Production Cost Functions
Lecture 7

Business Firm Organizations

1. Business firm.
   • Purchase resources from other firms and households.
   • Transform resources into products.
   • Sell products to consumers.
2. All countries have business firms.
   • Firms differ by freedom in decision making.
   • Socialist countries have less freedom.
3. Firms earn profits..
   • If business is doing well, the owners earn profits.
   • If business is doing badly, the owners earn a loss.
   • Strong incentive to
     • Produce at low cost.
     • Provide good service
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.
       • Ex: Long coffee & bathroom breaks.
5. Types of Business Firms.
   • Proprietorship - owned by a single individual.
     • Owner reliable for his business debts.
     • Business is dissolved when owner dies.
     • Accounts for 73% of business firms.
     • Collects 6% of the business revenue.
       • Farms.
       • Grocery stores.
       • Restaurants.
   • Partnership - owned by a two or more persons acting as co-owners.
     • High risk, because all partners are responsible for debts incurred by 1 partner.
     • If one partner dies, then business has to be reorganized.
     • Accounts for 7% of business firms.
     • Collects 5% of the business revenue.
       • Law firms.
       • Accounting firms.
   • Corporation - owned by stockholders.
     • Limited liability - if corporation bankrupts, the creditors cannot sue the stockholders.
       • The stockholders only loose the value of their stocks.
     • Ownership can be easily transferred.
       • Easy to buy and sell stock.
     • Theoretically, a corporation can live forever.
     • The stockholders elect the board directors who in turn select the managers to run the corporation.
     • Issuing stock allows the corporation to gather large amounts of capital.
     • Accounts for 20% of business firms.
     • Collects 89% of the business revenue.

Economic Costs

• Opportunity costs - the value or costs from the second best alternative, when an individual makes a decision
  • Look forward.
  • Included in all production costs.
  • If company could use resources to make a more valuable product, then it would make that product.
• Sunk costs - historical costs associated with past decisions that cannot be changed.
  • Provide information.
  • Not relevant to current choices.
  • Example: A 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.
      • A $1,000 loss.
  • What should the company do?
  • Economists - in Year 1, if the university knew this would be the outcome, then the machine should of not been purchased.
    • In Year 3, the machine cost is sunk cost; do not include this cost
    • Revenue is $3,000.
    • Paper/ink cost is $2,000 for paper/ink.
    • Keep the machine operating. (Minimizing a loss).
      • Activity is contributing $1,000.
• Explicit Costs - when a monetary payment is made.
  • Salaries for labor.
  • Tax payments.
  • Interest payments.
  • Buying resources
  • Pay utilities
• Opportunity costs - resources owned by the firm and do not involve a monetary payment.
  • Accountants usually omit opportunity costs.
  • A proprietor's opportunity cost is working for his business and earning salary.

Economic profit = total revenue - explicit costs - implicit costs

Accounting profit = total revenue - explicit costs

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.

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

Short run - a period of time so short that at least one factor of production is fixed. Usually buildings and large machines and equipment.

1. Fixed Costs

• 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.
• Average Fixed Costs (AFC) - fixed costs per good produced.
  • As production level increases, AFC will get smaller and smaller.
  • 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

2. Variable Costs

• Total Variable Costs (TVC) - the costs that varies when the production level changes.
  • Labor costs
  • Raw material costs
• 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

3. Marginal Cost (MC) - the increase in cost as production increases by one unit; MC will decline initially, reach a minimum, and then rise.

Marginal Cost
Cost per unit
Output/Quantity

• 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).
  • 60 workers - output is 1,100 units (18.3 units per worker)

4. 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

All relevant cost functions are graphed below:.

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

• 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 completed 2 tests.
  • 3rd test (i.e. marginal).
  • Scores 90%, average increases.
  • Scores 70%, average decreases.

5. 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: Expected market price (P e) > = min. of long-run ATC

2. Why unit costs differ in the long run?

Long Run ATC

• Economies of scale - per-unit costs fall as output (plant size) expands.
  • Mass production.
    • Large amounts of capital and machines.
  • Specialization of labor.
• 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.
    • Publishing.
    • Lumber.
    • Retailing.
• Diseconomies of scale - per-unit costs rises as output (plant size) expands.
  • Bureaucratic inefficiencies.
  • More difficult to coordinate workers
  • Monitoring problems.
  • Employees may not be working

Factors that Shift Firm's Cost Functions

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