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Chapter 8Chapter 8

Costs and the Supply of Costs and the Supply of GoodsGoods

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OverviewOverview

Shirking and the Principle-Agent ProblemShirking and the Principle-Agent Problem The 3 Types of Business FirmsThe 3 Types of Business Firms Economic vs. Accounting ProfitsEconomic vs. Accounting Profits The Normal Rate of ProfitThe Normal Rate of Profit Short-run vs. Long-runShort-run vs. Long-run Categories of CostsCategories of Costs Law of Diminishing ReturnsLaw of Diminishing Returns Cost Curves (short-run and long-run)Cost Curves (short-run and long-run) Sunk CostsSunk Costs

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Incentives and CooperationIncentives and Cooperation

Residual Claimants: Residual Claimants: Individuals who Individuals who personally receive the excess of personally receive the excess of revenues over costsrevenues over costs

They have the incentive to increase They have the incentive to increase revenues or reduce costsrevenues or reduce costs

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Incentives and CooperationIncentives and Cooperation

There are two ways to organize There are two ways to organize productive activityproductive activity

1. Contracting1. Contracting: using outside : using outside producers for specific tasksproducers for specific tasks

2. Team Production2. Team Production: Where : Where employees work together under the employees work together under the supervision of the owner (or owner’s supervision of the owner (or owner’s representative)representative)

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Incentives and CooperationIncentives and Cooperation

Shirking: Shirking: Working at less than the Working at less than the expected rate of productivity, which expected rate of productivity, which reduces output.reduces output.

Principle-agent problem: Principle-agent problem: The incentive The incentive problem that occurs when the purchaser problem that occurs when the purchaser of services lacks full information about the of services lacks full information about the circumstances faced by the seller, and circumstances faced by the seller, and therefore, cannot know how well the seller therefore, cannot know how well the seller performs the service.performs the service.

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Shirking and the Principle Agent Shirking and the Principle Agent ProblemProblem

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The 3 Types of Business Firms The 3 Types of Business Firms

1. Proprietorship: a business firm 1. Proprietorship: a business firm owned by a single individual.owned by a single individual.

Gets all the profits, but accepts all Gets all the profits, but accepts all the riskthe risk

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The 3 Types of Business FirmsThe 3 Types of Business Firms

2. Partnership: A business firm owned 2. Partnership: A business firm owned by two or more individualsby two or more individuals

They share the profits and the riskThey share the profits and the risk

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The 3 Types of Business FirmsThe 3 Types of Business Firms

3. Corporation: A business firm owned 3. Corporation: A business firm owned by shareholdersby shareholders

They have the right to the firm’s They have the right to the firm’s profits, but their liability is limited to profits, but their liability is limited to the amount of their investmentthe amount of their investment

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Calculating Economic Costs and Calculating Economic Costs and ProfitsProfits

1. Explicit Costs1. Explicit Costs: The payments a firm : The payments a firm makes to purchase the goods and makes to purchase the goods and services of productive resources.services of productive resources.

2. Implicit Costs2. Implicit Costs: The opportunity : The opportunity costs associated with the firm’s use costs associated with the firm’s use of resources that it ownsof resources that it owns

ex. Foregone interest, foregone rentex. Foregone interest, foregone rent

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Calculating Economic Costs and Calculating Economic Costs and ProfitsProfits

3. Total Costs (TC):3. Total Costs (TC): The costs (both The costs (both explicit and implicit) of all of the explicit and implicit) of all of the resources used by the firmresources used by the firm

includes the normal rate of return for includes the normal rate of return for the firms equity capital.the firms equity capital.

