1. CHAPTER 6 THE ORGANIZATION AND COSTS OF PRODUCTION
Part Two: Microeconomics
of Product Markets
CHAPTER 6 THE ORGANIZATION AND COSTS OF PRODUCTION

2. In this chapter you will learn:
6.1 The various organizational forms a firm can take
6.2 What are economic costs
6.3 About a firm’s short-run production relationships
6.4 About a firm’s short-run production costs
6.5 The link between a firm’s size and costs in the long run
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6

3. The Firm and the Business Sector
Different organizational structures:
Plant
Firm
Industry
Horizontal combinations
Vertical combinations
Conglomerates
Plant=factory
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.1

4. The Firm and the Business Sector
Legal Forms of Businesses:
Sole Proprietorship
Partnership
Corporation
Advantages of Corporations
The Principal-Agent Problem
Sole proprietorship: dnghiep 1 chu
Partnership: hiep hoi
The principal agent problem: van de nguoi uy thac
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.1

5. Economic Costs Opportunity Cost Explicit Costs
payments a firm must make
Implicit Costs
opportunity costs of firm’s own resources
include normal profits
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2

6. Total (explicit) costs
Normal Profit as a Cost
Total Revenue
$120,000
Cost of T -
shirts
$40,000
Clerk's salary
$18,000
Utilities
$ 5,000
Total (explicit) costs
$ 63,000
Accounting Profit
$ 57,000
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2

7. Total (explicit) costs
Normal Profit as a Cost
Total Revenue
$120,000
Cost of T -
shirts
$40,000
Clerk's salary
$18,000
Utilities
$ 5,000
Total (explicit) costs
$ 63,000
Accounting Profit
$ 57,000
Forgone interest
$ 1,000
Forgone rent
$ 5,000
Forgone wages $2 2
,000
Normal profit
Total
implicit c
osts
$ 3 3
Economic profit
$ 24,000
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2

8. Economic profit = total revenue – economic cost
Normal Profit as a Cost
Costs of production include all costs
explicit
implicit
including a normal profit
required to attract and retain factors of production
Economic profit = total revenue – economic cost
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2

9. Figure 6-1 Economic Profit vs. Accounting Profit
Profits
Accounting
Profits
Implicit costs
(including a
normal profit)
Total
Revenue
Economic (opportunity) Costs
Accounting
costs (explicit
costs only)
Explicit
Costs
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2

10. Short Run and Long Run Short Run Long Run Fixed Plant Variable Plant
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Chapter 6.3

11. Short-Run Production Relationships
Total Product (TP)
total quantity produced
Marginal Product (MP)
change in total product
change in labour input =
Average Product (AP)
total product
units of labour =
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2

12. Short-Run Production Relationships
Law of Diminishing Returns
marginal product eventually diminishes
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3

13. Table 6-1 Total, Marginal, and Average Product
Units of labour TP MP AP 1 10 2 25 3 45 4 60 5 70 6 75 7 8
change in total product
change in labour input
MP=
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3

14. Total, Marginal, and Average Product
Units of labour TP MP AP 1 10 2 25 3 45 4 60 5 70 6 75 7 8
Increasing marginal returns 10 15 20
Diminishing marginal returns 15 10 5
Negative marginal returns -5
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3

15. Total, Marginal, and Average Product
Units of labour TP MP AP 1 10 2 25 3 45 4 60 5 70 6 75 7 8
total product
total labour input
AP= 10
10.00 15
12.50 20
15.00 15
15.00
14.00
12.50
10.71
8.75 10 5 -5
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3

16. negative marginal returns
increasing
marginal
returns
diminishing
marginal returns TP
negative marginal returns AP MP
Figure 6-2
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Chapter 6.3

17. Marginal and Average Values
If the average value is rising, the marginal value must be ABOVE the average value
If the average value is falling, the marginal value must be BELOW the average value
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3

18. Marginal and Average Values
Average value falling MP
>AP
Average value rising AP MP
<AP MP
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3

19. Fixed, Variable, and Total Costs
Fixed Costs
do not vary with changes in output
Variable Costs
change with changes in output
Total Cost
sum of fixed and variable costs
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

20. Per-Unit, or Average, Costs
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

21. Marginal Cost
Marginal cost is the extra, or additional, cost of producing one more unit of output
Illustrated…
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

22. 100 Q TFC TVC TC AFC AVC ATC MC 1 2 3 4 5 6 7 8 9 10 90 170 240 3001 2 3 4 5 6 7 8 9 10 90
170
240
300
370
450
540
650
780
930
100
100
TC=TFC + TVC
190
270
340
400
470
550
640
750
880
1030
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

