©2005 McGraw-Hill Ryerson Ltd. Microeconomics, Chapter 7 Microeconomics, Chapter 71 The Organization and Costs of Production AFC AVC ATC MC SLIDES PREPARED

©2005 McGraw-Hill Ryerson Ltd.©2005 McGraw-Hill Ryerson Ltd. Microeconomics, Chapter 7Microeconomics, Chapter 7 11

The Organization and The Organization and Costs of ProductionCosts of Production

AFCAFC

AVCAVC

ATCATC

MCMC

SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGESLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

©2005 McGraw-Hill Ryerson Ltd.©2005 McGraw-Hill Ryerson Ltd. 22 Microeconomics, Chapter 7Microeconomics, Chapter 7

In this chapter you will learnIn this chapter you will learn

7.1 7.1 The various organizational forms a firm The various organizational forms a firm can takecan take

7.2 7.2 What economic costs areWhat economic costs are

7.3 7.3 About a firm’s short-run production About a firm’s short-run production relationshipsrelationships

7.4 7.4 About a firm’s short-run production costsAbout a firm’s short-run production costs

7.5 7.5 The link between a firm’s size and costs The link between a firm’s size and costs in the long runin the long run


Chapter 7 TopicsChapter 7 Topics

7.1 7.1 The Firm & the Business SectorThe Firm & the Business Sector

7.2 7.2 Economic CostsEconomic Costs

7.3 7.3 Short-run Production RelationshipsShort-run Production Relationships

7.4 7.4 Short-run Production CostsShort-run Production Costs

7.5 7.5 Long-run Production CostsLong-run Production Costs


The Firm & the Business SectorThe Firm & the Business Sector

Different organizational structures:Different organizational structures:

1.1. PlantPlant

physicalphysicalestablishmentestablishment

physicalphysicalestablishmentestablishment




1.1. PlantPlant

2.2. Firm Firm business organizationbusiness organizationthat owns & operatesthat owns & operatesone or many plantsone or many plants

business organizationbusiness organizationthat owns & operatesthat owns & operatesone or many plantsone or many plants




1.1. PlantPlant

2.2. Firm Firm

3.3. IndustryIndustry

NOTES:NOTES:

• horizontal horizontal combinationscombinations

• vertical combinationsvertical combinations• conglomeratesconglomerates


Legal Forms of BusinessesLegal Forms of Businesses

1.1. Sole ProprietorshipSole Proprietorship

2.2. PartnershipPartnership

3.3. CorporationCorporationadvantagesadvantages

&&disadvantages…disadvantages…

advantagesadvantages&&

disadvantages…disadvantages…


Sole Sole ProprietorProprietor PartnershipPartnership CorporationCorporation

setupsetup easyeasy easyeasy moremoredifficultdifficult

ownerownerautonomyautonomy highhigh lowerlower lowestlowest

accessaccessto capitalto capital lowestlowest higherhigher highesthighest

accessaccessto skillsto skills lowestlowest higherhigher highesthighest

liabilityliability unlimitedunlimited unlimitedunlimited limitedlimited

death of death of ownerowner dissolvesdissolves dissolvesdissolves continuescontinuescorporations subject to double taxationcorporations subject to double taxationcorporations subject to double taxationcorporations subject to double taxation


• owners hire managersowners hire managers conflict of interestconflict of interest

• stock options have not necessarily helpedstock options have not necessarily helped• Enron, WorldComEnron, WorldCom• 360 Networks, Nortel Networks360 Networks, Nortel Networks

The Principal-Agent ProblemThe Principal-Agent Problem









Economic Costs...Economic Costs...

