The Firm: Cost and Output Determination

1
Chapter 23

• The Firm Cost and Output Determination

2
Objectives

• Explain Explicit and implicit costs
• Distinguish between normal, accounting and
  economic profits
• Explain the law of diminishing returns
• Compute marginal, average and total product
• Explain relationship between total, marginal and
  average product
• continued

3
Objectives Contd

• Explain the law of diminishing returns to inputs
• Define and compute fixed, variable, marginal and
  total costs
• Compute and graph AFC, AVC, ATC and MC
• Relate AP to AVC and MP and MC
• Explain why AVC and ATC each intersect the MC
  curve at their minimum points
• 
  continued

4
Objectives Contd

• Distinguish between the short run and the long
  run based on costs
• Explain why the long run ATC curve is u-shaped
• Identify on graph and explain concepts of
  economies of scale, constant returns to scale and
  diseconomies of scale
• Define minimum efficient scale
• Explain the relationship between economies of
  scale and the number of firms in an industry

5
Profit

• Total Revenue Total Cost
• Losses are negative profits

6
What is profit?

• Accounting profit Total Revenue Explicit
  costs
• Explicit costs (direct costs) costs that
  business managers must take account of because
  they must be paid such as wages, raw materials

7
Implicit vs Explicit Costs

• Total Cost Implicit Cost Explicit Cost
• Implicit Costs Opportunity cost of inputs for
  which a direct payment is not made
• Ex. Normal rate of return on capital
• Explicit Costs Direct payment is made for use
  of an input
• Ex. Wages paid

8
What is profit?

• Economic profits Total Revenue Total costs
• Total costs Explicit costs Implicit costs
• Implicit costs opportunity costs of using
  factors that a producer does not buy or hire, but
  already owns expenses that managers do not have
  to pay from their own pocket and thus normally do
  not explicitly calculate such as the skills and
  land an owner has

9
Normal profit

• Normal profit (a normal rate of return)
• Zero economic profits or accounting profits equal
  to implicit costs
• If an entrepreneur does not earn at least a
  normal profit, he may not remain in business in
  the long run as other uses of the resources would
  provide the owner with a greater return

10
Example

• A new college graduate gets a job offer with a
  salary of 35,000
• This person decides to run a business instead
• He/she uses 10,000 to start a business
• This 10,000 can earn 10 interest if he/she puts
  the money in a bank

11
Example

• Total revenue 100,000
• Explicit costs(direct costs) 60,000
• Accounting profit 40,000
• Revenue minus explicit costs
• Economic costs 96,000
• (explicit costs plus normal profit)
• Economic profit 4,000
• (total revenue minus economic costs)

12
Remarks

• It is possible to have accounting profits and
  economic losses if normal profits cannot be
  earned
• A firm has normal profit if it has zero economic
  profit.
• Economic profit total revenue total costs
• Total costs explicit costs implicit costs

13
Production and Costs

• A firm produces goods/services by combining
  resources
• A firm incurs costs when it pays for the
  resources used in providing its good/service to
  markets

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Production measures

• Total product (TP) Total output of factory
• Average product (AP) output per unit of input
• TP/ units of one input
• Marginal product (MP) Change in output when one
  more unit of input is used
• (Change in TP) / (Change in units of input)
• NOTE The terms MP and AP are used in reference
  to a particular input, such as the marginal
  product of labor or the marginal product of
  capital

15
Example

• We have a small table top of factory
• We only need 3 tools a ruler, a saw and a sander
• We can vary only the amount of labor used.

16
Example
17
Concept

• Marginal product (or marginal physical product)
  is the change in total output when one more unit
  of an input is used.
• When the variable input increases continually,
  the total output increases by smaller and smaller
  increments.

18
Law of Diminishing Returns

• As additional amounts of a variable input are
  used, ceteris paribus, beyond a certain point
  output will increase by smaller and smaller
  increments for each additional unit of input
  added.

19
Lets do some calculation
20
Where do diminishing returns set in?
21
Relationship between TP, AP, and MP
22
Costs Adding price tags to production measures

• Fixed Costs (FC) costs which do not vary as
  output changes
• Ex. loan payment
• Variable Costs (VC) costs which increases as
  output changes
• Ex. Electricity, wage payments for hourly labor

23
More costs and formulas

• Total costs TC FC VC
• Average Fixed Costs AFC FC / TP
• Average Variable Costs AVC VC / TP
• Average Total Costs ATC TC / TP
• Marginal Costs MC either
• Change in TC / change in TP
• Change in VC / change in TP

24
Example
25
Graphing cost curves

• Cost measures on vertical axis
• TP or quantity of output on horizontal axis
• Label each curve
• Four curves (MC, AVC, AFC, ATC) referred to as
  cost structure of firm.

26
GRAPH
27
Remarks

• MC is minimum at the output level with maximum MP
• APC is minimum at the output level with maximum
  AP
• AVC ATC each intersect with MC at their
  respective minimum points
• If MC is below below AVC or ATC, MC will pull the
  average down
• AVC ATC are asymptotic, differing by decreasing
  AFC

28
Why minimum AVC and minimum ATC are at different
output levels?

• AVC reaches its minimum at a lower output level
  than ATC. Once AVC reaches its minimum, it will
  start to rise as output increases and this puts
  an upward pull on ATC. However, AFC always falls
  as output increases, and so ATC will continue to
  fall as long as the decrease in AFC is larger
  than the increase in AVC. Only when the increase
  in AVC is larger than the decrease in AFC will
  ATC begin to rise.

29
Short Run Vs Long Run

• Short run fixed and variable inputs (and
  costs).
• Long run all inputs (and costs) are variable.
• Firm operates in short run, plans in long run.
• Note There is no specified length of time in
  months or years.

30
LRATC (long run ATC curve)

• represents the general trend in ATC for plants
  of different sizes
• Gives a general idea of the lowest ATC possible
  for any given output

31
Long Run ATC

• Cost
• 
  Quantity

32
Economies of Scale (EOS)

• When ATC falls with larger plant size and output
• The larger the economies of scale in an industry,
  the smaller the number of firms which will
  typically survive in the industry.

33
Constant returns to scale

• Range in which changes in plant size and output
  do not affect minimum ATC

34
Diseconomies of Scale

• Increasing plant size and output leads to
  increase in the minimum possible ATC
• Present if factory is so large that it takes
  cumbersome layers of management to coordinate
  activity and bottlenecks slow production down

35
Long Run ATC

• Cost
• EOS
  CRS DOS
• 
  Quantity

36
Minimum Efficient Scale

• Smallest plant size that will allow firm to gain
  all possible economies of scale.
• Smallest plant size that will allow a firm to
  have lowest ATC possible across all plant sizes.

37
Natural Monopoly

• Industries with economies of scale so large that
  it only takes one plant to produce the output
  desired in the market if ATC is to be low
• Ex. Electricity companies