23. Total Cost is the Sum of Fixed Cost and Variable Cost
Figure 6-3
TFC
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Chapter 6.4

24. Total Cost is the Sum of Fixed Cost and Variable CostTC
Add vertically to get TC
TVC
TFC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

25. Q TFC TVC TC AFC AVC ATC MC 100 1 90 2 170 3 240 4 300 5 370 6 450 7
100 1 90 2
170 3
240 4
300 5
370 6
450 7
540 8
650 9
780 10
930
AVC=TVC / Q
100
ATC=TC / Q
AFC=TFC / Q
190
100 90
190
270 50 85
135
340
400
470
550
640
750
880
1030
33.33 80
113.33 25 20
16.67
14.29
12.50
11.11 10 75 74
77.14
81.25
86.67 93
100 94
91.67
91.43
93.75
97.78
103
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

26. Note: MC is graphed at average Q
TFC
TVC TC
AFC
AVC
ATC MC
100 1 90 2
170 3
240 4
300 5
370 6
450 7
540 8
650 9
780 10
930
MC=TC / Q
100 90
190
100 90
190 80
270 50 85
135
2.5 70
340
400
470
550
640
750
880
1030
33.33 80
113.33 60 70 80 90
110
130
150 25 20
16.67
14.29
12.50
11.11 10 75 74
77.14
81.25
86.67 93
100 94
91.67
91.43
93.75
97.78
103
Note: MC is graphed at average Q
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

27. AFC, AVC, and ATC
Figure 6-5
AFC continually declines as fixed cost is spread over more and more units
AFC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

28. AVC is U-shaped: it starts to rise when AP starts to fall
AFC, AVC, and ATC
AVC is U-shaped: it starts to rise when AP starts to fall
AVC
AFC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

29. Get ATC by vertically summing AFC and AVC
AFC, AVC, and ATC
Get ATC by vertically summing AFC and AVC
ATC
AVC
AFC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

30. MC cuts ATC and AVC at minimum points
MC, AVC, and ATC
MC cuts ATC and AVC at minimum points
ATC MC
AVC
AFC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

31. Figure 6-6 Productivity Curves and Cost Curves
Average Product and
Marginal Product AP MP
Labour MC
AVC
Costs (dollars)
Output
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

32. Relation of MC to AVC and ATC
When MC < current ATC
ATC will fall
When MC > current ATC
ATC will rise
MC intersects ATC and AVC at minimum points
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

33. Shifts of Cost Curves Factor Prices price of fixed input increases...
AFC and ATC shift up
AVC and MC unchanged
price of variable input increases...
AVC, ATC, and MC shift up
AFC unchanged
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

34. Shifts of Cost Curves Technology improved technology lower costs
cost curves shift down
curve shifts depend on whether technology affects FC, VC, or both
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4

35. Long-Run Production Costs
What will costs look like when the firm can choose the best plant size for any given situation?
For every plant capacity size, there is a short-run ATC curve
All such plant capacities can be plotted...
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5

36. Figure 6-7 The Long-Run Average-Total-Cost Curve
ATC-4
ATC-3
ATC-1
ATC-2
ATC-5
Choose the best plant for every output level
These choices determine the LRATC curve
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5

37. Figure 6-8 The Long-Run Average-Total-Cost Curve
LRATC
The number of possible plant sizes is virtually unlimited
The LRATC curve just envelops the short-run cost curves
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5

38. Economies of Scale Diseconomies of Scale Constant Returns to Scale
Labour Specialization
Managerial Specialization
Efficient Capital
Other Factors
Diseconomies of Scale
Constant Returns to Scale
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5

39. Figure 6-9 Economies and Diseconomies of Scale
Constant returns
to scale
Economies
of scale
Diseconomies
of scale
LRATC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5

40. Minimum Efficient Scale
ATC-4
ATC-3
ATC-1
ATC-2
ATC-5
MES is the smallest level of output that minimizes LRATC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5

41. Minimum Efficient Scale
Relatively large MES
natural monopoly
LRATC
MES
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Chapter 6.5

42. Minimum Efficient Scale
LRATC
Relatively small MES
competitive industry
MES
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5

43. Applications and Illustrations
Successful Startup Firms
The Daily Newspaper
The Verson Stamping Machine
Aircraft and Concrete Plants
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5

44. Chapter Summary 6.1 The Firm and the Business Sector
6.2 Economic Costs
Opportunity Cost
6.3 Short-Run Production Relationships
The Law of Diminishing Return
TP, AP and MP
6.4 Short-Run Production Costs
Fixed Cost, Average Cost, and Marginal Cost
6.5 Long-Run Production Costs
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6