1. Unit 3 – Theory of the Firm and

2. transformation of factors into goods & services Think about….production an economic institution that transforms factors of production into goods & services. A firm ….. We are a firm (1) organizes factors of production and/or (3) sells produced goods to individuals, gov’ts, businesses (2) produces goods, and/or

3. Let’s say this student started his own business (firm)...... He then burns a CD on his computer. Classmates are willing to pay $18.00 for a 10- song CD b/c Leonard puts together tunes better than.... He puts together Leo Jams CD’s for his classmates by downloading music from

4. Leo calculated the cost of producing each CD at per CD revenue = _________ per CD profit = __________ $ 2.00 for equipment 9.00 for songs.80 labor.20 blank CD’s He sells each CD for $16.00 $16.00 $4.00

5. Let’s say another student joined the market with her own mixes.... Now we have two suppliers in the market -- Leo Jams & Becca’s Boss Hits. What happens to the price of CD’s? Price falls to $11.50 per CD. 5 of 32

6. Should Leo burn the next CD at the new market price of $11.50? He’s already spent $ 2.00 for equipment He’d need to spend 9.00 for songs.80 labor.20 blank CD’s

7. Yes, he should burn that next CD. He should only be concerned with the costs in front of him. $ 2.00 for equipment 9.00 for songs.80 labor.20 blank CD’s These are fixed costs = sunk costs These are variable costs = the costs Leo should worry about

8. S U N K C O S T S Sunk costs – are fixed costs that are sunk, done, and over with. There is nothing you can do about them. They are irrelevant to your current decision-making process. **All Fixed Costs are Sunk Costs** It will cost Leo an additional _________ to burn the next CD & he will earn in revenue __________ for the next CD, therefore he should / should not burn it. $10.00 $11.50

9. In our book-producing firm…. What were our fixed costs? What were our variable costs?

10. Leo Jams CD’s take off. ¿….Decisions….decisions….?? How many workers do I hire? We examine productivity …. the amount of goods and services produced (output) per unit of productive resources used (input) in a specific period of time.

11. ¿….Decisions….decisions….?? How many workers do I hire? No. of workers 110 Total CD’s burned Marginal Product 10 222 12 3 33 11 How can marginal product decrease? 436 3 532-4 Explain how this is possible??

12. Law of …… Diminishing Marginal Productivity as more and more of a variable input is added to an existing fixed input, eventually the additional output one gets from that additional input is going to fall. 12 of 32

13. Q 0 10 11 12 13 14 15 16 17 18 19 20 FC 1,000 VC 0 1,085 1,215 1,365 1,540 1,780 2,105 2,530 3,065 3,720 4,500 5,430 TC 1,000 2,085 2,215 2,365 2,540 2,780 3,105 3,530 4,065 4,720 5,500 6,430 What are the definitions of each one of these costs? FC – Those costs that remain constant whether a firm produces 0 units to an infinite number of units. VC – Those costs that change (go up) when a firm produces from 1 unit to an infinite amount of units. TC = FC + VC

14. Q 0 10 11 12 13 14 15 16 17 18 19 20 FC 1,000 VC 0 1,085 1,215 1,365 1,540 1,780 2,105 2,530 3,065 3,720 4,500 5,430 TC 1,000 2,085 2,215 2,365 2,540 2,780 3,105 3,530 4,065 4,720 5,500 6,430 Let’s graph these columns to create our first, very own cost curves. (000) 1 2 3 4 5 6 10 11 12 13 14 15 16 17 18 19 20 FC VC TC

15. The total costs are important to firms, but more often under consideration are …. average costs average total cost = total cost divided by quantity produced average fixed cost = fixed cost divided by quantity produced average variable cost = variable cost divided by quantity produced ATC = TC/Q AFC = FC/Q AVC = VC/Q ATC = AFC + AVC

16. Q 7 8 9 10 11 12 13 14 15 16 17 18 AFC 1,430 1,250 1,110 1,000 910 830 770 710 670 630 590 560 Observe this row of data, what will usually be happening to AFC? It will be decreasing because quantity will normally increase whereas fixed costs remain the same.

