Lecture Essentials of economics (3/e): Chapter 6 - Brue, McConnell, Flynn

Chapter 6

Businesses and
Their Costs

McGraw­Hill/Irwin

Copyright © 2014 by The McGraw­Hill Companies, Inc. All rights reserved1­1


The Business Population

• Plant
• Factory, farm, mine, store, website,
•
•

warehouse
Firm
• Operates one or more plants
Industry
• Group of firms that produce the same
products
6­2


Corporation Advantages

• Stocks
• Ownership shares of a corporation
• Bonds

• Liabilities of a corporation
• Limited liability

LO1

6­3


Principal­Agent Problem

• Principals
• Stockholders
• Agents
• Executives

LO1

6­4


Economic Costs

• The payment that must be made to
•
•

LO2

obtain and retain the services of a
resource

Explicit costs
• Monetary payments
Implicit costs
• Value of next best use
• Self-owned resources
• Includes normal profit

6­5


Accounting Profit and Normal Profit

• Accounting profit
•
•

LO2

= Revenue – Explicit costs
Economic profit
= Accounting profit – Implicit costs
Economic profit (to summarize)
= Total revenue – Economic costs
= Total revenue – Explicit costs –
Implicit Costs
6­6


Economic Profit

LO2

Implicit costs
(including a
normal profit)

Explicit
costs

Total Revenue

Economic
(Opportunity)
Costs

Economic
profit

Accounting
profit

Accounting
costs (explicit
costs only)

6­7


Short Run and Long Run

• Short run
• Some variable inputs
• Fixed plant
• Long run
• All inputs are variable
• Variable plant
• Firms enter and exit
LO3

6­8


Short­Run Production Relationships

• Total product (TP)
• Marginal product (MP)
Marginal product

=

Change in total product
Change in labor input

product (AP)Total product
• Average
Average product
=

LO3

Units of labor

6­9


Law of Diminishing Returns

• Resources are of equal quality
• Technology is fixed
• Variable resources are added to fixed
•
•
LO3

resources
At some point, marginal product will
fall
Rationale
6­10


The Law of Diminishing Returns
Total, Marginal, and Average Product: The Law of
Diminishing Returns

LO3

(3)
Marginal
Product (MP)

Change in
(2)/ Change
in (1)

(1)
Units of the
Variable
Resource
(Labor)

(2)
Total Product
(TP)

0

0

1

10

10

2

25

15

3

45

20

4

60

15

5

70

10

6

75

5

7

75

0

8

70

-5

(4)
Average
Product (AP),
(2)/(1)
Increasing
marginal
returns

Diminishi
ng
marginal
returns
Negative
marginal
returns

10.00
12.50
15.00
15.00
14.00
12.50
10.71
8.75

6­11


Total Product, TP

The Law of Diminishing Returns
30

TP

20
10
0

Marginal Product, MP

1

LO3

20

2

3

Increasing
Marginal
Returns

4

5

6

7

8

9

Negative
Marginal
Returns

Diminishing
Marginal
Returns

10

AP
1

2

3

4

5

6

7

8 9
MP
6­12


Short­Run Production Costs

• Fixed costs (TFC)
• Costs do not vary with output
• Variable costs (TVC)
• Costs vary with output
• Total costs (TC)
• Sum of TFC and TVC
• TC = TFC + TVC
LO4

6­13


Per­Unit, or Average, Costs

•
•

•
•

LO4

Average fixed costs

AFC = TFC/Q

Average variable costs

AVC = TVC/Q

Average total costs

ATC = TC/Q

Marginal costs

MC =ΔTC/ΔQ

6­14


Short­Run Production Costs
Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run

Total Cost Data

LO4

Average Cost Data

Marginal Cost

(5)
Average
Fixed
Cost
(AFC)
AFC =
TFC/Q

(6)
Average
Variable
Cost
(AVC)
AVC=TVC/Q

(7)
Average
Total
Cost
(ATC)
ATC =
TC/Q

(8)
Marginal Cost

(MC)
MC =ΔTC/ΔQ

(1)
Total
Product
(Q)

(2)
Total
Fixed
Cost
(TFC)

(3)
Total
Variable
Cost
(TVC)

(4)
Total Cost
(TC)
TC = TFC
+ TVC

0

$100

$0

$100

1

100

90

190

$100.00

$90.00

$190.00

$90

2

100

170

270

50.00

85.00

135.00

80

3

100

240

340

33.33

80.00

113.33

70

4

100

300

400

25.00

75.00

100.00

60

5

100

370

470

20.00

74.00

94.00

70

6

100

450

550

16.67

75.00

91.67

80

7

100

540

640

14.29

77.14

91.43

90

8

100

650

750

12.50

81.25

93.75

110

9

100

780

880

11.11

86.67

97.78

130

10

100

930

1030

10.00

93.00

103.00

150

6­15


Marginal Cost
$200

MC

150

Costs

AFC
ATC

100

AVC

50

AVC
AFC

0
LO4

1

2

3

4

5

6

7

8

9

10

Q
6­16


Long­Run Production Costs

• The firm can change all input
•
•

LO5

amounts, including plant size
All costs are variable in the long run
Long-run ATC
• Different short-run ATCs

6­17


Average Total Costs

Firm Size and Costs

ATC-1

ATC-5
ATC-2
ATC-3

ATC-4

Output

LO5

6­18


Average Total Costs

The Long­Run Cost Curve 

ATC-1

ATC-5
ATC-2
ATC-3

ATC-4

Long-run
ATC

Output

LO4

6­19

Economies and Diseconomies of 
Scale

• Economies of scale
• Labor specialization
• Managerial specialization
• Efficient capital
• Other factors
• Constant returns to scale
LO5

6­20


Economies and Diseconomies of 
Scale

• Diseconomies of scale
• Control and coordination problems
• Communication problems
• Worker alienation
• Shirking

LO5

6­21

MES and Industry Structure

• Minimum efficient scale (MES):
• Lowest level of output where longrun average costs are minimized
• Can determine the structure of the
industry

LO5

6­22


Average Total Costs

MES and Industry Structure
Diseconomies
of Scale

Constant Returns
to Scale

Economies
of Scale

Long-run
ATC
q1

q2
Output

LO5

6­23


Average Total Costs

MES and Industry Structure
Economies
of Scale

Diseconomies
of Scale

Long-run
ATC

Output

LO5

6­24


Average Total Costs

MES and Industry Structure
Economies Diseconomies
of Scale

of Scale

Long-run
ATC
Output

LO5

6­25