firm behavior and the organization of industry

firm behavior and the organization of industry

1. 1
The Costs of Production
Chapter 13
PART FIVE: FIRM BEHAVIOR
AND THE ORGANISATION OF
INDUSTRY

2. 2
What did we learn so far?
•Below is a summary of the first half of the semester
•Part One introduced us to economics
–Ten principles (Ch.1); Thinking like an
economist (Ch.2); Exchange and trade (Ch.3)
•Part Two told us how markets work
–Supply and Demand (Ch.4); Elasticities (Ch.5);
Markets and government policies (Ch.6)
•Part Three introduced welfare and efficiency
–Consumer and Producer surplus(Ch.7); Costs of
taxation (Ch.8); International trade (Ch.9)
•Part Four looked at the public sector
–Externalities (Ch.10); Public goods and common
resources (Ch.11); Tax systems (Ch.12)

3. 3
What do we learn in this book?
•With Part Four, we finished our general introduction
to the science of economics
•Now we go into the details of microeconomics
•Millions of producer firms, of all sizes and kinds,
producing all types of goods or services constitute
the backbone of a modern market economy
•Some firms employ hundreds of thousands, operate
globally and are household names everywhere
•Others employ very few people and may not even be
known locally
•Yet, they must have many characteristics in common
to coexist in the market place
•It is time we take a close look at them

4. 4
Plan of Part Five
•Ch.13 analyses the cost structure of producers and
defines all the cost elements upon which we build
the remaining chapters
•The cost structure established in Ch.13 will be used
in the remaining chapters
•Ch.14 establishes the determinants of supply in
markets with a very high degree of competition
•Ch. 15 looks at the extreme case of a single supplier
in a market: monopoly
•Ch. 16 deals with markets where a a small number of
large firms dominate: oligopoly
•Ch. 17 takes the case of fierce competition among
large number of firms: monopolistic competition

5. 5
Law of supply and firm’s objective
•Remember the Law of Supply
•Firms are willing to produce and sell a greater
quantity of a good or service when its price is higher
and a smaller quantity when its price is lower
•This results in a supply curve that slopes upward
•The question becomes: why?
•We start by establishing the objective of the firm
•Firms exist to make as much money as possible for
their owners
•In other words, the economic goal of the firm is to
maximise its profits
•“Profit maximising firm” is a key concept for what
follows

6. 6
Revenue, cost and profit
•To see how firms maximise profits, we must begin
by defining the flows of income and expenditure of
the firm that results in profits
•Profits will be the difference between the revenues
and the costs of the firm
•Total Revenue is the amount that the firm receives
for the sale of its product
•Total cost is the amount that the firm pays to buy
inputs for production
•Profit is the amount a seller is paid minus its costs
Profit = Total Revenue – Total Cost
•For economic theory, profit is identical with the
producer surplus of Ch.7

7. 7
On measuring costs
•The way economists handle costs differs from the
way accounting or tax authorities do
•Opportunity costs:
–This is very important for economists even though
it is not so relevant for accountants
– A firm’s costs of production include all the
opportunity costs of the inputs used during the
production of its output of goods and services
•Explicit and implicit costs:
–Explicit costs involve a direct money outlay for
factors of production
–Implicit costs do not involve a direct money outlay
but are nevertheless real costs for the firm

8. 8
Profit: economic versus accounting
•The defition of profits differ:
–Economists include all opportunity costs when
measuring costs
–Accountants measure the explicit costs but as a
rule ignore the implicit costs
•The firm earn economic profits when total revenue
exceeds both explicit and implicit costs
•Economic profit is smaller than accounting profit
•The opportunity cost of capital invested and labour
spent has to be taken into account when we calculate
economic profit
•From this perspective a firm may have losses
economically despite showing accounting profit

9. 9
Economic profit versus
accounting profit
Revenue
Total
opportunity
costs
How an Economist
Views a Firm
Explicit
costs
Economic
profit
Implicit
costs
Explicit
costs
Accounting
profit
How an Accountant
Views a Firm
Revenue

10. 10
Cost and production function
•A firm’s costs reflect its production process
•In order to understand the cost structure we must
understand the relation between physical inputs such
as equipment, raw materials and labour and the
physical output obtained
•For this purpose economists use the concept of the
production function
•Which shows the relationship between quantity of
inputs used to make a good and the quantity of
output of that good
•We start with a fixed amount of machinery and
equipment and see the impact on production of an
increase in the amount of workers employed

