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CHAPTER 9: Firm Behavior and Costs of Production

Up until now, we have been concentrating on the demand side of the market. We

analyzed consumer behavior in detail. In this and the following chapters, our

objective is to look at the supply side more closely. The supply side of the market

is made up of firms that engage in production and trade activities. SLIDE 1. “Law

of supply”: Firms are willing to produce and sell a greater quantity of a good

when the price of the good is high. Now we want to study firms in more detail.

9.1 What is a Firm?

SLIDE 2. A firm’s objective is to MAXIMIZE PROFITS. Given this objective, firm

decides HOW MUCH TO PRODUCE and sell. We will study the decision-making

process of firms under different market conditions. Different market conditions

include: (i) total number of firms in the market (ii) cost structure of the industry.

SLIDE 3 Defn: Profit = Total Revenue – Total Cost

SLIDE 4. Total Revenue is the amount that the firm receives from the sale of its

product. Simply, TR can be calculated by multiplying price of the good by the

quantity of the good produced. If you sell 100 glasses of lemonade for 0.5 YTL

for each glass, then your total revenue is 50 YTL. This is the competitive market

case. But the price may not be constant for every unit of the good, think about it.

If you are a large seller in the market like Ford automakers, then price declines

as you sell more, right? So it depends on the aggregate demand and the

aggregate supply in the car market. We will talk about these later when we

discuss different market structures.

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Total Cost is the value of inputs a firm uses in production. TC calculation is not

as easy as TR calculation. TC depends on the particular sector in question,

technology used in production, etc. It increases as production increases, but this

may not be proportional. Total cost for making 200 glasses of lemonade may not

be exactly two times the cost of making 100 glasses. This depends on the

method of production used. Different industries have different cost structures.

SLIDE 5. The way the economists look at costs is a little different than an

accountant’s view. For us, TC is the sum of the opportunity costs of production.

Total Cost = Opportunity Costs = Implicit Costs + Explicit Costs

Opportunity cost includes implicit costs, i.e. costs that do not require an actual

payment of money but still constitute opportunity costs. Opp. Cost also includes

explicit costs, costs that require an actual payment of money. For an accountant,

Total Cost includes only explicit costs, i.e. costs that require an outlay of money

by the firm. To illustrate what I mean by these concepts, consider the following

examples:

Example 1: Farmer Mehmet gives “saz” lessons for $20 an hour. Assume that he

always finds a customer when he wants to give saz lessons. One day, he spends

10 hours planting $100 worth of wheat on his own farm. In that day, how much

total opportunity cost has he incurred? (Answer: $200 implicit + $100 explicit)

How much does an accountant measure as total cost? (Answer: $100)

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SLIDE 6. If the wheat will be sold for $400, what is Mehmet’s accounting profit?

His accounting profit is $300. What is his economic profit? His economic profit is

only $100.

SLIDE 7. SLIDE 8. Notice that economic profit is always less than or equal to

accounting profit.

Another example illustrates the opportunity cost of financial capital.

Example 2: Suppose that I invested $300,000 for a cookie factory. Suppose also

that the market interest rate is 5% annually. When calculating total costs of my

factory, my accountant would not include the opportunity cost of this capital,

which is equal to $15,000 a year. But I must think about such an alternative when

I am making my investment decision. This alternative is essential to my

investment decision. This is the difference between economist’s and accountant’s

perspectives. Economist is interested in the parameters of decision-making.

9.2 Production and Costs

SLIDE 9. A production function is a relationship between the quantity of inputs

of production and the quantity of output.

SLIDE 10. EMINE’S COOKIE FACTORY EXAMPLE:

In this example, we assume that Emine has only one oven and the only input is

the number of workers she employs. The first two columns of the table describes

the production function. Note that we ignore other inputs here like flour, sugar,

electricity etc. This is just for simplicity

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SLIDE 11. MARGINAL PRODUCT of an input is the additional amount of output

produced by an additional unit of that input. MP is important, because it will be

useful when the firm chooses how much to produce. Illustrate MP on SLIDE 10.

Notice on SLIDE 10 that as number of workers increases, marginal product

decreases. This is called DIMINISHING MARGINAL PRODUCT of labor. SLIDE

12. This results because number of ovens is fixed (one) and each additional

worker has to share the oven with previous workers.

SLIDE 13 plots the production function. Notice that the production function is

getting flatter as we add more workers. This is because an additional worker’s

contribution to total output decreases as we employ more workers.

Marginal product of an input can be expressed as:

MP of labor = change in output / change in the qty of labor.

Notice that the above expression is the slope of the production function. We can

see that slope of this function is getting smaller as number of workers increase.

SLIDE 14 summarizes the above.

9.2.1 Output and Total Cost

SLIDE 15: the Total Cost curve shows the relationship between quantity of output

produced and total cost of production.

On SLIDE16, we can plot the total cost curve for Emine’s factory by taking points

from the output column and total cost column.

SLIDE 17 shows the Total Cost curve for Emine’s cookie factory.

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9.2.2 Fixed Cost and Variable Cost

SLIDE 18: We divide total costs into FIXED COSTS and variable costs. Fixed

costs are the costs that do not depend on the quantity of output produced.

VARIABLE COSTS are the costs that do depend on the quantity of output.

Example of fixed cost includes the rent of the building, lump-sum taxes that govt.

collects regardless of revenue, monthly cost of leasing the machines, printers,

vehicles of the factory. Example of variable cost includes cost of labor, electricity,

sugar, flour, milk, eggs.

SLIDE 19 introduces some notation: TC = TFC + TVC.

SLIDE 20 shows the costs of Osman’s lemonade stand. Notice that fixed cost is

$3.00 and it does not change with qty of output. When you add fixed and variable

cost at each qty, you get total cost column. For example,….

