Decision Time Frames
To study the relationship between a firm’s output decisions and its costs, we use two decision time frames.
Short run: A time frame in which the quantity of at least one factor of production is fixed.
o For most firms: capital, land and entrepreneurship are fixed, while labour is the variable factor of production.
o To increase output in the short run, firms must increase the quantity of variable factor of production.
o Decisions are reversed easily.
o Fixed Plant: A firm’s fixed factor of production
Long run: A time frame in which the quantities of all factors of production can be varied.
o To increase output in the long run, firms can change their plants as well as the quantity of labour
o Decisions are not easily reversed.
o Sunk cost: Past expenditure on a plant that has no resale value, and is irrelevant to the firm’s current decisions
Short-Run Technology Constraint
Total product (TP): Maximum output that a given quantity of labour can produce
o The TP curve separates what is attainable from what is unattainable.
o The points on the TP curve are technologically efficient.
Marginal product (MP): Increase in total products that result from a one-unit increase in the quantity of labour.
o Measured by the slope of the TP curve.
o Height of the MP curve measures the slope of the TP curve.
o Increasing marginal returns:
Occurs when the MP of an additional worker exceeds the MP of the previous worker
Arises from increased specialization and division of labour in the production.
o Decreasing marginal returns:
Occurs when the MP of an additional worker is less than the MP of the previous worker
Arises because more and more workers are using the same capital and working space.
All products eventually reach a point of diminishing marginal returns.
Law of diminishing returns: As a firm uses more of a variable factor of production with a given
quantity of the fixed factor of production, the MP of the variable factor eventually diminishes.
Average product (AP): TP divided by the quantity of labour employed.
o When MP exceeds AP, AP is increasing.
o When MP is less than AP, AP is decreasing.
o When MP equals AP, AP is at its maximum.
Product curve: Graphs of the relationships between employment and the three product concepts Short-Run Cost
o Total cost (TC): The cost of all factors of production.
TC = TFC + TVC
o Total fixed cost (TFC): The cost of the firm’s fixed factors.
Does not change as output increases or decreases (horizontal curve).
Normal profit: The opportunity cost of running a business.
o Total variable cost (TVC): The cost of the firm’s variable factors.
Changes as output increase or decreases.
Since labour is the largest factor of production, wage makes a large component of TVC.
Marginal cost (MC): The increase in total cost that result from a one-unit increase in output.
o Calculated as the increase in total cost divided by the increase in output.
o Average total cost (ATC): The total cost per unit of output.
ATC = AFC + AVC
ATC curve is U shaped. This is because of two opposing forces:
Spreading TFC over a larger output decreases AFC.