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 0
1 3
2 10
3 20
4 27
5 31
6 32
7 30
Rib Restaurant Example
0
5
10
15
20
25
30
35
0 2 4 6 8
Quantity of Labor
To
tal
Pro
du
ct (
Q)
Total Product (Q)
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Rib Restaurant Example
Units 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
To
tal
Pro
du
ct
(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 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 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
Co
st
AFC AVC ATC MC