Supply: The Costs of Doing Business Chapter 22 Supply: The Costs of Doing Business

Morita’s Cost Curve (Sony Corp.) Akio Morita, founder of Sony Corporation, drew this cost curve for transistor radios. He saw that per-unit costs would fall initially and then rise. He turned down an order for 100,000 units because he thought it would be risky to increase production levels that high. He asked “What if there were no repeat order the next year?”

Firms and Production Review from Chapter 4 Recall that the terms company, business, and enterprise are used interchangeably with firm. Firms can be sole proprietorships, partnerships, or corporations. They can be national or multinational. We use the term “firm” to refer to all types of business organization. A public company has its shares traded on a stock exchange. A private company does not have its ownership shares traded on an exchange. Nonetheless, we can refer to the owners of a company whether the company is public or private.

Output and Resources Businesses pay households income for the use of resources in production—wages for their labor, rent for land, and interest for capital. Households buy goods and services with their income. The total payments received by businesses form the firm’s total revenue. The difference between the firm’s total revenue and the total payments for resources is profit, which also flows to households as income.

The Circular Flow

Total Physical Product (TPP) The total physical product (TPP) curve or schedule is the relationship between a variable resource and output, for a given quantity of fixed resource(s). Sometimes referred to as total product. TPP is subject to the law of diminishing marginal returns: when the amount of at least one of the resources is fixed, successive increases in the amount of a variable resource will eventually yield declining incremental increases in output.

APP and MPP The law of diminishing marginal returns shows up more clearly in the APP and MPP. The average physical product (APP) is the (average) output per unit of resource. The marginal physical product (MPP) is the amount of additional output that is produced when one additional unit of a resource is used in combination with the same amount of other resources.

Total, Average, and Marginal Product Mechanics Total Output Average Physical Product Marginal Physical Product -- 1 100 2 250 125 150 3 360 120 110 4 440 80 5 500 60 6 540 90 40 7 550 78.6 10 8 675 -10

Total, Average, and Marginal Product

Marginal and Average Physical Product Marginals and averages always behave the same way. When the marginal is above the average, the average is rising. When the marginal is below the average, the average is falling. MPP=APP at the maximum of the APP.

Total Costs The total cost (TC) schedule is plotted on a graph with output measure on the horizontal axis and total cost on the vertical. The total physical product (TPP) curve is plotted with the units of variable resource on the horizontal axis and total output on the vertical axis. The two curves have the same shape, but are mirror images of one another. Both are shaped by diminishing marginal returns.

Total Costs

Average Costs Because the total cost and total physical product have the same shape, average physical product and average cost should also have the same shape. Average total cost (ATC) is the cost per unit of output:

Average Costs

Average Costs

Marginal Costs

Marginal Costs

Cost Schedules and Cost Curves Total fixed costs (TFC) are costs that must be paid whether the firm produces or not. TFC do not change with output. Total variable costs (TVC) are the costs that rise or fall as production rises or falls. Total costs (TC) are the sum of total variable and total fixed costs Average total cost is sometimes referred to as short-run average total cost (SRATC) because there are only fixed resources and fixed costs in the short run. Over the long run, all resources and costs can be changed.

Marginal and Average Costs (1) Total Output (Q) (2) Total Fixed Costs (TFC) (3) Total Variable Costs (TVC) (4) Total Costs (TC) (5) Average Fixed Costs (AFC) (6) Average Variable Costs (AVC) (7) Average Total Costs (ATC) (8) Marginal Costs (MC) $10 $ 0 1 $20 2 $18 $28 $5 $9 $14 $8 3 $25 $35 $3.33 $8.33 $11.6 $7 4 $30 $40 $2.5 $7.5 5 $45 $2 6 $42 $52 $1.66 $8.66 7 $50.6 $60.6 $1.44 $7.2 $8.6 8 $60 $70 $1.25 $8.75 $9.4 9 $80 $90 $1.1 $8.8 A B

Marginal and Average Cost Curves

Marginal and Average Cost Curves

Long-Run Cost Curves When all resources are changed, we say that the scale of the firm has changed. In the short run, scale is fixed because at least one resource cannot be changed. In the long run, the firm can choose any of the SRATC curves. The lowest-cost combinations of resources with which each level of output is produced when all resources are variable is called the long-run average total cost (LRATC). The long run is sometimes referred to as a planning horizon because over the long run the firm has all options open to it.

Short-Run and Long-Run Average-Cost Curves

Shape of LRATC The LRATC curve gets its shape from economies and diseconomies of scale. If producing each unit of output becomes less costly as the amount of output increases, we say there are economies of scale. If producing each unit of output becomes more costly as output rises, we say there are diseconomies of scale. If unit costs remain constant as output rises, we say there are constant returns to scale.

Long-Run and Short-Run Cost Curves (1)

Long-Run and Short-Run Cost Curves (2)

Minimum Efficient Scale Most industries experience both economies and diseconomies of scale. If the long-run average total cost curve reaches a minimum, the level of output at which the minimum occurs is called the minimum efficient scale (MES). The MES varies considerably across industries.

Morita’s Problem and Minimum Efficient Scale