1. Chapter 5 The Firm: Production and Cost

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-2 Economic Rent  A payment for the use of any resource over and above its opportunity cost  Thus, rent has a different meaning in economics.

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-3 Economic Rent (cont'd) Determining land rent  Economists originally used the term rent to designate payment for use of land.  The concept of economic rent is associated with the British economist David Ricardo.

4. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-4 Figure 22-1 Economic Rent

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-5 Economic Rent (cont'd) Economic rent to labor  Professional sports superstars  Rock stars  Movie stars  World-class models  Successful inventors and innovators

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-6 Example: Do Entertainment Superstars Make Super Economic Rents? Superstars certainly do well financially. Forbes magazine has ranked them. How much of these earnings can be called economic rent?

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-7 Table 22-1 Superstar Earnings

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-8 Firms and Profits Firms or businesses, like individuals, seek to earn the highest possible returns. A firm brings together the factors of production to produce a product or service it hopes can be sold at a profit.

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-9 Firms and Profits (cont'd) Firm  A business organization that employs resources to produce goods or services for profit  A firm normally owns and operates at least one “plant” or facility in order to produce.

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-10 Firms and Profits (cont'd) The legal organization of firms  Proprietorship  Partnership  Corporation

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-11 Table 22-2 Forms of Business Organization

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-12 The Legal Organization of Firms Proprietorship  A business owned by one individual who  Makes the business decisions  Receives all the profits  Is legally responsible for all the debts of the firm

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-13 The Legal Organization of Firms (cont'd) Advantages of proprietorships  Easy to form and dissolve  All decision-making power resides with the sole proprietor  Profit is taxed only once

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-14 The Legal Organization of Firms (cont'd) Disadvantages of proprietorships  Unlimited Liability  The owner of the firm is personally responsible for all of the firm’s debts.  Limited ability to raise funds  Proprietorship normally ends with the death of the proprietor.

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-15 The Legal Organization of Firms (cont'd) Partnership  A business owned and managed by two or more co-owners, or partners, who  Share the responsibilities and the profits of the firm  Are individually liable for all the debts of the partnership

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-16 The Legal Organization of Firms (cont'd) Advantages of partnerships  Easy to form and dissolve  Partners retain decision-making power  Permits more effective specialization  Profit is taxed only once

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-17 The Legal Organization of Firms (cont'd) Disadvantages of partnerships  Unlimited liability  Decision making more costly  Dissolution often occurs when a partner dies or leaves the firm.

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-18 The Legal Organization of Firms (cont'd) Corporation  A legal entity that may conduct business in its own name just as an individual does  The owners of a corporation, called shareholders  Own shares of the firm’s profits  Enjoy the protection of limited liability

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-19 The Legal Organization of Firms (cont'd) Limited Liability  A legal concept whereby the responsibility, or liability, of the owners of a corporation is limited to the value of the shares in the firm that they own.

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-20 The Legal Organization of Firms (cont'd) Advantages of corporations  Limited liability  Continues to exist when owner leaves the business  Raising large sums of financial capital

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-21 The Legal Organization of Firms (cont'd) Disadvantages of corporations  Double taxation  Dividends  Portion of corporation’s profits paid to its owners (shareholders)  Separation of ownership and control

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-22 The Profits of a Firm Accounting Profit  Total revenue minus total explicit costs

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-23 The Profits of a Firm (cont'd) Explicit Costs  Costs that business managers must take account of because they must be paid  Examples are wages, taxes and rent

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-24 The Profits of a Firm (cont'd) Implicit Costs  Expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculate  Opportunity cost of factors of production that are owned  Owner-provided capital and owner- provided labor

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-25 The Profits of a Firm (cont'd) Normal Rate of Return  The amount that must be paid to an investor to induce investment in a business  Also known as the opportunity cost of capital

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-26 Let’s discuss Bertha Benson…

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-27 The Profits of a Firm (cont'd) Opportunity Cost of Capital  The normal rate of return, or the available return on the next-best alternative investment  Economists consider this a cost of production, and it is included in our cost examples.

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-28 The Profits of a Firm (cont'd) Opportunity cost of owner-provided land and capital  Single-owner proprietorships often exaggerate profit as they understate their opportunity cost of capital.  Consider a simple example of a skilled auto mechanic working at his/her own service station, six days a week.

