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In the last session we introduced the firm behaviour and the concept of profit
maximisation. In this session we will build on the concepts discussed
previously by examining cost structure, which is a key component of profit
maximisation. Irrespective of the size of the business, all firms, whether it is
Mercedes Benz, Nestlé or the corner store in our suburb, face a common
concern of costs. Focussing on costs will also provide a deeper understanding
of the firm’s supply function.
1
As discussed earlier Profit=Total Revenue – Total Cost; where total revenue is
simply price times quantity or the amount a firm receives for the sale of its
output. For the moment we will focus on the perfect competition. Let’s say that
a Primo pizza factory in Italy sells 500000 pizza and average price of each
pizza is €5, the total revenue will be 5 × 500 000 = €2.5 million.
To find profit we also need to consider the costs side of the equation. To
produce pizza, Primo will have to incur a range of costs such as employing
labour, buying machinery, paying rent, servicing equipment, buying ingredients
etc. These represent the total costs of Primo factory.
Profit is a firm's total revenue minus its total cost. That is:
Total revenue is often expressed as TR and Total cost as TC. The greek letter
pi (π) represents profit.
π = TR – TC
2
As expressed earlier, costs in economics represent opportunity costs.
Opportunity cost of something is what you give up to get it or the value of the
next best alternative forgone.
Sometimes opportunity costs are clear but sometimes they can be tricky to
spot. For example, if Primo factory obtains flour of €1000 then this amount
cannot be used for anything else or €1000 has to be sacrificed to obtain the
flour. Thus, €1000 is an opportunity cost. Because this cost requires firm to
pay out money, it is an example of explicit costs. Opportunity costs sometimes
do not require a cash outlay. For example, if Primo is a skilled computer
programmer and could earn €100 per hour working as a programmer but
chooses not to do so and instead uses the time to manage the pizza factory.
The €100 forgone is also an opportunity cost and is classified as implicit costs
as it does not require any financial outlay.
3
Thus, Total costs= Explicit costs + Implicit costs. Explicit costs are input costs
that require an outlay of money by the firm. Whereas implicit costs do not
require an outlay of money by the firm. Implicit costs are generally ignored by
accountants. In the case of Primo, the next best alternative forgone is working
as a computer programmer and earning €100. However, no financial outlay is
made if Primo does not pursue this option and works in the factory instead.
This will not be accounted at the end of the year financial statement or any
other accounting practices. The main difference between cost calculations
between economist and accountants is that economist include implicit costs
and accountants do not.
4
One of the most important implicit costs that most firms face is the opportunity
cost of capital that has been invested in the business. For example if Primo
used €300 000 of his own money to start up the company, then the interest
forgone on this money is part of implicit costs. The reason is that Primo could
have used this money to earn interest in the bank. So the forgone interest is
an implicit opportunity cost. This implicit costs are included by economists but
not shown as costs in standard accounting practices.
5
Because economic costs are different from accounting costs, there is a
difference in calculating profit.
Economic profit is total revenue minus total cost; where total costs includes
both explicit and implicit costs.
Accounting profit is total revenue minus total explicit cost.
6
Because accounting profit does not account for implicit costs, it is larger than
economic profit as shown in the slide above. As shown in the graph above the
total costs are much greater in the economists view of the world rather than an
accountants.
7
We are now moving on to the production side of firms operation.
Production function captures the relationship between the amount of output
that can be produced given the factor inputs. Factor inputs include land and
labour, capital. We will mainly focus on two factor inputs, capital and labour.
Some firms like car manufacturing require very large amounts of capital
whereas the others such as teaching tend to be more labour intensive.
The production function is an engineering relation that defines the maximum
amount of output that can be produced with a given set of inputs. The
production function is represented as Q=F(K,L). How land and labour can be
combined to produce any good depends on the technology available for
production. Technology summarises the know-how available at a given time to
convert raw materials into output. Lets say that the two basic factors of
production are capital (for e.g. machines) represented as K and labour
represented as L. The combination of these inputs are used to produce a
certain amount of output. Amongst other things, technology is a key factor in
how labour and capital are converted into output. For example, technology
summarizes the feasible means of converting raw inputs, such as steel, labour,
and machinery, into an output such as an automobile. An alternative way of
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thinking about technology is “engineering know-how”.
While deciding the optimal amounts of labour and capital to use, managers are
constrained by time frame. In the short run some factors of production are
fixed. For example, the size of the car plant is fixed in the short run. However,
labour can be more easily altered. In the long-run, both capital and labour are
variable factors.
Short-run
Period of time where some factors of production (inputs) are fixed, and
constrain a manager’s decisions. For example, building a car assembly
line takes several years.
Long-run
Period of time over which all factors of production (inputs) are variable,
and can be adjusted by a manager
There is no fixed time period known as the long run and will vary from
business to business. For example, for a restaurant owner the long run may be
a few months but for a steel factory the long run may be several years.
