Principles of Microeconomics Chapter 6 PDF

Principles of Microeconomics SAYRE // MORRIS // GHAYAD Eleventh Edition CHAPTER 6 A Firm’s Production Decisions and Costs in the Short Run Prepared by Ifeanyi Uzoka, Sheridan...

Principles of Microeconomics SAYRE // MORRIS // GHAYAD Eleventh Edition CHAPTER 6 A Firm’s Production Decisions and Costs in the Short Run Prepared by Ifeanyi Uzoka, Sheridan College  CHAPTER 6 A Firm’s Production Decisions and Costs in the Short Run Learning Objectives: 1. Explain what a firm is and list the different types of firms. 2. Describe how and why economists and accountants measure costs differently, and distinguish between the accountants’ and economists’ views of profits 3. Explain the crucial relationship between productivity and costs © 2024 McGraw Hill 6-2  CHAPTER 6 A Firm’s Production Decisions and Costs in the Short Run Learning Objectives: 4. Demonstrate the important difference between fixed costs and variable costs 5. List and graph the seven specific cost definitions used by economists 6. Explain the meanings of increasing productivity and cutting costs © 2024 McGraw Hill 6-3  LO1: The Role of the Firm © 2024 McGraw Hill 2-4  The Role of the Firm Firm: a business organization that hires and organizes factors of production in order to sell goods and services. – Also known as a company or a business – It embraces a number of different types of organizations such as: sole proprietorship, partnership, corporation, state-owned © 2024 McGraw Hill 6-5  The Role of the Firm Sole Proprietorship: whose owner/manager is responsible for all activities of the firm Partnership: which has two or more joint owners (in a limited partnership, some of the partners have no part in running the firm and are not liable for its © 2024 McGraw Hill 6-6  The Role of the Firm Corporation: whose owners are not personally responsible for debts and not personally involved in its operations State-owned enterprise: which is owned by the government and generally run by appointed officials – (also known as Crown corporation in Canada) © 2024 McGraw Hill 6-7  The Role of the Firm Non-profit organization: which is organized to achieve certain goals by providing goods and services, but not with the intention of making a profit. © 2024 McGraw Hill 6-8  Production Production The activity of a business organization or firm using inputs to obtain output of some product. © 2024 McGraw Hill 6-6  LO2: Explicit and Implicit Costs © 2024 McGraw Hill 2-10  Explicit and Implicit Costs Explicit Costs – A cost that is actually paid out in money, usually to non-owners Implicit Costs – The opportunity cost of using the owner’s resources that does not require an actual expenditure of money © 2024 McGraw Hill 6-7  Explicit and Implicit Costs PROFIT AND LOSS STATEMENT Total Revenue: Cash sales (excluding $250 000 sales tax) Explicit Costs: Rent $18 000 Materials and Supplies 50 000 Utilities 12 000 Hired labour 120 000 Total Explicit Costs: $200 000 Accounting Profit: $50 000 Implicit Costs: Opportunity costs of $150 000 put into business 15 000 © 2024 McGraw Hill 6-8 Labour put in by owners 80 000 Accounting vs. Economic Profit Accounting profit  total revenue  total explicit costs Economic profit  total revenue  total costs (including implicit and explicit costs) © 2024 McGraw Hill 6-9 Accounting vs. Economic Profit © 2024 McGraw Hill 6- 14 Accounting vs. Economic Profit Normal Profit – The minimum profit that must be earned