PART THREE
Product Markets
Chapter 6: Businesses and
Their Costs
The Business Population
In the economy, there are different types
of businesses which are organized in
several ways and vary in size.
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The Business Population
A plant is an establishment that performs
one or more functions in fabricating and
distributing goods and services.
A firm is a business organization that owns
and operates plants.
An industry is a group of firms that
produce the same, or similar, products.
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The Business Population
Firms can be organized vertically or
horizontally.
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Vertical integration means that firms own plants
that perform different functions in the various
stages of the production process.
Multiplant firms may be organized horizontally,
with several plants that perform much the same
function.
Conglomerates are firms that own plants that
produce products in several separate industries.
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Advantages of Corporations
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Although only 20 percent of all U.S. firms
are corporations, they account for 84
percent of all sales.
The corporation is the most effective form
of business organization for raising money
to finance the expansion of its facilities
and capabilities. Two ways to accomplish
this are to sell stocks and bonds.
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Advantages of Corporations
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A common stock represents a share in
the ownership of a corporation.
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Corporations provide limited liability to owners,
who risk only what they paid for their stock.
Corporate bonds represent certificates
indicating obligations to pay the principal
and interest on loans at a specific time in
the future.
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The Principal-Agent Problem
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The principle-agent problem is a conflict
of interest that occurs when agents
(managers) pursue their own objectives to
the detriment of the principals’
(stockholders’) goals.
This problem arises in corporations where
the owners (principals) usually do not
manage it; they hire others to do so.
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Economic Costs
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Costs exist because resources are scarce
and productive and have alternative uses.
An economic cost, or opportunity cost, is
the value of the best alternative use of a
resource.
From the firm’s perspective, an economic
cost is the payment it must make to attract
the resources it needs away from
alternative production opportunities.
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Explicit and Implicit Costs
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Payments to resource suppliers are
explicit or implicit.
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Explicit costs are the monetary payments a
firm must make to an outsider to obtain a
resource.
Implicit costs are the monetary income a firm
sacrifices when it uses a resource it owns
rather than supplying the resource in the
market.
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Normal Profit as a Cost
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Normal profit is a payment that must be
made by a firm to obtain and retain
entrepreneurial ability. It is also an implicit
cost.
If a business owner does not realize at
least the minimum payment for her effort,
she can withdraw from her business and
shift to a more attractive endeavor.
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Economic Profit
(or Pure Profit)
Economic profit, or pure profit, is a firm’s
total revenue less economic costs, where:
economic costs = explicit + implicit costs
and implicit costs include a normal profit to
the entrepreneur.
Economic profit = total revenue – economic cost
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Short Run and Long Run
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When the demand for a firm’s product
changes, it must adjust the amount of
resources it employs. Some firms can
easily adjust the quantities of certain
resources it uses, while other may need
more time.
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Because of these differences in time
adjustments, economists distinguish between
two time periods: the short run and the long
run.
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Short Run and Long Run

