Transcript Short-run Production Costs

The Firm, Production, and Cost
The Cost of Production
Lecture 15, 16 & 17
Chapter 10
Chapter 20
Forms of Business Organizations
• There are five main ways of organizing the
production of goods and services that are
sold on markets:
• Single Proprietorship – one owner who is
personally responsible for everything that
is done
• Partnership – two or more joint owners,
each of whom is personally responsible for
all of the partnership debt
Forms of Business Organizations
contd.
• Limited Partnership has two types of partners :
– General partners: run the business and have
unlimited liability
– Limited partners take no part in running of the
business and their liability is limited to the amount
they actually invest in the enterprise
• Joint-stock company (Corporations) - is a firm
which has an identity of its own. Its owners are
not personally responsible for anything that is
done in the name of the firm (though the Director
may be)
Forms of Business Organizations
contd.
• Joint stock companies can be:
– Public limited companies (PLC): the shares of the
company are traded on the stock exchange market.
Example?
– Private limited companies (PVT): the shares are not
sold on the stock exchange, instead they are owned
by a group of private investors. Example?
• Public corporations: nationalized industry,
owned by the state; it is usually under the
direction of a more or less independent stateappointed board
The financing of firms
• Two types of capital:
• Financial capital – the money capital
required for the running of the business
– It can be owner’s capital or borrowed from
financial institutions
• Real capital – the physical assets such as
factories, machineries, stocks of material,
finished goods etc.
Profit Maximization
• Neoclassical theory of the firm states :
– The desire to maximize profits is assumed to
motivate all decisions taken within a firm, and
such decisions are uninfluenced by who takes
them. Thus, the theory abstracts from the
peculiarities of the persons taking the
decisions and from the organizational
structure in which they work.
• This assumption allows economists to
predict firm behavior
Economic Costs
• The economic cost/opportunity cost of any
resource used to produce a good is the
value or worth the resource would have in
its best alternative use
• Explicit costs: are the monetary payments
made to those who supply labor services,
materials, fuel, transportation services etc.
Such money payments are for the use of
resources owned by others
Economic Costs
• Implicit costs: are the opportunity costs of
using self-owned , self-employed
resources. To the firm, the implicit costs
are the monetary payments that selfemployed resources could have earned in
their best alternative use.
• Economic Costs = explicit + implicit costs
• Accounting Costs = explicit costs
Types of Profits
• Accounting Profit = Total Revenue – Total
(explicit) Cost
• Economic Profit = Total Revenue - Total
(explicit + implicit) Cost
• Normal Profit is the cost of doing
businesses: Implicit + explicit cost
Short Run and Long Run
• Short Run : Fixed Plant
The short run is a period too short for a firm
to alter its plant capacity, yet long enough
to permit a change in the degree to which
the fixed plant is used (the firm can vary its
output produced by using smaller or larger
amounts of inputs while the plant capacity
is fixed)
Short Run and Long Run contd.
• Long Run : Variable Plant
The long run is a period long enough for
the firm to adjust the quantities of all the
resources that it employs, including the
plant size. It is a period long enough for
firms to enter and exit the market.
• The Short run and Long run vary from
industry to industry! why?
Short Run Production Concepts
A firm’s cost of producing a specific good
depends on the price of resources used
and the quantity required of these
resources.
The price of inputs is determined by their
respective supply and demand functions
Consider Labor as the only input for now!
Production of Firm
• Total Product (TP): the total quantity of
good produced
• Marginal Product (MP): is the extra output
or added product associated with adding a
unit of a variable resource, in this case
labor, to the production process
• MP= ∆ in total product
∆ in labor input
Short Run Production
Relationships
• Average Product (AP): also called input
productivity, output per unit of input
• AP:
Total Product
Total units of input
In case of labor: average product for labor is
the output per unit of labor input
Practice: Table 20.1 in class – draw curves
Law of Diminishing Returns
• The law assumes that technology is fixed and
thus the techniques of production do not change
• As successive units of a variable resource
(labor) are added to a fixed resource (capital,
land etc), beyond some point the extra, or
marginal product that can be attributed to each
additional unit of the variable resource will
decline.
• Eg. Workers & Capital Equipment
Crop & Land
Important Features (TP & MP)
• MP is the slope of the total product curve
• Where TP is increasing at an increasing
rate, MP is rising (each extra unit of labor
is adding more MP than the previous unit)
• Where TP rising at a decreasing rate, MP
is positive but falling (each extra unit of
labor adds less to the TP than the last
unit)
• When TP is at a maximum, MP is zero
• When TP declines, MP becomes negative
Important Features (MP & AP)
• Where MP exceeds AP, AP rises
• Where MP is less than AP, AP declines
• MP intersects AP where AP is at a
maximum
• This follows from the simple mathematical
concept of averages
• The law of Diminishing Returns is
embodied in the shapes of all 3 curves
Short-run Production Costs
• Fixed, Variable and Total Costs
• Fixed Costs (FC) – costs that do not vary
with output. These costs are associated
with the existence of a firm’s plant and
must be paid even if output is zero (e.g.
firm debts, bills, insurance premiums)
• Variable Costs (VC) – costs are those that
change with the level of output. They
include payments for materials, fuel,
power, transportation services, most labor
and similar variable resources
Shape of the Variable Cost
• Practice: Table 20.2, draw curves
• Total Variable cost initially increases with a
decreasing rate, (fourth unit, table 20.2), beyond
the 4th unit, VC rises by increasing amounts for
succeeding units of output
• Shape of VC: when MP increases, fewer units of
labor is needed to produce successive units of
output; hence VC decreases for those units.
