Section V Firm Behavior and the Organization of Industry

Chapter 13 The Costs of Production

Objective 2.) Understand the relationship between the firm’s production process and total cost. 3.) Know the meaning of average total cost and marginal cost - they are related. 4.) Be familiar with the shape of a typical firm’s cost curve 5.) Learn the relationship between short-run and long-run costs. 1.) Learn the items included in a firm’s cost of production.

Supply The Costs of Production The Law of Supply: Firms are willing to produce and sell a greater quantity of a good when the price of a good is high, this results in a supply curve that slopes upward.

Why Study Behavior of Firms? À Gain a better understanding of the decisions made by producers. Á Study how the behavior of a firm depends on the structure of the market.

The Firm’s Objective The economic goal of the firm is to maximize profits.

Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs. u Explicit costs involve a direct money outlay for factors of production. u Implicit costs do not involve a direct money outlay.

Economic Profit versus Accounting Profit u Economists measure a firm’s economic profit as total revenue minus all the opportunity costs (explicit and implicit). u Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. In other words, they ignore the implicit costs.

Economic Profit versus Accounting Profit u When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. u Economic profit is smaller than accounting profit.

Revenue EconomicProfitEconomicProfit ImplicitcostsImplicitcosts ExplicitcostsExplicitcosts AccountingprofitAccountingprofit ExplicitcostsExplicitcosts Total opportunity costs Revenue How an Economist Views a Firm How an Accountant Views a Firm

An Individual Firm’s Profit: Revenue minus Cost u Revenues: The amount that the firm receives for the sale of its product. (Market Price x Amount Sold)= Revenues u Costs: The amount that the firm pays to buy inputs. u Profit is often referred to as Producer Surplus: the amount a seller is paid minus the cost of production. A measure of the benefits to sellers. Chapter 7

Producer Surplus: Graphical S D PEPE QEQE Producer Surplus Production Costs

Costs of Production Explicit Costs Implicit Costs Sunk Costs u In general, three costs are often considered when making business strategy or supply decisions.

Costs as Opportunity Costs u The firm’s costs include Explicit Costs and Implicit Costs: –Explicit Costs: costs that involve a direct money outlay for factors of production. –Implicit Costs: costs that do not involve direct money outlay. (e.g. opportunity costs) v Both can include opportunity costs.

Costs as Opportunity Costs u Economists include all opportunity costs when measuring costs. u Accountants measure the explicit costs but often ignore the implicit costs. u When revenues exceed both explicit and implicit costs the firm earns economic profits.

Costs as Opportunity Costs u A third, not so obvious implicit cost includes sunk costs. u Sunk costs are costs that have already been committed and cannot be recovered. Sunk Costs are... –an opportunity cost –often ignored when making decisions about business strategy

Quick Quiz “A farmer has planted corn seeds but has not yet fertilized the field.” u Is the cost of seed an opportunity cost or a sunk cost? u Is the cost of fertilizer an opportunity cost or a sunk cost? u Which of these two costs is more likely to affect the decision to continue farming?

Definitions l Production function is the relationship between quantity of inputs used to make a good and the quantity of output of that good l Marginal product is is the increase in output that arises from an additional unit of input l Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases

Number of Workers OutputMarginal Product of Labor Cost of Factory Cost of Workers Total Cost of Inputs (cost of factory + Cost of Workers) $30 30 $ $ A Production Function and Total Cost: Hungry Helen’s Cookie Factory

The Production Function The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

Marginal Product The marginal product of any input in the production process is the increase in the quantity of output obtained from an additional unit of that input.

Marginal Product Additional input Additional output = Marginal product

Diminishing Marginal Product u Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. u Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.

Hungry Helen’s Production Function Number of workers Hired Quality of Output (cookies per hour)

Hungry Helen’s Total-Cost Curve $ Total-cost curve Quantity of Output (cookies per hour) Total Cost

A Production Function and Total Cost Hungry Helen’s Cookie Factory

Diminishing Marginal Product u The slope of the production function measures the marginal product of an input, such as a worker. u When the marginal product declines, the production function becomes flatter.

The Various Measures of Cost Costs of production may be divided into two specific categories: u Fixed Costs: –Those costs that do not vary with the amount of output produced. u Variable Costs: –Those costs that do vary with the amount of output produced.

Fixed versus Variable Costs u The division of costs between fixed and variable often depends on the time horizon being considered. –Over a period of weeks, i.e. short-run, some costs are fixed (e.g. plant size.) –Over a period of years, i.e. long-run, many fixed costs become variable costs. v Allows greater ability to respond to changing circumstances in the long run.

