Lecture Principles of Microeconomics - Chapter 8: Costs. After reading this chapter, you should be able to answer the following questions: What are different types of costs? What is diminishing marginal returns? Why do marginal costs increase? Why is the average total costs curve U-shaped? What is the relationship between the average total costs curve and marginal costs curve? What is the difference between short run and long run? What are economies and diseconomies of scale?
Chapter Costs McGrawưHill/Irwin Copyrightâ2009byTheMcGrawưHillCompanies,Inc.AllRightsReserved Learning Objectives ã ã • • • What are different types of costs? What is diminishing marginal returns? Why marginal costs increase? Why is the average total costs curve U-shaped? What is the relationship between the average total costs curve and marginal costs curve? • What is the difference between short run and long run? • What are economies and diseconomies of scale? 8-2 Costs: Economic Terms • Output = number of goods produced • Variable inputs = inputs that can be changed with output • Fixed inputs = inputs that can not be changed with output • Fixed costs = costs that are the same regardless of output • Variable costs = costs that vary with output • Total costs = fixed costs + variable costs • Marginal costs = the extra cost of making one more good 8-3 Average Costs Total Costs Average Total costs Output Total Costs = Fixed Costs + Variable Costs Total costs Fixed costs Variable costs Output Output Output 8-4 Average Costs Fixed Costs Average Fixed Costs Output Variable Costs Average Variable Costs Output Average Total Costs = Average Fixed Costs + Average Variable Costs 8-5 Rocket Ship vs Space Elevator Fixed Costs Variable Costs Total Costs Rocket Ship $1 billion Output $1 billion X $10 million + (Output X $10 million) Space Elevator Output X $1,000 $50 billion $50 billion + (Output X $1,000) 8-6 Costs For Rocket Ship Output Average Fixed Costs = $1 billion output Average Variable Costs = ( output )($10million) output Average Total Costs = Average Fixed Costs + Average Variable Costs $1 billion $10 million $1.01 billion 10 $100 million $10 million $110,000,000 1,000 $1 million $10 million $11,000,000 4,900 $0.2 million $10 million $10,200,000 1,000,000 $1,000 $10 million $10,001,000 billion $10 million $10,000,001 $1 8-7 Costs For Space Elevator Output Average Fixed Costs = $50 billion output Average Variable Costs = (output)($1,000) Average Total Costs = Average Fixed Costs + Average Variable Costs output $50 billion $1,000 $50 billion + $1,000 10 $5 billion $1,000 $5 billion + $1,000 1,000 $50 million $1,000 $50,001,000 4,900 $10.2 million $1,000 $10,201,000 1,000,000 $50,000 $1,000 $51,000 billion $1,000 $1,050 $50 8-8 Break Even Price • The break even price represents the minimum a firm can charge without losing money • A firm breaks even when Price = Average Total Costs 8-9 Firms With Constant Marginal Costs • Average fixed costs always decrease as output increases • When marginal costs are constant, average total costs continually decrease as output increases • Firms with constant marginal costs or high fixed costs benefit from having many customers 10 8-10 Increasing Marginal Costs • When production is subject to diminishing marginal returns, each additional increase in output requires more and more input • Hence, each additional output increases additional cost of production • If marginal costs are increasing then the cost of each new good is higher than the last, so average variable costs increase as well 15 8-15 U-shaped Average Total Costs Curve • Increase in marginal costs cause increase in average variable costs • At some point, increase in average variable costs is greater than the decrease in average fixed cost • With increasing output, average total costs first go down but then go up Costs Average total costs A B Too many workers Too few workers Output Per Month 16 8-16 Relationship Between Marginal Cost and Average Total Cost • When marginal costs are below average total costs, then average total costs must be falling • When marginal costs are above average total costs, then average total costs must be increasing • Marginal costs curve always goes through the lowest point on the average total cost curve Costs Marginal costs Average total costs Marginal costs < Average Total Costs Marginal costs > Average Total Costs Output Per Month 17 8-17 Diminishing Marginal Returns and Starvation • Thomas Malthus predicted that the human population would increase at a faster rate than the food supply, making starvation almost inevitable • Malthus believed in diminishing marginal returns to agriculture because land is a fixed input • Malthus proved to be wrong