THEORY OF FIRM BEHAVIOR Chapter 6: COSTS OF THE FIRM

Firm’s Choice: Firm’s Costs and Production Decision A firm chooses: What quantity of the good to produce, The price of the good (sometimes...). Firm’s decision depends on: Costs of production. The degree of competition in the market (if there are more sellers, more competitive).

Firm’s Choice: Firm’s Costs and Production Decision Firm’s Objective The goal of a firm is to maximize profits.

Total Revenue, Total Cost, and Profit Profit is the firm’s total revenue minus its total cost. Profit = Total Revenue - Total Cost

Total Revenue, Total Cost, and Profit The amount a firm receives for the sale of its output. For a competitive firm, TR = P x Q Total Cost The market value of the inputs a firm uses in production.

Economic Profit versus Accounting Profit Economic profit is not the same as accounting profit. When calculating economic profit, we include all opportunity costs including hidden (implicit) costs. Accounting profit (as it appears on balance sheets) refers to the firm’s total revenue minus only the firm’s open (explicit) costs.

Costs as Opportunity Costs Example: Costs of Your Textile Factory Worker’s wages, electricity, cost of machines, rent are open (explicit) costs. Instead of starting the textile factory, you could work as an engineer for 2,500 liras per month. Then the hidden (implicit) cost of running the textile factory is 2,500 liras per month.

Economic Profit versus Accounting Profit A firm earns positive economic profit only if total revenue exceeds both open and hidden opportunity costs. Economic profit is always less than or equal to accounting profit: A firm could be making positive accounting profit but at the same time zero or negative economic profit.

PRODUCTION AND COSTS The Production Function The production function shows the relationship between quantity of inputs (Ex: number of workers) used to make a good and the quantity of output of that good.

Table 1: A Production Function and Total Cost: Emine’s Cookie Factory Fixed Variable 1 Copyright©2004 South-Western

Figure 2 Emine’s Production Function Quantity of Output (cookies 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 Copyright © 2004 South-Western

The Production Function Marginal Product The marginal product of labor (any input) is the change in output produced by an additional worker (additional input).

The Production Function Diminishing Marginal Product Diminishing marginal product: Keeping all other inputs fixed, marginal product of one of the inputs declines as the quantity of that input increases. Ex: As more and more workers are hired at a firm, each additional worker contributes less and less to output because the firm has a fixed amount of machines & equipment & capacity. Another example: a farm with fixed area, machines, technology, labor. Try planting 100 gr. seeds or 200 gr. or 300 gr. seeds.

The Production Function Diminishing Marginal Product The slope of the production function measures the marginal product of labor. When the marginal product of labor declines, the production function becomes flatter.

Figure 2 Emine’s Production Function Quantity of Output (cookies 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 Copyright © 2004 South-Western

Table 1 A Production Function and Total Cost: Emine’s Cookie Factory Fixed Variable Copyright©2004 South-Western

The Various Measures Of Cost Costs of production may be separated into fixed costs and variable costs. Fixed costs are those costs that do not change with the quantity of output produced. Ex: Rent, accountant’s wage, some taxes.. Variable costs are those costs that do change with the quantity of output produced. Ex: Labor, Electricity, Transportation,...

Fixed and Variable Costs Total Costs Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC

Table 2 The Various Measures of Cost: Osman’s Lemonade Stand Copyright©2004 South-Western

Fixed and Variable Costs Average Costs Average costs can be determined by dividing the firm’s costs by the quantity of output it produces. Average cost answers the following question: How much does it cost to produce one unit of a good on average?

Fixed and Variable Costs Average Costs Average Fixed Cost (AFC) = Total Fixed Cost / Qty Average Variable Cost (AVC) = Total Variable Cost / Qty Average Total Costs (ATC) = Total Cost / Qty ATC = AFC + AVC

Table 2 The Various Measures of Cost: Osman’s Lemonade Stand Copyright©2004 South-Western

Marginal Cost Marginal Cost Marginal cost (MC) is the additional cost of producing the last unit. Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output?

Marginal Cost Osman’s Lemonade Stand

Marginal Cost

Figure 4 Osman’s Total-Cost Curves $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) Copyright © 2004 South-Western

Figure 5 Osman’s Marginal-Cost Curve 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) Copyright © 2004 South-Western

Cost Curves and Their Shapes Marginal cost increases as we produce more and more This is due to the property of diminishing marginal product. See example.

Figure 6 Osman’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) Copyright © 2004 South-Western

Table 2 The Various Measures of Cost: Osman’s Lemonade Stand Copyright©2004 South-Western

Cost Curves and Their Shapes The average total-cost (ATC) curve is U-shaped. At very low levels of output, ATC is high because fixed cost is spread over only a few units. ATC declines as output increases because fixed cost is spread over more units. As output increases further, ATC starts rising because average variable cost rises faster than the decline in AFC.

Cost Curves and Their Shapes The quantity where the firm achieves the lowest average cost is at the minimum point of the U-shaped ATC curve. This quantity is called the efficient scale of the firm.

Figure 7 Osman’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) Copyright © 2004 South-Western

Cost Curves and Their Shapes Relationship between Marginal Cost and Average Total Cost Whenever MC is smaller than ATC, ATC is falling. Whenever MC is greater than ATC, ATC is rising. ATC is like your cumulative GPA and MC is like your last semester’s grade average. As a result, MC crosses ATC at the minimum of ATC.

Figure 5 Osman’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) Copyright © 2004 South-Western

Cost Curves and Their Shapes Summarize Three Important Properties of Cost Curves Marginal cost eventually rises as the quantity of output increases. The ATC curve is U-shaped. The MC curve crosses the ATC curve at the minimum point of ATC.

Costs In The Short Run And In The Long Run 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 (Ex: rent of building and machines), some are variable (labor, energy, raw materials). In the long-run, fixed costs become variable costs (Ex: renting decisions can change, can buy/rent new machines and equipment). All costs are variable in the long-run.

Costs In The Short Run And In The Long Run Because many costs are fixed in the short-run but variable in the long-run, a firm’s long-run cost curves are different from its short-run cost curves.

Figure 7 Average Total Cost in the Short and Long Run ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory Cost $12,000 ATC in long run 1,200 Quantity of Cars per Day Copyright © 2004 South-Western

Figure 7 Average Total Cost in the Short and Long Run ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory Cost ATC in long run Economies of scale Diseconomies of scale 1,200 $12,000 1,000 10,000 Constant returns to scale Quantity of Cars per Day Copyright © 2004 South-Western

Costs versus Size of the Firm If long-run ATC falls as the quantity of output increases, the firm has Increasing Returns to Scale (=Economies of Scale). If long-run ATC rises as the quantity of output increases, the firm has Decreasing Returns to Scale (=Diseconomies of Scale). If long-run ATC stays constant as the quantity of output increases, the firm has Constant Returns to Scale.

Economies and Diseconomies of Scale The shape of LRATC depends on the type of industry. Some industries exhibit economies of scale (also called increasing returns to scale) like cable TV, GSM providers, electricity, oil extraction, high-tech goods, etc. Such industries are characterized by high fixed costs. Some industries show decreasing returns to scale because firms are too big. Coordination problems & bureaucracy. IBM and General Motors are examples.