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CHAPTER 6 THE ORGANIZATION AND COSTS OF PRODUCTION

Part Two: Microeconomics of Product Markets. CHAPTER 6 THE ORGANIZATION AND COSTS OF PRODUCTION. In this chapter you will learn:. 6.1 The various organizational forms a firm can take 6.2 What are economic costs 6.3 About a firm’s short-run production relationships

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CHAPTER 6 THE ORGANIZATION AND COSTS OF PRODUCTION

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  1. Part Two: Microeconomics of Product Markets CHAPTER 6 THE ORGANIZATION AND COSTS OF PRODUCTION

  2. In this chapter you will learn: 6.1 The various organizational forms a firm can take 6.2 What are economic costs 6.3 About a firm’s short-run production relationships 6.4 About a firm’s short-run production costs 6.5 The link between a firm’s size and costs in the long run Chapter 6

  3. The Firm and the Business Sector Different organizational structures: • Plant • Firm • Industry • Horizontal combinations • Vertical combinations • Conglomerates Chapter 6.1

  4. The Firm and the Business Sector • Legal Forms of Businesses: • Sole Proprietorship • Partnership • Corporation • Advantages of Corporations • The Principal-Agent Problem Chapter 6.1

  5. Economic Costs Opportunity Cost Explicit Costs • payments a firm must make Implicit Costs • opportunity costs of firm’s own resources • include normal profits Chapter 6.2

  6. Total Revenue $120,000 Cost of T - shirts $40,000 Clerk's salary $18,000 Utilities $ 5,000 Total (explicit) costs $ 63,000 Accounting Profit $ 57,000 Normal Profit as a Cost Chapter 6.2

  7. Total Revenue $120,000 Cost of T - shirts $40,000 Clerk's salary $18,000 Utilities $ 5,000 Total (explicit) costs $ 63,000 Accounting Profit $ 57,000 Forgone interest $ 1,000 Forgone rent $ 5,000 Forgone wages $2 2 ,000 Normal profit $ 5,000 Total implicit c osts $ 3 3 ,000 Economic profit $ 24,000 Normal Profit as a Cost Chapter 6.2

  8. Normal Profit as a Cost • Costs of production include all costs • explicit • implicit • including a normal profit required to attract and retain factors of production Economic profit = total revenue – economic cost Chapter 6.2

  9. Figure 6-1 Economic Profit vs. Accounting Profit Economic Profits Accounting Profits Implicit costs (including a normal profit) Total Revenue Economic (opportunity) Costs Accounting costs (explicit costs only) Explicit Costs Chapter 6.2

  10. Short Run and Long Run • Short Run • Fixed Plant • Long Run • Variable Plant Chapter 6.3

  11. change in total product total product = = change in labour input units of labour Short-Run Production Relationships • Total Product (TP) • total quantity produced • Marginal Product (MP) • Average Product (AP) Chapter 6.2

  12. Short-Run Production Relationships Law of Diminishing Returns • marginal product eventually diminishes Chapter 6.3

  13. change in total product MP= change in labour input Table 6-1Total, Marginal, and Average Product Chapter 6.3

  14. Increasing marginal returns Diminishing marginal returns Negative marginal returns Total, Marginal, and Average Product 10 15 20 15 10 5 0 -5 Chapter 6.3

  15. total product AP= total labour input 15.00 14.00 12.50 10.71 8.75 Total, Marginal, and Average Product 10 10.00 15 12.50 20 15.00 15 10 5 0 -5 Chapter 6.3

  16. increasing marginal returns diminishing marginal returns TP negative marginal returns AP MP Figure 6-2 Chapter 6.3

  17. Marginal and Average Values • If the average value is rising, the marginal value must be ABOVE the average value • If the average value is falling, the marginal value must be BELOW the average value Chapter 6.3

  18. Average value falling Average value rising Marginal and Average Values MP >AP AP MP <AP MP Chapter 6.3

  19. Fixed, Variable, and Total Costs • Fixed Costs • do not vary with changes in output • Variable Costs • change with changes in output • Total Cost • sum of fixed and variable costs Chapter 6.4

  20. Per-Unit, or Average, Costs Chapter 6.4

  21. Marginal Cost • Marginal cost is the extra, or additional, cost of producing one more unit of output Illustrated… Chapter 6.4

