Chapter 22

The Firm:
Cost and Output
Determination
Short Run versus Long Run
• Short Run : A time period when at least one input, such as plant size, cannot be
changed . ( Plant Size The physical size of the factories that a firm owns and operates
to produce its output

• Long Run : The time period in which all factors of production can be varied

The Relationship Between Output and Inputs

• Production : Any activity that results in the conversion of resources into products that can be
used in consumption

• Production Function
– The relationship between maximum physical output and the quantity of capital and labor
used in the production process

– technological relationship between inputs and output.

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The Relationship Between Output and Inputs
• A firm takes numerous inputs, combines them using a
technological production process and ends up with output.
• We classify production inputs in two broad categories—labor and
capital.

Output per time period = some function of capital and labor inputs

or
Q = ƒ(K,L)
Q = output / time period / K = capital L = labor

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The Relationship Between Output and Inputs
• Average Physical Product
– Total product divided by the variable input

• Marginal Physical Product

– Definition : The physical output that is due to the addition of one more
unit of a variable factor of production
– The change in total product occurring when a variable input is increased
and all other inputs are held constant
– Also called marginal product

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 Review the examples given in the text book.

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Diminishing Marginal Product
• Law of Diminishing Marginal Product
– The observation that after some point, successive equal-sized increases in
a variable factor of production, such as labor, added to fixed factors of
production, will result in smaller increases in output
• Point of saturation
– Given the amount of fixed inputs, there is no further positive use for more
of the variable input.

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Short-Run Costs to the Firm

• Total Costs
– The sum of total fixed costs and total variable costs
• Fixed Costs
– Costs that do not vary with output and are fixed for a certain period of
time, i.e. rent on a building
• Variable Costs
– Costs that vary with the rate of production, i.e. wages paid to workers
and purchases of materials

Total costs (TC) = TFC + TVC

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Short-Run Costs to the Firm Average Costs

total fixed costs (TFC)

Average fixed costs (AFC) =
output (Q)

total variable costs (TVC)

Average variable costs (AVC) =
output (Q)

total costs (TC)

Average total costs (ATC) =
output (Q)

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Short-Run Costs to the Firm (cont'd)

• Marginal Cost
– The change in total costs due to a one-unit change in
production rate

change in total cost

Marginal costs (MC) =
change in output

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Long-Run Cost Curves
• Planning Horizon
– The long run, during which all inputs are variable

• Long-Run Average Cost Curve

– The locus of points representing the minimum unit cost of
producing any given rate of output, given current
technology and resource prices

• Planning Curve
– The long-run average cost curve.

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Preferable Plant Size and the Long-Run Average Cost Curve

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 Why the Long-Run Average Cost Curve is U-
Shaped

• Economies of scale
• Constant returns to scale
• Diseconomies of scale

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Why the Long-Run Average Cost Curve is U-
Shaped (cont'd)
• Economies of Scale
– Decreases in long-run average costs resulting from increases
in output
• These economies of scale do not persist indefinitely, however.
• Once long-run average costs rise, the curve begins to slope upwards.

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Why the Long-Run Average Cost Curve is U-
Shaped (cont'd)
• Reasons for economies of scale
– Specialization
• Division of tasks or operations

– Dimensional factor
• Large-scale firms often require proportionately less input per unit of
output

– Improved productive equipment

• The larger the enterprise, the more the firm can take advantage of
larger-volume types of machinery.

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 If the annual interest rate remains unchanged over the next two years, and
the present value of ₪120 to be received one year from now is ₪100,
what will ₪100 be worth two years from now?

A) ₪120
B) ₪140
C) ₪144
D) Uncertain. We need to know the interest rate.

Suppose a family-owned grocery has ₪80,000 in total revenues, ₪36,000 in rent, and ₪20,000 in
additional operating costs. The husband and wife work in the shop and pay no wages to themselves or
others. The economic profits from the shop are
A) ₪2424,,000
000..
B) less than ₪2424,,000
000..
C) more than ₪24 24,,000
000..
D) ₪8080,,000
000..

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Calculate the yearly accounting and economic profit :
1. Paid utilities ( Electricity and water ) 2200 NIS per
month.
2. Paid monthly salaries of about 1500 NIS for each of his
three workers .
3. Each unit produced costs 8 NIS .
4. He bought machines for the factory paying 100,000 NIS
.
5. At the beginning of the year , he withdrew 30000 NIS
from his account where he used to earn 5% interest
revenue .
6. He sold 3500 units each month at 30 NIS each .
 Calculate the yearly accounting and economic profit :
1. Paid monthly salaries of about 9000 NIS .
2. Paid utilities ( Electricity and water ) 12000 NIS per year.
3. He bought machines for the factory paying 50,000 NIS .
4. At the beginning of the year , he withdrew 50000 NIS from
his account where he used to earn 10% interest revenue .
5. Each unit produced costs 15 NIS .
6. He sold 11000 units each month at 25 NIS each .
7. He used his stores as his factory estimated at 2500 NIS per
month.

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