Ch-8 - Ist Sem 23-24

Chapter
8
Short-Run Costs
and Output Decisions
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
Short-Run Costs 8
CHAPTER 8: Short-Run Costs and
and Output Decisions Chapter Outline

Output Decisions
Costs in the Short Run

Fixed Costs
Variable Costs
Total Costs
Short-Run Costs: A Review
Output Decisions: Revenues,

Costs, and Profit Maximization
Total Revenue (TR) and Marginal
Revenue (MR)
Comparing Costs and Revenues
to Maximize Profit
The Short-Run Supply Curve
Looking Ahead
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 31
SHORT-RUN COSTS AND OUTPUT DECISIONS:
Decisions Facing Firms
You have seen that firms in perfectly competitive industries

make three specific decisions.

Output Decisions
DECISIONS are based on INFORMATION

1. The quantity of output 1. The price of output
to supply
2. How to produce that 2. Techniques of
output (which production available*
technique to use)
3. The quantity of each 3. The price of inputs*
input to demand
*Determines production costs
FIGURE 8.1 Decisions Facing Firms
From last chapter (Revision)
Cost of Production Short run

(Technology & Input Prices) (Two Conditions)
▪ In the last chapter, we focused ▪ Short run is that period

Output Decisions
on the production process. during which two conditions

▪ This chapter focuses on the hold:
costs of production. ▪ (1) existing firms face limits
imposed by some fixed
▪ To calculate costs, a firm must factor of production, and
know two things: ▪ (2) new firms cannot
enter and existing firms
▪ what quantity and
cannot exit an industry.
combination of inputs it
needs to produce its product
and
▪ how much those inputs cost.
Costs in the Short Run
(Imp: Fixed cost only in short run)
▪ In the short run, all firms (competitive and noncompetitive)

have costs that they must bear regardless of their output.
▪ In fact, some costs must be paid even if the firm stops
Output Decisions
producing— that is, even if output is zero.
▪ These costs are called fixed costs, and firms can do nothing in
the short run to avoid them or to change them.
▪ In the long run, a firm has no fixed costs because it can

expand, contract, or exit the industry
COSTS IN THE SHORT RUN:
FC-VC-TC
fixed cost Any cost that does not depend on the firm’s level of
output. These costs are incurred even if the firm is producing
nothing. There are no fixed costs in the long run.

Output Decisions
variable cost A cost that depends on the level of production

chosen.
total cost (TC) Fixed costs plus variable costs.
TC = TFC + TVC
where TC denotes total costs, TFC denotes total fixed costs, and
TVC denotes total variable costs
Total fixed costs (TFC) or Overhead
FIXED COSTS
Total Fixed Cost (TFC)
total fixed costs (TFC) or overhead

Output Decisions
The total of all costs that do not change with output, even
if output is zero.
TABLE 8.1 Short-Run Fixed Cost (Total and

Average) of a Hypothetical Firm
(1) (2) (3)
Q TFC AFC (TFC/Q)
0 $1,000 $ -
1 $1,000 1,000
2 $1,000 500
3 $1,000 333
4 $1,000 250
5 $1,000 200
Firms have no control over fixed costs in the short run. For this reason, fixed costs are
sometimes called sunk costs.
Sunk costs & Average fixed costs
sunk costs
Another name for fixed costs in the short run because firms
have no choice but to pay them.
Output Decisions
Average Fixed Cost (AFC)
average fixed cost (AFC)

Total fixed cost divided by the number of units of output; a per-
unit measure of fixed costs.
TFC
AFC =
q
Why TFC is called Fixed costs-
Overhead Larger portion of total costs
for some firms than for others
Total fixed cost is sometimes called
overhead. ▪Fixed costs represent a larger

Output Decisions
portion of total costs for some firms

If you operate a factory than for others.
you must heat the building to keep the ▪Electric companies, for
pipes from freezing in the winter. instance, maintain generating
plants, thousands of miles of
distribution wires, poles,
Even if no production is taking place transformers, and so on.
you may have to keep the roof from ▪Small consulting firm
leaking, pay a guard to protect the
building from vandals, and make
payments on a long-term lease.
There may also be insurance premiums,

taxes, and city fees to pay, as well as
contract obligations to workers.
Assumption Imp: Fixed & Variable Capital
(Short Run)
Assumption – Only two inputs
It is sometimes assumed that capital
(Labor & Capital)

