Unit 6

Costs and Decision Making

Role of the Firm Goal

Firms make decisions to maximize profits

Production Transformation of factors into goods

Production Function Relationship between the amounts of inputs and

quantity of outputs a firm produces Q = A * fcn(Land, Labor, Capital, Entrepreneurship)

Production Decisions Time Frame

Short Run (SR) Time period where at least one input is fixed

Long Run (LR) Time period long enough to where all inputs are

variable

Very Long Run (VLR) Allows for technological change to occur

Short Run Costs Fixed Costs (FC)

Costs associated with use of fixed inputs (resources used by a firm that remain constant in the SR)

Example: Property tax, Rental payments, etc.

Variable Costs (VC) Costs associated with the use of variable inputs (inputs that

increase as the level of production increases) Example: Raw material costs, hourly wages, etc.

Total Costs (TC) = FC + VC

Marginal Costs (MC) Added cost of an additional unit of output Change in TC / Change in Q

Short Run Average Costs

Average Fixed Costs (AFC)AFC = FC / Q

Average Variable Costs (AVC)AVC = VC / Q

Average Total Costs (ATC)ATC = AVC + AFC

Observations of Cost Curves AFC continually declines as output

expands

AVC and ATC decrease at first, then begin to slowly increaseLaw of Diminishing Marginal Returns

Production Decision ExampleSimply - a market with only two inputs:

Labor and Capital

In the Short Run:

Capital is fixed

Labor is variable

Here, the output produced is said to be the product of labor since nothing is produced without workers.

Total Product of Labor = total quantity of output produced by the total number of workers.

Marginal Product of Labor = additional output (total product) produced from adding an additional

worker.

Law of Diminishing Returns When additional units of labor are added

to a fixed input, the Marginal Product of labor must eventually decrease.

Why do you think this occurs?

Rib Restaurant Example We have a BBQ Rib Restaurant that hires

employees in order to serve dinners to its customers.

Fixed Cost: Restaurant building, ovens, cooking equipment, plates, etc

Variable Cost Workers, dinner ingredients, beverages, etc.

Rib Restaurant Example Simplified to only Labor and Capital:

The Fixed Cost of Capital is $100 per hour rent.

The Variable Cost of Labor is $10 an hour per worker.

The Total Product is the number of dinners that the restaurant can serve in an hour.

Rib Restaurant ExampleUnits of Labor

Total Product (Q)

0 01 32 103 204 275 316 327 30

Rib Restaurant Example

0

5

10

15

20

25

30

35

0 2 4 6 8

Quantity of Labor

Tota

l Pro

duct

(Q)

Total Product (Q)

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Rib Restaurant ExampleUnits of Labor

Total Product (Q)

Marginal Product

Average Product

0 0

1 3

2 10

3 20

4 27

5 31

6 32

7 30

Rib Restaurant ExampleUnits of Labor

Total Product (Q)

Marginal Product

Average Product

0 0 --

1 3 3

2 10 7

3 20 10

4 27 7

5 31 4

6 32 1

7 30 -2

Rib Restaurant ExampleUnits of Labor

Total Product (Q)

Marginal Product

Average Product

0 0 -- --1 3 3 32 10 7 53 20 10 6.74 27 7 6.755 31 4 6.26 32 1 5.37 30 -2 4.3

Rib Restaurant Example

-4

-2

0

2

4

6

8

10

12

0 2 4 6 8

Labor

Tota

l Pro

duct

(Q)

Marginal Product Average Product

Rib Restaurant Example

Units of Labor

TP FC / hour

VC / hour

TC / hour

AFC / hour

AVC / hour

ATC / hour

MC / hour

0 0

1 3

2 10

3 20

4 27

5 31

6 32

Rib Restaurant Example

Units of Labor

TP FC / hour

VC / hour

TC / hour

AFC / hour

AVC / hour

ATC / hour

MC / hour

0 0 100

1 3 100

2 10 100

3 20 100

4 27 100

5 31 100

6 32 100

Rib Restaurant Example

Units of Labor

TP FC / hour

VC / hour

TC / hour

AFC / hour

AVC / hour

ATC / hour

MC / hour

0 0 100 0

1 3 100 10

2 10 100 20

3 20 100 30

4 27 100 40

5 31 100 50

6 32 100 60

Rib Restaurant Example

Units of Labor

TP FC / hour

VC / hour

TC / hour

AFC / hour

AVC / hour

ATC / hour

MC / hour

0 0 100 0 100

1 3 100 10 110

2 10 100 20 120

3 20 100 30 130

4 27 100 40 140

5 31 100 50 150

6 32 100 60 160

Rib Restaurant Example

Units of Labor

TP FC / hour

VC / hour

TC / hour

AFC / hour

AVC / hour

ATC / hour

MC / hour

0 0 100 0 100 --

1 3 100 10 110 33.33

2 10 100 20 120 10

3 20 100 30 130 5

4 27 100 40 140 3.7

5 31 100 50 150 3.23

6 32 100 60 160 3.13

Rib Restaurant Example

Units of Labor

TP FC / hour

VC / hour

TC / hour

AFC / hour

AVC / hour

ATC / hour

MC / hour

0 0 100 0 100 -- --

1 3 100 10 110 33.33 3.33

2 10 100 20 120 10 2.00

3 20 100 30 130 5 1.50

4 27 100 40 140 3.7 1.48

5 31 100 50 150 3.23 1.61

6 32 100 60 160 3.13 1.87

Rib Restaurant Example

Units of Labor

TP FC / hour

VC / hour

TC / hour

AFC / hour

AVC / hour

ATC / hour

MC / hour

0 0 100 0 100 -- -- --

1 3 100 10 110 33.33 3.33 36.66

2 10 100 20 120 10 2.00 12.00

3 20 100 30 130 5 1.50 6.50

4 27 100 40 140 3.7 1.48 5.18

5 31 100 50 150 3.23 1.61 4.84

6 32 100 60 160 3.13 1.87 5.00

Rib Restaurant ExampleUnits of Labor

TP FC / hour

VC / hour

TC / hour

AFC / hour

AVC / hour

ATC / hour

MC / hour

0 0 100 0 100 -- -- -- --

1 3 100 10 110 33.33 3.33 36.66 3.33

2 10 100 20 120 10 2.00 12.00 1.43

3 20 100 30 130 5 1.50 6.50 1.00

4 27 100 40 140 3.7 1.48 5.18 1.43

5 31 100 50 150 3.23 1.61 4.84 2.50

6 32 100 60 160 3.13 1.87 5.00 10.00

Rib Restaurant Example

Rib Restaurant Example

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Typical Short Run Cost Curves

0

5

10

15

20

25

30

35

0 10 20 30 40

Quantity

Cost

AFC AVC ATC MC