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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