Output Decisions
is a fixed input in the short run and

▪ For the purposes of our that labor is the only variable input.
discussion in this chapter,
▪ To be more realistic, however, we
we will assume that firms
will assume that capital has both
use only two inputs:
a fixed and a variable
labor and capital. component.
▪ After all, some capital can be
purchased in the short run.
Example (Fixed Capital, Variable Capital & Labor)
Consider a small consulting firm Variable Costs (The same firm also has
that employs several economists, costs that vary with output)
research assistants, and ▪When there is a great deal of work, the
secretaries. It rents space in an firm hires more employees at both the
office building and has a 5-year professional and research assistant levels.
Output Decisions
lease.
▪The capital used by the consulting firm
may also vary, even in the short run.
Fixed Costs: ▪Payments on the computer system
▪ The rent on the office space can do not change, but the firm may rent
be thought of as a fixed cost in additional computer time when
the short run. necessary.
▪ The monthly electric and heating ▪The firm can buy additional personal
computers, network terminals, or
bills are also essentially fixed, so
databases quickly if needed.
are the salaries of the basic
▪It must pay for the copy machine,
administrative staff.
but the machine costs more when it
▪ Payments on some capital is running than when it is not
equipment—a large copying
machine and the main word-
processing system, for
instance—can also be thought of
as fixed.
Graph/Curve: TFC & AFC &
Spreading Overhead
Output Decisions
FIGURE 8.2 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm
spreading overhead
The process of dividing total fixed costs by more units of output.
Average fixed cost declines as quantity rises.
Imp: AFC never actually reaches zero

Graph/Curve: TVC Curve
VARIABLE COSTS
Total Variable Cost (TVC)

Output Decisions
total variable cost (TVC)

The total of all costs that vary with output in the short run.
total variable cost curve

A graph that shows the relationship between total variable
cost and the level of a firm’s output.
Which Technology? (It depends on TVC)
but Choice of Technology also depends on Scale
▪ To find out which technology involves the least cost, a firm
must compare the total variable costs of producing that level of
output using different production techniques.
▪ If machinery is expensive and labor is cheap, you will probably
choose the labor-intensive technology.

Output Decisions
▪ If farm labor is expensive, then capital-intensive method
▪ Having compared the costs of alternative production techniques, the

firm may be influenced in its choice by the current scale of its
operation.
▪ Remember, in the short run, a firm is locked into a fixed scale of
operations.
▪ A firm currently producing on a small scale may find that a labor
intensive technique is least costly whether or not labor is
comparatively expensive.
▪ The same firm producing on a larger scale might find a capital-
intensive technique to be less costly.
Total Variable Cost Curve [TVC depends on ..]
▪ The total variable cost curve is a graph that shows the
relationship between total variable cost and the level of a firm’s
output (q).
Output Decisions
▪ At any given level of output, total variable cost depends on

▪ (1) the techniques of production that are available and
▪ (2) the prices of the inputs required by each technology
▪ IMP:
▪ For the purposes of this example, we focus on variable capital
—that is, on capital that can be changed in the short run.
▪ In our example, we will use K to denote variable capital.
▪ In practice, some capital (such as buildings and large, specialized
machines) is fixed in the short run.
Derivation of Total Variable Cost Schedule from
Technology and Factor Prices
▪ Analysis reveals that to produce 1 unit of output, the labor-intensive technique is

least costly.
▪ Technique A requires 4 units of both capital and labor, which would cost a total of
$12. Technique B requires 6 units of labor but only 2 units of capital for a total
cost of only $10.

Output Decisions
▪ To maximize profits, the firm would use technique B to produce 1 unit.

▪ The total variable cost of producing 1 unit of output would thus be $10
TABLE 8.2 Derivation of Total Variable Cost Schedule from Technology and Factor Prices
UNITS OF INPUT
REQUIRED TOTAL VARIABLE COST
USING (PRODUCTION FUNCTION) ASSUMING PK = $2, PL = $1
PRODUCE TECHNIQUE K L TVC = (K x PK) + (L x PL)
1 Unit of A 4 4 (4 x $2) + (4 x $1) = $12

