1. Production and Cost in the Firm
CHAPTER 7
© 2003 South-Western/Thomson Learning

2. Cost and Profit
In economics, we assume that producers try to maximize profit  this provides the motivation for their behavior
Firms transform resources into products in their attempt to accomplish this objective
They must make plans while confronting uncertainty about
Consumer demand
Resource availability
Intentions of other firms in the industry

3. Explicit and Implicit Costs
To hire resources, producers must pay resources at least their opportunity costs
For most resources, the cash payments approximate their opportunity cost
However, some resources are owned by the firm or the firm’s owners  there are no direct cast payments
Whether hired in resource markets or owned by the firm, all resources have an opportunity cost

4. Explicit and Implicit Costs
Explicit costs
Refer to the firm’s actual cash payments for resources  wages, rent, taxes, etc.
Implicit costs
The opportunity costs of using resources owned by the firm or provided by the firm’s owners
Require no cash payment and no entry in the firm’s accounting statement, which records its revenues, explicit costs, and accounting profits

5. Alternative Measures of Profit
A particular example may help to clarify the distinction between explicit and implicit costs and the alternative measure of profit that are used
Wanda Wheeler currently earns $50,000 in her current job
She decides to start her own business
She withdraws $20,000 from her savings account, hires and assistant and uses a spare bay in her garage that had been renting for $1,000 a year
Exhibit 1 shows the results after the first year

6. Exhibit 1: Accounts of Wheeler Dealer 2001
Total revenue $105,000
Less explicit costs:
Assistant's salary ,000
Material and equipment -20,000
Equals accounting profit $64,000
Less implicit costs:
Wanda's forgone salary 50,000
Forgone interest on savings -1,000
Forgone garage rental -1,200
Equals economic profit $11,800
Accounting profit equals total revenue minus explicit costs  used to determine a firm’s taxable income
However, this ignores the opportunity cost of Wanda’s own resources
Her forgone salary of $50,000
Annual interest of $1,000 from the savings used to start the business
Rental income of $1,200
Economic profit equals total revenue minus all costs, both explicit and implicit
Accounting profit of $64,000 less implicit costs of $52,200  economic profit of $11,800

7. Normal Profit
There is one other profit measure to consider: the accounting profit required to induce the firm’s owners to employ their resources in the firm
Alternatively, the accounting profit just sufficient to ensure that all resources used by the firm earn their opportunity cost  normal profit
Recall that the accounting profit = $64,000
Normal profits = $50,000 + $1,200 + $1,000 = $52,200  normal profit  $11,800 is an economic profit

8. Fixed and Variable Resources
Resources can be divided into two categories
Variable resources can be varied quickly to change the output rate
Fixed resources are those resources which cannot be easily changed
This provides us the distinction between the short run and the long run
Short run  at least one resource is fixed
Long run  all resources are variable

9. Short Run and Long Run
Output can be changed in the short run by adjusting variable resources
However, the size, or scale of the firm is fixed in the short run
In the long run, all resources can vary
The length of the short and long run differs from industry to industry because the nature of production differs

10. Law of Diminishing Marginal Returns
For the present, suppose we focus on the short-run link between resource use and the rate of output
Suppose the company’s fixed resources are already in place and consist of a warehouse, a moving van, and moving equipment
The only variable resource is labor
Exhibit 2 provides our illustration

11. Exhibit 2: Short-Run Relationship
Units of Labor and Tons of Furniture Moved
Units of the Total Marginal
Variable Product Product
Resource (tons moved (tons moved
(worker-days) per day) per day)
Labor measured in worker-days (1 worker for one day)
Output measured in tons of furniture moved per day.
Tons of furniture moved, or total product, at each level of employment is shown in the center column
Relationship between the amount of resources employed and total product is called the firm’s production function.
Last column shows the marginal product of each worker

12. Law of Diminishing Marginal Returns
As more of a variable resource is combined with a given amount of a fixed resource, marginal product eventually declines
This is the most important feature of production in the short run  dictates the shape of the production function and the cost curves

13. Total and Marginal Product Curves
Exhibit 3 illustrates the relationship between total product and marginal product
The values used in these figures are derived from the data presented in Exhibit 2

14. Exhibit 3: Total and Marginal Product
(a) Total Product
Because of increasing marginal returns, marginal product increases with each of the first three workers  total product is increasing at an increasing rate. 15
Total
Total product (tons/day)
product 10 5
However, once decreasing returns set in – adding the 4th worker – marginal product declines  total product continues to increase but at a decreasing rate. 5 10
(b) Marginal product
Workers per day
Increasing
Marginal
returns
Diminishing but
Positive
marginal returns
Negative
Marginal
returns 5 4
Marginal product (tons/day)
As long as marginal product is positive, total product increases  where marginal product turns negative, total product starts to fall. 3 2
Marginal
product 1 5 10
Workers per day

