chapter 5 the firm: production and cost. copyright © 2008 pearson addison wesley. all rights...

Chapter 5The Firm: Production and Cost

Economic Rent

• Economic Rent

A payment for the use of any resource over and above its opportunity cost

Thus, rent has a different meaning in economics.

Economic Rent (cont'd)

• Determining land rent

Economists originally used the term rent to designate payment for use of land.

The concept of economic rent is associated with the British economist David Ricardo.

Figure 22-1 Economic Rent

Economic Rent (cont'd)

• Economic rent to labor

Professional sports superstars

Rock stars

Movie stars

World-class models

Successful inventors and innovators

Example: Do Entertainment Superstars Make Super Economic Rents?

• Superstars certainly do well financially.

• Forbes magazine has ranked them.

• How much of these earnings can be called economic rent?

Table 22-1 Superstar Earnings

Firms and Profits

• Firms or businesses, like individuals, seek to earn the highest possible returns.

• A firm brings together the factors of production to produce a product or service it hopes can be sold at a profit.

Firms and Profits (cont'd)

• Firm

A business organization that employs resources to produce goods or services for profit

A firm normally owns and operates at least one “plant” or facility in order to produce.

Firms and Profits (cont'd)

• The legal organization of firms

Proprietorship

Partnership

Corporation

Table 22-2 Forms of Business Organization

The Legal Organization of Firms

• Proprietorship

A business owned by one individual whoMakes the business decisions

Receives all the profits

Is legally responsible for all the debts of the firm

The Legal Organization of Firms (cont'd)

• Advantages of proprietorships

Easy to form and dissolve

All decision-making power resides with the sole proprietor

Profit is taxed only once

• Disadvantages of proprietorships

Unlimited LiabilityThe owner of the firm is personally responsible

for all of the firm’s debts.

Limited ability to raise funds

Proprietorship normally ends with the death of the proprietor.

• Partnership

A business owned and managed by two or more co-owners, or partners, whoShare the responsibilities and the profits of

the firm

Are individually liable for all the debts of the partnership

• Advantages of partnerships

Easy to form and dissolve

Partners retain decision-making power

Permits more effective specialization

Profit is taxed only once

• Disadvantages of partnerships

Unlimited liability

Decision making more costly

Dissolution often occurs when a partner dies or leaves the firm.

• Corporation

A legal entity that may conduct business in its own name just as an individual does

The owners of a corporation, called shareholdersOwn shares of the firm’s profits

Enjoy the protection of limited liability

• Limited Liability

A legal concept whereby the responsibility, or liability, of the owners of a corporation is limited to the value of the shares in the firm that they own.

• Advantages of corporations

Limited liability

Continues to exist when owner leaves the business

Raising large sums of financial capital

• Disadvantages of corporations

Double taxation Dividends

Portion of corporation’s profits paid to its owners (shareholders)

Separation of ownership and control

The Profits of a Firm

• Accounting Profit

Total revenue minus total explicit costs

The Profits of a Firm (cont'd)

• Explicit Costs

Costs that business managers must take account of because they must be paid

Examples are wages, taxes and rent

• Implicit Costs

Expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculateOpportunity cost of factors of production that

are owned

Owner-provided capital and owner-provided labor

• Normal Rate of Return

The amount that must be paid to an investor to induce investment in a business

Also known as the opportunity cost of capital

• Let’s discuss Bertha Benson…

• Opportunity Cost of Capital

The normal rate of return, or the available return on the next-best alternative investment

Economists consider this a cost of production, and it is included in our cost examples.

• Opportunity cost of owner-provided land and capital

Single-owner proprietorships often exaggerate profit as they understate their opportunity cost of capital.

Consider a simple example of a skilled auto mechanic working at his/her own service station, six days a week.

• Accounting profits versus economic profits

The term profits in economics means the income entrepreneurs earn.Over and above all costs including their own

opportunity cost of time.

Plus the opportunity cost of capital they have invested in their business.

• Economic Profits

Total revenues minus total opportunity costs of all inputs used

The total of implicit and explicit costs

Figure 22-2 Simplified View of Economic and Accounting Profit

Interest

• Interest is the price paid from debtors to creditors for the use of loanable funds.

• Businesses use financial capital in order to invest in physical capital.

