Chapter 23 The Firm: Cost and Output Determination

Introduction Since 1989 there have been nearly 4000 commercial bank mergers. The most common rationale given is that large banks are more cost efficient than small banks. To be able to evaluate this rationale, you must understand the nature of cost curves faced by individual firms.

Chapter Outline The Firm Short Run versus Long Run The Relationship Between Output and InputsThe Relationship Between Output and Inputs Diminishing Marginal Returns Short-Run Costs to the Firm

Chapter Outline The Relationship Between Diminishing Marginal Returns and Cost Curves The Relationship Between Diminishing Marginal Returns and Cost Curves Long-Run Cost Curves Why the Long-Run Average Cost Curve is U-Shaped Why the Long-Run Average Cost Curve is U-Shaped Minimum Efficient Scale

There are more than 25 steps in the process of manufacturing a simple lead pencil? In the production of an automobile, there are literally thousands of steps? How do producers select the best combination of inputs for any desired output? Did You Know That...

Firm –An organization that brings together factors of production—labor, land, physical capital, human capital, and entrepreneurial skill—to produce a product or service that it hopes can be sold at a profit The Firm

Organizational structure –Entrepreneur Residual claimant –Gets what is left over after all expenses are paid Manager Workers The Firm

Profit and costs Accounting profits = total revenues - explicit costs Explicit Costs –Costs that business managers must take account of because they must be paid The Firm

Implicit Costs –Expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculate Opportunity costs of using factors that a producer does not buy or hire, but already owns The Firm

Normal Rate of Return –The amount that must be paid to an investor to induce investment in a business Opportunity Cost of Capital –The normal rate of return, or the available return on the next-best alternative investment The Firm

Example –A skilled auto mechanic owns a service station. –He works six days a week and 14 hours per day, or 84 hours/week. His opportunity cost is: –An employee mechanic makes $20/hour. –Opportunity cost 84 hours x $20 = $1,680 The Firm

The service station must make more than $1,680 to show an economic profit. The Firm

What do you think? –Is a building owned by a business “free”? The Firm

Accounting profits versus economic profits The Firm or Economic profits = total revenues - total opportunity cost of all inputs used Economic profits = total revenues - (explicit + implicit costs)

Simplified View of Economic and Accounting Profit Figure 22-1

The goal of the firm: profit maximization –Firms are expected to try to make the positive difference between total revenues and total costs as large as they can. The Firm

Short Run –A time period when at least one input, such as plant size, cannot be changed –Plant Size The physical size of the factories that a firm owns and operates to produce its output Short Run versus Long Run

Long Run –The time period in which all factors of production can be varied Short Run Versus Long Run

The Relationship Between Output and Inputs *Q = output/time period K = capital L = labor Q = ƒ(K,L)* or Output/time period = some function of capital and labor inputs

Production –Any activity that results in the conversion of resources into products that can be used in consumption The Relationship Between Output and Inputs

Production Function –The relationship between inputs and output –A technological, not an economic, relationship –The relationship between inputs and maximum physical output The Relationship Between Output and Inputs

The production function: a numerical example –Short-run model –Fixed input is capital –Variable input is labor The Relationship Between Output and Inputs

Law of Diminishing (Marginal) Returns –The observation that after some point, successive equal-sized increases in a variable factor of production, such as labor, added to fixed factors of production, will result in smaller increases in output Diminishing Marginal Returns

Average Physical Product –Total product divided by the variable input The Relationship Between Output and Inputs

Marginal Physical Product –The physical output that is due to the addition of one more unit of a variable factor of production –The change in total product occurring when a variable input is increased and all other inputs are held constant –Also called marginal product or marginal return The Relationship Between Output and Inputs

Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 22-2, Panel (a)

Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 22-2, Panel (b)

Figure 22-2, Panel (c) Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case

Assume two inputs –Capital (fixed) –Labor (variable) Short-Run Costs to the Firm

Total Costs –The sum of total fixed costs and total variable costs Fixed Costs –Costs that do not vary with output Variable Costs –Costs that vary with the rate of production Short-Run Costs to the Firm Total costs (TC) = TFC + TVC

Cost of Production: An Example Figure 22-3, Panel (a)

Cost of Production: An Example Figure 22-3, Panel (b)

Average Total Costs (ATC) Short-Run Costs to the Firm Average total costs (ATC) = total costs (TC) output (Q)

Average Variable Costs (AVC) Short-Run Costs to the Firm Average variable costs (ATC) = total variable costs (TC) output (Q)

Average Fixed Costs (ATC) Short-Run Costs to the Firm Average fixed costs (AFC) = total fixed costs (TC) output (Q)

TotalAverage TotalFixedFixed OutputCostsCosts (Q/day)(TFC)(AFC) 0$ ——— $ Costs (dollar per day) Output (calculators per day) Cost of Production: An Example AFC

TotalAverage TotalVariableVariable OutputCostsCosts (Q/day)(TVC)(AVC) 0$ ——— $ Costs (dollar per day) Output (calculators per day) Cost of Production: An Example AVC

Average TotalTotalTotal OutputCostsCosts (Q/day)(TVC)(AVC) 0$ ——— $ Costs (dollar per day) Output (calculators per day) Cost of Production: An Example ATC

Costs (dollar per day) Output (calculators per day) ATC AVC AFC Cost of Production: An Example

AVC Costs (dollar per day) Output (calculators per day) ATC Cost of Production: An Example AFC AVC AFC ATC Difference between AVC and ATC = AFC TP

AFC AVC Costs (dollar per day) Output (calculators per day) ATC Cost of Production: An Example AVC TP ATC = AVC + AFC AFC = ATC - AVC

