5

FIRM BEHAVIOR AND THE

ORGANIZATION OF INDUSTRY

The Costs of
Production

12

The Market Forces of Supply and

Demand
Supply and demand are the two words that economists use
most often.
Supply and demand are the forces that make market
economies work.
Modern microeconomics is about supply, demand, and
market equilibrium.
How do we know the supply curve of an industry or a firm?
We assumed that the supply curve summarizes the firms
production decisions.
This may be suitable for answering questions about market equilibrium,

Now we are going to study how firms decisions about prices and
quantities depend on the costs of production faced by the firms.

WHAT ARE COSTS?

According to the Law of Supply:
Firms are willing to produce and sell a greater quantity of
a good when the price of the good is high.
This results in a supply curve that slopes upward.

WHAT ARE COSTS?

The Firms Objective
The economic goal of the firm is to maximize profits.

Total Revenue, Total Cost, and Profit

Total Revenue
The amount a firm receives for the sale of its output.

Total Cost
The market value of the inputs a firm uses in production.

Total Revenue, Total Cost, and Profit

Profit is the firms total revenue minus its total cost.

Profit = Total revenue - Total cost

Automotive industrys costs and

profits

http://video.cnbc.com/gallery/?video=3000095750
http://money.cnn.com/video/news/2012/05/30/fleadership-gm-ceo-competition.fortune/
http://digitaljournal.com/article/330804
Global company, large scale. How does this affect GMs
costs?
Global platforms?
The sales of GM have gone up over the last two years
(everywhere except Europe). Nevertheless the profit and
stock price has gone down. Why?

Costs as Opportunity Costs

A firms cost of production includes all the opportunity
costs of making its output of goods and services.
A firms total opportunity cost of production include
explicit costs and implicit costs.
Explicit costs are input costs that require a direct outlay of money
by the firm.
Implicit costs are input costs that do not require an outlay of
money by the firm.
Distinction between the two types of costs is the major way in which
accountants and economists differ in analyzing the performance of a
company.
Accountants focus on only explicit costs, while economists examine both
explicit and implicit costs.

10

Economic Profit versus Accounting Profit

Economists measure a firms economic profit as
total revenue minus total cost, including both
explicit and implicit costs.
Accountants measure the accounting profit as the
firms total revenue minus only the firms explicit
costs.

11

The Cost of Capital as an Opportunity Cost

The opportunity cost of financial capital

An important cost element which must be included in any

analysis of firm performance.

Example:
1. Helen uses $300,000 of her savings to start her firm. It was in a
savings account paying 5 percent interest.
2. Since Helen could have earned $15,000 per year on this savings,
we must include this implicit opportunity cost.

Note that an accountant would not count this $15,000 as part of the firm's
costs.

3. If Helen had instead borrowed $200,000 from a bank at the

interest rate of 5% and used $100,000 from her savings, then

According to the economist the total opportunity cost would not change
But the accountant would only count the $10,000 in interest paid for the
bank loan.

12

Economic Profit versus Accounting Profit

When total revenue exceeds both explicit and

implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.
Because the total opportunity costs include implicit costs.

13

An Example
It is possible for a firm that appears profitable according to
an accountant to be unprofitable according to an economist.
Suppose a firm incurs $20,000 in explicit costs to produce
output that is sold for total revenue of $30,000.
However, the owner/manager of the firm could have worked
for another firm and earned $15,000 during this period.
According to the accountant, the firms profit is $30,000 $20,000
= $10,000
By contrast, the economist would argue that the firm is not
profitable because the total explicit and implicit costs are $20,000
+ $15,000 = $35,000 which exceeds the $30,000 of total revenue.

Economic View versus Accountants View

How an Economist
Views a Firm

How an Accountant
Views a Firm

Economic
profit
Accounting
profit

Revenue

Implicit
costs

Revenue
Total
opportunity
costs

Explicit
costs

Explicit
costs

Copyright 2004 South-Western

15

Important concepts
The Production Function
The production function shows the relationship between
quantity of inputs used to make a good and the quantity
of output of that good.