11. 11
Quantity of
Output
(cookies
per 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
A production function

12. 12
Marginal product
•The production function constitutes the basis upon
which the cost structure of the firm is built
•Understanding by how much output rises in case of
an additional input is very important
•The marginal product of an input in production is
the increase in the quantity of output obtained from
an additional unit of that input
•This is a key concept of the theory of the firm
•It will be used again and again in the next chapters
inputAdditional
outputAdditional
roduct=Marginal p

13. 13
Diminishing marginal product
•In the production function example above, each new
worker had a lower 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 at a
firm, each additional worker contributes less and less
to production because the firm has a limited amount
of equipment
•The slope of the production function measures the
marginal product of an input, such as a worker
•When the marginal product declines, the production
function becomes flatter

14. 14
Production function and total costs
•Production function allows us to understand the cost
structure of the firm
•Because pricing decisions are determined by the
relation between the quantity a firm can produce and
how much it costs to produce that quantity
•The total-cost curve shows this relationship
graphically
•Total-cost curve is a mirror image of the production
function
•After total-costs we will define marginal cost and
different kinds of average costs
•Almost all of the decisions by the producers are
based on different costs of production

15. 15
A production function and total
cost
Number of
Workers
Output
(Quantity)
Marginal
Product of
Labor
Cost of
Factory
Cost of
Workers
Total Cost
of Inputs
0 0 $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80

16. Total-cost curve
Total
Cost
$80
70
60
50
40
30
20
10
Quantity of Output
(cookies per hour)
0 2040 1401201008060
Total-cost
curve

17. 17
Various measures of cost
•Costs of production of the firm can be divided into
two basic categories:
–Fixed costs
–Variable costs
•Total Fixed costs are those costs that do not vary with
the quantity of output produced
•Total Variable costs are those costs that do vary with
the quantity of output produced.
•Family of Costs:
–Total Fixed Costs (TFC)
–Total Variable Costs (TVC)
–Total Costs (TC)
TC = TFC + TVCTC = TFC + TVC

18. Family of total costs
QuantityTotal CostFixed CostVariable Cost
0 $ 3.00 $3.00 $ 0.00
1 3.30 3.00 0.30
2 3.80 3.00 0.80
3 4.50 3.00 1.50
4 5.40 3.00 2.40
5 6.50 3.00 3.50
6 7.80 3.00 4.80
7 9.30 3.00 6.30
8 11.00 3.00 8.00
9 12.90 3.00 9.90
10 15.00 3.00 12.00

19. 19
Average costs
•Firms attach a big value to their average costs
•Average costs can be determined by dividing the
firm’s costs by the quantity of output produced
•The average cost is the typical cost of each unit of
product
•Obviously, fixed, variable and total costs can also be
expressed as averages, giving us the following
family of average costs:
–Average Fixed Costs (AFC)
–Average Variable Costs (AVC)
–Average Total Costs (ATC)
ATC = AFC + AVC

20. 20
Family of average costs
AFC=
Fixed cost
Quantity
=
FC
Q
AVC=
Variable cost
Quantity
=
VC
Q
ATC=
Total cost
Quantity
=
TC
Q
AFC=
Fixed cost
Quantity
=
FC
Q
AVC=
Variable cost
Quantity
=
VC
Q
ATC=
Total cost
Quantity
=
TC
Q

21. Family of average costs
Quantity AFC AVC ATC
0 — — —
1 $3.00 $0.30 $3.30
2 1.50 0.40 1.90
3 1.00 0.50 1.50
4 0.75 0.60 1.35
5 0.60 0.70 1.30
6 0.50 0.80 1.30
7 0.43 0.90 1.33
8 0.38 1.00 1.38
9 0.33 1.10 1.43
10 0.30 1.20 1.50

22. 22
Marginal cost
•Economists attach a big value to marginal cost of
production in firms
•Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production
•In plain language, marginal cost helps answer the
following question:
•How much does it cost to produce an additional unit
of output?
ΔQ
ΔTC
=
quantityin Change
cost in total Change
=MC

23. 23
Marginal cost
QuantityTotal CostMarginal CostQuantityTotal CostMarginal Cost
0 $3.00 —
1 3.30$0.30 6 $7.80$1.30
2 3.800.50 7 9.301.50
3 4.500.70 8 11.001.70
4 5.400.90 9 12.901.90
5 6.501.10 10 15.002.10

