Part 5 The Theory of Production and Cost Production normally organized in Firms A Firm hires inputs, organizes production, and sells goods or services A firm is a governance structure that can range from simple to highly complex (sole owner to large multi-nation corporation) Firms allocate resources and coordinate economic activities internally using commands and incentive systems

Why Firms? Why is all economic activity not coordinated through markets? Firms exist because they offer cost advantages over market transactions - Transactions costs - Monitoring - Economies of scale or scope - Economies of team production

Why Markets? Why is all economic activity not coordinated through organized firms (or just one giant firm)? Principal-agent and incentive problems Problems of information and management provide limits to firm size

The Firm’s Goals The goal of the owners of the firm is to maximize the return on their capital investment—to maximize profit Profit is revenue less cost-- defined as opportunity cost Explicit and implicit costs Normal profit and economic profit

The Firm’s Constraints Available technology Prices of inputs Fixed capital in the short run Degree of competition in the output market Given these constraints the firm needs to choose the method of production and output level that will maximize profit Maximizing profit implies minimizing the cost of production

Output and Cost: Short Run In the short run the firm has a plant of given size The firm can add or subtract labour and other inputs to vary output, but cannot alter the size of the plant The fixed plant size affects how output will change with changes in the inputs that can be varied

The Short Run Production Function Total product curve Output TP Inflection point TP increasing at a decreasing rate L’ Labour TP= Total output as labour (and other variable inputs) are added to a plant of fixed size

Short Run Production Functions Other possible shapes Output TP Labour Output TP Labour

Average and Marginal Product Curves TP TP AP max & AP = MP MP max L Point of diminishing marginal returns AP MP Point of diminishing average returns AP MP L L’ L”

Diminishing Returns When there is a fixed factor must eventually run into diminishing marginal returns The constraint of the fixed factor eventually makes it more and more difficult (costly) to obtain additional output from the plant of fixed size Law of Diminishing Returns Is our world a world of diminishing returns?

Short Run Cost Our production function showed output as a function of the quantity of variable input (labour) with a given quantity of a fixed input (capital). We need to convert this into a cost function showing cost as a function of output To do this we assume that the prices of inputs are given

Short Run Total Costs Total cost is total variable cost plus total fixed cost The total variable cost of a given level of output is the quantity of labour it takes to produce that output (with the fixed level of capital) times the price of labour The total fixed cost is the quantity of the fixed input times the price of that input Total fixed cost does not vary with output

TP and TVC Q TP Q’ L L’ $ TVC = L x Wage TVC’ (L’ x W) Q Q’

Total Cost Curves TC $ TVC TFC Q Diminishing returns due to the fixed factor Means that TVC and TC must eventually Rise at an increasing rate

Marginal and Average Costs Average total cost is total cost divided by output Average variable cost is total variable cost divided by output Average fixed cost is total fixed cost divided by output ATC = AVC + AFC Marginal cost is the additional cost of an additional unit of output MC = ΔTC/ΔQ

Marginal and Average Cost Curves $ Min ATC MC ATC AVC Min AVC AFC Q ATC = AVC + AFC

Marginal and Average Product and Cost Curves As a firm expands output along its production function the output at which average product is at its greatest will be where AVC is at a minimum The output level at which MP is at a maximum will the output level where MC is at a minimum As MP and AP eventually decline due to diminishing returns, so MC and AVC will eventually rise.

Shifts in Cost Curves New Technology Costs of inputs Fixed inputs Variable inputs Scale of plant (long run)

Long Run Cost Changes to the scale of the plant Each plant size has a TC curve Larger plant increases fixed cost but delays onset of diminishing returns Each plant size has a short run ATC curve Long run average cost curve is the lower boundary of all short run ATC curves Long run and the least possible cost of production

Long Run Cost $ TC1 TC2 Q1 Q

Long Run Cost $ ATC1 ATC2 LAC Q Q1 Constant returns to scale

Long Run Average Cost Generalized case: increasing followed by decreasing returns to scale $ ATC3 ATC1 ATC5 ATC2 ATC4 LRATC Q* Q Q’ Least cost plant size to produce Q’ is ATC2 Q* is the lowest possible average cost, but whether this is the firm’s profit maximizing output will depend on market structure.

Economies of Scale Economies of scale due to specialization of labour and capital Diseconomies of scale due to problems of information and management Constant returns to scale Minimum efficient scale