Production Costs
Lesson 8

The Business Firm

1. Business firm
   • Purchase resources from other firms and households
   • Transform resources into products
   • Sell products to consumers
2. All countries have business firms
   • Differ by freedom for decision making
   • Socialist countries have less freedom
3. Firm owners have strong incentive to produce at low cost
   • If business is doing well, the owners earn profits
   • If business is doing badly, the owners earn a loss
4. Organizing workers
   • Contracting - owner contracts with individual workers who work independently
     • Takes time, planning, and has high transaction costs
     • Example: Building a house or office building
   • Team production - workers are hired by a firm to work together under supervision
     • Reduces transaction costs
     • Employees are monitored
     • Prevent shirking
     • Shirking - employees working at less than normal rate of productivity
       • Examples: Long coffee & bathroom breaks

Economic Costs

1. Explicit costs - when a firm makes a monetary payment, using cash or a bank transfer

• Salaries for labor
• Tax payments
• Interest payments
• Buying resources

2. Implicit costs - a cost imposed on the firm, but does not involve a payment

• Accountants use depreciation of machines and equipment
  • Accountants recognize that machines wear out and is an expense to the firm
• Opportunity costs - the highest valued option that the decision maker expects to give up as the result of a choice
  • Economist include opportunity costs but accountants do not
  • A proprietor's opportunity cost is working for his business and earning salary
  • Look forward
  • Include all production costs
  • If company could use resources to make a more valuable product, then it would make that product

3. Sunk costs - historical costs associated with past decisions that cannot be changed

• Requires three things
  • Firm paid a cost in the past, or historical costs
  • Firm cannot undo the decision
  • Firm cannot sell or salvage
• Examples
  • Firm pays for a government license that it cannot resell
  • Firm pays for special machines and equipment with little salvage value
  • Person pays for a ticket to enter a cinema and the movies is bad
• Provide information
• Not relevant to current choices
• Example: Henderson State University buys a printing machine to publish a magazine
  • Machine costs $20,000 and will be depreciated over 10 years
    • Depreciation expense is $2,000 per year
  • In Year 3 , subscription revenue is $3,000
  • Depreciation expense is $2,000
  • Paper/ink costs $2,000
    • University earns a $1,000 loss
• What should the university do?
• Economists - in Year 1, if the administration knew this would be the outcome, then the machine should of not been purchased.
  • In Year 3, the machine cost is sunk cost
  • Revenue is $3,000
  • Paper/ink cost is $2,000 for paper/ink
  • Keep the machine operating and minimize the loss
    • Activity is contributing $1,000

Economic profit = total revenue - explicit costs - implicit costs (all costs)

Accounting profit = total revenue - explicit costs - implicit costs (i.e. depreciation)

Accounting profit > Economic profit

Firms earning zero economic profit are earning a normal rate of return. If economic profit is zero, then accounting profit is positive. If economic profit < 0, then firms are not using resources efficiently.

Someone quit his job (earning $20,000) and used his savings $5,000 to open a business His savings was earning 10%. The first year income statement is below:

Lemonade Stand at the Mall 1st year income statement
Total Revenue (30,000 lemonades @$1)	$30,000
Costs (explicit)
Lemons, sugar, paper cups, etc.	$10,000
Taxes	$2,000
Labor - employees	$5,000
Leasing space	$3,000
Accounting profit	$10,000
Costs (Implicit)
Salary	$20,000
Interest foregone	$500
Economic profit	($10,500)
He is not using all of his resources efficiently.
Note: There is a non-monetary benefit of being your own boss.

Output and Costs in the Short Run

1. Short run - a period of time so short that at least one factor of production is fixed, usually the physical capital, like structures, machines, and equipment.

• Total Fixed Costs (TFC) - the costs do not change when production level changes
  • Insurance premiums
  • Property taxes
  • Loans or bonds on factory building or machines
  • Overhead from administration
• Average Fixed Costs (AFC) - fixed costs per good produced
  • As production level increases, AFC will get smaller and smaller
    • "Spreading the overhead"
  • The fixed costs is spread out over more units

AFC = TFC / Output

Total Fixed Cost	Average Fixed Cost
Costs	Per-Unit Costs
Output/Quantity	Output/Quantity

• Total Variable Costs (TVC) - the costs that varies when the production level changes.
  • Labor costs
  • Raw material costs
  • Utilities like electricity, water, etc.
• Average Variable Cost (AVC) - variable costs per unit of a good produced

