Roger LeRoy Miller Economics Today

1. Roger LeRoy Miller Economics Today Chapter 22 The Firm: Cost and Output Determination

2. Since 1989 there have been nearly 4000 commercial bank mergers. The most common rationale given is that large banks are more cost efficient than small banks. To be able to evaluate this rationale, you must understand the nature of cost curves faced by individual firms. Introduction

3. Learning Objectives • Distinguish between accounting of profits and economic profits • Discuss the difference between the short run and the long run from the perspective of a firm

4. Learning Objectives • Understand why the marginal physical product of labor eventually declines as more units of labor are employed • Explain the short-run cost curves faced by a typical firm

5. Leaning Objectives • Describe the long-run cost curves a typical firm faces • Identify situations of economies and diseconomies of scale and define a firm’s minimum efficient scale

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

7. 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

8. Did You Know That... • There are more than 25 steps in the process of manufacturing a simple lead pencil? • In the production of an automobile, there are literally thousands of steps? • How do producers select the best combination of inputs for any desired output?

9. The Firm • Firm • An organization that brings together factors of production—labor, land, physical capital, human capital, and entrepreneurial skill—to produce a product or service that it hopes can be sold at a profit

10. The Firm • Organizational structure • Entrepreneur • Residual claimant • Gets what is left over after all expenses are paid • Manager • Workers

11. The Firm • Profit and costs Accounting profits = total revenues - explicit costs • Explicit Costs • Costs that business managers must take account of because they must be paid

12. The Firm • Implicit Costs • Expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculate • Opportunity costs of using factors that a producer does not buy or hire, but already owns

13. The Firm • Normal Rate of Return • The amount that must be paid to an investor to induce investment in a business • Opportunity Cost of Capital • The normal rate of return, or the available return on the next-best alternative investment

14. The Firm • Example • A skilled auto mechanic owns a service station. • He works six days a week and 14 hours per day, or 84 hours/week. • His opportunity cost is: • An employee mechanic makes $20/hour. • Opportunity cost • 84 hours x $20 = $1,680

15. The Firm • The service station must make more than $1,680 to show an economic profit.

16. The Firm • What do you think? • Is a building owned by a business “free”?

17. Economic profits = total revenues - total opportunity cost of all inputs used or Economic profits = total revenues - (explicit + implicit costs) The Firm • Accounting profits versus economic profits

18. Simplified View of Economic and Accounting Profit Figure 22-1

19. The Firm • The goal of the firm: profit maximization • Firms are expected to try to make the positive difference between total revenues and total costs as large as they can.

20. 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

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

22. 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

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

24. 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

25. The RelationshipBetween Output and Inputs • The production function: a numerical example • Short-run model • Fixed input is capital • Variable input is labor

26. 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

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

28. 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 productor marginal return

29. Diminishing Returns, the Production Function,and Marginal Product: A Hypothetical Case Figure 22-2, Panel (a)

30. Diminishing Returns, the Production Function,and Marginal Product: A Hypothetical Case Figure 22-2, Panel (b)

31. Diminishing Returns, the Production Function,and Marginal Product: A Hypothetical Case Figure 22-2, Panel (c)

32. Short-Run Costs to the Firm • Assume two inputs • Capital (fixed) • Labor (variable)

33. 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

34. Cost of Production: An Example Figure 22-3, Panel (a)

35. Cost of Production: An Example Figure 22-3, Panel (b)

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

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

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

39. AFC Cost of Production: An Example Total Average Total Fixed Fixed Output Costs Costs (Q/day) (TFC) (AFC) 16 14 0 $10 1 10 2 10 3 10 4 10 5 10 6 10 7 10 8 10 9 10 10 10 11 10 ——— $10.00 5.00 3.33 2.50 2.00 1.67 1.43 1.25 1.11 1.00 .91 12 10 Costs (dollar per day) 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

40. AVC Cost of Production: An Example Total Average Total Variable Variable Output Costs Costs (Q/day) (TVC) (AVC) 16 14 0 $0 1 5 2 8 3 10 4 11 5 13 6 16 7 20 8 25 9 31 10 38 11 46 ——— $5.00 4.00 3.33 2.75 2.60 2.67 2.86 3.13 3.44 3.80 4.18 12 10 Costs (dollar per day) 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

41. ATC Cost of Production: An Example Average Total Total Total Output Costs Costs (Q/day) (TVC) (AVC) 16 14 0 $10 1 15 2 18 3 20 4 21 5 23 6 26 7 30 8 35 9 41 10 48 11 56 ——— $15.00 9.00 6.67 5.25 4.60 4.33 4.28 4.38 4.56 4.80 5.09 12 10 Costs (dollar per day) 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

42. ATC AVC AFC Cost of Production: An Example 16 14 12 10 Costs (dollar per day) 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

43. ATC AVC AVC AFC AFC TP Cost of Production: An Example Difference between AVC and ATC = AFC Costs (dollar per day) ATC Output (calculators per day)

44. ATC AVC AFC AVC TP Cost of Production: An Example ATC = AVC + AFC AFC = ATC - AVC Costs (dollar per day) Output (calculators per day)

45. 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

46. $5 3 2 MC 1 2 3 4 5 6 7 8 Cost of Production: An Example Total Total Variable Total Marginal Output Costs Costs Cost (Q/day) (TVC) (TC) (MC) 16 14 0 $0 1 5 2 8 3 10 4 11 5 13 6 16 7 20 8 25 9 31 10 38 11 46 $10 15 18 20 21 23 26 30 35 41 48 56 12 10 Costs (dollar per day) 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

47. What do you think? Will a change in fixed cost change marginal cost? Example Increase in interest rate on adjustable rate mortgage Increase in insurance premium $5 3 2 1 2 3 4 5 6 7 8 Cost of Production: An Example Total Total Variable Total Marginal Output Costs Costs Cost (Q/day) (TVC) (TC) (MC) 0 $0 1 5 2 8 3 10 4 11 5 13 6 16 7 20 8 25 9 31 10 38 11 46 $10 15 18 20 21 23 26 30 35 41 48 56

48. Cost of Production: An Example Figure 22-3, Panel (c)

49. MC ATC AVC FC TC VC Cost of Production: An Example 16 AFC can be found by subtracting AVC from ATC 14 12 Costs (dollar per day) 10 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

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