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Chapter 23

Chapter 23. The Firm: Cost and Output Determination. Freight dispatchers use real-time information transmitted by computers to monitor the positions of locomotives and rolling stock along the nation’s railways.

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Chapter 23

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  1. Chapter 23 The Firm: Cost and Output Determination

  2. Freight dispatchers use real-time information transmitted by computers to monitor the positions of locomotives and rolling stock along the nation’s railways. In what respect does the availability of information affect the operating costs of any business? Introduction

  3. Learning Objectives • Discuss the difference between the short run and the long run from the perspective of a firm • Understand why the marginal physical product of labor eventually declines as more units of labor are employed

  4. Learning Objectives • Explain the short-run cost curves faced by a typical firm • Explain the long-run cost curves faced by a typical firm • Identify situations of economies and diseconomies of scale and define a firm’s minimum efficient scale

  5. Chapter Outline • Short Run versus Long Run • Relationship Between Output and Inputs • Diminishing Marginal Returns • Short-Run Costs to the Firm

  6. Chapter Outline • The Relationship Between Diminishing Marginal Returns and Cost Curves • Long-Run Cost Curves • Why the Long-Run Average Cost Curve is U-Shaped • Minimum Efficient Scale

  7. Did You Know That... • As electric utilities have increased their generating capacity over the past ten years, they also have lowered the average cost of producing power? • In some other industries, a higher productive capacity is associated with a higher average cost?

  8. Short Run versus Long Run • Short Run • A time period when at least one input, such as plant size, cannot be changed • Plant Size • The physical size of the factories that a firm owns and operates to produce its output

  9. Short Run versus Long Run • Long Run • The time period in which all factors of production can be varied

  10. Short Run versus Long Run • Short run and long run are terms that apply to planning decisions made by managers. The firm always operates in the short run in the sense that decisions can only be made in the present. • But some of these decisions result in a long-term commitment of resources.

  11. Output/time period = some function of capital and labor inputs or Q = ƒ(K,L) Q = output/time period K = capitalL = labor The RelationshipBetween Output and Inputs

  12. The RelationshipBetween Output and Inputs • Production • Any activity that results in the conversion of resources into products that can be used in consumption

  13. The RelationshipBetween Output and Inputs • Production Function • The relationship between inputs and output • A technological, not an economic, relationship • The relationship between inputs and maximum physical output

  14. Example:The Optimal Load Size for Trucks • Procter & Gamble is a consumer products company that supplies soap and personal care products to retailers. • Using inventory-tracking software, the company found that it could make more efficient use of all inputs if it dispatched trucks from its manufacturing facilities with less than full loads.

  15. Example:The Optimal Load Size for Trucks • The efficiency resulted from the fact that workers who loaded the trucks were more productive and that total fuel consumption was less when trucks were only partially loaded. • The inventory-tracking software allowed the company to identify parts of its production function that would have been difficult to determine through casual observation.

  16. Diminishing Marginal Returns • Law of Diminishing (Marginal) Returns • The observation that after some point, successive equal-sized increases in a variable factor of production, such as labor, added to fixed factors of production, will result in smaller increases in output

  17. The RelationshipBetween Output and Inputs • Average Physical Product • Total product divided by the variable input

  18. The RelationshipBetween Output and Inputs • 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 or marginal return

  19. Diminishing Returns, the Production Function, and Marginal Product: A Hypothetical Case Figure 23-1, Panel (a)

  20. Diminishing Returns, the Production Function,and Marginal Product: A Hypothetical Case Figure 23-1, Panel (b)

  21. Diminishing Returns, the Production Function,and Marginal Product: A Hypothetical Case Figure 23-1, Panel (c)

  22. An Example of the Law of Diminishing Returns • Production of computer printers • With a fixed amount of factory space, assembly equipment, and quality control diagnostic software, more workers can add to total output. • But the additional increments of quantity produced will lessen as more labor is added.

  23. An Example of the Law of Diminishing Returns • Beyond a certain point, as more workers as added, they will have to assemble the printers manually. • The marginal physical product of labor, while remaining positive, will decline.

