Chapter 8: The Firm and Costs of Production PDF

CHAPTER 8 The Firm and the Costs of Production Economic Costs Economic cost refers to all the costs associated with using resources to produce goods or services. It includes everything you need to pay for to get something done, not just the money you spend. Here’s how it breaks down: 1. Explicit C...

CHAPTER 8 The Firm and the Costs of Production Economic Costs Economic cost refers to all the costs associated with using resources to produce goods or services. It includes everything you need to pay for to get something done, not just the money you spend. Here’s how it breaks down: 1. Explicit Costs: Definition: These are the actual monetary payments you make when you buy resources or services. Example: If you run a lemonade stand, the money you spend on lemons, sugar, cups, and advertising are explicit costs. You can see and measure these costs directly because they involve actual cash outflows. 2. Implicit Costs: Definition: These are the opportunity costs of using resources that you already own instead of renting or selling them. They represent the benefits you could have gained if you used those resources in a different way. Example: If you own the lemonade stand building, the implicit cost includes what you could have earned if you rented it out instead of using it for your business. It also includes your time and effort spent running the lemonade stand instead of working at a job where you could earn a salary. Normal Profit: Implicit costs also include the idea of a normal profit, which is the profit you would expect to earn for your effort and investment. If you're not making at least this amount, you might be better off doing something else. * Firms economic costs=Explicit costs + Implicit costs* Accounting Profit=Revenue - Explicit costs Economic Profit=Accounting Profit - Implicit costs TOTAL PRODUCT (TP) – The total quantity, or total output, of a particular good or service produced. Marginal Product (MP)= Change in Total Product/Change in Labour input=∆Q/ ∆L Average Product (AP)= Total Product/Units of Labour LAW OF DIMINISHING RETURNS The Law of Diminishing Returns explains what happens when you keep adding more of one resource (like workers) to a resource that can’t change (like the size of a factory or piece of land). How It Works: Imagine you have a fixed amount of space, like a small kitchen where you make cookies. At first, adding more workers (a variable factor) helps you make more cookies because everyone can work efficiently. But eventually, if you keep adding more and more workers in the same small kitchen, they start to get in each other’s way. Key Point: Diminishing Returns means that, after a certain point, each extra worker will add less and less extra output because there’s only so much space and equipment to go around. Key Assumptions: To understand how this law works, there are some important assumptions (conditions we assume to be true): 1. Resources are of Equal Quality: ○ All workers, tools, and materials being added are equally good. For example, if you’re adding workers to a factory, each worker has similar skills and abilities. 2. Technology is Fixed: ○ There are no changes in technology that would make production faster or more efficient. For example, if you’re working in a kitchen, you aren’t suddenly getting new ovens or faster mixers. 3. Variable Resources are Added to Fixed Resources: ○ The resources you can change (like workers or ingredients) are being added to resources that stay the same (like the size of the factory or the number of machines). 4. At Some Point, Marginal Product Will Fall:  ○ This means that after adding a certain number of workers or resources, the extra output (the marginal product) from each additional worker will start to decrease. Short run production costs 1. Fixed Costs (TFC): Definition: Fixed costs are costs that do not change no matter how much or how little you produce. Example: If you own a bakery, fixed costs would include things like rent for the building, insurance, and salaries for managers. Whether you bake one cake or 100 cakes, these costs stay the same. 2. Variable Costs (TVC): Definition: Variable costs are costs that change with the level of output (how much you produce). Example: For the same bakery, variable costs would include flour, sugar, eggs, and other ingredients. The more cakes you bake, the more you spend on ingredients, so these costs go up with more production and down with less production. TOTAL COSTS= TFC+TVC Average Fixed costs (AFC)= TFC/Q Average variable costs (AVC)=TVC/Q Average Total Costs (ATC)=TC/Q Marginal Cost (MC)= ∆TC/ ∆Q or ∆TVC/ ∆Q AVERAGE COSTS CURVES 1. Average Fixed Cost (AFC): Behavior: AFC falls as output increases because you’re spreading the same fixed cost over more and more units. This means that each unit carries a smaller share of the fixed cost as you produce more. Example: If your fixed cost is $100 and you make 10 items, your AFC is $10 per item. But if you make 20 items, the AFC falls to $5 per item because you’re dividing the same $100 across more items. 