The short run is a time period in which
producers are able to change the
quantities of some but not all of the
resources they employ.
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A firm can adjust the number of workers but
not the plant’s capacity in the short run.
The long run is a time period sufficiently
long to enable producers to change the
quantities of all the resources they employ.
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Short-Run Production
Relationships
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A firm’s cost of producing a specific output
depends on the prices of the needed
resources and the quantities of those
resources needed to produce that output.
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Technologies determine the resources
needed.
Resource prices are determined by resource
supply and demand.
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Short-Run Production
Relationships
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Total product (TP) is the total output of a
particular good or service produced by a
firm.
Marginal product (MP) is the extra output
or added product associated with adding a
unit of a variable resource to the
production process.
Average product (AP) is output per unit
of input.
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Short-Run Production
Relationships
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The law of diminishing returns is the
principle that as successive units of a
variable resource are added to a fixed
resource, the marginal product of the
variable resource will eventually decline.
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This is assume that technology is fixed and
thus the technique of production do not
change.
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Short-Run Production
Relationships
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For production within firms, the law of
diminishing returns is highly relevant.
When a firm adds more labor to the
production process with a fixed amount of
capital equipment, the marginal product of
labor eventually declines. Total product
eventually will rise at a diminishing rate,
then reach a maximum, and finally decline.
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Tabular and Graphical
Representations
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The table in Figure 6.2 shows a numerical
illustration of the law of diminishing returns
followed by the graphs of TP, AP and MP.
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Column (3) illustrate increasing marginal
returns initially, followed by diminishing
marginal returns, and then negative marginal
returns as the variable resource increases by
1 unit.
Column (4) gives the average product which
equals total product divided by labor (input).
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Tabular and Graphical
Representations
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Short-Run Production Costs
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Production information must be coupled
with resource prices to determine the total
and per-unit costs of producing various
levels of output.
These costs are either fixed or variable
depending on whether they can change as
output changes.
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Short-Run Production Costs
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Fixed costs are cost that do not change in
total when the firm changes its output.
Variable costs are costs that increase or
decrease with a firm’s output.
Total cost is the sum of fixed cost and
variable cost.
TC = TFC + TVC
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Per-Unit, or Average, Costs
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Average-cost data allows a firm to make
comparisons with product price, which is
always stated on a per-unit basis.
Average fixed cost (AFC) is a firm’s total
fixed cost divided by output.
Average variable cost (AVC) is a firm’s
total variable cost divided by output.
Average total cost (ATC) is a firm’s total
cost divided by output.
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Per-Unit, or Average, Costs
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AFC = (TFC/Q)
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Average fixed cost decline as output
increases. This is because the total fixed cost
is spread over a larger and larger output.
AVC = (TVC/Q)
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As added variable resources increase output,
average variable cost declines initially,
reaches a minimum, and then increases
again. As a result, AVC is U-shaped.
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Per-Unit, or Average, Costs
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ATC = (TC/Q) or ATC = AFC + AVC
Graphically, ATC can be found by
vertically adding the AFC and AVC curves.
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Marginal Cost

Marginal cost (MC) is the extra or
additional cost of producing one more unit
of output.
change in TC
MC =
change in Q
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Marginal cost can also be calculated as the
change in total variable cost divided by the
change in quantity. As output rises, total cost
increases due to variable cost increases only.
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Marginal Cost
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A firm’s decisions as to how much to
produce are typically marginal decisions.
When coupled with marginal revenue (the
change in total revenue from 1 more or 1
less unit of output), marginal cost allows a
firm to determine if it is profitable to
expand or contract its production.
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Relation of MC
to AVC and ATC
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The marginal cost curve intersect the AVC
and ATC curves at their minimum points.
When the amount added to total cost is
less than the current average total cost,
ATC will fall, and vice versa.
As long as MC lies below ATC, ATC will
fall; whenever MC lies above ATC, ATC
will rise.
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Long-Run Production Costs
In the long run, an industry and the
individual firms it comprises can adjust all
resources employed. Growing firms can
construct larger plants or expand existing
one. For a time, successively larger plants
will lower average total cost. However,
eventually the building of a still larger plant
may cause ATC to rise.
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Firm Size and Costs
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The Long-Run Cost Curve
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The long-run average total cost curve is
made up of segments of the short-run ATC
curves for the various plant sizes that can
be constructed.
The long-run ATC curve represents the
lowest average total cost at which any
output level can be produced after the firm
has had time to make all appropriate
adjustments in its plant size.
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Economies and
Diseconomies of Scale

The U-shaped long-run average total cost
curve can be explained in terms of
economies of scale and diseconomies of
large-scale production.
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The Long-Run Cost Curve
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Economies of Scale
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Economies of scale explain the downward
part of the long-run ATC curve.
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As plant size increases, a number of factors
will for a time lead to lower average costs of
production.
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Economies of Scale
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Factors that contribute to lower average
total cost for the firm, allowing it to expand
its scale of operation, include:
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Labor specialization
Managerial specialization
Efficient capital
Learning by doing
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Diseconomies of Scale

Diseconomies of scale explain the upward
part of the long-run ATC curve.
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As plant size increases, a firm experiences
higher average total costs of production.
The main factor contributing to
diseconomies of scale is the difficulty of
efficiently controlling and coordinating a
firm’s operation as it becomes a largescale producer.
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Constant Returns to Scale

In some industries, there may be a range
of output in which long-run average cost
does not change. This is known as
constant returns to scale.
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This begins where economies of scale end
and ends where diseconomies of scale begin.
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Economies and
Diseconomies of Scale
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Minimum Efficient Scale
and Industry Structure

Minimum efficient scale (MES) is the
lowest level of output at which a firm can
minimize long-run average total cost.
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Minimum efficient scale varies for each
industry and depends on the shape of the
industry’s long-run average total cost curve.
Industries that experience constant returns to
scale over an extended range of output will
have multiple sizes of firms that are equally
efficient.
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