1. The Firm: Cost and Output Determination
Chapter 23
The Firm: Cost and Output Determination

2. Introduction
Why do some family physicians now make appointments themselves? Why do some family physicians now have small offices with no waiting rooms, no nurses and no receptionists?
This is the latest trend in family medicine, called the
“micropractice.” By the time you have completed this chapter, you will be able to understand why, for a family physician at least, it now pays to think small when it comes to operating a medical practice.

3. 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

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

5. Did You Know That...
Since 1997, openings of new U.S. manufacturing facilities of existing factories have declined from more than 3.5% per year to about 2.5% per year?
During the same period, U.S. companies have closed about 3.5% of existing factories each year.
Therefore, the number of U.S. manufacturing facilities has shrunk by about 1% per year since 1997.
However, economists point out that the trend has been toward larger U.S. manufacturing facilities. Thus, even as the overall number of factories has declined, the scale of production of the average plant has increased.
How does a company determine the scale of its production?

6. 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

7. Short Run versus Long Run (cont'd)
The time period in which all factors of production can be varied

8. 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.

9. 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.

10. The Relationship Between Output and Inputs (cont'd)
Output / time period = Some function of capital and labor inputs or
Q = ƒ(K,L)
Q = output/time period K = capital L = labor

11. 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

12. 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.

13. E-Commerce Example: Riding an Escalator to the Outer Edge of a Production Function
Since escalators were first invented back in 1891, figuring out how to put one together has been a highly labor-intensive process.
Until recently, working through the intricacies of a lower-cost process for escalator design and production took engineers more than one year.

14. E-Commerce Example: Riding an Escalator to the Outer Edge of a Production Function (cont'd)
Today, the use of three-dimensional software, such as a programs such as AutoCAD, enables engineers to devise production processes for producing escalators in less than three weeks.
Why do you suppose that business managers regard the process of developing the best procedures for producing goods and services as a fundamental requirement of operating at a point on a firm’s production function?

15. The Relationship Between Output and Inputs (cont'd)
Average Physical Product
Total product divided by the variable input

16. 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

17. Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (a)

18. Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (b)

19. Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (c)

20. Diminishing Marginal Product
Measuring marginal product
The concept of marginal profit applies to many situations
Specialization and marginal product
Diminishing marginal product
The Law of Diminishing Marginal Product

21. Diminishing Marginal Product (cont'd)
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

22. Diminishing Marginal Product (cont’d)
An example of the Law of Diminishing Marginal Profit: Production of computer printers
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.

23. 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.

24. Diminishing Marginal Product (cont’d)
Point of saturation
Given the amount of fixed inputs, there is no further positive use for more of the variable input.

25. 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 and are fixed for a certain period of time, i.e. rent on a building
Variable Costs
Costs that vary with the rate of production, i.e. wages paid to workers and purchases of materials
Total costs (TC) = TFC + TVC

26. Short-Run Costs to the Firm (cont'd)
Average Total Costs (ATC)
Also called average per-unit total costs
Average total costs (ATC) =
Total costs (TC)
Output (Q)

27. Short-Run Costs to the Firm (cont'd)
Average Variable Costs (AVC)
Average variable costs (AVC) =
Total variable costs (TVC)
Output (Q)

28. Short-Run Costs to the Firm (cont'd)
Average Fixed Costs (AFC)
Average fixed costs (AFC) =
Total fixed costs (TFC)
Output (Q)

29. Short-Run Costs to the Firm (cont'd)
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

30. Figure 23-2 Cost of Production: An Example, Panel (a)

31. Figure 23-2 Cost of Production: An Example, Panel (b)

32. Figure 23-2 Cost of Production: An Example, Panel (c)

33. 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?

34. 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.

35. Short-Run Costs to the Firm (cont’d)
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.

36. Short-Run Costs to the Firm (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.

37. 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.

38. The Relationship Between Diminishing Marginal Product and Cost Curves (cont'd)
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.

39. 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 (MPP) of labor increases.

