Roger LeRoy Miller
Economics Today
Chapter 22
The Firm: Cost and Output
Determination
Miller, Economics Today, © 2001 Addison Wesley Longman, Inc.
Introduction
Since 1989 there have been nearly 4000
commercial bank mergers. The most common
rationale given is that large banks are more
cost efficient than small banks.
To be able to evaluate this rationale, you must
understand the nature of cost curves faced
by individual firms.
Slide 22-2
Learning Objectives
 Distinguish between accounting
of profits and economic profits
 Discuss the difference between
the short run and the long run
from the perspective of a firm
Slide 22-3
Learning Objectives
 Understand why the marginal physical
product of labor eventually declines
as more units of labor are employed
 Explain the short-run cost curves
faced by a typical firm
Slide 22-4
Leaning Objectives
 Describe the long-run cost curves
a typical firm faces
 Identify situations of economies
and diseconomies of scale and
define a firm’s minimum efficient scale
Slide 22-5
Chapter Outline
 The Firm
 Short Run versus Long Run
 The Relationship Between Output
and Inputs
 Diminishing Marginal Returns
 Short-Run Costs to the Firm
Slide 22-6
Chapter Outline
 The Relationship Between Diminishing
Marginal Returns and Cost Curves
 Long-Run Cost Curves
 Why the Long-Run Average Cost
Curve is U-Shaped
 Minimum Efficient Scale
Slide 22-7
Did You Know That...
 There are more than 25 steps
in the process of manufacturing
a simple lead pencil?
 In the production of an automobile,
there are literally thousands of steps?
 How do producers select
the best combination of inputs
for any desired output?
Slide 22-8
The Firm
 Firm
– An organization that brings together
factors of production—labor, land,
physical capital, human capital, and
entrepreneurial skill—to produce
a product or service that it hopes
can be sold at a profit
Slide 22-9
The Firm
 Organizational structure
– Entrepreneur
• Residual claimant
– Gets what is left over after all expenses
are paid
• Manager
• Workers
Slide 22-10
The Firm
 Profit and costs
Accounting profits = total revenues - explicit costs
 Explicit Costs
– Costs that business managers must take
account of because they must be paid
Slide 22-11
The Firm
 Implicit Costs
– Expenses that managers do not have to
pay out of pocket and hence do not
normally explicitly calculate
• Opportunity costs of using factors that a
producer does not buy or hire, but already
owns
Slide 22-12
The Firm
 Normal Rate of Return
– The amount that must be paid
to an investor to induce investment
in a business
 Opportunity Cost of Capital
– The normal rate of return, or the available
return on the next-best alternative
investment
Slide 22-13
The Firm
 Example
– A skilled auto mechanic owns a service
station.
– He works six days a week and 14 hours
per day, or 84 hours/week.
 His opportunity cost is:
– An employee mechanic makes $20/hour.
– Opportunity cost
• 84 hours x $20 = $1,680
Slide 22-14
The Firm
 The service station must make more
than $1,680 to show an economic
profit.
Slide 22-15
The Firm
 What do you think?
– Is a building owned by a business “free”?
Slide 22-16
The Firm
 Accounting profits
versus economic profits
Economic profits = total revenues - total opportunity cost
of all inputs used
or
Economic profits = total revenues - (explicit + implicit costs)
Slide 22-17
Simplified View of Economic
and Accounting Profit
Figure 22-1
Slide 22-18
The Firm
 The goal of the firm:
profit maximization
– Firms are expected to try to make
the positive difference between total
revenues and total costs as large
as they can.
