Background to Supply: Firms in Competitive Markets 6 Background to Supply: Firms in Competitive Markets For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Costs Of Production A firm’s costs are a key determinant of its production and pricing decisions. Most firms in competitive markets are small For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

What Are The TS Costs? We will use Paolo’s Pizza Factory as an example of a small business. Paolo has to pay for: The ingredients used to make pizzas Equipment Workers to run his equipment Utilities Rent For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Costs As Opportunity Costs A firm’s cost of production includes all the opportunity costs of making its output of goods and services. Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs. Explicit costs are input costs that require a direct outlay of money by the firm. Implicit costs are input costs that do not require an outlay of money by the firm. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Production And Costs Time Periods For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. In the short run, some costs are fixed. In the long run, fixed costs become variable costs. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Production Function The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good. Marginal Product marginal product of any input in the production process is the increase in output that arises from an additional unit of that input. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Table 1 A Production Function and Total Cost: Paolo’s Pizza Factory

The Production Function Diminishing Marginal Product Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 1a. Paolo’s Production Function Quantity of Output (pizzas per hour) 150 Production function 140 130 120 110 100 90 80 70 60 50 40 30 20 10 1 2 3 4 5 Number of Workers Hired For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Production Function Diminishing Marginal Product The 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. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

From The Production Function To The Total Cost Curve The relationship between the quantity a firm can produce and its costs determines pricing decisions. The total cost curve shows this relationship graphically. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Table 1 A Production Function and Total Cost: Paolo’s Pizza Factory

Figure 1b. Paolo’s Total Cost Curve € 80 Total-cost curve 70 60 50 40 30 20 10 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity of Output For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 (pizzas per hour)

The Various Measures Of Cost Costs of production may be divided into fixed costs and variable costs. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Fixed and Variable Costs Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do vary with the quantity of output produced. Total Costs Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Table 2 The Various Measures of Cost: Luciano’s Lemonade Stand For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Fixed and Variable Costs Average Costs Average costs can be determined by dividing the firm’s costs by the quantity of output it produces. The average cost is the cost of each typical unit of product. Types of Average Cost Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) ATC = AFC + AVC For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Types of Average Costs For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Fixed and Variable Costs Marginal Cost Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production. Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output? For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Marginal Cost Luciano’s Lemonade Stand For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 2 Luciano’s Total Cost Curve €15.00 Total-cost curve 14.00 13.00 12.00 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour) For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 3a. Luciano’s Average Cost and Marginal Cost Curves Costs € 3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 ATC 1.25 AVC 1.00 0.75 0.50 AFC 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour)

Cost Curves and Their Shapes Marginal cost rises with the amount of output produced. This reflects the property of diminishing marginal product. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 3b. Luciano’s Average-Cost and Marginal-Cost Curves Costs € 3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour)

Cost Curves and Their Shapes The average total-cost curve is U-shaped. At very low levels of output average total cost is high because fixed cost is spread over only a few units. Average total cost declines as output increases. Average total cost starts rising because average variable cost rises substantially. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Cost Curves and Their Shapes The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 3c. Luciano’s Average Cost and Marginal Cost Curves Costs € 3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 ATC 1.25 1.00 0.75 0.50 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour)

Cost Curves and Their Shapes Relationship between Marginal Cost and Average Total Cost Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Cost Curves and Their Shapes Relationship Between Marginal Cost and Average Total Cost The marginal cost curve crosses the average total cost curve at the efficient scale. Efficient scale is the quantity that minimizes average total cost. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 3d. Luciano’s Average Cost and Marginal Cost Curves Costs € 3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 ATC 1.25 1.00 0.75 0.50 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour)

Typical Cost Curves It is now time to examine the relationships that exist between the different measures of cost. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Berit’s Cost Curves For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 4a. Berit’s Cost Curves (a) Total Cost Curve Total Cost €18.00 TC 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 2 4 6 8 10 12 14 Quantity of Output (bagels per hour)

