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!