Section V Firm Behavior and the Organization of Industry.
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Transcript of Section V Firm Behavior and the Organization of Industry.
Section V
Firm Behavior and the Organization of
Industry
Chapter 13
The Costs of Production
Objective
2.) Understand the relationship between the firm’s production process and total cost.
3.) Know the meaning of average total cost and marginal cost - they are related.
4.) Be familiar with the shape of a typical firm’s cost curve
5.) Learn the relationship between short-run and long-run costs.
1.) Learn the items included in a firm’s cost of production.
Supply
The Costs of Production
The Law of Supply:
Firms are willing to produce and sell a
greater quantity of a good when the price of a good is high, this results
in a supply curve that slopes upward.
Why Study Behavior of Firms?
Gain a better understanding of the decisions made by producers.
Study how the behavior of a firm depends on the structure of the market.
The Firm’s Objective
The economic goal of the firm is to maximize profits.
Explicit and Implicit Costs
A firm’s cost of production include explicit costs and implicit costs.
Explicit costs involve a direct money outlay for factors of production.
Implicit costs do not involve a direct money outlay.
Economic Profit versus Accounting Profit
Economists measure a firm’s economic profit as total revenue minus all the opportunity costs (explicit and implicit).
Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. In other words, they ignore the implicit costs.
Economic Profit versus Accounting Profit
When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.
Rev
enue
EconomicEconomicProfitProfit
EconomicEconomicProfitProfit
ImplicitImplicitcostscosts
ImplicitImplicitcostscosts
ExplicitExplicitcostscosts
ExplicitExplicitcostscosts
AccountingAccountingprofitprofit
AccountingAccountingprofitprofit
ExplicitExplicitcostscosts
ExplicitExplicitcostscosts
Totalopportunitycosts
Rev
enue
How an EconomistViews a Firm
How an AccountantViews a Firm
An Individual Firm’s Profit: Revenue minus Cost
Revenues: The amount that the firm receives for the sale of its product.
(Market Price x Amount Sold)= Revenues
Costs: The amount that the firm pays to buy inputs.
Profit is often referred to as Producer Surplus: the amount a seller is paid minus the cost of production. A measure of the benefits to sellers. Chapter 7
Producer Surplus: Graphical
S
D
PE
QE
ProducerSurplus
ProductionCosts
Costs of Production
Explicit Costs
Implicit Costs
Sunk Costs
In general, three costs are often considered when making business strategy or supply decisions.
Costs as Opportunity Costs
The firm’s costs include Explicit Costs and Implicit Costs:
– Explicit Costs: costs that involve a direct money outlay for factors of production.
– Implicit Costs: costs that do not involve direct money outlay. (e.g. opportunity costs) Both can include opportunity costs.
Costs as Opportunity Costs
Economists include all opportunity costs when measuring costs.
Accountants measure the explicit costs but often ignore the implicit costs.
When revenues exceed both explicit and implicit costs the firm earns economic profits.
Costs as Opportunity Costs
A third, not so obvious implicit cost includes sunk costs.
Sunk costs are costs that have already been committed and cannot be recovered. Sunk Costs are . . .
– an opportunity cost
– often ignored when making decisions about business strategy
Quick Quiz“A farmer has planted corn seeds but
has not yet fertilized the field.”
Is the cost of seed an opportunity cost or a sunk cost?
Is the cost of fertilizer an opportunity cost or a sunk cost?
Which of these two costs is more likely to affect the decision to continue farming?
Definitions
Production function is the relationship between quantity of inputs used to makea good and the quantity of output of that good
Marginal product is is the increase in output that arises from an additional unit of input
Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases
Number ofWorkers
Output MarginalProductof Labor
Cost ofFactory
Cost ofWorkers
Total Cost of Inputs(cost of factory + Cost
of Workers)
0
1
2
3
4
5
0
50
90
120
140
150
50
40
30
20
10
$30
30
30
30
30
30
$ 0
10
20
30
40
50
$30
40
50
60
70
80
A Production Function and Total Cost: Hungry Helen’s Cookie Factory
The Production Function
The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.
Marginal Product
The marginal product of any input in the production process is the increase in the quantity of output obtained from an additional unit of that input.
Marginal Product
Additional inputAdditional output=Marginal
product
Diminishing Marginal ProductDiminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.
Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.
