M3_Microeconomics Assignment

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M3ECONArnold_Econ13e_Ch21.pptx

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PRODUCTION AND

COSTS

CHAPTER

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ECONOMICS

Roger A. Arnold • Thirteenth Edition

21-1 Why Firms Exist

21-2 Two Sides to Every Business Firm

21-3 Production

21-4 Costs of Production: Total, Average, Marginal

21-5 Production and Costs in the Long Run

21-6 Shifts in Cost Curves

21-1 Why Firms Exist (1 of 3)

Business Firm: An entity that employs factors of production (resources) to produce goods and services to be sold to consumers, other firms, or the government

21-1a The Market and the Firm: Invisible Hand Versus Visible Hand

Market Coordination: The process in which individuals perform tasks, such as producing certain quantities of goods, on the basis of changes in market forces, such as supply, demand, and price

Managerial Coordination: The process in which managers direct employees to perform certain tasks

21-1 Why Firms Exist (2 of 3)

21-1b The Alchian-and-Demsetz Answer

Economists Armen Alchian and Harold Demsetz suggest that firms are formed when benefits can be obtained form individuals working as a team

21-1c Shirking on a Team

Shirking: The behavior of a worker who is putting forth less than the agreed-to effort

Monitor: A person in a business firm who coordinates team production and reduces shirking

Residual Claimant: Persons who share in the profits of a business firm

21-1 Why Firms Exist (3 of 3)

21-1d Ronald Coase on Why Firms Exist

Firms exist either to economize on buying and selling everything or to reduce transaction costs

21-1e Markets: Outside and Inside the Firm

Economics is largely about trades or exchanges, market transactions

In the theory of the firm, exchanges take place at two levels:

At the level of individuals coming together to form a team

At the level of workers choosing a monitor

They trade some control over their daily behavior in order to receive a larger absolute amount of the potential benefits of the team

21-2 Two Sides to Every Business Firm (1 of 3)

Profit: The difference between total revenue and total cost

There are two sides to every market: buying and selling

There are two sides to every business firm: revenue and cost sides; we can see both of these sides by focusing on profit

Total revenue is equal to the price of a good multiplied by the quantity of the good sold

The total cost that a firm incurs is related to the production of the firm; produce nothing, incur no costs; produce something, incur costs

21-2 Two Sides to Every Business Firm (2 of 3)

21-2a More on Total Cost

Explicit Cost: A cost incurred when an actual (monetary) payment is made

Implicit Cost: A cost that represents the value of resources used in production for which on actual (monetary) payment is made

A disagreement sometimes arises as to what total cost should include

21-2 Two Sides to Every Business Firm (3 of 3)

21-2b Accounting Profit vs. Economic Profit

Accounting Profit: The difference between total revenue and explicit costs

Economic Profit: The difference between total revenue and total cost, including both explicit and implicit costs

21-2c Zero Economic Profit is Not as Bad as it Sounds

Normal Profit: Zero economic profit, the level of profit necessary to keep resources employed in a firm. A firm that earns normal profit is earning revenue equal to its total costs (explicit plus implicit costs)

Accounting Profit and Economic Profit

EXHIBIT 1

21-3 Production (1 of 6)

Fixed Input: An input whose quantity cannot be changed as output changes

Variable Input: An input whose quantity can be changed as output changes

Short Run: A period during which some inputs in the production process are fixed

Long Run: A period during which all inputs in the production process can be varied. (No inputs are fixed.)

21-3 Production (2 of 6)

21-3a Common Misconceptions About the Short Run and Long Run

Individuals naturally think that the long run is a longer period than the short run, but this is not the right way to differentiate between the two

Instead, think of each as a period during which some condition exists:

The short run is the period during which at least one put is fixed (it could be for 6 months, 2 years, etc.

The long run is the period during which all inputs are variable (i.e., no input is fixed; the short run could be a longer period than the long run

21-3 Production (3 of 6)

21-3b Production in the Short Run

Marginal Physical Product (MPP): The change in output that results from changing the variable input by one unit, with all other inputs held fixed

Law of Diminishing Marginal Returns: As ever larger amounts of a variable input are combined with fixed inputs, eventually the marginal physical product of the variable input will decline

Why hire a 4th worker? (Exhibit 2) The firm must ask and answer these questions:

1. What can the additional 19 units of output be sold for?

2. What does it cost to hire the fourth worker?

Production in the Short Run and the Law of Diminishing Marginal Returns

EXHIBIT 2

21-3 Production (4 of 6)

21-3c Whose Marginal Productivity Are We Talking About?