to keep the entrepreneur in that type of business Economic Profit – Revenue over and above all costs, including normal profits © 2024 McGraw Hill 6-11 Test Your Understanding Abdi gave up a job that paid $1500 a month to open up his own store. He works full time in the store, which had a total revenue of $105 000 last year. His total (explicit) costs amounted to $65 000. He reckons his store is now worth $200 000. If he were to sell it and invest the proceeds, he would earn an 8 percent annual return. What is Abdi’s economic profit during the year? © 2024 McGraw Hill 6-12 Test Your Understanding Solution Total revenue: $105 000 Total explicit cost $65 000 Implicit costs: wages ($1500 X 12) 18 000 interest (8% X 200 000) 16 000 Total Cost © 2024 McGraw Hill 99 000 6-14  LO3: Theory of Production © 2024 McGraw Hill 2-18  Theory of Production Short Run – Any period of time in which at least one input in the production process is fixed (cannot be increased or decreased) Total Product – The total output of any productive process © 2024 McGraw Hill 6-15  Theory of Production Marginal Product – The increase in total product MPL = Δ as a result of adding one more TP unit of input (labour) ΔL Average Product – Total product (or total output) AP L = TP divided by the quantity of L inputs used to produce that total © 2024 McGraw Hill 6-16  Theory of Production Table 6.2 Marginal and Average Product Data Total Product Marginal Product Average Product Units of Labour (TP) (MP) (AP) 0 0 ― ― 1 4 4 4 2 16 12 8 3 36 20 12 4 60 24 15 5 75 15 15 6 84 9 14 7 84 0 12 8 72 -12 9 © 2024 McGraw Hill 6-17  Division of Labour Division of Labour: – Dividing the production process into a series of specialized tasks, each done by a different worker – Division of labour causes Marginal Product to increase initially © 2024 McGraw Hill 6-19 Benefits of Division of Labour – Ability to fit the best person to the right job – Increased dexterity achieved when one worker focuses on a single operation – Time savings from not having to change tools or switch machines © 2024 McGraw Hill 6-19 Benefits of Division of Labour cont’d – Time savings gained by not moving from one operation to another – Machine specialization can be developed around specific, discrete operations © 2024 McGraw Hill 6-19  Theory of Production Law of Diminishing Returns – As more of a variable input is added to a fixed input in the production process, the resulting increase in output will, at some point, begin to diminish © 2024 McGraw Hill 6-18  Theory of Production Law of Diminishing Returns causes marginal product to start falling © 2024 McGraw Hill 6-18  Total, Marginal and Average Product Curves Average product − will rise if marginal product is above it, © 2024 McGraw Hill 6-20  Test Your Understanding 4. Given the data in the table, calculate both the MPL and the APL for each unit of labour used. Quantity of Total Output MPL APL Labour 1 400 ̶ ̶ 2 1000 ̶ ̶ 3 1500 ̶ ̶ 4 1800 ̶ ̶ 5 1900 ̶ ̶ © 2024 McGraw Hill 6-21  Test Your Understanding 4. Given the data in the table, calculate both the MPL and the APL for each unit of labour used. Quantity of Total Output MPL APL Labour 1 400 400 400 2 1000 ̶ ̶ 3 1500 ̶ ̶ 4 1800 ̶ ̶ 5 1900 ̶ ̶ © 2024 McGraw Hill 6-21  Test Your Understanding 4. Given the data in the table, calculate both the MPL and the APL for each unit of labour used. Quantity of Total Output MPL APL Labour 1 400 400 400 2 1000 600 500 3 1500 500 500 4 1800 300 450 5 1900 