Slide 22-19
Short Run versus Long Run
 Short Run
– A time period when at least one input,
such as plant size, cannot be changed
– Plant Size
• The physical size of the factories that a firm
owns and operates to produce its output
Slide 22-20
Short Run Versus Long Run
 Long Run
– The time period in which all factors
of production can be varied
Slide 22-21
The Relationship
Between Output and Inputs
Output/time period = some function of capital and labor inputs
or
Q = ƒ(K,L)*
*Q = output/time period
K = capital
L = labor
Slide 22-22
The Relationship
Between Output and Inputs
 Production
– Any activity that results in the conversion
of resources into products that can be
used in consumption
Slide 22-23
The Relationship
Between Output and Inputs
 Production Function
– The relationship between inputs
and output
– A technological, not an economic,
relationship
– The relationship between inputs and
maximum physical output
Slide 22-24
The Relationship
Between Output and Inputs
 The production function:
a numerical example
– Short-run model
– Fixed input is capital
– Variable input is labor
Slide 22-25
Diminishing Marginal Returns
 Law of Diminishing (Marginal) Returns
– The observation that after some point,
successive equal-sized increases in a
variable factor of production, such as
labor, added to fixed factors of production,
will result in smaller increases in output
Slide 22-26
The Relationship
Between Output and Inputs
 Average Physical Product
– Total product divided by the variable input
Slide 22-27
The Relationship
Between Output and Inputs
 Marginal Physical Product
– The physical output that is due to the
addition of one more unit of a variable
factor of production
– The change in total product occurring
when a variable input is increased
and all other inputs are held constant
– Also called marginal product
or marginal return
Slide 22-28
Diminishing Returns, the Production Function,
and Marginal Product: A Hypothetical Case
Figure 22-2, Panel (a)
Slide 22-29
Diminishing Returns, the Production Function,
and Marginal Product: A Hypothetical Case
Figure 22-2, Panel (b)
Slide 22-30
Diminishing Returns, the Production Function,
and Marginal Product: A Hypothetical Case
Figure 22-2, Panel (c)
Slide 22-31
Short-Run Costs to the Firm
 Assume two inputs
– Capital (fixed)
– Labor (variable)
Slide 22-32
Short-Run Costs to the Firm
 Total Costs
– The sum of total fixed costs and total
variable costs
 Fixed Costs
– Costs that do not vary with output
 Variable Costs
– Costs that vary with the rate of production
Total costs (TC) = TFC + TVC
Slide 22-33
Cost of Production: An Example
Figure 22-3, Panel (a)
Slide 22-34
Cost of Production: An Example
Figure 22-3, Panel (b)
Slide 22-35
Short-Run Costs to the Firm
 Average Total Costs (ATC)
total costs (TC)
Average total costs (ATC) =
output (Q)
Slide 22-36
Short-Run Costs to the Firm
 Average Variable Costs (AVC)
Average variable costs (ATC) =
total variable costs (TC)
output (Q)
Slide 22-37
Short-Run Costs to the Firm
 Average Fixed Costs (ATC)
Average fixed costs (AFC) =
total fixed costs (TC)
output (Q)
Slide 22-38
Cost of Production: An Example
0
1
2
3
4
5
6
7
8
9
10
11
$10
10
10
10
10
10
10
10
10
10
10
10
Average
Fixed
Costs
(AFC)
———
$10.00
5.00
3.33
2.50
2.00
1.67
1.43
1.25
1.11
1.00
.91
16
Costs (dollar per day)
Total
Output
(Q/day)
Total
Fixed
Costs
(TFC)
14
12
10
8
6
4
2
0
AFC
1
2 3 4 5 6 7 8 9 10 11
Output (calculators per day)
Slide 22-39
Cost of Production: An Example
0
1
2
3
4
5
6
7
8
9
10
11
$0
5
8
10
11
13
16
20
25
31
38
46
Average
Variable
Costs
(AVC)
———
$5.00
4.00
3.33
2.75
2.60
2.67
2.86
3.13
3.44
3.80
4.18
16
Costs (dollar per day)
Total
Output
(Q/day)
Total
Variable
Costs
(TVC)
14
12
10
8
6
AVC
4
2
0
1
2 3 4 5 6 7 8 9 10 11
Output (calculators per day)
Slide 22-40
Cost of Production: An Example
Total
Costs
(TVC)
0
1
2
3
4
5
6
7
8
9
10
11
$10
15
18
20
21
23
26
30
35
41
48
56
———
$15.00
9.00
6.67
5.25
4.60
4.33
4.28
4.38
4.56
4.80
5.09
16
Costs (dollar per day)
Total
Output
(Q/day)
Average
Total
Costs
(AVC)
14
12
10
8
