THE FIRM AND COSTS OF PRODUCTION

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Chapter 7 THE FIRM AND COSTS OF
PRODUCTION Definition Firm Economic
institution that purchases inputs, organizes
production, and sells output. Objective is to
maximize profits. Firms exist because it is
cheaper to organize production activities by
command rather than market exchange. (Coase,
1937) Economize on transaction costs. Limits to
breadth and size of firms.
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Cost definitions once again Opportunity Costs
value of a resource in its next-best alternative
use Accounting Costs payments to resource
suppliers (out-of-pocket expenses) Explicit
Costs. Note These will reflect opportunity
costs of purchased inputs. Implicit Costs
opportunity costs of owned resources (e.g.,
capital, land, owners time). Economic Costs
Explicit Costs Implicit Costs
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Profits Motivate Supply Accounting Profit
Total Revenue Accounting Costs Economic
Profit Total Revenue Economic
Costs Generally, Accounting Profit gt Economic
Profit Example Fred owns 500 acres. Seed_______
_______________5,000 Planting___________________
10,000 Harvesting_________________20,000 Reven
ues__________________90,000 Deans
Job_________________150,000 Lease_______________
______30,000
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Accounting ? 90,000 35,000
55,000 Economic ? 90,000 35,000 180,000
-125,000 What Should Fred do?
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Production Theory Definitions Total Product
(TP) total output produced from a variable
input with all other inputs constant Average
Product (AP) total output divided by the number
of units of the variable input with all other
inputs constant APL TP/L Marginal Product
(MP) addition to total output obtained by
employing one additional unit of the variable
input with all other inputs constant. MPL?TP/
?L
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Law of diminishing marginal returns As
additional units of a variable input are combined
with a fixed quantity of other inputs, the
addition to output will begin to decline at some
point. I.e., MP must fall. An empirical
law. Proof by contradiction.
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Figure 7.2
Total, Average, and Marginal Product Curves
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Cost Theory Definitions Short Run Period of
time in which one or more inputs are fixed. Long
Run Period of time in which all inputs are
variable. Planning horizon. Total Fixed Costs
(TFC) Costs that do not vary with changes in
output. Exist in the short run. Equal to
expenditures (p x q) on fixed inputs. Example
costs of fixed plant. Total Variable Costs (TVC)
Costs that vary with changes in outputs.
Expenditures on variable inputs. Total Costs
(TC) TFC TVC
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Definitions (cont) Average Fixed Costs (AFC)
TFC/Q Average Variable Costs (AVC)
TVC/Q Average Total Cost (ATC) TC/Q
AFC AVC Marginal Costs (MC) Addition to
total cost caused by production of one additional
unit of output. Slope of the total cost
function. MC?TC/ ?Q
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Figure 7.3a
Short-Run Cost Curves
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Figure 7.1a
Short-Run Cost Curves of the Firm
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Figure 7.1b
Short-Run Cost Curves of the Firm
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Figure 7.1c
Short-Run Cost Curves of the Firm
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Relationships AFC declines throughout
(rectangular hyperbola) ATC and AVC are
U-shaped. AVC ? ATC as Q? MC intersects AVC and
ATC at their minimum points.
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Long-Run Costs shows the relationship between
output and costs in the long run. (i.e., no fixed
inputs) Firms may select any plant size. Each
size plant exhibits its own, unique, short-run
average total cost curve. Long-Run Average Cost
(LRAC) is the envelope (or lower bound) of all
short-run average cost curves. Shows unit costs
(TC/Q) in the long run. Long-Run Marginal Cost
(LRMC) Additional cost of producing one more
unit of output in the long run.
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Figure 7.4
Long-Run Average Total Cost and Marginal Cost
Curves
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Definition Economies of Scale Region of output
over which LRAC declines. Reasons -Division of
labor -Specialization of equipment -Geometry -S
tatistics (inventories) Definition Diseconomies
of scale Region of output over which LRAC is
increasing. Reason -Managerial diseconomies
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Figure 7.5a
Alternative LRATC Curves
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Figure 7.5b
Alternative LRATC Curves
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Determinants of Costs -Input Prices -Technolog
y -Taxes and regulations As we will
discover, costs are a major determinant of
supply.
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Figure 7.6
The Effect of a Decrease in Resource Prices on
Costs