The Firm, Production, and Cost

The Cost of Production

Lecture 15, 16 & 17

Chapter 10

Chapter 20

Forms of Business Organizations

• There are five main ways of organizing the production of goods and services that are sold on markets:

• Single Proprietorship – one owner who is personally responsible for everything that is done

• Partnership – two or more joint owners, each of whom is personally responsible for all of the partnership debt

Forms of Business Organizations contd.

• Limited Partnership has two types of partners : – General partners: run the business and have

unlimited liability– Limited partners take no part in running of the

business and their liability is limited to the amount they actually invest in the enterprise

• Joint-stock company (Corporations) - is a firm which has an identity of its own. Its owners are not personally responsible for anything that is done in the name of the firm (though the Director may be)

Forms of Business Organizations contd.

• Joint stock companies can be:– Public limited companies (PLC): the shares of the

company are traded on the stock exchange market. Example?

– Private limited companies (PVT): the shares are not sold on the stock exchange, instead they are owned by a group of private investors. Example?

• Public corporations: nationalized industry, owned by the state; it is usually under the direction of a more or less independent state-appointed board

The financing of firms

• Two types of capital:

• Financial capital – the money capital required for the running of the business– It can be owner’s capital or borrowed from

financial institutions

• Real capital – the physical assets such as factories, machineries, stocks of material, finished goods etc.

Profit Maximization

• Neoclassical theory of the firm states : – The desire to maximize profits is assumed to

motivate all decisions taken within a firm, and such decisions are uninfluenced by who takes them. Thus, the theory abstracts from the peculiarities of the persons taking the decisions and from the organizational structure in which they work.

• This assumption allows economists to predict firm behavior

Economic Costs

• The economic cost/opportunity cost of any resource used to produce a good is the value or worth the resource would have in its best alternative use

• Explicit costs: are the monetary payments made to those who supply labor services, materials, fuel, transportation services etc. Such money payments are for the use of resources owned by others

Economic Costs

• Implicit costs: are the opportunity costs of using self-owned , self-employed resources. To the firm, the implicit costs are the monetary payments that self-employed resources could have earned in their best alternative use.

• Economic Costs = explicit + implicit costs

• Accounting Costs = explicit costs

Types of Profits

• Accounting Profit = Total Revenue – Total (explicit) Cost

• Economic Profit = Total Revenue - Total (explicit + implicit) Cost

• Normal Profit is the cost of doing businesses: Implicit + explicit cost

Short Run and Long Run

• Short Run : Fixed Plant

The short run is a period too short for a firm to alter its plant capacity, yet long enough to permit a change in the degree to which the fixed plant is used (the firm can vary its output produced by using smaller or larger amounts of inputs while the plant capacity is fixed)

Short Run and Long Run contd.

• Long Run : Variable Plant

The long run is a period long enough for the firm to adjust the quantities of all the resources that it employs, including the plant size. It is a period long enough for firms to enter and exit the market.

• The Short run and Long run vary from industry to industry! why?

Short Run Production ConceptsA firm’s cost of producing a specific good

depends on the price of resources used and the quantity required of these resources.

The price of inputs is determined by their respective supply and demand functions

Consider Labor as the only input for now!

Production of Firm

• Total Product (TP): the total quantity of good produced

• Marginal Product (MP): is the extra output or added product associated with adding a unit of a variable resource, in this case labor, to the production process

• MP= ∆ in total product

∆ in labor input

Short Run Production Relationships

• Average Product (AP): also called input productivity, output per unit of input

• AP: Total Product

Total units of input

In case of labor: average product for labor is the output per unit of labor input

Practice: Table 20.1 in class – draw curves

Law of Diminishing Returns

• The law assumes that technology is fixed and thus the techniques of production do not change

• As successive units of a variable resource (labor) are added to a fixed resource (capital, land etc), beyond some point the extra, or marginal product that can be attributed to each additional unit of the variable resource will decline.

• Eg. Workers & Capital Equipment Crop & Land

Important Features (TP & MP)• MP is the slope of the total product curve

• Where TP is increasing at an increasing rate, MP is rising (each extra unit of labor is adding more MP than the previous unit)

• Where TP rising at a decreasing rate, MP is positive but falling (each extra unit of labor adds less to the TP than the last unit)

• When TP is at a maximum, MP is zero

• When TP declines, MP becomes negative

Important Features (MP & AP)• Where MP exceeds AP, AP rises

• Where MP is less than AP, AP declines

• MP intersects AP where AP is at a maximum

• This follows from the simple mathematical concept of averages

• The law of Diminishing Returns is embodied in the shapes of all 3 curves

Short-run Production Costs• Fixed, Variable and Total Costs

• Fixed Costs (FC) – costs that do not vary with output. These costs are associated with the existence of a firm’s plant and must be paid even if output is zero (e.g. firm debts, bills, insurance premiums)

• Variable Costs (VC) – costs are those that change with the level of output. They include payments for materials, fuel, power, transportation services, most labor and similar variable resources

Shape of the Variable Cost• Practice: Table 20.2, draw curves • Total Variable cost initially increases with a

decreasing rate, (fourth unit, table 20.2), beyond the 4th unit, VC rises by increasing amounts for succeeding units of output

• Shape of VC: when MP increases, fewer units of labor is needed to produce successive units of output; hence VC decreases for those units.

