Economics Today Chapter 22 The Firm: Cost and Output Determination Roger LeRoy Miller Economics Today Chapter 22 The Firm: Cost and Output Determination

Introduction Since 1989 there have been nearly 4000 commercial bank mergers. The most common rationale given is that large banks are more cost efficient than small banks. To be able to evaluate this rationale, you must understand the nature of cost curves faced by individual firms.

Learning Objectives Distinguish between accounting of profits and economic profits Discuss the difference between the short run and the long run from the perspective of a firm

Learning Objectives Understand why the marginal physical product of labor eventually declines as more units of labor are employed Explain the short-run cost curves faced by a typical firm

Leaning Objectives 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

Chapter Outline The Firm Short Run versus Long Run The Relationship Between Output and Inputs Diminishing Marginal Returns Short-Run Costs to the Firm

Chapter Outline The Relationship Between Diminishing Marginal Returns and Cost Curves Long-Run Cost Curves Why the Long-Run Average Cost Curve is U-Shaped Minimum Efficient Scale

Did You Know That... There are more than 25 steps in the process of manufacturing a simple lead pencil? In the production of an automobile, there are literally thousands of steps? How do producers select the best combination of inputs for any desired output?

The Firm Firm An organization that brings together factors of production—labor, land, physical capital, human capital, and entrepreneurial skill—to produce a product or service that it hopes can be sold at a profit

The Firm Organizational structure Entrepreneur Residual claimant Gets what is left over after all expenses are paid Manager Workers

Accounting profits = total revenues - explicit costs The Firm Profit and costs Accounting profits = total revenues - explicit costs Explicit Costs Costs that business managers must take account of because they must be paid

The Firm Implicit Costs Expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculate Opportunity costs of using factors that a producer does not buy or hire, but already owns

The Firm Normal Rate of Return Opportunity Cost of Capital The amount that must be paid to an investor to induce investment in a business Opportunity Cost of Capital The normal rate of return, or the available return on the next-best alternative investment

The Firm Example His opportunity cost is: A skilled auto mechanic owns a service station. He works six days a week and 14 hours per day, or 84 hours/week. His opportunity cost is: An employee mechanic makes $20/hour. Opportunity cost 84 hours x $20 = $1,680

The Firm The service station must make more than $1,680 to show an economic profit.

The Firm What do you think? Is a building owned by a business “free”?

The Firm Accounting profits versus economic profits or Economic profits = total revenues - total opportunity cost of all inputs used Economic profits = total revenues - (explicit + implicit costs)

Simplified View of Economic and Accounting Profit Figure 22-1

The Firm The goal of the firm: profit maximization Firms are expected to try to make the positive difference between total revenues and total costs as large as they can.

Short Run versus Long 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 The time period in which all factors of production can be varied

The Relationship Between Output and Inputs or Output/time period = some function of capital and labor inputs *Q = output/time period K = capital L = labor Q = ƒ(K,L)*

The Relationship Between Output and Inputs Production Any activity that results in the conversion of resources into products that can be used in consumption

The Relationship Between Output and Inputs Production Function The relationship between inputs and output A technological, not an economic, relationship The relationship between inputs and maximum physical output

The Relationship Between Output and Inputs The production function: a numerical example Short-run model Fixed input is capital Variable input is labor

Diminishing Marginal Returns Law of Diminishing (Marginal) Returns 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

The Relationship Between Output and Inputs Average Physical Product Total product divided by the variable input

The Relationship Between Output and Inputs 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 or marginal return

Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 22-2, Panel (a)

Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 22-2, Panel (b)

Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 22-2, Panel (c)

Short-Run Costs to the Firm Assume two inputs Capital (fixed) Labor (variable)

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 Total costs (TC) = TFC + TVC

Cost of Production: An Example Figure 22-3, Panel (a)

Cost of Production: An Example Figure 22-3, Panel (b)

Short-Run Costs to the Firm Average Total Costs (ATC) Average total costs (ATC) = total costs (TC) output (Q)

