Chapter 23
The Firm:
Cost and Output
Determination
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Introduction
Why do some family physicians now make appointments
themselves? Why do some family physicians now have small
offices with no waiting rooms, no nurses and no receptionists?
This is the latest trend in family medicine, called the
“micropractice.” By the time you have completed this chapter,
you will be able to understand why, for a family physician at
least, it now pays to think small when it comes to operating a
medical practice.
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Learning Objectives
• Discuss the difference between the short run and
the long run from the perspective of a firm
• Understand why the marginal physical product of
labor eventually declines as more units of labor are
employed
• Explain the short-run cost curves a typical firm
faces
• Describe the long-run cost curves a typical firm
faces
• Identify situations of economies and diseconomies
of scale and define a firm’s minimum efficient scale
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Chapter Outline
•
•
•
•
•
Short Run versus Long Run
The Relationship Between Output and Inputs
Diminishing Marginal Product
Short-Run Costs to the Firm
The Relationship Between Diminishing Marginal
Product and Cost Curves
• Long-Run Cost Curves
• Why the Long-Run Average Cost Curve is U-Shaped
• Minimum Efficient Scale
23-4
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Did You Know That...
• Since 1997, openings of new U.S. manufacturing facilities of
existing factories have declined from more than 3.5% per
year to about 2.5% per year?
• During the same period, U.S. companies have closed about
3.5% of existing factories each year.
• Therefore, the number of U.S. manufacturing facilities has
shrunk by about 1% per year since 1997.
• However, economists point out that the trend has been
toward larger U.S. manufacturing facilities. Thus, even as the
overall number of factories has declined, the scale of
production of the average plant has increased.
• How does a company determine the scale of its production?
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Short Run versus Long Run
• Short Run
– A time period when at least one input, such as
plant size, cannot be changed
– Plant Size
• The physical size of the factories that a firm owns and
operates to produce its output
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Short Run versus Long Run
(cont'd)
• Long Run
– The time period in which all factors of production
can be varied
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Short Run versus Long Run
(cont'd)
• Managers take account of both the shortrun and long-run consequences of their
behavior.
• While making decisions about what to do
today, tomorrow, and next week—they keep
an eye on the long-run benefits.
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The Relationship Between
Output and Inputs
• A firm takes numerous inputs, combines
them using a technological production
process and ends up with output.
• We classify production inputs in two broad
categories—labor and capital.
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The Relationship Between
Output and Inputs (cont'd)
Output / time period = Some function of capital and labor inputs
or
Q = ƒ(K,L)
Q = output/time period
K = capital
L = labor
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The Relationship Between
Output and Inputs (cont'd)
• Production
– Any activity that results in the conversion of
resources into products that can be used in
consumption
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The Relationship Between
Output and Inputs (cont'd)
• Production Function
– The relationship between maximum physical
output and the quantity of capital and labor used
in the production process
– The production function is a technological
relationship between inputs and output.
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E-Commerce Example: Riding an Escalator
to the Outer Edge of a Production Function
• Since escalators were first invented back in
1891, figuring out how to put one together
has been a highly labor-intensive process.
• Until recently, working through the
intricacies of a lower-cost process for
escalator design and production took
engineers more than one year.
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E-Commerce Example: Riding an Escalator
to the Outer Edge of a Production Function
(cont'd)
• Today, the use of three-dimensional software, such as a
programs such as AutoCAD, enables engineers to devise
production processes for producing escalators in less than
three weeks.
• Why do you suppose that business managers regard the
process of developing the best procedures for producing
goods and services as a fundamental requirement of
operating at a point on a firm’s production function?
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The Relationship Between
Output and Inputs (cont'd)
• Average Physical Product
– Total product divided by the variable input
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The Relationship Between
Output and Inputs (cont'd)
• Marginal Physical Product
– The physical output that is due to the addition of
one more unit of a variable factor of production
– The change in total product occurring when a
variable input is increased and all other inputs
are held constant
– Also called marginal product
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Figure 23-1
The Production
Function and
Marginal Product:
A Hypothetical
Case, Panel (a)
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Figure 23-1 The Production Function and
Marginal Product: A Hypothetical Case, Panel (b)
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Figure 23-1 The Production Function and
Marginal Product: A Hypothetical Case, Panel (c)
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Diminishing Marginal Product
• Measuring marginal product
• The concept of marginal profit applies to
many situations
• Specialization and marginal product
• Diminishing marginal product
• The Law of Diminishing Marginal Product
23-20
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Diminishing Marginal Product
(cont'd)
• Law of Diminishing Marginal Product
– The observation that after some point,
successive equal-sized increases in a variable
factor of production, such as labor, added to
fixed factors of production, will result in smaller
increases in output
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Diminishing Marginal Product
(cont’d)
• An example of the Law of Diminishing
Marginal Profit: Production of computer
printers
• We have a fixed amount of factory space,
assembly equipment, and quality control
diagnostic software.