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-29 The Profits of a Firm (cont'd) Accounting profits versus economic profits  The term profits in economics means the income entrepreneurs earn.  Over and above all costs including their own opportunity cost of time.  Plus the opportunity cost of capital they have invested in their business.

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-30 The Profits of a Firm (cont'd) Economic Profits  Total revenues minus total opportunity costs of all inputs used  The total of implicit and explicit costs

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-31 Figure 22-2 Simplified View of Economic and Accounting Profit

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-32 Interest Interest is the price paid from debtors to creditors for the use of loanable funds. Businesses use financial capital in order to invest in physical capital.

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-33 Interest (cont'd) Financial Capital  Funds used to purchase physical capital goods, such as buildings and equipment Interest  The payment for current rather than future command over resources; the cost of obtaining credit

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-34 Interest (cont'd) Variations in the rate of annual interest that must be paid for credit depend on 1. Length of loan 2. Risk 3. Handing charges

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-35 Interest (cont'd) Nominal Rate of Interest  The market rate of interest expressed in today’s dollars Real Rate of Interest  The nominal rate of interest minus the anticipated rate of inflation

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-36 Interest (cont'd) Present Value  The value of a future amount expressed in today’s dollars  The most that someone would pay today to receive a certain sum at some point in the future

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-37 Interest (cont'd) PV 1 = FV 1 / 1 + i where PV 1 = Present value of a sum one year hence FV 1 = Future sum paid or received one year hence i = Market rate of interest

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-38 Interest Rates and Present Value Present value of $105 to be received one year from now, if the interest rate is 5%:  PV = 105/(1.05) = $100  The present value is $100

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-39 Table 22-3 Present Value of a Future Dollar

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-40 Interest (cont'd) Your own personal discount rate will determine how willing you are to save and to borrow. The market interest rate lies between the upper and lower ranges of personal rates of discount.

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-41 Corporate Financing Methods When it all began—1602  Dutch East India Company raised financial capital by  Selling ownership shares (stock)  Using notes of indebtedness (bonds)  Some profits were retained for reinvestment

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-42 Corporate Financing Methods (cont'd) Share of Stock  A legal claim to a share of a corporation’s future profits  Common stock  Incorporates certain voting rights regarding major policy decisions of the corporation  Preferred stock  Owners are accorded preferential treatment in the payment of dividends

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-43 Corporate Financing Methods (cont'd) Bond  A legal claim against a firm  Usually entitling the owner of the bond to receive a fixed annual coupon payment, plus a lump-sum payment at the bond’s maturity date  Bonds are issued in return for funds lent to the firm.

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-44 Corporate Financing Methods (cont'd) Reinvestment  Profits (or depreciation reserves) used to purchase new capital equipment  Sales of stock are an important source of financing for new firms.  Reinvestment and borrowing are the primary means of financing for existing ones.

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-45 The Difference Between Stocks and Bonds 1.Stocks represent ownership. 2.Common stocks do not have a fixed dividend rate. 3.Stockholders can elect a board of directors, which controls the corporation. 4.Stocks do not have a maturity date; the corporation does not usually repay the stockholder. 5.All corporations issue or offer to sell stocks. This is the usual definition of a corporation. 6.Stockholders have a claim against the property and income of a corporation after all creditors’ claims have been met. 1.Bonds represent debt. 2.Interest on bonds must always be paid, whether or not any profit is earned. 3.Bondholders usually have no voice in or over management of the corporation. 4.Bonds have a maturity date on which the bondholder is to be repaid the face value of the bond. 5.Corporations need not issue bonds. 6.Bondholders have a claim against the property and income of a corporation that must be met before the claims of stockholders. StocksBonds

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-46 The Markets for Stocks and Bonds Economists often refer to the “market for wheat” or the “market for labor.” These are more conceptual places rather than actual ones. For securities there really are markets—physical locations.

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-47 The Markets for Stocks and Bonds (cont'd) Securities  Stocks and bonds

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-48 The Markets for Stocks and Bonds (cont'd) New York Stock Exchange (NYSE) Nasdaq London Stock Exchange (FTSE) Tokyo Stock Exchange Bombay Stock Exchange (BSE) Shanghai Stock Exchange

49. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-49 The Markets for Stocks and Bonds (cont'd) Inside Information  Information that is not available to the general public about what is happening in a corporation  One way to “beat the market,” although it is considered illegal, punishable by substantial fines and imprisonment

50. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-50 Table 22-4 Reading Stock Quotes

51. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22-51 Figure 22-3 The Price of a Seat on the New York Stock Exchange Since 1999

52. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-52 Did You Know That... Nanotechnology-enabled improvements may help computer manufactures lengthen the time components last, thereby reducing their costs? Production technologies and the costs producers face are related?

53. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-53 Short 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 Short Run versus Long Run

54. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-54 Short Run versus Long Run (cont'd) Long Run  The time period in which all factors of production can be varied

55. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-55 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.

56. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-56 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.

57. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-57 The Relationship Between Output and Inputs (cont'd) Q = output/time period K = capital L = labor Q = ƒ(K,L) or Output / time period = Some function of capital and labor inputs

58. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-58 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

59. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-59 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.

60. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-60 E-Commerce Example: Put Away the Clay and Turn on the Holographic Camera Once a company has integrated a holographic camera system into its existing computer network, creating holographic designs takes less time. Consequently, product developers using holographic techniques can now create more designs while utilizing fewer labor resources.

61. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-61 E-Commerce Example: Put Away the Clay and Turn on the Holographic Camera (cont'd) Why do technological improvements often reduce labor requirements for specific tasks, thereby allowing labor to be utilized for other purposes?

62. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-62 The Relationship Between Output and Inputs (cont'd) Average Physical Product  Total product divided by the variable input

63. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-63 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

64. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-64 Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (a)

65. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-65 Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (b)

66. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-66 Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (c)

67. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-67 Diminishing Marginal Product Measuring marginal product Specialization and marginal product Diminishing marginal product

68. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-68 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 Diminishing Marginal Product (cont'd)

69. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-69 An Example of the Law of Diminishing Marginal Product Production of computer printers example  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.

70. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-70 An Example of the Law of 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.

71. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-71 Total costs (TC) = TFC + TVC 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

72. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-72 Average Total Costs (ATC) Short-Run Costs to the Firm (cont'd) Average total costs (ATC) = Total costs (TC) Output (Q)

73. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-73 Average Variable Costs (AVC) Short-Run Costs to the Firm (cont'd) Average variable costs (AVC) = Total variable costs (TVC) Output (Q)

74. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-74 Average Fixed Costs (AFC) Short-Run Costs to the Firm (cont'd) Average fixed costs (AFC) = Total fixed costs (TFC) Output (Q)

75. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-75 Marginal Cost  The change in total costs due to a one-unit change in production rate Short-Run Costs to the Firm (cont'd) Marginal costs (MC) = Change in total cost Change in output

76. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-76 Figure 23-2 Cost of Production: An Example, Panel (a)

77. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-77 TotalAverage TotalFixedFixed OutputCostsCosts (Q/day)(TFC)(AFC) 0$10 110 210 310 410 510 610 710 810 91010 1110 ——— $10.00 5.00 3.33 2.50 2.00 1.67 1.43 1.25 1.11 1.00.91 Costs (dollar per day) 2 4 6 8 12 24681001357911 16 Output (calculators per day) 10 14 Cost of Production: AFC AFC

78. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-78 TotalAverage TotalVariableVariable OutputCostsCosts (Q/day)(TVC)(AVC) 0$0 15 28 310 411 513 616 720 825 931 1038 1146 ——— $5.00 4.00 3.33 2.75 2.60 2.67 2.86 3.13 3.44 3.80 4.18 Costs (dollar per day) 2 4 6 8 12 24681001357911 16 Output (calculators per day) 10 14 Cost of Production: AVC AVC

79. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-79 Average TotalTotalTotal OutputCostsCosts (Q/day)(TVC)(AVC) 0$10 115 218 320 421 523 626 730 835 941 1048 1156 ——— $15.00 9.00 6.67 5.25 4.60 4.33 4.28 4.38 4.56 4.80 5.09 Costs (dollar per day) 2 4 6 8 12 24681001357911 16 Output (calculators per day) 10 14 Cost of Production: ATC ATC

80. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-80 Costs (dollar per day) 2 4 6 8 12 24681001357911 16 Output (calculators per day) 10 14 ATC AVC AFC Cost of Production: An Example

81. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-81 AVC Costs (dollar per day) Output (calculators per day) ATC Cost of Production: An Example AFC AVC AFC ATC Difference between AVC and ATC = AFC TP

82. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-82 AFC AVC Costs (dollar per day) Output (calculators per day) ATC Cost of Production: An Example AVC TP ATC = AVC + AFC AFC = ATC - AVC

83. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-83 Marginal Cost  The change in total costs due to a one-unit change in production rate Short-Run Costs to the Firm Marginal costs (MC) = change in total cost change in output

84. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-84 Total TotalVariableTotalMarginal OutputCostsCostsCost (Q/day)(TVC)(TC)(MC) 0$0 15 28 310 411 513 616 720 825 931 1038 1146 $10 15 18 20 21 23 26 30 35 41 48 56 $5 3 2 1 2 3 4 5 6 78 Costs (dollar per day) 2 4 6 8 12 24681001357911 16 Output (calculators per day) 10 14 MC Cost of Production: MC

85. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-85 Cost of Production: An Example Figure 22-3, Panel (c)

86. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-86 Figure 23-2 Cost of Production: An Example, Panel (b)

87. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-87 Figure 23-2 Cost of Production: An Example, Panel (c)

88. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-88 In Class Example…

89. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-89 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?

90. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-90 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.

91. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-91 Example: Reducing the Marginal Cost of Air Transport with “Winglets” After years of experimentation, engineers created winglets by making jetliners’ wings slightly longer and curving them up at the ends. Since the early 2000s, most new planes ordered by airliners have included winglets, which provide fuel savings for every mile that a plane is in the air. Some airlines are in the process of adding winglets to their existing fleet of planes too.

92. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-92 Example: Reducing the Marginal Cost of Air Transport with “Winglets” (cont'd) How has airlines’ use of winglets affected their total cost curves?

93. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-93 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.

94. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-94 The Relationship Between Average and Marginal Costs (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.

95. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-95 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.

96. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-96 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. The Relationship Between Diminishing Marginal Product and Cost Curves (cont'd)

97. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-97 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 of labor increases.

98. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-98 Figure 23-3 The Relationship Between Output and Costs, Panel (a)

99. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-99 Figure 23-3 The Relationship Between Output and Costs, Panel (b)

100. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-100 Figure 23-3 The Relationship Between Output and Costs, Panel (c)

101. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-101 Figure 23-3 The Relationship Between Output and Costs, Panel (d)

102. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-102 Long-Run Cost Curves Planning Horizon  The long run, during which all inputs are variable

103. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-103 Figure 23-4 Preferable Plant Size and the Long-Run Average Cost Curve

104. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-104 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

105. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-105 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?

106. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-106 Why the Long-Run Average Cost Curve is U-Shaped Economies of scale Constant returns to scale Diseconomies of scale

107. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-107 Figure 23-5 Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with Long-Run Average Cost Curve

108. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-108 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.

109. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-109 Reasons for economies of scale  Specialization  Division of tasks or operations  Dimensional factor  Improved productive equipment Why the Long-Run Average Cost Curve is U-Shaped (cont'd)

110. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-110 Why the Long-Run Average Cost Curve is U-Shaped (cont'd) Explaining diseconomies of scale  Limits to the efficient functioning of management  Coordination and communication is more of a challenge as firm size increases

111. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-111 Policy Example: Economies of Scale in Payment Processing Since 2000, the annual volume of payments transmitted by the Federal Reserve’s ACH system has increased from 3.8 to more than 6 billion. At the same time, the average cost of transmitting a payment has declined from more than 1.6 cents to about 1 cent.

112. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-112 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

113. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-113 Figure 23-6 Minimum Efficient Scale

114. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-114 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

115. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-115 Example: A Company Thinks Smaller to Boost its MES Briggs & Stratton Corp. moved from a massive 2 million square foot facility in Milwaukee where it was located in the 1990s. Today, it has dispersed its production among six smaller plants, each of which utilizes more automated equipment and employs fewer workers than during the 1990s.

116. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23-116 Example: A Company Thinks Smaller to Boost its MES (cont'd) Downsizing its plants enabled the company to increase its overall scale of operations, from an output rate of 8 million engines per year to more than 10 million engines per year. The result of this output increase has been lower long-run average total cost, which has helped to boost the company’s annual profitability by more than 30%.

117. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 5-117 Key Terms and Concepts accounting profits average fixed costs average physical product average total cost average variable costs corporation costs economic profits explicit fixed costs law of diminishing returns limited liability limited liability company (LLC)

118. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 5-118 Key Terms and Concepts (cont.) marginal costs marginal physical product partnership production function S corporations short run sole proprietorship total costs unlimited liability variable costs