Chapter 7: Theory of the Firm and Production and Costs •The goal of the firm is to Maximize total profit given its production limitations. That is, •max. π = TR – TC = P*Q – ATC*Q = (P-ATC)*Q Subject to Q = f(Resources) Economic Cost and Economic Profit Economic profit is total revenue minus economic costs (π = TR – TC). Economic Cost and Economic Profit • Total Revenue is the money the firm gets from selling its product; it equals the price per unit of output times the quantity sold (TR = P*Q). Economic Cost and Economic Profit • Economic cost is the opportunity cost of the inputs used in the production process; equal to explicit cost plus implicit cost. Economic Cost and Economic Profit • Explicit cost is the actual monetary payment for inputs. Economic Cost and Economic Profit • Implicit cost is the opportunity cost of inputs that do not require a monetary payment. • That is the Opportunity Cost of using self-owned resources. Key Principle: Principle of Opportunity Cost The opportunity cost of something is what you sacrifice to get it. Accounting Profit 1. An accountant identifies all the firm’s explicit costs (actual cash payments for inputs) and calculates profits by subtracting explicit costs from total revenue. 2. Accounting cost is defined as the explicit costs of production. 3. Accounting profit is defined as total revenue minus accounting (or explicit) cost. Economic Profit 1. An economist includes the firm’s implicit costs (costs of the entrepreneur’s time and/or funds) and 2. calculates economic profit by subtracting economic cost (explicit plus implicit costs) from total revenue. Economic Profit LO1 Implicit costs (including a normal profit) Explicit costs Accounting profit Total revenue Economic (opportunity) costs Economic profit Accounting costs (explicit costs only) Short Run and Long Run • Short run • Some variable inputs • Fixed production facility • Long run • All inputs are variable • Firms can adjust their production facility • Firms can also enter and exit industry LO2 Short Run Production Relationships • Total product (TP) – Total quantity produced. • Marginal product (MP) Marginal product = ΔTP ΔL • Average product (AP) Average product = LO2 total product units of labor Principle or Law of Diminishing Returns Suppose that output is produced with two or more inputs and we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate. The Law of Diminishing Returns Total, Marginal, and Average Product: The Law of Diminishing Returns (3) Marginal Product (MP) Change in (2)/ Change in (1) (1) Units of the Variable Resource (Labor) (2) Total Product (TP) 0 0 1 10 10 2 25 15 3 45 20 4 60 15 5 70 10 6 75 5 7 75 0 8 70 -5 (4) Average Product (AP), (2)/(1) Increasing marginal returns 10.00 12.50 15.00 15.00 Diminishing marginal returns 14.00 12.50 10.71 Negative marginal returns 8.75 Total product, TP The Law of Diminishing Returns 30 TP 20 10 0 Marginal product, MP 1 LO2 20 2 3 Increasing Marginal Returns 4 5 6 7 8 9 Negative Marginal Returns Diminishing Marginal Returns 10 AP 1 2 3 4 5 6 7 8 9 MP Short Run Production Costs • Fixed Costs (TFC) Costs that do not change as quantity produced increases. • Variable Costs (TVC) Costs that changes as quantity produced increases. • Total Cost (TC) TC = TFC + TVC LO3 Short-Run Production Costs $1100 TC 1000 900 TVC 800 Costs 700 600 Fixed cost 500 400 Total cost 300 200 Variable cost 100 TFC 0 LO3 1 2 3 4 5 6 7 8 9 10 Q Short-Run Average Costs • • • • LO3 Average fixed cost Average variable cost Average total cost Marginal cost AFC = TFC/Q AVC = TVC/Q ATC = TC/Q MC = ΔTC/ΔQ Short-Run Marginal Costs • The change in short-run total cost resulting from a one-unit increase in output. • MC = ΔTC/ΔQ LO3 The Relationship Between Marginal Cost and Average Cost 1. If MC < AC, AC is decreasing. 2. If MC > AC, AC is rising. 3. If MC = AC, then the AC is not rising or falling, and this occurs only at the minimum point on the AC curve. Short-Run Production Costs Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run Total Cost Data Marginal Cost Average Cost Data (6) Average Variable Cost (AVC) (7) Average Total Cost (ATC) (8) Marginal Cost (MC) (1) Total Product (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Average Fixed Cost (AFC) TC=TFC+TVC AFC = TFC/Q AVC=TVC/Q ATC = TC/Q MC =ΔTC/ΔQ 0 $100 $0 $100 1 100 90 190 $100.00 $90.00 $190.00 $90 2 100 170 270 50.00 85.00 135.00 80 3 100 240 340 33.33 80.00 113.33 70 4 100 300 400 25.00 75.00 100.00 60 5 100 370 470 20.00 74.00 94.00 70 6 100 450 550 16.67 75.00 91.67 80 7 100 540 640 14.29 77.14 91.43 90 8 100 650 750 12.50 81.25 93.75 110 9 100 780 880 11.11 86.67 97.78 130 10 100 930 1030 10.00 93.00 103.00 150 LO3 Per-Unit, or Average, Costs $200 Costs 150 ATC AVC 100 AFC 50 AVC AFC 0 LO3 1 2 3 4 5 6 7 8 9 10 Q Marginal Cost $200 MC Costs 150 ATC AVC 100 AFC 50 AVC AFC 0 LO3 1 2 3 4 5 6 7 8 9 10 Q Average product and marginal product Marginal Cost and Marginal Product AP MP Quantity of labor Cost (dollars) MC AVC Cost curves LO3 Quantity of output Long Run Production Costs • The firm can change all input amounts, including plant size • All costs are variable in the long run • Long run ATC • Different short run ATCs LO4 Production and Cost in the Long-Run Expansion and Replication 1. The long-run total cost (LTC) is defined as the total cost of production when the firm is perfectly flexible in choosing its inputs, including its production facility. 