Interest (cont'd)

• Financial Capital Funds used to purchase physical capital

goods, such as buildings and equipment

• Interest The payment for current rather than future

command over resources; the cost of obtaining credit

Interest (cont'd)

• Variations in the rate of annual interest that must be paid for credit depend on

1. Length of loan

2. Risk

3. Handing charges

Interest (cont'd)

• Nominal Rate of Interest The market rate of interest expressed in

today’s dollars

• Real Rate of Interest The nominal rate of interest minus the

anticipated rate of inflation

Interest (cont'd)

• Present Value

The value of a future amount expressed in today’s dollars

The most that someone would pay today to receive a certain sum at some point in the future

Interest (cont'd)

PV1 = FV1 / 1 + i

PV1 = Present value of a sum one year hence

FV1 = Future sum paid or received one year hence

i = Market rate of interest

Interest Rates and Present Value

• Present value of $105 to be received one year from now, if the interest rate is 5%:

PV = 105/(1.05) = $100

The present value is $100

Table 22-3 Present Value of a Future Dollar

Interest (cont'd)

• Your own personal discount rate will determine how willing you are to save and to borrow.

• The market interest rate lies between the upper and lower ranges of personal rates of discount.

Corporate Financing Methods

• When it all began—1602

Dutch East India Company raised financial capital bySelling ownership shares (stock)

Using notes of indebtedness (bonds)

Some profits were retained for reinvestment

Corporate Financing Methods (cont'd)

• Share of Stock

A legal claim to a share of a corporation’s future profitsCommon stock

Incorporates certain voting rights regarding major policy decisions of the corporation

Preferred stock Owners are accorded preferential treatment in the

payment of dividends

• Bond

A legal claim against a firm

Usually entitling the owner of the bond to receive a fixed annual coupon payment, plus a lump-sum payment at the bond’s maturity date

Bonds are issued in return for funds lent to the firm.

• Reinvestment

Profits (or depreciation reserves) used to purchase new capital equipment

Sales of stock are an important source of financing for new firms.

Reinvestment and borrowing are the primary means of financing for existing ones.

The Difference Between Stocks and Bonds

1. Stocks represent ownership.

2. Common stocks do not have a fixed dividend rate.

3. Stockholders can elect a board of directors, which controls the corporation.

4. Stocks do not have a maturity date; the corporation does not usually repay the stockholder.

5. All corporations issue or offer to sell stocks. This is the usual definition of a corporation.

6. Stockholders have a claim against the property and income of a corporation after all creditors’ claims have been met.

1. Bonds represent debt.

2. Interest on bonds must always be paid, whether or not any profit is earned.

3. Bondholders usually have no voice in or over management of the corporation.

4. Bonds have a maturity date on which the bondholder is to be repaid the face value of the bond.

5. Corporations need not issue bonds.

6. Bondholders have a claim against the property and income of a corporation that must be met before the claims of stockholders.

Stocks Bonds

The Markets for Stocks and Bonds

• Economists often refer to the “market for wheat” or the “market for labor.”

• These are more conceptual places rather than actual ones.

• For securities there really are markets—physical locations.

The Markets for Stocks and Bonds (cont'd)

• Securities

Stocks and bonds

• New York Stock Exchange (NYSE)

• Nasdaq

• London Stock Exchange (FTSE)

• Tokyo Stock Exchange

• Bombay Stock Exchange (BSE)

• Shanghai Stock Exchange

• Inside Information

Information that is not available to the general public about what is happening in a corporation

One way to “beat the market,” although it is considered illegal, punishable by substantial fines and imprisonment

Table 22-4 Reading Stock Quotes

Figure 22-3 The Price of a Seat on the New York Stock Exchange Since 1999

Did You Know That...

• Nanotechnology-enabled improvements may help computer manufactures lengthen the time components last, thereby reducing their costs?

• Production technologies and the costs producers face are related?

• Short Run

A time period when at least one input, such as plant size, cannot be changed

Plant SizeThe physical size of the factories that a firm

owns and operates to produce its output

Short Run versus Long Run

Short Run versus Long Run (cont'd)

• Long Run

The time period in which all factors of production can be varied

Short Run versus Long Run (cont'd)

• Managers take account of both the short-run and long-run consequences of their behavior.

• While making decisions about what to do today, tomorrow, and next week—they keep an eye on the long-run benefits.

The Relationship Between Output and Inputs

• A firm takes numerous inputs, combines them using a technological production process and ends up with output.

• We classify production inputs in two broad categories—labor and capital.