because of innovations in agriculture • The gains from agricultural innovations have more than outweighed the harm of diminishing marginal returns 18 8-18 Diminishing Marginal Returns and Innovation • Neo-Malthusians predict disaster With the fixed inputs of the earth, if the human population increases and nothing else changes, human economic activity will become subject to diminishing marginal returns • In the long run, innovations can effectively multiply the existing supply of fixed inputs • The “invisible hand” of the market can overcome problems caused by fixed inputs 19 8-19 Short Run vs Long Run • The short run is the time period when firms cannot change fixed inputs Only variable inputs can be changed, e.g number of workers • The long run is the time period when firms can change fixed as well as variable inputs and innovate • In the long run, firms can move to another short run average total cost curve • The length of the long run is different for different firms 20 8-20 Long Run Analysis • In the long run, for any given level of output, a firm will choose its fixed input to minimize its average total costs • For any given level of output, the long run average total costs are the lowest short run average total costs for that level of output • A firm’s long run average total costs curve consists of the low points on its short run average total costs curves 21 8-21 Constant Returns to Scale = When long run average total costs are constant as output increases • If in the long run, all inputs increase by 10% then output increases by exactly 10% 22 8-22 Economies of Scale = When long run average total costs decrease as output increases • If in the long run, all inputs increase by 10% then output increases by more than 10% • Costs that don’t increase, even in the long run as output expands, can cause economies of scale 23 8-23 Diseconomies of Scale = When long run average total costs increase as output increases • If in the long run, all inputs increase by 10% then output increases by less than 10% • Diseconomies of scale can arise when a firm must use inferior inputs to expand or government regulations regarding large firms 24 8-24 Do You Know? • Why can fixed inputs cause diminishing marginal returns? A fixed input cannot be changed in the short run When the quantity used of a variable input with the fixed input is increased, there is overcrowding and benefits of increasing the variable input keep falling • Why diminishing marginal returns cause increasing marginal costs? When production is subject to diminishing marginal returns, each additional increase in output requires more and more input Hence, marginal cost keeps increasing 25 8-25 Do You Know? • Why was Malthus wrong? Malthus proved to be wrong in predicting massstarvation because he did not expect agricultural innovations to outweigh the harm of diminishing marginal returns • Why we expect sometime to observe economies of scale? Increase in all inputs allows division of labor and specialization Specialization leads to increase in production As a result, long run average total costs exhibit economies of scale 26 8-26 Summary • Fixed costs = costs that are the same regardless of output • Variable costs = costs that vary with output • Marginal costs = the extra cost of increasing output by one • Total costs = fixed costs + variable costs • Average fixed costs = fixed costs output variable costs • Average variable costs = output • Average total costs = average fixed costs + average total costs 27 8-27 Summary • Average fixed costs always decrease as output increases • Average variable costs increase with output if marginal costs increase • Fixed inputs cause diminishing marginal returns to variable inputs • Typical average total costs curve is U-shaped • Marginal costs curve goes through the low point on the average total costs curve • In the short run firms cannot innovate or change fixed inputs; in the long run they can • The long run average total costs curve consists of the low points on all the short run average total costs curves 28 8-28 Coming Up How firms produce in perfect competition? 29 8-29 ... 900 1,790 1,79 0-9 00 =89 0 2,500 2,50 0-1 ,790=710 3,100 3,10 0-2 ,500=600 3,400 3,40 0-3 ,100=300 3,500 3,50 0-3 ,400=100 3,510 3,51 0-3 ,500=10 3,511 3,51 1-3 ,510=1 14 8- 14 Increasing Marginal Costs • When... average total costs curve consists of the low points on all the short run average total costs curves 28 8- 28 Coming Up How firms produce in perfect competition? 29 8- 29 ... proved to be wrong because of innovations in agriculture • The gains from agricultural innovations have more than outweighed the harm of diminishing marginal returns 18 8- 18 Diminishing Marginal