– So the addition of more workers eventually
yields successively smaller increases in output.
23-22
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Diminishing Marginal Product
(cont'd)
• After a while, when all the assembly
equipment and quality-control diagnostic
software are being used, additional
workers will have to start assembling and
troubleshooting quality problems
manually.
• The marginal physical product of an
additional worker, given a specified
amount of capital, must eventually be less
than that for the previous workers.
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Diminishing Marginal Product
(cont’d)
• Point of saturation
– Given the amount of fixed inputs, there is no
further positive use for more of the variable
input.
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Short-Run Costs to the Firm
• Total Costs
– The sum of total fixed costs and total variable costs
• Fixed Costs
– Costs that do not vary with output and are fixed for a
certain period of time, i.e. rent on a building
• Variable Costs
– Costs that vary with the rate of production, i.e. wages paid
to workers and purchases of materials
Total costs (TC) = TFC + TVC
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Short-Run Costs to the Firm
(cont'd)
• Average Total Costs (ATC)
– Also called average per-unit total costs
Average total costs (ATC) =
Total costs (TC)
Output (Q)
23-26
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Short-Run Costs to the Firm
(cont'd)
• Average Variable Costs (AVC)
Average variable costs (AVC) =
Total variable costs (TVC)
Output (Q)
23-27
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Short-Run Costs to the Firm
(cont'd)
• Average Fixed Costs (AFC)
Average fixed costs (AFC) =
Total fixed costs (TFC)
Output (Q)
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Short-Run Costs to the Firm
(cont'd)
• Marginal Cost
– The change in total costs due to a one-unit
change in production rate
Marginal costs (MC) =
Change in total cost
Change in output
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Figure 23-2 Cost of Production: An
Example, Panel (a)
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Figure 23-2 Cost of Production: An
Example, Panel (b)
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Figure 23-2 Cost of Production: An
Example, Panel (c)
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Short-Run Costs to the Firm
(cont'd)
• Question
– What do you think—is there a predictable
relationship between the production function and
AVC, ATC, and MC?
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Short-Run Costs to the Firm
(cont'd)
• Answer
– As long as marginal physical product rises,
marginal cost will fall, and when marginal
physical product starts to fall (after reaching the
point of diminishing marginal product), marginal
cost will begin to rise.
23-34
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Short-Run Costs to the Firm
(cont’d)
• The relationship between average and
marginal costs
• When marginal costs are less than average
variable costs, the latter must fall.
• When marginal costs are greater than
average variable costs, the latter must rise.
23-35
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Short-Run Costs to the Firm
(cont'd)
• There is also a relationship between
marginal costs and average total costs.
– Average total cost is equal to total cost divided
by the number of units produced.
– Marginal cost is the change in total cost due to a
one-unit change in the production rate.
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The Relationship Between Diminishing
Marginal Product and Cost Curves
• Firms’ short-run cost curves are a
reflection of the law of diminishing
marginal product.
• Given any constant price of the variable
input, marginal costs decline as long as
the marginal product of the variable
resource is rising.
23-37
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The Relationship Between Diminishing
Marginal Product and Cost Curves (cont'd)
• At the point at which diminishing
marginal product begins, marginal
costs begin to rise as the marginal
product of the variable input begins to
decline.
23-38
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The Relationship Between Diminishing
Marginal Product and Cost Curves (cont'd)
• If the wage rate is constant, then the labor
cost associated with each additional unit of
output will decline as long as the marginal
physical product (MPP) of labor increases.
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Figure 23-3 The Relationship Between
Output and Costs, Panel (a)
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Figure 23-3 The Relationship Between
Output and Costs, Panel (b)
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Figure 23-3 The Relationship Between
Output and Costs, Panel (c)
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Figure 23-3 The Relationship Between
Output and Costs, Panel (d)
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The Relationship Between Diminishing
Marginal Product and Cost Curves (cont'd)
• Of course, the average total cost curve and
average variable cost curve are also
affected.
• They will have their familiar U shape in the
short run.
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Long-Run Cost Curves
• Planning Horizon
– The long run, during which all inputs are variable
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Long-Run Cost Curves (cont'd)
• Long-Run Average Cost Curve
– The locus of points representing the minimum
unit cost of producing any given rate of output,
given current technology and resource prices
• Planning Curve
– The long-run average cost curve.
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Figure 23-4 Preferable Plant Size and
the Long-Run Average Cost Curve
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Long-Run Cost Curves (cont'd)
• Observation
– Only at minimum long-run average cost curve is
short-run average cost curve tangent to long-run
average cost curve.
• Question
– Why do you think the long-run average cost
curve U-shaped?