...are Opportunity Costs...are Opportunity Costs


Explicit CostsExplicit Costs

• payments a firm must makepayments a firm must make

Implicit CostsImplicit Costs

• opportunity costs of firm’s own resourcesopportunity costs of firm’s own resources

• include normal profitsinclude normal profits

Economic CostsEconomic Costs


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


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


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



• Costs of production include all costsCosts of production include all costs– explicit &explicit &– implicitimplicit– including a normal profitincluding a normal profit

required to attract & retain factors of required to attract & retain factors of productionproduction

economic profit = total revenue – economic costeconomic profit = total revenue – economic costeconomic profit = total revenue – economic costeconomic profit = total revenue – economic cost


TotalTotalRevenueRevenue

Profits to anProfits to anEconomistEconomist

Profits to anProfits to anAccountantAccountant

Figure 7-1Figure 7-1


ExplicitExplicitCostsCosts

AccountingAccountingcosts (explicitcosts (explicit

costs only)costs only)









AccountingAccountingProfitsProfits






Implicit costsImplicit costs(including a(including a

normal profit)normal profit)





Ec

on

om

ic (

op

po

rtu

nit

y) C

os

tsE

co

no

mic

(o

pp

ort

un

ity)

Co

sts






EconomicEconomicProfitsProfits

Implicit costsImplicit costs(including a(including a

normal profit)normal profit)





Ec

on

om

ic (

op

po

rtu

nit

y) C

os

tsE

co

no

mic

(o

pp

ort

un

ity)

Co

sts






Short-run and Long-runShort-run and Long-run

• Short RunShort Run– Fixed PlantFixed Plant

• Long RunLong Run– Variable PlantVariable Plant









• Total ProductTotal Product– total quantity producedtotal quantity produced

• Marginal ProductMarginal Product

• Average ProductAverage Product

change in total productchange in total productchange in labour inputchange in labour input==

total producttotal productunits of labourunits of labour==

Short-run Production RelationshipsShort-run Production Relationships


Law of Diminishing ReturnsLaw of Diminishing Returns

• marginal product eventually diminishesmarginal product eventually diminishes

Short-run Production RelationshipsShort-run Production Relationships


units of units of labourlabour TPTP MPMP APAP

00 00

11 1010

22 2525

33 4545

44 6060

55 7070

66 7575

77 7575

88 7070

change in total productchange in total product

change in labour inputchange in labour inputMP=MP=

Table 7-1Table 7-1



00 00

11 1010

22 2525

33 4545

44 6060

55 7070

66 7575

77 7575

88 7070

1010

1515

2020

1515

1010

55

00

-5-5

increasing marginal increasing marginal returns returns

increasing marginal increasing marginal returns returns

diminishing marginal diminishing marginal returnsreturns

diminishing marginal diminishing marginal returnsreturns

negative marginal negative marginal returnsreturns

negative marginal negative marginal returnsreturns

Table 7-1Table 7-1



00 00

11 1010

22 2525

33 4545

44 6060

55 7070

66 7575

77 7575

88 7070

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

Table 7-1Table 7-1

total producttotal product

total labour inputtotal labour inputAP=AP=


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



Marginal & Average ValuesMarginal & Average Values

• if the average value is rising, the marginal if the average value is rising, the marginal value must be ABOVE the average valuevalue must be ABOVE the average value

• if the average value is falling, the marginal if the average value is falling, the marginal value must be BELOW the average valuevalue must be BELOW the average value


Marginal & Average ValuesMarginal & 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









Fixed, Variable, & Total CostsFixed, Variable, & Total Costs

• Fixed CostsFixed Costs– do not vary with changes in outputdo not vary with changes in output

• Variable CostsVariable Costs– change with changes in outputchange with changes in output

• Total CostTotal Cost– sum of fixed & variable costsum of fixed & variable cost


Per-Unit, or Average CostsPer-Unit, or Average Costs

QTFC

AFC

QTVC

AVC

AVCAFCQ

TVCQ

TFCQ

TCATC


Marginal CostMarginal Cost

• Marginal cost is the extra, or additional Marginal cost is the extra, or additional cost of producing one more unit of outputcost of producing one more unit of output