  24. Total costs (TC) = TFC + TVC Short-Run Costs to the Firm • Total Costs • The sum of total fixed costs and total variable costs • Fixed Costs • Costs that do not vary with output • Variable Costs • Costs that vary with the rate of production

  25. Cost of Production: An Example Figure 23-2, Panel (a)

  26. Total costs Total variable costs Total fixed costs Cost of Production: An Example Panel (b) 60 50 40 Total costs (dollars per day) 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Output (recordable DVDs per day) Figure 23-2, Panel (b)

  27. total costs (TC) Average total costs (ATC) = output (Q) Short-Run Costs to the Firm • Average Total Costs (ATC)

  28. total variable costs (TVC) Average variable costs (AVC) = output (Q) Short-Run Costs to the Firm • Average Variable Costs (AVC)

  29. total fixed costs (TFC) Average fixed costs (AFC) = output (Q) Short-Run Costs to the Firm • Average Fixed Costs (AFC)

  30. change in total cost Marginal costs (MC) = change in output Short-Run Costs to the Firm • Marginal Cost • The change in total costs due to a one-unit change in production rate

  31. Short-Run Costs to the Firm • What do you think? • Is there a predictable relationship between the production function and AVC, ATC, and MC?

  32. Short-Run Costs to the Firm • Answer • As long as marginal physical product rises, marginal cost will fall, and when marginal physical product starts to fall (after reaching the point of diminishing marginal returns), marginal cost will begin to rise.

  33. E-Commerce Example:Internet Package Tracking • The marginal cost incurred by FedEx in delivering one additional package includes the transportation expense and also the cost of providing information to senders or recipients who inquire about the status of the shipment.

  34. E-Commerce Example:Internet Package Tracking • As the internet has made it easier to provide this information for customers, FedEx has experienced a downward shift of its marginal cost curve.

  35. The Relationship Between Average and Marginal Costs • When marginal cost is less than average variable cost, then average variable cost will decline. • When marginal cost exceeds average variable cost, then average variable cost will increase.

  36. The Relationship Between Average and Marginal Costs • It is also true that the direction of change in average total cost will be determined by whether marginal cost exceeds the current average.

  37. The Relationship Between Diminishing Marginal Returns and Cost Curves • Firms’ short-run cost curves are a reflection of the law of diminishing marginal returns. • Given any constant price of the variable input, marginal costs decline as long as the marginal product of the variable resource is rising.

  38. The Relationship Between Diminishing Marginal Returns and Cost Curves • At the point at which diminishing marginal returns begin, marginal costs begin to rise as the marginal product of the variable input begins to decline.

  39. The Relationship Between Diminishing Marginal Returns and Cost Curves • If the wage rate is constant, then the labor cost associated with each additional unit of output will decline as long as the marginal physical product of labor increases.

  40. Long-Run Cost Curves • Planning Horizon • The long run, during which all inputs are variable

  41. SAC 8 SAC 1 SAC 7 SAC SAC SAC 1 2 6 SAC SAC 2 SAC 3 5 SAC 4 LAC SAC 3 Q Q 1 2 Preferable Plant Size and the Long-Run Average Cost Curve Panel (a) Panel (b) C 2 C 4 C 1 Average Cost (dollars per unit of output) Average Cost (dollars per unit of output) C 3 Output per Time Period Output per Time Period Figure 23-4, Panels (a) and (b)

  42. Long-Run Cost Curves • Long-Run Average Cost Curve • The locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices

  43. Long-Run Cost Curves • Observation • Only at minimum long-run average cost curve is short-run average cost curve tangent to long-run average cost curve • What do you think? • Why is the long-run average cost curve U-shaped?

  44. 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.

  45. Why the Long-Run Average Cost Curve is U-Shaped • Reasons for economies of scale • Specialization • Dimensional factor • Improved productive equipment

  46. Why the Long-Run Average Cost Curve is U-Shaped • Explaining diseconomies of scale • Limits to the efficient functioning of management • Coordination and communication is more of a challenge as firm size increases

  47. International Example:Reducing Firm Size to Reduce Costs • In the past decade, the Chinese government has sold many of the companies that were originally state-financed endeavors. • Although these firms received subsidies when they were government-sponsored enterprises, they had to be self-financing once they were in the hands of private investors.

  48. International Example:Reducing Firm Size to Reduce Costs • In many instances, the private owners chose to reduce the scale of operations. • This has resulted in lower long-run average costs, and the firms can expect to keep operating without subsidies.

  49. Minimum Efficient Scale • Minimum Efficient Scale (MES) • The lowest rate of output per unit time at which long-run average costs for a particular firm are at a minimum

  50. Minimum Efficient Scale • Small MES relative to industry demand: • There is room for many efficient firms • High degree of competition • Large MES relative to industry demand: • Room for only a small number of efficient firms • Small degree of competition

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