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Businesses and Their Costs

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1 Businesses and Their Costs
6 Businesses and Their Costs This chapter develops a number of crucial cost concepts that will be employed in the succeeding three chapters to analyze the four basic market models. A firm’s implicit and explicit costs are explained for both short- and long-run periods. The explanation of short-run costs includes arithmetic and graphic analyses of both the total-, average-, and marginal-cost concepts. These concepts prepare students for both total-revenue–total-cost and marginal-revenue–marginal-cost approaches to profit maximization, which are presented in the next few chapters. The law of diminishing returns is explained as an essential concept for understanding average and marginal cost curves. The general shape of each cost curve and the relationship they bear to one another are analyzed with special care. The final part of the chapter develops the long-run average cost curve and analyzes the characteristics and factors involved in economies and diseconomies of scale.

2 The Business Population
Plant Factory, farm, mine, store, website, warehouse Firm Operates one or more plants Industry Group of firms that produce the same products Like households, businesses are a major element in the circular flow diagram. There are many different types of businesses and it is helpful to first define a few terms related to businesses. The term “plant” is used to indicate an establishment such as a factory or store that performs one or more functions in making and distributing goods and services. A “firm” is an organization that employs resources to produce goods and services for profit and that operates one or more plants. An “industry” is comprised of a group of firms that all produce the same, or at least similar, products. Firms may be vertically integrated, meaning they own plants that perform different functions in the various stages of the production process, or horizontally integrated, meaning they own different plants performing much the same function. Conglomerates have plants that produce products in several separate industries. LO1

3 Corporation Advantages
Stocks Ownership shares of a corporation Bonds Liabilities of a corporation Limited liability The advantages related to the corporate form of business have made it a dominant force. It is able to easily raise the capital needed to finance expansion through the issuance of both stocks and bonds. Stock represents ownership of a corporation. Bonds are a form of an IOU and must be repaid with interest. These corporate securities allow investors the options of spreading their risk and gives the investor flexibility. Corporations also offer owners limited liability in that they only risk what was paid for their stock. LO1

4 Principal-Agent Problem
Principals Stockholders Agents Executives The large size of corporations can lead to the principal-agent problem. The owners/principals of the company hire executives/agents to run the company. The interests of these agents does not always coincide with the interests of the owners. LO1

5 Includes normal profit
Economic Costs The payment that must be made to obtain and retain the services of a resource Explicit costs Monetary payments Implicit costs Value of next best use Self-owned resources Includes normal profit Economic costs are the payments a firm must make, or incomes it must provide, to resource suppliers to attract those resources away from their best alternative production opportunities. Payments may be explicit or implicit. (Recall the opportunity-cost concept.) Explicit costs are payments to nonowners for resources they supply. In the textbook’s T-shirt example, this would include the cost of the T-shirts, clerk’s salary, and utilities, for a total of $63,000. Implicit costs are the money payments the self‑employed resources could have earned in their best alternative employment. In the textbook’s T-shirt example, this would include forgone interest, forgone rent, forgone wages, and forgone entrepreneurial income, for a total of $33,000. LO2

6 Accounting Profit and Normal Profit
= Revenue – Explicit costs Economic profit = Accounting profit – Implicit costs Economic profit (to summarize) = Total revenue – Economic costs = Total revenue – Explicit costs – Implicit Costs Economic or pure profits are total revenue less all costs (explicit and implicit, including a normal profit). Economic profit will always be smaller than an accounting profit, which excludes implicit costs. LO2

7 Economic Profit Economic profit Accounting profit
Implicit costs (including a normal profit) Total Revenue (Opportunity) Economic Costs Explicit costs Accounting costs (explicit costs only) Economic profit versus accounting profit. Economic profit is equal to total revenue less economic costs. Economic costs are the sum of explicit and implicit costs and include a normal profit to the entrepreneur. Accounting profit is equal to total revenue less accounting (explicit) costs. LO2

8 All inputs are variable Variable plant Firms enter and exit
Short Run and Long Run Short run Some variable inputs Fixed plant Long run All inputs are variable Variable plant Firms enter and exit The short run is a period of time that is too brief for a firm to alter its plant capacity, but the firm can change output somewhat by increasing or decreasing its variable inputs. The long run is a period of time that is long enough for the firm to adjust the plant size as well as enter or leave the industry. All inputs are variable in the long run. One of the primary characteristics of the long run is that it is enough time for firms to enter and exit the industry. Notice that the actual time associated with the short and long run will differ among industries. LO3

9 Short-Run Production Relationships
Total product (TP) Marginal product (MP) Average product (AP) Marginal product Change in total product Change in labor input = The production relationships reflect how labor and output are related in the short run. The total product is the total quantity that is produced. Marginal product (MP) is the amount that total product changes when labor changes by one unit. It reflects the change in output when one more unit of labor is hired. Average product is the output that is produced per unit of labor. Average product Total product Units of labor = LO3

