PART THREE Product Markets

Chapter 6: Businesses and Their Costs

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Business Population In the economy, there are different types of businesses which are organized in several ways and vary in size.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Business Population A plant is an establishment that performs one or more functions in fabricating and distributing goods and services. A firm is a business organization that owns and operates plants. An industry is a group of firms that produce the same, or similar, products.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Business Population Firms can be organized vertically or horizontally. Vertical integration means that firms own plants that perform different functions in the various stages of the production process. Multiplant firms may be organized horizontally, with several plants that perform much the same function. Conglomerates are firms that own plants that produce products in several separate industries.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Advantages of Corporations Although only 20 percent of all U.S. firms are corporations, they account for 84 percent of all sales. The corporation is the most effective form of business organization for raising money to finance the expansion of its facilities and capabilities. Two ways to accomplish this are to sell stocks and bonds.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Advantages of Corporations A common stock represents a share in the ownership of a corporation. Corporations provide limited liability to owners, who risk only what they paid for their stock. Corporate bonds represent certificates indicating obligations to pay the principal and interest on loans at a specific time in the future.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Principal-Agent Problem The principle-agent problem is a conflict of interest that occurs when agents (managers) pursue their own objectives to the detriment of the principals’ (stockholders’) goals. This problem arises in corporations where the owners (principals) usually do not manage it; they hire others to do so.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economic Costs Costs exist because resources are scarce and productive and have alternative uses. An economic cost, or opportunity cost, is the value of the best alternative use of a resource. From the firm’s perspective, an economic cost is the payment it must make to attract the resources it needs away from alternative production opportunities.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Explicit and Implicit Costs Payments to resource suppliers are explicit or implicit. Explicit costs are the monetary payments a firm must make to an outsider to obtain a resource. Implicit costs are the monetary income a firm sacrifices when it uses a resource it owns rather than supplying the resource in the market.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Normal Profit as a Cost Normal profit is a payment that must be made by a firm to obtain and retain entrepreneurial ability. It is also an implicit cost. If a business owner does not realize at least the minimum payment for her effort, she can withdraw from her business and shift to a more attractive endeavor.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economic Profit (or Pure Profit) Economic profit, or pure profit, is a firm’s total revenue less economic costs, where: economic costs = explicit + implicit costs and implicit costs include a normal profit to the entrepreneur. Economic profit = total revenue – economic cost

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short Run and Long Run When the demand for a firm’s product changes, it must adjust the amount of resources it employs. Some firms can easily adjust the quantities of certain resources it uses, while other may need more time. Because of these differences in time adjustments, economists distinguish between two time periods: the short run and the long run.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short Run and Long Run The short run is a time period in which producers are able to change the quantities of some but not all of the resources they employ. A firm can adjust the number of workers but not the plant’s capacity in the short run. The long run is a time period sufficiently long to enable producers to change the quantities of all the resources they employ.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short-Run Production Relationships A firm’s cost of producing a specific output depends on the prices of the needed resources and the quantities of those resources needed to produce that output. Technologies determine the resources needed. Resource prices are determined by resource supply and demand.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short-Run Production Relationships Total product (TP) is the total output of a particular good or service produced by a firm. Marginal product (MP) is the extra output or added product associated with adding a unit of a variable resource to the production process. Average product (AP) is output per unit of input.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short-Run Production Relationships The law of diminishing returns is the principle that as successive units of a variable resource are added to a fixed resource, the marginal product of the variable resource will eventually decline. This is assume that technology is fixed and thus the technique of production do not change.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short-Run Production Relationships For production within firms, the law of diminishing returns is highly relevant. When a firm adds more labor to the production process with a fixed amount of capital equipment, the marginal product of labor eventually declines. Total product eventually will rise at a diminishing rate, then reach a maximum, and finally decline.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Tabular and Graphical Representations The table in Figure 6.2 shows a numerical illustration of the law of diminishing returns followed by the graphs of TP, AP and MP. Column (3) illustrate increasing marginal returns initially, followed by diminishing marginal returns, and then negative marginal returns as the variable resource increases by 1 unit. Column (4) gives the average product which equals total product divided by labor (input).

