LECTURE 5

THE ORGANIZATION AND COSTS OF PRODUCTION (the first step in the construction of the supply curve

I THE ORGANIZATION OF PRODUCTION A Some definitions 1 Plant - the production unit, e.g., factory, farm, warehouse, dock, mill, etc. 2 Firm - (also called the enterprise) - the decision making unit (i.e., makes the decision of what, how much to produce), a legal entity, THE SUPPLY SIDE DECISION MAKER 3 Industry - a group of firms producing the same or similar product 4 Market - collection of buyers (consumers) and sellers (firms) of products viewed as close substitutes B A little history 1 18th century Great Britain, agriculture to industrial revolution 2 Move from feudalism (agriculture based) to "capitalism" resulted from confluence of several forces a Religion (Catholicism to Protestantism) b Politics (monarchy to democracy) c Scientific beliefs (creationism to evolution -- survival of the fittest) 3 Adam Smith and the "Wealth of Nations" C Rise of the corporation as a business form. Multiple advantages 1 Could raise money for very large investments 2 Had indefinite life 3 Limited liability 4 Shares could be transferred D Multiple industry structures and firm organizations 1 From pure competition to monopoly industry structure 2 From owner-operator to multi-national corporation enterprise organization. E The modern theory of the firm: "The firm is a collection of transactions that are done more efficiently by 'command' than by using the market". 1 There are costs to using the market. These are called transactions costs. a Search costs b Negotiation costs c Policing costs d Enforcement costs 2 The firm can "internalize" (i.e., vertically integrate, "make rather than buy") transactions and avoid the costs of using the market. However, this can raise other costs. a Agent-principal problems II The Costs of Production A Recall determinants of supply 1 Technology (influences costs) 2 Input prices (influences costs) 3 Price of alternative goods 4 Price expectations 5 Number of Sellers B Economic costs are the payments a firm must make, or incomes it must provide, to resource suppliers to attract those resources away from their best alternative production opportunities. 1 Recall opportunity cost definition 2 Explicit costs and Implicit cost 3 Profits a Normal Profits- an implicit cost because they are the minimum payments required to keep the owner’s entrepreneurial abilities employed in the current occupation. b Economic (also called pure, excess and super-normal) profits) profits are payments to the entrepreneur above normal profits (i.e., total revenue minus total costs, where total costs include normal profits) i Economic profits are important because they attract resources to industries where they are most valued. c "Accounting Profits" = economic profit plus implicit costs 4 Short Run vs Long Run costs a Short-run, a time period in which the quantity of at least one of the firm's inputs is fixed. Usually this is capital (e.g., a factory) but it can also be other factors (e.g., land might be fixed in the short-run) b Long-run, a time period in which all inputs are variable. C Technology and the technique of production 1 The technique of production (like a recipe for baking bread) is also called the production function 2 Relative prices of inputs are important in determining what technique the firm will adopt. 3 Once the recipe is chosen, the relationship between cost and quantity produced can be determined. D Short-run - the Law of Diminishing Returns (to a fixed input) (also known as the law of diminishing marginal product) The law states "with one or more inputs fixed, increases of the variable inputs will increase total quantity BUT at a decreasing rate" 1 Look at Table 6-1 and Figure 6-2 a Pay attention to the relationships between total product, average product and marginal product. 2 The law of diminishing returns assumes all units of variable inputs are of equal quality. For example, when labour is the variable input, marginal product diminishes not because successive workers are inferior but because more workers are being used relative to the amount of plant and equipment available E Short-Run - Costs of Production 1 Fixed, variable and total costs are the short-run classifications of costs; a Total fixed costs are those costs whose total does not vary with changes in short-run output. b Total variable costs are those costs which change with the level of output. They include payment for materials, fuel, power, transportation services, most labour, and similar costs. c Total cost is the sum of total fixed and total variable costs at each level of output. 2 Per unit or average costs. a Average fixed cost is the total fixed cost divided by the level of output (TFC/Q). It will decline as output rises. b Average variable cost is the total variable cost divided by the level of output (AVC = TVC/Q). c Average total cost is the total cost divided by the level of output (ATC = TC/Q), sometimes called unit cost or per unit cost. Note that ATC also equals AFC + AVC. 3 Marginal cost is the additional cost of producing one more unit of output (MC = change in TC/change in Q). a Marginal cost can also be calculated as MC = change in TVC/change in Q. b Marginal cost is a reflection of marginal product and diminishing returns. When diminishing returns begin, the marginal cost will begin its rise. c The marginal cost is related to AVC and ATC. These average costs will fall as long as the marginal cost is less than either average cost. As soon as the marginal cost rises above the average, the average will begin to rise. 4 Cost curves will shift if the resource prices change or if technology or efficiency change. F Long-Run - Costs of Production (all costs are variable) 1 Long-run cost ATC curve derived from short-run cost curves for different plant sizes. 2 The long-run ATC curve shows the least per unit cost at which any output can be produced after the firm has had time to make all appropriate adjustments in its plant size. 3 Why do long run costs decline and then increase (it cannot be the "law of diminishing returns to a fixed factor" because no factor is fixed in the long run). 4 Economies of scale i.e. as plant size increases, long-run ATC decrease. a Specialization of inputs (labour, capital, land, entrepreneurial talent) is most important reason for this. b Other factors may also be involved, such as design, development, or other “start up” costs such as advertising and “learning by doing.” 5 Diseconomies of scale may occur if a firm becomes too large. Some reasons for this include distant management, worker alienation, and problems with communication and coordination. 6 Constant returns to scale will occur when ATC is constant over a variety of plant sizes. 7 Both economies of scale and diseconomies of scale can be demonstrated in the real world. Larger corporations at first may successful in lowering costs and realizing economies of scale. To keep from experiencing diseconomies of scale, they may decentralize decision making by utilizing smaller production units. 8 The concept of minimum efficient scale defines the smallest level of output at which a firm can minimize its average costs in the long run. G Sunk Costs 1 Sunk costs should be disregarded in decision making. a Sunk costs are costs that cannot be recouped if the firm ceases production temporarily or permanently.

Tables.

The relationship between average and marginal Weight of Total Person Person Average Weight Entering Entering Weight in Room Room in Room Room (Marginal)

1st 100 100 100 2nd 90 190 95 3rd 80 270 90 4th 90 360 90 5th 100 460 92 6th 140 600 100 7th 170 770 110

Diminishing returns and increasing marginal cost Cost of Additional Additional Farm Cost of Kilos Kilo Worker Worker (marginal (marginal product) cost) $/kg

1st $10 5 $2.00 2nd $10 8 $1.25 3rd $10 5 $2.00 4th $10 4 $2.50 5th $10 3 $3.33 6th $10 2 $5.00