• When diminishing returns set in, MP starts declining, larger & larger additional amounts of labor needed to produce successive units of output. TVC therefore, rises at an increasing rate.

Short-Run Production CostsTotal Cost, Fixed and Variable Costs

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

100

200

300

400

500

600

700

800

900

1000

$1100

TFC

TC

TVC

TotalCost

VariableCost

FixedCost

TC = TFC + TVC

Per Unit, or Average, Costs• Average cost (AC) data are more

meaningful for making comparisons with product price which is always stated in per-unit basis

• Average Fixed Cost

• AFC declines as the output increases. Why? – Spreading out overhead

AFC =TFC

Q

Per Unit, or Average, Costs• Average Variable Cost –

• AVC is a U-shaped curve

• It declines initially, reaches a minimum, and then increases again when diminishing returns set in

AVC is derived from the TVC curve therefore:

• Since, TVC reflects the law of diminishing returns, so AVC must also reflect the same

AVC =TVC

Q

Short-Run Production CostsAverage and Marginal Costs

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

ATCAVC

AVC

AFC

• Average Total Cost -

• Marginal Cost –

• MC is the additional cost of producing 1 more unit of output

ATC =TCQ = AFC + AVC

MC =Change in TCChange in Q

MC and MP

• MC can also be calculated from the TVC column, as the only difference between the TVC and TC column is the constant amount of fixed cost

• MC curve is the mirror image of the MP curve

• If the price of the variable input stays constant, increasing marginal returns will be reflected in a declining MC, and diminishing returns in a rising MC

Ave

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arg

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Pro

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(D

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Short-Run Production Costs

MPAP

MCAVC

Quantity of Output

Quantity of Labor

Production Curves

Cost Curves

Relation Between MC, ATC & AVC• MC intersects AVC and ATC curves at

their minimum points

• When the amount (MC) added to total cost is less than the current ATC, ATC will fall

• Conversely, when the marginal cost exceeds ATC, ATC will rise

• As long as MC lies below ATC, ATC will fall and vice versa

• At the point of intersection, ATC = MC, ATC has just ceased to fall, but has not started rising yet !

MC, AVC & AFC

• The same holds true for AVC

• MC intersects AVC at its minimum (the same concepts apply here)

• MC has no relationship with FC

• Shifts in Cost curves?

Short-Run Production CostsAverage and Marginal Costs

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

MC

ATCAVC

AVC

AFC

G 8.1

Long-Run Production Costs

• Firm Size and Costs

• Long-Run Cost Curve

• Economies of Scale– Labor Specialization

– Managerial Specialization

– Efficient Capital

• Diseconomies of Scale

• Constant Returns to Scale

Long-Run Production CostsLong-Run ATC Curve

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sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

Any Number of Short-Run Optimum Size Cost Curves Can Be Constructed

Long-Run Production CostsLong-Run ATC Curve

Long-RunATC

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sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

The Long-Run ATC Curve Just“Envelopes” the Short Run ATCs

Long-Run Production CostsAlternative Long-Run ATC Shapes

Output

Long-Run ATC Curve Where EconomiesOf Scale Exist

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Long-RunATC

EconomiesOf Scale

Constant ReturnsTo Scale

DiseconomiesOf Scale

q1 q2

Long-Run Production CostsAlternative Long-Run ATC Shapes

Output

Long-Run ATC Curve Where Costs AreLowest Only When Large Numbers AreParticipating

Ave

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sEconomies

Of ScaleDiseconomies

Of Scale

Long-RunATC

Long-Run Production CostsAlternative Long-Run ATC Shapes

Output

Long-Run ATC Curve Where EconomiesOf Scale Exist, are Exhausted Quickly,And Turn Back Up Substantially

Ave

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Long-RunATC

EconomiesOf Scale

DiseconomiesOf Scale

Minimum Efficient Scale and Industry Structure

• Minimum Efficient Scale (MES)• Natural Monopoly• Applications and Illustrations

– Rising Cost of Insurance and Security– Successful Start-Up Firms– The Verson Stamping Machine– The Daily Newspaper– Aircraft and Concrete Plants

Don’t Cry Over Sunk Costs

• Sunk Costs Irrelevant in Decision Making

• Once Incurred, They Cannot Be Recovered

• Compare Marginal Analysis to Find MC and MB

• Previously Incurred Costs Do Not Impact the MB=MC Decision

• Sunk Costs Are Irrelevant!

Short-Run Production Costs• Per-Unit or Average Costs

–Average Fixed Cost (AFC)–Average Variable Cost (AVC)–Average Total Cost (ATC)–Marginal Cost (MC)

AFC =TFC

Q AVC =TVC

Q

ATC =TCQ

= AFC + AVC

MC =Change in TCChange in Q