Typically labor is a variable factor and capital is fixed in the short run .
8
Let take an example of a Cookie factory in the short run. The table above
shows the number of workers as well as total output produced per hour. As the
number of workers increases, the total output or total product increases, which
is shown in the second column. The marginal product of labour (MPL) of an
input is the change in total output as labour changes by a unit. Marginal
Product of Labor: MPL = change in Q/ change in L or the amount of extra
output produced by an additional worker or change in total output attributable
to the last unit of an input. So when the number of workers change from 0 to 1,
then the marginal product is 50 (50-0); when the number of workers increases
to 2, the total product increases to 90. The marginal product is 40.
Note as production is increasing marginal product is going down. This property
is called diminishing marginal product.
9
Diminishing marginal product emphasizes that the marginal product of an input
declines as the quantity of the input increases. If you take labor as the main
input in production, then the property of diminishing marginal product implies
that as we hire more labor units, the extra output or marginal product received
by employing each extra labor unit decreases. Again be very careful as we are
talking about marginal product, not total product. To simplify things lets take an
example. Lets say that a coffee shop opens on campus. The coffee shop
provides coffee+cake+sandwiches. At first there are only two people working in
the coffee shop who run around and do everything. However, they struggle
during peak lunch hour. So they employ another person. The extra output we
get from the third increases but does not jump as dramatically as when we
increased employment from one to two people. Thus marginal product
decreases. Now we continue hiring more people. As more people come into
the coffee shop there is less room for people to specialize. The total output
increases but not as much. Thus, marginal product is going down. The same
applies to Caroline’s cookie factory or any other business. As we keep
increasing our inputs, there comes a point when the extra output contributed
by each worker starts to decline. This is also reflected in the slope of the
production function. As we employ more inputs, the total product increases
sharply but then the increase slows down as diminishing returns set in. The
point at which diminishing returns set in will vary for different businesses.
10
The total cost curve and production function are opposite sides of the same
coin. The total cost curves get steeper as the amount produced rises. Why?
Essentially because of diminishing marginal product. As we hire more workers,
the kitchen used for production of cookies gets more and more crowded. The
workers are getting less productive as we produce more. Thus, producing one
additional unit of output requires a lot of additional units of inputs and hence
there is a steep rise in costs.
11
The production function in panel (a) shows the relationship between the
number of workers hired and the quantity of output produced. Here the number
of workers hired (on the horizontal axis), and the quantity of output produced
(on the vertical axis). The production function gets flatter as the number of
workers increases, reflecting diminishing marginal product. As we employ
more inputs, the total product increases sharply but then the increase slows
down as diminishing returns set in.
The total-cost curve in panel (b) shows the relationship between the quantity of
output produced and total cost of production. The total-cost curve gets steeper
as the quantity of output increases because of diminishing marginal product.
The workers are getting less productive as we produce more. Thus producing
one additional unit of output requires a lot of additional units of inputs and
hence there is a steep rise in costs.
12
We continue our examination of costs but initially from the short-run
perspective. We have two types of costs- short-run and the long-run costs.
Short run is the period when only some inputs are variable and we are stuck
with existing levels of fixed inputs. In the long run all inputs can be varied. So
lets begin by various types of costs in the short run. The costs that vary with
output are variable costs or VC(Q). Variable costs increase as output
increases. The costs that do not vary with output are fixed cost or FC. And the
sum of variable and fixed cost is total cost. Fixed costs do not change as
output changes. Example includes the leasing costs of land, machinery or a
factory.
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Now we have some more definitions. Average fixed cost (AFC) is defined as
fixed cost divided by the number of units of output. Fixed cost do not vary with
output but AFC declines as more and more output is produced.
Average variable cost is variable cost divided by the number of units of output.
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Average total cost, ATC:
Total cost divided by the quantity of output
Average total cost = Total cost / Quantity
ATC = TC / Q
Average total cost is the cost of the typical unit if the total cost is divided
evenly over all the units produced.
15
Marginal cost is the cost of producing an additional unit of output. Typically
marginal cost increase as production increases. Why? The answer is
embedded in the concept of diminishing marginal product which emphasizes
that the marginal product of an input declines as the quantity of the input
increases. If you take labor as the main input in production, then the property
of diminishing marginal product implies that as we hire more labor units, the
extra output or marginal product received from each labor unit decreases.
Again be very careful as we are talking about marginal product, not total
product. To simplify things lets take an example. Lets take the example of
coffee shop again.
The coffee shop provides coffee+cake+sandwiches. At first there are only two
people working in the coffee shop who run around and do everything. Lets say
they struggle during peak lunch hour. So they employ another person. The
extra output we get from the third increases but does not jump as dramatically
as when we increased employment from one to two people. Thus marginal
product decreases. Now we continue hiring more people. As more people
come into the coffee shop there is less room for people to specialize. The total
output increases but not as much. Thus, marginal product is going down. So
what we have here is that marginal product is going down, which essentially
implies that marginal cost is going up. Why are the two related? Because each
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additional worker is able to contribute less to the total cups of coffee in this
instance, but takes essentially takes the same wage. What this means is that
value of the product contributed by each additional worker is reducing but the
wage is not. Therefore marginal costs are increasing. Don’t confuse marginal
costs with average costs here!