100 380 © 2024 McGraw Hill 6-21  LO4: Marginal and Variable Costs © 2024 McGraw Hill 2-31  Marginal and Variable Costs Productivity relates the number of units produced to the amount of labour used Costs relate dollars to the number of units produced Costs depend on the level of production, i.e. how many workers and the level of total product © 2024 McGraw Hill 6-27  Marginal and Variable Costs Total Variable Cost (TVC) – The total of all costs that vary with the level of output Marginal Cost (MC)MC = Δ TVC – The increase in total Δ total variable costs as a resultoutput of producing one more unit of output © 2024 McGraw Hill 6-28  Marginal and Variable Costs Average Variable Cost (AVC) – Total variable cost divided by total output AVC = TVC total output © 2024 McGraw Hill 6-29  Cost Data for a Firm Table 6.3 Cost Data for a Firm (1) (2) (3) (4) (5) (6) (7) Units of TP MP AP TVC MC AVC Labour 0 0 / / 0 / / 1 4 4 4 $120 $30.00 $30.00 2 16 12 8 240 10.00 15.00 3 36 20 12 360 6.00 10.00 4 60 24 15 480 5.00 8.00 5 75 15 15 600 8.00 8.00 6 84 9 14 720 13.33 8.60 7 84 0 12 840 / 10.00 © 2024 McGraw Hill 6-30  The Marginal Cost and Average Variable Cost Curves MC is minimum when MP is maximum (point of diminishing returns) MP intersects AP at its maximum MC intersects AVC at its minimum Variable costs of production are a reflection of productivity © 2024 McGraw Hill 6-31 Test Your Understanding 5. a) Assuming that all units of labour cost the same, fill in the blanks in the table Unitshere. of Total TVC MC AVC Labour output 0 0 0 - - 1 100 200  ̶ ̶ 2 220 ̶  ̶ ̶ 3 320 ̶  ̶ ̶ 4 400 ̶  ̶ ̶ 5 460 ̶  ̶ ̶ 6 480 ̶  ̶ ̶ © 2024 McGraw Hill 6-32 Test Your Understanding 5. a) Assuming that all units of labour cost the same, fill in the blanks in the table Unitshere. of Total TVC MC AVC Labour output 0 0 0 - - 1 100 200  ̶ ̶ 2 220 400  ̶ ̶ 3 320 600  ̶ ̶ 4 400 800  ̶ ̶ 5 460 1000  ̶ ̶ 6 480 1200  ̶ ̶ © 2024 McGraw Hill 6-32 Test Your Understanding 5. a) Assuming that all units of labour cost the same, fill in the blanks in the table Unitshere. of Total TVC MC AVC Labour output 0 0 0 - - 1 100 200 2.00 2.00 2 220 400 1.67 1.82 3 320 600 2.00 1.88 4 400 800 2.50 2.00 5 460 1000 3.33 2.17 6 480 1200 10.00 2.50 © 2024 McGraw Hill 6-32 Test Your Understanding 5. b) When is marginal cost at a minimum? Units of Total TVC MC AVC Labour output 0 0 0 - - 1 100 200 2.00 2.00 2 220 400 1.67 1.82 3 320 600 2.00 1.88 4 400 800 2.50 2.00 5 460 1000 3.33 2.17 6 480 1200 10.00 2.50 © 2024 McGraw Hill 6-32 Test Your Understanding 5. b) When is marginal cost at a minimum? When two units of labour are used Units(output of Totalis 220) TVC MC AVC Labour output 0 0 0 - - 1 100 200 2.00 2.00 2 220 400 1.67 1.82 3 320 600 2.00 1.88 4 400 800 2.50 2.00 5 460 1000 3.33 2.17 6 480 1200 10.00 2.50 © 2024 McGraw Hill 6-32 Test Your Understanding 5. c) What is the marginal product of labour when 4 units of labour are used? Units of Total TVC MC AVC Labour output 0 0 0 - - 1 100 200 2.00 2.00 2 220 400 1.67 1.82 3 320 600 2.00 1.88 4 400 800 2.50 2.00 5 460 1000 3.33 2.17 6 480 1200 10.00 2.50 © 2024 McGraw Hill 6-32 Test Your Understanding 5. c) What is the marginal product of labour when 4 units of labour are used? 400 – 320 = 80 Units of Total TVC MC AVC Labour output 0 0 0 - - 1 100 200 2.00 2.00 2 220 400 1.67 1.82 3 320 600 2.00 1.88 4 400 800 2.50 2.00 5 460 1000 3.33 2.17 6 480 1200 10.00 2.50 © 2024 McGraw Hill 6-32  LO5: Total Costs and Average Total