9.2.3 Average Costs

SLIDE 21 introduces average costs. If we divide total costs by the qty of output,

we get average costs.

SLIDE 22 defines AFC, AVC, ATC. If we divide both sides of TC = TFC + TVC by

quantity of output Q, then we get

TC/Q = TFC/Q + TVC/Q

By definition of average costs, TC/Q is Average Total Cost, TFC/Q is Average

Fixed Cost, TVC/Q is Average Variable Cost. Then,

ATC = AFC + AVC

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SLIDE 23: Illustrate AFC, AVC, ATC. Show SLOWLY how the numbers are put on

the table. For example, in third row, AFC is 1.5 which is 3 divided by 2. AVC is

0.4, which is 0.80 divided by 2. ATC is 1.5 plus 0.4 equals 1.9.

9.2.4 Marginal Cost

SLIDE 24 defines Marginal Cost. MARGINAL COST is the additional cost of

producing one more unit of output.

SLIDE 25 calculates MC from the change in Total Cost at each qty level.

SLIDE 26 expresses MC mathematically: MC = change in TC/ change in Q.

In our example, change in qty is always 1 unit.

SLIDE 27 plots qty of output versus Total Cost: Osman’s Total Cost curve.

Notice that MC is the slope of the Total Cost curve.

SLIDE 28 plots MC as a function of output. Notice that MC is increasing as we

want to produce more.

SLIDE 29. This is a result of diminishing marginal product property. HOW?

Consider the following Example:

Example: Consider yourself as the manager of a small McDonald’s branch. Let

us assume you only have one grill and one cashier. If you have two workers, then

one of them cooks the hamburgers and the other works at the cashier. Let us

assume that they can make and sell MAXIMUM 20 hamburgers per hour. If you

pay each of them $10 per hour, then the average variable cost (and also

marginal cost for each hamburger) is $1 per hamburger. If you want to sell more

hamburgers, you hire one more worker to work at the grill. But the third worker

makes the grill crowded and adds only 5 hamburgers per hour. Also, the fact that

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you need to pay the third worker $10 per hour means that the marginal cost of

making the 21st hamburger is NOT $1, but $2.

Here in this example, we can see both diminishing marginal product of labor and

rising marginal cost of output. While each of the first two workers contribute 10

hamburgers per hour, the third worker adds only 5 hamburgers per hour. This is

diminishing marginal product of workers. At the same time, since each worker

costs $10 per hour, the hamburgers from 21st to the 25th costs $2 each.

SLIDE 30 shows all the elements of cost on the same graph: ATC, AFC, AVC,

MC. This is based on Osman’s costs table. Notice that ATC is the sum of AFC

and AVC.

9.2.5 Cost Curves

SLIDE 31 explains shape of ATC curve. Remember ATC = AFC + AVC. SHOW

on SLIDE 30: When qty is small, AFC is decreasing fast. This pulls down ATC.

But as qty increases, ATC starts to rise because AVC starts to increase fast.

SLIDE 32: The U-shape of the ATC means that at some qty, average cost can be

minimized. This particular qty of output is called the EFFICIENT SCALE of the

firm. This happens at the bottom of the ATC curve.

SLIDE 33: Show the efficient scale on the graph. The efficient scale of this firm is

5 or 6 units.

SLIDE 34 shows the relationship btw ATC and MC. ATC is like your cumulative

average and MC is like this semester’s grade. If your cumulative is 2.0, and you

get 1.5 this semester, your cumulative will decrease. If you get 2.5 this semester,

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then your cumulative will increase. In the same fashion, SLIDE 35 shows the

same relationship btw ATC and MC. SLIDE 36 summarizes.

SLIDE 37 summarizes the three properties of cost curves.

9.2.6 Short-run versus Long-run Costs

SLIDE 38: the time horizon being considered is important. For example, a small

Döner store cannot rent a second store in the short-run. Therefore, rent of the

store is fixed. However, in the long-run, store owner can rent a second place and

increase sales. So, size of a factory becomes a variable factor. AND rent

becomes a variable cost.

SLIDE 39&SLIDE 40 show the difference between the short-run ATC and Long-

run ATC curves. Long run ATC is flatter, because the firm can change its size in

the long-run. This allows the firm to increase production without increasing

average costs too much.

SLIDE 41 explains Economies and Diseconomies of Scale.

SLIDE 42 illustrates the above ideas as following: It is evident from the graph that

firms have greater flexibility in the long-run, i.e. they can achieve lower costs

given the time. For example, suppose that the firm initially produces at 1000 cars,

but wants to increase to 1200 cars per day. In the short-run, this will increase

costs to $12,000 per car, while in the long-run, firm adjusts easily and can

produce at $10,000 per car. The adjustment takes form of adding another

assembly line, as opposed to asking the workers to work overtime.

The shape of LRATC depends on the type of industry. For some industries,

greater quantity might imply lower AVERAGE costs. An example to this is the

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cable TV network, or telephone network companies. This type of firms is said to

be exhibiting INCREASING RETURNS TO SCALE or ECONOMIES OF SCALE.

This type of firm strives to get bigger to reduce average costs.

For other industries, the LRATC may show CONSTANT RETURNS TO SCALE.

CRS implies that as you increase quantity of output, your costs will increase

proportionately. ATC is constant.

For yet other industries, the LRATC may show DECREASING RETURNS TO

SCALE. Here AVERAGE costs are increasing as output increases. The reason to

increasing average costs might be coordination problems as a result of the firm

to be too big. Once IBM was criticized for not being able to adapt to innovations

in the PC industry because it is too big. This type of firm should try to reduce its

size.