chapter 23

Chapter 23

The Firm: Cost and Output Determination

2

Introduction

Freight dispatchers use real-time information transmitted by computers to monitor the positions of locomotives and rolling stock along the nation’s railways.

In what respect does the availability of information affect the operating costs of

any business?

3

Learning Objectives

Discuss the difference between the short run and the long run from the perspective of a firm

Understand why the marginal physical product of labor eventually declines as more units of labor are employed

4

Learning Objectives

Explain the short-run cost curves faced by a typical firm

Explain the long-run cost curves faced by a typical firm

Identify situations of economies and diseconomies of scale and define a firm’s minimum efficient scale

5

Chapter Outline

Short Run versus Long Run

Relationship Between Output and Inputs

Diminishing Marginal Returns

Short-Run Costs to the Firm

6

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

7

As electric utilities have increased their generating capacity over the past ten years, they also have lowered the average cost of producing power?

In some other industries, a higher productive capacity is associated with a higher average cost?

Did You Know That...

8

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


9

Long Run– The time period in which all factors of

production can be varied


10


Short run and long run are terms that apply to planning decisions made by managers. The firm always operates in the short run in the sense that decisions can only be made in the present.

But some of these decisions result in a long-term commitment of resources.

11

The RelationshipBetween Output and Inputs

Q = output/time period K = capitalL = labor

Q = ƒ(K,L)or

Output/time period = some function of capital and labor inputs

12

Production– Any activity that results in the conversion

of resources into products that can be used in consumption


13

Production Function– The relationship between inputs and

output

– A technological, not an economic, relationship

– The relationship between inputs and maximum physical output


14

Procter & Gamble is a consumer products company that supplies soap and personal care products to retailers.

Using inventory-tracking software, the company found that it could make more efficient use of all inputs if it dispatched trucks from its manufacturing facilities with less than full loads.

Example:The Optimal Load Size for Trucks

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Example:The Optimal Load Size for Trucks

The efficiency resulted from the fact that workers who loaded the trucks were more productive and that total fuel consumption was less when trucks were only partially loaded.

The inventory-tracking software allowed the company to identify parts of its production function that would have been difficult to determine through casual observation.

16

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

Diminishing Marginal Returns

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Average Physical Product– Total product divided by the variable input


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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


19

Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case

Figure 23-1, Panel (a)

20

Diminishing Returns, the Production Function,and Marginal Product: A Hypothetical Case

Figure 23-1, Panel (b)

21

Diminishing Returns, the Production Function,and Marginal Product: A Hypothetical Case

Figure 23-1, Panel (c)

22

An Example of the Law of Diminishing Returns

Production of computer printers– With a fixed amount of factory space,

assembly equipment, and quality control diagnostic software, more workers can add to total output.

– But the additional increments of quantity produced will lessen as more labor is added.

23

An Example of the Law of Diminishing Returns

Beyond a certain point, as more workers as added, they will have to assemble the printers manually.

The marginal physical product of labor, while remaining positive, will decline.

24

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

25

Cost of Production: An Example

Figure 23-2, Panel (a)

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Cost of Production: An Example

Figure 23-2, Panel (b)

1110

Total costs

Total variablecosts

9876543210

10

20

Panel (b)

60

50

40

30

Output (recordable DVDs per day)

Tota

l cos

ts (d

olla

rs p

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ay)

Total fixedcosts

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Average Total Costs (ATC)


Average total costs (ATC) = total costs (TC)

output (Q)

28

Average Variable Costs (AVC)


Average variable costs (AVC) = total variable costs (TVC)

output (Q)

29

Average Fixed Costs (AFC)


Average fixed costs (AFC) = total fixed costs (TFC)

output (Q)

30

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

31

What do you think?– Is there a predictable relationship

between the production function and AVC, ATC, and MC?


32

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.


33

E-Commerce Example:Internet Package Tracking

The marginal cost incurred by FedEx in delivering one additional package includes the transportation expense and also the cost of providing information to senders or recipients who inquire about the status of the shipment.

34

E-Commerce Example:Internet Package Tracking

As the internet has made it easier to provide this information for customers, FedEx has experienced a downward shift of its marginal cost curve.

35

The Relationship Between Average and Marginal Costs

When marginal cost is less than average variable cost, then average variable cost will decline.

When marginal cost exceeds average variable cost, then average variable cost will increase.

36

The Relationship Between Average and Marginal Costs

It is also true that the direction of change in average total cost will be determined by whether marginal cost exceeds the current average.

37

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.


38

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.


39


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.

40

Planning Horizon– The long run, during which all inputs are

variable


41

Preferable Plant Size and the Long-Run Average Cost Curve

Figure 23-4, Panels (a) and (b)

Panel (b)

Output per Time PeriodQ 2Q1

C3

C1

C4

C2

Panel (a)

Output per Time Period

SAC2

1SAC

SAC3

LAC

1SAC

2SAC

3SAC

4SAC5SAC

6SAC

SAC7

SAC8

Ave

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per

uni

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utpu

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Ave

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42

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


43

Observation– 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?


44

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.


45

Reasons for economies of scale– Specialization

– Dimensional factor

– Improved productive equipment


46


Explaining diseconomies of scale– Limits to the efficient functioning of

management

– Coordination and communication is more of a challenge as firm size increases

47

International Example:Reducing Firm Size to Reduce Costs

In the past decade, the Chinese government has sold many of the companies that were originally state-financed endeavors.

Although these firms received subsidies when they were government-sponsored enterprises, they had to be self-financing once they were in the hands of private investors.

48

International Example:Reducing Firm Size to Reduce Costs

In many instances, the private owners chose to reduce the scale of operations.

This has resulted in lower long-run average costs, and the firms can expect to keep operating without subsidies.

49

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


50

Small MES relative to industry demand:– There is room for many efficient firms

– High degree of competition

Large MES relative to industry demand:– Room for only a small number of efficient firms

– Small degree of competition


51


Figure 23-6

0

Output per Time Period

LAC

B

1,000

A

10

Long

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52

Example:Plant Size for Doughnuts

The Krispy Kreme Doughnut empire is a chain of stores, each one equipped with machinery designed to bake tens of thousands of doughnuts each day.

As the chain has expanded its number of locations, some stores are competing against one another.

53

Example:Plant Size for Doughnuts

The result is that, in some locations, many of the doughnuts produced are thrown out after aging for more than a day.

This raises the average cost of each doughnut sold.

The expansion of the chain has led to an increase in long-run average costs, suggesting that the company has surpassed the size of its minimum efficient scale.

54

With computers doing much of the work of monitoring locomotive engines and switching trains between tracks, the marginal product of labor in the railroad industry has been enhanced.

As economic theory would predict, this has resulted in lower average costs.

Issues and Applications: Railroad Locomotives as a High-Tech Gadget?

55

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

56


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

57


A firm’s long-run cost curve– Planning horizon

– All inputs are variable including plant size

Economies and diseconomies of scale and a firm’s minimum efficient scale

End of Chapter 23The Firm: Cost and Output Determination

chapter 23

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