Lecture Principles of Microeconomics: Chapter 8 - James D. Miller

Lecture Principles of Microeconomics - Chapter 8: Costs. After reading this chapter, you should be able to answer the following questions: What are different types of costs? What is diminishing marginal returns? Why do marginal costs increase? Why is the average total costs curve U-shaped? What is the relationship between the average total costs curve and marginal costs curve? What is the difference between short run and long run? What are economies and diseconomies of scale?

Chapter 8

Costs

Learning Objectives

• What are different types of costs?

• What is diminishing marginal returns?

• Why do marginal costs increase?

• Why is the average total costs curve U-shaped?

• What is the relationship between the average

total costs curve and marginal costs curve?

• What is the difference between short run and

long run?

• What are economies and diseconomies of

scale?

Costs: Economic Terms

• Output = number of goods produced

• Variable inputs = inputs that can be changed

• Variable costs = costs that vary with output

• Total costs = fixed costs + variable costs

• Marginal costs = the extra cost of making one

Average Costs

Output costs

Variable 

 Output costs

Fixed 

 Output costs

Total

Output

Costs  

Total  

   costs  

Total  

Average

Total Costs = Fixed Costs + Variable

Costs

Average Costs

Output   Costs

Fixed  

   Costs  

Fixed  

Average

Output

Costs  

Variable  

   Costs  

Variable  

Average

Average Total Costs

= Average Fixed Costs + Average Variable Costs

Rocket Ship vs Space Elevator

Fixed Costs Variable

Rocket Ship $1 billion Output

X $10 million

$1 billion + (Output

X $10 million)

Space

Elevator $50 billion Output X $1,000 $50 billion+ (Output

X $1,000)

Costs For Rocket Ship

Output Average Fixed

Costs

=

Average Variable Costs

=

Average Total Costs

= Average Fixed Costs + Average Variable Costs

1 $1 billion $10 million $1.01 billion

$1

output

) million 10

)($

output (

Costs For Space Elevator

Output Average Fixed

Costs

=

Average Variable Costs

=

Average Total Costs

= Average Fixed Costs + Average Variable Costs

1 $50 billion $1,000 $50 billion + $1,000

10 $5 billion $1,000 $5 billion + $1,000 1,000 $50 million $1,000 $50,001,000

$50

output 1,000) (output)($

Break Even Price

• The break even price represents the

minimum a firm can charge without losing money.

• A firm breaks even when Price = Average Total Costs.

Firms With Constant Marginal Costs

• Average fixed costs

always decrease as

output increases.

• When marginal costs are

constant, average total

costs continually

decrease as output

increases.

• Firms with constant

marginal costs or high

fixed costs benefit from

having many customers.

Firms With High Fixed Costs

• Firms producing goods with high fixed costs and low marginal costs can benefit tremendously from

• To attract international audience firms have to

produce common denominator movies.

Jet fighters:

• Political dilemma of whether to allow foreign sales to

A Fictional Story

In Ixion,

• Land is a fixed input

• Food is grown with both labor and land

• Villich increases only the workforce hoping to

increase output and reduce costs

• As a result, average total costs increase

because output increases by less than expected

• Average fixed costs decrease but average

U-shaped Average Total Costs Curve

• A fixed input causes diminishing marginal returns.

• Diminishing marginal returns cause

increasing marginal costs.

• Increasing marginal costs cause

increasing average variable costs.

• Increasing average variable costs cause the average total costs curve to be U-

shaped.

Diminishing Marginal Returns

• With one input fixed,

diminishing marginal

returns to the other

input occurs when

one receives lower

and lower benefits

from increasing the

amount of that input

used.

• When the amount of

land is fixed, workers

are subject to

diminishing marginal

Number

of workers

Bushels of wheat

production per year

Marginal benefits

of last worker hired.

Increasing Marginal Costs

• When production is subject to diminishing marginal returns, each additional increase

in output requires more and more input.

• Hence, each additional output increases additional cost of production

• If marginal costs are increasing then the

cost of each new good is higher than the last, so average variable costs increase as well.

U-shaped Average Total Costs Curve

• Increase in marginal

costs cause increase in

average variable costs.

• At some point, increase in

average variable costs is

greater than the decrease

in average fixed cost.

• With increasing output,

average total costs first

go down but then go up.

Too few workers

Too many workers

Average total costs

B A

Costs

Output Per Month

Relationship Between Marginal Cost

and Average Total Cost

• When marginal costs

are below average total

costs, then average total

costs must be falling.

• When marginal costs

are above average total

costs, then average total

costs must be

increasing.

• Marginal costs curve

always goes through the

lowest point on the

average total cost curve.

Marginal costs > Average Total Costs

Marginal costs <

Average Total Costs

Output Per Month

Marginal costs

Average total costs

Costs

Diminishing Marginal Returns

and Starvation

• Thomas Malthus predicted that the human

population would increase at a faster rate than the food supply, making starvation almost

inevitable

• Malthus believed in diminishing marginal returns

to agriculture because land is a fixed input

• Malthus proved to be wrong because of

innovations in agriculture

• The gains from agricultural innovations have

more than outweighed the harm of diminishing marginal returns

Diminishing Marginal Returns

and Innovation

• Neo-Malthusians predict disaster With the fixed inputs of the earth, if the human population

increases and nothing else changes, human

economic activity will become subject to

diminishing marginal returns

• In the long run, innovations can effectively

multiply the existing supply of fixed inputs

• The “invisible hand” of the market can overcome problems caused by fixed inputs

Short Run vs Long Run

• The short run is the time period when firms

cannot change fixed inputs Only variable inputs can be changed, e.g number of workers

• The long run is the time period when firms can change fixed as well as variable inputs and

Long Run Analysis

• In the long run, for any given level of output, a firm will choose its fixed input to minimize its

average total costs

• For any given level of output, the long run

average total costs are the lowest short run

average total costs for that level of output

• A firm’s long run average total costs curve

consists of the low points on its short run

average total costs curves

Constant Returns to Scale

= When long run

average total costs

Economies of Scale

= When long run average

total costs decrease as

• Costs that don’t increase,

even in the long run as

output expands, can

cause economies of

scale.

Diseconomies of Scale

= When long run average

total costs increase as

can arise when a firm

must use inferior inputs to

expand or government

regulations regarding

is increased, there is overcrowding and benefits of

increasing the variable input keep falling.

• Why do diminishing marginal returns cause increasing marginal costs?

When production is subject to diminishing marginal

returns, each additional increase in output requires more and more input Hence, marginal cost keeps increasing

Do You Know?

• Why was Malthus wrong?

Malthus proved to be wrong in predicting

mass-starvation because he did not expect agricultural

innovations to outweigh the harm of diminishing marginal returns.

• Why do we expect sometime to observe economies of scale?

Increase in all inputs allows division of labor and

specialization Specialization leads to increase in

production As a result, long run average total costs

exhibit economies of scale.

Summary

• Fixed costs = costs that are the same regardless of

output

• Variable costs = costs that vary with output.

• Marginal costs = the extra cost of increasing output by one.

• Total costs = fixed costs + variable costs.

• Average fixed costs =

• Average variable costs =

• Average total costs = average fixed costs + average

• Typical average total costs curve is U-shaped.

• Marginal costs curve goes through the low point on the average total costs curve.

• In the short run firms cannot innovate or change fixed inputs; in the long run they can.

• The long run average total costs curve consists of the low points on all the short run average total costs curves.

Coming Up

How do firms produce in perfect

competition?