Chapter 23 The Firm: Cost and Output Determination

Copyright © 2008 Pearson Addison Wesley. All rights reserved Introduction Why do publishers print so many books each year and then destroy them? How does doing this affect their costs of doing business? By the time you have completed this chapter, you will be able to analyze these questions.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Learning Objectives Discuss the difference between the short run and the long run from the perspective of a firm Understand why the marginal physical product of labor eventually declines as more units of labor are employed Explain the short-run cost curves a typical firm faces Describe the long-run cost curves a typical firm faces Identify situations of economies and diseconomies of scale and define a firm’s minimum efficient scale

Copyright © 2008 Pearson Addison Wesley. All rights reserved Chapter Outline Short Run versus Long Run Relationship Between Output and Inputs Diminishing Marginal Product Short-Run Costs to the Firm The Relationship Between Diminishing Marginal Product and Cost Curves The Relationship Between Diminishing Marginal Product and Cost Curves Long-Run Cost Curves Why the Long-Run Average Cost Curve is U-Shaped Minimum Efficient Scale

Copyright © 2008 Pearson Addison Wesley. All rights reserved Did You Know That... Nanotechnology-enabled improvements may help computer manufactures lengthen the time components last, thereby reducing their costs? Production technologies and the costs producers face are related?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Short Run  A time period when at least one input, such as plant size, cannot be changed  Plant Size  The physical size of the factories that a firm owns and operates to produce its output Short Run versus Long Run

Copyright © 2008 Pearson Addison Wesley. All rights reserved Short Run versus Long Run (cont'd) Long Run  The time period in which all factors of production can be varied

Copyright © 2008 Pearson Addison Wesley. All rights reserved Short Run versus Long Run (cont'd) Managers take account of both the short-run and long-run consequences of their behavior. While making decisions about what to do today, tomorrow, and next week— they keep an eye on the long-run benefits.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Output and Inputs A firm takes numerous inputs, combines them using a technological production process and ends up with output. We classify production inputs in two broad categories—labor and capital.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Output and Inputs (cont'd) Q = output/time period K = capital L = labor Q = ƒ(K,L) or Output / time period = Some function of capital and labor inputs

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Output and Inputs (cont'd) Production  Any activity that results in the conversion of resources into products that can be used in consumption

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Output and Inputs (cont'd) Production Function  The relationship between maximum physical output and the quantity of capital and labor used in the production process  The production function is a technological relationship between inputs and output.

Copyright © 2008 Pearson Addison Wesley. All rights reserved E-Commerce Example: Put Away the Clay and Turn on the Holographic Camera Once a company has integrated a holographic camera system into its existing computer network, creating holographic designs takes less time. Consequently, product developers using holographic techniques can now create more designs while utilizing fewer labor resources.

Copyright © 2008 Pearson Addison Wesley. All rights reserved E-Commerce Example: Put Away the Clay and Turn on the Holographic Camera (cont'd) Why do technological improvements often reduce labor requirements for specific tasks, thereby allowing labor to be utilized for other purposes?

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Output and Inputs (cont'd) Average Physical Product  Total product divided by the variable input

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Output and Inputs (cont'd) Marginal Physical Product  The physical output that is due to the addition of one more unit of a variable factor of production  The change in total product occurring when a variable input is increased and all other inputs are held constant  Also called marginal product

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (a)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (b)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (c)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Diminishing Marginal Product Measuring marginal product Specialization and marginal product Diminishing marginal product

Copyright © 2008 Pearson Addison Wesley. All rights reserved Law of Diminishing Marginal Product  The observation that after some point, successive equal-sized increases in a variable factor of production, such as labor, added to fixed factors of production, will result in smaller increases in output Diminishing Marginal Product (cont'd)

Copyright © 2008 Pearson Addison Wesley. All rights reserved An Example of the Law of Diminishing Marginal Product Production of computer printers example  We have a fixed amount of factory space, assembly equipment, and quality control diagnostic software.  So the addition of more workers eventually yields successively smaller increases in output.

Copyright © 2008 Pearson Addison Wesley. All rights reserved An Example of the Law of Diminishing Marginal Product (cont'd) After a while, when all the assembly equipment and quality-control diagnostic software are being used, additional workers will have to start assembling and troubleshooting quality problems manually. The marginal physical product of an additional worker, given a specified amount of capital, must eventually be less than that for the previous workers.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Total costs (TC) = TFC + TVC Short-Run Costs to the Firm Total Costs  The sum of total fixed costs and total variable costs Fixed Costs  Costs that do not vary with output Variable Costs  Costs that vary with the rate of production

Copyright © 2008 Pearson Addison Wesley. All rights reserved Average Total Costs (ATC) Short-Run Costs to the Firm (cont'd) Average total costs (ATC) = Total costs (TC) Output (Q)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Average Variable Costs (AVC) Short-Run Costs to the Firm (cont'd) Average variable costs (AVC) = Total variable costs (TVC) Output (Q)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Average Fixed Costs (AFC) Short-Run Costs to the Firm (cont'd) Average fixed costs (AFC) = Total fixed costs (TFC) Output (Q)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Marginal Cost  The change in total costs due to a one-unit change in production rate Short-Run Costs to the Firm (cont'd) Marginal costs (MC) = Change in total cost Change in output

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-2 Cost of Production: An Example, Panel (a)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-2 Cost of Production: An Example, Panel (b)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-2 Cost of Production: An Example, Panel (c)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Short-Run Costs to the Firm (cont'd) Question  What do you think—is there a predictable relationship between the production function and AVC, ATC, and MC?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Short-Run Costs to the Firm (cont'd) Answer  As long as marginal physical product rises, marginal cost will fall, and when marginal physical product starts to fall (after reaching the point of diminishing marginal product), marginal cost will begin to rise.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Example: Reducing the Marginal Cost of Air Transport with “Winglets” After years of experimentation, engineers created winglets by making jetliners’ wings slightly longer and curving them up at the ends. Since the early 2000s, most new planes ordered by airliners have included winglets, which provide fuel savings for every mile that a plane is in the air. Some airlines are in the process of adding winglets to their existing fleet of planes too.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Example: Reducing the Marginal Cost of Air Transport with “Winglets” (cont'd) How has airlines’ use of winglets affected their total cost curves?

