Production and Cost 2003 SouthWesternThomson Learning The Nature

Production and Cost © 2003 South-Western/Thomson Learning

The Nature of the Firm • Types of Business Firms • Why Employees? • The Limits to the Firm

The Nature of the Firm A business firm is an organization, owned and operated by private individuals, that specializes in production.

The Nature of the Firm Production is the process of combining inputs to make outputs.

The Nature of the Firm Profit Total revenue minus total cost

Types of Business Firms Sole Proprietorship A firm owned by a single individual

Types of Business Firms Partnership Firm owned and usually operated by several individuals who share in the profits and bear personal responsibility for any losses

Types of Business Firms Corporation A firm owned by those who buy shares of stock and whose liability is limited to the amount of their investment in the firm

The Firm and Its Environment

Why Employees? • Advantages of employment • Gains from specialization • Lower transaction costs –time and other costs required to carry out market exchanges • Reduced risk –Diversification – reducing risk by spreading sources of income among different alternatives

Thinking About Production Technology A method by which inputs are combined to produce a good or service.

Thinking About Production Function A function that indicates the maximum of output a firm can produce over some period of time from each combination of inputs.

Thinking About Production The Short Run and The Long Run

Thinking About Production Long Run A time horizon long enough for a firm to vary all of its inputs

Thinking About Production Short Run A time horizon during which at least one of the firm’s inputs cannot be varied

Production in the Short Run Fixed Input An input whose quantity remains constant, regardless of how much output is produced

Production in the Short Run Variable Input An input whose usage changes as the level of output changes

Production in the Short Run Total Product The maximum quantity of output that can be produced from a given combination of inputs

Thinking about Production Units of 196 Output 184 TP 161 DD from hiring fourth worker 130 DD from hiring third worker 90 DD from hiring second worker 30 DD from hiring first worker 1 2 3 4 5 6 Number of Workers

Production in the Short Run Marginal Product of Labor The additional output produced when one more worker is hired

Marginal Returns to Labor Increasing Marginal Returns to Labor The marginal product of labor increases as more labor is hired

Diminishing Marginal Returns to Labor The marginal product of labor decreases as more labor is hired

Law of Diminishing Marginal Returns As more and more of any input is added to a fixed amount of other inputs, its marginal product will eventually decline.

Thinking about Costs • The Irrelevance of Sunk Costs • Explicit Versus Implicit Costs

Sunk Costs A cost that was incurred in the past and does not change in response to a present decision

Explicit and Implicit Costs Explicit Costs Money actually paid out for the use of inputs

Explicit and Implicit Costs The cost of inputs for which there is no direct money payment

Costs in the Short Run • Measuring Short-Run Costs • Explaining the Shape of the Marginal Cost Curve • The Relationship Between Average and Marginal Costs

Costs in the Short Run Fixed Costs of fixed inputs

Costs in the Short Run Variable Costs of variable inputs

Costs in the Short Run Total Fixed Cost The cost of all inputs that are fixed in the short run

Costs in the Short Run Total Variable Cost The cost of all the variable inputs used in producing a particular level of output

Costs in the Short Run Total Cost The costs of all inputs -fixed and variable TC = TFC + TVC

Firm’s Total Costs Curves Cost TFC $400 TC TVC 300 200 100 TFC 0 30 90 130 155 185

Average Costs Average Fixed Cost Total fixed cost divided by the quantity of output produced

Average Costs Average Variable Cost Total variable cost divided by the quantity of output produced

Average Costs Average Total Cost Total cost divided by the quantity of output produced

Marginal Costs Marginal Cost The increase in total cost from producing one more unit of output

Average and Marginal Costs Dollars MC $4 3 ATC AFC AVC 2 1 0 30 90 130 161 196 Units of Output

Production and Cost in the Long Run • The Relationship Between Long -Run and Short-Run Cost • Explaining the Shape of the LRATC Curve

Production and Cost in the Long Run • In the Long-Run, there are no fixed inputs or fixed costs • All inputs and all costs are variable

Production and Cost in the Long Run To produce any given level of output, the firm will choose the input mix with the lowest cost.

Production and Cost in the Long Run Long-run Total Cost The cost of producing each quantity of output when the leastcost input mix is chosen in the long run

Production and Cost in the Long Run Long-run Average Total Cost The cost per unit of output in the long run, when all inputs are variable

Relationship between Longrun and Short-run Costs Long-run total cost of producing a given level of output can be less than or equal to, but never greater than, short-run total cost. LRTC TC

Average Cost and Plant Size Plant The collection of fixed inputs at a firm’s disposal ATC curve tells us how average cost behaves in the short run, when the firm uses a plant of a given size.

Long-run Average Total Cost Dollars $4. 00 ATC 1 ATC 0 ATC 3 ATC 2 3. 00 C D B 2. 00 LRATC E A 1. 00 0 30 Use 0 automated lines 90 130 161 184 175 196 Use 1 automated line 250 Use 2 automated lines 300 Use 3 automated lines Units

Explaining the Shape of the LRATC Curve • Economies of scale –LRATC decreases as output increases –Gains from specialization –More efficient use of lumpy inputs • Diseconomies of scale –LRATC increases as output increases • Constant returns to scale –LRATC is unchanged as output increases

Explaining the Shape of the LRATC Curve Dollars $4. 00 3. 00 LRATC 2. 00 1. 00 0 130 Economies of Scale 184 Constant Returns to Scale Diseconomies of Scale Units of Output