Short-Run Costs to the Firm Average Variable Costs (AVC) Average variable costs (ATC) = total variable costs (TC) output (Q)

Short-Run Costs to the Firm Average Fixed Costs (ATC) Average fixed costs (AFC) = total fixed costs (TC) output (Q)

Cost of Production: An Example Total Average Total Fixed Fixed Output Costs Costs (Q/day) (TFC) (AFC) 16 14 0 $10 1 10 2 10 3 10 4 10 5 10 6 10 7 10 8 10 9 10 10 10 11 10 ——— $10.00 5.00 3.33 2.50 2.00 1.67 1.43 1.25 1.11 1.00 .91 12 10 AFC Costs (dollar per day) 8 6 4 2 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

Cost of Production: An Example Total Average Total Variable Variable Output Costs Costs (Q/day) (TVC) (AVC) 16 14 0 $0 1 5 2 8 3 10 4 11 5 13 6 16 7 20 8 25 9 31 10 38 11 46 ——— $5.00 4.00 3.33 2.75 2.60 2.67 2.86 3.13 3.44 3.80 4.18 12 10 Costs (dollar per day) 8 6 AVC 4 2 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

Cost of Production: An Example Average Total Total Total Output Costs Costs (Q/day) (TVC) (AVC) 16 14 ATC 0 $10 1 15 2 18 3 20 4 21 5 23 6 26 7 30 8 35 9 41 10 48 11 56 ——— $15.00 9.00 6.67 5.25 4.60 4.33 4.28 4.38 4.56 4.80 5.09 12 10 Costs (dollar per day) 8 6 4 2 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

Cost of Production: An Example 16 14 ATC 12 10 AFC Costs (dollar per day) 8 6 4 AVC 2 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

Cost of Production: An Example ATC AFC Difference between AVC and ATC = AFC Costs (dollar per day) ATC AVC TP AVC AFC Output (calculators per day)

Cost of Production: An Example ATC ATC = AVC + AFC AFC = ATC - AVC Costs (dollar per day) AVC AFC TP AVC Output (calculators per day)

Short-Run Costs to the Firm Marginal Cost The change in total costs due to a one-unit change in production rate Marginal costs (MC) = change in total cost change in output

Cost of Production: An Example Total Total Variable Total Marginal Output Costs Costs Cost (Q/day) (TVC) (TC) (MC) 16 14 0 $0 1 5 2 8 3 10 4 11 5 13 6 16 7 20 8 25 9 31 10 38 11 46 $10 15 18 20 21 23 26 30 35 41 48 56 $5 12 3 10 2 MC Costs (dollar per day) 1 8 2 6 3 4 4 5 2 6 7 1 2 3 4 5 6 7 8 9 10 11 8 Output (calculators per day)

Cost of Production: An Example Total Total Variable Total Marginal Output Costs Costs Cost (Q/day) (TVC) (TC) (MC) What do you think? Will a change in fixed cost change marginal cost? Example Increase in interest rate on adjustable rate mortgage Increase in insurance premium 0 $0 1 5 2 8 3 10 4 11 5 13 6 16 7 20 8 25 9 31 10 38 11 46 $10 15 18 20 21 23 26 30 35 41 48 56 $5 3 2 1 2 3 4 5 6 7 8

Cost of Production: An Example Figure 22-3, Panel (c)

Cost of Production: An Example 16 AFC can be found by subtracting AVC from ATC 14 ATC 12 Costs (dollar per day) 10 MC 8 6 4 AVC VC FC TC 2 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

Short-Run Costs to the Firm What do you think? Is there a relationship between the production function and AVC, ATC, and MC?

Short-Run Costs to the Firm 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 returns), marginal cost will begin to rise.

