The Business Firm
- Business firm
- Purchase resources from other firms and households
- Transform resources into products
- Sell products to consumers
- All countries have business firms
- Differ by freedom for decision making
- Socialist countries have less freedom
- Firm owners have strong incentive to produce at low cost
- If business is doing well, the owners earn profits
- If business is doing badly, the owners earn a loss
- Organizing workers
- Contracting - owner contracts with individual workers who work independently
- Takes time, planning, and has high transaction costs
- Example: Building a house or office building
- Team production - workers are hired by a firm to work together under supervision
- Reduces transaction costs
- Employees are monitored
- Prevent shirking
- Shirking - employees working at less than normal rate of productivity
- Examples: Long coffee & bathroom breaks
1. Explicit costs - when a firm makes a monetary payment, using cash or a bank transfer
- Salaries for labor
- Tax payments
- Interest payments
- Buying resources
2. Implicit costs - a cost imposed on the firm, but does not involve a payment
- Accountants use depreciation of machines and equipment
- Accountants recognize that machines wear out and is an expense to the firm
- Opportunity costs - the highest valued option that the decision maker expects to give up as the result of a choice
- Economist include opportunity costs but accountants do not
- A proprietor's opportunity cost is working for his business and earning salary
- Look forward
- Include all production costs
- If company could use resources to make a more valuable product, then it would make that product
3. Sunk costs - historical costs associated with past decisions that cannot be changed
- Requires three things
- Firm paid a cost in the past, or historical costs
- Firm cannot undo the decision
- Firm cannot sell or salvage
- Firm pays for a government license that it cannot resell
- Firm pays for special machines and equipment with little salvage value
- Person pays for a ticket to enter a cinema and the movies is bad
- Provide information
- Not relevant to current choices
- Example: Henderson State University buys a printing machine to publish a magazine
- Machine costs $20,000 and will be depreciated over 10 years
- Depreciation expense is $2,000 per year
- In Year 3, subscription revenue is $3,000
- Depreciation expense is $2,000
- Paper/ink costs $2,000
- University earns a $1,000 loss
- What should the university do?
- Economists - in Year 1, if the administration knew this would be the outcome, then the machine should of not been purchased.
- In Year 3, the machine cost is sunk cost
- Revenue is $3,000
- Paper/ink cost is $2,000 for paper/ink
- Keep the machine operating and minimize the loss
- Activity is contributing $1,000
Economic profit = total revenue - explicit costs - implicit costs (all costs)
Accounting profit = total revenue - explicit costs - implicit costs (i.e. depreciation)
Accounting profit > Economic profit
||Firms earning zero economic profit are earning a normal rate of return. If economic profit is zero, then accounting profit is positive.
If economic profit < 0, then firms are not using resources efficiently.
Someone quit his job (earning $20,000) and used his savings $5,000 to open a business His savings was earning 10%. The first year income statement is below:
Lemonade Stand at the Mall
1st year income statement
|Total Revenue (30,000 lemonades @$1)
| Lemons, sugar, paper cups, etc.
| Labor - employees
| Leasing space
| Accounting profit
| Interest foregone
| Economic profit
|He is not using all of his resources efficiently.|
|Note: There is a non-monetary benefit of being your own boss.|
Output and Costs in the Short Run
1. Short run - a period of time so short that at least one factor of production is fixed, usually the physical capital, like structures, machines, and equipment.
- Total Fixed Costs (TFC) - the costs do not change when production level changes
- Insurance premiums
- Property taxes
- Loans or bonds on factory building or machines
- Overhead from administration
- Average Fixed Costs (AFC) - fixed costs per good produced
- As production level increases, AFC will get smaller and smaller
- The fixed costs is spread out over more units
AFC = TFC / Output
|Total Fixed Cost
||Average Fixed Cost|
- Total Variable Costs (TVC) - the costs that varies when the production level changes.
- Labor costs
- Raw material costs
- Utilities like electricity, water, etc.
