Summary
The Production Function
- 1. The relationship between inputs and output is represented by a firm’s production function. In the short run, the quantity of a fixed input cannot be varied but the quantity of a variable input, by definition, can. In the long run, the quantities of all inputs can be varied. For a given amount of the fixed input, the total product curve shows how the quantity of output changes as the quantity of the variable input changes. The marginal product of an input is the increase in output that results from using one more unit of that input.
- 2. There are diminishing returns to an input when its marginal product declines as more of the input is used, holding the quantity of all other inputs fixed.
Firm Costs
- 3. Total cost, represented by the total cost curve, is equal to the sum of fixed cost, which does not depend on output, and variable cost, which does depend on output. Due to diminishing returns, marginal cost, the increase in total cost generated by producing one more unit of output, normally increases as output increases.
- 4. Average total cost (also known as average cost) is the total cost divided by the quantity of output. Economists believe that U shaped average total cost curves are typical because average total cost consists of two parts: average fixed cost, which falls when output increases (the spreading effect), and average variable cost, which rises with output (the diminishing returns effect).
- 5. When average total cost is U-shaped, the bottom of the U is the level of output at which average total cost is minimized, the point of minimum-cost output. This is also the point at which the marginal cost curve crosses the average total cost curve from below. Due to gains from specialization, the marginal cost curve may slope downward initially before sloping upward, giving it a “swoosh” shape.
Long-Run Costs and Economies of Scale
- 6. In the long run, a firm can change its fixed input and its level of fixed cost. By accepting higher fixed cost, a firm can lower its variable cost for any given output level, and vice versa. The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost at each level of output. A firm moves along its short-run average total cost curve as it changes the quantity of output, and it returns to a point on both its short-run and long-run average total cost curves once it has adjusted fixed cost to its new output level.
- 7. As output increases, long-run average total cost changes. There are increasing returns to scale if long-run average total cost falls as output rises; decreasing returns to scale if long-run average cost rises as output rises; and constant returns to scale if long-run average total cost does not change as output rises.