1. Production and Cost in the Firm
CHAPTER 7
© 2003 South-Western/Thomson Learning

2. Cost and Profit
In economics, we assume that producers try to maximize profit  this provides the motivation for their behavior
Firms transform resources into products in their attempt to accomplish this objective
They must make plans while confronting uncertainty about
Consumer demand
Resource availability
Intentions of other firms in the industry

3. Explicit and Implicit Costs
To hire resources, producers must pay resources at least their opportunity costs
For most resources, the cash payments approximate their opportunity cost
However, some resources are owned by the firm or the firm’s owners  there are no direct cast payments
Whether hired in resource markets or owned by the firm, all resources have an opportunity cost

4. Explicit and Implicit Costs
Explicit costs
Refer to the firm’s actual cash payments for resources  wages, rent, taxes, etc.
Implicit costs
The opportunity costs of using resources owned by the firm or provided by the firm’s owners
Require no cash payment and no entry in the firm’s accounting statement, which records its revenues, explicit costs, and accounting profits

5. Alternative Measures of Profit
A particular example may help to clarify the distinction between explicit and implicit costs and the alternative measure of profit that are used
Wanda Wheeler currently earns $50,000 in her current job
She decides to start her own business
She withdraws $20,000 from her savings account, hires and assistant and uses a spare bay in her garage that had been renting for $1,000 a year

6. Normal Profit
There is one other profit measure to consider: the accounting profit required to induce the firm’s owners to employ their resources in the firm
Alternatively, the accounting profit just sufficient to ensure that all resources used by the firm earn their opportunity cost  normal profit
Recall that the accounting profit = $64,000
Normal profits = $50,000 + $1,200 + $1,000 = $52,200  normal profit  $11,800 is an economic profit

7. Fixed and Variable Resources
Resources can be divided into two categories
Variable resources can be varied quickly to change the output rate
Fixed resources are those resources which cannot be easily changed
This provides us the distinction between the short run and the long run
Short run  at least one resource is fixed
Long run  all resources are variable

8. Short Run and Long Run
Output can be changed in the short run by adjusting variable resources
However, the size, or scale of the firm is fixed in the short run
In the long run, all resources can vary
The length of the short and long run differs from industry to industry because the nature of production differs

9. Law of Diminishing Marginal Returns
For the present, suppose we focus on the short-run link between resource use and the rate of output
Suppose the company’s fixed resources are already in place and consist of a warehouse, a moving van, and moving equipment
The only variable resource is labor

10. Law of Diminishing Marginal Returns
As more of a variable resource is combined with a given amount of a fixed resource, marginal product eventually declines
This is the most important feature of production in the short run  dictates the shape of the production function and the cost curves

11. Costs in the Short Run There are two kinds of costs in the short run
Fixed costs pay for fixed resources and must be paid even if no output is produced  do not vary when output varies
In our example the fixed costs are assumed to be $200
Variable cost is the cost of variable resources – labor in our example – and vary with the amount of labor employed in the production process  as more labor is employed, output and variable cost both increase
The firm can hire labor at $100 per worker day  variable cost equals $100 times the number of workers hired

12. Marginal Cost and Marginal Productivity
When the firm experiences increasing marginal returns – marginal product is increasing – the marginal cost decreases
When the firm experiences diminishing marginal returns – marginal product begins to decline – the marginal cost of output increases

13. Summary
The total cost curve can be divided into two sections, based on what happens to marginal cost
Because of increasing marginal returns from labor, marginal cost at first declines  total cost initially increases by successively smaller amounts  total cost curve gets flatter
Because of diminishing marginal returns from labor, marginal cost starts increasing  a steeper total cost curve

14. Summary Marginal cost is the key to economic decisions made by firms
The firm operating in the short run has no control over its fixed cost, but, by, varying output, the firm can alter its variable cost and hence its total cost
Marginal cost indicates how much total cost will increase if one more unity is produced and how much total cost will drop if production declines by one unit

15. Average Cost in the Short Run
The average cost per unit of output is another of the useful cost measures
There are average cost measures corresponding to variable cost, fixed cost and variable cost

16. Marginal and Average Cost
The relationship between marginal and average cost is also important
When marginal cost is below or less than average cost it pulls average cost down
When marginal cost is above or higher than average cost it pulls average cost up

17. Costs in the Long Run
Thus far we have focused on how costs vary as the rate of output expands in the short run for a firm of a given size
In the long run, all inputs that are under the firm’s control can be varied  there are no fixed costs
The long run is not just a succession of short runs

18. Costs in the Long Run
The long run is best thought of as a planning horizon
In the long run, the choice of input combinations is flexible, but that flexibility is available only to firms that have not yet acted on their plans
Firms plan for the long run, but they produce in the short run

19. Long-Run Average Cost Curve
Suppose that, because of the special nature of technology in the industry, a firm must choose among only three possible sizes
Small
Medium
Large

20. Long-Run Average Cost Curve
Now suppose there are many possible plan sizes
The long-run average cost curve, shown in red, is formed by connecting the points on the various short-run average cost curves that represent the lowest per-unit cost for each rate of output

21. Economies of Scale Notice that the long-run average curve is U-shaped
The U-shape here is a result of economies and diseconomies of scale
Economies of scale imply that long-run average costs decline as output expands while diseconomies of scale imply that long-run average costs increase as output increases

22. Economies of Scale
A larger size often allows for larger, more efficient, machines and allows workers a greater degree of specialization  Production techniques such as the assembly line can be utilized only if the rate of output is large enough
Typically, as the scale of the firm increases, capital substitutes for labor and complex machines substitute for simpler machines

23. Diseconomies of Scale
As a firm expands, diseconomies of scale, eventually take over  long-run average cost increase as output expands
As the amount and variety of resources employed increase, so does the task of coordinating all these inputs
However, as the work force grows, additional layers of management are needed to monitor production

24. Diseconomies of Scale
In the thicket of bureaucracy that develops, communications may get mangled
The more levels of management there are in an organization, the more difficult it is for top management to communicate with those that perform most of the production tasks

25. Constant Long-Run Average Costs
It is possible for average cost to neither increase nor decrease with changes in firm size
In these situations, the firm experiences constant long-run average costs

26. Economies and Diseconomies of Scale at the Firm Level
Thus far we have focused on a particular plant
However, a firm could also be a collection of plants
And it is possible that economies and diseconomies of scale can exist at the firm level as well as the plant level