output B 2 6 (2 x $2) + (6 x $1) = $10
2 Units of A 7 6 (7 x $2) + (6 x $1) = $20
output B 4 10 (4 x $2) + (10 x $1) = $18
3 Units of A 9 6 (9 x $2) + (6 x $1) = $24
output B 6 14 (6 x $2) + (14 x $1) = $26
Total Variable Cost Curve
Output Decisions
FIGURE 8.3 Total Variable Cost Curve
The total variable cost curve embodies information about both factor, or input,
prices and technology. It shows the cost of production using the best available
technique at each output level given current factor prices.
Marginal Cost (MC)
marginal cost (MC)
The increase in total cost that results from producing one more unit of output.
Marginal costs reflect changes in variable costs.
Focusing on the “margin” is one way of looking at variable costs: marginal costs reflect
changes in variable costs because they vary when output changes.

Output Decisions
Fixed costs do not change when output changes.
TABLE 8.3 Derivation of Marginal Cost from Total Variable Cost
UNITS OF OUTPUT TOTAL VARIABLE COSTS ($) MARGINAL COSTS ($)
0 0 0
1 10 10
2 18 8
3 24 6
Although the easiest way to derive marginal cost is to look at total variable cost and
subtract, do not lose sight of the fact that when a firm increases its output level, it
hires or demands more inputs.
Marginal cost measures the additional cost of inputs required to produce each
successive unit of output.
Marginal Cost Curve (Relation with MP Curve)
The Shape of the Marginal Cost Curve in the

Short Run
Output Decisions
FIGURE 8.4 Declining Marginal Product Implies That

Marginal Cost Will Eventually Rise with Output
Decreasing marginal product, imply
Increasing marginal cost
▪ The assumption of a fixed factor of production in the short run means that a
firm is stuck at its current scale of operation (in our example, the size of the
plant).
▪ As a firm tries to increase its output, it will eventually find itself trapped by
that scale.
Output Decisions
▪ Thus, our definition of the short run also implies that marginal cost
eventually rises with output.
▪ The firm can hire more labor and use more materials— that is, it can add
variable inputs—but diminishing returns eventually set in
▪ Imp:
▪ If each additional unit of labor adds less and less to total output, it
follows that more labor is needed to produce each additional unit of
output.
▪ Thus, each additional unit of output costs more to produce.
▪ In other words, diminishing returns, or decreasing marginal product, imply

increasing marginal cost as illustrated in Figure 8.4.
COSTS IN THE SHORT RUN:
The Shape of the Marginal Cost Curve in the Short Run
In the short run, every firm is constrained by some fixed factor of production.
A fixed factor implies diminishing returns (declining marginal product) and a limited
capacity to produce.
As that limit is approached, marginal costs rise.
Output Decisions
FIGURE 8.4 Declining Marginal Product Implies That

Marginal Cost Will Eventually Rise with Output
Summary:
▪ To reiterate:
▪ In the short run, every firm is constrained by some fixed
input that
▪ (1) leads to diminishing returns to variable inputs &

Output Decisions
▪ (2) limits its capacity to produce.
▪ As a firm approaches that capacity, it becomes

increasingly costly to produce successively higher levels
of output.
▪ Marginal costs ultimately increase with output in the
short run
Graphing Total Variable Costs and Marginal Costs
Output Decisions
FIGURE 8.5 Total Variable Cost and Marginal

Cost for a Typical Firm
TVC TVC
slope of TVC = = = TVC = MC
Δq 1
▪ Figure 8.5 shows the total variable cost curve and the marginal cost
curve of a typical firm.
▪ Notice first that the shape of the marginal cost curve is consistent
with short-run diminishing returns.
Output Decisions
▪ At first, MC declines, but eventually the fixed factor of production

begins to constrain the firm and marginal cost rises.
▪Up to 100 units of output, producing each successive unit of
output costs slightly less than producing the one before.
▪Beyond 100 units, however, the cost of each successive unit
is greater than the one before
▪ More output costs more than less output.