Costs © 2024 McGraw Hill 2-44  Total and Average Total Costs Total Fixed Costs (TFC) – Costs that do not vary with the level of output Average Fixed Cost (AFC) – Total fixed cost divided by the quantity of output AFC = TFC total © 2024 McGraw Hill output 6-40  Total and Average Total Costs Total Cost (TC) TC = TVC – The sum of both total variable cost + TFC and total fixed cost ATC = AVC Average Total Cost (ATC) + AFC – Total cost divided by ATC = quantity of output TC total © 2024 McGraw Hill output 6-41  Marginal Costs Recall that, MC = Δ TVC Δ total output – Since fixed costs do not change with output, total costs will change as variable costs do, and: MC = Δ TC Δ total output © 2024 McGraw Hill 6-42 Fixed, Variable, and Total Costs © 2024 McGraw Hill 6-43  The MC, ATC, AVC, and AFC Curves MC intersects AVC and ATC at their minimums AFC is always declining © 2024 McGraw Hill 6-44  Three Important Cost Curves and Three Important Outputs Q1 is the point of diminishing returns, where MC is at its lowest Q2 is the point of most productive output, where AVC is at its lowest Q3 is economic capacity where ATC is at its lowest © 2024 McGraw Hill 6-45  The TC, TVC, and TFC Curves TFC is constant TC starts at TFC TVC starts at zero, since there is no variable cost when there is no output As TVC increases, TC increases by the same amount © 2024 McGraw Hill 6-46 Test Your Understanding 6. Fill in the blanks in the table below. Output (per TC TVC AVC TFC AFC ATC MC day) 0 $200 0 / ̶ / / / 1 280 ̶ ̶ ̶ ̶ ̶ ̶ 2 340 ̶ ̶ ̶ ̶ ̶ ̶ 3 420 ̶ ̶ ̶ ̶ ̶ ̶ 4 520 ̶ ̶ ̶ ̶ ̶ ̶ 5 640 ̶ ̶ ̶ ̶ ̶ ̶ 6 780 ̶ ̶ ̶ ̶ ̶ ̶ © 2024 McGraw Hill 6-47 Test Your Understanding 6. Fill in the blanks in the table below. Output (per TC TVC AVC TFC AFC ATC MC day) 0 $200 0 / $200 / / / 1 280 ̶ ̶ 200 ̶ ̶ ̶ 2 340 ̶ ̶ 200 ̶ ̶ ̶ 3 420 ̶ ̶ 200 ̶ ̶ ̶ 4 520 ̶ ̶ 200 ̶ ̶ ̶ 5 640 ̶ ̶ 200 ̶ ̶ ̶ 6 780 ̶ ̶ 200 ̶ ̶ ̶ © 2024 McGraw Hill 6-47 Test Your Understanding 6. Fill in the blanks in the table below. Output (per TC TVC AVC TFC AFC ATC MC day) 0 $200 0 / $200 / / / 1 280 $80 $80.00 200 $200 $280 $80 2 340 140 70 200 100 170 60 3 420 220 73.33 200 66.67 140 80 4 520 320 80 200 50 130 100 5 640 440 88 200 40 128 120 6 780 580 96.67 200 33.34 130 140 © 2024 McGraw Hill 6-47  LO6: How Can a Firm Cut Costs? © 2024 McGraw Hill 2-55  Cutting Costs Cutting costs involves a reduction in average costs rather than total costs – The firm is assumed to be producing at the lowest possible cost for each output level. © 2024 McGraw Hill 6-54  Cutting Costs Average Costs will decrease if: – the price of fixed or variable inputs decreases – Technological improvement causes the marginal product of a productive process to increase – a firm is operating at excess capacity, and then increases output or is operating above economic capacity and decreases © 2024 McGraw Hill 6-54 A Shift in the Marginal and Average Total Cost Curves If input prices decrease, costs will shift down If technology improves, costs will shift down © 2024 McGraw Hill 6-55  CHAPTER 6 Key Concepts to Remember 1. The distinction between implicit and explicit costs 2. The difference between normal and economic profit 3. Total product, average product and marginal product © 2024 McGraw Hill 6-59  CHAPTER 6 Key Concepts to Remember 4. The division of labour and law of diminishing returns 5. Total costs, variable costs and fixed costs 6. The various relationships between the different product and cost curves © 2024 McGraw Hill 6-60