İktisada Giriş Costs & Production (Chapter 9) 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 closel y. The supply side of the market is made up of firms that engage in production and trade activities. SLIDE 1 . “ L aw 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 firm s 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. W e will study the decision-making process of firms under different market conditions. Different mark et 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 consta nt 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 t hese later when we discuss different market structures . 1 1Total Cost is the value of inputs a firm use s 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 in creases 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 co st 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 re quire an actual payment of money. For an accountant, T otal C ost includes only explicit costs, i.e. costs that require an outlay of money by the firm. To illustrate what I mean by th ese concepts , consider the following examples: Example 1 : Farmer Mehmet gives “ saz ” lessons for $20 an hour. Assume that he always finds a customer whe n 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 cos t? (Answer: $ 100) 2 2SLIDE 6. If the wheat will be sold for $ 4 00 , what is Mehmet ’ s accounting profit? His a ccounting profit is $ 3 00. 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 o pportunity 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, m y 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 pr oduction and the quantity of output. SLIDE 10. EMINE ’ S COOKIE FACTORY EXAMPLE: In this example, we assume that E mine has only one oven and the only input is the number of workers she e mploy s . The first two columns of the table describes the production fun ction. Note that we ignore other inputs here like flour, sugar, electricity etc. This is just for simplicity 3 3SLIDE 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 1 0 . Notice on SLIDE 1 0 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 wo rker ’ s contribution to total output decreases as we employ more workers. M arginal product of a n input can be expressed as: MP of labor = change in output / change in the qty of labor . Notice that th e above expression is the slope of the production fun ction. 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 SLIDE1 6 , w e 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. 4 49.2.2 Fixed Cost and Variable Cost SLIDE 1 8 : We divide total costs into F IXED 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 introduce s 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 5 5SLIDE 2 3 : 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 2 4 defines Marginal Cost. MARGINAL COST is the additional cost of producing one more unit of output. SLIDE 2 5 calculat es MC from the change in Total Cost at each qty level. SLIDE 2 6 expresses MC mathematically : MC = change in TC/ change in Q . In our example, change in qty is always 1 unit. SLIDE 2 7 plots qty of output versus Total Cost: Osman ’ s Total Cost curve. Notic e that MC is the slope of the Total Cost curve. SLIDE 28 plots MC as a function of output. Notice that MC is increas i ng as we want to produce more. SLIDE 29. This is a result of diminishing marginal product property. HOW? Consider the following Example: E xample: 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 worker s , then one of them cooks the hamburgers and the other works at the cashier . Let us assume that they can mak e and sell MAXIMUM 20 hamburgers per hour. If you pay each of them $10 per hour, then the avera ge variable cost (and also marginal cost for each hamburger) is $1 per hamburger. If you want to sell m ore hamburgers, you hire one more worker to work at the gr ill. But the third worker makes the grill crowded and adds only 5 hamburgers per hour. Also, the fact that 6 6you need to pay the third worker $10 per hour means that the marginal cost of making the 21 st 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 h am burgers per hour, the thi r d 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 21 st to the 25 th 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 A FC 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 s cale 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 , 7 7then 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 D ö ner 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 l ong-run, i.e. they can achieve lower costs given the time. For example, suppose that the firm initially produces at 1000 cars, but want s 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 take s 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 quantit y might imply lower AVERAGE costs. An example to this is the 8 8cable 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 RETU RNS 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 i ndustry because it is too big. This type of firm should try to reduce its size . 9 9