Cost of Production: An Example When MC < AVC, AVC declines MC Costs (dollar per day) AVC MC TP AVC Output (calculators per day)

Cost of Production: An Example When MC > AVC, AVC increases MC Costs (dollar per day) MC TP AVC AVC Output (calculators per day)

Cost of Production: An Example When MC = AVC, AVC at the minimum MC Costs (dollar per day) AVC MC = AVC TP Output (calculators per day)

Cost of Production: An Example ATC When MC < ATC, ATC declines MC Costs (dollar per day) ATC TP MC Output (calculators per day)

Cost of Production: An Example ATC When MC > ATC, ATC increases MC Costs (dollar per day) ATC TP MC Output (calculators per day)

Cost of Production: An Example ATC When MC = ATC, ATC at the minimum Costs (dollar per day) MC MC = ATC TP Output (calculators per day)

Short-Run Costs to the Firm The relationship: a summary The change on the margin leads to a change in the average Example To raise your GPA, your GPA this semester must exceed your current GPA

Policy Example: Can “Three Strikes” Laws Reduce Crime? What happens to the MC of murder when committing a felony after two prior convictions? The MC of murder falls to zero.

The Relationship Between Diminishing Marginal Returns and Cost Curves Labor cost assumed constant MC = DTC DOutput Recall: labor is the variable input MC = W MPP

The Relationship Between Diminishing Marginal Returns and Cost Curves Figure 22-4, Panel (a)

The Relationship Between Physical Output and Costs Figure 22-4, Panels (b) and (c)

The Relationship Between Physical Output and Costs Figure 22-4, Panels (c) and (d)

The Relationship Between Diminishing Marginal Returns and Cost Curves Firms’ short-run cost curves are a reflection of the law of diminishing marginal returns. Given any constant price of the variable input, marginal costs decline as long as the marginal product of the variable resource is rising.

The Relationship Between Diminishing Marginal Returns and Cost Curves At the point at which diminishing marginal returns begin, marginal costs begin to rise as the marginal product of the variable input begins to decline.

The Relationship Between Diminishing Marginal Returns and Cost Curves AVC = TVC output AVC = W AP

Long-Run Cost Curves Planning Horizon The long run, during which all inputs are variable

Preferable Plant Size and the Long-Run Average Cost Curve Figure 22-5, Panels (a) and (b)

Long-Run Cost Curves 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

Long-Run Cost Curves Planning Curve The long-run average cost curve

Long-Run Cost Curves Observation What do you think? Only at minimum long-run average cost curve is short-run average cost curve tangent to Long-run average cost curve What do you think? Why is the long-run average cost curve U-shaped?

Why the Long-Run Average Cost Curve is U-Shaped Economies of Scale Decreases in long-run average costs resulting from increases in output

Why the Long-Run Average Cost Curve is U-Shaped Reasons for economies of scale Specialization Dimensional factor Improved productive equipment

Why the Long-Run Average Cost Curve is U-Shaped Explaining diseconomies of scale Limits to the efficient functioning of management

Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with the Long-Run Average Cost Curve Figure 22-6, Panel (a)

Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with the Long-Run Average Cost Curve Figure 22-5, Panel (b)

Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with the Long-Run Average Cost Curve Figure 22-6, Panel (c)

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

Minimum Efficient Scale Small MES relative to industry demand: High degree of competition Large MES relative to industry demand: Small degree of competition

Minimum Efficient Scale Figure 22-7

Issues and Applications: Are Bigger Banks Necessarily More Efficient Banks? Bank managers claim that mergers and acquisitions result in cost savings. Until the mid-1990s cost savings of 15 to 20 percent have been realized in bank mergers. Due to economies of scale New technologies

Web Links The following Web links appear in the margin of this chapter in the textbook: http://www.census.gov/epcd/www/ smallbus.html http://ingramayne.saintjoe.edu/econ/ TheFirm/ProductionFunct.html

Summary Discussion of Learning Objectives Accounting profit versus economic profit Accounting profit = total revenue- total explicit costs Economic profit = accounting profits- implicit costs

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 available

Summary Discussion of Learning Objectives The law of diminishing marginal returns 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

Summary Discussion of Learning Objectives A firm’s long-run cost curve Planning horizon All inputs are variable including plant size Economies and disceconomies of scale and a firm’s minimum efficient scale

End of Chapter Chapter 22 The Firm: Cost and Output Determination