Firms, Production, and Costs

Chapter 9: Firms, Production, and Costs

Objectives After studying this chapter, you will be able to: Explain the firm s economic problem and function Explain the relationship between a firm s output and inputs in the short run Derive and explain a firm s short-run cost curves Explain the relationship between a firm s output and costs in the long run and derive its long-run average cost curve 9-2

Spinning a Web When Tim Berners-Lee s invented the World Wide Web in 1990, he paved the way for the creation of thousands of profitable business. There are many different types and sizes of firms producing vast range of goods. But regardless of size all firms must decide how much to produce and how to produce This chapter deals with the economics of the firm the supply side of the markets for goods and services 9-3

The Firm and Its Economic Problem The firm s goal A firm is an institution that hires factors of production and organises them to produce and sell goods and services. A firm s goal is to maximise profit. If the firm fails to maximise profits it is either eliminated or bought out by other firms seeking to maximise profit. 9-4

The Firm and Its Economic Problem Measuring a firm s profit Accountants measure cost and profit to ensure that the firm pays the correct amount of income tax and to show the bank how its loan has been used. Economists measure profit based on opportunity cost and economic profit. 9-5

Opportunity cost The Firm and Its Economic Problem A firm s decisions respond to opportunity cost and economic profit. A firm s opportunity cost of producing a good is the best, forgone alternative use of its factors of production, usually measured in dollars. Opportunity cost includes both: Explicit costs Implicit costs 9-6

The Firm and Its Economic Problem Explicit costs Explicit costs are costs paid directly in money. The firm can rent capital and pay an explicit rental cost reflecting the opportunity cost of using the capital. Implicit costs Implicit costs are costs incurred when a firm uses its own capital or its owners time for which it does not make a direct monetary payment. The firm can also buy capital and incur an implicit opportunity cost of using its own capital, called the implicit rental rate of capital. 9-7

The Firm and Its Economic Problem The implicit rental rate of capital is made up of: Economic depreciation Interest forgone Economic depreciation is the change in the market value of capital over a given period. Interest forgone is the return on the funds used to acquire the capital. 9-8

The Firm and Its Economic Problem The cost of the owner s resources is his or her entrepreneurial ability and labour expended in running the business. The opportunity cost of the owner s entrepreneurial ability is the average return from this contribution that can be expected from running another firm. This return is called a normal profit. The opportunity cost of the owner s labour spent running the business is the wage income forgone by not working in the next best alternative job. 9-9

The Firm and Its Economic Problem Economic profit Economic profit equals a firm s total revenue minus its opportunity cost of production. A firm s opportunity cost of production is the sum of the explicit costs and implicit costs. Normal profit is part of the firm s opportunity costs, so economic profit is profit over and above normal profit. Table 9.1 on page 201 summarises the economic accounting concepts. 9-10

The Firm and Its Economic Problem The firm s constraints Three features of a firm s environment impose constraints that limit the profit it can make: 1. Technology constraints 2. Information constraints 3. Market constraints 9-11

The Firm and Its Economic Problem Technology constraints Technology is any method of producing a good or service. Technology advances over time. Using the available technology, the firm can only produce more if it hires more resources, which will increase its costs and limit the profit of additional output. 9-12

The Firm and Its Economic Problem Information constraints A firm never possesses complete information about either the present or the future. It is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. The cost of coping with limited information limits profit. 9-13

The Firm and Its Economic Problem Market constraints What a firm can sell and the price it can obtain are constrained by its customers willingness to pay and by the prices and marketing efforts of other firms. The resources that a firm can buy and the prices it must pay for them are limited by the willingness of people to work for and invest in the firm. The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make. 9-14

Firms and Markets Markets and firms both coordinate production. Chapter 3 explains how demand and supply coordinate the plans of buyers and sellers. Market coordination of production E.g. market transactions such as the many facets of producing a concert Firm coordination of production E.g. capital use and employment of labour 9-15

Why Firms? Why are firms sometimes more efficient coordinators of economic activity? Lower transactions costs Economies of scale Economies of scope Economies of team production 9-16

Why Firms? Transactions costs The costs arising from finding someone with whom to do business, of reaching an agreement about the price and other aspects of the exchange, and of ensuring that the terms of the agreement are fulfilled. 9-17

Why Firms? Economies of scale exist when the cost of producing a unit of a good falls as output increases. Economies of scope exist when a firm uses specialised resources to produce a range of goods and services. Team production A production process in which the individuals in a group specialise in mutually supportive tasks. 9-18

