Chapter 22 & 23

THEORY OF THE FIRM:Cost of Production

Cost

• Economists and accountants use the term "cost" to mean different although related things.

• Economists include Opportunity Costs (weirdos!)

Opportunity Cost

• The economic benefits (Utility) that you did without because you bought (or did) that particular something and thus can no longer buy (or do) something else.

Opportunity Cost

• The opportunity cost of moving from point B to point C in the above graph is equal to 25 units of clothing.

2 types of costs

A) Explicit Costs: clear, obvious cash outflows

B) Implicit Costs: The costs associated with an action’s tradeoff. (i.e. opportunity costs)

Economists’ Total Cost =

Explicit + Implicit Costs

Is It An Explicit or Implicit Cost?

1. Oil a car repair shop uses.

2. Bonus an executive gets

3. A bad review a new movie gets

4. A antique dealer chooses between a show in NYC or one in DC, they went to NYC. Cost of hotel is NYC is a ___ Cost

Those crazy economists!

Accounting Profit = Total Revenue – Explicit Costs

Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)

Example of Economic Profit

• Normal Profit aka Accounting Profit:

Revenue (sales) -cost of NYC hotel, dinner, shopping & cabs.

• Economic Profit = Total

Revenue - {(cost of NYC hotel, dinner, shopping & cabs) + cost of DC hotel, dinner, shopping & cabs

Short Run vs Long Run:

• Short run: period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.

• Long run: period of time in which the quantities of all inputs can be varied.

Short Run: Can’t Change Production Costs

• Short Run: no time to alter ALL the means of production; at least one Cost is a Fixed Cost.

• Short Run Adjustments: Labor +, readily available inputs +

• In the Long Run: ALL costs are Variable Costs.

• Long Run Adjustments: Build Buildings, etc.

Law of Diminishing Returns i.e ‘too many cooks in the kitchen’

• If one factor of production (number of workers, for example) is increased while other factors (machines and workspace, for example) are held constant, the resulting increase in output will level-off after some time and then decline.

i.e. Workers

Diminishing Returns occurs at ________.

Marginal Product of 6th worker is _______.

Like Law of Diminishing Marginal Utility

• At some point one more unit of production actually creates negative output.

• i.e. too many cooks in the kitchen

Example of Law of Diminishing Returns

• Suppose that one kilogram of seed applied to a plot of land of a fixed size produces one ton of crop.

• You might expect that an additional kilogram of seed would produce an additional ton of output. However, if there are diminishing marginal returns, that additional kilogram will produce less than one additional ton of crop (ceteris paribus).

• The 2nd kilogram of seed may only produce a half ton of extra output.

• A 3rd kilogram of seed will produce an additional crop that is even less than a half ton of additional output, say, one quarter of a ton.

Fixed Cost:

• Fixed costs are costs that are independent of output. At zero output these costs still exist.

• Examples: rent, buildings, machinery, insurance

Fixed Cost: Lemonade Stand

• Lemonade Stand’s Fixed Costs are: the table, sign, pitcher & cooler (labor can be)

• If Fixed costs are costs that are independent of output.

Variable Cost: (VC)

• Costs that vary with output. • Examples: wages, utilities, materials used in

production, • In the Long Run, all costs are Variable.

Variable Cost: Lemonade Stand

• Lemonade Stand’s Variable Costs are: lemonade, paper cups, (labor could be: commission)

• Costs that vary with output

Total Cost: (TC)

• TC = VC + FC

• In the Long Run as Quantity produced increases, the Fixed Cost per Unit decreases.

• LONG RUN Supply is Elastic: time to adjust to price changes

TC, FC, VC

• In the Short Run as long as Variable Costs are covered by Total Revenue (Price x Quantity) the firm should stay in business (hotel & airplane tickets deals)

Average Total Cost

• the sum of all the production costs divided by the number of units produced.

• ATC = TC

Q

Average Variable Cost

• Total variable cost per unit of output, found by dividing total variable cost by the quantity of output.

• AVC = VC

Q

Average Fixed Cost

• Fixed cost per unit of output, found by dividing total fixed cost by the quantity of output.