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Economic vs. Accounting ProfitEconomic vs. Accounting Profit

Economic Profit:Economic Profit: The difference The difference between the firms total revenue and between the firms total revenue and its total costs (including both explicit its total costs (including both explicit and implicit costs)and implicit costs)

Accounting Profit: Accounting Profit: The sales The sales revenue minus the expenses of the revenue minus the expenses of the firm (does not usually include implicit firm (does not usually include implicit costs) costs)

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Normal Profit RateNormal Profit Rate

Normal Profit Rate: Normal Profit Rate: Zero economic Zero economic profit, the competitive rate of return profit, the competitive rate of return on the capital and labor of the owners on the capital and labor of the owners

*Note: Zero economic profit does *Note: Zero economic profit does NOTNOT mean the business is failing mean the business is failing

≠≠

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Short Run vs. Long RunShort Run vs. Long Run

Short Run: Short Run: A time period so short A time period so short that a firm is unable to vary some of that a firm is unable to vary some of its factors of production.its factors of production.

Long RunLong Run: A time period long enough : A time period long enough to allow the firm to vary all of its to allow the firm to vary all of its factors of production.factors of production.

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Lets Throw a Party!Lets Throw a Party!

What do we need?What do we need?

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Categories Of CostsCategories Of Costs

Total Fixed Costs (TFC)Total Fixed Costs (TFC):: The sum of The sum of the costs that do not vary with outputthe costs that do not vary with output

Fixed costs will remain unchanged as Fixed costs will remain unchanged as output rises or falls in the short runoutput rises or falls in the short run

Ex. Insurance premiums, property Ex. Insurance premiums, property taxes, etc. taxes, etc.

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Categories Of CostsCategories Of Costs

Average Fixed Costs (AFC):Average Fixed Costs (AFC): Total Total Fixed Costs divided by the number of Fixed Costs divided by the number of units produced units produced

AFCAFC = = TFCTFC / Q / Q

average fixed costs always declines average fixed costs always declines with outputwith output

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Categories Of CostsCategories Of Costs

Total Variable Costs (TVC):Total Variable Costs (TVC): The The sum of those costs that change with sum of those costs that change with outputoutput

Ex. wages, raw materialsEx. wages, raw materials

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Categories Of CostsCategories Of Costs

Average Variable Costs (AVC):Average Variable Costs (AVC): Total variable costs divided by the Total variable costs divided by the number of units producednumber of units produced

AVCAVC = = TVCTVC / Q / Q

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Categories Of CostsCategories Of Costs

One can get Total Costs (One can get Total Costs (TCTC) by adding ) by adding together Total Fixed Costs (together Total Fixed Costs (TFCTFC) and ) and Total Variable Costs (Total Variable Costs (TVCTVC))

TCTC = = TFCTFC + + TVCTVC

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Categories Of CostsCategories Of Costs

Average Total Costs (ATC):Average Total Costs (ATC): Total Cost Total Cost divided by the number of units produceddivided by the number of units produced

ATCATC = = TCTC / Q / Q oror

ATC ATC = = AFCAFC + + AVCAVC

The The ATCATC curve is U-shaped because Average curve is U-shaped because Average Total Cost will be high for both an under-Total Cost will be high for both an under-utilized plant (utilized plant (AFC AFC is high) and an over-is high) and an over-utilized plant (utilized plant (MCMC is high) is high)

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Categories Of CostsCategories Of Costs

Marginal Costs (MC):Marginal Costs (MC): The change in The change in total costs required to produce an total costs required to produce an additional unit of output.additional unit of output.

To increase profits: one only produces if To increase profits: one only produces if the additional revenue from one more the additional revenue from one more unit is greater than the marginal cost unit is greater than the marginal cost of that unitof that unit

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Diminishing Returns and Diminishing Returns and ProductionProduction

Law of Diminishing Returns: Law of Diminishing Returns: As As more and more units of a variable more and more units of a variable resource are applied to a fixed resource are applied to a fixed amount of other resources, output amount of other resources, output will eventually increase by smaller will eventually increase by smaller and smaller amountsand smaller amounts

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Diminishing Returns and Diminishing Returns and ProductionProduction

Total Product (TP): Total Product (TP): The total output The total output of a good at a given rate of inputof a good at a given rate of input

Marginal Product (MP):Marginal Product (MP): the change the change in total product associated with each in total product associated with each additional unit of laboradditional unit of labor

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Diminishing Returns and Diminishing Returns and Production (pg. 181)Production (pg. 181)

Average Product (AP):Average Product (AP): The total product The total product divided by the number of variable units divided by the number of variable units (labor) used to get that total product(labor) used to get that total product

AP = TP / QAP = TP / Q

*Note: Average product increases as long as *Note: Average product increases as long as marginal product is greater than the marginal product is greater than the average productaverage product

Ex. Your GPA Ex. Your GPA

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The Cost Curves!The Cost Curves!