24. 24
Shape of the marginal cost curve
•Now we must establish how cost curves behave on
our graphs
•We begin with the marginal cost curve
•Marginal cost curve rises with the amount of output
produced
•Due to the effect of diminishing marginal product
•At low levels of output, an increase in production
will occur at a relatively small cost
•Increasing output is more costly when the amount
being produced is already high
•Usually we show marginal cost as a curve that first
declines then rises
•But at times only as a rising curve

25. Shape of the marginal cost curve
Quantity of Output
(bagels per hour)
Costs
$3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
01 432 765 98 1413121110
MC

26. 26
Shape of average cost curves
•Average cost curves have different shapes
•The average total-cost curve is U-shaped
•In other words, at very low levels of output average
total cost is high because fixed cost is spread over
only a few units
•Average total-cost declines as output increases
•Average total cost starts rising because average
variable cost rises substantially
•Average fixed cost curve is always downward
•As its name implies, larger quantities of output means
smaller fixed costs per unit produced
•Average variable cost curve reflects the marginal cost
curve and behaves like it

27. 27
Shape of average cost curves
Quantity of Output
(bagels per hour)
Costs
$3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
01 432 765 98 1413121110
ATC
AVC
AFC

28. 28
Relationship between marginal cost
and average total-cost
•There exists a very peculiar and important relation
between marginal and average total-cost curves
•Whenever marginal cost is less than average total-
cost, average total-cost is falling
•Whenever marginal cost is greater than average total-
cost, average total-cost is rising
•The marginal cost curve intersects with the average
total-cost curve at the efficient scale
•Efficient scale is the quantity that minimizes average
total-cost
•In other words MC curve crosses the ATC curve at
the minimun point of the latter

29. 29
Relationship between marginal cost
and average total cost
Quantity of Output
(bagels per hour)
Costs
$3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
01 432 765 98 1413121110
MC
ATC

30. 30
Costs in the long run
•The cost structure we studied until now is based on
the characteristics of the production function
•Where we allowed changes in one input while the
other inputs (i.e. stock of capital) were constant
•In the long run all inputs become variables
•For many firms, the division of total costs between
fixed and variable costs depends on the time horizon
being considered
•In the short run some costs are fixed
•In the long run fixed costs become variable costs
•Because many costs are fixed in the short run but
variable in the long run, a firm’s long-run cost curves
differ from its short-run cost curves

31. 31
Scale and long-run costs
•Once we allow the stock of capital such as
machinery and equipment to be variable new issues
appear
•An increase in the size or scale of the firm may have
vaıious effects on its cost
•Economies of scale occur when long-run average
total-cost falls as the quantity of output increases
•Diseconomies of scale occur when long-run average
total-cost rises as the quantity of output increases
•Constant returns to scale occur when long-run
average total-cost stays the same as the quantity of
output increases

32. 32
Long-run average-total costs
Quantity of
Cars per Day
0
Average
Total
Cost
ATC in short
run with
small factory
ATC in short
run with
medium factory
ATC in short
run with
large factory

33. 33
U-shaped long-run average total
cost
Quantity of
Cars per Day
0
Average
Total
Cost
Economies
of scale
ATC in long run
Diseconomies
of scale
Constant
returns to
scale

34. 34
Conclusion
•The goal of firms is to maximize profit, which
equals total revenue minus total cost
•Economists calculate opportunity costs of all inputs
even there is no apparent payment for some of them
•Accounting practise covers only explicit cost but not
implicit opportunity costs
•Economic profit is usually smaller than accounting
profit
•The production function establishes the basis upon
which costs are calculated
•It shows the relation between the quantities of inputs
and the quantity of output
•Diminishing marginal product is assumed

35. 35
Conclusion
•A firm has fixed and variable costs: fixed costs don’t
vary with quantities produced and variable costs do
•Average total-cost is total-cost divided by the
quantity of output
•Marginal cost is the amount by which total cost rises
if output is increased by one unit
•Shapes of the cost curves are very important for
economic analysis
•Marginal cost generally rises with the quantity of
output
•Average total-cost first falls as output increases and
then eventually rises with further output

36. 36
Conclusion
•Average fixed cost falls as output increases
•Average variable cost is closely related to the
marginal cost and behaves similar to it
•A firm’s costs often depend on the time horizon
being considered
•Many costs are fixed in the short run but variable in
the long run
•Long-run changes in the size and scale of the firm
have an impact on its cost structure
•When the level of production changes, average total-
cost may rise more in the short run than in the long
run