The Firm: Cost and Output Determination

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The Firm Cost and Output Determination

• How much output can a firm produce?
• How do the costs of production vary with the rate
  of output
• Do larger firms have a cost advantage over
  smaller firms?
• We are talking about the Production Functioni.e.
  Costs of Production

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Next Step for Production Function

• How many inputs does it take to arrive at the
  desired mix of outputs. (from the factors)
• How many workers will it take to make the new
  Board Game I LOVE ECONOMICS?
• Definition of Production Function
• Relationship between the maximum quantity of a
  good attainable from different combinations of
  factor inputs.

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The Relationship Between Output and Inputs

• A firm takes numerous inputs, combines them using
  a technological production process and ends up
  with output.
• We classify production inputs in two broad
  categorieslabor and capital.

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Maximum Output/Minimum Inputs

• Production of goods equates cost!
• Idea for a firm (large or small) is to minimize
  the cost while maximizing output.
• How best to produce?
• Whats the smallest amount of resources needed to
  produce a specific product? What is the least
  number of workers we can hire to handle the noon
  counter trade? (McDonalds). Can we lay off
  another 1,000 workers and still be competitive
  (IBM) Ford lays off 15,000 workers
• (Factors of productionland,labor,capital,
  entrepreneurship

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Answers to Production Q

• The Production Function will answer what the
  maximum amount of output is attainable from
  various combinations of factor inputs. (this is
  getting the mixing bowl filled with right
  ingredients)
• With a fixed amount of capital adding labor
  inputs can predict outputs---up to a certain
  point---then more capital needs to be added.

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Law of Diminishing Returns

• Did you ever fall asleep reading your economics
  text after a long day at work? Or maybe you just
  procrastinated on getting that book open.. Of
  course you have.. you have experienced
• Diminishing returns.
• In the short runProduction function defines the
  limit to output and how much each worker will
  contribute to that limit.

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• The factor that can be adjusted quickly in the SR
  is Labor.
• Yet as more labor is hired, each unit of labor
  has less capital and land to work with
• Things get constrained.. Hence. Marginal Physical
  Product declines
• This refers to how many widgets

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Example/Build a City game

• Set up a small factory
• Fixed factor of production(4 machines)
• Functions of machines
• Add variable factors one at a time.

• If you keep adding workers- will reach a point
  where the marginal worker adds nothing to our
  total output.
• A business person must be aware of the law of
  diminishing returns if he wants to operate
  efficiently.

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Bottom Line

• If we keep adding workers we will reach a Point
  where--- the Marginal Worker ads nothing to our
  total output All the checkout lanes are filled
  with Tom Thumb Employees very few people are
  checking out. (Is this productive for TT?)
• What happens to their Profit Margin?
• Cost exceeds any benefits of hiring additional
  workers.

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Diminishing Marginal Product (contd)

• An example of the Law of Diminishing Marginal
  Profit Production of computer printers
• We have a fixed amount of factory space, assembly
  equipment, and quality control diagnostic
  software.
• So the addition of more workers eventually yields
  successively smaller increases in output.

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Long run/short run productivity

• Short run period in which the quantity (and
  quality of some inputs) cannot be changed.
• General assumption In SR labor can change while
  capital is held constant
• Generally, as amount of labor used increases, the
  output will also increase (with reservations) See
  diminishing returns

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Marginal Productivity

• MPP (marginal physical product)
• The change in total output that results from
  employment of one additional unit of input.

Formula MPP change in total output
change in input quantity
same figure as approximate avg output. On
diminishing returns chart
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Employment Dilemmas

• Sometimes employees
• dont measure
• up
• Output does
• not justify
• Their negative
• inputs

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Marginal Physical Product MPP-

• Marginal Productivity
• When the MPP of labor (MPPL gt0), then total
  output increases.
• Improving the ratio of labor to other factors
  increases the MPP of labor.

