08

Short-Run Costs
and Output Decisions

Chapter 8
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Decisions Facing Firms
DECISIONS
INFORMATION
are based on
1. The quantity of output to

supply
1. The price of output
2. How to produce that

output (which technique
to use)
2. Techniques of production
available*
3. The quantity of each

input to demand
3. The price of inputs*
*Determines production costs
Karl Case, Ray Fair
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
Karl Case, Ray Fair
Costs in the Short Run

Fixed cost is any cost that does not depend on the
firms level of output. These costs are incurred even if
the firm is producing nothing, i.e., output=0.
Variable cost is a cost that depends on the level of
production chosen.
TC TFC TVC
Total Cost = Total Fixed + Total Variable

Cost
Cost
Karl Case, Ray Fair
Total Fixed Costs and Average Fixed Costs

Total fixed costs are also called overheads
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
Karl Case, Ray Fair
Short-Run Fixed Cost (Total and

Average) of a Hypothetical Firm
(1)
q (output)
(2)
TFC
(3)
AFC =(TFC/q)
$1,000
1,000
1,000
1,000
500
1,000
333
1,000
250
1,000
200
AFC falls as output rises; a

phenomenon sometimes
called spreading overhead.
AFC never reaches zero
Karl Case, Ray Fair
Variable Costs
The total variable cost curve is a graph
that shows the relationship between total
variable cost and the level of a firms output.
The total variable
cost depends on:
1.Technique of production and
2. input prices.
Karl Case, Ray Fair
Derivation of Total Variable Cost Schedule

from Technology and Factor Prices
UNITS OF
INPUT REQUIRED
(PRODUCTION FUNCTION)
PRODUCT
USING
TECHNIQUE
TOTAL VARIABLE
COST ASSUMING
PK = $2, PL = $1
TVC = (K x PK) + (L x P
$10
L)
1 Units of
output
A
B
4
2
4
6
(4 x $2) + (4 x $1) = $12

(2 x $2) + (6 x $1) =
$18
2 Units of
output
A
B
7
4
6
10
(7 x $2) + (6 x $1) = $20

$24
(4 x $2) + (10 x $1) =
3 Units of
A
9
6
(9 x $2) + (6 x $1) =
output
B curve shows
6 the cost
14of production
(6 x $2)using
+ (14 xthe
$1)best
= $26
The total
variable cost
available technique at each output level, given current factor prices
Here, K denotes variable capital in the short run
Karl Case, Ray Fair
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
(fixed costs do not change when output changes,
hence the only relevant cost here is the variable
cost)
TC
TFC
TVC
M C
Q
Q
Q
Karl Case, Ray Fair
Derivation of Marginal Cost from

Total Variable Cost
TOTAL VARIABLE COSTS
($)
0
10
MARGINAL COSTS
($)
0
10
18
24
UNITS OF OUTPUT
0
1
Marginal cost measures the additional cost

of inputs required to produce each successive
unit of output (refer to previous table)
Karl Case, Ray Fair
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.
Hence diminishing returns or decreasing marginal

product imply increasing marginal cost
Karl Case, Ray Fair
The Shape of the Marginal Cost Curve

in the Short Run
Marginal costs ultimately increases with

output in the short run.
Karl Case, Ray Fair
Graphing Total Variable Costs and

Marginal Costs
Total variable costs always

increases with output-slope
always positive.
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.
Karl Case, Ray Fair
Average Variable Cost

Average variable cost (AVC) is the total
variable cost divided by the number of units of
output. (AVC =TVC/q)
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.
Karl Case, Ray Fair
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
At 200 units of output, AVC
variable cost at the
is minimum, and MC = AVC.
minimum point of AVC.
Karl Case, Ray Fair
Short-Run Costs of a Hypothetical Firm

(1)
q
0
(2)
TVC
$
(3)
MC
( TVC)
(4)
AVC
(TVC/q)
$
(5)
TFC
(6)
TC
(TVC + TFC)
$ 1,000
$ 1,000
(7)
AFC
(TFC/q)
$
(8)
ATC
(TC/q or AFC + AVC)
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
Karl Case, Ray Fair
18
Total Costs
Adding TFC to TVC
means adding the same
amount of total fixed cost
to every level of total
variable cost.
TC TFC TVC
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.
Karl Case, Ray Fair
Average Total Cost

Average total cost (ATC)
is total cost divided by
the number of units of
output (q).
ATC AFC AVC

TC
TFC TVC
ATC
q
q
q
Because AFC falls with

output, an ever-declining
amount is added to AVC.
Karl Case, Ray Fair
Relationship Between Average Total

Cost and Marginal Cost
ATC follows the MC curve but
lags behind it
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.
Karl Case, Ray Fair
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.
Karl Case, Ray Fair
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 )
M R
P
q
q
Karl Case, Ray Fair
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.
Karl Case, Ray Fair
Profit Analysis for a Simple Firm

(1)
q
(2)
TFC
(3)
TVC
$
(4)
MC
$
(5)
P = MR
(6)
TR
(P x q)
$ 15
$ 10
10
10
10
15
10
15
10
20
10
5
6
$ -10
15
20
-5
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
(8)
PROFIT
(TR TC)
10
(7)
TC
(TFC + TVC)
Karl Case, Ray Fair
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 firms short-run supply curve.
Karl Case, Ray Fair

08

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Short-Run Costs

and Output Decisions

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Decisions Facing Firms

1. The quantity of output to

1. The price of output

2. How to produce that

3. The quantity of each

3. The price of inputs*

*Determines production costs

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Costs in the Short Run

The short run is a period of time for which two

The firm is operating under a fixed scale (fixed

Firms can neither enter nor exit an industry.

In the short run, all firms have costs that they

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Costs in the Short Run

Total Cost = Total Fixed + Total Variable

Principles of Economics, 6/e

Karl Case, Ray Fair

Total Fixed Costs and Average Fixed Costs

Principles of Economics, 6/e

Karl Case, Ray Fair

Short-Run Fixed Cost (Total and

AFC falls as output rises; a

Principles of Economics, 6/e

Karl Case, Ray Fair

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Derivation of Total Variable Cost Schedule

(4 x $2) + (4 x $1) = $12

(7 x $2) + (6 x $1) = $20

available technique at each output level, given current factor prices

Here, K denotes variable capital in the short run

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Principles of Economics, 6/e

Karl Case, Ray Fair

Derivation of Marginal Cost from

Marginal cost measures the additional cost

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Shape of the Marginal Cost Curve in

The fact that in the short run every firm is

The firm faces diminishing returns to variable inputs, and

The firm has limited capacity to produce output.

As a firm approaches that capacity, it becomes

Hence diminishing returns or decreasing marginal

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Shape of the Marginal Cost Curve

Marginal costs ultimately increases with

2002 Prentice Hall Business Publishing