AVC = TVC / Output

Total Variable Costs	Average Variable Costs
Costs	Per-Unit Costs

2. Marginal Cost (MC) - the increase in cost as production increases by one unit.

• MC will decline initially, reach a minimum, and then rise
• Example: A factory starts with 0 workers
  • Specialization of labor
    • Production gains
    • MC decreases
      • 1 worker - output is 10 units (10 units per worker)
      • 2 workers - output is 30 units (15 units per worker)
      • 3 workers - output is 60 units (20 units per worker)
  • Law of Diminishing Returns
    • Output increases by a smaller and smaller amount as more labor (variable resource) is added to a factory (fixed resource)
    • Production inefficiency
    • Exists only in the short run
      • 50 workers - output is 1,000 units (20 units per worker)
      • 51 workers - output is 1,100 units (18.3 units per worker)

Marginal Cost
Cost per unit
Output/Quantity

3. The Total Costs and Average Curves.

Total Cost (TC) = Total Fixed Cost + Total Variable Cost

TC = TFC + TVC

Average Total Cost (ATC) = Average Fixed Cost + Average Variable Cost.

ATC = AFC + AVC = TC / Output

• Relationship between marginal cost and total variable costs
  • MC < ATC, then ATC is decreasing
  • MC > ATC. then ATC is increasing
  • MC intersects ATC at its minimum point
  • Example: Student's score is 80% and student took 2 tests
    • 3rd test (i.e. marginal)
    • Scores 90%, average increases
    • Scores 70%, average decreases

Total Cost Curves	Average Cost Curves
Total cost	Per-unit cost
Output/Quantity	Output/Quantity

4. Product curves - Do not worry about the shape of these curves

• Total product - total output of a good associated with different levels of a variable input (e.g. labor).
• Marginal product - change in total product with a one more unit of a variable input (e.g. labor).
• Average product - total product divided by the number of the units of the variable input (e.g. labor).

Output and Costs in the Long Run

1. Long run - is a period of time sufficient for the firm to alter all factors of production.

• Firms can enter and exit the industry.
• Long run differs by industry.
  • Examples: Long run for an automobile factory using lots of machines may be 7 years.
  • The long run for an internet company may be 1 year.
• Long-Run ATC - shows the minimum average cost of producing each output level when a firm is able to vary all production resources, including factory size.
  • Allow the firm to vary among 3 factory sizes: ATC ₁ , ATC ₂, ATC ₃ . Which factory size should the firm produce at?

Long Run ATC
Per-Unit Cost
Output

ATC 2 will give the factory the lowest per unit costs in the long run. The firm will be able to recuperate all its total costs, when: Market price (P*) > = minimum of long-run ATC

2. Why unit costs differ in the long run.

Long Run ATC
Per-Unit Cost
Output

• Economies of scale - per-unit costs fall as output (plant size) expands
  • Mass production - large amounts of capital and machines
  • Specialization of labor - adding more labor allows workers to specialize in task that they are good at
  • Management specialization - departments can specialize in finance, personnel, and marketing
  • Examples
    • Automobile
    • Electricity
    • Natural gas
    • Telecommunications including internet services
    • Computer chips
• Constant returns to scale - per-unit costs are constant as plant size is changed.
  • Small firms can be just as efficient as large firms.
    • Apparel
    • Food processing
    • Publishing
    • Lumber
    • Retailing
    • Wood products
• Diseconomies of scale - per-unit costs rises as output (plant size) expands
  • Bureaucratic inefficiencies
  • More difficult to coordinate workers
  • Monitoring problems, such as workers shirking

Factors that Shifts Firm's Cost Curves

Everything that shifts a supply function will also shift the production function

1. Prices of resources - if a price of a resource used in production increases, the cost curves shift higher.
   • Labor costs increase.
   • Example: Price of steel increases for automobile industry.
     • Supply decreases.
2. Taxes - increasing taxes on businesses.
   • Supply decreases.
3. Regulations - increasing regulations on businesses. Firm has to hire compliance specialists, gather data and information, and submit reports. This can be a large cost.
   • Environmental regulations
   • Health & safety regulations
   • Labor regulations
     • Supply decreases.
4. Technology - allows firms to produce more output while using the same level of resources.
   • Microprocessor - compressed millions of transistors onto one chip. Uses less silicone wafers, less labor, less wires, uses less energy, etc.
     • Supple increases.

Decrease in Production Costs	Increase in Production Costs
Per-unit cost	Per-unit cost
Output/Quantity	Output/Quantity

Terminology