2. The firm’s long-run average cost (LAC) is defined as the long-run total cost divided by the quantity produced (LAC = LTC/Q). 3. Constant returns to scale is a situation in which the longrun total cost increases proportionately with output, so long-run average cost (LAC) is constant. 4. The firm’s long-run marginal cost (LMC) is the change in long-run cost resulting from a one-unit increase in output (ΔLTC/ΔQ). Reducing Output with Indivisible Inputs 1. An indivisible input cannot be scaled down to produce a small quantity of output. For example, a railroad must lay the same amount of track between two cities whether one train or many trains use it. 2. If there are indivisible inputs, cutting output in half will not cut costs in half, and thus the LAC curve is negatively sloped. Scaling Down and Labor Specialization 1. Specialization may initially make additional workers more productive, as less time is spent switching between tasks and specific skills are improved; thus perunit costs (LAC) fall as quantity increases. 2. If there are gains from specialization of inputs, cutting output in half will not cut costs in half, because less specialization causes workers to be less productive, and thus the LAC curve is negatively sloped. Economies of Scale : 1. A firm experiences economies of scale, a situation in which the long-run average cost (LAC) of production decreases as output increases, if the LAC curve is negatively sloped. 2. The minimum efficient scale (MES) for a firm is defined as the output level at which scale economies are exhausted. In this situation, the long-run average cost curve becomes horizontal. Beyond this point, a firm will not have lower perunit costs if it produces more. Diseconomies of Scale 1. Diseconomies of scale is a situation in which the longrun average cost (LAC) of production increases as output increases. 2. Diseconomies often occur due to: a. Coordination problems: Larger firms are more difficult to coordinate and may require several layers of management, increasing per-unit costs. b. Increasing input costs: As a firm expands, it increases its demand for inputs. At some point, this demand may be sufficiently large to drive up input prices and thus raise input costs. Actual Long-Run Average-Cost Curves 1. Actual long-run average cost curves tend to be L-shaped because: a. They are negatively sloped for small quantities of output due to economies of scale resulting from indivisible inputs and specialization. b. These economies of scale are exhausted as output becomes large and the long-run average cost curve becomes horizontal over a wide range of output. Short-Run Vs Long-Run Average Cost 1. The difference between the short-run and long-run curve is predominantly with large quantities. 2. The short-run average cost curve is positively sloped for large quantities of outputs due to diminishing returns and the resulting increases in labor cost per unit of output. 3. In the long-run, the firms can scale up its operation so that the firm does not suffer from diminishing returns. If there are no diseconomies of scale, the long-run average-cost curve will be negatively sloped or horizontal. Average total costs Firm Size and Costs ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Output LO4 Average total costs The Long-Run Cost Curve ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Output LO4 Long-run ATC Economies of Scale • Economies of scale refers to the idea that, for a time, larger plant sizes will lead to lower unit costs. An increase in inputs where there are economies of scale will lead to a more than proportionate increase in output because of: • Labor specialization leads to economies of scale because it makes use of special skills; proficiency is gained as the worker concentrates on one task and time is saved. • Managerial Specialization leads to economies of scale because managers can manage more workers with no increased cost, and managers can specialize in their respective area of expertise. • Efficient Capital leads to economies of scale because high volume production warrants the expensive large scale equipment. • Other factors lead to economies of scale because costs such as design, development, and advertising are spread out over larger quantities. LO4 Constant Returns to Scale • Occurs when LAC is constant over a variety of • LO4 plant sizes. When there are constant returns to scale, an increase in inputs will result in a proportionate increase in output. Diseconomies of Scale • may occur if a firm becomes too large, as illustrated by the rising part of the LAC curve. • As the firm expands over time, the expansion may lead to higher average total costs. • With diseconomies of scale, an increase in inputs will cause a less than proportionate increase in output. • Reasons that diseconomies of scale may occur: 1) difficulty in controlling and coordinating large scale operations, 2) a large bureaucracy leads to communication problems, 3) workers may feel alienated and therefore may not work efficiently and 4) shirking, or work avoidance, may be easier in a larger firm. LO4 Average total costs MES and Industry Structure Constant returns to scale Economies of scale Long-run ATC q1 q2 Output LO5 Diseconomies of scale
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