Unit 3 – Theory of the Firm
and
transformation of factors into goods & services
Think about….production
an economic institution that transforms factors of production into goods & services. A firm …..
We are a firm
(1) organizes factors of production and/or
(3) sells produced goods to individuals, gov’ts, businesses
(2) produces goods, and/or
Let’s say this student started his own business (firm)......
He then burns a CD on his computer. Classmates are willing to pay $18.00 for a 10-song CD b/c Leonard puts together tunes better than....
He puts together Leo Jams CD’s for his classmates by downloading music from
Leo calculated the cost of producing each CD at
per CD revenue = _________
per CD profit = __________
$ 2.00 for equipment
9.00 for songs
.80 labor
.20 blank CD’s
He sells each CD for $16.00$16.00
$4.00
Let’s say another student joined the market with her own mixes....
Now we have two suppliers in the market -- Leo Jams & Becca’s Boss Hits. What happens to the price of CD’s?
Price falls to $11.50 per CD.5 of 32
Should Leo burn the next CD at the new market price of $11.50?
He’s already spent $ 2.00 for equipment
He’d need to spend
9.00 for songs
.80 labor
.20 blank CD’s
Yes, he should burn that next CD. He should only be concerned with the costs in front of him.
$ 2.00 for equipment
9.00 for songs
.80 labor
.20 blank CD’s
These are fixed costs = sunk costs
These are variable costs = the costs Leo should worry about
SUNK
COSTS
Sunk costs – are fixed costs that are sunk, done, and over with. There is nothing you can do about them. They are irrelevant to your current decision-making process.**All Fixed Costs are Sunk Costs**
It will cost Leo an additional _________ to burn the next CD & he will earn in revenue __________ for the next CD, therefore he should / should not burn it.
$10.00$11.50
In our book-producing firm….
What were our fixed costs?
What were our variable costs?
Leo Jams CD’s take off. ¿….Decisions….decisions….??
How many workers do I hire?
We examine productivity ….
the amount of goods and services produced (output) per unit of productive resources used (input) in a specific period of time.
¿….Decisions….decisions….??
How many workers do I hire?
No. of workers
1 10
Total CD’s burned
Marginal Product
10
2 22 12
3 33 11How can marginal product decrease?
4 36 3
5 32 -4
Explain how this is possible??
Law of ……
Diminishing Marginal Productivity
as more and more of a variable input is added to an existing fixed input, eventually the additional output one gets from that additional input is going to fall.
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Q 0
1011121314151617181920
FC1,000
1,0001,0001,0001,0001,0001,0001,0001,0001,0001,0001,000
VC 0
1,0851,2151,3651,5401,7802,1052,5303,0653,7204,5005,430
TC1,000
2,0852,2152,3652,5402,7803,1053,5304,0654,7205,5006,430
What are the definitionsof each one of these costs?
FC – Those costs that remain constant whethera firm produces 0 units toan infinite number of units.
VC – Those costs thatchange (go up) when afirm produces from 1 unitto an infinite amount ofunits.
TC = FC + VC
Q 0
1011121314151617181920
FC1,000
1,0001,0001,0001,0001,0001,0001,0001,0001,0001,0001,000
VC 0
1,0851,2151,3651,5401,7802,1052,5303,0653,7204,5005,430
TC1,000
2,0852,2152,3652,5402,7803,1053,5304,0654,7205,5006,430
Let’s graph these columnsto create our first, veryown cost curves.
(000)
1
2
3
4
5
6
10 11 12 13 14 15 16 17 18 19 20
FC
VC
TC
The total costs are important to firms, but more often under consideration are …. average costs
average total cost = total cost divided by quantity produced
average fixed cost = fixed cost divided by quantity produced
average variable cost = variable cost divided by quantity produced
ATC = TC/Q
AFC = FC/Q
AVC = VC/Q
ATC = AFC + AVC
Q
7 8 9 101112131415161718
AFC
1,4301,2501,1101,000 910 830 770 710 670 630 590 560
Observe this row of data, what will usually be happening to AFC?
It will be decreasing because quantity will normally increase whereas fixed costs remain the same.
Q
7 8 9 101112131415161718
AFC
1,4301,2501,1101,000 910 830 770 710 670 630 590 560
AVC
1,2901,2401,1301,0901,1001,1401,1801,2701,4001,5801,8002,070
ATC
2,7102,4902,2402,0902,0101,9701,9501,9902,0702,2212,3902,620
Why do average variable costs rise?
Why is ATC rising?
Law of Diminishing Marginal Returns
Because AVC is getting bigger
Q 5 6 7 8 9 101112131415161718
AFC2,0001,6701,4301,2501,1101,000 910 830 770 710 670 630 590 560
6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
AFC
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Q 5 6 7 8 9 101112131415161718
AVC6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
1,3801,3301,2901,2401,1301,0901,1001,1401,1801,2701,4001,5801,8002,070
AVC
The lowest point on the AVCcurve is at quantity 10.
AFC
Q 5 6 7 8 9 101112131415161718
ATC6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
AVC
3,3803,0002,7102,4902,2402,0902,0101,9701.9501,9902,0702.2212.3902,620
ATC
The lowest point on the ATCcurve is at quantity 13.
AFC
6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
AFC
AVC
ATC
A fewimportantpoints:
1. The ATCcurve lookslike a smileyface.
ATC
2. The AVCcurve lookslike a smirk.
AVC
6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
AVC
ATC
ATC
AVC
AFC
If we got ridof the AFCcurve, couldyou figure outwhat theAFC are withoutthe curve?
6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
AVC
ATC
From now on, we will NOT be drawing too many AFC curves because....
AFC = ATC - AVC
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In economics we say firms and individuals….
make decisions on the margin
We saw this when we studied demand and marginal utility analysis.
a consumer will choose ice cream until…
and
When choosing between
MU of hamburger/P hamburger = MU of ice cream / P ice cream
Q
7 8 9 101112131415161718
AFC
1,4301,2501,1101,000 910 830 770 710 670 630 590 560
AVC
1,2901,2401,1301,0901,1001,1401,1801,2701,4001,5801,8002,070
ATC
2,7102,4902,2402,0902,0101,9701.9501,99020702.2212.3902620
MC
1,000 900 300 6501,3001,5001,7502,4003,2504,2505,3506,550
So…marginal cost is important to firm.
The firm is concerned with the cost of the next unit, just as the consumer is concerned with the …
Q
5 6 7 8 9 101112131415161718
MC
1,2001,1001,000 900 300 6501,3001,5001,7502,4003,2504,2505,3506,550
6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
AVC
ATC
MC
6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
AVC
ATC
MCA few importantpoints:
1. The MCcurve lookslike theNike Swoosh
MC
2. MC touchesAVC andATC at their lowestpoints.
6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
AVC
ATC
MCLaw of diminishing marginalreturns-- As more and more
of a variable input areadded to a fixed input,the additional outputbegins to go down.
DiminishingMarginalReturns setsin here
Explain why
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Review: In firm cost analysis
What’s on the y axis?
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14
cost
What’s on the x axis?
quantity
Review: In firm cost analysis
What’s the shape of the ATC curve?
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14
cost
What’s the shape of the AVC curve?
quantity
ATC
AVC
Review: In firm cost analysis
What’s the shape of the MC curve?
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14
cost
quantity
ATC
AVC
MC
6,000
5,000
4,000
3,000
2,000
1,000
5 6 7 8 9 10 11 12 13 14 15 16 17 18
AVC
ATC
MC
Where does the MC curve have to intersect the ATC & AVC curves?
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