17. Q 7 8 9 10 11 12 13 14 15 16 17 18 AFC 1,430 1,250 1,110 1,000 910 830 770 710 670 630 590 560 AVC 1,290 1,240 1,130 1,090 1,100 1,140 1,180 1,270 1,400 1,580 1,800 2,070 ATC 2,710 2,490 2,240 2,090 2,010 1,970 1,950 1,990 2,070 2,221 2,390 2,620 Why do average variable costs rise? Why is ATC rising? Law of Diminishing Marginal Returns Because AVC is getting bigger

18. Q 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AFC 2,000 1,670 1,430 1,250 1,110 1,000 910 830 770 710 670 630 590 560 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AFC 18 of 32

19. Q 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AVC 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 1,380 1,330 1,290 1,240 1,130 1,090 1,100 1,140 1,180 1,270 1,400 1,580 1,800 2,070 AVC The lowest point on the AVC curve is at quantity 10. AFC

20. Q 5 6 7 8 9 10 11 12 13 14 15 16 17 18 ATC 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AVC 3,380 3,000 2,710 2,490 2,240 2,090 2,010 1,970 1.950 1,990 2,070 2.221 2.390 2,620 ATC The lowest point on the ATC curve is at quantity 13. AFC

21. 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AFC AVC ATC A few important points: 1. The ATC curve looks like a smiley face. ATC 2. The AVC curve looks like a smirk. AVC

22. 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AVC ATC AVC AFC If we got rid of the AFC curve, could you figure out what the AFC are without the curve?

23. 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AVC ATC From now on, we will NOT be drawing too many AFC curves because.... AFC = ATC - AVC 23 of 32

24. In economics we say firms and individuals…. make decisions on the margin We saw this when we studied demand and marginal utility analysis. a consumer will choose ice cream until… and When choosing between MU of hamburger/P hamburger = MU of ice cream / P ice cream

25. Q 7 8 9 10 11 12 13 14 15 16 17 18 AFC 1,430 1,250 1,110 1,000 910 830 770 710 670 630 590 560 AVC 1,290 1,240 1,130 1,090 1,100 1,140 1,180 1,270 1,400 1,580 1,800 2,070 ATC 2,710 2,490 2,240 2,090 2,010 1,970 1.950 1,990 2070 2.221 2.390 2620 MC 1,000 900 300 650 1,300 1,500 1,750 2,400 3,250 4,250 5,350 6,550 So…marginal cost is important to firm. The firm is concerned with the cost of the next unit, just as the consumer is concerned with the …

26. Q 5 6 7 8 9 10 11 12 13 14 15 16 17 18 MC 1,200 1,100 1,000 900 300 650 1,300 1,500 1,750 2,400 3,250 4,250 5,350 6,550 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AVC ATC MC

27. 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AVC ATC MC A few important points: 1. The MC curve looks like the Nike Swoosh MC 2. MC touches AVC and ATC at their lowest points.

28. 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AVC ATC MC Law of diminishing marginal returns-- As more and more of a variable input are added to a fixed input, the additional output begins to go down. Diminishing Marginal Returns sets in here Explain why 28 of 32

29. Review:In firm cost analysis What’s on the y axis? 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 cost What’s on the x axis? quantity

30. Review:In firm cost analysis What’s the shape of the ATC curve? 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 cost What’s the shape of the AVC curve? quantity ATC AVC

31. Review:In firm cost analysis What’s the shape of the MC curve? 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 cost quantity ATC AVC MC

32. 6,000 5,000 4,000 3,000 2,000 1,000 5 6 7 8 9 10 11 12 13 14 15 16 17 18 AVC ATC MC Where does the MC curve have to intersect the ATC & AVC curves? 32 of 32