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Chapter 7

ECON-UA 2 Chapter Notes - Chapter 7: Diminishing Returns, Sunk Costs, Active Valve Control System

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Marc Lieberman

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Chapter 7: Production & Cost
1. Production is the process of combining inputs to make goods & services
a. Inputs include the four resources
2. Technology & Production
a. A firm’s technology refers to the methods it can use to turn inputs into outputs
(produced goods or services)
i. Assume firm will choose cheapest method
3. Short-run Vs. Long-run decisions
a. Adjustments on the amount of inputs used depend on the time horizon the firm’s
managers are thinking about
b. Long Run: time period long enough for a firm to change the quantity of all its
i. All the inputs the firm uses are viewed as variable inputs: can be adjusted
up or down as desired
c. Short Run: a time period during which at least one of the firm’s inputs is fixed
4. Production in the Short Run
a. Total Product: maximum quantity of output that can be produced from a given
combination of inputs
b. Marginal Product of Labor: change in total product divided by the number of
workers employed
i. Tells us the rise in output when produced when one more worker is hired
5. Marginal Returns to Labor
a. Typical pattern in many firms is that MPL first increases as more workers are
hired, and then decreases
b. Increasing Marginal Returns to Labor
i. Additional workers may allow production to become more specialized
c. Diminishing Marginal Returns to Labor
i. MPL is still positive but the rise in output is smaller & smaller w/each
successive worker
ii. Each worker will have less of the fixed inputs w/which to work
iii. Law of Diminishing (marginal) returns: as we continue to add more of any
one input (holding others constant), its marginal product will eventually
6. Thinking about Costs
a. A firm’s total cost of producing a given level of output is the opportunity cost of
the owners - everything they must give up in order to produce that amount of
b. The Irrelevance of Sunk Costs
i. Sunk Cost: a cost that has already been paid, or must be paid, regardless
of any future action being considered
1. Ex. You already bought the ticket to a concert but are now unsure
whether to go or no - the price of the ticket is a sunk cost
2. Should not be considered when making decisions
7. Explicit Vs. Implicit Costs
a. A firm’s “cost” is its opportunity cost, which include both implicit & explicit costs
b. Explicit cost: anything involving actual payments
i. Rent paid out, interest on loans, managers’ salaries, hourly workers’
wages, cost of raw materials
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c. Implicit: foregone rent, foregone interest, foregone labor income
i. Mistakes w/foregone interest
1. The initial investment is only paid out once, so as long as you own
the business, the interest that could be earned on that initial
investment is an ongoing, yearly cost
a. Ex. $5000 per year if the going interest rate is 5% of the
initial investment of $100,000
2. If conditions change, some of the foregone interest on the initial
investment can become a sunk cost
a. Ex. invest $100,000 to open a restaurant, and then the
restaurant industry falls out of favor. If you sell now, you
will only get $40,000. Then the ongoing interest cost of
owning the business has just dropped to $2,000 per year—
the interest forgone on $40,000 at 5 percent. The leftover
$60,000 is sunk
8. The Least-cost Rule
a. A business firm will produce any given output level using the least-cost
combination of inputs available to it
i. In the long run, more choices are available to the firm
ii. Any given level of input should be produced at the lowest possible cost
for that output level
9. Cost in the Short Run
a. Fixed Costs: costs of a firm’s fixed inputs that remain the same no matter what
the level of output
i. Typically, rent & interest
ii. Overhead costs
b. Variable Costs: costs of obtaining the firm’s variable inputs
i. Rises as output increases
ii. Wages of hourly employees, costs of raw materials
10. Measuring Short-run Costs
a. Total Cost (TC): sum of all the fixed & variable costs
i. Total Fixed Cost (TFC): cost of all inputs that are fixed
ii. Total Variable Cost (TVC): cost of all variable inputs
b. Average Costs
i. Average Fixed Cost (AFC): total fixed cost divided by the output
1. Will always fall as output rises
2. “Spreading their overhead”
ii. Average Variable Cost (AVC): cost of the variable inputs per unit of output
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iii. Average Total Cost (ATC): total cost per unit of output
1. U shaped
2. At each level of output, the vertical distance b/w AVC & ATC is
equal to AFC
a. AFC declines as output increase
b. s, so ATC & AVC get closer & closer as output increases
c. Marginal Cost: change in total cost divided by the change in output
i. Tells us how much cost rises per unit increase in output
ii. U shaped, reflects first increasing & then diminishing marginal returns to
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