2. Average Variable Cost (AVC): Behavior: AVC tends to follow a U-shape: Initially, AVC falls as output increases because of increasing marginal returns — adding more workers or resources makes each one more productive. Eventually, AVC rises as output continues to increase, due to diminishing marginal returns — after a certain point, adding more workers or resources makes each one less effective because they start getting in each other’s way. Marginal Cost (MC) Marginal Cost (MC) is an important concept in economics. It tells us the extra cost of making one more unit of a product. What Marginal Cost Means: Marginal Cost shows how much total cost increases when one more unit of output is produced. It's useful because it helps businesses decide if producing an extra unit is worth the additional cost. How to Calculate Marginal Cost: 1. Look at the Change in Total Cost: Marginal cost is found by looking at how much total cost increases when you add one more unit of production. ○ Formula: MC=ΔTC/ΔQ ΔTC = Change in Total Cost ΔQ = Change in Quantity (usually by one unit) 2. Since Fixed Costs Don’t Change: Only variable costs increase when you produce more, so marginal cost can also be found by looking at the change in total variable cost. ○ Formula: MC=ΔTVC/ΔQC​where: ΔTVC = Change in Total Variable Cost Example: Imagine you’re making T-shirts: If it costs $50 to make 10 T-shirts and $54 to make 11 T-shirts, the marginal cost of making that 11th T-shirt is $4 (because the total cost increased by $4). Relationship of Marginal Cost (MC) to Average Total Cost (ATC) and Average Variable Cost (AVC) Key Relationships: 1. When MC is less than the current ATC: ○ If the marginal cost (extra cost of producing one more unit) is less than the average total cost, then the ATC will go down. ○ Example: Think of ATC as an average grade in a class. If your next test score (MC) is lower than your current average grade, it pulls your average down. 2. When MC is greater than the current ATC: ○ If the marginal cost is more than the average total cost, then the ATC will go up. ○ Example: If your next test score is higher than your current average, it will raise your overall average. 3. MC Intersects ATC and AVC at Their Minimum Points: ○ The marginal cost curve always crosses the average total cost (ATC) and average variable cost (AVC) curves at their lowest points (minimum points). ○ This is because, at the minimum point of ATC and AVC, MC is exactly equal to ATC or AVC. After this point, if MC rises, it starts to pull ATC and AVC upward. Why This Matters: Production Decision: This relationship helps businesses figure out the most efficient production level. When MC is rising but still below ATC, the business knows that it’s operating efficiently. When MC exceeds ATC, it indicates a less efficient level of production where costs are increasing. Shifts of Cost Curves 1. When the Price of a Fixed Input Increases: Fixed inputs are things that don’t change no matter how much you produce (like a building). Effect: ○ AFC and ATC shift up: Since fixed costs are now higher, when you divide them by the number of products made, the average cost goes up. ○ AVC and MC remain unchanged: Since variable costs haven’t changed, the costs for each unit produced don’t change. 2. When the Price of a Variable Input Increases: Variable inputs are things that change with the amount you produce (like ingredients for a product). Effect: ○ AVC, ATC, and MC shift up: When the price of variable inputs increases, it costs more to produce each unit. Therefore, the average variable cost, average total cost, and the cost of producing one more unit all go up. ○ AFC remains unchanged: The fixed costs (like rent) haven’t changed, so the average fixed cost stays the same. How Technology Affects Costs When a company uses better technology, it can change how much it costs to produce things. Here’s how that works: 1. Improved Technology Lowers Costs: When a company upgrades its technology (like using a new machine or software), it often makes production cheaper. This means that it costs less to make each item, which is a good thing for the business! 2. Cost Curves Shift Down: When costs go down because of better technology, the cost curves shift downward. This means that for any given level of production, the average costs (like AFC, ATC, and AVC) are now lower. So the business can produce the same amount for less money! 3. How the Shift Depends on Technology:  The direction of the curve shift can depend on whether the technology affects Fixed Costs (FC), Variable Costs (VC), or both: ○ If technology lowers Fixed Costs (like a cheaper building or equipment): AFC and ATC will shift down. This is because the fixed costs are lower when spread out over the number of units produced. ○ If technology lowers Variable Costs (like cheaper materials or faster production): AVC, ATC, and MC will shift down. This is because each unit produced costs less to make. ○ If technology lowers both Fixed and Variable Costs: All the curves (AFC, ATC, AVC, and MC) will shift down, meaning production is cheaper all around! LONG-RUN PRODUCTION COSTS Long Run vs. Short Run 1. Short Run: This is a time period when some inputs (like machinery or buildings) are fixed and can’t be changed easily. For example, if a company has a factory, it can't just build a new one overnight. 