1. Chapter 23 The Firm: Cost and Output Determination

2. Slide 23-2 Introduction Freight dispatchers use real-time information transmitted by computers to monitor the positions of locomotives and rolling stock along the nation’s railways. In what respect does the availability of information affect the operating costs of any business?

3. Slide 23-3 Learning Objectives Discuss the difference between the short run and the long run from the perspective of a firm Understand why the marginal physical product of labor eventually declines as more units of labor are employed

4. Slide 23-4 Learning Objectives Explain the short-run cost curves faced by a typical firm Explain the long-run cost curves faced by a typical firm Identify situations of economies and diseconomies of scale and define a firm’s minimum efficient scale

5. Slide 23-5 Chapter Outline Short Run versus Long Run Relationship Between Output and Inputs Diminishing Marginal Returns Short-Run Costs to the Firm

6. Slide 23-6 Chapter Outline The Relationship Between Diminishing Marginal Returns and Cost Curves The Relationship Between Diminishing Marginal Returns and Cost Curves Long-Run Cost Curves Why the Long-Run Average Cost Curve is U-Shaped Why the Long-Run Average Cost Curve is U-Shaped Minimum Efficient Scale

7. Slide 23-7 As electric utilities have increased their generating capacity over the past ten years, they also have lowered the average cost of producing power? In some other industries, a higher productive capacity is associated with a higher average cost? Did You Know That...

8. Slide 23-8 Short Run –A time period when at least one input, such as plant size, cannot be changed –Plant Size The physical size of the factories that a firm owns and operates to produce its output Short Run versus Long Run

9. Slide 23-9 Long Run –The time period in which all factors of production can be varied Short Run versus Long Run

10. Slide 23-10 Short Run versus Long Run Short run and long run are terms that apply to planning decisions made by managers. The firm always operates in the short run in the sense that decisions can only be made in the present. But some of these decisions result in a long-term commitment of resources.

11. Slide 23-11 The Relationship Between Output and Inputs Q = output/time period K = capital L = labor Q = ƒ(K,L) or Output/time period = some function of capital and labor inputs

12. Slide 23-12 Production –Any activity that results in the conversion of resources into products that can be used in consumption The Relationship Between Output and Inputs

13. Slide 23-13 Production Function –The relationship between inputs and output –A technological, not an economic, relationship –The relationship between inputs and maximum physical output The Relationship Between Output and Inputs

14. Slide 23-14 Procter & Gamble is a consumer products company that supplies soap and personal care products to retailers. Using inventory-tracking software, the company found that it could make more efficient use of all inputs if it dispatched trucks from its manufacturing facilities with less than full loads. Example: The Optimal Load Size for Trucks

15. Slide 23-15 Example: The Optimal Load Size for Trucks The efficiency resulted from the fact that workers who loaded the trucks were more productive and that total fuel consumption was less when trucks were only partially loaded. The inventory-tracking software allowed the company to identify parts of its production function that would have been difficult to determine through casual observation.

16. Slide 23-16 Law of Diminishing (Marginal) Returns –The observation that after some point, successive equal-sized increases in a variable factor of production, such as labor, added to fixed factors of production, will result in smaller increases in output Diminishing Marginal Returns

17. Slide 23-17 Average Physical Product –Total product divided by the variable input The Relationship Between Output and Inputs

18. Slide 23-18 Marginal Physical Product –The physical output that is due to the addition of one more unit of a variable factor of production –The change in total product occurring when a variable input is increased and all other inputs are held constant –Also called marginal product or marginal return The Relationship Between Output and Inputs

19. Slide 23-19 Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 23-1, Panel (a)

20. Slide 23-20 Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 23-1, Panel (b)

21. Slide 23-21 Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 23-1, Panel (c)

22. Slide 23-22 An Example of the Law of Diminishing Returns Production of computer printers –With a fixed amount of factory space, assembly equipment, and quality control diagnostic software, more workers can add to total output. –But the additional increments of quantity produced will lessen as more labor is added.

23. Slide 23-23 An Example of the Law of Diminishing Returns Beyond a certain point, as more workers as added, they will have to assemble the printers manually. The marginal physical product of labor, while remaining positive, will decline.

24. Slide 23-24 Total Costs –The sum of total fixed costs and total variable costs Fixed Costs –Costs that do not vary with output Variable Costs –Costs that vary with the rate of production Short-Run Costs to the Firm Total costs (TC) = TFC + TVC

25. Slide 23-25 Cost of Production: An Example Figure 23-2, Panel (a)

26. Slide 23-26 Cost of Production: An Example Figure 23-2, Panel (b) 1110 Total costs Total variable costs 9876543210 10 20 Panel (b) 60 50 40 30 Output (recordable DVDs per day) Total costs (dollars per day) Total fixed costs

27. Slide 23-27 Average Total Costs (ATC) Short-Run Costs to the Firm Average total costs (ATC) = total costs (TC) output (Q)

28. Slide 23-28 Average Variable Costs (AVC) Short-Run Costs to the Firm Average variable costs (AVC) = total variable costs (TVC) output (Q)

29. Slide 23-29 Average Fixed Costs (AFC) Short-Run Costs to the Firm Average fixed costs (AFC) = total fixed costs (TFC) output (Q)

30. Slide 23-30 Marginal Cost –The change in total costs due to a one- unit change in production rate Short-Run Costs to the Firm Marginal costs (MC) = change in total cost change in output

31. Slide 23-31 What do you think? –Is there a predictable relationship between the production function and AVC, ATC, and MC? Short-Run Costs to the Firm

32. Slide 23-32 Answer –As long as marginal physical product rises, marginal cost will fall, and when marginal physical product starts to fall (after reaching the point of diminishing marginal returns), marginal cost will begin to rise. Short-Run Costs to the Firm

33. Slide 23-33 E-Commerce Example: Internet Package Tracking The marginal cost incurred by FedEx in delivering one additional package includes the transportation expense and also the cost of providing information to senders or recipients who inquire about the status of the shipment.

