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?

Teaching Objectives

The primary purpose of this chapter is to introduce students to production and cost theory from the perspective of short- and long-run analysis. Whereas Chapter 20 dealt with the demand side of the market, this chapter deals with supply.

The unique features of this chapter include the explanation of the difference between economic and accounting costs and the discussion of minimum efficient scale of production.

The concepts that warrant special coverage because of their complexity are the construction of the TPP, APP, and MPP curves and the short- and long-run cost curves. Special care is needed to show how the law of diminishing marginal returns produces the shapes of these curves and how average and marginal curves are related. An emphasis on the relation between MPP and MC and between APP and AC will pay off later.

Production and cost analysis are relied on heavily in the discussion of the different market structures in later chapters. Also incorporated is a previous discussion of opportunity costs.

Key Term Review

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

Lecture Outline and Teaching Strategies

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.

Teaching Strategy: Explain that 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.

Teaching Strategy: Carefully construct Figure 3(a) from the data given in the chapter. The students need both the text and your lecture to review. Track the airline examples presented in the text in this section.

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.

Teaching Strategy: Carefully construct Figure 3(b). Demonstrate the concept of diminishing marginal returns by asking students how the productivity of studying late into the night diminishes the longer one studies.

1.b.1. Average and Marginal

Teaching Strategy: To illustrate the relationship between average and marginal, list a series of exam scores from a course and relate the marginal (last) exam score to the course average 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.

Teaching Strategy: Discuss the economic profit of a local pizzeria owner if the owner could have earned a salary managing Burger King instead of owning the pizzeria.

2.b. The U shape of cost 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.

Teaching Strategy: Carefully draw Figure 6(a) in class.

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.

Teaching Strategy: Carefully draw Figure 6(b) in class.

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.

Teaching Strategy: Construct carefully Figures 9(a), 9(b), and 9(c) to demonstrate different-shaped LRATCs.

4.b. The reasons for economies and diseconomies of scale

Teaching Strategy: Cite reasons from actual companies, for example, Ford, AT&T, IBM, Toyota, as to why the LRATC would be U-shaped.

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.

Teaching Strategy: Draw LRATCs for three firms-one at the upper end, for example, refrigerators; one in the middle, for example, paperboard; and one at the lower end, for example, shoes. Show where the MES is located in each LRATC.

4.d. The planning horizon

Teaching Strategy: Discuss MES sizes of steel firms in the former Soviet Union and Sri Lanka, as given in 4.d. Stress that the demand for a product must be large enough so that the firm can operate at the MES point of production.