McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 20 Cost

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Learning Objectives  This chapter introduces these concepts: 1.Fixed cost, variable costs, and total cost. 2.Marginal cost. 3.Short run and long run. 4.Shut-down and go-out-of-business decisions. 5.Average cost. 6.Graphing the AFC, AVC, ATC, and MC curves. 7.The production function. 8.The law of diminishing returns. 9.Economies and diseconomies of scale.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Costs Sales – Costs = Profit Total Revenue - Total Cost = Profit or Total Revenue (TR) – Total Cost (TC) Profit (the bottom line)

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fixed Costs (FC)  Fixed costs stay the same no matter how much output changes. Examples: rent, insurance, salaries, property taxes, and interest payments. Even when a firm’s output is zero, it incurs the same fixed cost. Sometimes called “sunk cost” because once you have obligated yourself to pay them, that money has been sunk into your firm. The trick is to spread these (fixed) costs over as much output as possible. In other words, to spread your overhead over a large output.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Variable Costs (VC)  Variable costs vary with output. As output goes up, VC goes up. As output goes down, VC goes down. Examples: wages, fuel, raw materials, electricity, and shipping. Sometimes a cost may be part fixed and part variable. The electricity used by production is a variable cost because it will go up or down with production. Even if your output fell to zero, you would still have to pay something on your electric bill.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Total Cost (TC)  Total cost is the sum of fixed and variable costs. TC = FC + VC

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Hypothetical Cost Schedule Let’s first try graphing these 3 costs curves.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved FC + VC = TC Hypothetical Cost Schedule (continued)

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Marginal Cost (MC) Output FC VC TC MC 0 $500 $ 0 $500 $ , , ,500 2,  MC is the cost of producing one additional unit of output.  MC = change in TC ÷ change in Q

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Marginal Cost (MC) Output FC VCTC MC 0 $500 $ 0 $500 $ , , ,500 2,  MC is the cost of producing one additional unit of output. At an output of zero, VC is always zero At an output of zero, FC is equal to TC

 2009 by The McGraw-Hill Companies, Inc. All rights reserved The Short Run (SR)  As long as there are any fixed costs, we are in the short run. The present time is always the short run.  The short run is the length of time it takes all fixed costs to become variable costs. In other words, the length of time it takes to eliminate all fixed costs. A steel firm might need 10 years to pay off such fixed costs as interest and rent. Even a grocery store would need a few weeks or months to sublet the store and discharge its other obligations.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved The Long Run (LR)  The long run is the time at which all costs become variable costs. Never exists except in theory…you never rally reach the long run. You will never have a situation in which all your costs are variable. This would mean no rent, no insurance, no guaranteed salaries, no depreciation, etc. As you proceed through the short run, you are forced to make decisions that will push the long run farther into the future.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Another Cost Table: Find TC Output FC VC TC AFC AVC ATC MC 0 $500 $ 0 $ , , , ,400 Recall TC = FC + VC

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Average Cost: Now Adding AFC, AVC, and ATC Output FC VC TC AFC AVC ATC MC 0 $500 $ 0 $500 $ - $ - $ , , , , AFC = FC / Output AVC = VC / Output ATC = TC / Output Recall TC = FC + VC

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Average Cost: Finally Adding MC Output FC VC TC AFC AVC ATC MC 0 $500 $0 $500 $ - $ - $ - $ , , ,200 1, ,900 2, MC is the cost of producing one additional unit of output. It is best to use the VC column to calculate the MC. If the TC column is used, you cannot calculate the MC for the first unit of output.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Output FC VC TC AFC AVC ATC MC 0 $500 $ 0 $500 $ 0 $ 0 $ 0 $ , , ,200 1, ,900 2, Much of microeconomic analysis involves: Graphing the AFC, AVC, ATC & MC curves   Filling in a table   Drawing a graph  Analyzing the graph

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Output FC VC TC AFC AVC ATC MC 0 $500 $ 0 $500 $ 0 $ 0 $ 0 $ Graphing the AVC, ATC, and MC curves Always do MC first! MC intersects ATC and AVC at their minimum points. What is min. AVC? What is min. ATC? AVC and ATC are U-shaped About $135 About $260

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Minimum AVC: $70Minimum ATC: $166 Further Discussion: You Try Finding Minimum AVC and ATC points

 2009 by The McGraw-Hill Companies, Inc. All rights reserved The MC curve intersects the ATC and AVC at their minimum points. Review

 2009 by The McGraw-Hill Companies, Inc. All rights reserved The Law of Diminishing Returns  Production function: relationship between the maximum amount a firm can produce and various quantities of inputs.  Marginal output: the additional output produced by the last worker hired.  Law of diminishing returns: as successive units of a variable resource (say, labor) are added to a fixed resource, beyond some point, the extra or marginal product attributable to each additional unit of the variable resource will decline.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Total Output and Marginal Output