15. Costs in the Short Run There are two kinds of costs in the short run
Fixed costs pay for fixed resources and must be paid even if no output is produced  do not vary when output varies
In our example the fixed costs are assumed to be $200
Variable cost is the cost of variable resources – labor in our example – and vary with the amount of labor employed in the production process  as more labor is employed, output and variable cost both increase
The firm can hire labor at $100 per worker day  variable cost equals $100 times the number of workers hired

16. Exhibit 4: Short-Run Cost Data
Tons Moved Fixed Variable Marginal
per Day cost Workers Cost Total Cost Cost
(q) (FC) per Day (VC) TC=FC+VC MC=TC/ q
(1) (2) (3) (4) (5) (6)
$ $ $ $
Notice that fixed costs – column (2) – remain constant at $200 per day regardless of output.
Column (3) shows the amount of labor needed to produce each rate of output based on the the productivity figures introduced previously.
The variable and total cost associated with each level of output are shown in columns (4) and (5), respectively.
TC = FC + VC
Since total cost is the opportunity cost of all resources employed by the firm, it includes a normal profit but not an economic profit. Marginal cost is provided in the last column.
Marginal cost is simply the change in total cost divided by the change in output  MC = ΔTC / Δq
Changes in MC reflect changes in marginal productivity of the variable resource employed

17. Marginal Cost and Marginal Productivity
When the firm experiences increasing marginal returns – marginal product is increasing – the marginal cost decreases
When the firm experiences diminishing marginal returns – marginal product begins to decline – the marginal cost of output increases
Exhibit 5 provides a graphical illustration of our cost curves

18. Exhibit 5: Total and Marginal Cost Curves(
(a) Total cost curve
Since total cost does not vary with output, the fixed cost curve is a horizontal line at $200.
$1,000
Total
cost
Variable cost is zero when output is zero  the variable cost curve starts at zero, then increases slowly then sharply.
Total dollars
Variable
cost
500
The total cost curve sums the variable and fixed cost curves.
Fixed
cost
Fixed
cost
200
Marginal cost declines until the 9th unit of output and then increases reflecting labor’s increasing and then diminishing marginal returns. 3 6 9 12 15
Tons per day
(b) Marginal cost curve
$100
The change in total cost resulting from a one-unit change in production equals marginal cost  the slope of the total cost curve at each rate of output equals the marginal cost at that rate of output.
Cost per ton 50
Marginal
cost 25 3 6 9 12 15
Tons per day

19. Summary
The total cost curve can be divided into two sections, based on what happens to marginal cost
Because of increasing marginal returns from labor, marginal cost at first declines  total cost initially increases by successively smaller amounts  total cost curve gets flatter
Because of diminishing marginal returns from labor, marginal cost starts increasing  a steeper total cost curve

20. Summary Marginal cost is the key to economic decisions made by firms
The firm operating in the short run has no control over its fixed cost, but, by, varying output, the firm can alter its variable cost and hence its total cost
Marginal cost indicates how much total cost will increase if one more unity is produced and how much total cost will drop if production declines by one unit

21. Average Cost in the Short Run
The average cost per unit of output is another of the useful cost measures
There are average cost measures corresponding to variable cost, fixed cost and variable cost
Exhibit 6 provides a detailed listing of the variable costs for our example

22. Exhibit 6: Short Run Cost Data
Tons Moved Variable Marginal Average Average
per Day Cost Total Cost Cost Variable Cost Total Cost
(q) (VC) TC=FC+VC MC=TC/ q AVC=VC/q ATC=TC /q
(1) (2) (3) (4) (5) =(2) / (1) (6)=(3) / (1)
$ $ $
$ $150.00
Average variable cost, AVC, equals variable cost divided by output  AVC = VC / q
Average total cost, ATC, equals total cost divided by output  ATC = TC / q
Both average variable cost and average total cost first decline as output expands, then increase

23. Marginal and Average Cost
The relationship between marginal and average cost is also important
When marginal cost is below or less than average cost it pulls average cost down
When marginal cost is above or higher than average cost it pulls average cost up
Exhibit 7 depicts this relationship

24. Exhibit 7: Average and Marginal Cost Curves
Marginal cost declines as output expands because of increasing marginal returns to labor  so long as marginal cost is below average cost, average cost falls as output expands.
The distance between the average variable and total cost gets smaller as output increases because average fixed costs decline as output increases
$150
125 n o
Marginal cost t
100 r e p t s 75
At higher rates of output, marginal cost increases o C
Average total cost 50
Average variable cost
Where marginal cost exceeds average cost, marginal cost pulls up the average. 25
Tons per day
Because marginal cost first pulls down average cost and then pulls up average cost, each average cost curve has a U shape.
Notice also that the rising marginal cost curve intersects both the average variable and total cost curves at their minimums.

