Chapter 5 The Firm: Production and Cost. Copyright © 2005 Pearson Addison-Wesley. All rights...

Chapter 5

The Firm: Production and Cost

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 5-2

Learning Objectives

• List the advantages and disadvantages of the sole proprietorship, partnership, and corporation.

• Distinguish between average and marginal product and relate this distinction to the law of diminishing returns.

• Define and distinguish between fixed and variable costs and explain why marginal costs are the most important guide to decisions.

• Explain how to calculate economic profits and why they differ from accounting profits.


Types of Business Organizations

• The three main types of business organizations in the United States are: (1) the sole proprietorship, (2) the partnership, and (3) the corporation.

• There are also certain hybrid forms of these types of business organizations, which have become more popular in recent years.


Sole Proprietorship

• This is a business owned by one person.• Advantages: the proprietor answers to no

one else when making decisions about how run the business, and the owner receives all of the profits.

• Disadvantage: the owner has unlimited liability, meaning that he or she has complete legal responsibility for all debts and damages arising from doing business.


Partnerships

• This is a business that two or more individuals own and operate.

• Advantages: more than one person is available for specialized management, partners can pool their financial capital in order to have a larger business base .


Partnerships (cont.)

• Disadvantages: partners have unlimited liability for debts incurred while in business—if one partner cannot pay his or her share of a debt, the other partner or partners have to ante up the rest; also, when a partner decides to leave the partnership or dies, the partnership normally ends—it must be reorganized.


Corporations

• A corporation is a legal entity that may conduct business in its own name just as an individual does. The owners of a corporation are called shareholders.

• Advantage: By law, shareholders enjoy limited liability—up to the value of their shares.

• Disadvantage: Double taxation of corporate income.


Table 5-1: Forms of Business Organization


Hybrids

• S Corporation—a corporation in which all of the net profits are passed directly to the individual owner or owners, and are taxed as their income.

• The Limited Liability Company, or LLC—in addition to avoiding double taxation, LLC’s also have the limited liabilities of a corporation.


Businesses

• A business firm has a goal—profits.

• To make profits, business firms combine land, labor, capital, and entrepreneurship.

• A combination of these factors of production constitutes the inputs into the production process.


The Production Function

• A business takes all of its inputs and combines them to produce an output. Hence, output is some function of inputs.

• Assuming that all inputs are fixed except the labor input, there exists a production function that relates output per some specific time period with the amount of labor input used.


The Production Function

• The physical output of each worker is called physical product.

• Average Physical Product is equal to total output divided by the number of workers.

• Marginal Physical Product of labor is the change in total output that occurs when a worker joins an existing production process.


Law of Diminishing Marginal Returns

• As successive equal increases in a variable factor of production (such as labor) are added to fixed factors of production, there will be a point beyond which the extra, or marginal, product that can be attributed to each additional unit of the variable factor of production will decline.


The Firm Faces Its Costs

• All firms have costs. • Businesses need to have a handle on

what their costs are in order to determine whether they are producing the way they should and even whether they should stay in business.

• In order to analyze costs correctly, we must look at the different types of costs that each firm encounters.


Fixed Costs

• Some costs are fixed in the short run.

• Fixed costs are those cost that by definition cannot change. In other words, fixed costs to not vary with the rate of output. For example, monthly rent of an office space.


Variable Costs

• Variable costs change with the level of output.

• Labor costs normally are variable costs. Businesses can hire and fire without too much trouble. They can also have workers increase hours or decrease hours.


Total Costs

• When you add up all fixed costs and all variable costs, you end up with total costs.

• In Figure 5-2, next, we graph total costs, total variable costs, and total fixed costs. To do so, we put total costs in dollars on the vertical axis and output on the horizontal axis.


Figure 5-2: Total Cost Curves


Average Costs

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

output (Q)

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

output (Q)

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

output (Q)


Marginal Costs

• Firms are very interested in their marginal costs—costs that result from a one-unit change in the production rate.

• Typically, marginal costs of production fall as output increases up to a certain point and then start to rise.

Change in total costMarginal cost =

Change in output


The Short Run and the Long Run

• The short run is defined as the period during which the firm effectively cannot alter all of its inputs.

• The long run is defined as a period long enough that the firm can change all of these inputs.


In the Long Run, There Are No Fixed Costs

• In the long run, all costs are marginal costs and therefore all decisions are decisions made on the margin that considers the usage of all inputs.


Accounting Profits

• Explicit costs are expenses that business managers must take into account of because they must directly be paid by the firm such as taxes, rent, and workers’ salaries.

Accounting profits = total revenues - total explicit costs


Economic Profits

• Economic Profits are calculated by considering not only explicit costs, but also the opportunity cost of all other inputs used by the firm.

Economics profits

total revenues

total opportunity cost of all inputs used

= –


Figure 5-5: Simplified View of Economic and Accounting Profits


Profits Are What Matters

• To be more accurate, we say that the firm wishes to maximize economic profits.

• This means that the firm is expected to try to make as great as possible the positive difference between total revenues and the total opportunity cost of all production inputs.


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 © 2005 Pearson Addison-Wesley. All rights...

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