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MPP ?Q ? L
Marginal Physical Product
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MPP Graph(actually diminishing marginal physical
product.
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Total output (per day)
45
40
10 jeans
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Third worker
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Marginal physical product (per worker)
15
10
5
0
3
4
5
1
2
6
7
8
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Falling MPP implies Rising MC

• The MPP actually mirrors the output/worker.
• MPP is the additional output obtained by
  employing one more unit of input..
• If MPP each additional unit of input is
• producing less and ultimately adds more cost
  to each additional input.
• . (i.e. input cost is rising marginal cost is
  increasing

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Falling MPP Implies Rising Marginal Cost

Diminishing marginal productivity implies . . .
Rising marginal cost
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The Relationship Between Output and Inputs
(cont'd)

• Average Physical Product
• Total product divided by the variable input

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The Relationship Between Output and Inputs
(cont'd)

• Marginal Physical Product
• The physical output that is due to the addition
  of one more unit of a variable factor of
  production
• The change in total product occurring when a
  variable input is increased and all other inputs
  are held constant
• Also called marginal product

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Figure 23-1 The Production Function and
Marginal Product A Hypothetical Case, Panel (a)
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• What about Marginal Revenue? The change in total
  revenue associated with one additional unit of
  input.
• If marginal costs are increasing marginal revenue
  is decreasing.

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Productivity- Right Mix of Output
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REVIEW TERMINOLOGY

• Factors of production- Resource inputs used to
  produce goods and services (land,labor,capital,
  entrepreneurship)
• Productivity-Output per unit of input (output per
  labor hour)
• Efficiency-maximum output of a good from the
  resources used in production
• Opportunity Cost-The MOST DESIRABLE
• GS that are forgone in order to obtain something
  else.
• Short Run-The period in which the quantity
  (and/or quality) of some inputs cannot be changed.

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Quick quiz

• If input prices are rising, will Marginal cost be
  rising?
• If you have a fixed amount of capital and
  continue to add labor inputs, will marginal
  product always increase?
• What is marginal physical product?

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Costs, Prices, Output in Competitive Markets

• All competition that is not PURE is IMPERFECT
• Whether a firm exists in a perfectly competitive
  market or imperfectly competitive market, it will
  TRY to MAXIMIZE PROFITS or MINIMIZE LOSSES.

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Fixed, Variable, Total Costs

• What is a definition of profit?

Which market might this carton apply today?
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ANSWER!

• TR-TCPROFIT
• How much money am I taking in? (TR)
• How much is it costing me to produce my output?
  (TC)

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Economic Profit vs Accounting Profit(the
difference lies in how cost is defined)

• Economic Cost Explicit Cost Implicit Cost

• Accounting Costs are all the costs that have an
  explicit dollar cost attached to it. TR-TC

• Economic cost represents the value of all
  resources used to produce a good or service
  opportunity cost.

The two diverge whenever a factor of production
is not paid an explicit wage (rent) (own the
land) (not paying yourself a salary)
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Accounting, Economic and Normal Profit II
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• Suppose a company incurs the following costs
  labor, 400 equipment, 300 and materials,
  100. The company owns the building so it doesnt
  have to pay the usual 800 in rent.
• What is the total accounting cost?
• What is the total economic cost?
• How would accounting and economic costs change if
  the company sold the building and then leased it
  back?

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Fixed Costs

• All costs are classified as fixed or variable. In
  the short run, the firm can only use its existing
  facilities to increase its output. During the
  short-run, there are several important costs that
  are fixed.
• Fixed costs do not change when the firm changes
  its level of output
• Name some
• -interest on debts of the firm, payments for
  rent, insurance premiums, taxes on real property,
  salaries.

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Average Fixed Cost AFC

• Average fixed cost, AFC declines as the firm
  increases its output.
• Divide TFC by Q AFC
• TFC/Q AFC

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Graph

• 2 3 4 5 6 7 8 9 10

c O S T S
AFC
Quantity
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Graph explanation

• If a firm had nothing but fixed costs, the more
  it produced the lower its unit cost (AFC)
  However, the firm is also confronted by variable
  costs.
• What are Variable Costs?
• Variable Costs increase as the firm increases its
  output.
• All costs that are not fixed---are variable!

