CHAPTER 7 COSTS OF THE CONSTRUCTION FIRM Firm

CHAPTER 7 COSTS OF THE CONSTRUCTION FIRM

• Firm: A firm is an organization that brings together different factors of production, such as labour, land capital, to produce a product or service which it is hoped can be sold for a profit. Cost of Owner’s Resources – The income that the owner could have earned in the best alternative job. – Normal profit is the expected return for supplying entrepreneurial ability.

Economic Profit – A firm’s total revenue minus its opportunity costs. – The firm’s opportunity cost is the sum of its explicit costs and implicit costs. – Not the same as accounting profit.

The Objective: Profit Maximization – All of the firm’s decisions are aimed at one overriding objective: maximum attainable profit. To study the relationship between a firm’s output decision and its costs, we distinguish two decision time frames: – The short-run – The long-run

The Short-Run and the Long-Run The short-run is a time frame in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. The long-run is a time frame in which the quantities of all inputs can be varied.

Production Function: The relationship between physical output and the quantity of capital and labour used in the production process is sometimes called a production function. To increase output in the short-run, a firm must increase the quantity of labor employed. Total product is the total output produced. Marginal product is the increase in total product that result from a one-unit increase in an input. Average product is the total product divided by the quantity of inputs.

Total Product Curve • Read the schedule page 102 • Table: 7. 1 Diminishing returns: a hypothetical case in construction

Output (sweaters per day) Total Product Curve 15 f e Unattainable TP d 10 c Attainable 5 b a 0 1 2 3 4 5 Labor (workers per day)

Marginal product is also measured by the slope of the total product curve. Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker.

Diminishing marginal returns Occur when the marginal product of an additional worker is less than the marginal product of the previous worker Law of diminishing returns As a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes

15 d 13 10 TP c 5 4 Marginal product (sweaters per day per worker) Output (sweaters per day) Marginal Product 6 4 3 2 MP 0 1 2 3 4 5 Labor (workers per day)

Short-Run Cost Total cost (TC) is the cost of all productive resources used by a firm. Total fixed cost (TFC) is the cost of all the firm’s fixed inputs. Total variable cost (TVC) is the cost of all the firm’s variable inputs.

Total cost (TC) is the cost of all productive resources used by a firm. TC = TFC + TVC

Cost (dollars per day) Total Cost Curves TC TC = TFC + TVC 150 TVC 100 50 TFC 0 5 10 15 Output (sweaters per day)

Marginal Cost Marginal cost is the increase in total cost that results from a one-unit increase in output. It equals the increase in total cost divided by the increase in output. Marginal costs decrease at low outputs because of the gains from specialization, but it eventually increases due to the law of diminishing returns.

Average Cost Average fixed cost (AFC) is total fixed cost per unit of output. Average variable cost (AVC) is total variable cost per unit of output. Average total cost (ATC) is total cost per unit of output.

Average Cost TC = TFC + TVC TC Q = TFC Q + TVC Q OR ATC = AFC + AVC

Cost (dollars per sweater) Marginal Cost and Average Costs 15 ATC = AFC + AVC MC ATC AVC 10 5 AFC 0 5 10 15 Output (sweaters per day)

Average product and marginal product Product Curves and Cost Curves 6 AP 4 MP 2 Rising MP and falling MC: rising AP and falling AVC 0 Falling MP and rising MC: rising AP and falling AVC 1. 5 Falling MP and rising MC: falling AP and rising AVC 2. 0 Labor

Average product and marginal product Product Curves and Cost Curves 12 9 MC 6 AVC 3 Maximum MP and minimum MC 0 6. 5 Maximum AP and minimum AVC 10 Labor

Long-Run Cost Long-run cost – The cost of production when a firm uses the economically efficient quantities of labor and capital. Long-run costs are affected by the production function. Production function – The relationship between the maximum output attainable and the quantities of both labor an capital.

The Long-Run Average Cost Curve The long-run average total cost curve is derived from the short-run average total cost curves. The segment of the short-run average total cost curves along which average total cost is the lowest make up the long-run average total cost curve.

Short-Run Costs of Four Different Plants

Long-Run Average Cost Curve

Returns to Scale Returns to scale are the increases in output that result from increasing all inputs by the same percentage. Three possibilities: – Constant returns to scale – Increasing returns to scale – Decreasing returns to scale

Returns to Scale Constant returns to scale Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by the same percentage

Returns to Scale Increasing returns to scale Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a larger percentage

Returns to Scale Decreasing returns to scale Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a smaller percentage

Minimum Efficient Scale A firm’s minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level.

The End