Decision Time Frames The firm makes many decisions to achieve its main objective: profit maximisation. All decisions can be placed in two time frames: 1. The short run 2. The long run 9-19

Decision Time Frames 1. The Short Run The short run is a time frame in which the quantity of one or more resources used in production is fixed. For most firms, the capital, called the firm s plant, is fixed in the short run. Other resources used by the firm (such as labour, raw materials, and energy) can be changed in the short run. Short-run decisions are easily reversed. 9-20

Decision Time Frames 2. The Long Run The long run is a time frame in which the quantities of all resources including the plant size can be varied. Long-run decisions are not easily reversed. A sunk cost is a cost incurred by the firm and cannot be changed. If a firm s plant has no resale value, the amount paid for it is a sunk cost. Sunk costs are irrelevant to a firm s decisions. 9-21

Short-Run Technology Constraint To increase output in the short run, a firm must increase the amount of labour employed. Three concepts describe the relationship between output and the quantity of labour employed: Total product Marginal product Average product 9-22

Total Product, Marginal Product, and Average Product Total Marginal Average Labour product product product (workers (T-shirts (T-shirts per (T-shirts per day) per day) worker) per worker) Table 9.2 A 0 0 - B 1 4 4 4.00 C 2 10 6 5.00 D 3 13 3 4.33 E 4 15 2 3.75 F 5 16 1 3.20 9-23

Short-Run Technology Constraint Product schedules Total product is the maximum output that a given quantity of labour can produce The marginal product of labour is the change in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same. The average product of labour is equal to total product divided by the quantity of labour employed. 9-24

Short-Run Technology Constraint Product curves Product curves are graphs of the three product concepts that show how total product, marginal product, and average product change as the quantity of labour employed changes. 9-25

Short-Run Technology Constraint The total product curve Figure 9.1 shows a total product curve. The total product curve shows how total product changes with the quantity of labour employed. 9-26

Output (T-shirts per hour) Total Product Curve 15 E F Unattainable D 10 C Attainable 5 B A TP Figure 9.1 0 1 2 3 4 5 Labour (workers per day) 9-27

Marginal Product Curve Marginal product is also measured by the slope of the total product curve. Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker. 9-28

Marginal Product Curve Diminishing marginal returns Occur when the marginal product of an additional worker is less than the marginal product of the previous worker Law of diminishing returns As a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes 9-29

Marginal Product Output (T-shirts per hour) Figure 9.2 95 90 80 60 25 A B C D E F TP Marginal product (T-shirts per hour per worker) 35 30 25 20 15 10 5 The red highlights the point of diminishing returns MP 0 1 2 3 4 5 Labour (workers per day) 0 1 2 3 4 5 Labour (workers per day) 9-30

Average Product Curve When marginal product exceeds average product, average product increases. When marginal product is below average product, average product decreases. When marginal product equals average product, average product is at its maximum. 9-31

Average Product Figure 9.3 Average product & Marginal product (T-shirts per day per worker) 6 4.33 4 2 B C D Maximum average product E F AP MP 0 1 2 3 4 5 Labor (workers per day) 9-32

Short-Run Technology Constraint Marginal grades and average grades The relationship between a student s marginal grade and average grade is similar to that between marginal product and average product. A students average grade increases when the marginal grade exceeds his average grade, decreases when his marginal grade is below his average, and is constant when his marginal grade equals his average grade 9-33

Short-Run Cost To produce more output in the short run, the firm must employ more labour, which means that it must increase its costs. We describe the way a firm s costs change as total product changes by using three cost concepts and three types of cost curve: Total cost Marginal cost Average cost 9-34

Short-Run Cost Total Cost A firm s total cost (TC) is the cost of all resources used. Total fixed cost (TFC) is the cost of the firm s fixed inputs. Fixed costs do not change with output. Total variable cost (TVC) is the cost of the firm s variable inputs. Variable costs do change with output. Total cost equals total fixed cost plus total variable cost. That is: TC = TFC + TVC 9-35

Total Cost Curves Figure 9.4 Table Total Total fixed variable Total cost cost cost Labor Output (TFC) (TVC) (TC) (workers (T-shirts per day) per day) (dollars per day) A 0 0 25 0 25 B 1 4 25 25 50 C 2 10 25 50 75 D 3 13 25 75 100 E 4 15 25 100 125 F 5 16 25 125 150 9-36

Total Cost Curves Figure 9.4 Cost (dollars per day) 150 100 50 TC = TFC + TVC TC TVC TFC 0 5 10 15 Output (T-shirts per day) 9-37