1.1. Remember that Remember that ATCATC is U-shaped is U-shaped

2.2. Remember that Remember that AFCAFC falls with output falls with output

3.3. AVC AVC is a is a smallsmall part of part of ATCATC when output is when output is

smallsmall and a and a LARGELARGE part of part of ATCATC when when

output is output is LARGELARGE4.4. MCMC curve may decrease at first, but then curve may decrease at first, but then

risesrises

5.5. MCMC < < AVCAVC ( (ATCATC) ) → → AVCAVC ( (ATCATC) decreases) decreases

MCMC > > AVCAVC ( (ATCATC) → ) → AVCAVC ( (ATCATC) increases) increases

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Output and Costs in the Long RunOutput and Costs in the Long Run

The Long Run Average Total Cost The Long Run Average Total Cost Curve (LRATC):Curve (LRATC): shows the shows the minimum average cost of producing minimum average cost of producing each output level when the firm is each output level when the firm is free to choose among all possible free to choose among all possible plant sizes plant sizes

Outlines the possibilities available in Outlines the possibilities available in the planning stage.the planning stage.

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Economies of Scale (pg. 188)Economies of Scale (pg. 188)

Economies of Scale: Economies of Scale: Occurs when Occurs when the firm’s per-unit costs decrease as the firm’s per-unit costs decrease as output increases (Qoutput increases (Q↑ → LRATC↓)↑ → LRATC↓)

Diseconomies of Scale: Diseconomies of Scale: Occurs Occurs when the firm’s per-unit costs when the firm’s per-unit costs increase as output increases (Qincrease as output increases (Q↑ → ↑ → LRATCLRATC↑↑))

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Economies of ScaleEconomies of Scale

Constant Economies of Scale:Constant Economies of Scale: Occurs when Occurs when the firms per-unit costs do not change as the firms per-unit costs do not change as output changes.output changes.

Economies and diseconomies of scale are long Economies and diseconomies of scale are long run concepts (where all factors are variable).run concepts (where all factors are variable).

Increasing and diminishing returns are short Increasing and diminishing returns are short run concepts (where at least one factor of run concepts (where at least one factor of production is fixed).production is fixed).

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Production: Economies of ScaleProduction: Economies of Scale

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Shifting The Cost CurvesShifting The Cost Curves

Shifters of the Cost CurvesShifters of the Cost Curves

1.1. Price of resourcesPrice of resources

2.2. TaxesTaxes

3.3. RegulationsRegulations

4.4. TechnologyTechnology

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Sunk CostsSunk Costs

Sunk Costs: Sunk Costs: Costs that have already Costs that have already been incurred as a result of past been incurred as a result of past decisionsdecisions

Sunk costs should be ignoredSunk costs should be ignoredEx. Painting your roomEx. Painting your roomEx. Taking a classEx. Taking a class

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ReviewReview

1.1. Understand the principle-agent Understand the principle-agent problemproblem

2.2. Know the difference between economic Know the difference between economic profits and accounting profits and what profits and accounting profits and what we mean by the normal rate of profitwe mean by the normal rate of profit

3.3. Know the difference between the short Know the difference between the short run and the long runrun and the long run

4.4. Be able to fill in the cost tableBe able to fill in the cost table5.5. Be able to recognize the cost curves Be able to recognize the cost curves

and why they slope the way they do and why they slope the way they do

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ReviewReview

6.6. Know the law of diminishing returns Know the law of diminishing returns

7.7. Know what we mean by economies Know what we mean by economies and diseconomies of scale.and diseconomies of scale.

8.8. Understand the idea of sunk costs.Understand the idea of sunk costs.