Firms, Production, and Costs - CSUSAP: Student & …athene.mit.csu.edu.au/~hskoko/subjects/eco110/lect6ho.pdfA firm’s opportunity cost of production is the sum of the explicit costs

McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia

Chapter 9:

Firms, Production, and Costs

9-2McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia

Objectives

After studying this chapter, you will be able to:§ Explain the firm’s economic problem and function§ Explain the relationship between a firm’s output and inputs in

the short run§ Derive and explain a firm’s short-run cost curves§ Explain the relationship between a firm’s output and costs in

the long run and derive its long-run average cost curve


Spinning a Web

§ When Tim Berners-Lee’s invented the World Wide Web in 1990, he paved the way for the creation of thousands of profitable business.

§ There are many different types and sizes of firms producing vast range of goods. But regardless of size all firms must decide how much to produce and how to produce

§ This chapter deals with the economics of the firm – the supply side of the markets for goods and services


The Firm and Its Economic Problem

§ The firm’s goal§ A firm is an institution that hires factors of production and

organises them to produce and sell goods and services.

§ A firm’s goal is to maximise profit.

§ If the firm fails to maximise profits it is either eliminated or bought out by other firms seeking to maximise profit.



§ Measuring a firm’s profit§ Accountants measure cost and profit to ensure that the firm

pays the correct amount of income tax and to show the bank how its loan has been used.

§ Economists measure profit based on opportunity cost andeconomic profit.



§ Opportunity cost§ A firm’s decisions respond to opportunity cost and

economic profit.§ A firm’s opportunity cost of producing a good is the best,

forgone alternative use of its factors of production, usually measured in dollars.§ Opportunity cost includes both: § Explicit costs § Implicit costs



§ Explicit costs§ Explicit costs are costs paid directly in money.

§ The firm can rent capital and pay an explicit rental cost reflecting the opportunity cost of using the capital.

§ Implicit costs§ Implicit costs are costs incurred when a firm uses its own

capital or its owners’ time for which it does not make a direct monetary payment.

§ The firm can also buy capital and incur an implicit opportunity cost of using its own capital, called the implicit rental rate of capital.



§ The implicit rental rate of capital is made up of:§ Economic depreciation

§ Interest forgone

§ Economic depreciation is the change in the market valueof capital over a given period.

§ Interest forgone is the return on the funds used to acquire the capital.



§ The cost of the owner’s resources is his or her entrepreneurial ability and labour expended in running the business.

§ The opportunity cost of the owner’s entrepreneurial ability is the average return from this contribution that can be expected from running another firm. This return is called a normal profit.

§ The opportunity cost of the owner’s labour spent running the business is the wage income forgone by not working in the next best alternative job.



§ Economic profit§ Economic profit equals a firm’s total revenue minus its

opportunity cost of production.

§ A firm’s opportunity cost of production is the sum of the explicit costs and implicit costs.

§ Normal profit is part of the firm’s opportunity costs, so economic profit is profit over and above normal profit.

§ Table 9.1 on page 201 summarises the economic accounting concepts.



§ The firm’s constraints§ Three features of a firm’s environment impose constraints

that limit the profit it can make:1. Technology constraints2. Information constraints3. Market constraints



§ Technology constraints § Technology is any method of producing a good or service. § Technology advances over time. § Using the available technology, the firm can only produce

more if it hires more resources, which will increase its costs and limit the profit of additional output.



§ Information constraints § A firm never possesses complete information about either

the present or the future. § It is constrained by limited information about the quality

and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. § The cost of coping with limited information limits profit.



§ Market constraints § What a firm can sell and the price it can obtain are

constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms. § The resources that a firm can buy and the prices it must pay

for them are limited by the willingness of people to work for and invest in the firm. § The expenditures a firm incurs to overcome these market

constraints will limit the profit the firm can make.


Firms and Markets

§ Markets and firms both coordinate production.§ Chapter 3 explains how demand and supply coordinate the

plans of buyers and sellers.

§ Market coordination of production§ E.g. market transactions such as the many facets of

producing a concert

§ Firm coordination of production§ E.g. capital use and employment of labour


Why Firms?

§ Why are firms sometimes more efficient coordinators of economic activity?

§ Lower transactions costs

§ Economies of scale

§ Economies of scope

§ Economies of team production


Why Firms?

§ Transactions costs § The costs arising from finding someone with whom to do

business, of reaching an agreement about the price and other aspects of the exchange, and of ensuring that the terms of the agreement are fulfilled.


Why Firms?

§ Economies of scale § exist when the cost of producing a unit of a good falls as

output increases.

§ Economies of scope § exist when a firm uses specialised resources to produce a

range of goods and services.

§ Team production § A production process in which the individuals in a group

specialise in mutually supportive tasks.