Hungry Helen’s Production Function
0
10
0 1 2 3 4 5
Number of workers Hired
Quality ofOutput
(cookiesper hour)
2030405060708090
100110120130140150
Hungry Helen’s Total-Cost Curve
0
10
20
30
40
50
60
70
$80
0 50 90 120 140 150
Total-costcurve
Quantity of Output(cookies per hour)
TotalCost
40302010 60 70 80 100 110 130
A Production Function and Total CostNumber ofWorkers
Output MarginalProduct of
Labor
Cost ofFactory
Cost ofWorkers
Total Cost ofInputs
0 0 $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
Hungry Helen’s Cookie Factory
Diminishing Marginal Product
The slope of the production function measures the marginal product of an input, such as a worker.
When the marginal product declines, the production function becomes flatter.
The Various Measures of Cost
Costs of production may be divided into two specific categories:
Fixed Costs:
–Those costs that do not vary with the amount of output produced.
Variable Costs:
–Those costs that do vary with the amount of output produced.
Fixed versus Variable Costs
The division of costs between fixed and variable often depends on the time horizon being considered.
– Over a period of weeks, i.e. short-run, some costs are fixed (e.g. plant size.)
– Over a period of years, i.e. long-run, many fixed costs become variable costs. Allows greater ability to respond to changing
circumstances in the long run.
Family of Total Costs...
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC):
TC = TFC + TVC
Family of Total Costs
Quantity Total CostFixed CostVariable Cost0 $ 3.00 $3.00 $ 0.001 3.30 3.00 0.302 3.80 3.00 0.803 4.50 3.00 1.504 5.40 3.00 2.405 6.50 3.00 3.506 7.80 3.00 4.807 9.30 3.00 6.308 11.00 3.00 8.009 12.90 3.00 9.90
10 15.00 3.00 12.00
Family of Average Costs. . .
Average Costs:
Specific Cost / Output Level
– Average Fixed Costs (AFC)
– Average Variable Costs (AVC)
– Average Total Costs (ATC)
Marginal Cost: “How much does it cost to produce an
additional unit of output?”
Marginal Cost (MC):
“The extra or additional cost of producing one more unit of output.”
– MC is the addition to the cost of production that must be covered by additional revenue for profit maximization
Mathematical Definitions of Costs
Average Total Cost:
ATC = TC ÷ Q Marginal Cost:
MC = TC ÷ Q
Diminishing Marginal Product
The slope of the production function measures the marginal product of an input, such as a worker.
When the marginal product declines, the production function becomes flatter.
Quick Quiz!
If Ford’s total cost of producing 4 cars is $225,000 and its total cost of producing 5 cars is $250,000. . .
...what is the average total cost and marginal cost of producing the fifth car?
The Shape of Typical Cost Curves
Marginal Cost rises with the amount of output produced. (Figure 13-1)
– At small levels of output, an increase in production will occur at relatively small costs.
– Increasing output is more costly when the amount being produced is already high.
– Marginal cost rises more in the short run.
Marginal Cost
Quantity TotalCost
MarginalCost
Quantity TotalCost
MarginalCost
0 $3.00 —1 3.30 $0.30 6 $7.80 $1.302 3.80 0.50 7 9.30 1.503 4.50 0.70 8 11.00 1.704 5.40 0.90 9 12.90 1.905 6.50 1.10 10 15.00 2.10
Cost Curves and Their Shapes
The average total-cost curve is U-shaped. At very low levels of output average total cost is
high because fixed cost is spread over only a few units.
Average total cost declines as output increases.
Average total cost starts rising because average variable cost rises substantially.
The Shape of Typical Cost CurvesC
ost
($’
s)
Quantity
MC
The Shape of Typical Cost CurvesC
ost
($’
s)
Quantity
MCATC
Cost Curves and Their Shapes
U-shape The bottom of the curve shows the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.
The Shape of Typical Cost CurvesC
ost
($’
s)
Quantity
MCATC
AVC
Relationship Between Marginal Cost and Average Total Cost
Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is rising.
The Various Measures of Cost
It is now time to examine the relationships that exist between the
different measures of cost.
