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Chapter 21 (8 Micro)
Costs and the Supply of Goods
OUTLINE
I. Organization of the Business Firm
A. Incentives, Cooperation, and Nature of the Firm
1. In a market economy, firm owners are residual claimants.
a. They have right to any revenue after costs have been paid.
2. Methods of Production
a. Contracting.
(1) Owner contracts with individual workers who work independently.
b. Team Production.
3. Shirking
a. With team production, owners must reduce the problem of shirking employees
working at less than normal rate of productivity.
(1). Example: Long coffee break.
b. Control with incentives and monitoring.
4. Principal-Agent Problem
a. The incentive problem caused by when the buyer has less information than the
seller about purchased services.
B. Types of Business Firms
1. Proprietorship
2. Partnership
3. Corporation
a. Owned by stockholders.
b. In contrast to the unlimited liability of proprietorships and partnerships, the
c. Account for 88 percent of business revenue
II. Costs, Competition, and the Corporation
A. Three major factors in a market economy promote cost efficiency and customer service
within the corporation, thus limiting the power of corporate managers to shirk on their
duties to shareholders.
1. Competition Among Firms for Investment Funds and Customers
3. Threat of Corporate Takeover
B. How Well Does the Corporate Structure Work?
1. There is strong evidence that, despite its defects, the corporation is generally a
cost-efficient, consumer-sensitive form of organization.
III. The Economic Role of Costs
A. Role of Demand and Production Costs
1.
2. The (opportunity) cost of producing the item indicates the desire of consumers for
other goods.
B. Explicit and Implicit Costs
1. Costs may explicit or implicit.
a. Explicit costs result when a monetary payment is made.
b. Implicit costs involve re
monetary payment.
C. Total Cost
1. Total Cost = explicit + implicit costs
D. Accounting and Economic Profit
1. Economic profit is total revenues minus total costs (including all opportunity
costs).
2. Economic profit requires an above normal rate of return, a rate of return greater
than the opportunity cost of capital.
3. Accounting profit is total revenue minus expenses of firm over a designated time
period.
IV. Short Run and Long Run Time Periods
A. Short Run
1. The short run is a period of time so short that at least one factor of production is
fixed.
2. In the short run, output can only be altered by changing the usage of variable
resources, such as labor and raw materials.
B. Long Run
1. The long run is a period of time sufficient for the firm to alter all factors of
production.
Chapter 21 (8 Micro)/Costs and the Supply of Goods 197
V. Categories of Costs
A. Total Fixed Costs
1. Total Fixed Costs (TFC) are costs that remain unchanged in the short run when
B. Average Fixed Costs
1. Average Fixed Costs (AFC) are fixed costs per unit (i.e., TFC/output).
C. Variable Costs
1. Total Variable Costs (TVC) are the sum of costs that rise as output expands.
a. Examples: cost of labor and raw material.
2. Average Variable Costs (AVC) are variable costs per unit (i.e., TVC/output).
D. Total Cost
1. Total Cost (TC) = Total Fixed Cost + Total Variable Cost.
2. Average Total Cost (ATC) = Average Fixed Cost + Average Variable Cost.
E. Marginal Cost
1. Marginal Cost (MC) is the increase in total cost associated with a one-unit increase
in production.
a. MC will decline initially, reach a minimum, and then rise.
VI. Output and Costs in the Short Run
A. Shape of ATC Curve
1. The ATC curve is U-shaped.
a. ATC is high for an underutilized plant because AFC is high.
b. ATC is high for an overutilized plant because MC is high.
B Law of Diminishing Returns
1. Law of Diminishing Returns: as more units of a variable resource are applied to a
C Product Curves
1. Total Product: total output of a good associated with different levels of a variable
input.
3. Average Product: Total product divided by the number of the units of the variable
input.
D. Diminishing Returns and Cost Curves
1. If a firm faces diminishing returns, MC will rise with additional
output.
a. As MC continues to rise, it will eventually exceed ATC and raise ATC.
(1) Before that point, MC is below ATC and is bringing down ATC
VII. Output and Costs in the Long Run
A. Long-Run ATC
1. The long-run ATC shows the minimum average cost of producing each output
level when a firm is able to choose plant size.
B. Planning Curve
C. Economies of Scale
1. Economies of Scale: Reductions in per unit costs as output (plant size) expands can
occur for three reasons.
a. Mass production.
b. Specialization.
D. Diseconomies of Scale
1. Diseconomies of Scale: rises in per unit costs as output (plant size) expands can
occur.
a. Bureaucratic inefficiencies may result as size expands.
E. Constant Returns to Scale
1. Constant Returns to Scale: Unit costs that are constant as plant size is changed.
VIII. What
A. Cost Curve Shifters
1. Prices of resources.
3. Regulations.
4. Technology.
IX. Economic Way of Thinking About Costs
A. Sunk Costs
1. Sunk costs are historical costs associated w
a. Sunk costs may provide information, but are not relevant to current choices.
B. Cost and Supply
1. In the short run, when making supply decisions, the marginal cost of producing
additional units is the relevant cost consideration.
2. In the long run, the average total cost is vital to the supply decision.
OBJECTIVES
In this chapter, we discuss the organization of the firm and analyze the decision process that
cost curves are developed for both the short and long runs.
he ability of the producer to expand output. Given
the law of diminishing returns, the general shape of the total, average, and marginal product curves
is derived. The corresponding cost curves are then presented. In the short run, diminishing returns
will -run average total cost curve
will be U-shaped for small outputs; ATC will be high because AFC is high. For large outputs
(relative to plant size), ATC will be high because marginal costs, reflecting diminishing returns, are
high. Our approach emphasizes the relationship between production theory and the general shape
Chapter 21 (8 Micro)/Costs and the Supply of Goods 199
reasons why the opportunity to plan a larger output (both rate and volume) will initially generate
economies: (a) greater opportunity to adopt mass production techniques, (b) specialization, and (c)
learning by doing. Managerial diseconomies are behind the eventual rise of long run ATC.
