Unit 3 – Theory of the Firm

and

transformation of factors into goods & services

Think about….production

an economic institution that transforms factors of production into goods & services. A firm …..

We are a firm

(1) organizes factors of production and/or

(3) sells produced goods to individuals, gov’ts, businesses

(2) produces goods, and/or

Let’s say this student started his own business (firm)......

He then burns a CD on his computer. Classmates are willing to pay $18.00 for a 10-song CD b/c Leonard puts together tunes better than....

He puts together Leo Jams CD’s for his classmates by downloading music from

Leo calculated the cost of producing each CD at

per CD revenue = _________

per CD profit = __________

$ 2.00 for equipment

9.00 for songs

.80 labor

.20 blank CD’s

He sells each CD for $16.00$16.00

$4.00

Let’s say another student joined the market with her own mixes....

Now we have two suppliers in the market -- Leo Jams & Becca’s Boss Hits. What happens to the price of CD’s?

Price falls to $11.50 per CD.5 of 32

Should Leo burn the next CD at the new market price of $11.50?

He’s already spent $ 2.00 for equipment

He’d need to spend

9.00 for songs

.80 labor

.20 blank CD’s

Yes, he should burn that next CD. He should only be concerned with the costs in front of him.

$ 2.00 for equipment

9.00 for songs

.80 labor

.20 blank CD’s

These are fixed costs = sunk costs

These are variable costs = the costs Leo should worry about

SUNK

COSTS

Sunk costs – are fixed costs that are sunk, done, and over with. There is nothing you can do about them. They are irrelevant to your current decision-making process.**All Fixed Costs are Sunk Costs**

It will cost Leo an additional _________ to burn the next CD & he will earn in revenue __________ for the next CD, therefore he should / should not burn it.

$10.00$11.50

In our book-producing firm….

What were our fixed costs?

What were our variable costs?

Leo Jams CD’s take off. ¿….Decisions….decisions….??

How many workers do I hire?

We examine productivity ….

the amount of goods and services produced (output) per unit of productive resources used (input) in a specific period of time.

¿….Decisions….decisions….??

How many workers do I hire?

No. of workers

1 10

Total CD’s burned

Marginal Product

10

2 22 12

3 33 11How can marginal product decrease?

4 36 3

5 32 -4

Explain how this is possible??

Law of ……

Diminishing Marginal Productivity

as more and more of a variable input is added to an existing fixed input, eventually the additional output one gets from that additional input is going to fall.

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Q 0

1011121314151617181920

FC1,000

1,0001,0001,0001,0001,0001,0001,0001,0001,0001,0001,000

VC 0

1,0851,2151,3651,5401,7802,1052,5303,0653,7204,5005,430

TC1,000

2,0852,2152,3652,5402,7803,1053,5304,0654,7205,5006,430

What are the definitionsof each one of these costs?

FC – Those costs that remain constant whethera firm produces 0 units toan infinite number of units.

VC – Those costs thatchange (go up) when afirm produces from 1 unitto an infinite amount ofunits.

TC = FC + VC

Q 0

1011121314151617181920

FC1,000

1,0001,0001,0001,0001,0001,0001,0001,0001,0001,0001,000

VC 0

1,0851,2151,3651,5401,7802,1052,5303,0653,7204,5005,430

TC1,000

2,0852,2152,3652,5402,7803,1053,5304,0654,7205,5006,430

Let’s graph these columnsto create our first, veryown cost curves.

(000)

1

2

3

4

5

6

10 11 12 13 14 15 16 17 18 19 20

FC

VC

TC

The total costs are important to firms, but more often under consideration are …. average costs

average total cost = total cost divided by quantity produced

average fixed cost = fixed cost divided by quantity produced

average variable cost = variable cost divided by quantity produced

ATC = TC/Q

AFC = FC/Q

AVC = VC/Q

ATC = AFC + AVC

Q

7 8 9 101112131415161718

AFC

1,4301,2501,1101,000 910 830 770 710 670 630 590 560

Observe this row of data, what will usually be happening to AFC?

It will be decreasing because quantity will normally increase whereas fixed costs remain the same.

Q

7 8 9 101112131415161718

AFC

1,4301,2501,1101,000 910 830 770 710 670 630 590 560

AVC

1,2901,2401,1301,0901,1001,1401,1801,2701,4001,5801,8002,070

ATC

2,7102,4902,2402,0902,0101,9701,9501,9902,0702,2212,3902,620

Why do average variable costs rise?

Why is ATC rising?

Law of Diminishing Marginal Returns

Because AVC is getting bigger

Q 5 6 7 8 9 101112131415161718

AFC2,0001,6701,4301,2501,1101,000 910 830 770 710 670 630 590 560

6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

AFC

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Q 5 6 7 8 9 101112131415161718

AVC6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

1,3801,3301,2901,2401,1301,0901,1001,1401,1801,2701,4001,5801,8002,070

AVC

The lowest point on the AVCcurve is at quantity 10.

AFC

Q 5 6 7 8 9 101112131415161718

ATC6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

AVC

3,3803,0002,7102,4902,2402,0902,0101,9701.9501,9902,0702.2212.3902,620

ATC

The lowest point on the ATCcurve is at quantity 13.

AFC

6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

AFC

AVC

ATC

A fewimportantpoints:

1. The ATCcurve lookslike a smileyface.

ATC

2. The AVCcurve lookslike a smirk.

AVC

6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

AVC

ATC

ATC

AVC

AFC

If we got ridof the AFCcurve, couldyou figure outwhat theAFC are withoutthe curve?

6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

AVC

ATC

From now on, we will NOT be drawing too many AFC curves because....

AFC = ATC - AVC

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In economics we say firms and individuals….

make decisions on the margin

We saw this when we studied demand and marginal utility analysis.

a consumer will choose ice cream until…

and

When choosing between

MU of hamburger/P hamburger = MU of ice cream / P ice cream

Q

7 8 9 101112131415161718

AFC

1,4301,2501,1101,000 910 830 770 710 670 630 590 560

AVC

1,2901,2401,1301,0901,1001,1401,1801,2701,4001,5801,8002,070

ATC

2,7102,4902,2402,0902,0101,9701.9501,99020702.2212.3902620

MC

1,000 900 300 6501,3001,5001,7502,4003,2504,2505,3506,550

So…marginal cost is important to firm.

The firm is concerned with the cost of the next unit, just as the consumer is concerned with the …

Q

5 6 7 8 9 101112131415161718

MC

1,2001,1001,000 900 300 6501,3001,5001,7502,4003,2504,2505,3506,550

6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

AVC

ATC

MC

6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

AVC

ATC

MCA few importantpoints:

1. The MCcurve lookslike theNike Swoosh

MC

2. MC touchesAVC andATC at their lowestpoints.

6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

AVC

ATC

MCLaw of diminishing marginalreturns-- As more and more

of a variable input areadded to a fixed input,the additional outputbegins to go down.

DiminishingMarginalReturns setsin here

Explain why

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Review: In firm cost analysis

What’s on the y axis?

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14

cost

What’s on the x axis?

quantity

Review: In firm cost analysis

What’s the shape of the ATC curve?

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14

cost

What’s the shape of the AVC curve?

quantity

ATC

AVC

Review: In firm cost analysis

What’s the shape of the MC curve?

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14

cost

quantity

ATC

AVC

MC

6,000

5,000

4,000

3,000

2,000

1,000

5 6 7 8 9 10 11 12 13 14 15 16 17 18

AVC

ATC

MC

Where does the MC curve have to intersect the ATC & AVC curves?

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