2. Long Run: In this period, firms can change all inputs. They can adjust everything they use to produce their products, including: ○ Hiring more workers ○ Buying new machinery ○ Building larger or smaller factories Choosing the Best Plant Size When firms can adjust their plant size, they can choose the best size for their production needs based on how much they want to produce and the costs involved. Here’s how this affects costs: 1. Different Plant Sizes and Costs: For every size of plant (like small, medium, or large), there will be a short-run average total cost (ATC) curve. This curve shows the average cost of producing goods at that specific plant size. Each curve represents the costs associated with a different plant capacity. 2. Plotting the Cost Curves: If you have multiple plant sizes, you can plot all of these ATC curves on a graph.  Each curve will show the relationship between the quantity produced and the average cost for that specific plant size. Visualizing the Concept ATC Curves: Each curve will typically be U-shaped, meaning: ○ At first, as you produce more, the average cost decreases because you're spreading the fixed costs over more units (this is called economies of scale). ○ After a certain point, producing more can increase average costs again (called diseconomies of scale) because the company might become too large to manage efficiently. THE LONG-RUN AVERAGE-TOTAL-COST CURVE: FIVE POSSIBLE PLANT SIZES Short-Run Cost Curves: These curves represent the average total cost for different sizes of plants when a firm is limited in how much it can change in the short term. For example, if a firm has a small plant, it has a specific ATC curve (let’s call it ATC-1). If it builds a bigger plant, it has a different ATC curve (let’s say ATC-2). Understanding the Planning Curve 1. What is the Planning Curve? ○ The planning curve refers to the long-run average total cost curve (LRATC). It shows how much it costs, on average, to produce different amounts of goods when a company can adjust everything about its production, including the size of its factory (or plant). 2. What is Unit Cost? ○ Unit cost is the average cost of producing one single item. For example, if a company spends $1,000 to produce 100 items, the unit cost is $10 per item ($1,000 divided by 100). How This Works 1. Making Changes: ○ When a company wants to increase production or change how it operates, it might need to change the size of its factory or invest in better equipment. This can take time. ○ Once they have made these adjustments and settled into their new way of producing, they can find the best size for their factory to keep costs down. 2. Finding the Best Option: ○ For example, if a company wants to produce 200 items, it looks at the planning curve to find the point that corresponds to 200 items. That  point tells them the least amount of money they can spend to produce each of those items. ○ If the curve shows that it costs $8 per item to produce 200 items at the optimal plant size, that means they can’t produce those items for any less than $8 each, given their current setup. When a company can choose from a lot of different sizes for its factory (called a plant), it helps them find the best way to produce things at the lowest cost. The long-run average total cost curve (or LRATC curve) shows how much it costs, on average, to make different amounts of products when they can change everything about how they operate. If there are many possible plant sizes, the LRATC curve looks smooth, like a gentle wave, instead of bumpy. This smooth curve means the company can easily find the cheapest option for making whatever they want because they can pick the perfect plant size for their needs Economies of Scale Definition: Economies of scale occur when a company increases its production size, leading to lower average costs for making each product. Factors Leading to Lower Average Costs: Labor Specialization: ○ As a plant gets larger, workers can specialize in specific tasks. ○ This means they become more skilled and efficient at their jobs, which speeds up production and reduces costs. Managerial Specialization: ○ A larger company can hire more managers who are experts in different areas (like marketing, finance, etc.). ○ This specialization helps the company operate more efficiently, reducing mistakes and improving decision-making. Efficient Capital: ○ Bigger plants can invest in advanced machinery and technology that can produce goods faster and with less waste. ○ This leads to lower production costs per unit. Other Factors: ○ Bulk Buying: Larger companies can purchase materials in bulk, getting discounts and reducing costs. ○ Research