ATC
6
4
2
0
1
2 3 4 5 6 7 8 9 10 11
Output (calculators per day)
Slide 22-41
Cost of Production: An Example
Costs (dollar per day)
16
14
12
10
8
6
ATC
AVC
4
2
0
AFC
1
2 3 4 5 6 7 8 9 10 11
Output (calculators per day)
Slide 22-42
Costs (dollar per day)
Cost of Production: An Example
Difference between
AVC and ATC = AFC
ATC
AVC
ATC
AVC
AFC
AFC
TP
Output (calculators per day)
Slide 22-43
Costs (dollar per day)
Cost of Production: An Example
ATC = AVC + AFC
AFC = ATC - AVC
ATC
AVC
AFC
AVC
TP
Output (calculators per day)
Slide 22-44
Short-Run Costs to the Firm
 Marginal Cost
– The change in total costs due
to a one-unit change in production rate
Marginal costs (MC) =
change in total cost
change in output
Slide 22-45
Cost of Production: An Example
0
1
2
3
4
5
6
7
8
9
10
11
Total
Costs
(TC)
$0
5
8
10
11
13
16
20
25
31
38
46
$10
15
18
20
21
23
26
30
35
41
48
56
Marginal
Cost
(MC)
$5
3
2
1
2
3
4
5
6
7
8
16
Costs (dollar per day)
Total
Output
(Q/day)
Total
Variable
Costs
(TVC)
14
12
10
MC
8
6
4
2
0
1
2 3 4 5 6 7 8 9 10 11
Output (calculators per day)
Slide 22-46
Cost of Production: An Example
Total
Output
(Q/day)
0
1
2
3
4
5
6
7
8
9
10
11
Total
Variable
Costs
(TVC)
Total
Costs
(TC)
$0
5
8
10
11
13
16
20
25
31
38
46
$10
15
18
20
21
23
26
30
35
41
48
56
Marginal
Cost
(MC)
$5
3
2
1
2
3
4
5
6
7
8
 What do you think?
– Will a change in
fixed cost change
marginal cost?
– Example
• Increase in interest
rate on adjustable
rate mortgage
• Increase in
insurance premium
Slide 22-47
Cost of Production: An Example
Figure 22-3, Panel (c)
Slide 22-48
Cost of Production: An Example
Costs (dollar per day)
16
12
10
MC
8
6
4
TC
AFC can be found
by subtracting AVC
from ATC
14
2
0
ATC
AVC
FC
VC
1
2 3 4 5 6 7 8 9 10 11
Output (calculators per day)
Slide 22-49
Short-Run Costs to the Firm
 What do you think?
– Is there a relationship between
the production function and AVC, ATC,
and MC?
Slide 22-50
Short-Run Costs to the Firm
 Answer
– As long as marginal physical product
rises, marginal cost will fall, and when
marginal physical product starts to fall
(after reaching the point of diminishing
marginal returns), marginal cost will begin
to rise.
Slide 22-51
Costs (dollar per day)
Cost of Production: An Example
When MC < AVC,
AVC declines
MC
AVC
MC
AVC
TP
Output (calculators per day)
Slide 22-52
Costs (dollar per day)
Cost of Production: An Example
When MC > AVC,
AVC increases
MC
MC
AVC
AVC
TP
Output (calculators per day)
Slide 22-53
Cost of Production: An Example
Costs (dollar per day)
When MC = AVC,
AVC at the minimum
MC
AVC
MC = AVC
TP
Output (calculators per day)
Slide 22-54
Costs (dollar per day)
Cost of Production: An Example
When MC < ATC,
ATC declines
MC
MC
ATC
ATC
TP
Output (calculators per day)
Slide 22-55
Costs (dollar per day)
Cost of Production: An Example
When MC > ATC,
ATC increases
MC
MC
ATC
ATC
TP
Output (calculators per day)
Slide 22-56
Costs (dollar per day)
Cost of Production: An Example
When MC = ATC,
ATC at the minimum
MC
ATC
MC = ATC
TP
Output (calculators per day)
Slide 22-57
Short-Run Costs to the Firm
 The relationship: a summary
– The change on the margin leads
to a change in the average
– Example
• To raise your GPA, your GPA this semester
must exceed your current GPA
Slide 22-58
Policy Example:
Can “Three Strikes” Laws Reduce Crime?
 What happens to the MC of murder
when committing a felony after two
prior convictions?
 The MC of murder falls to zero.
Slide 22-59
The Relationship Between Diminishing
Marginal Returns and Cost Curves
MC =
DTC
DOutput
Labor cost assumed constant
MC =
W
MPP
Recall: labor is the variable input
Slide 22-60
The Relationship Between Diminishing
Marginal Returns and Cost Curves
Figure 22-4, Panel (a)
Slide 22-61
The Relationship Between
Physical Output and Costs
Figure 22-4, Panels (b) and (c)
Slide 22-62
The Relationship Between
Physical Output and Costs
Figure 22-4, Panels (c) and (d)
Slide 22-63
The Relationship Between Diminishing
Marginal Returns and Cost Curves
 Firms’ short-run cost curves
are a reflection of the law
of diminishing marginal returns.