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Tabular and Graphical Representations

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short-Run Production Costs Production information must be coupled with resource prices to determine the total and per-unit costs of producing various levels of output. These costs are either fixed or variable depending on whether they can change as output changes.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short-Run Production Costs Fixed costs are cost that do not change in total when the firm changes its output. Variable costs are costs that increase or decrease with a firm’s output. Total cost is the sum of fixed cost and variable cost. TC = TFC + TVC

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Per-Unit, or Average, Costs Average-cost data allows a firm to make comparisons with product price, which is always stated on a per-unit basis. Average fixed cost (AFC) is a firm’s total fixed cost divided by output. Average variable cost (AVC) is a firm’s total variable cost divided by output. Average total cost (ATC) is a firm’s total cost divided by output.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Per-Unit, or Average, Costs AFC = (TFC/Q) Average fixed cost decline as output increases. This is because the total fixed cost is spread over a larger and larger output. AVC = (TVC/Q) As added variable resources increase output, average variable cost declines initially, reaches a minimum, and then increases again. As a result, AVC is U-shaped.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Per-Unit, or Average, Costs ATC = (TC/Q) or ATC = AFC + AVC Graphically, ATC can be found by vertically adding the AFC and AVC curves.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Marginal Cost Marginal cost (MC) is the extra or additional cost of producing one more unit of output. change in TC change in Q Marginal cost can also be calculated as the change in total variable cost divided by the change in quantity. As output rises, total cost increases due to variable cost increases only. MC =

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Marginal Cost A firm’s decisions as to how much to produce are typically marginal decisions. When coupled with marginal revenue (the change in total revenue from 1 more or 1 less unit of output), marginal cost allows a firm to determine if it is profitable to expand or contract its production.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Relation of MC to AVC and ATC The marginal cost curve intersect the AVC and ATC curves at their minimum points. When the amount added to total cost is less than the current average total cost, ATC will fall, and vice versa. As long as MC lies below ATC, ATC will fall; whenever MC lies above ATC, ATC will rise.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Long-Run Production Costs In the long run, an industry and the individual firms it comprises can adjust all resources employed. Growing firms can construct larger plants or expand existing one. For a time, successively larger plants will lower average total cost. However, eventually the building of a still larger plant may cause ATC to rise.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Firm Size and Costs

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Long-Run Cost Curve The long-run average total cost curve is made up of segments of the short-run ATC curves for the various plant sizes that can be constructed. The long-run ATC curve represents the lowest average total cost at which any output level can be produced after the firm has had time to make all appropriate adjustments in its plant size.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economies and Diseconomies of Scale The U-shaped long-run average total cost curve can be explained in terms of economies of scale and diseconomies of large-scale production.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Long-Run Cost Curve

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economies of Scale Economies of scale explain the downward part of the long-run ATC curve. As plant size increases, a number of factors will for a time lead to lower average costs of production.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economies of Scale Factors that contribute to lower average total cost for the firm, allowing it to expand its scale of operation, include: Labor specialization Managerial specialization Efficient capital Learning by doing

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Diseconomies of Scale Diseconomies of scale explain the upward part of the long-run ATC curve. As plant size increases, a firm experiences higher average total costs of production. The main factor contributing to diseconomies of scale is the difficulty of efficiently controlling and coordinating a firm’s operation as it becomes a large- scale producer.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Constant Returns to Scale In some industries, there may be a range of output in which long-run average cost does not change. This is known as constant returns to scale. This begins where economies of scale end and ends where diseconomies of scale begin.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economies and Diseconomies of Scale

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Minimum Efficient Scale and Industry Structure Minimum efficient scale (MES) is the lowest level of output at which a firm can minimize long-run average total cost. Minimum efficient scale varies for each industry and depends on the shape of the industry’s long-run average total cost curve. Industries that experience constant returns to scale over an extended range of output will have multiple sizes of firms that are equally efficient.