Short-Run Cost Marginal Cost Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product. Over the output range with increasing marginal returns, marginal cost falls as output increases. Over the output range with diminishing marginal returns, marginal cost rises as output increases. 9-38

Short-Run Cost Average Cost Average cost measures can be derived from each of the total cost measures: Average fixed cost (AFC) is total fixed cost per unit of output. Average variable cost (AVC) is total variable cost per unit of output. Average total cost (ATC) is total cost per unit of output. ATC = AFC + AVC 9-39

Marginal Cost and Average Costs Table 9.5 9-40

Marginal Cost and Average Costs Figure 9.5 15 Cost (dollars per T-shirts) 10 5 ATC = AFC + AVC MC ATC AVC AFC 0 5 10 15 Output (T-shirts per day) 9-41

Short-Run Cost Why the Average Total Cost Curve Is U-Shaped ATC is the sum of AFC and AVC The AVC is U-shaped The ATC is U-shaped because of two reasons Spreading fixed cost over a larger output Eventually diminishing returns 9-42

Short-Run Cost Cost Curves and Product Curves The shapes of a firm s cost curves are determined by the technology it uses: MC is at its minimum at the same output level at which marginal product is at its maximum. When marginal product is rising, marginal cost is falling. AVC is at its minimum at the same output level at which average product is at its maximum. When average product is rising, average variable cost is falling. 9-43

Product Curves and Cost Curves Figure 9.6(a) Average product and marginal product 6 4 2 Rising MP and falling MC: rising AP and falling AVC Falling MP and rising MC: rising AP and falling AVC 0 1.5 2.0 Falling MP and rising MC: falling AP and rising AVC Labor AP MP 9-44

Product Curves and Cost Curves 12 Figure 9.6(b) Average product and marginal product 9 6 3 Maximum MP and minimum MC MC AVC Maximum AP and minimum AVC 0 6.5 10 Output 9-45

Short-Run Cost Shifts in Cost Curves The position of a firm s cost curves depend on two factors: Technology Prices of factors of production 9-46

Short-Run Cost Technology An increase in productivity shifts the average and marginal product curves upward and the average and marginal cost curves downward. If a technological advance brings more capital and less labour into use, fixed costs increase and variable costs decrease. In this case, ATC increases at low output levels and decreases at high output levels. 9-47

Short-Run Cost Prices of factors of production Changes in the prices of resources shift the cost curves. An increase in a fixed cost shifts the total cost (TC) and average total cost (ATC) curves upward, but does not shift the marginal cost (MC) curve. An increase in a variable cost shifts the total cost (TC), average total cost (ATC), and marginal cost (MC) curves upward. 9-48

Long-Run Cost In the long run, all inputs are variable and all costs are variable. The Production Function The behaviour of long-run cost depends upon the firm s production function, which is the relationship between the maximum output attainable and the quantities of both capital and labour. 9-49

Long-Run Cost The Production Function Diminishing Returns Regardless of the plant size, as the labour input increases, its marginal product (eventually) decreases Diminishing Marginal Product of Capital The marginal product of capital is the change in total product divided by the change in capital employed when the amount of labour employed is constant 9-50

Long-Run Cost Short-Run Cost and Long-Run Cost The average cost of producing a given output varies, and depends on the size of the firm s plant. The larger the plant size, the greater is the output at which ATC is at a minimum. Each plant has a short-run ATC curve which is U-shaped The firm can compare the ATC for each given output at different plant sizes. 9-51

Short-Run Costs of Four Different Plants Figure 9.7 9-52

Long-Run Cost Long-Run Average Cost Curve The long-run average cost curve is the relationship between the lowest attainable average total cost and output when both the plant size and labour are varied. Once the firm has chosen the plant size, it incurs the costs that correspond to the ATC curve for that plant. 9-53

Long-Run Average Cost Curve Figure 9.8 9-54

Long-Run Cost Economies and Diseconomies of Scale Economies of scale are features of a firm s technology that lead to falling long-run average cost as output increases. Diseconomies of scale are features of a firm s technology that lead to rising long-run average cost as output increases. Constant returns to scale are features of a firm s technology that lead to constant long-run average cost as output increases. 9-55

Long-Run Cost A firm experiences economies of scale up to some output level. Beyond that output level, it moves into constant returns to scale or diseconomies of scale. Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its lowest level. If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale output level. 9-56

END CHAPTER 9 9-57