Chapter 7 Production and Cost in the Firm © 2009 South-Western/Cengage Learning

22 Cost for the firm All costs are opportunity costs –the true measure of doing something is its full opportunity cost Explicit costs –cost of market purchased inputs Implicit costs –cost of owner-owned resources

Profit Economic profit –Total revenue minus total costs Includes full opportunity cost of all resources Accounting profit –Total revenue minus explicit costs Can see positive accounting profit where zero or negative economic profit exists 3

Profit Normal profit –that level of accounting profit necessary to pay all resources their full opportunity cost A normal profit implies zero economic profit Any accounting profit in excess of a normal profit is economic profit Firm’s goal is to maximize profit 4

Exhibit 1 Wheeler Dealer Accounts, Total revenue$105,000 Less explicit costs: Assistant’s salary Material and equipment - $21,000 - $20,000 Equals accounting profit$64,000 Less implicit costs: Wanda’s forgone salary Forgone interest on savings Forgone garage rental -$50,000 - $1,000 - $1,200 Equals economic profit$11,800

Planning horizons matter 2 planning horizons Short run –period of time where at least 1 resource is fixed Long run –period of time where all resources vary 6

Decisions made Short Run decision making revolves around choosing those inputs that can vary Long Run decision making revolves around choosing the scale of operation Both types of decisions are being made simultaneously 7

Short Run Choosing our variable inputs Total Product –total output as a function of our variable input Marginal product –change in total product for a change in the variable input MP L = ∆TP L / ∆L 8

Law of Diminishing Returns As we increase the use of 1 input only, eventually output increases at a decreasing rate –eventually MP falls 9

Costs in the Short Run Fixed cost FC –cost of hiring the fixed resources Variable cost VC –cost of hiring the variable resources Full opportunity costs are being included in FC and VC Total cost TC = FC + VC Marginal cost MC = ∆TC/∆q –change in TC to produce one more unit of output 10

Costs in the Short Run Changes in MC –Reflect changes in marginal productivity Increasing marginal returns –MC falls Diminishing marginal returns –MC increases 11

More SR Costs Average Cost AC = TC / q = (FC + VC) / q = FC/q + VC/q Average Fixed Cost AFC = FC/q Average Variable Cost AVC = VC/q 12

Average Cost in the Short Run AC = TC/q When MC < AC AC is falling When MC > AC AC is rising When MC = AC AC is minimum U-shape of average cost curves reflects the law of diminishing returns 13

Costs in the Long Run All resources can be varied –maybe not all are but they can be Decision here involves choosing the scale of operation –how large of a business? –what should be our optimal level of output? 14

Costs in the Long Run U-shaped long-run average cost curve –LRAC = TC/q (when all inputs can vary) Economies of scale –LRAC falls as output expands Diseconomies of scale –LRAC increases as output expands Constant returns to scale –LRAC remains unchanged as output expands –LRAC is at minimum 15

Exhibit 8 Short-run ATC curves form the LRAC curve 16 Cost per unit 0qqaqa q’Output per periodqbqb S S’ M M’ L L’ SS’, MM’, LL’ are short run ATC curves Long run ATC curve: SabL’ a b

ATC 1 ATC 2 Exhibit 9 Many short-run ATC curves form firm’s LRAC curve 17 0qq’Output per period Many possible plant sizes Cost per unit $ b ATC 3 ATC 4 ATC 5 ATC 6 ATC 7 ATC 8 ATC 9 ATC 10 Long-run average cost c a Each short-run curve is tangent to the long run average cost curve Each point of tangency represents the least cost way of producing that level of output

Sources of Economies of Scale Specialization of inputs lowers costs Better technology available at higher levels of production Some financial expenditures are spread out Multi-plant operations save costs 18

Sources of Diseconomies of Scale Organizational –large bureaucracy can result in increased costs cost of decision making cost of management 19

Exhibit 10 A firm’s long-run average cost curve 20 Cost per unit 0AOutput per periodB Economies of scale Long-run average cost Diseconomies of scale Constant average cost

LRAC Minimum Efficient Scale –level of output where constant returns to scale is achieved lowest q where LRAC is minimized –All economies of scale have been taken advantage of and diseconomies of scale have not kicked in yet economies of scale balance out diseconomies of scale 21

Review on Costs Short Run Costs –MC and AC are U-shaped due to law of diminishing returns Long Run Costs –AC is U-shaped due to economies and diseconomies of scale 22