Supply: The Cost of Doing Business

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Supply The Cost of Doing Business
ECN112 Microeconomic Principles Lecture February
17, 1999 Igor Lukashin
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The Circular Flow of Goods and Services
Land, Labor, Capital
Businesses
Households
Costs of Production and Profit
Total Revenue
Goods and Services
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The Relationship Between Output and Resources
For a given restaurant,
Total Physical Product the maximum output that
can be produced when successive units of a
variable resource are added to fixed amounts of
other resources (what are fixed resources in this
example?) TPP(2) 55
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Total, Average and Marginal Physical Products
Average Product (APP) output per unit of
resource Marginal Product (MPP) the additional
quantity that is produced when one additional
unit of a resource is used in combination with
the same quantities of other resources
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Total, Average Marginal Products Graphs
Law of Diminishing Marginal Returns when
successive equal amounts of a variable resource
are combined with a fixed amount of another
resource, marginal increases in output that can
be attributed to each additional unit of the
variable resource will eventually decline
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Why Diminishing Marginal Returns?

• Whats the fixed resource in Pizza example?
• Kitchen space, stove space, access to ingredients
• Why do additional cooks produce less extra pizzas
  as we increase the of cooks?
• Getting in each others way
• getting to ingredients, lack of counter space,
  utensils
• Not having enough stove space to cook all pizzas
  at the same time
• Does additional labor ever produce more extra
  goods?
• Two-handed saw operationlumber production
• Jack London The Sea Wolf

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Average and Marginal

• If Marginal is less than Average, the Average
  falls (low semester grades drag down average GPA)
• Give examples from your daily experiences
• If Marginal is greater than Average, the Average
  rises

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From Production to Costs
Suppose each mechanic costs 1000. Then we can
graph total costs (1000 of mechanic) as a
function of output
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Average And Marginal Costs
Marginal Cost the additional cost of producing
one more unit of output, MC?TC/?TPP
Average Total Cost per unit cost AC TC/TPP
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APP MPP vs ATC MC
Both Average and Marginal Products eventually
fall as you add more of the resource (diminishing
returns)
At fixed resource price, it means average and
marginal costs rise as more units are being
produced (U-shape)
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Costs Some Definitions

• Total Fixed Costs (TFC)
• costs that must be paid whether a firm produces
  or not (rent, insurance, etc.)
• Total Variable Costs (TVC)
• cost that rise or fall as production rises or
  falls (wages, parts, etc.)
• Total Costs (TC)
• TC TFC TVC

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Costs Averages

• Average Fixed Costs (AFC)
• AFC TFC / Q
• Average Variable Costs (AVC)
• AVC TVC / Q
• Average Total Costs (TC)
• ATC TC / Q AFC AVC
• Marginal Cost (MC)
• MC (Change in TC) / (Change in Q)

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Average Costs Graphs
MC crosses AVC at A, which is minimum of AVC MC
crosses ATC at B, the minimum of ATC Assumed TFC
to be 10,000
B
A
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Short-Run Average Total Cost
SRATC the total cost of production divided by
the total quantity of output produced when at
least one resource is fixed (short-run at least
one of the resources is fixed)
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The Long Run

• Long Run
• all resources are allowed to change
• e.g. can build a new plant, install machinery,
  relocate
• The law of diminishing returns does not apply in
  the long run, since all the resources are now
  variable

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Long-Run Average Total Cost (LRATC)
SRATC1
Cost per Unit (dollars)
SRATC3
Remember the Sony Corp. example at the start of
Ch. 8
In the short run, one of the resources is fixed
Quantity of Output

• LRATC
• the lowest-cost combination of resources with
  which each level of output is produced when all
  resources are variable

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Long-Run Average Total Cost (LRATC)
SRATC1
Cost per Unit (dollars)
SRATC3
Remember the Sony Corp. example at the start of
Ch. 8
Can lower Cost in LR
Q1
Quantity of Output

• LR allows to adjust more and, therefore, produce
  at a lower cost a given amount of output

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Economies of Scale
SRATC1
Cost per Unit (dollars)
SRATC3
Diseconomies of Scale
Economies of Scale

• Scale
• size all resources change when scale changes
• Economies of Scale
• per unit costs decline as the quantity of
  production increases and all resources are
  variable

Quantity of Output
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Diseconomies of Scale Constant Returns
LRATC
Cost per Unit (dollars)
Economies of Scale
Diseconomies of Scale
Constant Returns To Scale

• Constant Returns to Scale
• unit costs remain constant as the quantity of
  production is increased and all resources are
  variable
• Diseconomies of Scale
• per unit costs increase as the quantity of
  production increases and all resources are
  variable

Quantity of Output
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Reasons for Economies Diseconomies of Scale

• Specialization
• marketing, sales, pricing, research
• Large machinery may be more efficient than small
  ones
• Blast furnaces, power generators, copiers
• Size doesnt cause efficiency
• Size Up gt coordination problems, overhead up,
  paperwork up, etc gt diseconomies of scale

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The Minimum Efficient Scale

• MES
• the minimum point of the long-run average-cost
  curve the output level at which the cost per
  unit of output is lowest
• Intuition behind MES
• you are producing a small fraction of market
  supply
• if youre producing at a scale smaller than MES,
  your costs are higher than they could be and
  youre at a competitive disadvantage (other
  produce at MES)

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The Planning Horizon

• LRATC can be used to plan expansion
• Suppose you expect that you will need to produce
  X (profit-maximization given expected demand)
  units of the good several years from now
  (long-run)
• Then you can select a point on the LRATC that
  minimizes per unit cost at that production scale
• Once youre committed, any short-run adjustments
  must be carried out on the SRATC passing through
  that point on LRATC