The Relationship Between Output and Inputs (cont'd)

Q = output/time periodK = capitalL = labor

Q = ƒ(K,L)

Output / time period = Some function of capital and labor inputs

• Production

Any activity that results in the conversion of resources into products that can be used in consumption

• Production Function

The relationship between maximum physical output and the quantity of capital and labor used in the production process

The production function is a technological relationship between inputs and output.

E-Commerce Example: Put Away the Clay and Turn on the Holographic Camera

• Once a company has integrated a holographic camera system into its existing computer network, creating holographic designs takes less time.

• Consequently, product developers using holographic techniques can now create more designs while utilizing fewer labor resources.

E-Commerce Example: Put Away the Clay and Turn on the Holographic Camera (cont'd)

• Why do technological improvements often reduce labor requirements for specific tasks, thereby allowing labor to be utilized for other purposes?

• Average Physical Product

Total product divided by the variable input

• 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

Figure 23-1 The Production Function and Marginal Product:

A Hypothetical Case, Panel (a)

Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (b)

Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (c)

Diminishing Marginal Product

• Measuring marginal product

• Specialization and marginal product

• Diminishing marginal product

• Law of Diminishing Marginal Product

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

Diminishing Marginal Product (cont'd)

An Example of the Law of Diminishing Marginal Product

• Production of computer printers example

We have a fixed amount of factory space, assembly equipment, and quality control diagnostic software.

So the addition of more workers eventually yields successively smaller increases in output.

An Example of the Law of Diminishing Marginal Product (cont'd)

• After a while, when all the assembly equipment and quality-control diagnostic software are being used, additional workers will have to start assembling and troubleshooting quality problems manually.

• The marginal physical product of an additional worker, given a specified amount of capital, must eventually be less than that for the previous workers.

Total costs (TC) = TFC + TVC

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

• Average Total Costs (ATC)

Short-Run Costs to the Firm (cont'd)

Average total costs (ATC) = Total costs (TC)

Output (Q)

• Average Variable Costs (AVC)

Average variable costs (AVC) = Total variable costs (TVC)

Output (Q)

• Average Fixed Costs (AFC)

Average fixed costs (AFC) = Total fixed costs (TFC)

Output (Q)

• 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

Figure 23-2 Cost of Production: An Example, Panel (a)

Total AverageTotal Fixed Fixed

Output Costs Costs(Q/day) (TFC) (AFC)

0 $101 102 103 104 105 106 107 108 109 10

10 1011 10

———$10.00

5.003.332.502.001.671.431.251.111.00.91

2 4 6 8 100 1 3 5 7 9 11

Output (calculators per day)

Cost of Production: AFC

Total AverageTotal Variable Variable

Output Costs Costs(Q/day) (TVC) (AVC)

0 $01 52 83 104 115 136 167 208 259 31

10 3811 46

———$5.004.003.332.752.602.672.863.133.443.804.18

2 4 6 8 100 1 3 5 7 9 11

Cost of Production: AVC

AverageTotal Total Total

Output Costs Costs(Q/day) (TVC) (AVC)

0 $101 152 183 204 215 236 267 308 359 41

10 4811 56

———$15.00

9.006.675.254.604.334.284.384.564.805.09

2 4 6 8 100 1 3 5 7 9 11

Cost of Production: ATC

2 4 6 8 100 1 3 5 7 9 11

ATCAVC

Cost of Production: An Example

Difference between AVC and ATC = AFC

ATC = AVC + AFCAFC = ATC - AVC

• Marginal Cost The change in total costs due

to a one-unit change in production rate

Short-Run Costs to the Firm

Marginal costs (MC) = change in total cost

change in output

TotalTotal Variable Total Marginal

Output Costs Costs Cost(Q/day) (TVC) (TC) (MC)

0 $01 52 83 104 115 136 167 208 259 31

10 3811 46

$101518202123263035414856

2 4 6 8 100 1 3 5 7 9 11

Cost of Production: MC

Figure 22-3, Panel (c)

Figure 23-2 Cost of Production: An Example, Panel (b)

Figure 23-2 Cost of Production: An Example, Panel (c)

In Class Example…

• Question

What do you think—is there a predictable relationship between the production function and AVC, ATC, and MC?

• 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 product), marginal cost will begin to rise.

Example: Reducing the Marginal Cost of Air Transport with “Winglets”

• After years of experimentation, engineers created winglets by making jetliners’ wings slightly longer and curving them up at the ends.