10 Law of Diminishing Returns
Resources are of equal quality Technology is fixed Variable resources are added to fixed resources At some point, marginal product will fall Rationale As successive increments of a variable resource are added to a fixed resource, the marginal product of the variable resource will decrease. Essentially the fixed plant gets overcrowded with variable resources. If we focus on labor being the variable resource, when there isn’t any labor, then the plant is underused because none of the machinery is being used, etc. When hiring one unit of labor, the machinery is still underused — there is machinery that is often idle as that one unit of labor has to perform all of the tasks. As the firm continues to hire more and more labor, the TP is rising by increasing amounts because the machinery is being used more and more to its capacity. However, at some point there will be so much labor that the fixed resources are overutilized and the individuals will have to wait to use the necessary equipment. This is where we might see diminishing marginal returns — where the TP is still increasing when hiring one more unit of labor, but it doesn’t increase as much as it did with the previous unit of labor. The table on the next slide presents a numerical example of the law of diminishing returns. LO3

11 The Law of Diminishing Returns
Total, Marginal, and Average Product: The Law of Diminishing Returns (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP) Change in (2)/ Change in (1) (4) Average Product (AP), (2)/(1) - 1 10 Increasing marginal returns 10.00 2 25 15 12.50 3 45 20 15.00 4 60 Diminishing 5 70 14.00 6 75 7 10.71 8 -5 Negative 8.75 You can see that at first TP is rising at an increasing rate. So MP is positive and getting larger. This is called increasing marginal returns. Then TP continues to increase, but by smaller and smaller amounts. This is called diminishing marginal returns. TP is still positive and rising, but it is now rising at a slower rate. MP measures the rate of change of TP. So, when the firm has hired so many workers that it is overcrowded and impedes the workers’ abilities to produce, the TP starts to fall and MP becomes negative. AP starts out increasing due to increasing marginal returns. Then, at some point, AP will begin to fall as a result of the effects of diminishing marginal returns. It takes AP longer to reflect the diminishing marginal returns. LO3

12 The Law of Diminishing Returns
30 TP Total Product, TP 20 10 1 2 3 4 5 6 7 8 9 Increasing Marginal Returns The law of diminishing returns. (a) As a variable resource (labor) is added to fixed amounts of other resources (land or capital) the total product that results will eventually increase by diminishing amounts, reach a maximum, and then decline. (b) Marginal product is the change in total product associated with each new unit of labor. Average product is simply output per labor unit. Note that marginal product intersects average product at the maximum average product. Diminishing Marginal Returns Negative Marginal Returns 20 Marginal Product, MP 10 AP 1 2 3 4 5 6 7 8 9 MP LO3

13 Short-Run Production Costs
Fixed costs (TFC) Costs do not vary with output Variable costs (TVC) Costs vary with output Total costs (TC) Sum of TFC and TVC TC = TFC + TVC Fixed, variable, and total costs are the short‑run classifications of costs. In the short run, costs can be variable or fixed. Fixed cost examples: rental payments, insurance premiums, interest payments. Variable cost examples: payments for materials, fuel, power, transportation services, labor. Total cost is the sum of total fixed and total variable costs at each level of output. LO4

14 Per-Unit, or Average, Costs
Average fixed costs AFC = TFC/Q Average variable costs AVC = TVC/Q Average total costs ATC = TC/Q Marginal costs MC = ΔTC/ΔQ These per-unit costs are useful in making comparisons to price. Average fixed costs reflect the fixed costs per unit produced, whereas the average variable costs reflect the variable costs per unit produced. The average total costs can also be found by adding the AFC and AVC. Marginal costs play an extremely important role in the firm’s decision making about how much they will produce. Marginal costs reflect the additional cost associated with producing one more unit of output. MC tells a firm how much it will cost to increase output by one more unit. Marginal cost essentially measures the rate of the change of the total costs. LO4

15 Short-Run Production Costs
Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run Total Cost Data Average Cost Data Marginal Cost (1) Total Product (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) TC = TFC + TVC (5) Average Fixed Cost (AFC) AFC = TFC/Q (6) Average Variable Cost (AVC) AVC=TVC/Q (7) Average Total Cost (ATC) ATC = TC/Q (8) (MC) MC =ΔTC/ΔQ $100 $0 1 100 90 190 $100.00 $90.00 $190.00 $90 2 170 270 50.00 85.00 135.00 80 3 240 340 33.33 80.00 113.33 70 4 300 400 25.00 75.00 100.00 60 5 370 470 20.00 74.00 94.00 6 450 550 16.67 91.67 7 540 640 14.29 77.14 91.43 8 650 750 12.50 81.25 93.75 110 9 780 880 11.11 86.67 97.78 130 10 930 1030 10.00 93.00 103.00 150 This table shows the total and average costs. LO4

