Slides prepared by Dr. Amy Peng, Ryerson University CHAPTER 6 THE ORGANIZATION AND COSTS OF PRODUCTION Part Two: Microeconomics of Product Markets

©2007 McGraw-Hill Ryerson Ltd.Chapter 62 In this chapter you will learn: 6.1 The various organizational forms a firm can take 6.2 What economic costs are 6.3 About a firm’s short-run production relationships 6.4 About a firm’s short-run production costs 6.5 The link between a firm’s size and costs in the long run

©2007 McGraw-Hill Ryerson Ltd.Chapter 6.13 The Firm and the Business Sector Different organizational structures: 1.Plant 2.Firm 3.Industry Horizontal combinations Horizontal combinations Vertical combinations Vertical combinations Conglomerates Conglomerates

©2007 McGraw-Hill Ryerson Ltd.Chapter 6.14 The Firm and the Business Sector Legal Forms of Businesses: 1.Sole Proprietorship 2.Partnership 3.Corporation Advantages of Corporations The Principal-Agent Problem

©2007 McGraw-Hill Ryerson Ltd.Chapter 6.25 Opportunity Cost Explicit Costs payments a firm must make Implicit Costs opportunity costs of firm’s own resources include normal profits Economic Costs

©2007 McGraw-Hill Ryerson Ltd.Chapter 6.26 Total Revenue $120,000 Cost of T -shirts $40,000 Clerk's salary $18,000 Utilities Utilities $ 5,000 Total (explicit) costs $ 63,000 Accounting Profit $ 57,000 Normal Profit as a Cost

©2007 McGraw-Hill Ryerson Ltd.Chapter 6.27 Total Revenue $120,000 Cost of T -shirts $40,000 Clerk's salary $18,000 Utilities Utilities $ 5,000 Total (explicit) costs $ 63,000 Accounting Profit $ 57,000 Normal Profit as a Cost Forgone interest $ 1,000 Forgone rent $ 5,000 Forgone wages $22,000 Normal profit $ 5,000 Totalimplicitcosts $ 3 3,000 Economic profit $ 24,000

©2007 McGraw-Hill Ryerson Ltd.Chapter 6.28 Normal Profit as a Cost Costs of production include all costs –explicit –implicit –including a normal profit required to attract and retain factors of production Economic profit = total revenue – economic cost

©2007 McGraw-Hill Ryerson Ltd.Chapter 6.29 EconomicProfits Implicit costs (including a normal profit) ExplicitCosts Accounting costs (explicit costs only) AccountingProfits Economic (opportunity) Costs TotalRevenue Figure 6-1 Economic Profit vs. Accounting Profit

©2007 McGraw-Hill Ryerson Ltd.Chapter Short Run and Long Run Short Run –Fixed Plant Long Run –Variable Plant

©2007 McGraw-Hill Ryerson Ltd.Chapter Total Product (TP) –total quantity produced Marginal Product (MP) Average Product (AP) change in total product change in labour input = total product units of labour = Short-Run Production Relationships

©2007 McGraw-Hill Ryerson Ltd.Chapter Law of Diminishing Returns marginal product eventually diminishes Short-Run Production Relationships

©2007 McGraw-Hill Ryerson Ltd.Chapter Units of labour TPMPAP change in total product change in labour input MP= Table 6-1 Total, Marginal, and Average Product

©2007 McGraw-Hill Ryerson Ltd.Chapter Units of labour TPMPAP Increasing marginal returns Diminishing marginal returns Negative marginal returns Total, Marginal, and Average Product

©2007 McGraw-Hill Ryerson Ltd.Chapter Units of labour TPMPAP total product total labour input AP= Total, Marginal, and Average Product

©2007 McGraw-Hill Ryerson Ltd.Chapter AP MP TP increasing marginal returns diminishing marginal returns negative marginal returns Figure 6-2

©2007 McGraw-Hill Ryerson Ltd.Chapter Marginal and Average Values If the average value is rising, the marginal value must be ABOVE the average value If the average value is falling, the marginal value must be BELOW the average value

©2007 McGraw-Hill Ryerson Ltd.Chapter Marginal and Average Values AP MP MP>APMP>AP MP<APMP<AP Average value rising Average value falling

©2007 McGraw-Hill Ryerson Ltd.Chapter Fixed, Variable, and Total Costs Fixed Costs –do not vary with changes in output Variable Costs –change with changes in output Total Cost –sum of fixed and variable costs

©2007 McGraw-Hill Ryerson Ltd.Chapter Per-Unit, or Average, Costs

©2007 McGraw-Hill Ryerson Ltd.Chapter Marginal Cost Marginal cost is the extra, or additional, cost of producing one more unit of output Illustrated…