Decision Time Frames

§ The firm makes many decisions to achieve its main objective: profit maximisation.§ All decisions can be placed in two time frames:

1. The short run2. The long run



1. The Short Run

§ The short run is a time frame in which the quantity of one or more resources used in production is fixed.

§ For most firms, the capital, called the firm’s plant, is fixed in the short run.

§ Other resources used by the firm (such as labour, raw materials, and energy) can be changed in the short run.

§ Short-run decisions are easily reversed.



2. The Long Run

§ The long run is a time frame in which the quantities of allresources—including the plant size—can be varied.§ Long-run decisions are not easily reversed.

§ A sunk cost is a cost incurred by the firm and cannot be changed. § If a firm’s plant has no resale value, the amount paid for it is a sunk

cost.

§ Sunk costs are irrelevant to a firm’s decisions.


Short-Run Technology Constraint

§ To increase output in the short run, a firm must increase the amount of labour employed.

§ Three concepts describe the relationship between output and the quantity of labour employed:§ Total product

§ Marginal product

§ Average product


Total Product, Marginal Product, and Average Product

Total Marginal AverageLabour product product product

(workers (T-shirts (T-shirts per (T-shirts per day) per day) worker) per worker)

A 0 0 -B 1 4 4.00C 2 10 5.00D 3 13 4.33E 4 15 3.75F 5 16 3.20

46321

Table 9.2



§ Product schedules§ Total product is the maximum output that a given quantity

of labour can produce

§ The marginal product of labour is the change in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same.

§ The average product of labour is equal to total product divided by the quantity of labour employed.



§ Product curves§ Product curves are graphs of the three product concepts

that show how total product, marginal product, and average product change as the quantity of labour employed changes.



§ The total product curve§ Figure 9.1 shows a total product curve.

§ The total product curve shows how total product changes with the quantity of labour employed.


Attainable

Total Product Curve

0 1 2 3 4 5Labour (workers per day)

5

10

15 TP

Unattainable

AB

C

D

E FO

utpu

t (T-

shirt

s p

er h

our)

Figure 9.1


Marginal Product Curve

§ Marginal product is also measured by the slope of the total product curve.

§ Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker.


Marginal Product Curve

§ Diminishing marginal returns§ Occur when the marginal product of an additional worker is

less than the marginal product of the previous worker

§ Law of diminishing returns § As a firm uses more of a variable input, with a given

quantity of fixed inputs, the marginal product of the variable input eventually diminishes


Marginal Product

Labour (workers per day)

C

TP

Out

put (

T-sh

irts

per

hou

r)

Labour (workers per day)

Mar

gina

l pro

duct

(T-s

hirts

pe

r hou

r per

wor

ker)

MP

D

The red highlightsthe point of diminishing returns

0 1 2 3 4 5

60

90

25

80

95

0 1 2 3 4 5

5

15

10

25

20

30

35E

F

BA

Figure 9.2


Average Product Curve

§ When marginal product exceeds average product, average product increases.

§ When marginal product is below average product, average product decreases.

§ When marginal product equals average product, average product is at its maximum.


Average Product

0 1 2 3 4 5Labor (workers per day)

2

4

6

Ave

rage

pro

duct

& M

argi

nal p

rodu

ct(T

-shi

rts

per d

ay p

er w

orke

r)

4.33

MP

AP

Maximumaverageproduct

C

D

EF

B

Figure 9.3



§ Marginal grades and average grades§ The relationship between a student’s marginal grade and

average grade is similar to that between marginal product and average product.

§ A students average grade increases when the marginal grade exceeds his average grade, decreases when his marginal grade is below his average, and is constant when his marginal grade equals his average grade


Short-Run Cost

§ To produce more output in the short run, the firm must employ more labour, which means that it must increase its costs.

§ We describe the way a firm’s costs change as total product changes by using three cost concepts and three types of cost curve:§ Total cost§ Marginal cost§ Average cost


Short-Run Cost

§ Total Cost§ A firm’s total cost (TC) is the cost of all resources used.

§ Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output.

§ Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output.

§ Total cost equals total fixed cost plus total variable cost. That is:

§ TC = TFC + TVC


Total Cost Curves

Total Totalfixed variable Totalcost cost cost

Labor Output (TFC) (TVC) (TC)(workers (T-shirtsper day) per day) (dollars per day)

A 0 0 25 0 25

B 1 4 25 25 50

C 2 10 25 50 75

D 3 13 25 75 100

E 4 15 25 100 125

F 5 16 25 125 150

Figure 9.4 Table


Total Cost Curves

0 5 10 15Output (T-shirts per day)

50

100

150

Cos

t (do

llars

per

day

)

TFC

TVC

TC

TC = TFC + TVC

Figure 9.4


Short-Run Cost

§ Marginal Cost§ Marginal cost (MC) is the increase in total cost that results

from a one-unit increase in total product.

§ Over the output range with increasing marginal returns,marginal cost falls as output increases.