▪ Total variable costs (TVC), therefore, always increase when
output increases.
▪ Even though the cost of each additional unit changes, total variable
cost rises when output rises.
▪ Thus, the total variable cost curve always has a positive slope.
Output Decisions
FIGURE 8.5 Total Variable Cost and Marginal

Cost for a Typical Firm
TVC TVC
slope of TVC = = = TVC = MC
Δq 1
Marginal cost actually is the slope of the
total variable cost curve
▪ The slope of a total variable cost curve is thus the change in total variable
cost divided by the change in output (TVC/ q).
▪ Because marginal cost is by definition the change in total variable cost
resulting from an increase in output of one unit ( q = 1), marginal cost

Output Decisions
actually is the slope of the total variable cost curve:

slope of TVC = ∆TVC/ ∆q = ∆TVC/ 1
= ∆TVC = MC
▪ Notice:
▪ Up to 100 units of output-
▪ Marginal cost decreases and the variable cost curve becomes flatter.
▪ The slope of the total variable cost curve is declining — that is, total
variable cost increases, but at a decreasing rate.
▪ Beyond 100 units of output-
▪ Marginal cost increases and the total variable cost curve gets
steeper — total variable costs continue to increase, but at an
increasing rate.
Average variable cost (AVC)
average variable cost (AVC)

Total variable cost divided by the number of units of output.
TVC
Output Decisions
AVC =
q
Short-Run Costs of a Hypothetical Firm
TABLE 8.4 Short-Run Costs of a Hypothetical Firm
(3) (4) (6) (7) (8)
(1) (2) MC AVC (5) TC AFC ATC
q TVC ( TVC) (TVC/q) TFC (TVC + TFC) (TFC/q) (TC/q or AFC + AVC)
0 $ 0 $ - $ - $1,000 $ 1,000 $ - $ -
Output Decisions
1 10 10 10 1,000 1,010 1,000 1,010

2 18 8 9 1,000 1,018 500 509
3 24 6 8 1,000 1,024 333 341
4 32 8 8 1,000 1,032 250 258
5 42 10 8.4 1,000 1,042 200 208.4
- - - - - - - -
- - - - - - - -
- - - - - - - -
500 8,000 20 16 1,000 9,000 2 18
Marginal cost is the cost of one additional unit.
Average variable cost is the total variable cost divided by the total
number of units produced.
Graphing Average Variable Costs & Marginal Costs
When marginal cost is below average variable cost, average variable cost declines toward it.
When marginal cost is above average variable cost, average variable cost increases toward it.
As the graph shows, average variable cost follows marginal cost but lags behind.
Output Decisions
FIGURE 8.6 More Short-Run Costs
Marginal cost intersects average variable cost at the lowest, or minimum, point of AVC.
Graphing Average Variable Costs & Marginal Costs
▪ As we increase production, marginal cost—which at low levels of production is above $3.50
per unit— falls as coordination and cooperation begin to play a role.
▪ At 100 units of output, marginal cost has fallen to $2.50.
▪ After 100 units of output, we begin to see diminishing returns.

▪ Marginal cost begins to increase as higher and higher levels of output are produced.
Output Decisions
▪ However, notice that average cost is still falling until 200 units because marginal cost remains
below it.
▪ At 100 units of output, marginal cost is $2.50 per unit but the average variable cost of production
is $3.50. Thus, even though marginal cost is rising after 100 units, it is still pulling the average of
$3.50 downward
▪ At 200 units, however, marginal cost has risen to $3 and average cost has fallen to $3;
marginal and average costs are equal. At this point, marginal cost continues to rise with
higher output.
▪ From 200 units upward, MC is above AVC and thus exerts an upward pull on the average
variable cost curve.
▪ At levels of output above 200 units, MC is above AVC and AVC increases as output inc.
▪ If you follow this logic, you will see that marginal cost intersects average variable cost at
the lowest, or minimum, point of AVC.
Total Costs Curve
Total Cost = Total Fixed Cost + Total Variable Cost
Adding TFC to TVC means adding the same amount of total fixed cost to every level of total
variable cost. 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.
TOTAL COSTS
Output Decisions
FIGURE 8.7 Total Cost = Total Fixed Cost + Total Variable Cost
Average Total Cost (ATC)
Average Total Cost (ATC)

average total cost (ATC) Total cost

Output Decisions
divided by the number of units of output.
TC
ATC =
q
ATC = AFC + AVC
The Relationship Between Average Total Cost
and Marginal Cost
The Relationship Between Average Total

Cost and Marginal Cost
Output Decisions
The relationship between average total cost and

marginal cost is exactly the same as the relationship
between average variable cost and marginal cost.
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. As a
result, marginal cost intersects average total cost at ATC’s minimum point, for the same
reason that it intersects the average variable cost curve at its minimum point.
Average Total Cost Curve
FIGURE 8.8 Average Total Cost = Average
Variable Cost + Average
Fixed Cost
Figure 8.8 derives average total cost

