Robert F. Mulligan WESTERN CAROLINA UNIVERSITY COLLEGE OF BUSINESS Department of Economics, Finance, & International Business

MBA 505 ECONOMICS AND PUBLIC POLICY

Chapter 7 COST ANALYSIS

FUNDAMENTAL QUESTIONS
1. What is the law of diminishing marginal returns?
2. What is the relationship between costs and output in the short run? 
3. What is the relationship between costs and output in the long run?

Key Terms

total physical product (TPP)	marginal costs (MC)	average variable costs (AVC)
law of diminishing marginal returns	total fixed costs (TFC)	short-run average total cost (SRATC)
average physical product (APP)	total variable costs (TVC)	long-run average total cost (LRATC)
marginal physical product (MPP)	total costs (TC)	scale
average total costs (ATC)	average fixed costs (AFC)	economies of scale
constant returns to scale	minimum efficient scale (MES)	diseconomies of scale

1. Firms and Production
A business firm is an organization that brings together different resources to produce a product or service and is controlled by a single management.

A business firm can be very small, for example, the neighborhood barbershop, or very large, for example, GM or IBM.

1.a. The relationship between output and resources: Total physical output is the maximum output that can be produced when variable resources are added to fixed amounts of other resources. This is short-run analysis. The short run is defined as the period of time in which at least some inputs must be held fixed.

An airline can provide different numbers of passenger miles with different combinations of mechanics and airplanes. Either can be the fixed input in the short-run. Normally the number of planes is fixed in the short run, but mechanics could be hired or laid off.

1.b. Diminishing marginal returns: The law of diminishing marginal returns states that when successive equal amounts of a variable resource (labor) are combined with a fixed amount of a fixed resource (capital), increases in output will eventually decline. The law of diminishing returns can be portrayed by the average physical product and the marginal physical product. The average physical product is the total output divided by the quantity of variable resources used to make that output. The marginal physical product is the additional output produced by an additional unit of the variable resource.

An illustration of diminishing marginal returns: the productivity of studying late into the night diminishes the longer one studies.

1.b.1. Average and Marginal
An average is the sum of some items divided by the number of items. A marginal quantity is the items which are averaged. If you have a series of exam scores from a course, the marginal (last) exam score raises your course average if it is above the average, and lowers it if it is below the average. This is true for each exam taken.

2. From Production to Costs

2.a. The calculation of costs: The cost of production is determined by the firm’s production capabilities and the price of inputs. Cost curves are mirror images of production curves. The various types of cost curves show the relationships between costs and output produced.

If a local pizzeria owner could have earned a salary managing Burger King instead of owning the pizzeria, the owner earns an economic profit only if the pizzeria (accounting) profits are greater than the Burger King manager's salary (opportunity cost.) The difference is the economic profit.

2.b. The U shape of cost curves: MC and ATC curves are U shaped. They decline because of scale economies and rise at higher output levels because of diminishing marginal returns, at least in the short-run.

Geoffrey Gerdes's Perfectly Competitive Firm JAVA Applet  Note the characteristic shape of the MC, ATC, and AVC curves

3. Cost Schedules and Cost Curves

3.a. An example of costs: Total fixed costs are the costs that must be paid whether the firm produces or not. Total variable costs are the costs that rise or fall as production rises or falls. Total costs = TFC + TVC.

Average total costs = TC/Q. Average variable costs = VC/Q. Average fixed costs = FC/Q. Marginal costs are the additional costs that come from producing one more unit of output.

4. The Long Run

The long run is a productive period in which all resources are variable.

4.a. Economies of scale and long-run cost curves: The long-run average cost curve is a series of short-run average cost curves. Economies of scale occur if unit costs decrease when all resources are variable. Diseconomies of scale occur if unit costs increase when all resources are variable.

4.b. The reasons for economies and diseconomies of scale: Some firms can benefit from greater specialization as they increase scale. Size can cause diseconomies of scale if it causes organizational inefficiency.

4.c. The minimum efficient scale. The MES is the level at which the LRATC first reaches a minimum. That is the least cost level of production.

4.d. The planning horizon

The MES size of steel firms in the former Soviet Union is much greater than for a small country like Sri Lanka because the demand for a product must be large enough so that the firm can operate at the MES point of production.

Opportunities for Discussion

1. List firms that you feel have small, moderate, and large MES points and discuss why the differences occur.

2. Why is the LRATC for an auto producer U shaped?

3. Why do public utilities like Duke Energy or CP&L tend to experience economies of scale at all output levels?