1. Businesses and the Costs of Production Theory of the Firm I

2. Terminology Economic cost = opportunity cost (the value or worth the resource would have in its best alternative use) Explicit costs – monetary payments a firm makes to those who supply inputs (resources owned by others) Implicit costs – opportunity costs of using a firm’s self-owned, self-employed resources Sunk costs –Costs already incurred that cannot be recovered

3. Two Kinds of Profit Accounting Profit: Revenue minus expenses (explicit costs) Economic Profit: Accounting profit minus implicit costs

4. Normal Profit Implicit cost of entrepreneurial talent The minimum income entrepreneurial ability must receive to induce it to perform entrepreneurial functions for a firm

5. Timing Issues Short Run (fixed plant): the period of time too brief for a firm to alter its plant capacity, yet long enough to permit a change in the degree to which the fixed plant is used (output can vary) Long run (variable plant): the period of time long enough for a firm to adjust the quantities of all the resources it employs including plant capacity Also includes enough time for firms to enter or leave the industry

6. Determining Costs of Production Cost of producing a specific level of output depends on the prices of needed resources and the quantities of resources need to produce that output Determined by supply and demand Total Product (TP) – total quantity (output) of a particular good or service

7. Short-Run Relationships - Terminology Marginal Product (MP) – extra output or added product associated with adding a unit of a variable resource (e.g., labor) MP = Change in total product Change in variable input Average Product (AP), also called labor productivity, is the output per unit of labor input AP = total product units of labor

8. Law of Diminishing Returns Assumes: Technology is fixed Techniques of production do not change As successive units of a variable resource (labor) are added to a fixed resource (capital or land), beyond some point the marginal product that can be attributed to each additional unit of the variable resource will decline`

9. Marginal Returns

10. Marginal Returns - the graphic!

11. Short-Run Production Costs Fixed costs – those costs that in total do not vary with changes in output. Must be paid regardless of output Variable Costs – those costs that change with the level of output Payments for variable resources Total Cost = total fixed cost (TFC) + total variable cost (TVC)

12. Short-Run Production Cost Schedules

13. Short-Run Production Cost Graph

14. Average or Per-Unit Costs Average fixed cost (AFC) AFC = TFC Q Average variable cost AVC = TVC Q Average total cost ATC = AFC + AVC

15. Marginal Cost Marginal Cost (MC) = change in TC change in output (Q) MC designates all the cost incurred in producing the last unit of output. The cost that can be “saved” by not producing that last unit Firms make decisions on the margin MC curve’s shape is a consequence of the law of diminishing returns

16. MC and Marginal Product Assume the price of labor is $10 As long as MP is rising, MC will fall Mirror images MP at max = MC at min Units of LaborTPMPMC 0000 110 $1 22515$.67 ($10/15) 34520$.5 46015$.67 57010$1 6755$2

17. Marginal Cost Curve

18. Relation of MC to AVC and ATC MC intersects both the AVC and ATC at their respective minimum points When the MC added to total cost is less than the current ATC, then ATC will fall When the MC added to TVC is less than the current AVC, then AVC will fall MC is the addition to TC or TVC resulting from one more unit of output MC has no relationship with AFC or TFC since fixed costs do not change

19. Relation of MC to AVC and ATC

20. Shifts of Cost Curves Changes in either resource prices or technology will cause costs to change Curves shift to reflect the changing costs

21. Long-Run Production Costs An industry and the individual firms can undertake all desired resource adjustments Overall capacity can change Sufficient time for new firms to enter or for existing firms to leave

22. Firm Size and Costs As a manufacturing expands its plant size, ATC may fall (for a time) Eventually, ATC may rise

23. Long-Run Cost Curve  Points on previous graph indicate where firm should change plant size to attain lowest ATC  Per unit costs for a larger plant < per unit cost for current plant  The long run ATC is made up of segments of the short-run ATC curves for the various plant sizes that can be constructed  The lowest ATC at which any output level can be produced (in the long run)  The firm’s planning curve

24. Long-Run Average Cost Curve (unlimited number of plant sizes)

25. Economies and Diseconomies of Scale The long-run ATC curve is U-shaped Expanding will not always yield lower costs Assume resource prices are constant Assume that the law of diminishing returns does not apply to production in the long run (remember the definition?)

26. Economies of Scale As plant size increase, a number of factors will for a time lead to lower average costs of production The downward sloping portion of the long-run ATC curve Labor specialization Managerial specialization Efficient capital Other factors (“start-up costs”, advertising, learning by doing )

27. Diseconomies of Scale Expansion that leads to higher ATC Upward sloping portion of the long-run ATC Difficulty of efficiently controlling and coordinating a firm’s operations Employee alienation and shirking

28. Constant Returns to Scale The long-run ATC does not change as the firm expands The “flat” portion of the long-run ATC

29. Scale Graph

30. Minimum Efficient Scale and Industry Structure Minimum efficient Scale (MES) – the lowest level of output at which a firm can minimize long-run average costs (q 1 ) Depends on how long economies of scale can be achieved Natural monopoly – rare market situation in which average total cost is minimized when only one firm produces that particular good or service (Utilities, first class mail(?))

31. Structure of an Industry Long –run ATC curve is determined by technology and the economies and diseconomies of scale that result Can determine the industry composition (few large firms or many smaller firms) Other considerations: government policies, geographic size of markets, managerial strategy and skill