Marginal Cost –The change in total costs due to a one-unit change in production rate Short-Run Costs to the Firm Marginal costs (MC) = change in total cost change in output

Total TotalVariableTotalMarginal OutputCostsCostsCost (Q/day)(TVC)(TC)(MC) 0$ $ $ Costs (dollar per day) Output (calculators per day) MC Cost of Production: An Example

What do you think? –Will a change in fixed cost change marginal cost? –Example Increase in interest rate on adjustable rate mortgage Increase in insurance premium Cost of Production: An Example Total TotalVariableTotalMarginal OutputCostsCostsCost (Q/day)(TVC)(TC)(MC) 0$ $ $

Cost of Production: An Example Figure 22-3, Panel (c)

VC FC TC Costs (dollar per day) Output (calculators per day) ATC Cost of Production: An Example AVC AFC can be found by subtracting AVC from ATC MC

What do you think? –Is there a relationship between the production function and AVC, ATC, and MC? Short-Run Costs to the Firm

Answer –As long as marginal physical product rises, marginal cost will fall, and when marginal physical product starts to fall (after reaching the point of diminishing marginal returns), marginal cost will begin to rise. Short-Run Costs to the Firm

When MC < AVC, AVC declines Costs (dollar per day) Output (calculators per day) AVC MC TP Cost of Production: An Example AVC MC

When MC > AVC, AVC increases Costs (dollar per day) Output (calculators per day) AVC MC AVC TP Cost of Production: An Example MC

When MC = AVC, AVC at the minimum Costs (dollar per day) Output (calculators per day) AVC MC MC = AVC TP Cost of Production: An Example

When MC < ATC, ATC declines Costs (dollar per day) Output (calculators per day) MC Cost of Production: An Example ATC TP MC

When MC > ATC, ATC increases Costs (dollar per day) Output (calculators per day) MC Cost of Production: An Example ATC TP MC

When MC = ATC, ATC at the minimum Costs (dollar per day) Output (calculators per day) MC Cost of Production: An Example ATC MC = ATC TP

The relationship: a summary –The change on the margin leads to a change in the average –Example To raise your GPA, your GPA this semester must exceed your current GPA Short-Run Costs to the Firm

What happens to the MC of murder when committing a felony after two prior convictions? The MC of murder falls to zero. Policy Example: Can “Three Strikes” Laws Reduce Crime?

The Relationship Between Diminishing Marginal Returns and Cost Curves Labor cost assumed constant MC =  TC  Output Recall: labor is the variable input MC = W MPP

The Relationship Between Diminishing Marginal Returns and Cost Curves Figure 22-4, Panel (a)

Figure 22-4, Panels (b) and (c) The Relationship Between Physical Output and Costs

Figure 22-4, Panels (c) and (d) The Relationship Between Physical Output and Costs

Firms’ short-run cost curves are a reflection of the law of diminishing marginal returns. Given any constant price of the variable input, marginal costs decline as long as the marginal product of the variable resource is rising. The Relationship Between Diminishing Marginal Returns and Cost Curves

At the point at which diminishing marginal returns begin, marginal costs begin to rise as the marginal product of the variable input begins to decline. The Relationship Between Diminishing Marginal Returns and Cost Curves

AVC = TVC output AVC = W AP

Planning Horizon –The long run, during which all inputs are variable Long-Run Cost Curves

Preferable Plant Size and the Long-Run Average Cost Curve Figure 22-5, Panels (a) and (b)

Long-Run Average Cost Curve –The locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices Long-Run Cost Curves

Planning Curve –The long-run average cost curve Long-Run Cost Curves

Observation –Only at minimum long-run average cost curve is short-run average cost curve tangent to Long-run average cost curve What do you think? –Why is the long-run average cost curve U-shaped? Long-Run Cost Curves

Economies of Scale –Decreases in long-run average costs resulting from increases in output Why the Long-Run Average Cost Curve is U-Shaped

Reasons for economies of scale –Specialization –Dimensional factor –Improved productive equipment Why the Long-Run Average Cost Curve is U-Shaped

Explaining diseconomies of scale –Limits to the efficient functioning of management

Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with the Long-Run Average Cost Curve Figure 22-6, Panel (a)

Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with the Long-Run Average Cost Curve Figure 22-5, Panel (b)

Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with the Long-Run Average Cost Curve Figure 22-6, Panel (c)

Minimum Efficient Scale (MES) –The lowest rate of output per unit time at which long-run average costs for a particular firm are at a minimum Minimum Efficient Scale

Small MES relative to industry demand: –High degree of competition Large MES relative to industry demand: –Small degree of competition Minimum Efficient Scale

Figure 22-7

Bank managers claim that mergers and acquisitions result in cost savings. –Until the mid-1990s cost savings of 15 to 20 percent have been realized in bank mergers. Due to economies of scale New technologies Issues and Applications: A re Bigger Banks Necessarily More Efficient Banks?

Summary Discussion of Learning Objectives Accounting profit versus economic profit –Accounting profit = total revenue- total explicit costs –Economic profit = accounting profits- implicit costs

Summary Discussion of Learning Objectives The short run versus the long run from a firm’s perspective –Short run: a period in which at least one input is fixed –Long run: a period in which all inputs are available

Summary Discussion of Learning Objectives The law of diminishing marginal returns –As more units of a variable input are employed with a fixed input, marginal physical product eventually begins to decline A firm’s short-run cost curves –Fixed and average fixed cost –Variable and average variable cost –Total and average total cost –Marginal cost

Summary Discussion of Learning Objectives A firm’s long-run cost curve –Planning horizon –All inputs are variable including plant size Economies and disceconomies of scale and a firm’s minimum efficient scale