25. Costs in the Long Run
Thus far we have focused on how costs vary as the rate of output expands in the short run for a firm of a given size
In the long run, all inputs that are under the firm’s control can be varied  there are no fixed costs
The long run is not just a succession of short runs

26. Costs in the Long Run
The long run is best thought of as a planning horizon
In the long run, the choice of input combinations is flexible, but that flexibility is available only to firms that have not yet acted on their plans
Firms plan for the long run, but they produce in the short run

27. Long-Run Average Cost Curve
Suppose that, because of the special nature of technology in the industry, a firm must choose among only three possible sizes
Small
Medium
Large
Exhibit 8 presets this simple case

28. Exhibit 8: Short-Run Cost Curves and the Long-Run Planning Curve
The long-run average cost curve connects portions of the three-short run average cost curves that are lowest for each output rate  S,a,b, and L'
Cost per unit
The appropriate size or scale for the new plant depends on how much the firm wants to produce. S L' M M'
Cost per unit S' L
For example, if q is the desired rate of output in the long run, the average cost per unit is lowest with a small plant. If the desired output rate is q', the medium plant size ensures lowest cost. a b
Output per period q q q' q a b
Generally, for any output less than qa average cost is the lowest when the plant is small, for output rates between qa and qb, for the medium plant, and when output exceeds qb, the large plant has the lowest average costs.

29. Long-Run Average Cost Curve
Now suppose there are many possible plan sizes
Exhibit 9 presents a sample of short-run average total cost curves shown in pink
The long-run average cost curve, shown in red, is formed by connecting the points on the various short-run average cost curves that represent the lowest per-unit cost for each rate of output

30. Exhibit 9: Family of Many Short-Run Cost Curves Forming a Firm’s Long-Run Planning Curve
Each of the short-run average cost curves is tangent to the long-run average cost curve, or planning curve. 10 9
Output per period
q q'
ATC 1 2 3 4 5 6 7 8
Long-run
average cost a b c
$11
If we could display enough short-run cost curves, we would have a different plant size for each rate of output.
Cost per unit
These points of tangency represent the least-cost way of producing each particular rate of output, given the technology and resource prices.

31. Exhibit 9: Family of Many Short-Run Cost Curves Forming a Firm’s Long-Run Planning Curve
The short-run average total cost ATC1 is tangent at point a  the least-cost way of producing output rate q is with the plant size associated with ATC1
ATC
ATC 10 1
ATC
ATC 9
$11 2 a b
ATC 10
ATC 8 3 9
ATC c 7
ATC 4
ATC 6
ATC 5
Long-run
average cost
Cost per unit
Note that other output rates along ATC1 have a lower average cost of production.
Output per period
q q'

32. Exhibit 9: Family of Many Short-Run Cost Curves Forming a Firm’s Long-Run Planning Curve
If the firm decides to produce q', it could select the plant associated with ATC1
ATC
ATC 10 1
ATC
ATC 9 2
$11 a b
ATC 10
ATC 8 3 9
ATC c 7
However, average cost is lower with a larger plant. With ATC2, the average cost of producing q' would be minimized at $9 per unit at point c
ATC 4
ATC 6
ATC 5
Long-run
average cost
Cost per unit
Output per period
q q'

33. Economies of Scale Notice that the long-run average curve is U-shaped
The U-shape here is a result of economies and diseconomies of scale
Economies of scale imply that long-run average costs decline as output expands while diseconomies of scale imply that long-run average costs increase as output increases

34. Economies of Scale
A larger size often allows for larger, more efficient, machines and allows workers a greater degree of specialization  Production techniques such as the assembly line can be utilized only if the rate of output is large enough
Typically, as the scale of the firm increases, capital substitutes for labor and complex machines substitute for simpler machines

35. Diseconomies of Scale
As a firm expands, diseconomies of scale, eventually take over  long-run average cost increase as output expands
As the amount and variety of resources employed increase, so does the task of coordinating all these inputs
However, as the work force grows, additional layers of management are needed to monitor production

36. Diseconomies of Scale
In the thicket of bureaucracy that develops, communications may get mangled
The more levels of management there are in an organization, the more difficult it is for top management to communicate with those that perform most of the production tasks

37. Constant Long-Run Average Costs
It is possible for average cost to neither increase nor decrease with changes in firm size
In these situations, the firm experiences constant long-run average costs
Exhibit 10 presents a firm’s long run average cost curve, which is divided into segments reflecting all these possibilities

38. Exhibit 10: A Firm’s Long-Run Average Cost Curve
The rate of production must reach quantity A for the firm to achieve the minimum efficient scale, which is the lowest rate of output at which long-run average cost is a minimum.
Cost per Unit
Long-run
average cost A B
Output per period
Economies
of scale
Constant
average cost
Diseconomies
of scale
From output A to rate B, average cost is constant. Beyond output rate B, diseconomies of scale increase long-run average cost.

39. Economies and Diseconomies of Scale at the Firm Level
Thus far we have focused on a particular plant
However, a firm could also be a collection of plants
And it is possible that economies and diseconomies of scale can exist at the firm level as well as the plant level