1. Chapter 6 The Organization and Costs of Production 1

2. 6.1 Businesses: terminology A plant A firm An industry 2

3. Multi-plant firms Horizontally integrated Vertically integrated Conglomerate 3

4. 4 The Firm and the Business Sector  Legal Forms of Businesses: Sole Proprietorship Partnership Corporation What are the advantages of each? Disadvantages? 4

5. Principal-agent problem Principals are stockholders ➔ hire agents to run their business What is the problem? interests of agent and goals of principals are not always in agreement ➔ conflict of interest 5

6. Principal-agent problem in the real world Executive stock options in 1990s to correct principal-agent problem led to fraud and abuse, as in the Enron and WorldCom cases. Deceptive accounting practices were used to inflate company stock prices so that executives could sell their shares and reap huge windfalls. 6

7. 6.2 Economic Costs Explicit costs –payments to non-owners for resources they supply Implicit costs –money payments the self ‑ employed resources could have earned in their best alternative employments 7

8. 8 EconomicProfits Implicit costs (including a normal profit) ExplicitCosts Accounting costs (explicit costs only) AccountingProfits Economic (opportunity) Costs TotalRevenue Figure 6-1 Economic Profit vs. Accounting Profit

9. Normal profits an implicit cost because they are the minimum payments required to keep the owner’s entrepreneurial abilities self ‑ employed. 9

10. Example Start your own business – use $20,000 of savings (was in bank earning $1,000/year in interest) –give up present job (earned $35,000 / year) –use office space that you own (previously rented out for $500/month) –your entrepreneurial talent is worth $6,000 per year in other business endeavors 10

11. Example continued After 1 year: total revenue is $150,000. Calculate the accounting profit. Calculate the economic profit. Calculate the normal profit. 11

12. 12 Short Run and Long Run Short Run –Fixed Plant Long Run –Variable Plant

13. 6.3 Short-Run Production Relationships 13

14. 14 Total Product (TP) –total quantity produced Marginal Product (MP) Average Product (AP) change in total product change in labour input = total product units of labour =

15. Calculate MP & AP Units of variable resource (labour) Total product (TP) Marginal product (MP) Average Product (AP) 012345678012345678 0 10 23 39 52 62 65 61 15

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17. 17 Marginal and Average Values  If the average value is rising, the marginal value must be ABOVE the average value  If the average value is falling, the marginal value must be BELOW the average value 17

18. Relationships in previous slide a.When marginal product begins to diminish, the rate of increase in total product stops accelerating and grows at a diminishing rate. b.The average product declines at the point at which the marginal product slips below average product (AP is max where MP=AP) c.Total product declines when the marginal product becomes negative. 18

19. 19 6.4 Short-Run Production Costs  Fixed Costs  do not vary with changes in output  Variable Costs  change with changes in output  Total Cost  sum of fixed and variable costs 19

20. 20 Per-Unit, or Average, Costs

21. 21 Marginal Cost  Marginal cost is the extra, or additional, cost of producing one more unit of output Illustrated…

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23. Short-run costs for a firm TP (Q) TFCTVCTCAFCAVCATCMC 012345678012345678 60 0 45 85 120 150 185 225 270 325 23

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26. Cost curves can shift When? change in resource prices change in technology 26

27. Example How do the following changes affect AFC, AVC, TC, & MC? 1.wage rates rise 2.Price of steel falls 3.Increase in property insurance rate 4.New technology to improve productivity 27

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29. 29 6.5 Long-Run Production Costs  What will costs look like when the firm can choose the best plant size for any given situation?  For every plant capacity size, there is a short-run ATC curve  All such plant capacities can be plotted... 29

30. 30 ATC-1ATC-2 ATC-3 ATC-4 ATC-5 Choose the best plant for every output level The Long-Run Average-Total-Cost Curve These choices determine the LRATC curve

31. 31 The number of possible plant sizes is virtually unlimited The number of possible plant sizes is virtually unlimited The Long-Run Average-Total-Cost Curve The LRATC curve just envelops the short-run cost curves LRATC

32. Economies of scale explain the downward sloping part of the long ‑ run ATC curve Why does this occur? 32

33. Diseconomies of scale may occur if a firm becomes too large as illustrated by the rising part of the long ‑ run ATC curve. Why does this occur? Constant returns to scale are a possibility. 33

34. Minimum efficient scale defines the smallest level of output at which a firm can minimize its average costs in the long run. depends on the industry. 34

35. Sunk Costs should be disregarded in decision making. 35