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Continued Variable Costs

• When a firm increases its output, it must acquire
  more productive resources.
• Examples
• More laborers
• Wages
• Electricity
• Paint, sugar, plastic, steel, etc.
• Variable costs any costs that rises as the
  firm produces more and costs that fall as the
  firm produces less.
• This is the cost that producers have control
  over.

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Quick QuizIdentify which is Fixed or Variable
Cost

• Mortgage payments on a factory
• Electric bills at a print shop
• The cost of a new robot at General Motors plant
• Premiums on liability insurance at the XYZ
  Corporation
• Wages paid to auto workers
• Contract paid to top management at GE

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Bottom Line---

• The bottom line is productivity whether it is a
  worker on an assembly line or a CEO.
• Remember Harry Truman said recession is when a
  neighbor loses his job..depression is when you
  lose yours! ?

Why is productivity measured by the federal
government?
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Total Variable Cost and Average Variable Cost

• AVC is found by dividing TVC by Q
• TVC/Q AVC
• Although Average fixed cost declines continually,
  average variable cost does not. At first AVC
  usually declines as the firms output increases.
  After reaching a minimum, then AVC begins to rise.

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AVC and Diminishing Returns

• The AVC curve will have the general shape of the
  letter U. This is explained by the Law of
  diminishing returns.
• Law says as more and more units of a variable
  factor of production are added to a fixed factor
  of production (such as capital equipment)
  eventually a point will be reached at which the
  output accounted for by each additional unit of
  the variable factor will start to decline.

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Total Cost

• Total Cost is the sum of total fixed cost and
  total variable cost.
• When a firm increases its output, total cost
  tends to rise
• Fixed cost remains unchanged, naturally, but
  total cost will be pulled up by the rise in total
  variable cost with the rise in output.
• ATC TC/Q or adding AFC AVC

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• Marginal Resource Cost
• Marginal cost (MC) is the increase in total costs
  associated with a one unit increase in
  production. (see overhead chart)

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Graph ATC/AVC/AFC
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Minimum Average Cost

• The bottom of the U-shaped average total cost
  curve represents the minimum average total costs.
  
• It identifies the lowest possible opportunity
  costs to produce the product.

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A Cost Summary

• The output decision has to be based not only on
  the capacity to produce (the production function)
  but also on the costs of production (the cost
  functions).

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A Cost Summary

• The marginal cost curve always intersects the ATC
  curve at its lowest point.

MC
ATC
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Basic Cost Curves
MC
ATC
AVC
m
AFC
n
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Friendly reminders

• If marginal is greater than average, then average
  must be rising..(your 3 exams average to 85..
  Your 4th is 92.. Your average will increase above
  85)
• If marginal is less than average, then average
  must be falling(your 4th grade is 74. This will
  pull down the average of 85)
• If marginal equals average, then average is at
  its extreme (neither rising or falling) at that
  point..With a grade of 85 on your 4th test, your
  average grade will not change if you had an 85
  average on the other three exams.

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Mathematical Rule

• Whenever a number added to a series of numbers is
  less than their average, the average must
  decline.
• When a number added to a series of numbers is
  larger than their average, the average must
  rise..
• Marginal Cost helps a firm decide whether to
  increase or decrease output.
• Marginal cost is the cost that the firm can
  control most directly.

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Adding numbers
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A Cost Summary

• If MC gt ATC, ATC is increasing
• If MC lt ATC, ATC is decreasing
• If MC ATC, ATC at minimum

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Identify these curves!
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Production and CostShort and Long Run

• Short Run - A period of time in which some inputs
  in the production process are fixed.
• Long Run - A period of time in which all inputs
  in the production process can be varied (no
  inputs are fixed).

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Short Run versus Long Run (cont'd)

• Managers take account of both the short-run and
  long-run consequences of their behavior.
• While making decisions about what to do today,
  tomorrow, and next weekthey keep an eye on the
  long-run benefits.

