Economics 1021A/B Lecture Notes - Average Cost, Average Variable Cost, Sunk Costs
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Nov 7, 2011
Economics – Lecture #15
Decision Time Frames
The firm makes many decisions to achieve its main objective: profit maximization.
Some decisions are critical to the survival of the firm.
Some decisions are irreversible (or very costly to reverse).
Other decisions are easily reversed and are less critical to the survival of the firm, but still
All decisions can be placed in two time frames:
The short run
The long run
The short run is a time frame in which the quantity of one or more resources
used in production is fixed.
For most firms, the capital, called the firm’s plant, is fixed in the short run.
Other resources used by the firm (such as labour, raw materials, and energy) can
be changed in the short run.
o Short-run decisions are easily reversed
The long run is a time frame in which the quantities of all resources—including
the plant size—can be varied.
o Long-run decisions are not easily reversed.
A sunk cost is a cost incurred by the firm and cannot be changed.
o If a firm’s plant has no resale value, the amount paid for it is a sunk cost.
o Sunk costs are irrelevant to a firm’s current decisions.
Short-Run Technology Constraint
To increase output in the short run, a firm must increase the amount of labour employed.
Three concepts describe the relationship between output and the quantity of labour
1. Total product
2. Marginal product
3. Average product
Total product is the total output produced in a given period.
The marginal product of labour is the change in total product that results from a
one-unit increase in the quantity of labour employed, with all other (capital)
inputs remaining the same.
The average product of labour is equal to total product divided by the quantity of
Nov 7, 2011
Table 11.1 shows a firm’s product schedules.
As the quantity of labour employed increases:
Total product increases.
Marginal product increases initially but eventually
Average product increases initially but eventually
Product curves are graphs of the three product concepts that show how total product,
marginal product, and average product change as the quantity of labour employed
Total Product Curve
Figure 11.1 shows a total product curve.
The total product curve shows how total product
changes with the quantity of labour employed.
o Increases at an increasing rate
o Increases at a decreasing rate
The total product curve is similar to the PPF.
It separates attainable output levels from unattainable
output levels in the short run.
Marginal Product Curve
Figure 11.2 shows the marginal product of labour curve
and how the marginal product curve relates to the total
o The first worker hired produces 4 units of output.
o The second worker hired produces 6 units of
output and total product becomes 10 units.
Nov 7, 2011
The height of each bar measures the marginal product of labour.
For example, when labour increases from 2 to 3, total product increases from 10
so the marginal product of the third worker is 3 units of output.
To make a graph of the marginal product of labour, we
can stack the bars in the previous graph side by side.
The marginal product of labour curve passes through
the mid-points of these bars.
Almost all production processes are like the one shown
here and have:
o Increasing marginal returns initially
o Diminishing marginal returns eventually
Increasing Marginal Returns Initially
o When the marginal product of a worker exceeds
the marginal product of the previous worker, the
marginal product of labour increases and the firm experiences increasing
Diminishing Marginal Returns Eventually
When the marginal product of a worker is less than the marginal product of the
previous worker, the marginal product of labour decreases.
The firm experiences diminishing marginal returns.
Increasing marginal returns arise from increased specialization and division of labour.
Diminishing marginal returns arises from the fact that employing additional units of
labour means each worker has less access to capital and less space in which to work.
Diminishing marginal returns are so pervasive that they are elevated to the status of a
The law of diminishing returns states that:
As a firm uses more of a variable input with a given quantity of fixed inputs, the marginal
product of the variable input eventually diminishes.
Average Product Curve
Figure 11.3 shows the average product curve and its
relationship with the marginal product curve.
When marginal product exceeds average
product, average product increases.
When marginal product is below average
product, average product decreases.
When marginal product equals average
product, average product is at its maximum.