Family of Total Costs... u Total Fixed Costs (TFC) u Total Variable Costs (TVC) u Total Costs (TC): TC = TFC + TVC

Family of Total Costs QuantityTotal CostFixed CostVariable Cost 0$ 3.00 $

Family of Average Costs... u Average Costs: Specific Cost / Output Level –Average Fixed Costs (AFC) –Average Variable Costs (AVC) –Average Total Costs (ATC)

Marginal Cost: “How much does it cost to produce an additional unit of output?” u Marginal Cost (MC): “The extra or additional cost of producing one more unit of output.” –MC is the addition to the cost of production that must be covered by additional revenue for profit maximization

Mathematical Definitions of Costs u Average Total Cost: ATC = TC ÷ Q u Marginal Cost: MC = TC ÷ Q

Diminishing Marginal Product u The slope of the production function measures the marginal product of an input, such as a worker. u When the marginal product declines, the production function becomes flatter.

Quick Quiz! u If Ford’s total cost of producing 4 cars is $225,000 and its total cost of producing 5 cars is $250, what is the average total cost and marginal cost of producing the fifth car?

The Shape of Typical Cost Curves u Marginal Cost rises with the amount of output produced. (Figure 13-1) –At small levels of output, an increase in production will occur at relatively small costs. –Increasing output is more costly when the amount being produced is already high. –Marginal cost rises more in the short run.

Marginal Cost

Cost Curves and Their Shapes The average total-cost curve is U-shaped. u At very low levels of output average total cost is high because fixed cost is spread over only a few units. u Average total cost declines as output increases. u Average total cost starts rising because average variable cost rises substantially.

The Shape of Typical Cost Curves Cost ($’s) Quantity MC

The Shape of Typical Cost Curves Cost ($’s) Quantity MC ATC

Cost Curves and Their Shapes U-shape The bottom of the curve shows the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.

The Shape of Typical Cost Curves Cost ($’s) Quantity MC ATC AVC

Relationship Between Marginal Cost and Average Total Cost u Whenever marginal cost is less than average total cost, average total cost is falling. u Whenever marginal cost is greater than average total cost, average total cost is rising.

The Various Measures of Cost It is now time to examine the relationships that exist between the different measures of cost.

The Various Measures of Cost Big Bob’s Bagel Bin

Big Bob’s Cost Curves... $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00 $16.00 $18.00 $ Quantity of Output (bagels per hour) Total Cost Total Cost Curve

Three Important Properties of Cost Curves u Marginal cost eventually rises with the quantity of output. u The average-total-cost curve is U- shaped. u The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.

Costs in the Long Run u For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. u In the short run some costs are fixed. u In the long run fixed costs become variable costs.

The Shape of Typical Cost Curves Cost ($’s) Quantity MC ATC AVC AFC

Costs in the Long Run Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

Quantity of Cars per Day Average Total Cost $12,000 $10,000 Economics of scale ATC in short run with small factory

Quantity of Cars per Day Average Total Cost $12,000 $10,000 Economics of scale ATC in short run with small factory ATC in short run with medium factory Constant returns to scale

Quantity of Cars per Day ATC in long run Average Total Cost $12,000 $10,000 Economics of scale ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory Diseconomies of scale Constant returns to scale

Return to a Single Input 1.) Holding all other input quantities unchanged 2.) The law of diminishing returns demanding marginal returns

Return to a Single Input 1.) Holding all other input quantities unchanged 2.) The law of diminishing returns demanding marginal returns Return to Scale 1.) Long rule 2.) Opportunity to change all input quantities

Return to a Single Input 1.) Holding all other input quantities unchanged 2.) The law of diminishing returns demanding marginal returns Return to Scale 1.) Long rule 2.) Opportunity to change all input quantities Why Return to Scale 1.) Specialization 2.) Dimensional Factor 3.) Improved Productive Equipment

1.) Economies of scale - Increasing returns to scale

2.) Diseconomies of scale - Decreasing returns to scale

1.) Economies of scale - Increasing returns to scale 2.) Diseconomies of scale - Decreasing returns to scale 3.) Constant returns to scale

The Shape of Typical Cost Curves U-Shaped Average Total Cost: –Economies of Scale: occurs when a firm has large fixed costs. v ATC declines as output increases –Diseconomies of Scale: occurs when some important input is limited. v ATC rises as output increases

The Shape of Typical Cost Curves u U-Shaped Average Total Cost: –The bottom of the U-Shape occurs at the quantity that minimizes average total cost –This is called the Efficient Size of the firm.

The Relationship Between Marginal Cost and Average Total Cost u When marginal cost is less than average total cost, average total cost is falling. MC < ATC ATC u When marginal cost is greater than average total cost, average total cost is rising. MC > ATC ATC

The Relationship Between Marginal Cost and Average Total Cost The marginal-cost curve crosses the average-total-cost at the efficient scale. Why?

Conclusion u When analyzing firm behavior, it is often useful to graph average total cost and marginal cost. u For a typical firm, marginal cost rises with the amount of output. u Average total cost first falls as output increases (showing economies of scale) and then rises as output increases further (showing diseconomies of scale.)

The Relationship Between Marginal Cost and Average Total Cost Cost ($’s) Quantity MC ATC The marginal cost curve always crosses the average total cost curve at the minimum average total cost!