and Development: Bigger firms can spend more on R&D, leading to better products and processes that lower costs. Diseconomies of Scale 1. Definition: ○ Diseconomies of scale occur when a company's growth leads to higher average total costs instead of lower ones. 2. Reasons for Higher Costs: ○ Control and Coordination Problems: As a company gets bigger, it can become harder to manage everything effectively. Managers might struggle to keep track of all the departments and employees, leading to inefficiencies. ○ Communication Problems: Larger companies often have many layers of management, which can slow down communication. Important information might not get shared quickly, causing delays in decision-making and operations. ○ Worker Alienation: In a big company, individual workers may feel like just a small part of a large machine, which can decrease their motivation. When workers feel disconnected from the company's goals, they might not perform at their best. ○ Shirking: Some employees may take advantage of the size of the company and not work as hard, knowing their individual contributions are less noticeable. This lack of effort can reduce overall productivity and increase costs. Why the Long-Run Average Total Cost Curve is U-Shaped 1. Resulting U-Shape: ○ The curve starts to go down due to economies of scale, reaches a low point, and then rises again due to diseconomies of scale. ○ This creates the U-shape of the long-run average total cost curve. Minimum Efficient Scale (MES) 1. Definition: ○ Minimum Efficient Scale (MES) is the lowest level of production at which a company can produce goods at the lowest average cost. 2. Importance of MES: ○ Cost Minimization: At this point, the company is using its resources efficiently, which means it is not wasting money on production costs. 3. Impact on Industry Structure: ○ Natural Monopoly: If the MES is very large, it means that the long-run average costs are minimized when only one firm produces the product. This often leads to a natural monopoly, where a single company can provide the product more efficiently than multiple companies could. ○ Number of Producers: The MES can help determine how many companies can exist in the industry. If the MES is small, many producers can compete in the market. If the MES is large, there may only be a few producers, or possibly just one, because only a large company can operate efficiently at that scale. 4. Size of Firms: ○ The MES also influences whether firms in the industry will be large, small, or of different sizes, depending on how much output they need to produce to minimize their costs. Rising Gasoline Prices 1. Impact on Firms: ○ Increased Costs: When gasoline prices rise, it increases the costs for firms in several ways: Short-Run Variable Costs: These are costs that change with the level of production. Higher gasoline prices mean higher transportation costs, which can increase variable costs.  Marginal Costs: This is the cost of producing one more unit of a product. As variable costs rise, the marginal costs also increase, making it more expensive for firms to produce additional items. Average Total Costs: As both variable and marginal costs rise, the average total costs (the total cost per unit produced) also go up, impacting overall profitability. The Version Stamping Machine 1. Description: ○ A metal-stamping machine is used to cut and shape raw sheets of steel into parts like automobile hoods and fenders. 2. Efficiency: ○ Speed: This new stamping machine allows automakers to create parts in just 5 minutes, compared to 8 hours with older stamping presses. ○ Benefits: Increased Productivity: Faster production times mean that automakers can produce more parts in a shorter period, increasing overall efficiency. Cost Savings: By reducing the time it takes to make parts, companies can lower their labor costs and increase their output, which can help offset rising costs from other areas (like gasoline). Successful Start-Up Firms 1. Lower Costs Over Time: ○ When a new company (or start-up) begins, it often starts with high costs. But as it grows and gets better at what it does, its average costs to make each product usually go down over the years. This happens because they learn how to operate more efficiently and make more products. 2. Minimum Efficient Scale (MES): ○ The goal for these firms is to reach a point called Minimum Efficient Scale. This is the level of production where they can make items at the lowest average cost. Once they reach this point, they can produce efficiently without wasting resources. Aircraft and Concrete Plants in Canada 1. Few Plants: ○ In Canada, there are only two major plants that make aircraft and concrete, and they are located in Toronto and Montreal. Both are run by a company called Bombardier. 2. Small Size Efficiency: ○ These plants can produce efficiently without needing to be very large. This means they don’t have to expand a lot to keep their costs down. They reach their best production efficiency at a smaller size compared to other industries.