İktisada Giriş THEORY OF FIRM BEHAVIOR (Chapter 9) THEORY OF FIRM BEHAVIOR Week 9: COSTS OF THE FIRMFirm ’ s Choice: Firm ’ s Costs and Production Decision A firm chooses: ? What quantity of the good to produce, ? The price of the good. ? Firm ’ s decision depends on: ? Costs of production. ? The degree of competition in the market ? (if there are more sellers, more competitive). Firm ’ s Choice: Firm ’ s Costs and Production Decision Firm ’ s Objective ? The goal of a firm is to maximize profits. ?Total Revenue, Total Cost, and Profit Profit is the firm ’ s total revenue ? minus its total cost. Profit = Total Revenue - Total CostTotal Revenue, Total Cost, and Profit Total Revenue ? The amount a firm receives for the sale ? of its output. For a competitive firm, TR = P x Q Total Cost ? The market value of the inputs a firm ? uses in production.Costs as Opportunity Costs Total Cost = All Opportunity Costs ? = Explicit Costs + Implicit Costs Explicit and Implicit Costs ? A firm ’ s costs of production include ? explicit costs and implicit costs. Explicit costs are input costs that require a ? direct payment of money by the firm. Implicit costs are input costs that do not ? require a payment of money by the firm.Costs as Opportunity Costs Example: Costs of Your Textile ? Factory Worker ’ s wages, electricity, cost of ? machines, rent are explicit costs. Instead of managing the textile factory, ? you could work as an engineer for 2500 liras per month. Then the implicit cost of running the textile factory is 2500 liras per month.Economic Profit versus Accounting Profit Economists measure a firm ’ s ? economic profit as total revenue minus total cost, including both explicit and implicit costs. Accountants measure the accounting ? profit (on balance sheet) as the firm ’ s total revenue minus only the firm ’ s explicit costs. Economic Profit versus Accounting Profit When total revenue exceeds both ? explicit and implicit costs, only then the firm earns positive economic profit. Economic profit is smaller than ? accounting profit.Figure 1 Economists versus Accountants Copyright © 2004 South-Western Revenue Total opportunity costs How an Economist Views a Firm How an Accountant Views a Firm Revenue Economic profit Implicit costs Explicit costs Explicit costs Accounting profitPRODUCTION AND COSTS The Production Function ? The production function shows the ? relationship between quantity of inputs (Ex: number of workers) used to make a good and the quantity of output of that good.1 12 Table 1 A Production Function and Total Cost: Emine ’ s Cookie Factory Copyright©2004 South-Western Fixed VariableFigure 2 Emine ’ s Production Function Copyright © 2004 South-Western Quantity of Output (cookies per hour) 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 Number of Workers Hired 0 1 2 3 4 5 Production functionThe Production Function Marginal Product ? The marginal product of labor (any input) ? is the change in output that arises from an additional worker (that input). workers of Number Output ? ? ? MPLThe Production Function Diminishing Marginal Product ? Diminishing marginal product is the ? property whereby the marginal product of an input declines as the quantity of the input increases. Example: As more and more workers are ? hired at a firm, each additional worker contributes less and less to output because the firm has a limited amount of machines & equipment. The Production Function Diminishing Marginal Product ? The slope of the production function ? measures the marginal product of labor. When the marginal product of labor ? declines, the production function becomes flatter.Figure 2 Emine ’ s Production Function Copyright © 2004 South-Western Quantity of Output (cookies per hour) 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 Number of Workers Hired 0 1 2 3 4 5 Production functionTOTAL-COST CURVE The total-cost curve shows the ? relationship between the quantity a firm can produce and its total cost. Table 1 A Production Function and Total Cost: Emine ’ s Cookie Factory Copyright©2004 South-Western Fixed VariableFigure 3 Emine ’ s Total-Cost Curve Copyright © 2004 South-Western Total Cost $80 70 60 50 40 30 20 10 Quantity of Output (cookies per hour) 0 10 20 30 150 130 110 90 70 50 40 140 120 100 80 60 Total-cost curveThe Various Measures Of Cost Costs of production may be divided into ? fixed costs and variable costs. Fixed costs are those costs that do not ? change with the quantity of output produced. Ex: Rent, accountant ’ s wage, some taxes.. Variable costs are those costs that do ? change with the quantity of output produced. Ex: Labor, Electricity, Transportation,... Fixed and Variable Costs Total Costs ? Total Fixed Costs (TFC) ? Total Variable Costs (TVC) ? Total Costs (TC) ? TC = TFC + TVC ?Table 2 The Various Measures of Cost: Osman ’ s Lemonade Stand Copyright©2004 South-WesternFixed and Variable Costs Average Costs ? Average costs can be determined by ? dividing the firm ’ s costs by the quantity of output it produces. Average cost answers the following ? question: How much does it cost to make one unit of a good on average?Fixed and Variable Costs Average Costs ? Average Fixed Cost (AFC) = Total Fixed Cost / ? Qty of Output Average Variable Cost (AVC) = Total Variable Cost ? / Qty of Output Average Total Costs (ATC) = Total Cost / ? Qty of Output ATC = AFC + AVC ?Table 2 The Various Measures of Cost: Osman ’ s Lemonade Stand Copyright©2004 South-WesternFixed and Variable Costs Marginal Cost ? Marginal cost (MC) measures the ? increase in total cost that arises from an extra unit of production. Marginal cost helps answer the following ? question: How much does it cost to produce an ? additional unit of output?Marginal Cost Osman ’ s Lemonade Stand Quantity Total Cost Marginal Cost