§ Over the output range with diminishing marginal returns,marginal cost rises as output increases.


Short-Run Cost

§ Average Cost§ Average cost measures can be derived from each of the total

cost measures:

§ Average fixed cost (AFC) is total fixed cost per unit of output.

§ Average variable cost (AVC) is total variable cost per unit of output.

§ Average total cost (ATC) is total cost per unit of output.

§ ATC = AFC + AVC


Marginal Cost and Average Costs

Table 9.5


ATCAVC

Marginal Cost and Average Costs

0 5 10 15Output (T-shirts per day)

5

10

15C

ost (

dolla

rs p

er T

-shi

rts)

AFC

MCATC = AFC + AVC

Figure 9.5


Short-Run Cost

§ Why the Average Total Cost Curve Is U-Shaped§ ATC is the sum of AFC and AVC

§ The AVC is U-shaped

§ The ATC is U-shaped because of two reasons§ Spreading fixed cost over a larger output§ Eventually diminishing returns


Short-Run Cost

§ Cost Curves and Product Curves§ The shapes of a firm’s cost curves are determined by the

technology it uses:

§ MC is at its minimum at the same output level at which marginal product is at its maximum.

§ When marginal product is rising, marginal cost is falling.

§ AVC is at its minimum at the same output level at which average product is at its maximum.

§ When average product is rising, average variable cost is falling.


Product Curves and Cost Curves

Labor

Ave

rage

pro

duct

and

mar

gina

l pro

duct

0 1.5 2.0

2

4

6

MP

AP

Rising MP andfalling MC:rising AP andfalling AVC

Falling MP andrising MC:rising AP andfalling AVC

Falling MP andrising MC:falling AP andrising AVC

Figure 9.6(a)


Maximum MP and minimum MC

Maximum AP and minimum AVC

Product Curves and Cost Curves

Output

Ave

rage

pro

duct

and

mar

gina

l pro

duct

0 6.5 10

3

6

9MC

AVC

12

Figure 9.6(b)


Short-Run Cost

§ Shifts in Cost Curves

§ The position of a firm’s cost curves depend on two factors:§ Technology

§ Prices of factors of production


Short-Run Cost

§ Technology§ An increase in productivity shifts the average and marginal

product curves upward and the average and marginal cost curves downward.

§ If a technological advance brings more capital and less labour into use, fixed costs increase and variable costs decrease.

§ In this case, ATC increases at low output levels and decreases at high output levels.


Short-Run Cost

§ Prices of factors of production§ Changes in the prices of resources shift the cost curves.§ An increase in a fixed cost shifts the total cost (TC) and

average total cost (ATC) curves upward, but does not shift the marginal cost (MC) curve.§ An increase in a variable cost shifts the total cost (TC),

average total cost (ATC), and marginal cost (MC) curves upward.


Long-Run Cost

§ In the long run, all inputs are variable and all costs are variable.

§ The Production Function§ The behaviour of long-run cost depends upon the firm’s

production function, which is the relationship between the maximum output attainable and the quantities of both capital and labour.


Long-Run Cost

§ The Production Function

§ Diminishing Returns§ Regardless of the plant size, as the labour input increases, its

marginal product (eventually) decreases

§ Diminishing Marginal Product of Capital§ The marginal product of capital is the change in total

product divided by the change in capital employed when the amount of labour employed is constant


Long-Run Cost

§ Short-Run Cost and Long-Run Cost§ The average cost of producing a given output varies, and

depends on the size of the firm’s plant.

§ The larger the plant size, the greater is the output at which ATC is at a minimum.

§ Each plant has a short-run ATC curve which is U-shaped

§ The firm can compare the ATC for each given output at different plant sizes.


Short-Run Costs of Four Different Plants Figure 9.7


Long-Run Cost

§ Long-Run Average Cost Curve§ The long-run average cost curve is the relationship

between the lowest attainable average total cost and output when both the plant size and labour are varied.

§ Once the firm has chosen the plant size, it incurs the costs that correspond to the ATC curve for that plant.


Long-Run Average Cost CurveFigure 9.8


Long-Run Cost

§ Economies and Diseconomies of Scale§ Economies of scale are features of a firm’s technology that

lead to falling long-run average cost as output increases.§ Diseconomies of scale are features of a firm’s technology

that lead to rising long-run average cost as output increases.§ Constant returns to scale are features of a firm’s

technology that lead to constant long-run average cost as output increases.


Long-Run Cost

§ A firm experiences economies of scale up to some output level.

§ Beyond that output level, it moves into constant returns to scale or diseconomies of scale.

§ Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its lowest level.

§ If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale output level.


ENDCHAPTER 9

Documents

Firms, Production, and Costs - CSUSAP: Student & …athene.mit.csu.edu.au/~hskoko/subjects/eco110/lect6ho.pdfA firm’s opportunity cost of production is the sum of the explicit costs