• Since the early 2000s, most new planes ordered by airliners have included winglets, which provide fuel savings for every mile that a plane is in the air.

• Some airlines are in the process of adding winglets to their existing fleet of planes too.

Example: Reducing the Marginal Cost of Air Transport with “Winglets” (cont'd)

• How has airlines’ use of winglets affected their total cost curves?

The Relationship Between Average and Marginal Costs

• When marginal costs are less than average variable costs, the latter must fall.

• When marginal costs are greater than average variable costs, the latter must rise.

The Relationship Between Average and Marginal Costs (cont'd)

• There is also a relationship between marginal costs and average total costs.

Average total cost is equal to total cost divided by the number of units produced.

Marginal cost is the change in total cost due to a one-unit change in the production rate.

The Relationship Between Diminishing Marginal Product and Cost Curves

• Firms’ short-run cost curves are a reflection of the law of diminishing marginal product.

• Given any constant price of the variable input, marginal costs decline as long as the marginal product of the variable resource is rising.

• At the point at which diminishing marginal product begins, marginal costs begin to rise as the marginal product of the variable input begins to decline.

The Relationship Between Diminishing Marginal Product and Cost Curves (cont'd)

• If the wage rate is constant, then the labor cost associated with each additional unit of output will decline as long as the marginal physical product of labor increases.

Figure 23-3 The Relationship Between Output and Costs, Panel (a)

Figure 23-3 The Relationship Between Output and Costs, Panel (b)

Figure 23-3 The Relationship Between Output and Costs, Panel (c)

Figure 23-3 The Relationship Between Output and Costs, Panel (d)

Long-Run Cost Curves

• Planning Horizon

The long run, during which all inputs are variable

Figure 23-4 Preferable Plant Size and the Long-Run Average Cost Curve

Long-Run Cost Curves (cont'd)

• 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

Long-Run Cost Curves (cont'd)

• Observation Only at minimum long-run average cost

curve is short-run average cost curve tangent to long-run average cost curve.

• Question Why do you think the long-run average

cost curve U-shaped?

Why the Long-Run Average Cost Curve is U-Shaped

• Economies of scale

• Constant returns to scale

• Diseconomies of scale

Figure 23-5 Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with Long-Run Average Cost Curve

Why the Long-Run Average Cost Curve is U-Shaped (cont'd)

• Economies of Scale

Decreases in long-run average costs resulting from increases in outputThese economies of scale do not persist

indefinitely, however.

Once long-run average costs rise, the curve begins to slope upwards.

• Reasons for economies of scale

SpecializationDivision of tasks or operations

Dimensional factor

Improved productive equipment

• Explaining diseconomies of scale

Limits to the efficient functioning of management

Coordination and communication is more of a challenge as firm size increases

Policy Example: Economies of Scale

in Payment Processing• Since 2000, the annual volume of

payments transmitted by the Federal Reserve’s ACH system has increased from 3.8 to more than 6 billion.

• At the same time, the average cost of transmitting a payment has declined from more than 1.6 cents to about 1 cent.

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

Figure 23-6 Minimum Efficient Scale

Minimum Efficient Scale (cont'd)

• Small MES relative to industry demand There is room for many efficient firms.

High degree of competition

• Large MES relative to industry demand There is room for only a small number of

efficient firms.

Small degree of competition

Example: A Company Thinks Smaller to Boost its MES

• Briggs & Stratton Corp. moved from a massive 2 million square foot facility in Milwaukee where it was located in the 1990s.

• Today, it has dispersed its production among six smaller plants, each of which utilizes more automated equipment and employs fewer workers than during the 1990s.

Example: A Company Thinks Smaller to Boost its MES (cont'd)

• Downsizing its plants enabled the company to increase its overall scale of operations, from an output rate of 8 million engines per year to more than 10 million engines per year.

• The result of this output increase has been lower long-run average total cost, which has helped to boost the company’s annual profitability by more than 30%.

Key Terms and Concepts

• accounting profits

• average fixed costs

• average physical product

• average total cost

• average variable costs

• corporation

• costs

• economic profits

• explicit

• fixed costs

• law of diminishing returns

• limited liability

• limited liability company (LLC)

Key Terms and Concepts (cont.)

• marginal costs

• marginal physical product

• partnership

• production function

• S corporations

• short run

• sole proprietorship

• total costs

• unlimited liability

• variable costs

chapter 5 the firm: production and cost. copyright © 2008 pearson addison wesley. all rights...

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