Quantity Total Cost Marginal Cost 0 $3.00 — 1 3.30 $0.30 6 $7.80 $1.30 2 3.80 0.50 7 9.30 1.50 3 4.50 0.70 8 11.00 1.70 4 5.40 0.90 9 12.90 1.90 5 6.50 1.10 10 15.00 2.10 Marginal Cost MC TC Q ? ? ( change in total cost ) (change in quantity) ? ?Figure 4 Osman ’ s Total-Cost Curves Copyright © 2004 South-Western Total Cost $15.00 14.00 13.00 12.00 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 Quantity of Output (glasses of lemonade per hour) 0 1 4 3 2 7 6 5 9 8 10 Total-cost curveFigure 5 Osman ’ s Marginal-Cost Curve Copyright © 2004 South-Western Costs $3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 Quantity of Output (glasses of lemonade per hour) 0 1 4 3 2 7 6 5 9 8 10 MCCost Curves and Their Shapes Marginal cost rises with the amount of ? output produced. This reflects the property of diminishing ? marginal product. See example.Figure 6 Osman ’ s Average-Cost and Marginal-Cost Curves Copyright © 2004 South-Western Costs $3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 Quantity of Output (glasses of lemonade per hour) 0 1 4 3 2 7 6 5 9 8 10 MC ATC AVC AFCTable 2 The Various Measures of Cost: Osman ’ s Lemonade Stand Copyright©2004 South-WesternCost Curves and Their Shapes The average total-cost (ATC) curve is U- ? shaped. At very low levels of output, ATC is high ? because fixed cost is spread over only a few units. ATC declines as output increases because fixed ? cost is spread over more units. As output increases further, ATC starts rising ? because average variable cost rises faster than the decline in AFC.Cost Curves and Their Shapes The quantity where the firm achieves ? the lowest average cost is at the bottom of the U-shaped ATC curve. This quantity is called the efficient scale of the firm. Figure 7 Osman ’ s Average-Cost and Marginal- Cost Curves Copyright © 2004 South-Western Costs $3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 Quantity of Output (glasses of lemonade per hour) 0 1 4 3 2 7 6 5 9 8 10 ATCCost Curves and Their Shapes Relationship between Marginal Cost ? and Average Total Cost Whenever marginal cost is less than ? average total cost, average total cost is falling. Whenever marginal cost is greater than ? average total cost, average total cost is rising. ATC is like your cumulative GPA and MC ? is like your last semester ’ s grade average.Figure 5 Osman ’ s Average-Cost and Marginal-Cost Curves Copyright © 2004 South-Western Costs $3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 Quantity of Output (glasses of lemonade per hour) 0 1 4 3 2 7 6 5 9 8 10 ATC MCCost Curves and Their Shapes Summarize Three Important ? Properties of Cost Curves Marginal cost eventually rises with the ? quantity of output. The average-total-cost curve is U- ? shaped. The marginal-cost curve crosses the ? average-total-cost curve at the minimum of average total cost.Costs In The Short Run And In The Long Run For many firms, the division of total ? costs between fixed and variable costs depends on the time horizon being considered. In the short-run, some costs are fixed ? (Ex: rent), some are variable (labor, energy). In the long-run, fixed costs become ? variable costs (Ex: renting decisions can change).Costs In The Short Run And In The Long Run Because many costs are fixed in the ? short-run but variable in the long-run, a firm ’ s long-run cost curves differ from its short-run cost curves.Figure 7 Average Total Cost in the Short and Long Run Copyright © 2004 South-Western Quantity of Cars per Day 0 Average Total Cost 1,200 $12,000 ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long runCosts versus Size of the Firm If long-run ATC falls as the quantity of ? output increases, the firm has Increasing Returns to Scale (Economies of scale). If long-run ATC rises as the quantity of ? output increases, the firm has Decreasing Returns to Scale. If long-run average total cost stays ? constant as the quantity of output increases, the firm has Constant returns to scale.Figure 7 Average Total Cost in the Short and Long Run Copyright © 2004 South-Western Quantity of Cars per Day 0 Average Total Cost 1,200 $12,000 1,000 10,000 Economies of scale ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run Diseconomies of scale Constant returns to scaleEconomies and Diseconomies of Scale The shape of LRATC depends on the type of ? industry. Some industries exhibit economies of scale ? (also called increasing returns to scale) like cable TV or GSM providers. Some industries show decreasing returns to ? scale because they are too big. Coordination problems & bureaucracy. IBM and General Motors are examples.Summary The goal of firms is to maximize ? profit, which equals total revenue minus total cost. When analyzing a firm ’ s behavior, it is ? important to include all the opportunity costs of production. Some opportunity costs are explicit ? while other opportunity costs are implicit.Summary A firm ’ s costs reflect its production process. ? A typical firm ’ s production function gets ? flatter as the quantity of input increases, displaying the property of diminishing marginal product. A firm ’ s total costs are divided between ? fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced.Summary Average total cost is total cost divided ? by the quantity of output. Marginal cost is the amount by which ? total cost would rise if output were increased by one unit. The marginal cost always rises with ? the quantity of output. Average cost first falls as output ? increases and then rises.Summary The average-total-cost curve is U- ? shaped. The marginal-cost curve always ? crosses the average-total-cost curve at the minimum of ATC. A firm ’ s costs often depend on the ? time horizon being considered. In particular, many costs are fixed in ? the short run but variable in the long run.