Marginal Product
The marginal product of any input in the production
process is the increase in output that arises from an
additional unit of that input.

A Production Function and Total Cost: Hungry

Helens Cookie Factory
The size of the factory is assumed fixed;
Helen can vary her output (cookies) only by varying the labor used:

17

Diminishing Marginal Product

Marginal product of a variable input declines as the quantity of the
variable input increases.
As more workers are hired at a firm, each additional worker contributes less to
production because the firm has a limited amount of equipment.
Is the amount of equipment always limited?
No, only in the short run.
In the long-run, the firm can install more equipment.
The long run is the period of time necessary for all inputs to become variable.

Short run variable: Number of workers

Long run variable: Amount of equipment
Note that the long run differs across industries.
It may take many years for all of the inputs of a railroad to become variable
because the railroad tracks are quite permanent and the right-of-way for a
new track is difficult to obtain.
An ice cream shop could add on to its production facility in just a matter of
months.

18

An Example
Consider the short-run production of a small firm that
makes sweaters.
These sweaters are made using a combination of labor and knitting
machines.
The firm has signed a lease to rent 1 machine.
Therefore, in the short run, the firm cannot vary the amount of knitting machines
it uses.

However, the firm can vary the amount of labor it employs.

Recall Hungry Helens Cookie Factory

19

As the number of employed workers increases, the productivity of each

additional worker goes down => We can represent this graphically =>

Hungry Helens Production Function

Quantity of
Output
(cookies
per hour)
Production function

150
140
130
120
110
100

When the marginal product

declines, the production
function becomes flatter.

90
80
70
60
50
40
30
20
10

The slope of the production

function measures the
marginal product of an
additional worker.
Diminishing Marginal
Product

5Number of Workers Hired

21

From the Production Function to the TotalCost Curve

The relationship between the quantity of output a
firm can produce and its costs
determines pricing decisions.

The total-cost curve shows this relationship

graphically.
Consider Hungry Helens Cookie Factory

A Production Function and Total Cost: Hungry

Helens Cookie Factory

We can represent the relationship between the output and the total cost
graphically =>

Hungry Helens Total-Cost Curve

Total
Cost
Total-cost
curve

$80
70
60
50
40
30
20
10

10 20 30 40 50 60 70

Quantity
of Output
(cookies per hour)

80 90 100 110 120 130 140 150

Example

24

Use the following data to graph the farmers production function and the total-cost
curve.

If Farmer Jones plants no seeds on his farm, he gets no harvest.

If he plants 1 bag of seeds, he gets 3 bushels of wheat.
If he plants 2 bags, he gets 5 bushels.
If he plants 3 bags, he gets 6 bushels.
A bag of seeds costs $100, and seeds are his only cost.

The total-cost curve is convex, as the curve gets steeper as

The production function is concave because of
the amount of production increases.
diminishing marginal product. As the number of bags
Because of diminishing marginal product, since each
of seeds increases, the marginal product declines, and
additional bag of seeds has lower marginal product
and thus the cost of producing additional bushels of
the production function becomes flatter.
wheat goes up.

25

THE VARIOUS MEASURES OF

COST
Costs of production may be divided into fixed costs
and variable costs.
Fixed costs are those costs that do not vary with the
quantity of output produced.
Regardless of the number of cars it produces, Ford Motors Inc.
has to maintain the head office in Detroit with hundreds of
office workers.

Variable costs are those costs that do vary with the

quantity of output produced.
The number of workers at the assembly lines varies with the
number of cars produced by Ford.

26

Fixed and Variable Costs

Total Costs (TC)

Fixed Costs (FC)

Variable Costs (VC)

TC = FC + VC

The Various Measures of Cost: Thirsty Thelmas Lemonade Stand

Copyright2004 South-Western

28

Fixed and Variable Costs

Average Costs
Average costs can be determined by dividing the firms
total costs by the quantity of output it produces.
The average cost is the cost of each typical unit of
product.

Average Fixed Costs (AFC)

Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC

Fixed cost FC
AFC

Quantity
Q
AVC

ATC

Variable cost VC

Quantity
Q
Total cost TC

Quantity
Q

29

Marginal Cost
Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production.
(change in total cost) TC
MC

(change in quantity)
Q
is a Greek letter Delta, which is used to represent the
change in variable.

