ECON 356 - Outline Eleven
The Theory of the Firm: Costs - The Mainstream Theory
The Economist's View of Costs: (don't forget the difference between implicit and explicit costs):
Profits from an Economic Perspective:
Zero Economic Profit or a Normal Rate of Return:
Economic Profit or Economic Rent:
Costs in the Short Run
Variable Costs:
Not surprisingly, the shape of the variable cost curve is systematically related to the shape of the short-run production function or the total product curve. Why? The production function tells us how much labor we need to produce a given level of output, and this quantity of labor, when multiplied by the wage rate, gives us variable cost.
GRAPH: (see handout Figure 7.10)
Average Variable Costs:
GRAPH: (see handout Figure 7.10)
Fixed Costs:
GRAPH: (see handout Figure 7.11)
Average Fixed Costs:
GRAPH: (see handout Figure 7.11)
Total Costs:
Determining Total Costs -
GRAPH: (see handout Figure 7.12)
Average Total Cost:
GRAPH: (see handout Figure 7.13)
Marginal Cost:
GRAPH: (see handout Figure 7.13)
Note that the MC curve would intersect the ATC and AVC curves at their minimum points. When MC is less than average cost, the average cost curve must be decreasing with output; and when the MC is greater than average cost, average cost must be increasing with output.
Costs in the Long Run - Long-Run Versus Short-Run Production Choices
Choosing the Optimal Input Combination
Isocost Line: a set of input bundles each of which costs the same amount. The isocost line translates resource usage into dollar terms.
Total cost of any combination of labor and capital is the sum of the expenditures on each input (quantity purchases x price).
GRAPH (assume that total cost or expenditure = $1,000, price of labor = $50 and the price of capital = $100):
Why or how would our isocost line change? If the firm's available revenue decreased? Increased?
GRAPH
If we had a change in the price of an input? What if the price of labor increased?
GRAPH
Output Maximization:
Remember our isoquant curve - the combinations of capital and labor that give us the same output level.
So where do you think we will find the maximum output for a Given Expenditure? How about where our highest isoquant line is tangent to our isocost line. (sound familiar?) Why? Because you can reach your highest output level given your expenditure (which basically is your Total Cost) when the isoquant curve is tangent to the isocost line. Note that otherwise, the output level can't be produced with the given expenditures anywhere else on the isoquant curve.
GRAPH: (see handout Figure 7.5)
Question: How would you graph (using isocost and isoquant lines) the answer to the following question?
Why is gravel made by hand in Nepal but by machine in the United States? Hint: You should have two isocost lines -- and then draw one isoquant line that is tangent to both isocost lines (in other words, assume that output is = to 1,000 in both places but they will not use the same combination of capital and labor).
GRAPH
Sample Problem:
Assume our two inputs are capital (K) and labor (L) again.
The prices of the inputs are fixed: price of K = r, price of L = w
Total Costs = K(r) + L(w)
Example: if K = 100, r = $10, L = 50, w = $10
100 (10) + 50(10) = 1000 + 500 = 1,500 = TC
GRAPH this information (isocost line - then show three different isoquant curves - one tangent to the isocost line, one below it and one above it)
Output Expansion Path (OEP): tangencies (min-cost input combinations) traced out by an isocost line of given slope as it shifts outward into the isoquant map for a production process (remember, input prices are fixed).
GRAPH: (see handout Figure 7.6)
This shows us the least costly ways of producing higher levels of output. You can think of each isocost/isoquant tangency as a new firm size -- so we are in the long run, looking at increasing production and finding the least cost way of doing it at each level of output (firm size).
So at each point on our OEP, if we took TC/Q = LRATC and it would be the minimum LRATC at each point. That is what these points tell us.
Long Run Average Total Cost (LRATC) - the planning or envelope curve
GRAPH:
Note where the short run ATC curves are tangent to the LRATC -- it is NOT at their minimum points (necessarily). Each short run ATC represents a different firm size and a different short run (hence the diminishing marginal returns on each). The shape of the LRATC curve depends upon:
Increasing (economies), decreasing (diseconomies) or constant (no effects) returns to scale:
GRAPHS: (see handout Figure 7.9)
Minimum Efficient Scale (MES): quantity at which long run average costs reach their lowest level. In Figure 7.9 on your handout, this is Q*. So it is also where the long run MC curve intersects the long run AC curve.
Economies of Scope: We have assumed a single output with the curves above. This is not very realistic. One reason that firms produce more than one output is economies of scope - cost savings that result from producing a number of products. The costs of producing one good might be reduced by producing another.
Example: The fabricator of steel transmission towers for power companies may reduce its costs of producing towers by producing other products that are also fabricated from steel (can buy more steel - get better prices, for example).
Diseconomies of Scope: Of course -- this can happen too -- costs rise with diversification of the firm's product line. One source is the limited ability of managers to control operations.
The so-called "natural monopoly" theory: Where the LRATC curve falls throughout the output level. Justification for government-granted monopolies in telephone, cable, electricity, post office, etc.
But what's the problem with this theory?