• When diminishing returns set in, MP starts
declining, larger & larger additional amounts of
labor needed to produce successive units of
output. TVC therefore, rises at an increasing
rate.
Short-Run Production Costs
Total Cost, Fixed and Variable Costs
$1100
TC
1000
TC = TFC + TVC
900
TVC
800
Costs
700
600
Fixed
Cost
500
400
Total
Cost
300
Variable
Cost
200
100
TFC
0
1
2
3
4
5
6
7
8
9
10
Q
Per Unit, or Average, Costs
• Average cost (AC) data are more
meaningful for making comparisons with
product price which is always stated in
per-unit basis
TFC
AFC =
• Average Fixed Cost
Q
• AFC declines as the output increases.
Why?
– Spreading out overhead
Per Unit, or Average, Costs
• Average Variable Cost –
TVC
AVC =
• AVC is a U-shaped curve
Q
• It declines initially, reaches a minimum,
and then increases again when
diminishing returns set in
AVC is derived from the TVC curve
therefore:
• Since, TVC reflects the law of diminishing
returns, so AVC must also reflect the
same
Short-Run Production Costs
Average and Marginal Costs
$200
Costs
150
AFC
ATC
AVC
100
50
AVC
AFC
0
1
2
3
4
5
6
7
8
9
10
Q
• Average Total Cost TC
ATC = Q = AFC + AVC
• Marginal Cost –
• MC is the additional cost of producing 1
more unit of output
Change in TC
MC =
Change in Q
MC and MP
• MC can also be calculated from the TVC
column, as the only difference between
the TVC and TC column is the constant
amount of fixed cost
• MC curve is the mirror image of the MP
curve
• If the price of the variable input stays
constant, increasing marginal returns will
be reflected in a declining MC, and
diminishing returns in a rising MC
Average Product and
Marginal Product
Short-Run
Production
Costs
Production Curves
Cost Curves
AP
MP
Quantity of Labor
MC
Cost (Dollars)
AVC
Quantity of Output
Relation Between MC, ATC & AVC
• MC intersects AVC and ATC curves at
their minimum points
• When the amount (MC) added to total cost
is less than the current ATC, ATC will fall
• Conversely, when the marginal cost
exceeds ATC, ATC will rise
• As long as MC lies below ATC, ATC will
fall and vice versa
• At the point of intersection, ATC = MC,
ATC has just ceased to fall, but has not
started rising yet !
MC, AVC & AFC
• The same holds true for AVC
• MC intersects AVC at its minimum (the
same concepts apply here)
• MC has no relationship with FC
• Shifts in Cost curves?
Short-Run Production Costs
Average and Marginal Costs
$200
MC
Costs
150
AFC
ATC
AVC
100
50
AVC
AFC
0
1
2
3
4
5
6
7
8
9
10
Q
G 8.1
Long-Run Production Costs
• Firm Size and Costs
• Long-Run Cost Curve
• Economies of Scale
– Labor Specialization
– Managerial Specialization
– Efficient Capital
• Diseconomies of Scale
• Constant Returns to Scale
Long-Run Production Costs
Average Total Costs
Long-Run ATC Curve
ATC-1
ATC-5
ATC-2
ATC-3
ATC-4
Output
Any Number of Short-Run Optimum
Size Cost Curves Can Be Constructed
Long-Run Production Costs
Average Total Costs
Long-Run ATC Curve
ATC-1
ATC-5
ATC-2
ATC-3
ATC-4
Long-Run
ATC
Output
The Long-Run ATC Curve Just
“Envelopes” the Short Run ATCs
Long-Run Production Costs
Average Total Costs
Alternative Long-Run ATC Shapes
Constant Returns
To Scale
Economies
Of Scale
Diseconomies
Of Scale
Long-Run
ATC
q1
q2
Output
Long-Run ATC Curve Where Economies
Of Scale Exist
Long-Run Production Costs
Average Total Costs
Alternative Long-Run ATC Shapes
Economies
Of Scale
Diseconomies
Of Scale
Long-Run
ATC
Output
Long-Run ATC Curve Where Costs Are
Lowest Only When Large Numbers Are
Participating
Long-Run Production Costs
Average Total Costs
Alternative Long-Run ATC Shapes
Economies
Of Scale
Diseconomies
Of Scale
Long-Run
ATC
Output
Long-Run ATC Curve Where Economies
Of Scale Exist, are Exhausted Quickly,
And Turn Back Up Substantially
Minimum Efficient Scale
and Industry Structure
• Minimum Efficient Scale (MES)
• Natural Monopoly
• Applications and Illustrations
– Rising Cost of Insurance and Security
– Successful Start-Up Firms
– The Verson Stamping Machine
– The Daily Newspaper
– Aircraft and Concrete Plants
Don’t Cry Over Sunk Costs
• Sunk Costs Irrelevant in
Decision Making
• Once Incurred, They Cannot Be
Recovered
• Compare Marginal Analysis to
Find MC and MB
• Previously Incurred Costs Do
Not Impact the MB=MC
Decision
• Sunk Costs Are Irrelevant!
Short-Run Production Costs
• Per-Unit or Average Costs
–Average Fixed Cost (AFC)
–Average Variable Cost (AVC)
–Average Total Cost (ATC)
–Marginal Cost (MC)
TFC
TVC
AFC =
AVC =
Q
Q
TC
= AFC + AVC
ATC =
Q
Change in TC
MC =
Change in Q