Marginal cost helps answer the following question:

How much does it cost to produce an additional unit of
output?

30

Marginal Cost
Thirsty Thelmas Lemonade Stand
Quantity

Total
Cost

0
1
2
3
4
5

$3.00
3.30
3.80
4.50
5.40
6.50

Marginal
Cost

$0.30
0.50
0.70
0.90
1.10

Quantity

6
7
8
9
10

Total
Cost

$7.80
9.30
11.00
12.90
15.00

Marginal
Cost

$1.30
1.50
1.70
1.90
2.10

Figure 4 Thirsty Thelmas Total-Cost Curves

Total Cost
Total-cost curve

$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
0

Quantity
of Output
(glasses of lemonade per hour)
8

10

Thirsty Thelmas Marginal-Cost Curve

Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC

2.00
1.75

1.50
1.25
1.00
0.75
0.50

0.25
0

Quantity
of Output
(glasses of lemonade per hour)
9

10

Marginal cost
rises with the
amount of
output
produced.
This reflects
the property of
diminishing
marginal
product.

The average total-cost curve is U-shaped.

Costs
$3.50
3.25
3.00

2.75
2.50
2.25
MC

2.00

1.75
1.50

ATC

1.25

AVC

1.00
0.75

0.50
AFC

0.25
0

Quantity
of Output
(glasses of lemonade per hour)
9

10

AFC declines as
output expands
AFC is high when
output levels are low.
AVC typically
increases as output
expands.
As output expands,
AFC declines pulling
ATC down.
As fixed costs get
spread over a large
number of units, the
effect of AFC on ATC
falls and ATC begins
to rise because of
diminishing marginal
product.

The efficient Scale of the Firm

Costs
$3.50

The bottom of the

U-shaped ATC
curve occurs at the
quantity that
minimizes average
total cost.

3.25
3.00
2.75
2.50
2.25
2.00
1.75
ATC

1.50
1.25

This quantity is
sometimes called
the efficient scale
of the firm.

1.00
0.75
0.50

0.25
0

Quantity
of Output
(glasses of lemonade per hour)
9

10

Figure 5 Thirsty Thelmas Average-Cost and Marginal-Cost

Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC

2.00
1.75

ATC

1.50
1.25
1.00
0.75
0.50
0.25
0

Quantity
of Output
(glasses of lemonade per hour)
9

10

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.
The marginal-cost
curve crosses the
average-total-cost
curve at the efficient
scale.
Efficient scale is
the quantity that
minimizes average
total cost.

36

Example
Two twins are enrolled in Principles of Economics.
They each had a B average (GPA = 3.0) before
taking the class.
Twin One gets a C in the course and Twin Two
gets an A in the class.
What happens to their GPAs?

Twin One will have a lower GPA (less than 3.0) and
Twin Two a higher GPA (greater than 3.0).
A marginal grade lower than the average will pull
down the average.
A marginal grade higher than the average will increase
the average.
The same is true of marginal cost and average costs. If marginal cost is less
than average cost, the average cost will fall. If marginal cost is higher than
average cost the average cost will rise.

In reality cost curves are more subtle:

Big Bobs Bagel Bin

37

Figure 6 Big Bobs Cost Curves

(a) Total-Cost Curve

Total
Cost
TC

$18.00

16.00
14.00

Total cost curve is

not everywhere
convex.
Initially it is
concave and then
convex.

12.00

10.00
8.00
6.00

4.00

Why? =>

2.00
0

10

12

Quantity of Output (bagels per hour)

14

Figure 6 Big Bobs Cost Curves

Costs

=> Because the

Marginal Cost first
declines and then
increases.

(b) Marginal- and Average-Cost Curves

$3.00
2.50
MC
2.00
1.50

ATC
AVC

1.00

Adding variable
inputs when there are
few of them, might
initially increase
productivity of each
additional input:
Team effect,

0.50
AFC
0

10

12

Quantity of Output (bagels per hour)

14

Synergies
between workers.
But then marginal
product begins to
diminish =>MC rises

40

Typical Cost Curves

Regardless of these nuances we have 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.

