slides prepared by dr. amy peng, ryerson university chapter 6 the organization and costs of...
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Slides prepared by Dr. Amy Peng, Ryerson University
CHAPTER 6 CHAPTER 6 THE THE
ORGANIZATION ORGANIZATION AND COSTS OF AND COSTS OF PRODUCTIONPRODUCTION
Part Two: Microeconomics Part Two: Microeconomics of Product Marketsof Product Markets
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6 2
In this chapter you will learn:In this chapter you will learn:
6.1 The various organizational forms a firm can take
6.2 What economic costs are6.3 About a firm’s short-run
production relationships6.4 About a firm’s short-run
production costs6.5 The link between a firm’s size
and costs in the long run
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.1 3
The Firm and the Business SectorThe Firm and the Business Sector
Different organizational structures:
1. Plant2. Firm 3. Industry
• Horizontal Horizontal combinationscombinations• Vertical combinationsVertical combinations• ConglomeratesConglomerates
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.1 4
The Firm and the Business Sector The Firm and the Business Sector
• Legal Forms of Businesses:1. Sole Proprietorship2. Partnership3. Corporation
• Advantages of Corporations• The Principal-Agent Problem
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2 5
Opportunity CostExplicit Costs• payments a firm must makeImplicit Costs• opportunity costs of firm’s own
resources• include normal profits
Economic CostsEconomic Costs
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2 6
Total RevenueTotal Revenue $120,000$120,000 Cost of TCost of T-- shirtsshirts $40,000$40,000 Clerk's salaryClerk's salary $18,000$18,000 UtilitiesUtilities $ 5,000$ 5,000 Total (explicit) costsTotal (explicit) costs $ 63,000$ 63,000 Accounting ProfitAccounting Profit $ 57,000$ 57,000
Normal Profit as a CostNormal Profit as a Cost
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2 7
Total RevenueTotal Revenue $120,000$120,000 Cost of TCost of T-- shirtsshirts $40,000$40,000 Clerk's salaryClerk's salary $18,000$18,000 UtilitiesUtilities $ 5,000$ 5,000 Total (explicit) costsTotal (explicit) costs $ 63,000$ 63,000 Accounting ProfitAccounting Profit $ 57,000$ 57,000
Normal Profit as a CostNormal Profit as a Cost
Forgone interestForgone interest $ 1,000$ 1,000 Forgone rentForgone rent $ 5,000$ 5,000 Forgone wagesForgone wages $2$222,000,000 Normal profitNormal profit $ 5,000$ 5,000 TotalTotal implicit implicit ccostsosts $ 3$ 333,000,000 Economic profitEconomic profit $ 24,000$ 24,000
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2 8
Normal Profit as a CostNormal Profit as a Cost
• Costs of production include all costs– explicit– implicit– including a normal profit
required to attract and retain factors of production
Economic profit = total revenue – economic costEconomic profit = total revenue – economic costEconomic profit = total revenue – economic costEconomic profit = total revenue – economic cost
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2 9
EconomicEconomicProfitsProfits
Implicit costsImplicit costs(including a(including a
normal profit)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 Figure 6-1 Economic Profit vs. Accounting ProfitEconomic Profit vs. Accounting Profit
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3 10
Short Run and Long RunShort Run and Long Run
• Short Run– Fixed Plant
• Long Run– Variable Plant
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.2 11
• 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==
Short-Run Production Short-Run Production RelationshipsRelationships
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3 12
Law of Diminishing Returns• marginal product eventually
diminishes
Short-Run Production Short-Run Production RelationshipsRelationships
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3 13
Units of
labourTP MP AP
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 70
change in total productchange in total product
change in labour inputchange in labour inputMP=MP=
Table 6-1Table 6-1Total, Marginal, and Average ProductTotal, Marginal, and Average Product
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3 14
Units of labour
TP MP AP
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 70
1010
1515
2020
1515
1010
55
00
-5-5
Increasing marginal Increasing marginal returns returns
Increasing marginal Increasing marginal returns returns
Diminishing Diminishing marginal returnsmarginal returns
Diminishing Diminishing marginal returnsmarginal returns
Negative marginal Negative marginal returnsreturns
Negative marginal Negative marginal returnsreturns
Total, Marginal, and Average Total, Marginal, and Average ProductProduct
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3 15
Units of labour
TP MP AP