Figure 4b. Berit’s Cost Curves (b) Marginal and Average Cost Curves Costs € 3.00 2.50 MC 2.00 1.50 ATC AVC 1.00 0.50 AFC 2 4 6 8 10 12 14 Quantity of Output (bagels per hour)

Typical Cost Curves Three Important Properties of Cost Curves Marginal 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 its lowest point. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Costs In The Short Run And In The Long Run For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Costs In The Short And In Long Run The division of total costs into fixed and variable costs will vary from firm to firm. Some costs are fixed in the short run, but all are variable in the long run. For example, in the long run a firm could choose the size of its factory. Once a factory is chosen, the firm must deal with the short-run costs associated with that plant size. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Relationship Between Short-Run and Long-Run Average Cost The long-run average-total-cost curve lies along the lowest points of the short- run average-total-cost curves because the firm has more flexibility in the long run to deal with changes in production. The long-run average total cost curve is typically U-shaped, but is much flatter than a typical short-run average-total-cost curve. The length of time for a firm to get to the long run will depend on the firm involved. In the short-run some factors of production cannot be changed. In the long-run all factors of production can be altered. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Returns to Scale Constant returns to scale the property whereby long-run average total cost stays the same as the quantity of output change Economies of scale the property whereby long-run average total cost falls as the quantity of output increases. Diseconomies of scale the property whereby long- run average total cost rises as the quantity of output increases For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Returns to Scale Causes of Economies and Diseconomies of Scale. Specialization among workers and technology that can be used. Negotiate more favourable borrowing rates or can secure lower supply costs because they are buying in larger quantities and can agree discounts from suppliers. External economies arising from locating where there is a specialist pool of labour or the infrastructure is better. Diseconomies arise because of coordination and communication problems that are inherent in any large organization. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Returns to Scale The Implications of Economies of Scale. Large-scale production that result in lower average or unit costs. that offers … …opportunity to either increase in profits or reduction in price dependent of level of competition. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Costs Of Production A firm’s costs are a key determinant of its production and pricing decisions. Most firms in competitive markets are small For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

What Are The TS Costs? We will use Paolo’s Pizza Factory as an example of a small business. Paolo has to pay for: The ingredients used to make pizzas Equipment Workers to run his equipment Utilities Rent For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Costs As Opportunity Costs A firm’s cost of production includes all the opportunity costs of making its output of goods and services. Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs. Explicit costs are input costs that require a direct outlay of money by the firm. Implicit costs are input costs that do not require an outlay of money by the firm. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Production And Costs Time Periods For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. In the short run, some costs are fixed. In the long run, fixed costs become variable costs. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Production Function The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good. Marginal Product marginal product of any input in the production process is the increase in output that arises from an additional unit of that input. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Table 1 A Production Function and Total Cost: Paolo’s Pizza Factory

The Production Function Diminishing Marginal Product Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 1a. Paolo’s Production Function Quantity of Output (pizzas per hour) 150 Production function 140 130 120 110 100 90 80 70 60 50 40 30 20 10 1 For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 2 3 4 5 Number of Workers Hired

The Production Function Diminishing Marginal Product The 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. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

From The Production Function To The Total Cost Curve The relationship between the quantity a firm can produce and its costs determines pricing decisions. The total cost curve shows this relationship graphically. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Table 1 A Production Function and Total Cost: Paolo’s Pizza Factory

Figure 1b. Paolo’s Total Cost Curve € 80 Total-cost curve 70 60 50 40 30 20 10 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 of Output (pizzas per hour)