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Average and Marginal Costs When marginal costs are less than average variable costs, the latter must fall. When marginal costs are greater than average variable costs, the latter must rise.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Average and Marginal Costs (cont'd) There is also a relationship between marginal costs and average total costs.  Average total cost is equal to total cost divided by the number of units produced.  Marginal cost is the change in total cost due to a one-unit change in the production rate.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Diminishing Marginal Product and Cost Curves Firms’ short-run cost curves are a reflection of the law of diminishing marginal product. Given any constant price of the variable input, marginal costs decline as long as the marginal product of the variable resource is rising.

Copyright © 2008 Pearson Addison Wesley. All rights reserved At the point at which diminishing marginal product begins, marginal costs begin to rise as the marginal product of the variable input begins to decline. The Relationship Between Diminishing Marginal Product and Cost Curves (cont'd)

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Diminishing Marginal Product and Cost Curves (cont'd) If the wage rate is constant, then the labor cost associated with each additional unit of output will decline as long as the marginal physical product of labor increases.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-3 The Relationship Between Output and Costs, Panel (a)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-3 The Relationship Between Output and Costs, Panel (b)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-3 The Relationship Between Output and Costs, Panel (c)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-3 The Relationship Between Output and Costs, Panel (d)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Long-Run Cost Curves Planning Horizon  The long run, during which all inputs are variable

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-4 Preferable Plant Size and the Long-Run Average Cost Curve

Copyright © 2008 Pearson Addison Wesley. All rights reserved Long-Run Cost Curves (cont'd) Long-Run Average Cost Curve  The locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices

Copyright © 2008 Pearson Addison Wesley. All rights reserved Long-Run Cost Curves (cont'd) Observation  Only at minimum long-run average cost curve is short-run average cost curve tangent to long-run average cost curve. Question  Why do you think the long-run average cost curve U-shaped?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Why the Long-Run Average Cost Curve is U-Shaped Economies of scale Constant returns to scale Diseconomies of scale

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-5 Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with Long-Run Average Cost Curve

Copyright © 2008 Pearson Addison Wesley. All rights reserved Why the Long-Run Average Cost Curve is U-Shaped (cont'd) Economies of Scale  Decreases in long-run average costs resulting from increases in output  These economies of scale do not persist indefinitely, however.  Once long-run average costs rise, the curve begins to slope upwards.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Reasons for economies of scale  Specialization  Division of tasks or operations  Dimensional factor  Improved productive equipment Why the Long-Run Average Cost Curve is U-Shaped (cont'd)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Why the Long-Run Average Cost Curve is U-Shaped (cont'd) Explaining diseconomies of scale  Limits to the efficient functioning of management  Coordination and communication is more of a challenge as firm size increases

Copyright © 2008 Pearson Addison Wesley. All rights reserved Policy Example: Economies of Scale in Payment Processing Since 2000, the annual volume of payments transmitted by the Federal Reserve’s ACH system has increased from 3.8 to more than 6 billion. At the same time, the average cost of transmitting a payment has declined from more than 1.6 cents to about 1 cent.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Minimum Efficient Scale Minimum Efficient Scale (MES)  The lowest rate of output per unit time at which long-run average costs for a particular firm are at a minimum

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 23-6 Minimum Efficient Scale

Copyright © 2008 Pearson Addison Wesley. All rights reserved Minimum Efficient Scale (cont'd) Small MES relative to industry demand  There is room for many efficient firms.  High degree of competition Large MES relative to industry demand  There is room for only a small number of efficient firms.  Small degree of competition

Copyright © 2008 Pearson Addison Wesley. All rights reserved Example: A Company Thinks Smaller to Boost its MES Briggs & Stratton Corp. moved from a massive 2 million square foot facility in Milwaukee where it was located in the 1990s. Today, it has dispersed its production among six smaller plants, each of which utilizes more automated equipment and employs fewer workers than during the 1990s.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Example: A Company Thinks Smaller to Boost its MES (cont'd) Downsizing its plants enabled the company to increase its overall scale of operations, from an output rate of 8 million engines per year to more than 10 million engines per year. The result of this output increase has been lower long-run average total cost, which has helped to boost the company’s annual profitability by more than 30%.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Issues and Applications: Book Publishers Search for a Lower-Cost Business Model In publishing, destruction is part of production:  There is a 34% chance that any book from the “happy” warehouse finds its way back to the “sad” one. The costs of production:  Once a publisher has incurred the fixed costs of printing a book, the marginal cost is relatively small.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives The short run versus the long run from a firm’s perspective  Short run—a period in which at least one input is fixed  Long run—a period in which all inputs are variable

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) The law of diminishing marginal product  As more units of a variable input are employed with a fixed input, marginal physical product eventually begins to decline. A firm’s short-run cost curves  Fixed and average fixed cost  Variable and average variable cost  Total and average total cost  Marginal cost

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) A firm’s long-run cost curve  Planning horizon  All inputs are variable including plant size Economies and diseconomies of scale and a firm’s minimum efficient scale

End of Chapter 23 The Firm: Cost and Output Determination