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Economies of Scale  Economies of scale: the economies of mass production, which drive down ATC. Evidenced by the declining part of the ATC curve.  In general, we expect large firms to undersell small firms. Reasons are: Quantity discounts. Economies of being established. Spreading fixed cost.  Economies of scale enable a business to reduce its cost per unit as output expands.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Diseconomies of Scale  Diseconomies of scale: the inefficiencies that become endemic in large firms. Evidenced by the rising part of the ATC curve.  In general, at some point, the larger firms get the more inefficient they become. Reasons are: An expanding and growing bureaucracy. A huge and growing corporate authority.  Diseconomies of scale increase inefficiencies and also increase cost per unit.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved A Summing Up  The overlapping forces of increasing returns and economies of scale drive down ATC.  Eventually, the overlapping forces of diminishing returns and diseconomies of scale push ATC back up again.  The U-shaped ATC is very important in economic analysis and in business strategy. What size size plant do we build? How many workers do we hire? What is the output at which our firm would operate most efficiently?

 2009 by The McGraw-Hill Companies, Inc. All rights reserved The Decision to Operate or Shut Down: The Short Run  A firm has 2 options in the short run: operate or shut down.  When TR > VC, operate. If it operates, it will produce the output that will yield the highest possible profits. If it is losing money, it will operate at that output at which losses are minimized.  When TR < VC, shut down. If the firm shuts down, output is zero. Shutting down does not mean zero total costs. The firm must still meet its fixed costs. Remember, at an output of zero, TC = FC. The firm can not go out of business until all fixed cost obligations are eliminated.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Summary Table: Let’s Try 3 Problems  Problem #1: Operate or shut down in the short run? TC = FC + VC ($5 + $6) = $11 TR = $7 Loss = $4  TR ($7) > VC ($6), so operate to cover FC and then some.  Note: Fixed costs are not relevant in the operate/shut down decision.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Summary Table: Let’s Try 3 Problems  Problem #2: Operate or shut down in the short run? TC = FC + VC ($10 + $9) = $19 TR = $8 Loss = $11  TR ($8) < VC ($9), so shut down  Note: Fixed costs are not relevant in the operate/shut down decision.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Summary Table: Let’s Try 3 Problems  Problem #3: Operate or shut down in the short run? TC = FC + VC ($8 + $12) = $20 TR = $10 Loss = $10  TR ($10) < VC ($12), so shut down  Note: Fixed costs are not relevant in the operate/shut down decision.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved The Decision to Stay In or Go Out of Business: The Long Run  In the long run, firms must decide to stay in business or go out of business. The firm will stay in business if the total revenue is greater than its total cost. The firm will go out of business if the total cost exceeds total revenue. Going out of business means that all fixed cost obligations are met.  Does everybody who is losing money go out of business? Eventually (most sooner rather than later). There are always exceptions to the rule.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Deriving the Shut-Down and Break-Even Points  The firm can make the same shut-down or operate decisions on the basis of price and average variable cost. Recall, a firm will shut down if VC > TR, or A firm will shut down if VC > P x Q Let’s divide both side of the above equation by Output: VC> Price x Output Output AVC> Price OPERATE AVC < Price SHUT DOWN

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Deriving the Shut-Down and Break-Even Points  The firm can make the same stay in business or go out of business decisions on the basis of price and average total cost. Recall, a firm will go out of business if TC > TR, or A firm will go out of business if TC > P x Q Let’s divide both side of the above equation by Output: TC> Price x Output Output ATC> Price STAY IN BUSINESS ATC < Price GO OUT OF BUSINESS

 2009 by The McGraw-Hill Companies, Inc. All rights reserved ATC, AVC and MC: Graphing These Business Decisions

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Questions for Thought and Discussion  Pretend you are the owner of a coffee house. What would be the difference between shutting down and going out of business? What are the fixed costs? What are the variable costs?  Why does it take longer to go out of business than to shut down?

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Varying Factory Capacities: Choosing Plant Size Each of these ATCs represents a different size factory, with a different optimum level of output represented by the minimum point on the ATC curve.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Varying Factory Capacities: Choosing Plant Size ATC 1 has the lowest capacity while ATC 5 has the highest. Which size factory would a firm choose to produce 400 units of output? Answer: plant size 4

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Varying Factory Capacities: Choosing Plant Size Changes in plant size are long run changes. In the long run, a firm could be virtually any size provided it has the requisite financing.

 2009 by The McGraw-Hill Companies, Inc. All rights reserved Current Issue: Wedding Hall or City Hall?  Every wedding, big or small incurs fixed cost and variable cost. Fixed costs: flowers, photographer, the wedding hall, the gowns, the videographer, tux rentals, clergy. Variable costs: food and drinks; the number of guest will affect the size of the wedding hall.  A relatively small wedding that cost $20,000 and might pull in gifts worth $10,000.  A much larger wedding might cost $100,000 and might pull in gifts worth $50,000.  Do you go for the large wedding or smaller one?