  22. 340 400 470 550 640 750 880 1030 100 100 TC=TFC + TVC 190 270 Chapter 6.4

  23. Total Cost is the Sum of Fixed Cost and Variable Cost Figure 6-3 TFC Chapter 6.4

  24. Total Cost is the Sum of Fixed Cost and Variable Cost TC Add vertically to get TC TVC TFC Chapter 6.4

  25. 340 25 400 75 100 94 20 470 74 550 75 91.67 16.67 640 91.43 14.29 77.14 750 93.75 12.50 81.25 880 97.78 11.11 86.67 10 93 1030 103 AVC=TVC / Q AFC=TFC / Q ATC=TC / Q 100 190 100 190 90 270 50 135 85 80 33.33 113.33 Chapter 6.4

  26. 340 60 25 400 75 100 70 94 20 470 74 80 550 75 91.67 16.67 90 640 91.43 14.29 77.14 110 750 93.75 12.50 81.25 130 880 97.78 11.11 86.67 150 10 93 1030 103 MC=TC / Q 100 90 190 100 190 90 80 270 50 135 85 2.5 70 80 33.33 113.33 Note: MC is graphed at average Q Chapter 6.4

  27. AFC, AVC, and ATC Figure 6-5 AFC continually declines as fixed cost is spread over more and more units AFC Chapter 6.4

  28. AFC, AVC, and ATC AVC is U-shaped: it starts to rise when AP starts to fall AVC AFC Chapter 6.4

  29. AFC, AVC, and ATC Get ATC by vertically summing AFC and AVC ATC AVC AFC Chapter 6.4

  30. MC, AVC, and ATC MC cuts ATC and AVC at minimum points ATC MC AVC AFC Chapter 6.4

  31. AVC Figure 6-6 Productivity Curves and Cost Curves Average Product and Marginal Product AP MP Labour MC Costs (dollars) Output Chapter 6.4

  32. Relation of MC to AVC and ATC • When MC < current ATC • ATC will fall • When MC > current ATC • ATC will rise • MC intersects ATC and AVC at minimum points Chapter 6.4

  33. Shifts of Cost Curves Factor Prices price of fixed input increases... • AFC and ATC shift up • AVC and MC unchanged price of variable input increases... • AVC, ATC, and MC shift up • AFC unchanged Chapter 6.4

  34. Shifts of Cost Curves Technology • improved technology • lower costs • cost curves shift down • curve shifts depend on whether technology affects FC, VC, or both Chapter 6.4

  35. Long-Run Production Costs • What will costs look like when the firm can choose the best plant size for any given situation? • For every plant capacity size, there is a short-run ATC curve • All such plant capacities can be plotted... Chapter 6.5

  36. Figure 6-7 The Long-Run Average-Total-Cost Curve ATC-4 ATC-3 ATC-1 ATC-2 ATC-5 Choose the best plant for every output level These choices determine the LRATC curve Chapter 6.5

  37. Figure 6-8 The Long-Run Average-Total-Cost Curve LRATC The number of possible plant sizes is virtually unlimited The LRATC curve just envelops the short-run cost curves Chapter 6.5

  38. Economies of Scale • Labour Specialization • Managerial Specialization • Efficient Capital • Other Factors • Diseconomies of Scale • Constant Returns to Scale Chapter 6.5

  39. Figure 6-9 Economies and Diseconomies of Scale Constant returns to scale Economies of scale Diseconomies of scale LRATC Chapter 6.5

  40. Minimum Efficient Scale ATC-4 ATC-3 ATC-1 ATC-2 ATC-5 MES is the smallest level of output that minimizes LRATC Chapter 6.5

  41. Minimum Efficient Scale Relatively large MES natural monopoly LRATC MES Chapter 6.5

  42. Minimum Efficient Scale LRATC Relatively small MES competitive industry MES Chapter 6.5

  43. Applications and Illustrations • Successful Startup Firms • The Daily Newspaper • The Verson Stamping Machine • Aircraft and Concrete Plants Chapter 6.5

  44. Chapter Summary • 6.1 The Firm and the Business Sector • 6.2 Economic Costs • Opportunity Cost • 6.3 Short-Run Production Relationships • The Law of Diminishing Return • TP, AP and MP • 6.4 Short-Run Production Costs • Fixed Cost, Average Cost, and Marginal Cost • 6.5 Long-Run Production Costs Chapter 6

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