The Various Measures Of Cost Costs of production may be divided into fixed costs and variable costs. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Fixed and Variable Costs Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do vary with the quantity of output produced. Total Costs Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Table 2 The Various Measures of Cost: Luciano’s Lemonade Stand For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Fixed and Variable Costs Average Costs Average costs can be determined by dividing the firm’s costs by the quantity of output it produces. The average cost is the cost of each typical unit of product. Types of Average Cost Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) ATC = AFC + AVC For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Types of Average Costs For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Fixed and Variable Costs Marginal Cost Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production. Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output? For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Marginal Cost Luciano’s Lemonade Stand For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 2 Luciano’s Total Cost Curve €15.00 Total-cost curve 14.00 13.00 12.00 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 1 2 3 4 5 6 7 8 9 10 Quantity of Output For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 (glasses of lemonade per hour)

Figure 3a. Luciano’s Average Cost and Marginal Cost Curves Costs € 3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 ATC 1.25 AVC 1.00 0.75 0.50 AFC 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour)

Cost Curves and Their Shapes Marginal cost rises with the amount of output produced. This reflects the property of diminishing marginal product. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 3b. Luciano’s Average-Cost and Marginal-Cost Curves Costs € 3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour)

Cost Curves and Their Shapes The average total-cost curve is U-shaped. At very low levels of output average total cost is high because fixed cost is spread over only a few units. Average total cost declines as output increases. Average total cost starts rising because average variable cost rises substantially. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Cost Curves and Their Shapes The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 3c. Luciano’s Average Cost and Marginal Cost Curves Costs € 3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 ATC 1.25 1.00 0.75 0.50 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour)

Cost Curves and Their Shapes Relationship between Marginal Cost and Average Total Cost Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Cost Curves and Their Shapes Relationship Between Marginal Cost and Average Total Cost The marginal cost curve crosses the average total cost curve at the efficient scale. Efficient scale is the quantity that minimizes average total cost. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 3d. Luciano’s Average Cost and Marginal Cost Curves Costs € 3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 ATC 1.25 1.00 0.75 0.50 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour)

Typical Cost Curves It is now time to examine the relationships that exist between the different measures of cost. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Berit’s Cost Curves For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 4a. Berit’s Cost Curves (a) Total Cost Curve Total Cost €18.00 TC 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 2 4 6 8 10 12 14 Quantity of Output (bagels per hour)

Figure 4b. Berit’s Cost Curves (b) Marginal and Average Cost Curves Costs € 3.00 2.50 MC 2.00 1.50 ATC AVC 1.00 0.50 AFC 2 4 6 8 10 12 14 Quantity of Output (bagels per hour)

Typical Cost Curves Three Important Properties of Cost Curves Marginal 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 its lowest point. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Costs In The Short Run And In The Long Run For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Costs In The Short And In Long Run The division of total costs into fixed and variable costs will vary from firm to firm. Some costs are fixed in the short run, but all are variable in the long run. For example, in the long run a firm could choose the size of its factory. Once a factory is chosen, the firm must deal with the short-run costs associated with that plant size. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Relationship Between Short-Run and Long-Run Average Cost The long-run average-total-cost curve lies along the lowest points of the short- run average-total-cost curves because the firm has more flexibility in the long run to deal with changes in production. The long-run average total cost curve is typically U-shaped, but is much flatter than a typical short-run average-total-cost curve. The length of time for a firm to get to the long run will depend on the firm involved. In the short-run some factors of production cannot be changed. In the long-run all factors of production can be altered. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Returns to Scale Constant returns to scale the property whereby long-run average total cost stays the same as the quantity of output change Economies of scale the property whereby long-run average total cost falls as the quantity of output increases. Diseconomies of scale the property whereby long-run average total cost rises as the quantity of output increases For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Returns to Scale Causes of Economies and Diseconomies of Scale. Specialization among workers and technology that can be used. Negotiate more favourable borrowing rates or can secure lower supply costs because they are buying in larger quantities and can agree discounts from suppliers. External economies arising from locating where there is a specialist pool of labour or the infrastructure is better. Diseconomies arise because of coordination and communication problems that are inherent in any large organization. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Returns to Scale The Implications of Economies of Scale. Large-scale production that result in lower average or unit costs. that offers … …opportunity to either increase in profits or reduction in price dependent of level of competition. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017