©2007 McGraw-Hill Ryerson Ltd.Chapter QTFCTVCTCAFCAVCATCMC TC=TFC + TVC

©2007 McGraw-Hill Ryerson Ltd.Chapter TFC Total Cost is the Sum of Fixed Cost and Variable Cost Figure 6-3

©2007 McGraw-Hill Ryerson Ltd.Chapter TFC TVC TC Total Cost is the Sum of Fixed Cost and Variable Cost Add vertically to get TC

©2007 McGraw-Hill Ryerson Ltd.Chapter QTFCTVCTCAFCAVCATCMC AFC=TFC / Q AVC=TVC / Q ATC=TC / Q

©2007 McGraw-Hill Ryerson Ltd.Chapter QTFCTVCTCAFCAVCATCMC MC=  TC /  Q Note: MC is graphed at average Q 2.5

©2007 McGraw-Hill Ryerson Ltd.Chapter AFC AFC continually declines as fixed cost is spread over more and more units AFC, AVC, and ATC Figure 6-5

©2007 McGraw-Hill Ryerson Ltd.Chapter AFC AVC AVC is U-shaped: it starts to rise when AP starts to fall AFC, AVC, and ATC

©2007 McGraw-Hill Ryerson Ltd.Chapter AFC ATC AVC Get ATC by vertically summing AFC and AVC AFC, AVC, and ATC

©2007 McGraw-Hill Ryerson Ltd.Chapter AFC ATC MC AVC MC cuts ATC and AVC at minimum points MC, AVC, and ATC

©2007 McGraw-Hill Ryerson Ltd.Chapter Labour Costs (dollars) Average Product and Marginal Product Output MP AP MCAVC Figure 6-6 Productivity Curves and Cost Curves

©2007 McGraw-Hill Ryerson Ltd.Chapter Relation of MC to AVC and ATC When MC < current ATC  ATC will fall When MC > current ATC  ATC will rise  MC intersects ATC and AVC at minimum points

©2007 McGraw-Hill Ryerson Ltd.Chapter Shifts of Cost Curves Factor Prices price of fixed input increases... AFC and ATC shift up AVC and MC unchanged price of variable input increases... AVC, ATC, and MC shift up AFC unchanged

©2007 McGraw-Hill Ryerson Ltd.Chapter Technology improved technology lower costs cost curves shift down curve shifts depend on whether technology affects FC, VC, or both Shifts of Cost Curves

©2007 McGraw-Hill Ryerson Ltd.Chapter Long-Run Production Costs What will costs look like when the firm can choose the best plant size for any given situation? For every plant capacity size, there is a short-run ATC curve All such plant capacities can be plotted...

©2007 McGraw-Hill Ryerson Ltd.Chapter ATC-1ATC-2 ATC-3 ATC-4 ATC-5 Choose the best plant for every output level Figure 6-7 The Long-Run Average-Total-Cost Curve These choices determine the LRATC curve

©2007 McGraw-Hill Ryerson Ltd.Chapter The number of possible plant sizes is virtually unlimited The number of possible plant sizes is virtually unlimited Figure 6-8 The Long-Run Average-Total-Cost Curve The LRATC curve just envelops the short-run cost curves LRATC

©2007 McGraw-Hill Ryerson Ltd.Chapter Economies of Scale –Labour Specialization –Managerial Specialization –Efficient Capital –Other Factors Diseconomies of Scale Constant Returns to Scale

©2007 McGraw-Hill Ryerson Ltd.Chapter Economies of scale LRATC Figure 6-9 Economies and Diseconomies of Scale Constant returns to scale Diseconomies of scale

©2007 McGraw-Hill Ryerson Ltd.Chapter Minimum Efficient Scale ATC-1ATC-2 ATC-3 ATC-4 ATC-5 MES is the smallest level of output that minimizes LRATC

©2007 McGraw-Hill Ryerson Ltd.Chapter Minimum Efficient Scale LRATC Relatively large MES Relatively large MES natural monopoly Relatively large MES Relatively large MES natural monopoly MESMES

©2007 McGraw-Hill Ryerson Ltd.Chapter Minimum Efficient Scale MESMES LRATC Relatively small MES Relatively small MES competitive industry Relatively small MES Relatively small MES competitive industry

©2007 McGraw-Hill Ryerson Ltd.Chapter Applications and Illustrations Successful Startup Firms The Daily Newspaper The Verson Stamping Machine Aircraft and Concrete Plants

©2007 McGraw-Hill Ryerson Ltd.Chapter 644 Chapter Summary 6.1 The Firm and the Business Sector 6.2 Economic Costs –Opportunity Cost 6.3 Short-Run Production Relationships –The Law of Diminishing Return –TP, AP and MP 6.4 Short-Run Production Costs –Fixed Cost, Average Cost, and Marginal Cost 6.5 Long-Run Production Costs