AFC = FC

Q

Marginal Cost: (MC)

• Cost of an additional unit of output

• Change in TC with 1 more unit of output

• It is not the same for all levels (economies of scale)

MC = dTC dQ

MC intersects ATC and AVC at theirMinimums.

MC is useful

• MC intersects ATC and AVC at their Minimums

ATC: what it tells us

ATC = TC

Q

• When ATC is declining as output increases, MC < ATC

• When ATC is rising, MC > ATC.

• When average cost is neither rising nor falling (at minimum or maximum),

ATC = MC

Diseconomies of Scale

• Occur when the cost per unit output increases as output rises.

• Occur as a firm grows in size and complexity.

• Not b/c of Diminishing Returns! (i.e. too many cooks in the kitchen)

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Causes Economies of Scale:

A) Purchasing bulk (long-term contracts) B) Managerial (specialization) C) Financial (lower interest charges)D) Marketing (spreading the cost of advertising)

an E) Technological

Each of these factors reduces the Long Run Average Costs (LRAC)

Economies of scaleDiseconomies of Scale

• Exist when the cost per unit output falls as output rises. Economies of scale are due to specialization and division of labor.

* on AC3 Where Firm should produce

*

Constant Return to Scale:

• Outputs change proportionally (1 for 1) with changes in inputs.

Minimum Efficient Scale:

• Output for a business in the long run where the internal economies of scale have been fully exploited. (AC3 optimum level of output).

2 ways to determining profit maximization in the short run

Profit = Total Revenue – Total Cost

Problem:requires knowledge of the firm's Demand curve.

Profit Maximum when Marginal Revenue = Marginal Cost

Competitive Market

Marginal Revenue is the Price of a good

MR = the additional revenue added by an additional unit of output sold

MR = dTR

dQIndividual firms in a

competitive market are price takers, so Demand for competitive market is perfectly elastic.

2nd way to determining profit maximization in the short run

As long as the additional revenue earned from producing another unit of the good exceeds the incremental cost, then profits increase as output expands.

As long as MR > MC, the firm should expand output.

When MR = MC , marginal profit is zero

Marginal Revenue = Marginal Cost

Allocative Efficiency

• the value consumers place on a good or service (reflected in the price they are willing to pay) equals the cost of the resources used up in production.

• Condition required is that price = marginal cost.

• When this condition is satisfied, total economic welfare is maximized.

How much should we make?

• The intersection of the Marginal Cost and the ATC & AVC curves determines production levels.

Breakeven Q & P is where MC = ATC

Shutdown Q & P where MC < AVC

Remember, MR = P for Competitive Markets

As long as MR > or = AVC

When should we throw in the towel?

• Shutdown: the intersection of the Marginal Cost and the Average Variable Cost curves determines the "shut-down" point of production

MC < AVC

Short Run: Economic Profits possible:

• If this is the situation (where P = MR which is > than MC); people will enter the market and bring MR down to MC

All the new people drive MR to MC

• So both the optimal point (no losses and no incentive for new entrants) is where MC intersects ATC curve @ its minimum. Below that, shutdown.

Relationship Between Average Variable Cost and Marginal Cost

• When marginal cost is below average cost, average cost is declining.

• When marginal cost is When marginal cost is above average cost, above average cost, average cost is average cost is increasing.increasing.

• Rising marginal cost Rising marginal cost intersects average intersects average variable cost at the variable cost at the minimum point of minimum point of AVCAVC.. At 200 units of output, At 200 units of output,

AVC is minimum, and AVC is minimum, and MCMC = = AVCAVC..

The 4 types of market structures:

• Perfect Competition: infinite number of producers who are Price Takers farmers

• Monopolistic Competition: the product of one supplier can be differentiated from that of another producer (advertising, color, style). Shoes, restaurants

• Oligopoly: a small number of firms (usually under ten). OPEC, cars

• Monopoly: Vanderbilt, Rockefeller (horizontal & vertical)

The 4 types of market structures:

The number and relative strength of buyers and sellers and degree of collusion among them, level and forms of competition, extent of product differentiation, and ease of entry into and exit from the market.

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The Pure Competition Model

• Purely competitive firms are price takers and make decisions based on marginal cost.