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Why the Long-Run Average Cost
Curve is U-Shaped
• Economies of scale
• Constant returns to scale
• Diseconomies of scale
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Why the Long-Run Average Cost
Curve is U-Shaped (cont'd)
• Economies of Scale
– Decreases in long-run average costs resulting
from increases in output
• These economies of scale do not persist indefinitely,
however.
• Once long-run average costs rise, the curve begins to
slope upwards.
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Why the Long-Run Average Cost
Curve is U-Shaped (cont'd)
• Reasons for economies of scale
– Specialization
• Division of tasks or operations
– Dimensional factor
• Large-scale firms often require proportionately less
input per unit of output
– Improved productive equipment
• The larger the enterprise, the more the firm can take
advantage of larger-volume types of machinery.
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Figure 23-5 Economies of Scale, Constant
Returns to Scale, and Diseconomies of Scale
Shown with Long-Run Average Cost Curve
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Why the Long-Run Average Cost
Curve is U-Shaped (cont'd)
• Explaining why a firm might experience
diseconomies of scale
– Limits to the efficient functioning of management
– Coordination and communication is more of a
challenge as firm size increases
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International Example: Global Cargo
Shippers Pursue Scale Economies
• For an international shipping firm, a “plant” is a cargo
ship.
• In recent years, shippers have reduced their long-run
average variable costs both by expanding the number of
ships afloat and by increasing the absolute size of these
ships.
• Expanding scale through the use of additional ships has
allowed global cargo shippers to experience economies
of scale.
• What could you conclude if you were to notice several
years from now that shipping firms stop putting any
additional massive container ships out to sea?
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Minimum Efficient Scale
• Minimum Efficient Scale (MES)
– The lowest rate of output per unit time at which
long-run average costs for a particular firm are
at a minimum
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Figure 23-6 Minimum Efficient
Scale
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Minimum Efficient Scale (cont'd)
• Small MES relative to industry demand
– There is room for many efficient firms.
– High degree of competition
• Large MES relative to industry demand
– There is room for only a small number of
efficient firms.
– Small degree of competition
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Example: Toyota Finds Itself Just
Beyond Its Minimum Efficient Scale
• Since 2002, Japanese automaker Toyota has increased by
more than 50% the number of vehicles it sells in the United
States.
• Recently, Toyota decided it will build no more plants in the
foreseeable future. The reason for this is that the company’s
long-run average cost of producing autos began to increase in
the late 2000s.
• To avoid experiencing any further diseconomies and get back
to its minimum efficient scale, Toyota has cut back slightly on
production of vehicles in portions of U.S. facilities built just a
few years ago.
• In the long-run, why might Toyota choose not to expand its
production capabilities further even if it could sell more
vehicles than it is currently producing?
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Issues and Applications: Family Physicians
Downsize to Reduce Long-Run Average
Costs
• As Figure 23-7 indicates, the number of
medical school graduates opting for
medical-school residency positions in the
area of family medicine has dropped by
about one-half since 1997.
• The average costs of operating family
practices have risen to where a family
medical practice is just not as lucrative as it
once was.
23-59
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Figure 23-7 The Number of Medical Students
Opting for Family Practice Residencies
Source: U.S. Department of Health and Human Services.
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Issues and Applications: Family Physicians
Downsize to Reduce Long-Run Average
Costs (cont’d)
• The long-run average cost curve faced by
family physicians is bending upwards at
ever-smaller scales of operation. The
minimum efficient scale in the provision of
family medicine has declined.
• More family physicians are opting to
downsize their operations considerably.
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Issues and Applications: Family Physicians
Downsize to Reduce Long-Run Average
Costs (cont’d)
• Operating these high-tech “micropractices” allows
family physicians to avoid higher overhead
expenses that they would otherwise incur.
• Why do you suppose that most family practitioners
who do opt to set up micropractices increasingly
are opting to partner with numerous physicians in
offices that previously would have been occupied
by only one physician?
23-62
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Summary Discussion of Learning
Objectives
• The short run versus the long run from a
firm’s perspective
– Short run—a period in which at least one input is
fixed
– Long run—a period in which all inputs are
variable
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Summary Discussion of Learning
Objectives (cont'd)
• The law of diminishing marginal product
– As more units of a variable input are employed with a fixed
input, marginal physical product eventually begins to
decline.
• A firm’s short-run cost curves
– Fixed and average fixed cost
– Variable and average variable cost
– Total and average total cost
– Marginal cost
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Summary Discussion of Learning
Objectives (cont'd)
• A firm’s long-run cost curve
– Planning horizon
– All inputs are variable including plant size
• Economies and diseconomies of scale and a firm’s
minimum efficient scale
– Along the down-ward sloping range of the firm’s long-run
average cost curve, the firm experiences economies of
scale.
– Along the upward sloping portion, the firm encounters
diseconomies of scale.
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