41

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.
In the long run, fixed costs become variable costs.

Many costs are fixed in the short run but variable in the long
run => a firms long-run cost curves differ from its shortrun cost curves.
For example, in the long run a firm could choose the size of its
factory.
Once the factory size is chosen, the firm must deal with the shortrun costs associated with that plant size.

Average Total Cost in the Short and Long Run

Average
Total
Cost

ATC in short
run with
small factory

ATC in short ATC in short

run with
run with
medium factory large factory

ATC in long run

$12,000
10,000

If the size of the assembly line is fixed, then the only way to increase the output of cars from
5000 to 6000 is by hiring more workers

5,000 6,000

Quantity of
Cars per Day

=> because of the diminishing marginal product the AC rises from $10K to $12K

In the long run, the capacity of the assembly line can be increased, the AC will return to $10K.

Figure 7 Average Total Cost in the Short and Long Run

Average
Total
Cost

ATC in short
run with
small factory

ATC in short ATC in short

run with
run with
medium factory large factory

ATC in long run

Quantity of
Cars per Day

The long-run average-total-cost curve lies along the lowest points of the
short-run average-total-cost curves because the firm has more flexibility
in the long run to deal with changes in production.

44

Economies and Diseconomies of Scale

Economies of scale refer to the property whereby long-run
average total cost falls as the quantity of output increases.
Mainly due to specialization and learning effects

Diseconomies of scale refer to the property whereby longrun average total cost rises as the quantity of output
increases.
Mainly due to coordination problems inherent in large
organizations (bureaucracy).

Constant returns to scale refers to the property whereby

long-run average total cost stays the same as the quantity of
output increases

Economies and Diseconomies of Scale

The long-run average total cost curve is typically U-shaped, but is
much flatter than a typical short-run average-total-cost curve.

45

46

Example
If Boeing produces 9 jets per month, its long-run total cost
is $9.0 million per month.
If it produces 10 jets per month, its long run total cost is
$9.5 million per month.
Does Boeing exhibit economies or diseconomies of scale?
The long-run average total cost of producing 9 planes is
$9 million/9 = $1 million.
The long-run average total cost of producing 10 planes is:
$9.5 million/10 = $0.95 million.
Since the long-run average total cost declines as the number
of planes increases, Boeing exhibits economies of scale.

47

An example
John owns a car painting shop with fixed costs of $200 (rent
of the building per week) and the following schedule for
variable costs:

Calculate average fixed cost (AFC), average variable cost

(AVC), and average total cost ( ATC) for each quantity of
cars.
What is the efficient scale of the painting company?

48

An Example: Cont.
Calculate average fixed cost (AFC), average variable cost
(AVC), and average total cost ( ATC) for each quantity of
cars.

What is the efficient scale of the painting company?

The efficient scale is 4 cars per week, since that minimizes
average total cost.

Consider the following table of the long run total cost

for three different firms.
Does each of these firms experience economies of
scale or diseconomies of scale?
Quantity
1
2
3
4
5
6
7

Firm A
TC
ATC
60
60
70
35
80
26.7
90
22.5
100
20
110
18.3
120
17.1

Firm B
TC
ATC
11
11
24
12
39
13
56
14
75
15
96
16
119
17

Firm C
TC
ATC
21
21
34
17
49
16.3
66
16.5
85
17
106
17.7
129
18.4

49

50

Summary
The goal of firms is to maximize profit, which
equals total revenue minus total cost.
When analyzing a firms behavior, it is important to
include all the opportunity costs of production.
Some opportunity costs are explicit while other
opportunity costs are implicit.

51

Summary
A firms costs reflect its production process.
A typical firms production function gets flatter as
the quantity of input increases, displaying the
property of diminishing marginal product.
A firms 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.

52

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.

53

Summary
The average-total-cost curve is U-shaped.
The marginal-cost curve always crosses the averagetotal-cost curve at the minimum of ATC.
A firms 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.