40. Figure 23-3 The Relationship Between Output and Costs, Panel (a)

41. Figure 23-3 The Relationship Between Output and Costs, Panel (b)

42. Figure 23-3 The Relationship Between Output and Costs, Panel (c)

43. Figure 23-3 The Relationship Between Output and Costs, Panel (d)

44. They will have their familiar U shape in the short run.
The Relationship Between Diminishing Marginal Product and Cost Curves (cont'd)
Of course, the average total cost curve and average variable cost curve are also affected.
They will have their familiar U shape in the short run.

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

46. 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
Planning Curve
The long-run average cost curve.

47. Figure 23-4 Preferable Plant Size and the Long-Run Average Cost Curve

48. 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?

49. Why the Long-Run Average Cost Curve is U-Shaped
Economies of scale
Constant returns to scale
Diseconomies of scale

50. 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.

51. Why the Long-Run Average Cost Curve is U-Shaped (cont'd)
Reasons for economies of scale
Specialization
Division of tasks or operations
Dimensional factor
Large-scale firms often require proportionately less input per unit of output
Improved productive equipment
The larger the enterprise, the more the firm can take advantage of larger-volume types of machinery.

52. Figure Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with Long-Run Average Cost Curve

53. Why the Long-Run Average Cost Curve is U-Shaped (cont'd)
Explaining why a firm might experience diseconomies of scale
Limits to the efficient functioning of management
Coordination and communication is more of a challenge as firm size increases

54. International Example: Global Cargo Shippers Pursue Scale Economies
For an international shipping firm, a “plant” is a cargo ship.
In recent years, shippers have reduced their long-run average variable costs both by expanding the number of ships afloat and by increasing the absolute size of these ships.
Expanding scale through the use of additional ships has allowed global cargo shippers to experience economies of scale.
What could you conclude if you were to notice several years from now that shipping firms stop putting any additional massive container ships out to sea?

55. 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

56. Figure 23-6 Minimum Efficient Scale

57. 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

58. Example: Toyota Finds Itself Just Beyond Its Minimum Efficient Scale
Since 2002, Japanese automaker Toyota has increased by more than 50% the number of vehicles it sells in the United States.
Recently, Toyota decided it will build no more plants in the foreseeable future. The reason for this is that the company’s long-run average cost of producing autos began to increase in the late 2000s.
To avoid experiencing any further diseconomies and get back to its minimum efficient scale, Toyota has cut back slightly on production of vehicles in portions of U.S. facilities built just a few years ago.
In the long-run, why might Toyota choose not to expand its production capabilities further even if it could sell more vehicles than it is currently producing?

59. Issues and Applications: Family Physicians Downsize to Reduce Long-Run Average Costs
As Figure 23-7 indicates, the number of medical school graduates opting for medical-school residency positions in the area of family medicine has dropped by about one-half since 1997.
The average costs of operating family practices have risen to where a family medical practice is just not as lucrative as it once was.

60. Figure 23-7 The Number of Medical Students Opting for Family Practice Residencies
Source: U.S. Department of Health and Human Services.

61. Issues and Applications: Family Physicians Downsize to Reduce Long-Run Average Costs (cont’d)
The long-run average cost curve faced by family physicians is bending upwards at ever-smaller scales of operation. The minimum efficient scale in the provision of family medicine has declined.
More family physicians are opting to downsize their operations considerably.

62. Issues and Applications: Family Physicians Downsize to Reduce Long-Run Average Costs (cont’d)
Operating these high-tech “micropractices” allows family physicians to avoid higher overhead expenses that they would otherwise incur.
Why do you suppose that most family practitioners who do opt to set up micropractices increasingly are opting to partner with numerous physicians in offices that previously would have been occupied by only one physician?

63. 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

64. 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

65. 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
Along the down-ward sloping range of the firm’s long-run average cost curve, the firm experiences economies of scale.
Along the upward sloping portion, the firm encounters diseconomies of scale.