copyright © 2004 south-western/ what are costs? a firm’s objective the economic goal of a firm is...

Copyright © 2004 South-Western/

WHAT ARE COSTS?

• A Firm’s Objective• The economic goal of a firm is to maximize profits.


Total Revenue, Total Cost, and Profit

• Total Revenue

• The amount a firm receives for the sale of its output.

• Price times Quantity (TR)

• Total Cost

• The market value of the inputs a firm uses in production.

• Opportunity cost, implicit and explicit (TC)Profit = TR- TCProfit = TR- TC


Costs as Opportunity Costs

• A firm’s cost of production includes all of the opportunity costs of making its output of goods and services.

• Explicit and Implicit Costs• A firm’s cost of production include explicit costs and

implicit costs.• Explicit costs are input costs that require a direct outlay of

money by the firm. • Implicit costs are input costs that do not require an outlay of

money by the firm.


Economic Profit versus Accounting Profit

• Economic profit is total revenue minus total cost, including both explicit and implicit costs.

• Accounting profit is the firm’s total revenue minus only the firm’s explicit costs.

• When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.

• Joe’s Boat Factory Example.


SHORT RUN AND LONG RUN

• In the short run, at least one factor of production (input) is fixed (cannot be changed).

-fixed costs and variable costs

-kapital constrained (add workers to fixed kapital stock)

• In the long run, all factors of production (inputs) are variable (can be changed).

-all costs are variable (increase entire scale of operation)


SHORT RUN AND LONG RUN

• Firm is nearly always in the Short Run

-Long Run envelopes series of Short Runs

• Short Run/Long Run time periods vary across industry

-Kapital intensive industry is likely to be longer period

-Hot Dog Vendor vs. General Motors


Fixed and Variable Costs (Short Run)

• Fixed costsFixed costs are those costs that do not vary with the quantity of output produced.

• Variable costsVariable costs are those costs that do vary with the quantity of output produced.

CostsFixed Costs (FC)

Variable Costs (VC)

Total Costs (TC)

TC = FC + VC


PRODUCTION AND COSTS

• The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

• The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.

• MPL = change in output / change labor


Production Function Characteristics

• Diminishing Marginal Product

• Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.

• Example: As more and more workers are hired, each additional worker contributes less to production because the firm has a limited amount of equipment. -Kapital constrained


Production Function and Total Cost: Hungry Helen’s Cookie Factory


Figure 2 Hungry Helen’s Production Function

Copyright © 2004 South-Western

Quantity ofOutput

(cookiesper hour)

150

140

130

120

110

100

90

80

70

60

50

40

30

20

10

Number of Workers Hired0 1 2 3 4 5

Production function


From the Production Function to the Total-Cost Curve• The firm uses inputs to produce output

-the production function

• The total-cost curve graphically shows the relationship between the amount of output produced by the firm and the cost associated with this production.


Marginal Cost

• Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.

• How much does it cost to produce one additional unit?

M CTCQ

( ch an g e in to ta l co st)

(ch an g e in q u an tity )

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Production Function and Total Cost: Hungry Helen’s Cookie Factory


Figure 3 Hungry Helen’s Total-Cost Curve


TotalCost

$80

70

60

50

40

30

20

10

Quantityof Output

(cookies per hour)

0 10 20 30 15013011090705040 1401201008060

Total-costcurve


Marginal Cost Characteristics

• Marginal cost eventually rises as output increases.

• This reflects diminishing marginal product.


Marginal Product and Marginal Cost

• A more likely story as a firm adds labor to a fixed kapital stock….

• A firm will initially experience increasing marginal product. -teamwork and specialization, grow into factory

• But eventually a firm will experience decreasing marginal product and rising marginal cost.-grow out of factory


Big Bob’s Production & Costs


Figure 6 Big Bob’s Cost Curves


(a) Total-Cost Curve

$18.00

16.00

14.00

12.00

10.00

8.00

6.00

4.00

Quantity of Output (bagels per hour)

TC

42 6 8 141210

2.00

TotalCost

0

Big Bob’s Production Function?


Economies and Diseconomies of Scale (Long Run)

• Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases.

• Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases.

• Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases

Figure 7 Average Total Cost in the Short and Long Run


Quantity ofCars per Day

0

AverageTotalCost

1,200

$12,000

1,000

10,000

Economiesof

scale

ATC in shortrun with

small factory


medium factory


large factory ATC in long run

Diseconomiesof

scale

Constantreturns to

scale


Economies and Diseconomies of Scale

• If an industry exhibits economies of scale over a large range then we would expect that market to be served by one or at most a few large firms.

• If an industry exhibits diseconomies of scale early on then we would expect that market to be served by many small competing firms.


Summary

• The goal of firms is to maximize profit, which equals total revenue minus total cost.

• When analyzing a firm’s behavior, it is important to include all the opportunity costs of production.

• Some costs are explicit while other costs are implicit; total opportunity cost includes both.


Summary

• A firm’s costs reflect its production process.

• A typical firm’s production function exhibits the property of diminishing marginal product.


Summary

• A firm’s total costs are divided between fixed costs and variable costs.

• Fixed costs do not change when the firm alters the quantity of output produced.

• Variable costs do change as the firm alters quantity of output produced.


Summary

• Marginal cost is the amount by which total cost would rise if output were increased by one unit.

• The marginal cost eventually rises with the quantity of output in the short run.

• Grow into factory, grow out of factory.

copyright © 2004 south-western/ what are costs? a firm’s objective the economic goal of a firm is...

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