- Average Variable Cost (AVC) - variable costs per unit of a good produced
AVC = TVC / Output
|Total Variable Costs
||Average Variable Costs|
2. Marginal Cost (MC) - the increase in cost as production increases by one unit.
- MC will decline initially, reach a minimum, and then rise
- Example: A factory starts with 0 workers
- Specialization of labor
- Production gains
- MC decreases
- 1 worker - output is 10 units (10 units per worker)
- 2 workers - output is 30 units (15 units per worker)
- 3 workers - output is 60 units (20 units per worker)
- Law of Diminishing Returns
- Output increases by a smaller and smaller amount as more labor (variable resource) is added to a factory (fixed resource)
- Production inefficiency
- Exists only in the short run
- 50 workers - output is 1,000 units (20 units per worker)
- 51 workers - output is 1,100 units (18.3 units per worker)
|Cost per unit|
3. The Total Costs and Average Curves.
Total Cost (TC) = Total Fixed Cost + Total Variable Cost
TC = TFC + TVC
Average Total Cost (ATC) = Average Fixed Cost + Average Variable Cost.
ATC = AFC + AVC = TC / Output
- Relationship between marginal cost and total variable costs
- MC < ATC, then ATC is decreasing
- MC > ATC. then ATC is increasing
- MC intersects ATC at its minimum point
- Example: Student's score is 80% and student took 2 tests
- 3rd test (i.e. marginal)
- Scores 90%, average increases
- Scores 70%, average decreases
|Total Cost Curves
||Average Cost Curves|
4. Product curves - Do not worry about the shape of these curves
- Total product - total output of a good associated with different levels of a variable input (e.g. labor).
- Marginal product - change in total product with a one more unit of a variable input (e.g. labor).
- Average product - total product divided by the number of the units of the variable input (e.g. labor).
||Average Costs Curves
|TC, TVC, TFC
||ATC, AFC, AVC, MC
||Total Product, Marginal Product, Average Product|
|Total costs for output
||Per-unit costs for output
||Output for a resource input|
|All curves are related to each other! However, the Average Costs Curves are the most important, because we can derive the supply curve.|
Output and Costs in the Long Run
1. Long run - is a period of time sufficient for the firm to alter all factors of production.
- Firms can enter and exit the industry.
- Long run differs by industry.
- Examples: Long run for an automobile factory using lots of machines may be 7 years.
- The long run for an internet company may be 1 year.
- Long-Run ATC - shows the minimum average cost of producing each output level when a firm is able to vary all production resources, including factory size.
- Allow the firm to vary among 3 factory sizes: ATC1,
ATC2, ATC3. Which factory size should the firm produce at?
|Long Run ATC|
ATC2 will give the factory the lowest per unit costs in the long run. The firm will be able to recuperate all its total costs, when:
Market price (P*) > = minimum of long-run ATC
2. Why unit costs differ in the long run.
|Long Run ATC|
- Economies of scale - per-unit costs fall as output (plant size) expands
- Mass production - large amounts of capital and machines
- Specialization of labor - adding more labor allows workers to specialize in task that they are good at
- Management specialization - departments can specialize in finance, personnel, and marketing
- Natural gas
- Telecommunications including internet services
- Computer chips
- Constant returns to scale - per-unit costs are constant as plant size is changed.
- Small firms can be just as efficient as large firms.
- Food processing
- Wood products
- Diseconomies of scale - per-unit costs rises as output (plant size) expands
- Bureaucratic inefficiencies
- More difficult to coordinate workers
- Monitoring problems, such as workers shirking
Factors that Shifts Firm's Cost Curves
Everything that shifts a supply function will also shift the production function
- Prices of resources - if a price of a resource used in production increases, the cost curves shift higher.
- Labor costs increase.
- Example: Price of steel increases for automobile industry.
- Taxes - increasing taxes on businesses.
- Regulations - increasing regulations on businesses. Firm has to hire compliance specialists, gather data and information, and submit reports. This can be a large cost.
- Environmental regulations
- Health & safety regulations
- Labor regulations
- Technology - allows firms to produce more output while using the same level of resources.
- Microprocessor - compressed millions of transistors onto one chip. Uses less silicone wafers, less labor, less wires, uses less energy, etc.
|Decrease in Production Costs
||Increase in Production Costs|
- business firm
- team production
- principal-agent problem
- explicit costs
- implicit costs
- opportunity costs
- sunk costs
- normal rate of return
- economic profit
- short run
- total fixed costs
- average fixed costs (AFC)
- total variable costs
- average variable cost (AVC)
- marginal costs (MC)
- law of diminishing returns
- specialization of labor
- total cost
- average total cost (ATC)
- long run
- long-run average total costs (ATC-LR)
- economies of scale
- diseconomies of scale
- constant returns to scale