Costs and the Changes at Firms over Time Chapter Eight Costs and the Changes at Firms over Time

Costs determine how large firms should be. Intro Purpose of chapter is to develop a model for analyzing when a firm decides to maintain, shut down, or expand their production process. Costs determine how large firms should be. Economists can capture the whole essence of a firm with a graph of its costs. Can determine the profitability of a firm and whether it should shut down or expand. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Finding Average Cost at an Individual Firm Total Costs: Sum of variable costs and fixed costs The more that is produced, the larger total costs will be. Fixed Costs: The part of total costs that do not vary with the amount produced in the short run Examples include land, factories, and machines Variable Costs: The costs of production that vary with the quantity produced Examples include wages and gasoline for trucks TC = FC + VC Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Short Run and the Long Run Short Run: Period of time during which it is not possible to change all inputs to production. Only some inputs, like labor, can be changed. Can’t build factory in the short run Long Run: The minimum period of time during which all inputs to production can be changed Frequent examples of short run and long run Capital can NOT change in the short run Labor CAN change in the short run Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Average and Marginal Cost Q TC FC VC ATC AFC AVC MC 300 -- 1 450 150 2 570 270 285 135 120 3 670 370 223 100 123 4 780 480 195 75 110 5 900 600 180 60 Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.1: Fixed Costs versus Variable Costs Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.2: Total Costs Minus Fixed Costs Equal Variable Costs (For On-The-Move) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Marginal Cost The change in total costs due to a one-unit change in quantity produced. In other words, how much does cost go up when you produce one more unit Marginal cost declines in very low levels of production, but then increases as production increases Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Average Variable Cost (AVC): Variable costs divided by the Quantity Average Cost Average Total Cost (ATC): Total costs of production divided by the quantity produced Also referred to as Cost Per Unit ATC = TC/Q Average Variable Cost (AVC): Variable costs divided by the Quantity AVC = VC/Q ATC decreases at first, then increases as production rises AVC decreases at first, then increases as production rises Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Costs Depend on the Firm’s Production Function Production Function: Relationship that shows the quantity of output for any given amount of input Marginal Product of Labor: Change in production that can be obtained with an additional unit of labor Decreasing marginal product of labor = Diminishing Returns to Labor Increasing marginal product of labor = Increasing Returns to Labor Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.3: On-the-Move's Production Function Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Increasing marginal product of labor = Decreasing marginal cost Production Function Increasing marginal product of labor = Decreasing marginal cost Decreasing marginal product of labor = Increasing marginal cost Average Product of Labor = The quantity produced divided by the amount of labor input APL = Q/L Marginal Product of Labor = ΔQ/ΔL Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.4: Average Cost and Marginal Cost from a Numerical Example Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Average Cost Curves (ATC, AVC) are both U-shaped Lowest point of ATC and AVC are where they intersect the MC curve Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.5: Generic Sketch of Average Cost and Marginal Cost Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Costs and Production: The Short Run If a firm is maximizing profits, it will choose to produce a quantity where price = marginal cost Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.6: Price Equals Marginal Cost Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.7: Showing Profits on the Cost Curve Diagram Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.8: Showing a Loss on the Cost Curve Diagram Copyright © by Houghton Mifflin Company, Inc. All rights reserved

The Breakeven Point The Breakeven Point is where price equals the minimum of average total cost (ATC) Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.9: The Breakeven Point Copyright © by Houghton Mifflin Company, Inc. All rights reserved

The Shutdown Point A firm should shut down when the price falls below the minimum point of the average variable cost curve and is not expected to rise again. Two Important Points: Shutdown point: P = Minimum AVC Breakeven point: P = Minimum ATC Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.10: The Shutdown Point Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Costs and Production: The Long Run All costs can be adjusted in the long run If a firm increases its capital (factories, for example) Fixed costs will rise Variable costs decline What happens to Total Cost? New total cost will be higher at low levels of output (fixed costs dominate) ATC will also be higher at low levels New total cost will be lower at high levels of output (variable costs dominate) ATC will be lower at high levels Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.11: Shifts in Total Costs as a Firm Increases Its Capital Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.12: Shifts in Average Total Cost Curves When a Firm Expands Its Capital Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Remember: A firm will always act to maximize profits Long-run ATC Curve The Long-Run Average Total Cost Curve is the curve that connects the short-run ATC curves at the lowest ATC for each quantity produced as the firm expands in the long run Remember: A firm will always act to maximize profits Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.13: Long-Run versus Short-Run Average Total Cost Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Economies of Scale When all inputs to production increase, we say that the SCALE of the firm increases. Long run ATC describes what happens to a firm’s ATC when its scale increases Economies of Scale (Increasing Returns to Scale): Situation in which long run ATC decreases as output increases Diseconomies of Scale (Decreasing Returns to Scale): Situation in which long run ATC increases as output increases Constant Returns to Scale: Situation in which long run ATC is constant as the output changes Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Economies of Scale The long run ATC for most firms declines at low levels of output, then remains flat, and finally increases at high levels of output As a firm gets very large, administrative expenses, coordination, and incentive problems, will begin to raise ATC. Minimum efficient scale: The smallest scale of production for which long-run ATC is at a minimum. Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.14: Economies and Diseconomies of Scale Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Figure 8.15: Typical Shape of the Long-Run Average Total Cost Curve Copyright © by Houghton Mifflin Company, Inc. All rights reserved

Mergers and Economies of Scope If product lines of 2 firms are similar, then such mergers may be a way to reduce costs. Example: Exxon and Mobil Also merge to combine different skills or resources to develop new products Combining different types of firms to reduce costs or create new products is called ECONOMIES OF SCOPE. Copyright © by Houghton Mifflin Company, Inc. All rights reserved