Presentation on theme: "FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY"— Presentation transcript:
1FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY 5FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
2CHAPTER 13 THE COSTS OF PRODUCTION CompetitionIn this part of the course, we will look at how the functioning of an economy depends on the degree to which businesses can exert control over the prices they setHow much freedom a firm has to set prices depends on the intensity of the competition it faces from other firmsThis is why the analysis of prices depends on the intensity of competitionCHAPTER 13 THE COSTS OF PRODUCTION
3The Costs of Production 13The Costs of Production
4CHAPTER 13 THE COSTS OF PRODUCTION A Firm’s CostsIn Chapter 4 we saw the theory of supply and demand, which assumes perfect competitionIn Chapter 7 we saw that Chapter 4’s supply curve is constructed from data on production costsRecall the example of the house painters Mary, Frieda, Georgia and GrandmaIn this chapter, we take a closer look at costsCHAPTER 13 THE COSTS OF PRODUCTION
5CHAPTER 13 THE COSTS OF PRODUCTION A Firm’s CostsAnother reason to study costs is that the intensity of competition between firms can depend on the relationship between a firm’s costs and its level of productionIn crude terms, if firms’ costs per unit produced tend to be lower when production levels are higher, existing mega-firms are likely to crush any competition from firms that are new and smallCHAPTER 13 THE COSTS OF PRODUCTION
6Profit, the firm’s objective The economic goal of a firm is to maximize its profit. Profit = Total revenue - Total cost
7Total Revenue, Total Cost, and Profit Profit = Total Revenue – Total CostTotal RevenueThe money a firm receives from the sale of its output.TR = P QWe saw this is chapter 5Total CostThe market value of all the inputs (resources) a firm uses in production.
8Explicit and Implicit Costs Total Cost = Explicit Cost + Implicit Cost.Explicit costs are costs that require a direct outlay of money by the firm’s owner(s).Implicit costs are costs that do not require an outlay of money by the firmIf some of the resources used in production are provided by the owner(s) of the firm, the firm may not have to pay for them.The market value of such resources is the implicit cost.Implicit costs are included in total cost.
9Implicit Costs: Examples You own a restaurant and you work eighteen hours a day in itYou could have worked elsewhere and earned a wage. This lost income is an implicit costYou have invested $20,000 of your own savings in your restaurantYou could have earned interest had you put that money in a bank instead. This lost interest income is an implicit costCHAPTER 13 THE COSTS OF PRODUCTION
10Economic Profit versus Accounting Profit Economic profit = total revenue – total cost = total revenue – (explicit costs + implicit costs)Accounting profit = total revenue – explicit costsAs a result, accounting profit > economic profit
11Figure 1 Economists versus Accountants How an EconomistHow an AccountantViews a FirmViews a FirmRevenueEconomicprofitAccountingprofitRevenueImplicitcostsTotalopportunitycostsExplicitcostsExplicitcosts
12Economic Profit and Firm Sustainability Non-negative economic profit is essential for the long-run viability of a firmCaroline’s Cookie Factorytotal revenue = $700 per hourtotal explicit costs = $650 per hourfor labor and raw materialstotal implicit costs = $110 per hourin wages Caroline could have earned as a computer programmerAccounting profit = $50 per hour.This indicates short-run financial viabilityEconomic profit = – $60 per hour.This indicates a dire long-run future.Dissatisfied with the $50 per hour profit, Caroline will eventually shut down the firm and take a programming jobCHAPTER 13 THE COSTS OF PRODUCTION
14PRODUCTION FUNCTIONThe production function shows how the quantity of output of a good depends on the quantity of inputs used to make that good.
15Marginal ProductThe marginal product of any resource is the increase in output that arises from one additional unit of that resource, provided the technology and the amounts of all other resources are unchanged.Note that the marginal product diminishes as more of the resource is used. This is a common assumption in economics.
16Diminishing Returns in Production Diminishing marginal product is the property whereby the marginal product of an input decreases as the quantity of the input increases.Example: As more and more workers are hired at a firm, the output produced would increase by less and less because the firm has a limited amount of equipment that all workers must share.
17Figure 2 Caroline’s Production Function Quantity ofOutput(cookiesper hour)150Production function140130120Note that this production function graph shows diminishing marginal product.11010090807060504030201012345Number of Workers Hired
19Table 1 A Production Function and Total Cost: Caroline’s Cookie Factory Fixed CostVariable CostNumberof workersOutput(quantity of cookiesproduced per hour)Marginalproductof laborCost offactoryworkersTotal cost of inputs(cost of factory +cost of workers)1234565090120140150155$3030$010204060708050403020105Turning the two bordered columns into a graph yields the cost curve. See next slide.