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LONG RUN Costs

• Over the long-run---ALL COSTS ARE VARIABLE.
• Taxes, interest rates, and other costs that are
  fixed in the SR can change.
• The size of the firm can also affect costs. The
  principle that explains this is called
• ECONOMIES OF SCALE- (means as firms enlarge their
  plants, their unit costs decline because of mass
  production and other factors such as
• Specialization, factor substitution, better
  equipment, research, marketing advantages,
  stability.

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Long- Run Costs Continued

• There are no fixed costs in the long-run
• The long-run cost curve is just a summary of our
  best short-run cost possibilities using existing
  technology facilities.
• Like all average cost curves, the long-run LATC
  curve has its own marginal cost curve. The
  long-run marginal cost LMC curve is not a
  composite of short-run marginal cost curves.
  Rather it is computed on the basis of the costs
  reflected in the long-run ACT curve itself.

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Marginal Physical Product and Marginal Cost I
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Notice that as the MPP curve rises, the MC curve
falls and as the MPP curve falls, the MC curve
rises.
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Sunk Cost

• A cost incurred in the past that cannot be
  changed by current decisions and therefore cannot
  be recovered.

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Figure 23-4 Preferable Plant Size and the
Long-Run Average Cost Curve
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Long-Run Marginal Costs

• The long-run marginal costs curve intersects our
  long-run cost curve at its lowest point.

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Long-Run Costs with Unlimited Options
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Economies of Scale

• There are many optional plant sizes available in
  long-run production.

• One option is the decision to use one large plant
  or several smaller plants to produce a given
  amount of output.

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Why the Long-Run Average Cost Curve is U-Shaped

• Economies of Scale
• Decreases in long-run average costs resulting
  from increases in output
• These economies of scale do not persist
  indefinitely, however.
• Once long-run average costs rise, the curve
  begins to slope upwards.

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Why the Long-Run Average Cost Curve is U-Shaped
(cont'd)

• Reasons for economies of scale
• Specialization
• Division of tasks or operations
• Dimensional factor
• Large-scale firms often require proportionately
  less input per unit of output
• Improved productive equipment
• The larger the enterprise, the more the firm can
  take advantage of larger-volume types of
  machinery.

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Constant Returns to Scale and Diseconomies of
Scale

• Constant Returns increases in plant size do not
  affect minimum average cost minimum per-unit
  costs are identical for small plants and large
  plants.
• Diseconomies of Scaleincrease in plant size
  results in reducing operating efficiency

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Economies of Scale
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Question Are trade deficits a signal that the
U.S. cannot compete in the global marketplace?Is
Outsourcing Good?

• Answer No and Yes respectively. Low wages are
  not a reliable measure of global competitiveness.
• Competition regardless of where it takes place,
  has to produce MORE OUTPUT for a given quantity
  of INPUTS.
• A workers contribution to the production
  process is measured by MPP. A workers MPP
  depends on the quantity and quality of other
  resources in the production process plus the
  workers educational skills and skill-level.

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U.S. Labor vs Mexico Labor

• The higher wages paid in America as opposed to
  Mexico reflects the capital used in American
  production, education of the worker, advanced
  technology, etc.---must measure UNIT LABOR COST

Should the federal government be criticized for
NAFTA?
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Checking unit labor costUnit Labor cost wage
rate MPP

• America
• Unit Labor Cost
• 12.00 per hour
• 6 units per hour
• 2/unit of output

• Mexico
• Unit Labor Cost
• 3.00 per hour
• 1 unit/hr
• 3/unit of output

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Real World Labor Cost/wage rate

• Low wage rate does not always indicate lower unit
  output cost. Service jobs are an exception if
  education stays levelChina has lower wage
  rateso should HP produce printers there?
• Mexican labor in the previous example would be
  more costly to use even though the wage rate is
  lower.

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Bottom Line Productive Statement

• Productivity in any economy means staying
  competitive in the global markets and making
  more things than others.