 Given any constant price
of the variable input, marginal costs
decline as long as the marginal product
of the variable resource is rising.
Slide 22-64
The Relationship Between Diminishing
Marginal Returns and Cost Curves
 At the point at which diminishing
marginal returns begin, marginal costs
begin to rise as the marginal product
of the variable input begins to decline.
Slide 22-65
The Relationship Between Diminishing
Marginal Returns and Cost Curves
TVC
AVC =
output
W
AVC =
AP
Slide 22-66
Long-Run Cost Curves
 Planning Horizon
– The long run, during which all inputs are
variable
Slide 22-67
Preferable Plant Size
and the Long-Run Average Cost Curve
Figure 22-5, Panels (a) and (b)
Slide 22-68
Long-Run Cost Curves
 Long-Run Average Cost Curve
– The locus of points representing the
minimum unit cost of producing any given
rate of output, given current technology
and resource prices
Slide 22-69
Long-Run Cost Curves
 Planning Curve
– The long-run average cost curve
Slide 22-70
Long-Run Cost Curves
 Observation
– Only at minimum long-run average cost
curve is short-run average cost curve
tangent to Long-run average cost curve
 What do you think?
– Why is the long-run average cost curve
U-shaped?
Slide 22-71
Why the Long-Run Average Cost
Curve is U-Shaped
 Economies of Scale
– Decreases in long-run average costs
resulting from increases in output
Slide 22-72
Why the Long-Run Average Cost
Curve is U-Shaped
 Reasons for economies of scale
– Specialization
– Dimensional factor
– Improved productive equipment
Slide 22-73
Why the Long-Run Average Cost
Curve is U-Shaped
 Explaining diseconomies of scale
– Limits to the efficient functioning
of management
Slide 22-74
Economies of Scale, Constant Returns to Scale,
and Diseconomies of Scale Shown with the
Long-Run Average Cost Curve
Figure 22-6, Panel (a)
Slide 22-75
Economies of Scale, Constant Returns to Scale,
and Diseconomies of Scale Shown with the
Long-Run Average Cost Curve
Figure 22-5, Panel (b)
Slide 22-76
Economies of Scale, Constant Returns to Scale,
and Diseconomies of Scale Shown with the
Long-Run Average Cost Curve
Figure 22-6, Panel (c)
Slide 22-77
Minimum Efficient Scale
 Minimum Efficient Scale (MES)
– The lowest rate of output per unit time
at which long-run average costs
for a particular firm are at a minimum
Slide 22-78
Minimum Efficient Scale
 Small MES relative to industry
demand:
– High degree of competition
 Large MES relative to industry
demand:
– Small degree of competition
Slide 22-79
Minimum Efficient Scale
Figure 22-7
Slide 22-80
Issues and Applications:
Are Bigger Banks Necessarily More Efficient Banks?
 Bank managers claim that mergers
and acquisitions result in cost savings.
– Until the mid-1990s cost savings
of 15 to 20 percent have been realized
in bank mergers.
• Due to economies of scale
• New technologies
Slide 22-81
Web Links
 The following Web links appear in the
margin of this chapter in the textbook:
– http://www.census.gov/epcd/www/
smallbus.html
– http://ingramayne.saintjoe.edu/econ/
TheFirm/ProductionFunct.html
Slide 22-82
Summary Discussion
of Learning Objectives
 Accounting profit
versus economic profit
– Accounting profit = total revenuetotal explicit costs
– Economic profit = accounting profitsimplicit costs
Slide 22-83
Summary Discussion
of Learning Objectives
 The short run versus the long run
from a firm’s perspective
– Short run: a period in which at least one
input is fixed
– Long run: a period in which all inputs are
available
Slide 22-84
Summary Discussion
of Learning Objectives
 The law of diminishing marginal returns
– As more units of a variable input are employed
with a fixed input, marginal physical product
eventually begins to decline
 A firm’s short-run cost curves
– Fixed and average fixed cost
– Variable and average variable cost
– Total and average total cost
– Marginal cost
Slide 22-85
Summary Discussion
of Learning Objectives
 A firm’s long-run cost curve
– Planning horizon
– All inputs are variable including plant size
 Economies and disceconomies of
scale and a firm’s minimum efficient
scale
Slide 22-86
End of Chapter
Chapter 22
The Firm: Cost and Output
Determination