20Figure 2 Caroline’s production function and total-cost curve Quantityof Output(cookiesper hour)10080604020160140120(a) Production function(b) Total-cost curveTotalCost5040302010807060$90ProductionfunctionTotal-cost curveNumber ofWorkers Hired123456Quantityof Output(cookies per hour)20406080100120140160
21THE VARIOUS MEASURES OF COST Total Cost = fixed cost + variable cost.Fixed costs are those costs that do not vary with the quantity produced.Variable costs are those costs that vary with the quantity produced.TC = FC + VC
22CHAPTER 13 THE COSTS OF PRODUCTION Fixed CostsFixed costs are those costs that do not vary with the quantity producedFactory rentSecurity costsMarketing costsResearch and development costsCHAPTER 13 THE COSTS OF PRODUCTION
23CHAPTER 13 THE COSTS OF PRODUCTION Variable CostsVariable costs are those costs that vary with the quantity producedCost of raw materialsLabor costsCHAPTER 13 THE COSTS OF PRODUCTION
24The various measures of cost: Conrad’s Coffee Shop Quantityof coffee(cups per hour)TotalCostFixedVariableAverageMarginal12345678910$3.003.303.804.505.406.507.809.3011.0012.9015.003.00$0.000.300.801.502.403.504.806.308.009.9012.00-1.000.750.600.500.430.380.33$0.300.400.700.901.101.20$3.301.901.351.301.331.381.43$0.300.500.700.901.101.301.501.701.902.10Check that TC = FC + VC
25Figure 3 Conrad’s Coffee Shop Total-Cost Curve $15.00Total-cost curve14.00Quantityof coffee(cups per hour)TotalCost12345678910$3.003.303.804.505.406.507.809.3011.0012.9015.0013.0012.0011.0010.009.008.007.006.005.004.003.002.001.0012345678910Quantityof Output(cups of coffee per hour)
26Average CostsAverage cost is also called per-unit cost or, simply, unit costAverage cost can be determined by dividing the firm’s total cost by the quantity of output it produces.
28Average Fixed and Variable Costs We know that TC = FC + VCTherefore, TC/Q = FC/Q + VC/QTherefore, ATC = AFC + AVC
29The various measures of cost: Conrad’s coffee shop Quantityof coffee(cups per hour)TotalCostFixedVariableAverageMarginal12345678910$3.003.303.804.505.406.507.809.3011.0012.9015.003.00$0.000.300.801.502.403.504.806.308.009.9012.00-1.000.750.600.500.430.380.33$0.300.400.700.901.101.20$3.301.901.351.301.331.381.43$0.300.500.700.901.101.301.501.701.902.10Check that ATC = TC/Q, AFC = FC/Q, and AVC = VC/QCheck that ATC = AFC + AVC
30Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves Costs$3.50AFC = FC/Q As FC is constant, FC/Q decreases as Q increases. Therefore, AFC decreases as Q increases3.253.002.752.502.252.001.751.501.251.000.750.50AFC0.2512345678910Quantityof Output(cups of coffee per hour)
31Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves CostsAFC decreases as Q increases,AVC increases as Q increases, because of diminishing returns.As ATC = AFC + AVC, ATC is U-shaped; as Q increases, it decreases initially and then begins to increase.$3.503.253.002.752.502.252.001.751.50ATC1.25AVC1.000.750.50AFC0.2512345678910Quantityof Output(cups of coffee per hour)
32Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves The quantity at which ATC is lowest is called the efficient scale output.Costs$3.503.253.002.752.502.252.001.751.50ATC1.25For Conrad’s Coffee Shop, the efficient scale is 5 or 6 cups of coffee per hour1.000.750.500.2512345678910Quantityof Output(cups of coffee per hour)
33Cost Curves and Their Shapes The average total-cost curve is U-shaped.At very low levels of output average total cost is high because the fixed cost is spread over only the few units that are produced.Average fixed cost declines as output increases.Average variable cost rises as output increases.These features of a firm’s costs explains the U-shape of the ATC curveRecall that ATC = AFC + AVC
34Marginal CostMarginal cost (MC) is the increase in total cost (TC) that arises from an additional unit of production.The increase in cost that arises from an extra unit of production is entirely due to the use of additional raw materials and laborTherefore, marginal cost can also be defined as the increase in total variable cost (VC) that arises from an additional unit of production.