Looking at Exhibit 2, it is easy to fall into the trap of believing that 19 units is the marginal productivity of the 4th worker, but its not

Instead, an MPP of 19 can easily be attached to any of the workers

21-3d Marginal Physical Product and Marginal Cost

Fixed Costs: Costs that do not vary with output; the costs associated with fixed inputs

Variable Costs: Costs that vary with output; the costs associated with variable inputs

21-3 Production (5 of 6)

21-3d Marginal Physical Product and Marginal Cost (cont)

Total Cost (TC): The sum of fixed costs and variable costs (TC = TFC + TVC)

Marginal Cost (MC): The change in total cost that results from a change in output: MC = TC/Q

In Exhibit 3, we establish the link between the MPP of a variable input and MC

Marginal Physical Product and Marginal Cost (1 of 2)

EXHIBIT 3

Marginal Physical Product and Marginal Cost (2 of 2)

EXHIBIT 3

21-3 Production (6 of 6)

21-3e Average Productivity

When the press or laypersons use the word productivity, they are usually referring to average physical product instead of marginal physical product

Usually, when the term labor productivity is used in the newspaper and in government documents, it refers to the average hourly (physical) productivity of labor

21-4 Costs of Production: Total, Average, Marginal (1 of 3)

Average Fixed Cost (AFC): Total fixed cost divided by quantity of output: AVC = TVC/Q

Average Variable Cost (AVC): Total variable cost divided by quantity of output: AVC = TVC/Q

Average Total Cost (ATC): Total cost divided by quantity of output: ATC = TC/Q

Alternatively, we can say that ATC equals the sum of AFC and AVC:

ATC = AFC + AVC

Exhibit 5 brings together much of the material re short-run production and costs

Total, Average, and Marginal Costs (1 of 2)

EXHIBIT 4

Total, Average, and Marginal Costs (2 of 2)

EXHIBIT 4

A Review of Production and Costs in the Short Run

EXHIBIT 5

21-4 Costs of Production: Total, Average, Marginal (2 of 3)

21-4a The AVC and ATC Curves in Relation to the MC Curve

Average-marginal rule: When the marginal magnitude is above the average magnitude, the average magnitude rises; when the marginal magnitude is below the average magnitude, the average magnitude falls

We can apply the average-marginal rule to find out what the ATC and AVC curves look like in relation to the MC curve (Exhibit 6)

The analysis holds for both the ATC curve and the AVC curve

Average and Marginal Cost Curves

EXHIBIT 6

21-4 Costs of Production: Total, Average, Marginal (3 of 3)

21-4b Tying Short-Run Production to Costs

To summarize our earlier discussion, see Exhibit 7

21-4c One More Cost Concept: Sunk Cost

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

Economists’ Advice: Ignore Sunk Costs; a present decision can affect only the future, never the past

Behavior Economics and Sunk Cost: In a study, researchers found that people who paid more for their tickets to the theater attended more often than those who paid less

It seems likely that the greater the sunk cost, the more likely they were to attend the performance

Tying Production to Costs

EXHIBIT 7

21-5 Production and Costs in the Long Run (1 of 5)

21-5a Long-Run Average Total Cost Curve

Long-Run Average Total Cost (LRATC) Curve: A curve that shows the lowest (unit) cost at which a firm can produce any given level of output

Given a decision between 3 different plant sizes, a manager will choose the plant size represented by SRATC that corresponds to the quantity he wants to produce, which yields the lowest unit cost

If we were to ask the same question for every possible output level, we would derive the LRATC

Exhibit 8 shows a host of SRATC curves and one LRATC curve

Long-Run Average Total Cost Curve (LRATC)

EXHIBIT 8

21-5 Production and Costs in the Long Run (2 of 5)

21-5b Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale

Economies of Scale: Economies that exist when inputs are increased by some percentage and output increases by a greater percentage, causing unit costs to call

Constant Returns to Scale: The condition when inputs are increased by some percentage and output increases by an equal percentage, causing unit costs to remain constant

Diseconomies of Scale: The condition when inputs are increased by some percentage and output increases by a smaller percentage, causing unit costs to rise

21-5 Production and Costs in the Long Run (3 of 5)

21-5b Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale (cont)

Minimum Efficient Scale: The lowest output level at which average total costs are minimized

A Review of Production and Costs in the Long Run

EXHIBIT 9

21-5 Production and Costs in the Long Run (4 of 5)

21-5c Why Economies of Scale?

Up to a certain point, long-run unit costs of production fall as a firm grows, for two main reasons:

1. Growing firms offer greater opportunities for employees to specialize; workers can become highly proficient at narrowly defined tasks, often producing more output at lower unit costs

2. Growing firms (especially large ones) can take advantage of highly efficient mass production techniques and equipment that ordinarily require large setup costs and are economical only if they can be spread over large numbers of units

21-5 Production and Costs in the Long Run (5 of 5)

21-5d Why Diseconomies of Scale?

These usually arise at the point where a firm’s size causes coordination, communication, and monitoring problems

There is also a monetary incentive not to pass the point of operation at which diseconomies of scale exist, and firms usually find ways to do so, including reorganizing, dividing operations, etc.

21-5d Minimum Efficient Scale and Number of Firms in an Industry

Some industries have a smaller number of firms

The MES as a percentage of US consumption or total sales is not the same for all industries

By dividing the MES as a percentage of total sales into 100, we can estimate the number of efficient firms it takes to satisfy total consumption for a product

21-6 Shifts in Cost Curves (1 of 1)

21-6a Taxes

A tax won’t affect a firm’s fixed costs because the tax is paid only when output is produced, and fixed cost is present even if output is zero

21-6b Input Prices

A rise or fall in variable input prices causes a corresponding change in the firm’s average total, average variable, and marginal cost curves

21-c Technology

Technology often brings (1)the capability of using fewer inputs to produce a good, or (2) lower input prices

In either case, technological changes lower variable costs and so average variable cost, average total cost, and marginal costs; the cost curves shift downward