Output Decisions
graphically for a typical firm.
The bottom part of the figure graphs

average fixed cost.
At 100 units of output, average fixed
cost is TFC/q = $1,000/100 = $10.
At 400 units of output, AFC =
$1,000/400 = $2.50.
The top part of Figure 8.8 shows the

declining AFC added to AVC at each
level of output.
Because AFC gets smaller and
smaller, ATC gets closer and closer
to AVC as output increases, but the
two lines never meet
OUTPUT DECISIONS:
REVENUES, COSTS, & PROFIT MAXIMIZATION
▪ To calculate potential profits, firms must combine their cost
analyses with information on potential revenues from sales.
▪ After all, if a firm cannot sell its product for more than the cost
of production, it will not be in business long.

Output Decisions
▪ In contrast, if the market gives the firm a price that is

significantly greater than the cost it incurs to produce a unit of
its product, the firm may have an incentive to expand output.
Perfect Competition
Perfect competition exists in an industry that Perfect Competition (Firms- Price Takers)
contains many relatively small firms producing Each firm takes prices as given
identical products. Prices are determined in the market by the
laws of supply and demand
In a perfectly competitive industry, no single
firm has any control over prices. and decides only how much to produce
Output Decisions
In other words, an individual firm cannot affect and how to produce it

the market price of its product or the prices of
the inputs that it buys. We mean that given the availability of
perfect substitutes, any product priced
Perfect Competition (Why no control over over the market price will not be sold.
prices?)
This important characteristic follows from
two assumptions. These assumptions also imply that the
First, a competitive industry is composed of demand for the product of a competitive
many firms, each small relative to the size of the firm is perfectly elastic (Imp)
industry.
Second, every firm in a perfectly competitive
industry produces homogeneous products,
which means that one firm’s output cannot be
distinguished from the output of the others.
Demand Facing a Single Firm in a
Perfectly Competitive Market
Output Decisions
FIGURE 8.9 Demand Facing a Typical Firm in a Perfectly Competitive Market
In the short run, a competitive firm faces a demand curve that is simply a horizontal
line at the market equilibrium price. In other words, competitive firms face perfectly
elastic demand in the short run.
Demand Facing a Single Firm in a
Perfectly Competitive Market
▪ If a representative firm in a perfectly competitive market
raises the price of its output above $5.00, the quantity
demanded of that firm’s output will drop to zero.
Output Decisions
▪ Each firm faces a perfectly elastic demand curve, d.
OUTPUT DECISIONS:
REVENUES, COSTS, & PROFIT MAXIMIZATION
TOTAL REVENUE (TR) & MARGINAL REVENUE (MR)
total revenue (TR) The total amount that a firm takes in from
the sale of its product: the price per unit times the quantity of
Output Decisions
output the firm decides to produce (P x q).

total revenue = price x quantity
TR = P x q
A perfectly competitive firm sells each unit of product for

the same price, regardless of the output level it has
chosen.
marginal revenue (MR) The additional revenue that a firm

takes in when it increases output by one additional unit.
In perfect competition, P = MR.
Why MR = P MR Curve & DD Curve
(Market Price) [They are Identical]
If a firm producing 10,521 units of The marginal revenue curve and the
output per month increases that output demand curve facing a competitive
Output Decisions
to 10,522 units per month, it will take in firm are identical.

an additional amount of revenue each
month. The horizontal line in Figure 8.9(b)
▪The revenue associated with the can be thought of as both the demand
10,522nd unit is the amount for which curve facing the firm and its marginal
the firm sells that 1 unit. revenue curve:
P* = d = MR
Thus, for a competitive firm, marginal
revenue is equal to the current market
price of each additional unit sold.
▪In Figure 8.9, for example, the market
price is $5.00.
▪Thus, if the representative firm raises
its output from 10,521 units to 10,522
units, its revenue will increase by $5.00
Comparing costs & Revenues to Maximize profit
The Profit-Maximizing Level of Output