Q in changeTC in change

MC


QQ TFCTFC TVCTVC TCTC AFCAFC AVCAVC ATCATC MCMC

00 100100

11

22

33

44

55

66

77

88

99

1010



00 100100

11 100100

22 100100

33 100100

44 100100

55 100100

66 100100

77 100100

88 100100

99 100100

1010 100100



00 100100 00

11 100100 9090

22 100100 170170

33 100100 240240

44 100100 300300

55 100100 370370

66 100100 450450

77 100100 540540

88 100100 650650

99 100100 780780

1010 100100 930930



00 100100 00

11 100100 9090

22 100100 170170

33 100100 240240

44 100100 300300

55 100100 370370

66 100100 450450

77 100100 540540

88 100100 650650

99 100100 780780

1010 100100 930930

100100190190

270270

340340

400400

470470550550

640640

750750

880880

10301030

TC=TFC + TVCTC=TFC + TVCTC=TFC + TVCTC=TFC + TVC


Figure 7-3

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

0 2 4 6 8 10

Q

Cos

ts

TFC


Figure 7-3

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

0 2 4 6 8 10

Q

Cos

ts

TFC

TVC

add vertically to get TCadd vertically to get TCadd vertically to get TCadd vertically to get TC


Figure 7-3

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

0 2 4 6 8 10

Q

Cos

ts

TFC

TVC

TC



00 100100 00

11 100100 9090

22 100100 170170

33 100100 240240

44 100100 300300

55 100100 370370

66 100100 450450

77 100100 540540

88 100100 650650

99 100100 780780

1010 100100 930930

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



00 100100 00

11 100100 9090

22 100100 170170

33 100100 240240

44 100100 300300

55 100100 370370

66 100100 450450

77 100100 540540

88 100100 650650

99 100100 780780

1010 100100 930930

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

AVC=TVC / QAVC=TVC / QAVC=TVC / QAVC=TVC / Q



00 100100 00

11 100100 9090

22 100100 170170

33 100100 240240

44 100100 300300

55 100100 370370

66 100100 450450

77 100100 540540

88 100100 650650

99 100100 780780

1010 100100 930930

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

ATC=TC / QATC=TC / QATC=TC / QATC=TC / Q



00 100100 00

11 100100 9090

22 100100 170170

33 100100 240240

44 100100 300300

55 100100 370370

66 100100 450450

77 100100 540540

88 100100 650650

99 100100 780780

1010 100100 930930

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


Figure 7-4

$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 & more unitsover more & more units

AFC continually declines AFC continually declines as fixed cost is spread as fixed cost is spread over more & more unitsover more & more units


Figure 7-4

$0

$50

$100

$150

$200

0 2 4 6 8 10

Q

Cos

ts

AFC

AVCAVC

AVC is U-shaped: AVC is U-shaped: AVC starts to rise AVC starts to rise

when AP starts to fallwhen AP starts to fall

AVC is U-shaped: AVC is U-shaped: AVC starts to rise AVC starts to rise

when AP starts to fallwhen AP starts to fall


Figure 7-4

$0

$50

$100

$150

$200

0 2 4 6 8 10

Q

Cos

ts

AFC

AVCAVC

get ATC by get ATC by vertically vertically

summing AFC summing AFC & AVC& AVC

get ATC by get ATC by vertically vertically

summing AFC summing AFC & AVC& AVC


Figure 7-4

$0

$50

$100

$150

$200

0 2 4 6 8 10

Q

Cos

ts

AFCAFC

ATC

AVCAVC


Figure 7- 5

$0

$50

$100

$150

$200

0 2 4 6 8 10

Q

Cos

ts

AFCAFC

ATC MC

AVCAVC

MC cuts ATC & MC cuts ATC & AVC at minimum AVC at minimum

pointspoints

MC cuts ATC & MC cuts ATC & AVC at minimum AVC at minimum

pointspoints


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

Productivity & Cost Curve Relationship, Figure 7-6Productivity & Cost Curve Relationship, Figure 7-6


LabourLabour

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


MPMP

MCMC

Co

sts

(d

olla

rs)

Co

sts

(d

olla

rs)


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


Relation of MC to AVC & ATCRelation of MC to AVC & ATC

• when MC < current ATCwhen MC < current ATC ATC will fallATC will fall

• when MC > current ATCwhen MC > current ATC ATC will riseATC will rise MC intersects ATC & AVC at minimum MC intersects ATC & AVC at minimum

pointspoints


Shifts of Cost CurvesShifts of Cost Curves

Factor PricesFactor Prices

• price of fixed input increases...price of fixed input increases...

