Production & Costs

Chapter: 21
 Agenda
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

• 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

• 21-1b The Alchian-and-Demsetz Answer

• Economists Armen Alchian and Harold Demsetz suggest
that firms are formed when benefits can be obtained from
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

• 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
 21-2 Two Sides to Every Business Firm

• 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

• 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 no
actual (monetary) payment is made
• A disagreement sometimes arises as to what
total cost should include
• It is a cost incurred as a result of a firm’s using
resources that it owns or that the owners of the firm
contribute to it
 21-2 Two Sides to Every Business Firm

• 21-2b Accounting Profit vs. Economic Profit

• Accounting Profit: The difference between total revenue
and explicit costs.
• Zero accounting profit implies that some part of total cost
has not been covered by total revenue.
• 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)
Exhibit-1 Accounting Profit & Economic Profit
 21-3 Production

• 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

• 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
input 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

• 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?
Exhibit-2 Production the Short Run and The Law of
Diminishing Marginal Returns
 21-3 Production

• 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

• 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
Exhibit-3 Marginal Physical Product & Marginal
Cost
Exhibit-3 Marginal Physical Product & Marginal
Cost
 21-3 Production

• 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 Cost of Production: Total, Average &
Marginal
• Average Fixed Cost (AFC): Total fixed cost divided by
quantity of output: AFC = TFC/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 in short-
run production and costs
Exhibit-4 Total, Average and Marginal Costs
Exhibit-4 Total, Average and Marginal Costs
Exhibit-5 A Review of Production & Costs in Short
Run
 21-4 Cost of Production: Total, Average &
Marginal
• 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
Exhibit-6 Average and Marginal Cost Curves
 21-4 Cost of Production: Total, Average &
Marginal
• 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
Exhibit-7 Tying Production to Costs
 Note: Answers to be discussed solely in
class. Please attend the classes to
optimize your learning experience!

Class Discussion:
Q/A
 Class Discussion Q/A
1. If the short run is six months, does it follow that the long run is longer than six
months? Explain your answer.

2. Suppose an MC curve falls when output is in the range from 1 unit to 10 units.
Then it flattens out and remains constant over an output range from 10 units to
20 units, after which it rises over a range from 20 units to 30 units. What does
the curve’s behavior have to say about the MPP of the variable input?

3. Price =$20, quantity = 400 units, unit cost = $15,

implicit costs = $4,000. What does economic profit equal?

4. Answer the following:

a. If TVC = $80 and AVC = 4, then what does quantity (Q) equal?
b. If total cost is $40 when Q = 2 and total cost is $45 when Q = 3, then what
does marginal cost equal?
c. What does average fixed cost equal at Q = 2 if total variable cost is $15 at Q
= 2?
 Solution to Class Discussion
1. If the short run is six months, does it follow that the long run is longer than six
months? Explain your answer.
No, short run and long run doesn’t only represent time. Short run represents the
period during which at least one input in the production process is fixed. On the
other hand, long run represents the period during which all the inputs in the
production process can be varied.
2. Suppose an MC curve falls when output is in the range from 1 unit to 10 units.
Then it flattens out and remains constant over an output range from 10 units to
20 units, after which it rises over a range from 20 units to 30 units. What does
the curve’s behavior have to say about the MPP of the variable input?
As the MC curve falls, the MPP curve rises from 1unit to 10 unit. And, as the MC
starts rising, MPP curve starts to fall
3. Price =$20, quantity = 400 units, unit cost = $15,
implicit costs = $4,000. What does economic profit equal?
Economic Profit = TR – Implicit cost- Explicit cost
Economic Profit = (20 X400) – 4000 – (400 X 15) = -2000.
Negative profit means loss of 2000
 Solution to Class Discussion
4. Answer the following:
a. If TVC = $80 and AVC = 4, then what does quantity (Q) equal?
b. If total cost is $40 when Q = 2 and total cost is $45 when Q = 3, then what
does marginal cost equal?
c. What does average fixed cost equal at Q = 2 if total variable cost is $15 at Q
= 2?
4.a. TVC = 80, AVC = TVC/ Q
4 = 80 / Q
Q = 20
b. Marginal cost = $45 -$40 = $5

c. Given that total variable cost (TVC) is $15 at Q = 2, and you know total cost (TC) is $40
from at Q = 2 from part b., you can find Total Fixed Cost (TFC) at Q = 2:
TC = TFC + TVC
$40 = TFC + $15
TFC = $25
Now, you can calculate AFC at Q = 2: AFC = $25 / 2 AFC = $12.50
So, the average fixed cost at Q = 2 equals $12.50.
 Class Discussion Q/A
5. Fill in the spaces in the following table:

Quantity Total Average Total Average Total Average Marginal

Fixed Fixed Variable Variable Cost Total Cost
Cost Cost Cost Cost Cost
0 $100 ------- 0 ------- ------- ----------

1 100 50

2 100 80

3 100 100

4 100 110
 Class Discussion Solution
5. Fill in the spaces in the following table: The steps to each calculation
were discussed in class
Quantity Total Average Total Average Total Average Marginal
Fixed Fixed Variable Variable Cost Total Cost
Cost Cost Cost Cost Cost
0 $100 ------- 0 ------- 100 ------- ----------

1 100 100 50 50 150 150 50

2 100 50 80 40 180 90 30

3 100 33.33 100 33.33 200 66.67 20

4 100 25 110 27.5 210 52.5 10

21-5 Production and Costs in the Long Run

• 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
Exhibit-8 Long-Run Average Total Cost Curve
(LRATC)
21-5 Production and Costs in the Long Run

• 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 fall
• 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

• 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
Exhibit-9 A Review of Production and Costs in the
Long Run
21-5 Production and Costs in the Long Run

• 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

• 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,
 21-6 Shifts in Cost Curves

• 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