Output Decisions
FIGURE 8.10 The Profit-Maximizing Level of Output for a Perfectly Competitive Firm
Comparing costs & Revenues to Maximize profit:
Two Assumptions
▪ We are working under two assumptions:
▪ (1) that the industry we are examining is perfectly

competitive and
Output Decisions
▪ (2) that firms choose the level of output that yields the
maximum total profit.
▪ Figure 8.10.
▪ Once again, we have the whole market, or industry, on the
left and a single, typical small firm on the right. And again
the current market price is P*.
Output Decisions
▪ First, the firm observes the market price [Figure 8.10(a)]

and knows that it can sell all that it wants for P* = $5 per
unit.
▪ Next, the firm must decide how much to produce.
Comparing costs & Revenues to Maximize profit

Output Decisions
FIGURE 8.10 The Profit-Maximizing Level of Output for a Perfectly Competitive Firm
The Profit-Maximizing Level of Output for a
Perfectly Competitive Firm: Three Cases
▪ Case I: At q = 100 units (MC is Minimum)

▪ Here the difference between marginal revenue, $5.00,
and marginal cost, $2.50, is the greatest.
▪ As it happens, 100 units is not the optimal production

Output Decisions
level.
▪ Case II: P > MC [For eg at q = 100 & q = 250 units]

▪ Profits can be increased by raising output; each
additional unit increases revenues by more than it
costs to produce the additional output.
▪ Case III: P < MC [Beyond q* = 300, for example at q = 340]

▪ Added output will reduce profits.
The Profit-Maximizing Level of Output for a
Perfectly Competitive Firm
Profit-maximizing output is thus q*, the point at which

P* = MC.
Output Decisions
Remember that a firm wants to maximize the difference

between total revenue and total cost, not the difference
between marginal revenue and marginal cost.
Why profit is not maximized at q = 100 Why profit is not maximized at
The fact that marginal revenue is greater than
q > 300
marginal cost at a level of 100 indicates that
profit is not being maximized. ▪Notice that if the firm were to
▪Think about the 101st unit. produce more than 300 units,
Output Decisions
marginal cost would rise above

▪Adding that single unit to production each period
marginal revenue.
adds $5.00 to revenues but adds only about
▪At 340 units of output, for
$2.50 to cost. Profits each period would be
example, the cost of the 341st
higher by about $2.50. unit is about $5.70 while that
added unit of output still brings in
Thus, the optimal (profit-maximizing) level of only $5 in revenue, thus reducing
output is clearly higher than 100 units. profit.
▪As long as marginal revenue is greater than
marginal cost, even though the difference ▪It simply does not pay to increase
between the two is getting smaller, added output above the point where
output means added profit. marginal cost rises above marginal
▪Whenever marginal revenue exceeds revenue because such increases will
marginal cost, the revenue gained by reduce profit.
increasing output by 1 unit per period
exceeds the cost incurred by doing so.
Why profit is maximized at q = 300
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 level of
output at which P* = MC
Output Decisions
▪ This logic leads us to 300 units of output.

▪ At 300 units, marginal cost has risen to $5.
▪ At 300 units of output, P* = MR = MC = $5.
Profit Maximizing Condition [P = MR = MC]
▪ The profit-maximizing output level for all firms is the

output level where MR = MC.
▪
Output Decisions
In perfect competition, however, MR = P, as shown

earlier.
▪ Hence, for perfectly competitive firms, we can rewrite

our profit-maximizing condition as P = MC.
Important note:
▪ The key idea here is that firms will produce as long as

marginal revenue exceeds marginal cost.
▪ When marginal cost rises smoothly, as it does in

Output Decisions
Figure 8.10, the profit-maximizing condition is that MR

(or P) exactly equals MC.
▪ If marginal cost moves up in increments—as it
does in the following numerical example—marginal
revenue or price may never exactly equal marginal
cost.
▪ The key idea still holds.
Profit Maximizing Condition: Summary
As long as marginal revenue is greater than marginal cost, even though the difference
between the two is getting smaller, added output means added profit. Whenever marginal
revenue exceeds marginal cost, the revenue gained by increasing output by one unit per
Output Decisions
period exceeds the cost incurred by doing so.
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 level of output at
which P* = MC.
The profit-maximizing output level for all firms is the output level where MR = MC.
Profit Maximizing Condition: A Numerical Example
TABLE 8.6 Profit Analysis for a Simple Firm

(1) (2) (3) (4) (5) (6) (7) (8)
TR TC PROFIT
q TFC TVC MC P = MR (P x q) (TFC + TVC) (TR - TC)

