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Transcript of Chapter 5 The Firm: Production and Cost. Copyright © 2008 Pearson Addison Wesley. All rights...
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Chapter 5The Firm: Production and Cost
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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.
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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.
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Figure 22-1 Economic Rent
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Economic Rent (cont'd)
• Economic rent to labor
Professional sports superstars
Rock stars
Movie stars
World-class models
Successful inventors and innovators
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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?
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Table 22-1 Superstar Earnings
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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.
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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.
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Firms and Profits (cont'd)
• The legal organization of firms
Proprietorship
Partnership
Corporation
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Table 22-2 Forms of Business Organization
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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
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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
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The Legal Organization of Firms (cont'd)
• 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.
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The Legal Organization of Firms (cont'd)
• 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
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The Legal Organization of Firms (cont'd)
• Advantages of partnerships
Easy to form and dissolve
Partners retain decision-making power
Permits more effective specialization
Profit is taxed only once
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The Legal Organization of Firms (cont'd)
• Disadvantages of partnerships
Unlimited liability
Decision making more costly
Dissolution often occurs when a partner dies or leaves the firm.
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The Legal Organization of Firms (cont'd)
• 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
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The Legal Organization of Firms (cont'd)
• 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.
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The Legal Organization of Firms (cont'd)
• Advantages of corporations
Limited liability
Continues to exist when owner leaves the business
Raising large sums of financial capital
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The Legal Organization of Firms (cont'd)
• Disadvantages of corporations
Double taxation Dividends
Portion of corporation’s profits paid to its owners (shareholders)
Separation of ownership and control
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The Profits of a Firm
• Accounting Profit
Total revenue minus total explicit costs
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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
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The Profits of a Firm (cont'd)
• 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
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The Profits of a Firm (cont'd)
• 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
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• Let’s discuss Bertha Benson…
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The Profits of a Firm (cont'd)
• 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.
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The Profits of a Firm (cont'd)
• 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.
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The Profits of a Firm (cont'd)
• 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.
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The Profits of a Firm (cont'd)
• Economic Profits
Total revenues minus total opportunity costs of all inputs used
The total of implicit and explicit costs
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Figure 22-2 Simplified View of Economic and Accounting Profit
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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.
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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
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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
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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
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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
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Interest (cont'd)
PV1 = FV1 / 1 + i
where
PV1 = Present value of a sum one year hence
FV1 = Future sum paid or received one year hence
i = Market rate of interest
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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
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Table 22-3 Present Value of a Future Dollar
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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.
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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
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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
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Corporate Financing Methods (cont'd)
• 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.
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Corporate Financing Methods (cont'd)
• 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.
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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
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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.
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The Markets for Stocks and Bonds (cont'd)
• Securities
Stocks and bonds
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The Markets for Stocks and Bonds (cont'd)
• New York Stock Exchange (NYSE)
• Nasdaq
• London Stock Exchange (FTSE)
• Tokyo Stock Exchange
• Bombay Stock Exchange (BSE)
• Shanghai Stock Exchange
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The Markets for Stocks and Bonds (cont'd)
• 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
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Table 22-4 Reading Stock Quotes
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Figure 22-3 The Price of a Seat on the New York Stock Exchange Since 1999
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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?
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• 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
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Short Run versus Long Run (cont'd)
• Long Run
The time period in which all factors of production can be varied
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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.
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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.
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The Relationship Between Output and Inputs (cont'd)
Q = output/time periodK = capitalL = labor
Q = ƒ(K,L)
or
Output / time period = Some function of capital and labor inputs
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The Relationship Between Output and Inputs (cont'd)
• Production
Any activity that results in the conversion of resources into products that can be used in consumption
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The Relationship Between Output and Inputs (cont'd)
• 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.
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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.
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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?
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The Relationship Between Output and Inputs (cont'd)
• Average Physical Product
Total product divided by the variable input
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The Relationship Between Output and Inputs (cont'd)
• 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
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Figure 23-1 The Production Function and Marginal Product:
A Hypothetical Case, Panel (a)
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Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (b)
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Figure 23-1 The Production Function and Marginal Product: A Hypothetical Case, Panel (c)
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Diminishing Marginal Product
• Measuring marginal product
• Specialization and marginal product
• Diminishing marginal product
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• 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)
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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.
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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.