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 70
1010
1515
2020
1515
1010
55
00
-5-5
10.0010.00
12.5012.50
15.0015.00
15.0015.00
14.0014.00
12.5012.50
10.7110.71
8.758.75
total producttotal product
total labour inputtotal labour inputAP=AP=
Total, Marginal, and Average Total, Marginal, and Average ProductProduct
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3 16
0
25
50
75
0 1 2 3 4 5 6 7 8 9
Quantity of labour
Tot
al P
rodu
ct, T
P
0
10
20
0 1 2 3 4 5 6 7 8 9
Quantity of labour
MP
& A
P
APAP
MPMP
TPTP
increasing
marginalreturns
diminishingmarginal returns
negative marginal returns
Figure 6-2Figure 6-2
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3 17
Marginal and Average ValuesMarginal and Average Values
• If the average value is rising, the marginal value must be ABOVE the average value
• If the average value is falling, the marginal value must be BELOW the average value
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.3 18
Marginal and Average ValuesMarginal and Average Values
0
10
20
0 1 2 3 4 5 6 7 8 9
Quantity of labour
MP
& A
P
APAP
MPMP
MPMP>AP>APMPMP>AP>AP
MPMP<AP<APMPMP<AP<APAverage Average
value value risingrising
Average Average value value risingrising
Average value Average value fallingfalling
Average value Average value fallingfalling
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 19
Fixed, Variable, and Total CostsFixed, Variable, and Total Costs
• Fixed Costs– do not vary with changes in output
• Variable Costs– change with changes in output
• Total Cost– sum of fixed and variable costs
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 20
Per-Unit, or Average, CostsPer-Unit, or Average, Costs
QTFC
AFC
QTVC
AVC
AVCAFCQ
TVCQ
TFCQ
TCATC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 21
Marginal CostMarginal Cost
• Marginal cost is the extra, or additional, cost of producing one more unit of output
Q in changeTC in change
MC
IllustratedIllustrated……
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 22
100
100
100
100
100
100
100
100
100
100
100
Q TFC TVC TC AFC AVC ATC MC
0
1
2
3
4
5
6
7
8
9
10
0
90
170
240
300
370
450
540
650
780
930
100100190190
270270
340340
400400
470470550550
640640
750750
880880
10301030
TC=TFC + TVCTC=TFC + TVCTC=TFC + TVCTC=TFC + TVC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 23
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
$1,000
0 2 4 6 8 10
Q
Cos
ts
TFC
Total Cost is the Sum of Fixed Cost and Total Cost is the Sum of Fixed Cost and Variable CostVariable Cost
Figure 6-3
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 24
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
$1,000
0 2 4 6 8 10
Q
Cos
ts
TFC
TVC
TC
Total Cost is the Sum of Fixed Cost and Total Cost is the Sum of Fixed Cost and Variable CostVariable Cost
Add vertically to get TCAdd vertically to get TCAdd vertically to get TCAdd vertically to get TC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 25
Q TFC TVC TC AFC AVC ATC MC
0 100 0
1 100 90
2 100 170
3 100 240
4 100 300
5 100 370
6 100 450
7 100 540
8 100 650
9 100 780
10 100 930
100100190190
270270
340340
400400
470470550550
640640
750750
880880
10301030
100100
505033.3333.33
2525
2020
16.6716.67
14.2914.29
12.5012.50
11.1111.11
1010
AFC=TFC / QAFC=TFC / QAFC=TFC / QAFC=TFC / Q
9090
85858080
7575
7474
7575
77.1477.14
81.2581.25
86.6786.67
9393
AVC=TVC / QAVC=TVC / QAVC=TVC / QAVC=TVC / Q
190190
135135113.33113.33
100100
9494
91.6791.67
91.4391.43
93.7593.75
97.7897.78
103103
ATC=TC / QATC=TC / QATC=TC / QATC=TC / Q
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 26
Q TFC TVC TC AFC AVC ATC MC
0 100 0
1 100 90
2 100 170
3 100 240
4 100 300
5 100 370
6 100 450
7 100 540
8 100 650
9 100 780
10 100 930
100100190190
270270
340340
400400
470470550550
640640
750750
880880
10301030
100100
505033.3333.33
2525
2020
16.6716.67
14.2914.29
12.5012.50
11.1111.11
1010
9090
85858080
7575
7474
7575
77.1477.14
81.2581.25
86.6786.67
9393
190190
135135113.33113.33
100100
9494
91.6791.67
91.4391.43
93.7593.75
97.7897.78
103103
9090
8080
7070
6060
7070
8080
9090
110110
130130
150150
MC=MC=TC / TC / QQMC=MC=TC / TC / QQ
Note: MC is graphed at average QNote: MC is graphed at average QNote: MC is graphed at average QNote: MC is graphed at average Q
2.52.5
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 27
$0
$50
$100
$150
$200
0 2 4 6 8 10
Q
Cos
ts
AFC
AFC continually declines AFC continually declines as fixed cost is spread as fixed cost is spread over more and more over more and more
unitsunits
AFC continually declines AFC continually declines as fixed cost is spread as fixed cost is spread over more and more over more and more
unitsunits
AFC, AVC, and ATCAFC, AVC, and ATC
Figure 6-5
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 28
$0
$50
$100
$150
$200
0 2 4 6 8 10
Q
Cos
ts
AFC
AVCAVC
AVC is U-shaped: it AVC is U-shaped: it starts to rise when starts to rise when
