Firm Theory 2

Producer Behaviour

Outline

• Conceptualizing costs

• Common measures of costs

• Costs in the short run and long run

• The learning curve

• The costs of producing multiple goods

Conceptualizing Costs

• Understanding costs in production involves more than just technical input-output relationships.

• Costs of inputs significantly influence production decisions.

Explicit and Implicit Costs

• Explicit Costs: Direct out-of-pocket payments for labor, capital, energy, and materials.

• Implicit Costs: Reflect forgone opportunities rather than actual expenditures.

• Managers must consider both types of costs for effective decision-making.

Opportunity Costs

• The opportunity cost of a resource is the value of its best alternative use.

• Example: Taylor's consulting firm

  • Monthly revenue: $55k

  • Monthly costs: $46k (including $2k salary for Taylor)

  • Opportunity loss if she takes a $12k monthly salary elsewhere affects the effective use of Taylor's labor.

Trumpian Opportunity Costs

• Graphical representation of Donald Trump's potential wealth had he invested in the S&P 500 rather than pursuing other ventures.

Opportunity Costs of Inputs

• Market determines opportunity costs for inputs that can be bought in the same period (e.g., labor).

• More complex for durable inputs (e.g., capital, land).

Durable Input Costs

• Two Issues:

  • Allocating initial purchase costs over time.

  • Managing changes in value over time.

• Using rental instead of purchasing may simplify these issues.

Sunk Costs

• Some costs are irrelevant to managerial decisions (sunk costs).

• Sunk costs should be disregarded as they cannot be recovered.

Common Measures of Costs

• Fixed Costs (F): Do not change with output levels (e.g., rent).

• Variable Costs (VC): Change with output (e.g., materials).

• Total Cost (C): Sum of fixed and variable costs (C = F + VC).

Average Costs

• Average Fixed Cost (AFC) = F / q

• Average Variable Cost (AVC) = VC / q

• Average Cost (AC) = AFC + AVC

Marginal Cost

• Marginal Costs (MC): Change in total cost when production increases by one unit (MC = ∆C / ∆q).

• Marginal costs also equal the change in variable costs (MC = ∆VC / ∆q).

Cost Example: Ben’s Pizza Shop

• Understanding how costs vary with increased pizza sales.

Cost Curves

• Graphical representation of costs as output varies shows the relationship between costs and quantity produced.

Short Run Costs

• Cost structures in the short run are defined by fixed and variable inputs.

• Short run analysis focuses on diminishing returns to labor affecting cost curves.

Diminishing Marginal Returns

• Influences both marginal and average cost curves: added labor increases cost disproportionately as input use rises.

Long Run Costs

• Firms can change all inputs in the long run to optimize production and minimize costs.

• Fixed costs become avoidable in the long run.

Cost Minimization

• Goal is to find the combination of inputs that minimizes costs while maintaining efficient output levels.

• Key rules:

  • Lowest Isocost Rule: Use the combination of inputs on the lowest isocost line that touches the isoquant.

  • Tangency Rule: MRTS = -w/r at the optimal input mix.

  • Last-Dollar Rule: MPL/w = MPK/r ensures efficiency in spending.

Cost Minimization When Input Prices Change

• Analyze how changing input prices, like labor costs, affects firm behavior and production levels.

Long-Run Average Costs

• U-shaped LRAC curve represents varying returns to scale: increasing, constant, and decreasing as output grows.

• Market structure influences the shape of LRAC curves.

Learning Curve

• Costs may decline over time due to learning by doing, where experience enhances productivity.

Conclusion: Costs of Producing Multiple Goods

• Economies of scope provide benefits when producing multiple related goods jointly compared to separately.

• Situation arises when producing linked products leads to lower costs than producing each separately.

Part 2: Takeaways

• Opportunity costs are critical for managerial decisions.

• Short run costs relate to fixed costs and diminishing returns.

• Long run cost minimization depends on optimal input allocation and scale effectiveness.