16 Marginal Cost AFC Costs AVC Q 1 2 3 4 5 6 7 8 9 10 50 100 150 $200 MC
Q 50 100 150 $200 MC AFC ATC AVC Shifts in the curves will occur if either resource prices or technology changes. For example, if fixed costs increase, both AFC and ATC shift up. If labor costs (or some other variable input costs) rise, then the AVC, ATC, and MC would shift up. This graph shows the relationship of the marginal-cost curve to the average-total-cost and average-variable-cost curves. The marginal-cost (MC) curve cuts through the average-total-cost (ATC) curve and the average-variable-cost (AVC) curve at their minimum points. When MC is below average total cost, ATC falls; when MC is above average total cost, ATC rises. Similarly, when MC is below average variable cost, AVC falls; when MC is above average variable cost, AVC rises. Marginal decisions are very important in determining profit levels. In order to make marginal decisions, marginal revenue and marginal cost are compared. Marginal cost is a reflection of marginal product and diminishing returns. When diminishing returns begin, the marginal cost will begin its rise. AVC AFC LO4

17 Long-Run Production Costs
The firm can change all input amounts, including plant size All costs are variable in the long run Long-run ATC Different short-run ATCs The next example is of a single firm changing its plant capacity. Since all costs are variable in the long run, the focus is on average total costs and we begin by looking at various plant sizes and each associated ATC curve. LO5

18 Firm Size and Costs Average Total Costs Output ATC-1 ATC-5 ATC-2 ATC-3
Any number of short-run optimum size cost curves can be constructed. The long-run average-total-cost curve is made up of segments of the short-run cost curves (ATC-1, ATC-2, etc.) of the various-size plants from which the firm might choose. Each point on the bumpy planning curve shows the lowest unit cost attainable for any output when the firm has had time to make all desired changes in its plant size. Output LO5

19 The Long-Run Cost Curve
ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Long-run ATC Average Total Costs The long-run ATC curve just “envelopes” the short-run ATCs. If the number of possible plant sizes is very large, the long-run average-total-cost curve approximates a smooth curve. Economies of scale, followed by diseconomies of scale, cause the curve to be U-shaped. Output LO4

20 Economies and Diseconomies of Scale
Labor specialization Managerial specialization Efficient capital Other factors Constant returns to scale Economies of scale refers to the idea that, for a time, larger plant sizes will lead to lower unit costs. An increase in inputs where there are economies of scale will lead to a more than proportionate increase in output. Labor specialization leads to economies of scale because it makes use of special skills; proficiency is gained as the worker concentrates on one task and time is saved. Managerial specialization leads to economies of scale because managers can manage more workers with no increased cost, and managers can specialize in their respective area of expertise. Efficient capital leads to economies of scale because high-volume production-warrants the expensive large scale equipment. Other factors lead to economies of scale because costs such as design, development, and advertising are spread out over larger quantities. Constant returns to scale will occur when ATC is constant over a variety of plant sizes. When there are constant returns to scale, an increase in inputs will result in a proportionate increase in output. LO5

21 Economies and Diseconomies of Scale
Control and coordination problems Communication problems Worker alienation Shirking Diseconomies of scale may occur if a firm becomes too large, as illustrated by the rising part of the long-run ATC curve. As the firm expands over time, the expansion may lead to higher average total costs. With diseconomies of scale, an increase in inputs will cause a less-than-proportionate increase in output. Reasons that diseconomies of scale may occur: (1) it is difficult in controlling and coordinate large-scale operations (2) a large bureaucracy leads to communication problems (3) workers may feel alienated and therefore may not work efficiently, and (4) shirking, or work avoidance, may be easier in a larger firm. LO5

22 MES and Industry Structure
Minimum efficient scale (MES): Lowest level of output where long-run average costs are minimized Can determine the structure of the industry Where MES occurs on an industry’s long-run ATC determines if there will be many or few producers and whether they will be large, small, or different sizes. LO5

23 MES and Industry Structure
Economies of Scale Constant Returns to Scale Diseconomies of Scale Average Total Costs Long-run ATC This is a long-run ATC curve showing industries with an extended range of constant returns to scale. These industries will be populated by firms of many different sizes. Small- and large-scale producers will coexist and be equally successful. MES occurs at an output of q1. q1 q2 Output LO5

24 MES and Industry Structure
Economies of Scale Diseconomies of Scale Average Total Costs Industries with economies of scale over a wide range of outputs will lead to a few large- scale firms. The long-run ATC curve is lowest only when there is a large output. Long-run ATC Output LO5

25 MES and Industry Structure
Economies of Scale Diseconomies of Scale Average Total Costs Long-run ATC This is a long-run ATC curve where economies of scale exist, are exhausted quickly, and turn back up substantially. Here minimum efficient scale occurs at a very low level of output. This results in a large number of small producers. Output LO5


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