AP starts to fallAP starts to fall
AVC is U-shaped: it AVC is U-shaped: it starts to rise when starts to rise when
AP starts to fallAP starts to fall
AFC, AVC, and ATCAFC, AVC, and ATC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 29
$0
$50
$100
$150
$200
0 2 4 6 8 10
Q
Cos
ts
AFCAFC
ATC
AVCAVC
Get ATC by Get ATC by vertically vertically
summing AFC summing AFC and AVCand AVC
Get ATC by Get ATC by vertically vertically
summing AFC summing AFC and AVCand AVC
AFC, AVC, and ATCAFC, AVC, and ATC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 30
$0
$50
$100
$150
$200
0 2 4 6 8 10
Q
Cos
ts
AFCAFC
ATC MC
AVCAVC
MC cuts ATC and MC cuts ATC and AVC at minimum AVC at minimum
pointspoints
MC cuts ATC and MC cuts ATC and AVC at minimum AVC at minimum
pointspoints
MC, AVC, and ATCMC, AVC, and ATC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 31
LabourLabour
Co
sts
(d
olla
rs)
Co
sts
(d
olla
rs)
Ave
rag
e P
rod
uct
an
dA
vera
ge
Pro
du
ct a
nd
Mar
gin
al P
rod
uct
Mar
gin
al P
rod
uct
OutputOutput
MPMPAPAP
MCMCAVCAVC
Figure 6-6 Productivity Curves and Cost Figure 6-6 Productivity Curves and Cost CurvesCurves
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 32
Relation of MC to AVC and ATCRelation of MC to AVC and ATC
• When MC < current ATCATC will fall• When MC > current ATCATC will riseMC intersects ATC and AVC at
minimum points
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 33
Shifts of Cost CurvesShifts of Cost Curves
Factor Pricesprice of fixed input increases...• AFC and ATC shift up• AVC and MC unchangedprice of variable input increases...• AVC, ATC, and MC shift up• AFC unchanged
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.4 34
Technology• improved technology• lower costs• cost curves shift down• curve shifts depend on whether
technology affects FC, VC, or both
Shifts of Cost CurvesShifts of Cost Curves
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5 35
Long-Run Production CostsLong-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...
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5 36
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
Figure 6-7 Figure 6-7 The Long-Run Average-Total-Cost The Long-Run Average-Total-Cost
CurveCurve
These choices determine the LRATC curveThese choices determine the LRATC curveThese choices determine the LRATC curveThese choices determine the LRATC curve
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5 37
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
Figure 6-8 Figure 6-8 The Long-Run Average-Total-Cost The Long-Run Average-Total-Cost
CurveCurve
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
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5 38
Economies of ScaleEconomies of Scale
– Labour Specialization– Managerial Specialization– Efficient Capital– Other Factors
• Diseconomies of Scale• Constant Returns to Scale
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5 39
Figure 6-9(a)
Output
Ave
rage
Tot
al C
osts
EconomiesEconomiesof scaleof scale
LRATC
Figure 6-9 Economies and Figure 6-9 Economies and Diseconomies of ScaleDiseconomies of Scale
Constant Constant returnsreturnsto scaleto scale
DiseconomiesDiseconomiesof scaleof scale
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5 40
Minimum Efficient ScaleMinimum Efficient Scale
Figure 6-7
0 10 20 30 40 50 60 70 80 90
Output
Ave
rag
e T
ota
l Co
sts
ATC-1 ATC-2ATC-3
ATC-4
ATC-5
MES is the smallest level of output that MES is the smallest level of output that minimizes LRATCminimizes LRATC
MES is the smallest level of output that MES is the smallest level of output that minimizes LRATCminimizes LRATC
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5 41
Minimum Efficient ScaleMinimum Efficient Scale
Figure 6-9(b)
Output
Ave
rag
e T
ota
l Co
sts
LRATC
Relatively large MESRelatively large MESnatural monopolynatural monopoly
Relatively large MESRelatively large MESnatural monopolynatural monopoly
MESMESMESMES
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5 42
Minimum Efficient ScaleMinimum Efficient Scale
Figure 6-9(c)
Output
Ave
rag
e T
ota
l Co
sts
MESMESMESMES
LRATC Relatively small MESRelatively small MEScompetitive industrycompetitive industry
Relatively small MESRelatively small MEScompetitive industrycompetitive industry
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6.5 43
Applications and IllustrationsApplications and Illustrations
• Successful Startup Firms• The Daily Newspaper• The Verson Stamping Machine• Aircraft and Concrete Plants
©2007 McGraw-Hill Ryerson Ltd.
Chapter 6 44
Chapter SummaryChapter Summary
6.1 The Firm and the Business Sector6.2 Economic Costs
– Opportunity Cost
6.3 Short-Run Production Relationships– The Law of Diminishing Return– TP, AP and MP
6.4 Short-Run Production Costs– Fixed Cost, Average Cost, and Marginal
Cost
6.5 Long-Run Production Costs