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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
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• Average Total Costs (ATC)
Short-Run Costs to the Firm (cont'd)
Average total costs (ATC) = Total costs (TC)
Output (Q)
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• Average Variable Costs (AVC)
Short-Run Costs to the Firm (cont'd)
Average variable costs (AVC) = Total variable costs (TVC)
Output (Q)
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• Average Fixed Costs (AFC)
Short-Run Costs to the Firm (cont'd)
Average fixed costs (AFC) = Total fixed costs (TFC)
Output (Q)
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• Marginal Cost
The change in total costs due to a one-unit change in production rate
Short-Run Costs to the Firm (cont'd)
Marginal costs (MC) = Change in total cost
Change in output
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Figure 23-2 Cost of Production: An Example, Panel (a)
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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
Cos
ts (
dolla
r pe
r da
y)
2
4
6
8
12
2 4 6 8 100 1 3 5 7 9 11
16
Output (calculators per day)
10
14
Cost of Production: AFC
AFC
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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
Cos
ts (
dolla
r pe
r da
y)
2
4
6
8
12
2 4 6 8 100 1 3 5 7 9 11
16
Output (calculators per day)
10
14
Cost of Production: AVC
AVC
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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
Cos
ts (
dolla
r pe
r da
y)
2
4
6
8
12
2 4 6 8 100 1 3 5 7 9 11
16
Output (calculators per day)
10
14
Cost of Production: ATC
ATC
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Cos
ts (
dolla
r pe
r da
y)
2
4
6
8
12
2 4 6 8 100 1 3 5 7 9 11
16
Output (calculators per day)
10
14
ATCAVC
AFC
Cost of Production: An Example
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AVC
Cos
ts (
dolla
r pe
r da
y)
Output (calculators per day)
ATC
Cost of Production: An Example
AFC
AVC
AFC
ATC
Difference between AVC and ATC = AFC
TP
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AFC
AVC
Cos
ts (
dolla
r pe
r da
y)
Output (calculators per day)
ATC
Cost of Production: An Example
AVC
TP
ATC = AVC + AFCAFC = ATC - AVC
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• 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
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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
$5
32
1
23
45
67
8
Cos
ts (
dolla
r pe
r da
y)
2
4
6
8
12
2 4 6 8 100 1 3 5 7 9 11
16
Output (calculators per day)
10
14
MC
Cost of Production: MC
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Cost of Production: An Example
Figure 22-3, Panel (c)
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Figure 23-2 Cost of Production: An Example, Panel (b)
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Figure 23-2 Cost of Production: An Example, Panel (c)
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In Class Example…
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Short-Run Costs to the Firm (cont'd)
• Question
What do you think—is there a predictable relationship between the production function and AVC, ATC, and MC?
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Short-Run Costs to the Firm (cont'd)
• 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.
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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.
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Example: Reducing the Marginal Cost of Air Transport with “Winglets” (cont'd)
• How has airlines’ use of winglets affected their total cost curves?
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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.
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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.
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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.
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• 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)
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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.
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Figure 23-3 The Relationship Between Output and Costs, Panel (a)
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Figure 23-3 The Relationship Between Output and Costs, Panel (b)
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Figure 23-3 The Relationship Between Output and Costs, Panel (c)
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Figure 23-3 The Relationship Between Output and Costs, Panel (d)
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Long-Run Cost Curves
• Planning Horizon
The long run, during which all inputs are variable
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Figure 23-4 Preferable Plant Size and the Long-Run Average Cost Curve
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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
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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?
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Why the Long-Run Average Cost Curve is U-Shaped
• Economies of scale
• Constant returns to scale
• Diseconomies of scale
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Figure 23-5 Economies of Scale, Constant Returns to Scale, and Diseconomies of Scale Shown with Long-Run Average Cost Curve
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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.
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• Reasons for economies of scale
SpecializationDivision of tasks or operations
Dimensional factor
Improved productive equipment
Why the Long-Run Average Cost Curve is U-Shaped (cont'd)
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Why the Long-Run Average Cost Curve is U-Shaped (cont'd)
• Explaining diseconomies of scale
Limits to the efficient functioning of management
Coordination and communication is more of a challenge as firm size increases
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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.
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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
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Figure 23-6 Minimum Efficient Scale
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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
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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.
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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%.
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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)
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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