Output Decisions
0 $ 10 $ 0 $ - $ 15 $ 0 $ 10 $ -10
1 10 10 10 15 15 20 -5
2 10 15 5 15 30 25 5
3 10 20 5 15 45 30 15
4 10 30 10 15 60 40 20
5 10 50 20 15 75 60 15
6 10 80 30 15 90 90 0
Profit Maximizing Condition: A Numerical Example
Let us assume that the market has set a $15 unit price for the firm’s product. At all other output
levels, they are lower.
Case I: Q = 0: First, should the firm produce at all? If it produces nothing, it suffers losses equal to
$10.
Output Decisions
Case II: Q = 1: If it increases output to 1 unit, marginal revenue is $15 (remember that it sells each
unit for $15) and marginal cost is $10. Thus, it gains $5, reducing its loss from $10 each period to $5.
Case III: Q = 2: Should the firm increase output to 2 units? The marginal revenue from the second
unit is again $15, but the marginal cost is only $5. Thus, by producing the second unit, the firm gains
$10 ($15 – $5) and turns a $5 loss into a $5 profit.
Case IV: Q = 3:The third unit adds $10 to profits. Again, marginal revenue is $15 and marginal cost
is $5, an increase in profit of $10, for a total profit of $15
Case V: Q = 4: The fourth unit offers still more profit. Price is still above marginal cost, which means
that producing that fourth unit will increase profits.
Case VI: Q = 5: At unit number five, however, diminishing returns push marginal cost above price.
The marginal revenue from producing the fifth unit is $15, while marginal cost is now $20.
The profit-maximizing level of output is thus 4 units. The firm produces as long as price (marginal
revenue) is greater than marginal cost.
The short-run Supply Curve
Output Decisions
FIGURE 8.11 Supply Curve of a Perfectly Competitive Firm
The short-run Supply Curve
▪ In Figure 8.11(a), assume that ▪ The MC curve in Figure 8.11(b) relates
something causes demand to price and quantity supplied.
increase (shift to the right), ▪ At any market price, the marginal
driving price from $5 to $6 and cost curve shows the output level
finally to $7. that maximizes profit.
Output Decisions
▪ When price is $5, a profit- ▪ A curve that shows how much output a
maximizing firm will choose an profit-maximizing firm will produce at
output level of 300 in Figure every price also fits the definition of a
8.11(b). supply curve.
▪ To produce any less, or to ▪ Thus, the marginal cost curve of a
raise output above that level, competitive firm is the firm’s short-
would lead to a lower level of run supply curve.
profit.
▪ At $6, the same firm would ▪ Hence, Marginal Cost Is the Supply
increase output to 350, but it Curve of a Perfectly Competitive Firm
would stop there. ▪ At any market price, the marginal cost
▪ Similarly, at $7, the firm would curve shows the output level that
raise output to 400 units of maximizes profit.
output
▪ IMP:
▪ This is true except when price is so
low that it pays a firm to shut down
Case Study in Marginal Analysis:
An Ice Cream Parlor
Output Decisions
Output Decisions
Output Decisions
Output Decisions
Output Decisions
Output Decisions
Practice Sums
IInd Sem 2021-22
Output Decisions
Q2
Output Decisions
Ans: B) increasing; decreasing
Ans: A) increasing; increasing
Output Decisions
Q3
Output Decisions
Ans: C) more, the costs of Xʹs factory will exceed those of Yʹs factory
Ans: D) less, the costs of Xʹs factory will exceed those of Yʹs factory.
Output Decisions
Q5
Output Decisions
Ans: C) marginal costs can be either increasing or decreasing.
Ans: B) average variable cost is decreasing.
Output Decisions
Q6
Output Decisions
Ans: B) False
Ans: B) False
Output Decisions
Q9 & Q10
Output Decisions
Ans: B) marginal cost to decrease
Ans: C) move closer together as output increases, with average
variable cost reaching its minimum level first