36The various measures of cost: Conrad’s coffee shop Quantityof coffee(cups per hour)TotalCostFixedVariableAverageMarginal12345678910$3.003.303.804.505.406.507.809.3011.0012.9015.003.00$0.000.300.801.502.403.504.806.308.009.9012.00-1.000.750.600.500.430.380.33$0.300.400.700.901.101.20$3.301.901.351.301.331.381.43$0.300.500.700.901.101.301.501.701.902.10Check that MC = TC/ Q = VC / Q
37Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves Marginal cost rises with the amount of output produced. This reflects the assumption of diminishing marginal productCosts$3.503.253.002.752.502.25MC2.001.751.501.251.000.750.500.2512345678910Quantityof Output(cups of coffee per hour)
38Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves Costs$3.503.253.002.752.502.25MC2.001.751.50ATC1.25AVC1.000.750.50AFC0.2512345678910Quantityof Output(cups of coffee per hour)
39Cost Curves and Their Shapes Whenever marginal cost is less than average total cost, average total cost must be decreasing (negatively sloped).Whenever marginal cost is more than average total cost, average total cost must be increasing (positively sloped).Whenever marginal cost is equal to average total cost, average total cost must be constant (horizontal).
40Cost Curves and Their Shapes The marginal-cost curve crosses the average-total-cost curve at the efficient scale output.Efficient scale output is the quantity that minimizes average total cost.
41Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves Costs$3.503.253.002.752.502.25MC2.001.751.50ATC1.251.000.750.500.2512345678910Quantityof Output(cups of coffee per hour)
42Typical cost curves are assumed to be slightly different from the ones we have just seen
44Figure 5 Cost Curves of a Typical Firm (a) Total-Cost CurveTotalCost$18.00TC16.0014.0012.0010.008.006.004.002.002468101214Quantity of Output
45Figure 5 Cost Curves of a Typical Firm (b) Marginal- and Average-Cost CurvesCosts$3.002.50MC2.001.50ATCAVC1.000.50AFC2468101214Quantity of Output
46Three Important Properties of Cost Curves Typical Cost CurvesThree Important Properties of Cost CurvesMarginal 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.
47COSTS IN THE SHORT RUN AND IN THE LONG RUN How much of a firm’s total costs are fixed costs and how much are variable costs depends on the time horizon being considered.In the short run, some costs are fixed.In the long run, all costs are variable.
48COSTS IN THE SHORT RUN AND IN THE LONG RUN Because some costs are fixed in the short run and variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.
49Figure 6 Average Total Cost in the Short and Long Run ATCin shortrun withsmall factoryATCin shortrun withmedium factoryATCin shortrun withlarge factoryCost$12,000ATCin long run1,200Quantity ofCars per Day
50Economies and Diseconomies of Scale Economies of scale exist when long-run average total cost falls as the quantity of output increases.Diseconomies of scale exist when long-run average total cost rises as the quantity of output increases.Constant returns to scale exists when long-run average total cost stays unchanged as the quantity of output increases
51Figure 6 Average Total Cost in the Short and Long Run ATCin shortrun withsmall factoryATCin shortrun withmedium factoryATCin shortrun withlarge factoryCostATCin long runEconomiesofscaleDiseconomiesofscale1,200$12,0001,00010,000Constantreturns toscaleQuantity ofCars per Day
52SummaryThe goal of firms is to maximize profit, which equals total revenue minus total cost.When analyzing a firm’s behavior, it is important to include all the opportunity costs of production.Some opportunity costs are explicit while other opportunity costs are implicit.
53Summary A firm’s costs reflect its production process. A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product.A firm’s total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced.
54SummaryAverage total cost is total cost divided by the quantity of output.Marginal cost is the amount by which total cost would rise if output were increased by one unit.The marginal cost always rises with the quantity of output.Average cost first falls as output increases and then rises.
55Summary The average-total-cost curve is U-shaped. The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC.A firm’s costs often depend on the time horizon being considered.In particular, many costs are fixed in the short run but variable in the long run.
56Table 1 A Production Function and Total Cost: Caroline’s Cookie Factory Fixed CostVariable Cost
57The Production Function Diminishing Marginal ProductThe 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.
58From the Production Function to the Total-Cost Curve The relationship between the quantity a firm can produce and its costs determines supply decisions.A firm will not produce a certain quantity unless the price of the product is high enough to cover the costs of productionThe total-cost curve shows this relationship graphically.