Costs

Production and Costs: Part 2

Short Run Average Cost Curves

Dr. Saima Khan (SaKn)

ECO 101: Introduction to Microeconomics

Department of Economics, School of Business,

North South University

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Fixed vs Variable Inputs

 Production - transformation of resources into goods and services

I How to combine land, labour, capital and entrepreneur to
produce an output.
 Fixed vs. Variable Input
I Fixed Input - an input whose quantity CANNOT be changed
aas output changes.
I Variable Input - an input whose quantity CAN be changed as
output changes.
 Let’s look a an example (go to next slide).

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Fixed vs Variable Inputs

Rahim Carpenters
Example - Say Rahim carpenters produces bookshelves. To produce these
bookshelves the firm leases a workshop for one year at BDT 30,000 per
month. They suddenly get a bulk order from a big company. So to in-
crease bookshelf production, Rahim carpenters hires more employees as
carpenters, accountants, assistants etc. At the same time they increase
how much raw materials they are using such as wood, paint, nails etc.
What is Rahim Carpenter’s Fixed Input(s)? Variable Input(s)?

 Fixed Input: Factory/workshop

I Does not change if you vary production. Whether Rahim
Carenters produces 0 or 100 or 300 bookshelves, they must pay
the rent for one year because they signed a one year contract.
 Variable Input: Labour, wood, paint, nails.
I How many carpenters/wood/nail/paint is used varies based on
number of bookshelves produced.
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Short Run vs Long Run

 Short Run: If any inputs of the firm are fixed, then the firm is
producing in the short run.
 Long Run: If all inputs can be changed, then the firm is
producing in the long run.

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Total Product and Marginal Product

Table 1: Law of Diminishing Marginal Product

Labour (variable input) Total Product (TP) Marginal Product (MP)

0 0 -
1 18 18
2 37 19
3 57 20
4 76 19
5 94 18
6 111 17
7 127 16
8 137 10
9 133 -4
10 125 -8
(a) Total Product is the Total Output produced by the firm;
(b) Here labour is the only variable input; the firm does not increase amount of capital or land used for production. Thus land and capital are fixed
inputs.

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Explaining Law of Diminishing MP

 Note that after 3rd unit of Labour, MP starts to fall and keeps
falling - Why?
 Think of the case of 1 computer lab with 4 computers.
 Initially as you hire 2nd or 3rd or 4th worker,
I Each person’s productivity goes up
I This could be because they can now do group work and better
utilize the existing resources.
I Thus MP is rising.
 But as you start to hire the 5th or the 6th guy, now they have to
share the 4 computers
I Each person has less time to work on his computer.
I As you put in more and more Labour and have them share one
lab, there may be more fights/arguments.
I Each labour is now less productive.
I Thus each person’s contribution starts to fall ⇒ MP is falling.
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Explaining Law of Diminishing MP

 So why does MP of labour ULTIMATELY fall?

I It is because more and more labour is being combined with fixed
amount of Land and Labour.

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Total Product and Marginal Product

 Note that the TP can actually be sketched using information on MP.

 In the table on previous slide, note that MP starts from a very high
number, falls to zero and then becomes negative.
 Recall that MP is simply the slope of the TP curve.
 So if we sketch the slopes ⇒ as slope goes from steep to flat ⇒ slope value
goes form infinity to zero ⇒ a falling slope means a falling MP
 Thus, we have shown the law of diminishing returns on the TP curve.

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Deriving Marginal Product from Total Product Curve

 The MP curve can be derived from the

TP curve by looking at the behaviour of
the slopes.
 First slope increases, reaches a
maximum, and then starts to fall until it
finally becomes flat (slope value=0) and
then slopes downwards (slope
value=negative)
 Thus the mirroring Marginal product
follows the same pattern first reaching a
peak at A and then falling until it hits
zero (on the x -axis) and then becoming
negative.

