9 10 11 12

1,000

2,000

3,000

4,000

5,000

DOLLARS

13QUANTITY

0 1 2

Old total costs (TC1)

New total costs (TC2)

New fixed costs (FC2)Old fixed costs (FC1)

New variable costs

Old variable costs

08_12

0 1 2 3 4 5 6 7 8 9 10 11 12

100

200

300

400

500

600

700

DOLLARS

13

QUANTITY

ATC2

ATC1

The Long Run Average Total Cost Curve

• Sketch a different ATC curve for each level of capital

• The long run ATC curve is the lowest ATC curve for each quantity produced

08_13

3 4 5 6 7 8 9 10 11 120

100

200

300

400

500

DOLLARS

13

QUANTITY

14 15 16

ATC1 ATC2ATC3 ATC4

ATC1 curve lowest

ATC2 curve lowest

ATC3 curve lowest

ATC4 curve lowest

Long-run average total cost curve

Economies and Diseconomies of Scale

08_14

QUANTITY QUANTITY

COST

QUANTITY

Economies of Scale Constant Returns to Scale Diseconomies of Scale

COSTCOST

Declining long-run

ATCFlat long-run

ATC

Increasing long-run

ATC

Warning: Diminishing Returns to Labor

and Increasing Returns to Scale can Occur at the Same Firm

• Returns to labor – the other factors ( e.g.

capital) are unchanged

• More teachers in one classroom

• Returns to scale– all factors change

– analogy with Gulliver

• Teachers and classrooms both increase