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

2. 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.

3. 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

4. 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

5. 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

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

7. 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

8. 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?

9. 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

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

11. 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

12. 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

13. 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

14. 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

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

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

17. 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)

18. Simplified View of Economic and Accounting Profit
Figure 22-1

19. 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.

20. 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

21. Short Run Versus Long Run
The time period in which all factors of production can be varied

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

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

24. 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

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

26. 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

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

28. 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

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

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

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

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

33. 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

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

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

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

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

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

39. 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)

40. 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)

41. 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)

42. Cost of Production: An Example16 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)

43. 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)

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

45. 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

46. 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)

47. 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

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

49. Cost of Production: An Example16
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)

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

51. 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.

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

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

54. 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)

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

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

57. 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)

58. 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

59. 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.

60. 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

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

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

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

64. 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.

65. 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.

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

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

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

69. 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

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

71. 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?

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

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

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

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

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

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

78. 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

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

80. Minimum Efficient Scale
Figure 22-7

81. 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

82. Web Links
The following Web links appear in the margin of this chapter in the textbook:
smallbus.html
TheFirm/ProductionFunct.html

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

84. 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

85. 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

86. 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

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