The Various Measures of Cost Big Bob’s Bagel Bin
Quantity of
BagelsTotal Cost
FixedCost
VariableCost
AverageFixedCost
AverageVariable
Cost
AverageTotalCost
Marginal
Cost0 $2.00 $2.00 $0.001 $3.00 $2.00 $1.00 $2.00 $1.00 $3.00 $1.002 $3.80 $2.00 $1.80 $1.00 $0.90 $1.90 $0.803 $4.40 $2.00 $2.40 $0.67 $0.80 $1.47 $0.604 $4.80 $2.00 $2.80 $0.50 $0.70 $1.20 $0.405 $5.20 $2.00 $3.20 $0.40 $0.64 $1.04 $0.406 $5.80 $2.00 $3.80 $0.33 $0.63 $0.97 $0.607 $6.60 $2.00 $4.60 $0.29 $0.66 $0.94 $0.808 $7.60 $2.00 $5.60 $0.25 $0.70 $0.95 $1.009 $8.80 $2.00 $6.80 $0.22 $0.76 $0.98 $1.20
10 $10.20 $2.00 $8.20 $0.20 $0.82 $1.02 $1.4011 $11.80 $2.00 $9.80 $0.18 $0.89 $1.07 $1.6012 $13.60 $2.00 $11.60 $0.17 $0.97 $1.13 $1.8013 $15.60 $2.00 $13.60 $0.15 $1.05 $1.20 $2.0014 $17.80 $2.00 $15.80 $0.14 $1.13 $1.27 $2.20
Big Bob’s Cost Curves...
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
$18.00
$20.00
0 2 4 6 8 10 12 14 16
Quantity of Output(bagels per hour)
To
tal
Co
st
Total Cost Curve
Three Important Properties of Cost Curves
Marginal cost eventually rises with the quantity of output.
The average-total-cost curve is U-shaped.
The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.
Costs in the Long Run
For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered.
In the short run some costs are fixed.
In the long run fixed costs become variable costs.
The Shape of Typical Cost CurvesC
ost
($’
s)
Quantity
MCATC
AVC
AFC
Costs in the Long Run
Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.
Quantity ofCars per Day
AverageTotalCost
$12,000
$10,000
Economicsof scale
ATC in shortrun with
small factory
Quantity ofCars per Day
AverageTotalCost
$12,000
$10,000
Economicsof scale
ATC in shortrun with
small factory
ATC in shortrun with
medium factory
Constantreturns to
scale
Quantity ofCars per Day
ATC in long run
AverageTotalCost
$12,000
$10,000
Economicsof scale
ATC in shortrun with
small factory
ATC in shortrun with
medium factory
ATC in shortrun with
large factory
Diseconomiesof
scale
Constantreturns to
scale
Return to a Single Input1.) Holding all other input quantities unchanged
2.) The law of diminishing returns demanding marginal returns
Return to a Single Input1.) Holding all other input quantities unchanged
2.) The law of diminishing returns demanding marginal returns
Return to Scale1.) Long rule
2.) Opportunity to change all input quantities
Return to a Single Input1.) Holding all other input quantities unchanged
2.) The law of diminishing returns demanding marginal returns
Return to Scale1.) Long rule
2.) Opportunity to change all input quantities
Why Return to Scale1.) Specialization
2.) Dimensional Factor
3.) Improved Productive Equipment
1.) Economies of scale -Increasing returns to scale
1.) Economies of scale -Increasing returns to scale
2.) Diseconomies of scale -Decreasing returns to scale
1.) Economies of scale -Increasing returns to scale
2.) Diseconomies of scale -Decreasing returns to scale
3.) Constant returns to scale
The Shape of Typical Cost Curves
U-Shaped Average Total Cost:
– Economies of Scale: occurs when a firm has large fixed costs. ATC declines as output increases
– Diseconomies of Scale: occurs when some important input is limited. ATC rises as output increases
The Shape of Typical Cost Curves
U-Shaped Average Total Cost:
– The bottom of the U-Shape occurs at the quantity that minimizes average total cost
– This is called the Efficient Size of the firm.
The Relationship Between Marginal Cost and Average Total Cost
When marginal cost is less than average total cost, average total cost is falling.
MC < ATC ATC When marginal cost is greater than average
total cost, average total cost is rising.
MC > ATC ATC
The Relationship Between Marginal Cost and Average Total Cost
The marginal-cost curve crosses the
average-total-cost at the efficient scale.
Why?
Conclusion
When analyzing firm behavior, it is often useful to graph average total cost and marginal cost.
For a typical firm, marginal cost rises with the amount of output.
Average total cost first falls as output increases (showing economies of scale) and then rises as output increases further (showing diseconomies of scale.)
The Relationship Between Marginal Cost and Average Total Cost
Co
st (
$’s)
Quantity
MCATC
The marginal cost curve always crossesthe average total costcurve at the minimum
average total cost!