5 FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

The Costs of Production Copyright© 2004 South-Western 13

The Firm’s Objective • … is to MAXIMIZE PROFIT • Total Revenue = The amount a firm receives for the sale of its output (P x Q) • Total Cost = market value of inputs firm uses in production • Profit = TR - TC Copyright © 2004 South-Western/

Costs as Opportunity Costs • Cost of producing an item must include all opportunity costs of inputs used • Includes explicit costs and implicit costs • Explicit costs = input costs that require a direct outlay of money by the firm. • Implicit costs = input costs that do not require an outlay of money by the firm • When TR exceeds both explicit and implicit costs, the firm earns economic profit • Economic profit is smaller than accounting profit. • Quick Quiz 1 Copyright © 2004 South-Western/

Figure 1 Economic versus Accountants How an Economist Views a Firm How an Accountant Views a Firm Economic profit Accounting profit Revenue Implicit costs Explicit costs Revenue Total opportunity costs Explicit costs Copyright © 2004 South-Western

Quick Quiz #1 • Farmer Mc. Donald gives banjo lessons for $20 an hour. One day, he spends 10 hours planting $100 worth of seeds on his farm. What opportunity cost has he incurred? What cost would his accountant measure? If these seeds yield $200 worth of crops, does Mc. Donald earn an accounting profit? Does he earn an economic profit? Copyright © 2004 South-Western/

Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory Copyright© 2004

PRODUCTION AND COSTS • The Production Function shows the relationship between quantity of inputs

Quick Quiz #2 • Plot Helen’s production function; place the level of labor on the x-axis against the level of output on the y-axis. • What happens to the marginal change in output as Helen hires more workers? Copyright © 2004 South-Western/

The Production Function • Marginal Product = increase in output that arises from an additional unit of input • Marginal Product of Labor = slope of the production function (change in output / change in labor) • Property of Diminishing Marginal Product = marginal product of an input declines as the quantity of the input increases • Short-run phenomenon! • Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment. Copyright © 2004 South-Western/

The Production Function • Diminishing Marginal Product • The slope of the production function measures the marginal product of an input, such as a worker. • When the marginal product declines, the production function becomes flatter. Copyright © 2004 South-Western/

RICE GAME • I need two volunteers to start the game… Copyright © 2004

Refresher #1 • Answer the following in your notes: • Draw the production function curve using the data from our simulation. What does the slope of this curve indicate? (Put output on the y-axis and labor on the xaxis). • How did this simulation demonstrate the law of diminishing marginal product? • How would the results of this simulation differ if we were looking at the long-run scenario? Copyright © 2004 South-Western/

Economics, Yada, Yada… • Happy Thursday. Any Seinfeld fans in here? ? ? Copyright

Lots of Graphing Today… • Production Function Curve • (We did this on yesterday) • • • Total Cost Curve Marginal Cost Curve Average Total Cost Curve Average Fixed Cost Curve Average Variable Cost Curve • (We are doing these today) Copyright © 2004 South-Western/

Total-Cost Curve • Relationship between quantity firm can produce and its costs determines pricing

Quick Quiz #1 • If Farmer Jones plants no seeds on his farm, he gets no harvest. If he plants 1 bag of seeds, he gets 3 bushels of wheat. If he plants 2 bags, he gets 5 bushels. If he plants 3 bags, he gets 6 bushels. A bag of seeds costs $100, and seeds are his only cost. Use these data to graph the farmer’s production function and total-cost curve. Explain their shapes. Copyright © 2004 South-Western/

VARIOUS MEASURES OF COST • Costs of production may be divided into: • Fixed costs: do not vary with the quantity of output produced • Variable costs: do vary with the quantity of output produced TC = TFC + TVC Copyright © 2004 South-Western/

Krzyzanowski quits her teaching job… Copyright © 2004 South-Western/

… and opens a coffee shop! Copyright © 2004 South-Western/

Decisions, Decisions… • How should I price my coffee? How much should I make? • Things to consider: • How much does it cost to make the typical cup of coffee? • How much does it cost to increase production of coffee by 1 cup? Copyright © 2004 South-Western/

Average Costs • Represents cost of each typical unit produced Copyright © 2004 South-Western/

Marginal Cost • Tells us how much it costs to produce an additional unit

Why it’s important to understand both ATC & MC… • ATC tells us cost of the typical unit, but doesn’t tell us how much total cost will change as a firm alters its level of production – MC does! • Business managers need to keep both in mind when deciding how much of their product to supply to the market! Copyright © 2004 South-Western/

Plot the following curves on your graph: ATC, AFC, AVC, and MC Hypothesize: • Why is each curve shaped the way it is? Come up with a hypothesis for each. • What is the relationship between ATC and MC? Copyright © 2004 South-Western/

Cost Curves & Their Shapes • MC < ATC decreases • MC > ATC

Quick Quiz 2: Relationship Between MC & ATC • Two twins are enrolled in AP Microeconomics. They each had a “B” average (GPA = 3. 0) before taking the class. 1. Twin One gets a “C” in the course. What happens to her GPA? 2. Twin Two gets an “A” in the course. What happens to her GPA? 3. What can you imply about a “marginal” grade lower than the average? 4. What can you imply about a “marginal” grade higher than the average? Copyright © 2004 South-Western/

Cost Curves & Their Shapes • Marginal cost rises with the amount of output

Cost Curves & Their Shapes • Average Fixed Cost always declines as output rises

Cost Curves & Their Shapes • Average Variable Cost typically rises as output increases b/c of diminishing marginal product (Think about what happened during our game on Thursday as we added more workers! Variable costs increased but productivity declined!) Copyright © 2004 South-Western/

Cost Curves and Their Shapes • ATC curve is U-shaped and reflects both AFC & AVC. • At very low levels of output ATC is high because fixed cost is spread over only a few units. • ATC declines as output increases. • Eventually, ATC starts rising because average variable cost rises substantially. Copyright © 2004 South-Western/

Cost Curves and Their Shapes • Bottom of the U-shaped ATC curve occurs at quantity that minimizes average total cost • Called the efficient scale of the firm • The marginal-cost curve crosses the average-total-cost curve at the efficient scale Copyright © 2004 South-Western/

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. • In the long run, fixed costs become variable costs. Copyright © 2004 South-Western/

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 differ from its short-run cost curves. Copyright © 2004 South-Western/

Figure 7 Average Total Cost in the Short and Long Run Average Total Cost ATC in short run with small factory ATC in short run with medium factory large factory $12, 000 ATC in long run 0 1, 200 Quantity of Cars per Day Copyright © 2004 South-Western

Economies and Diseconomies of Scale • Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases. • Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases. • Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases Copyright © 2004 South-Western/

Figure 7 Average Total Cost in the Short and Long Run Average Total Cost ATC in short run with small factory ATC in short run with medium factory large factory ATC in long run $12, 000 10, 000 Economies of scale 0 Constant returns to scale 1, 000 1, 200 Diseconomies of scale Quantity of Cars per Day Copyright © 2004 South-Western