16
Lets take an example of Conrad’s coffee shop to understand the cost
structures better. The fixed cost in this case is the rent on the rent of the coffee
shop, which is $3.00. As discussed previously, variable costs change as output
changes. In the above case the variable costs include milk, sugar, beans,
workers salaries etc. As the number of coffee produced increases, the variable
costs go up. Total cost is the sum of the fixed cost and variable costs. Marginal
cost is the change in total cost/change in quantity. So lets say we move from 0
to 1 cups of coffee. The marginal cost is $0.30 ($3.30-$3.00). Now if output
increase from 1 to 2 cups of coffee; the marginal cost is $0.50 ($3.80-$3.30).
Thus, MC increases as we increase production. Also note MC is not the same
as ATC.
17
Here the quantity of output produced (on the horizontal axis) is from the first
column in Table 2, and the total cost (on the vertical axis) is from the second
column. As illustrated, the total-cost curve gets steeper as the quantity of
output increases because of diminishing marginal product.
18
This figure shows the average total cost (ATC), average fixed cost (AFC),
average variable cost (AVC), and marginal cost (MC) for Conrad’s Coffee
Shop. All of these curves are obtained by graphing the data in Table 2. These
cost curves show three features that are typical of many firms: (1) Marginal
cost rises with the quantity of output. (2) The average-total-cost curve is U-
shaped. (3) The marginal-cost curve crosses the average-total-cost curve at
the minimum of average total cost.
As discussed earlier marginal cost rises output goes up due to diminishing
marginal product. Average variable costs also rises because of diminishing
marginal product. The shape of average fixed cost is straightforward as well.
Average fixed cost (AFC) is defined as fixed cost divided by the number of
units of output. Fixed cost do not vary with output but AFC declines as more
and more output is produced.
The U-shaped ATC requires some explanation. The ATC curve is essentially
linked to MC curve.
When MC < ATC: average total cost is falling
When MC > ATC: average total cost is rising
19
The marginal-cost curve crosses the average-total-cost curve at its
minimum
This mathematical relationship applies in all scenarios. Lets take an example.
Say you have a distinction average and get a pass in this course. The
marginal mark is now pass. What will this do to your average- pull it down.
Similarly when marginal cost is below average total cost, ATC goes down.
Now take the scenario when you have a overall average of pass and you get a
high distinction in this course. What will this do to your overall average?
Possibly pull it up towards a credit. Similarly the average cost increases when
marginal cost is above the ATC curve.
The marginal-cost curve crosses the average-total-cost curve at its minimum.
19
Many firms experience increasing marginal product before diminishing
marginal product. As a result, they have cost curves shaped like those in this
figure. Notice that marginal cost and average variable cost fall for a while
before starting to rise. This occurs because initially when we hire more people,
there is room for specialization. As people specialize in different activities,
marginal product increases. The gains to this eventually fade away leading to
increasing marginal costs. Again think of the coffee shop example. If there is
only one person in the coffee shop who does everything, he/she is unlikely to
be very productive. However, hiring one more person allows the two workers
to focus on separate activities, improving the output/customer service etc.
dramatically. Hiring a third worker may not have the same sort of dramatic
effect though.
20
So far we have looked at the firms short run cost curves. The firms in the short
run have fixed costs but in the long run all costs are variable. The firms have
greater flexibility in the long run and can change all inputs of production.
21
In the long run the manager can change the plant size, labor, get new
machines etc. So in terms of costs, the manager is faced with Long-run
Average Cost (LRAC) curve which is a envelope of all the short-run average
cost curves. The bold red line on the diagram is the long-run average cost
curve facing firms in the long-run. So basically what we have here is that the in
the long run firms can alter all the inputs of production and is not restricted to
just labour. LRAC is composed of SRAC curves corresponding to different
plant sizes. In the long run firms pick the best short run curve corresponding to
a particular level of output. The U-shape of the LRAC curve reflects the
principle of Economies of Scale and Diseconomies of Scale. Economies of
scale occurs when LRAC declines as output increases or average costs
decreases as output increases. Diseconomies of scale occurs when LRAC
goes up as output increases
Economies of scale
Long-run average total cost falls as the quantity of output increases.
This is the most common type of phenomenon. As plant size increase,
average costs fall due increasing specializations.
Constant returns to scale
Long-run average total cost stays the same as the quantity of output
22
changes
Diseconomies of scale
Long-run average total cost rises as the quantity of output increases.
This occurs if the firm gets so big that it increasingly runs into
coordination problems. This is not commonly noted in the real world as
recent times have shown that firms are adept at coordinating large
scale operations across national borders.
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