When cost curves are constructed, it is assumed that the prices of resources, taxes, and level of
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. Be sure to relate cost analysis to the decisions of producers. Whereas the choices of consumers
underlie demand analysis, the choices of producers form the foundation for cost (and supply)
analysis.
2. Students often fail to consider adequately the opportunity cost of a factor owned (or supplied)
3. The boxed feature on economic and accounting costs will help students better understand the
4. This chapter contains more new definitions of key terms than any other chapter of the text.
5. Exhibits 3 and 4 illustrate the implications of the law of dimi
6. Building on the data presented in Exhibits 3 and 4, Exhibit 6 illustrates the implications of
–
7. Be sure to note that the long-run ATC curve is a planning curve. No single firm could achieve
8. The traditional economies of scale can more properly be thought of as cost reductions that stem
from the ability of the producer to plan a large volume (rather than rate) of output. Accordingly,
9. Textbooks have traditionally discussed costs in a mechanistic fashion. The section on costs and
10. Decision making under uncertain conditions, the role of time, and sunk costs are all points
emphasized in the myth, which explains why decision makers sometimes sell at a loss.
11. Question 2 illustrates common sources of economic confusion due to the failure of decision
makers to understand the concept of cost. Discuss these examples with your students.
12. The quotation by Thomas Sowell at the beginning of the chapter contains much food for
13. Our experience has shown that, since a large number of new terms and concepts are introduced
14. There are many good illustrations of the theory of the firm, shirking, principle-agent problems,
etc., that students are more familiar with than traditional business application and that can be
useful ways of helping students to see the intuition involved. Perhaps the two most useful areas
to find these illustrations are family life (e.g., how does your mom get you to do those chores?)
16. With all the new material being introduced in this chapter, which is then built upon in
subsequent chapters, it is important to emphasize student understanding of the verbal logic
17. A useful example for discussing production functions, fixed and variable factors, etc., is to talk
about production functions for grades in your course. You can talk about varying the
18. A good classroom illustration of implicit versus explicit costs is to ask students whether it is
19. Games 1 to 3 provide some ways to demonstrate the concepts stressed in Chapter 21.
GAMES
1. Growing Rice on a Chalkboard
Type: In-Class Demonstration
Topics: diminishing returns and increasing costs
Textbook: Chapter 20 Costs and the Supply of Goods
Materials Needed:
Time: 25 minutes
Class limitations: works in classes with more than 15 students
Purpose
Students often have difficulty understanding why diminishing returns exist in short run
production. This activity vividly demonstrates how fixed factors constrain the returns to variable
inputs. Then, the cause of increasing marginal cost is obvious.
Instructions
paper with a large dollar sign ($) written on one side and the word
The volunteers are farmers and the outlined areas are their farm fields. They produce rice by
202 Chapter 21 (8 Micro)/Costs and the Supply of Goods
A typical result would look like this
Labor Total Output
0 0
1 3
2 15
Points for discussion
Marginal product can be calculated to show the contribution of additional workers.
Labor Total Output Marginal Product
0 0
1 3 3
2. Intensive Production
Type: In-Class activity
Topics: marginal cost
Textbook: Chapter 20 Costs and the Supply of Goods
Materials Needed: none
Time: 5 minutes
Class limitations: works in any size class
Purpose
This example illustrates how fixed factors cause short-run costs to increase as output increases.
Using an agricultural example with a very tight constraint helps make the idea clear.
Instructions
Explain to the class that you are interested in growing wheat on a very small plot of land, a plot
the size of an average dorm room. This amount of land is fixed, but any other factors can be added
to increase production. The current method of production involves throwing seeds on the land and
returning months later to harvest the grain. Ask the students to list techniques and inputs that
could be used to maximize production from this plot. Graph the relation between output and
marginal cost.
Common Answers:
plant more seed
cultivate
fertilize
use herbicide
irrigate
transplant seedlings
use a greenhouse
heat the greenhouse
add high-intensity grow lights in the greenhouse
Points for discussion
Increasing production by adding more and more inputs increases the marginal costs of production.
Extra wheat can be produced from this small plot only at higher cost per bushel.
3. Average and Marginal Grades
Type : In-Class demonstration
Topics: Relation of marginal and average cost
Textbook: Chapter 20 Costs and the Supply of Goods
Materials Needed: none
Time: 5 minutes
Class limitations: works in any size class
Purpose
This quick exercise uses an analogy to illustrate to students that they already know the relation
between marginals and averages.
Instructions
Tell the class that two twins a
(GPA = 3.0) before taking the class.
Common answers and points for discussion
The entire class will know that Twin One will have a lower GPA and Twin Two a higher GPA. A
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
2. a. The amount paid for the course is a sunk cost. It is not directly relevant to whether one
7. ost.
9. Diminishing marginal returns to the variable factor reflect the fact that another factor is fixed
in quantity so that the variable factor eventually produces less at the margin when, as the
13. Normal returns are a cost because they are necessary to keep the resources in the industry. If
16. Implicit costs are costs associated with the use of resources owned by the firm. Since they are
owned by the firm, an explicit payment for their services generally does not accompany their