Production and Cost in the Firm CHAPTER 7 © 2003 South-Western/Thomson Learning

Cost and Profit In economics, we assume that producers try to maximize profit  this provides the motivation for their behavior Firms transform resources into products in their attempt to accomplish this objective They must make plans while confronting uncertainty about Consumer demand Resource availability Intentions of other firms in the industry

Explicit and Implicit Costs To hire resources, producers must pay resources at least their opportunity costs For most resources, the cash payments approximate their opportunity cost However, some resources are owned by the firm or the firm’s owners  there are no direct cast payments Whether hired in resource markets or owned by the firm, all resources have an opportunity cost

Explicit and Implicit Costs Explicit costs Refer to the firm’s actual cash payments for resources  wages, rent, taxes, etc. Implicit costs The opportunity costs of using resources owned by the firm or provided by the firm’s owners Require no cash payment and no entry in the firm’s accounting statement, which records its revenues, explicit costs, and accounting profits

Alternative Measures of Profit A particular example may help to clarify the distinction between explicit and implicit costs and the alternative measure of profit that are used Wanda Wheeler currently earns $50,000 in her current job She decides to start her own business She withdraws $20,000 from her savings account, hires and assistant and uses a spare bay in her garage that had been renting for $1,000 a year

Normal Profit There is one other profit measure to consider: the accounting profit required to induce the firm’s owners to employ their resources in the firm Alternatively, the accounting profit just sufficient to ensure that all resources used by the firm earn their opportunity cost  normal profit Recall that the accounting profit = $64,000 Normal profits = $50,000 + $1,200 + $1,000 = $52,200  normal profit  $11,800 is an economic profit

Fixed and Variable Resources Resources can be divided into two categories Variable resources can be varied quickly to change the output rate Fixed resources are those resources which cannot be easily changed This provides us the distinction between the short run and the long run Short run  at least one resource is fixed Long run  all resources are variable

Short Run and Long Run Output can be changed in the short run by adjusting variable resources However, the size, or scale of the firm is fixed in the short run In the long run, all resources can vary The length of the short and long run differs from industry to industry because the nature of production differs

Law of Diminishing Marginal Returns For the present, suppose we focus on the short-run link between resource use and the rate of output Suppose the company’s fixed resources are already in place and consist of a warehouse, a moving van, and moving equipment The only variable resource is labor

Law of Diminishing Marginal Returns As more of a variable resource is combined with a given amount of a fixed resource, marginal product eventually declines This is the most important feature of production in the short run  dictates the shape of the production function and the cost curves

Costs in the Short Run There are two kinds of costs in the short run Fixed costs pay for fixed resources and must be paid even if no output is produced  do not vary when output varies In our example the fixed costs are assumed to be $200 Variable cost is the cost of variable resources – labor in our example – and vary with the amount of labor employed in the production process  as more labor is employed, output and variable cost both increase The firm can hire labor at $100 per worker day  variable cost equals $100 times the number of workers hired

Marginal Cost and Marginal Productivity When the firm experiences increasing marginal returns – marginal product is increasing – the marginal cost decreases When the firm experiences diminishing marginal returns – marginal product begins to decline – the marginal cost of output increases

Summary The total cost curve can be divided into two sections, based on what happens to marginal cost Because of increasing marginal returns from labor, marginal cost at first declines  total cost initially increases by successively smaller amounts  total cost curve gets flatter Because of diminishing marginal returns from labor, marginal cost starts increasing  a steeper total cost curve

Summary Marginal cost is the key to economic decisions made by firms The firm operating in the short run has no control over its fixed cost, but, by, varying output, the firm can alter its variable cost and hence its total cost Marginal cost indicates how much total cost will increase if one more unity is produced and how much total cost will drop if production declines by one unit

Average Cost in the Short Run The average cost per unit of output is another of the useful cost measures There are average cost measures corresponding to variable cost, fixed cost and variable cost

Marginal and Average Cost The relationship between marginal and average cost is also important When marginal cost is below or less than average cost it pulls average cost down When marginal cost is above or higher than average cost it pulls average cost up

Costs in the Long Run Thus far we have focused on how costs vary as the rate of output expands in the short run for a firm of a given size In the long run, all inputs that are under the firm’s control can be varied  there are no fixed costs The long run is not just a succession of short runs

Costs in the Long Run The long run is best thought of as a planning horizon In the long run, the choice of input combinations is flexible, but that flexibility is available only to firms that have not yet acted on their plans Firms plan for the long run, but they produce in the short run

Long-Run Average Cost Curve Suppose that, because of the special nature of technology in the industry, a firm must choose among only three possible sizes Small Medium Large

Long-Run Average Cost Curve Now suppose there are many possible plan sizes The long-run average cost curve, shown in red, is formed by connecting the points on the various short-run average cost curves that represent the lowest per-unit cost for each rate of output

Economies of Scale Notice that the long-run average curve is U-shaped The U-shape here is a result of economies and diseconomies of scale Economies of scale imply that long-run average costs decline as output expands while diseconomies of scale imply that long-run average costs increase as output increases

Economies of Scale A larger size often allows for larger, more efficient, machines and allows workers a greater degree of specialization  Production techniques such as the assembly line can be utilized only if the rate of output is large enough Typically, as the scale of the firm increases, capital substitutes for labor and complex machines substitute for simpler machines

Diseconomies of Scale As a firm expands, diseconomies of scale, eventually take over  long-run average cost increase as output expands As the amount and variety of resources employed increase, so does the task of coordinating all these inputs However, as the work force grows, additional layers of management are needed to monitor production

Diseconomies of Scale In the thicket of bureaucracy that develops, communications may get mangled The more levels of management there are in an organization, the more difficult it is for top management to communicate with those that perform most of the production tasks

Constant Long-Run Average Costs It is possible for average cost to neither increase nor decrease with changes in firm size In these situations, the firm experiences constant long-run average costs

Economies and Diseconomies of Scale at the Firm Level Thus far we have focused on a particular plant However, a firm could also be a collection of plants And it is possible that economies and diseconomies of scale can exist at the firm level as well as the plant level