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Relating Marginal Product to Marginal Cost

 MC curve derived from the MP curve -

How?
∆TC
 MC =
∆Q
 Before some point, say A, MP is rising.
This means:
I TC is ↑ but Q is ↑ MORE because
of increasing MP.
I Since ↑ Q >↑ TC ⇒ MC ↓.
 After point say A, MP is falling. This
means:
I TC is ↑ but Q is ↑ LESS because
of decreasing MP.
I Since ↑ TC >↑ Q ⇒ MC ↑.
 Thus we see is MC is mirror image of
MP.
 Shape of MC determined by Law of
diminishing MP.
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A Deep Dive into Costs

Table 2: Cost of Production

Q TFC TVC TC AFC AVC ATC/AC MC

0 $100 $0 $100 - - - -
1 100 50 150 $100.00 $50.00 $150.00 $50
2 100 80 180 50.00 40.00 90.00 30
3 100 100 200 33.33 33.33 66.67 20
4 100 110 210 25.00 27.50 52.50 10
5 100 130 230 20.00 26.00 46.00 20
6 100 160 260 16.67 26.67 43.33 30
7 100 200 300 14.29 28.57 42.86 40
8 100 250 350 12.50 31.25 43.75 50
9 100 310 410 11.11 34.44 45.56 60
10 100 380 480 10.00 38.00 48.00 70

 Fixed Cost - the cost of fixed input such as rent on factory space - does not change with
output.
 Variable Cost (VC) - say the wage of each labour is $20 ⇒ as add each extra worker, VC
goes up by $20.
FC VC TC TFC + TVC
 TC = FC + VC k AFC = k AVC = k ATC = = = AFC + AVC
Q Q Q Q
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Total Cost Curves

 This figure gives an overview of different  TVC starts at origin - Why? because
types of total costs. when produce nothing, firm is not hiring
labour or raw materials ⇒ so cost of
variable inputs=0.

 TVC first increases at decreasing rate,

 TFC Curve - horizontal line - Why?
I Whether firm produces 0 units, 5
units or 10 units, TFC remains the
same ($ 100).
then increases at increasing rate.
I Because MC firts falls and then
rises - Why?
I MC influenced by MP curve
(Diminishing MP)
 TC = TVC + TFC
 TC starts at 100, because when
Q = 0, TC = 100 + 0
 TC shape - influenced by share of TVC
I So TC first increases at decreasing
rate and then increases at
increasing rate.

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Shape of TC curve

 What do we mean when we say “TC first increases at decreasing

rate and then at a increasing rate”
 Compare TC before and after X (refer to class diagram)
 First look at TC before some quantity X
∆TC
I Note that slope of TC = which is actually the MC.
∆Q
I Before X, we see that slope is getting flatter.
I Slope value is falling from infinity to zero
I So, slope of TC = MC is falling.
 First look at TC after some quantity X
I After X, we see that slope is getting steeper.
I Slope value is rising from zero to infinity.
I So, slope of TC = MC is rising.

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Average Cost Curvers

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Average Cost Curves - Explained

 Rising marginal costs - why? because of law of diminishing MP

(covered this in previous slides)
 AFC is falling as produce more output - a fixed amount is spread
over larger and larger output.

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Shrinking gap between ATC and AVC

 Let’s rewrite the expression for ATC:

ATC = AFC + AVC

or, ATC − AVC = AFC

 So the gap between ATC and AVC is
simply the AFC.
 So, at low levels of output, say Qlow ,
since AFC is very BIG, gap between ATC
and AVC is big.
 On the other hand, at higher levels of
output, say Qhigh , since AFC is smaller,
the gap between ATC and AVC is
smaller.

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Why is ATC U-shaped?

 ATC = AFC + AVC

I ATC depends on the
relative strength of AFC
and AVC.
 At low levels of output
I AFC is big and AVC is small
⇒ AFC > AVC
I AFC will determine what happens
to ATC
I Since AFC is falling, it pulls ATC
down.

 At high levels of output

I AVC is big and AFC is small
⇒ AVC > AFC
I AVC will determine what happens
to ATC
I Since AVC is rising, it pulls ATC
down.

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Relating MC and ATC

 Why does MC intersect ATC at its minimum - math!

 When MC < ATC, it pulls down the average.
 When MC > ATC, it pull up the average.
 Thus, the only place where MC can intersect the ATC curve is
at its minimum!
 For details refer to the online video I uploaded.

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