Firms and Cost

• The Firm and the Business Sector

  Economic Cost<|>Production Relationships
• Sole Proprietorship


  Business owned and controlled by one person. Proprietor is the owner who personally supervises the operation
• Partnership


  Two or more individuals (the partners) agree to own and operate a business together. They pool their resources and business skills and consequently share the risks and the profits and the losses
• Principal-Agent Problem


  Conflict of interest that can occur when agents (executives) pursue their own objectives to the detriment of the principals (stockholders') goals
• Economic (opportunity) Cost


  Value equal to the quantity of other products that cannot be produced when resources are instead used to make a particular product
• Explicit Costs


  Monetary payments a firm must make to an outsider to obtain a resource
• Implicit Costs


  Monetary income a firm sacrifices when it uses a resource it owns rather than supplying the resource in the market, equal to what the resource could have earned in the best-paying alternative employment (including normal profit)
• Normal profit


  Payment by a firm to obtain and retain entrepreneurial ability
• Cost of Production


  Includes all costs - explicit and implicit, including normal profit, required to attract and retain factors of production in a specific line of production
• Economic Profit


  Total revenue of a firm less its economic costs (which includes both explicit cost and implicit costs)
• Short Run


  Period of time in which producers are able to change the quantities of some but not all of the resources they employ
• Long Run


  Period of time long enough to enable a producers of a product to change the quantities of all the resources they employ
• Total Product (TP)


  Total quantity or total output, of a particular goods or service produced
• Marginal Product (MP)


  Extra output associated with adding a unit of variable output to the production process
• Average Product (AP)


  Output per unit of labor input
• Law of Diminishing Returns


  As successive units of variable factor (say labor) are added to a fixed factor (say capital or land), beyond some point the extra, or marginal product that can be attributed to each additional unit of variable factor will decline
• Fixed Cost (FC)


  Costs that in total do not vary with changes in output
• Variable Cost (VC)


  Costs that change with the level of output (or costs that increase or decrease with a firm's output)
• Total Cost (TC)


  Sum of fixed cost and variable cost at each level of output
• Average Fixed Costs (AFC)


  Total fixed cost divided by output
• Average Variable Costs (AVC)


  Total variable costs divided by output
• Average Total Costs (ATC)


  Total cost divided by output
• Total Cost (TC)


  The sum of fixed cost and variable cost at each level of output
• Per Unit or Average Costs


  Costs stated on a per unit basis, including average fixed costs, average variable costs and average total costs
• Average Fixed Costs (AFC)


  Calculated by dividing total fixed cost (TFC) by output (Q)
• Average Variable Costs (AVC)


  Calculated by dividing total variable costs (TVC) by output (Q)
• Average Total Costs (ATC)


  Calculated by dividing total costs (TC) by output (Q), or by dividing AFC and AVC at that output
• Marginal Costs (MC)


  The extra or additional cost of producing one more unit of output, determined by the change in total cost divided by the change in quantity
• Relationship between Productivity Curves and Cost Curves

  Not provided
• Long-Run Production Cost


  • In the long-run, firms can undertake all desired input adjustments, including altering plant capacity, building larger or smaller plants, and new firms entering or existing firms leaving the industry
  • All inputs and costs are variable in the long run
• Firm Size and Costs


  As a firm expands to successively larger plant sizes, average total costs will initially decrease but eventually increase as plant size gets too large
• Constructing Larger Plants


  Will lower the minimum average total costs through a certain plant size, but then larger plants will mean higher minimum average total cost
• Long-Run Cost Curve


  Indicates the outputs at which the firm should change plant size to realize the lowest attainable average total costs of production
• In most lines of production, the choice of plant size is much wider, with virtually unlimited possible plant sizes
• Long-Run ATC Curve


  Made up of all the points of tangency of the unlimited number of short-run ATC curves, resulting in a smooth planning curve
• Economies of Scale


  Reductions in the average total cost of producing a product as the firm expands the size of its plants (output) in the long-run, due to factors like labour specialization, managerial specialization, and efficient capital
• Diseconomies of Scale


  Increases in the average total cost of producing a product as the firm expands the size of its plants (output) in the long-run, mainly due to difficulties in efficiently controlling and coordinating a larger firm
• Constant Returns to Scale


  The range of output between the output at which economies of scale and diseconomies of scale begin
• Minimum Efficient Scale


  The lowest level of output at which a firm can minimize long-run average costs
• Short run production relationships

  • the focus will be on the labor-output relationship, given a fixed plant capacity.