• AFC & ATC shift upAFC & ATC shift up

• AVC & MC unchangedAVC & MC unchanged


$0

$50

$100

$150

$200

0 2 4 6 8 10

Q

Cos

ts

AFCAFC

ATC MC

AVCAVC


$0

$50

$100

$150

$200

0 2 4 6 8 10

Q

Cos

ts

AFCAFC

ATC MC

AVCAVC

Fixed costs increase by $25Fixed costs increase by $25Fixed costs increase by $25Fixed costs increase by $25


Factor PricesFactor Prices

• price of variable input increases...price of variable input increases... AVC, ATC & MC shift upAVC, ATC & MC shift up

• AFC unchangedAFC unchanged



$0

$50

$100

$150

$200

0 2 4 6 8 10

Q

Cos

ts

AFCAFC

ATC MC

AVCAVC


$0

$50

$100

$150

$200

0 2 4 6 8 10

Q

Cos

ts

AFCAFC

ATC MC

AVCAVC

Variable costs increase by 15%Variable costs increase by 15%Variable costs increase by 15%Variable costs increase by 15%


TechnologyTechnology

• improved technologyimproved technology lower costslower costs cost curves shift downcost curves shift down

• curve shifts depend on whether curve shifts depend on whether technology affects FC, VC or bothtechnology affects FC, VC or both










Long-run Production CostsLong-run Production Costs

• What will costs look like when the firm can What will costs look like when the firm can choose the best plant size for any given choose the best plant size for any given situation?situation?


• For every plant capacity size, there is a For every plant capacity size, there is a short-run ATC curve short-run ATC curve

• All such plant capacities can be plotted....All such plant capacities can be plotted....

Firm Size & CostsFirm Size & Costs


Figure 7-7

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 7-7

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



Figure 7-7

0 10 20 30 40 50 60 70 80 90

Output

Avera

ge T

ota

l C

osts

these choices determine the LRATC curvethese choices determine the LRATC curvethese choices determine the LRATC curvethese choices determine the LRATC curve

LRATC

The Long-run Cost CurveThe Long-run Cost Curve


Figure 7-8

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 7-8

Output

Ave

rage

Tot

al C

osts

the LR ATC curve just envelops the short-run cost the LR ATC curve just envelops the short-run cost curvescurves

the LR ATC curve just envelops the short-run cost the LR ATC curve just envelops the short-run cost curvescurves

LRATC



Figure 7-8

Output

Ave

rage

Tot

al C

osts

LRATC



Figure 7-9

Output

Ave

rage

Tot

al C

osts

EconomiesEconomiesof scaleof scale

LRATC

Economies & Diseconomies of ScaleEconomies & Diseconomies of Scale


Figure 7-9

Output

Ave

rage

Tot

al C

osts


Constant Constant returnsreturnsto scaleto scale

LRATC



Figure 7-9

Output

Ave

rage

Tot

al C

osts


Constant Constant returnsreturnsto scaleto scale

DiseconomiesDiseconomiesof scaleof scale

LRATC



Economies of ScaleEconomies of Scale

– Labour specializationLabour specialization– Managerial specializationManagerial specialization– Efficient capitalEfficient capital– Other factorsOther factors

• Diseconomies of ScaleDiseconomies of Scale

• Constant Returns to ScaleConstant Returns to Scale


Applications & IllustrationsApplications & Illustrations

• successful startup firmssuccessful startup firms




• the daily newspaperthe daily newspaper




• the daily newspaperthe daily newspaper

• General MotorsGeneral Motors


Minimum Efficient ScaleMinimum Efficient Scale

Figure 7-7

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



Figure 7- 9b

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



Figure 7- 9c

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








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©2005 McGraw-Hill Ryerson Ltd. Microeconomics, Chapter 7 Microeconomics, Chapter 71 The Organization and Costs of Production AFC AVC ATC MC SLIDES PREPARED