McGraw-Hill/Irwin Chapter 6: Businesses and Their Costs Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

The Business Population  There are different types of businesses which are organized in several ways and vary in size.  Useful concepts to discuss business organization:  A plant is an establishment that performs one or more functions in fabricating and distributing goods and services.  A firm is a business organization that owns and operates plants.  An industry is a group of firms that produce the same, or similar, products. LO:

Multiplant Firms  Multiplant firms:  May be organized horizontally, with several plants performing much the same function.  They may be vertically integrated – own plants that perform different functions in the various stages of the production process.  They may represent conglomerates that own plants that produce products in several separate industries. LO:

Corporations  Corporations are firms that pool resources of large number of people.  The resources are pooled through sale of stocks and bonds.  Although only 20 percent of all U.S. firms are corporations, they account for 84 percent of all sales. LO: 6-1 Stocks are ownership shares of a corporation. Bonds are certificates indicating obligations to pay the principal and interest on loans at a specific time in the future. 6-4

The Principal-Agent Problem  The principle-agent problem is a conflict of interest that occurs when agents (managers) pursue their own objectives to the detriment of the principals’ (stockholders’) goals.  This problem arises in corporations where the owners (principals) usually do not manage it; they hire others to do so. LO:

Economic Costs  When society uses a specific combination of resources to produce some product, it forgoes all alternative opportunities to use those resources for other purposes.  The measure of the economic cost, or opportunity cost, of any resource is the value or worth it would have in its best alternative use. LO: 6-2 From the firm’s perspective, an economic cost is the payment it must make or the income it must provide to attract the resources it needs away from alternative production opportunities. 6-6

Explicit and Implicit Costs  Firms must consider both explicit and implicit costs:  Explicit costs are the monetary payments that a firm must make to an outsider to obtain a resource.  Implicit costs equal the monetary income that a firm sacrifices when it uses a resource that it owns rather than supplying the resource in the market.  An important part of implicit costs is normal profit. LO: 6-2 Normal profit is a payment that must be made by a firm to obtain and retain entrepreneurial ability. 6-7

Economic Profit Economic, or pure, profit is equal to total revenue less economic cost (including explicit and implicit costs). Economic Profit Accounting Costs (Explicit Costs Only) Accounting Profit Explicit Costs Implicit Costs (Including a Normal Profit) Economic (Opportunity) Costs Total Revenue Economic Profit Accounting Profit LO:

Short Run and Long Run  The short run is a time period in which producers are able to change the quantities of some but not all of the resources they employ.  A firm can adjust the number of workers, but not the plant’s capacity, in the short run.  The long run is a time period sufficiently long enough to enable producers to change the quantities of all the resources they employ. LO:

Labor-Output Relationship  Total product (TP) is the total output of a particular good or service produced by a firm.  Marginal product (MP) is the extra output or added product associated with adding a unit of a variable resource to the production process.  Average product (AP) is output per unit of input. LO: 6-3 Marginal Product Change in Total Product Change in Labor Input = Average Product Total Product Units of Labor = 6-10

Law of Diminishing Returns The law of diminishing returns: As successive units of a variable resource are added to a fixed resource, the marginal product of the variable resource will eventually decline. Because the plant size is fixed in the short run, increasing variable inputs such as labor will lead to diminishing returns. LO:

Law of Diminishing Returns LO: 6-3 Increasing Marginal Returns (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) ] ] ] ] ] ] ] ] Diminishing Marginal Returns Negative Marginal Returns 6-12

LO: Total Product, TP Marginal Product, MP TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns 6-13

Short-Run Production Costs  Fixed costs (TFC) are costs that do not change in total when the firm changes its output.  Variable costs (TVC) are costs that increase or decrease with a firm’s output.  Total costs (TC) is the sum of fixed costs and variable costs. TC = TFC + TVC LO:

Average Costs  Q is quantity of output  Average fixed costs: AFC=TFC/Q  Average fixed costs decline as output increases because the total fixed costs are spread over a larger and larger output.  Average variable costs: AVC=TVC/Q  As added variable resources increase output, average variable costs declines initially, reaches a minimum, and then increases again. As a result, AVC is U-shaped.  Average total costs: ATC=TC/Q=AFC+AVC  Graphically, ATC can be found by vertically adding the AFC and AVC curves. LO:

Marginal Costs  Marginal cost (MC) is the extra or additional cost of producing one more unit of output.  Marginal costs are costs the firm can control directly and immediately by deciding whether or not to produce an additional unit of output. LO: 6-4 Marginal Cost Change in TC Change in Q = Graphically, the MC curve intersects the AVC curve at its minimum… 6-16

Costs Q $200 AFC MC ATC AVC AFC LO:

Long-Run Production Costs  In the long run, firms can enter and exit the industry.  In the long run, firms can adjust their plant size or build new plants.  In the beginning, adding plants would lower average costs (economies of scale), but beyond some point, adding new plants would increase average costs (diseconomies of scale), thus the long-run ATC curve is U-shaped. LO:

Long-Run ATC Curve Long-Run ATC Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output The long-run ATC curve just “envelopes” the short run ATCs 6-19