34. Slide 23-34 E-Commerce Example: Internet Package Tracking As the internet has made it easier to provide this information for customers, FedEx has experienced a downward shift of its marginal cost curve.

35. Slide 23-35 The Relationship Between Average and Marginal Costs When marginal cost is less than average variable cost, then average variable cost will decline. When marginal cost exceeds average variable cost, then average variable cost will increase.

36. Slide 23-36 The Relationship Between Average and Marginal Costs It is also true that the direction of change in average total cost will be determined by whether marginal cost exceeds the current average.

37. Slide 23-37 Firms’ short-run cost curves are a reflection of the law of diminishing marginal returns. Given any constant price of the variable input, marginal costs decline as long as the marginal product of the variable resource is rising. The Relationship Between Diminishing Marginal Returns and Cost Curves

38. Slide 23-38 At the point at which diminishing marginal returns begin, marginal costs begin to rise as the marginal product of the variable input begins to decline. The Relationship Between Diminishing Marginal Returns and Cost Curves

39. Slide 23-39 The Relationship Between Diminishing Marginal Returns and Cost Curves If the wage rate is constant, then the labor cost associated with each additional unit of output will decline as long as the marginal physical product of labor increases.

40. Slide 23-40 Planning Horizon –The long run, during which all inputs are variable Long-Run Cost Curves

41. Slide 23-41 Preferable Plant Size and the Long-Run Average Cost Curve Figure 23-4, Panels (a) and (b) Panel (b) Output per Time Period Q 2 Q 1 C 3 C 1 C 4 C 2 Panel (a) Output per Time Period SAC 21 3 LAC 1 SAC 2 3 4 5 6 7 8 Average Cost (dollars per unit of output)

42. Slide 23-42 Long-Run Average Cost Curve –The locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices Long-Run Cost Curves

43. Slide 23-43 Observation –Only at minimum long-run average cost curve is short-run average cost curve tangent to long-run average cost curve What do you think? –Why is the long-run average cost curve U-shaped? Long-Run Cost Curves

44. Slide 23-44 Economies of Scale –Decreases in long-run average costs resulting from increases in output These economies of scale do not persist indefinitely, however. Once long-run average costs rise, the curve begins to slope upwards. Why the Long-Run Average Cost Curve is U-Shaped

45. Slide 23-45 Reasons for economies of scale –Specialization –Dimensional factor –Improved productive equipment Why the Long-Run Average Cost Curve is U-Shaped

46. Slide 23-46 Why the Long-Run Average Cost Curve is U-Shaped Explaining diseconomies of scale –Limits to the efficient functioning of management –Coordination and communication is more of a challenge as firm size increases

47. Slide 23-47 International Example: Reducing Firm Size to Reduce Costs In the past decade, the Chinese government has sold many of the companies that were originally state-financed endeavors. Although these firms received subsidies when they were government-sponsored enterprises, they had to be self-financing once they were in the hands of private investors.

48. Slide 23-48 International Example: Reducing Firm Size to Reduce Costs In many instances, the private owners chose to reduce the scale of operations. This has resulted in lower long-run average costs, and the firms can expect to keep operating without subsidies.

49. Slide 23-49 Minimum Efficient Scale (MES) –The lowest rate of output per unit time at which long-run average costs for a particular firm are at a minimum Minimum Efficient Scale

50. Slide 23-50 Small MES relative to industry demand: –There is room for many efficient firms –High degree of competition Large MES relative to industry demand: –Room for only a small number of efficient firms –Small degree of competition Minimum Efficient Scale

51. Slide 23-51 Minimum Efficient Scale Figure 23-6 0 Output per Time Period LAC B 1,000 A 10 Long-Run Average Costs (dollars per unit)

52. Slide 23-52 Example: Plant Size for Doughnuts The Krispy Kreme Doughnut empire is a chain of stores, each one equipped with machinery designed to bake tens of thousands of doughnuts each day. As the chain has expanded its number of locations, some stores are competing against one another.

53. Slide 23-53 Example: Plant Size for Doughnuts The result is that, in some locations, many of the doughnuts produced are thrown out after aging for more than a day. This raises the average cost of each doughnut sold. The expansion of the chain has led to an increase in long-run average costs, suggesting that the company has surpassed the size of its minimum efficient scale.

54. Slide 23-54 With computers doing much of the work of monitoring locomotive engines and switching trains between tracks, the marginal product of labor in the railroad industry has been enhanced. As economic theory would predict, this has resulted in lower average costs. Issues and Applications: Railroad Locomotives as a High-Tech Gadget?

55. Slide 23-55 Summary Discussion of Learning Objectives The short run versus the long run from a firm’s perspective –Short run: a period in which at least one input is fixed –Long run: a period in which all inputs are available

56. Slide 23-56 Summary Discussion of Learning Objectives The law of diminishing marginal returns –As more units of a variable input are employed with a fixed input, marginal physical product eventually begins to decline A firm’s short-run cost curves –Fixed and average fixed cost –Variable and average variable cost –Total and average total cost –Marginal cost

57. Slide 23-57 Summary Discussion of Learning Objectives A firm’s long-run cost curve –Planning horizon –All inputs are variable including plant size Economies and diseconomies of scale and a firm’s minimum efficient scale

58. End of Chapter 23 The Firm: Cost and Output Determination