• Because each Supplier’s (price taker) output is small relative to the total market,

• Has a horizontal demand curve for its product. (Perfectly Elastic)

Pure Competition

A market characterized by:• a large number of

independent sellers• standardized products, • free flow of information,• free entry and exit. • each seller is a "price

taker" rather than a "price maker".

Pure Competition Supply Curve:

In the Short Run, Purely Competitive Firms only Supply where MC > AVC

A Purely Competitive firm has a Perfectly Elastic demand curve

• As price rises, consumer has many other options to buy goods.

The demand curve in a purely competitive industry is downward sloping

MR for Perfect Competition

MR = Price

Because they are

Price Takers

The demand curve to a single firm in that industry is perfectly elastic

In a perfectly competitive market structure in the long run

A) Entry of Firms: new entrants appear as soon as profits exist above Marginal Cost which drives profits to zero

B) Exodus of Firms: As soon as profits become negative (losses;) firms disappear (bankrupt) and prices increase to Marginal Cost again

The Pure Competition Model

Helps us understand markets that are somewhat less than "purely" competitive.

The relationship between the decision-making of individual firms and market supply.

No Economic Profits in the Long run.

Monopolistic Competition

• Several or many sellers each produce similar, but slightly differentiated products. Each producer can set its price and quantity without affecting the marketplace as a whole.

• Ex. restaurants

Oligopoly

• a market or industry is dominated by a small number of sellers (oligopolists).

Marginal Revenue for Monopolistic Competition, Oligopoly, Monopoly:

Monopoly Demand Curve

• Is downward sloping, (not perfectly Inelastic).

• I don’t have to buy a monopolist good unless it’s a necessity.

Competitive Market vs the other 3 Market Structures’ Marginal Revenue

MR = Monopoly Marginal Revenue

Pc Competitive Market Marginal Revenue

Deadweight Loss

Monopolists raise prices, cut production: Deadweight Loss

Why Monopolies are bad: Less output at higher prices

The long run supply curve in a constant cost industry

• In the long-run, firms can vary all of their input factors.

The long run supply curve look like in an increasing cost industry

An increase in DEMAND triggers higher production cost as new firms entering the industry bid up the prices of key resources.

Result: an upward shift of the long-run average cost curve.

4 positive results of competitive pricing: 1. Productive Efficiency: P=AC

It is achieved when the output is produced at minimum average total cost (AC).

Refers to a firm's

costs of production and can be applied both to the short and long run.

4 positive results of competitive pricing

2) Allocative Efficiency:

P = MC When the value consumers

place on a good or service (price) equals the cost of the resources used up in production (MC).

When this condition is

satisfied, total economic welfare is maximized.

4 positive results of competitive pricing3) Dynamic Adjustments:

Competitive markets can restore efficiency after a change in the economy (technological change, resources, taste) by reassigning resources.

4 positive results of competitive pricing 4) Invisible Hand:

• Adam Smith: the natural phenomenon that guides free markets and capitalism through competition for scarce resources.

6 shortcomings of the competitive pricing system: 1) Market Failure:

• Spillovers: negative & positive externalities

• Inefficiencies created: over or under production of goods

6 shortcomings of the competitive pricing system: 2) Economies of Scale

• Some firms have increased costs compared to larger firms creating barriers to entry and competition disappears.

6 shortcomings of the competitive pricing system: 3) Diseconomies of Scale

• an increase in size (output) actually causes an increase in production costs.

6 shortcomings of the competitive pricing system: 4) Technological Progress

Most technological advances require additional capital goods.

Some economists claim that perfect competition is not an optimal market structure for high levels of research and development spending as profit margin is negligible in the competitive market.

6 shortcomings of the competitive pricing system: 5) Range of Consumer Choices

pure competition is less likely to earn long run profits that can be reinvested to create new products.

6 shortcomings of the competitive pricing

system: 6) Income Distribution • (Equity) If income is

unequally distributed in an economy, the price system will not change that.

• Whether this is a “shortcoming” or not remains a point of debate among economists.

monopsony

• A monopsony is a firm which is the only purchaser of a good or service.