Output Decisions
Previous years questions
Output Decisions
Q3 & Q6:
Output Decisions
3. Ans- c
6. Ans- c
Output Decisions
Q9:
Output Decisions
Ans- a
Output Decisions
Q4 & Q5
Q4: Suppose a schedule of marginal cost and marginal revenue is given. As output
increases, the marginal cost initially decreases and then starts increasing. MR is
fixed. Further suppose for the N-th unit of output, MR>MC and for (N+1)-th
unit of output, MR<MC. Then what is the optimal output?
a. N
Output Decisions
b. N+1
c. both N as well as N+1 are optimal.
d. can’t say
Q5: The average variable cost of producing ice cream sundaes are minimized when
100 sundaes are produced. The total cost of producing 100 sundaes is $500. If
fixed cost of production is $200, what is the marginal cost of producing the
100th sundae?
a. $2
b. $3
c. $5
d. Data insufficient to answer.
Ans: a) N
Ans: b) $3
Output Decisions
Q6 & Q7
Q6: Both Jignesh and Jadav own diya factories. Jignesh’s factory has low fixed costs and
high variable costs. Jadav’s factory has high fixed costs and low variable costs.
Currently, each factory is producing 1,650 boxes of diyas at the same total cost.
Output Decisions
Complete the following statement with the correct answer. If each produces
a. less, their costs will be equal.
b. more, their costs will be equal.
c. more, the costs of Jignesh’s factory will exceed those of Jadav’s factory.
d. less, the costs of Jignesh’s factory will exceed those of Jadav’s factory.
Q7: If the cost function of a firm is TC=Q3-20Q2-240Q, the output beyond which
average cost will increase is
a. 10 units
b. 15 units
c. 20 units
d. 25 units
e. 12 units
f. None of the given options
Ans: c) more, the costs of Jignesh’s factory will exceed those of Jadav’s factory.
Ans: a) 10 units
Output Decisions
THANK YOU
Output Decisions

Ch-8 - Ist Sem 23-24

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Chapter

Fernando & Yvonn Quijano

and Output Decisions Chapter Outline

Costs in the Short Run

Output Decisions: Revenues,

You have seen that firms in perfectly competitive industries

make three specific decisions.

DECISIONS are based on INFORMATION

FIGURE 8.1 Decisions Facing Firms

Cost of Production Short run

▪ In the last chapter, we focused ▪ Short run is that period

on the production process. during which two conditions

▪ In the short run, all firms (competitive and noncompetitive)

producing— that is, even if output is zero.

▪ In the long run, a firm has no fixed costs because it can

nothing. There are no fixed costs in the long run.

variable cost A cost that depends on the level of production

total cost (TC) Fixed costs plus variable costs.

total fixed costs (TFC) or overhead

TABLE 8.1 Short-Run Fixed Cost (Total and

Average Fixed Cost (AFC)

average fixed cost (AFC)

overhead. ▪Fixed costs represent a larger

portion of total costs for some firms

There may also be insurance premiums,

(Labor & Capital)

is a fixed input in the short run and

Imp: AFC never actually reaches zero

Total Variable Cost (TVC)

total variable cost (TVC)

total variable cost curve

choose the labor-intensive technology.

▪ If farm labor is expensive, then capital-intensive method

▪ Having compared the costs of alternative production techniques, the

▪ At any given level of output, total variable cost depends on

▪ Analysis reveals that to produce 1 unit of output, the labor-intensive technique is

cost of only $10.

▪ To maximize profits, the firm would use technique B to produce 1 unit.

1 Unit of A 4 4 (4 x $2) + (4 x $1) = $12

FIGURE 8.3 Total Variable Cost Curve

changes in variable costs because they vary when output changes.

Fixed costs do not change when output changes.

TABLE 8.3 Derivation of Marginal Cost from Total Variable Cost

UNITS OF OUTPUT TOTAL VARIABLE COSTS ($) MARGINAL COSTS ($)

The Shape of the Marginal Cost Curve in the

FIGURE 8.4 Declining Marginal Product Implies That

▪ In other words, diminishing returns, or decreasing marginal product, imply

FIGURE 8.4 Declining Marginal Product Implies That

▪ (1) leads to diminishing returns to variable inputs &

▪ (2) limits its capacity to produce.

▪ As a firm approaches that capacity, it becomes

FIGURE 8.5 Total Variable Cost and Marginal

▪ At first, MC declines, but eventually the fixed factor of production

▪ More output costs more than less output.

FIGURE 8.5 Total Variable Cost and Marginal

resulting from an increase in output of one unit ( q = 1), marginal cost

actually is the slope of the total variable cost curve:

average variable cost (AVC)

1 10 10 10 1,000 1,010 1,000 1,010

Marginal cost is the cost of one additional unit.

FIGURE 8.6 More Short-Run Costs

▪ After 100 units of output, we begin to see diminishing returns.