Chapter 6 The Organization and Costs of Production 1.

Chapter 6

The Organization and Costs of Production

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6.1 Businesses: terminology

• A plant

• A firm

• An industry

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Multi-plant firms

• Horizontally integrated

• Vertically integrated

• Conglomerate

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The Firm and the Business Sector Legal Forms of Businesses:

• Sole Proprietorship• Partnership• Corporation

What are the advantages of each?

Disadvantages?

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Principal-agent problem

• Principals are stockholders hire agents ➔to run their business

What is the problem?

interests of agent and goals of principals are not always in agreement conflict of ➔interest

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Principal-agent problem in the real world

Executive stock options in 1990s to correct principal-agent problem led to fraud and abuse, as in the Enron and WorldCom cases.

Deceptive accounting practices were used to inflate company stock prices so that executives could sell their shares and reap huge windfalls.

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6.2 Economic Costs

• Explicit costs– payments to non-owners for resources they

supply

• Implicit costs– money payments the self‑employed resources

could have earned in their best alternative employments

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EconomicEconomicProfitsProfits

Implicit costs(including a

normal profit)

ExplicitExplicitCostsCosts

AccountingAccountingcosts (explicitcosts (explicit

costs only)costs only)

AccountingAccountingProfitsProfits

Ec

on

om

ic (

op

po

rtu

nit

y) C

os

tsE

co

no

mic

(o

pp

ort

un

ity)

Co

sts

TotalTotalRevenueRevenue

Figure 6-1 Economic Profit vs. Accounting Profit

Normal profits• an implicit cost because they are the

minimum payments required to keep the owner’s entrepreneurial abilities self‑employed.

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Example

• Start your own business– use $20,000 of savings (was in bank earning

$1,000/year in interest)– give up present job (earned $35,000 / year)– use office space that you own (previously rented

out for $500/month)– your entrepreneurial talent is worth $6,000 per

year in other business endeavors

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Example continued

• After 1 year: total revenue is $150,000.

• Calculate the accounting profit.

• Calculate the economic profit.

• Calculate the normal profit.

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Short Run and Long Run

• Short Run– Fixed Plant

• Long Run– Variable Plant

6.3 Short-Run Production Relationships

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• Total Product (TP)– total quantity produced

• Marginal Product (MP)

• Average Product (AP)

change in total productchange in total productchange in labour inputchange in labour input==

total producttotal productunits of labourunits of labour==

Calculate MP & AP

Units of variable resource (labour)

Total product (TP)

Marginal product (MP)

Average Product (AP)

012345678

01023395262656561

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Marginal and Average Values

If the average value is rising, the marginal value must be ABOVE the average valueIf the average value is falling, the marginal value must be BELOW the average value

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Relationships in previous slide

a. When marginal product begins to diminish, the rate of increase in total product stops accelerating and grows at a diminishing rate.

b. The average product declines at the point at which the marginal product slips below average product (AP is max where MP=AP)

c. Total product declines when the marginal product becomes negative.

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6.4 Short-Run Production CostsFixed Costs

do not vary with changes in output

Variable Costschange with changes in output

Total Costsum of fixed and variable costs

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Per-Unit, or Average, Costs

QTFC

AFC

QTVC

AVC

AVCAFCQ

TVCQ

TFCQ

TCATC

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Marginal Cost

Marginal cost is the extra, or additional, cost of producing one more unit of output

Q in changeTC in change

MC

Illustrated…Illustrated…

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Short-run costs for a firm

TP(Q)

TFC TVC TC AFC AVC ATC MC

012345678

606060606060606060

04585

120150185225270325

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Cost curves can shift

When?

change in resource prices

change in technology

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Example

How do the following changes affect AFC, AVC, TC, & MC?

1.wage rates rise

2.Price of steel falls

3.Increase in property insurance rate

4.New technology to improve productivity

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6.5 Long-Run Production Costs

What will costs look like when the firm can choose the best plant size for any given situation?For every plant capacity size, there is a short-run ATC curve All such plant capacities can be plotted...

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Figure 6-7

0 10 20 30 40 50 60 70 80 90

Output

Avera

ge T

ota

l C

osts

ATC-1 ATC-2ATC-3

ATC-4

ATC-5

Choose the best plant for every output levelChoose the best plant for every output levelChoose the best plant for every output levelChoose the best plant for every output level

The Long-Run Average-Total-Cost Curve

These choices determine the LRATC curveThese choices determine the LRATC curveThese choices determine the LRATC curveThese choices determine the LRATC curve

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Figure 6-8

Output

Ave

rage

Tot

al C

osts

The number of possible plant sizes is virtually The number of possible plant sizes is virtually unlimitedunlimited

The number of possible plant sizes is virtually The number of possible plant sizes is virtually unlimitedunlimited

The Long-Run Average-Total-Cost Curve

The LRATC curve just envelops the short-run cost The LRATC curve just envelops the short-run cost curvescurves

The LRATC curve just envelops the short-run cost The LRATC curve just envelops the short-run cost curvescurves

LRATC

Economies of scale

• explain the downward sloping part of the long‑run ATC curve

• Why does this occur?

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Diseconomies of scale

• may occur if a firm becomes too large as illustrated by the rising part of the long‑run ATC curve.

• Why does this occur?

Constant returns to scale are a possibility.33

Minimum efficient scale

• defines the smallest level of output at which a firm can minimize its average costs in the long run.

• depends on the industry.

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Sunk Costs

• should be disregarded in decision making.

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