Chapter 8
Costs and the Supply of Goods
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Overview
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Shirking and the Principle-Agent Problem
The 3 Types of Business Firms
Economic vs. Accounting Profits
The Normal Rate of Profit
Short-run vs. Long-run
Categories of Costs
Law of Diminishing Returns
Cost Curves (short-run and long-run)
Sunk Costs
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Incentives and Cooperation
Residual Claimants: Individuals who
personally receive the excess of revenues
over costs
They have the incentive to increase
revenues or reduce costs
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Incentives and Cooperation
There are two ways to organize productive
activity
1. Contracting: using outside producers
for specific tasks
2. Team Production: Where employees
work together under the supervision of
the owner (or owner’s representative)
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Incentives and Cooperation
Shirking: Working at less than the expected rate
of productivity, which reduces output.
Principle-agent problem: The incentive problem
that occurs when the purchaser of services lacks
full information about the circumstances faced
by the seller, and therefore, cannot know how
well the seller performs the service.
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Shirking and the Principle Agent
Problem
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The 3 Types of Business Firms
1. Proprietorship: a business firm owned by
a single individual.
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Gets all the profits, but accepts all the
risk
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The 3 Types of Business Firms
2. Partnership: A business firm owned by
two or more individuals
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They share the profits and the risk
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The 3 Types of Business Firms
3. Corporation: A business firm owned by
shareholders
They have the right to the firm’s profits, but
their liability is limited to the amount of
their investment
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Calculating Economic Costs and
Profits
1. Explicit Costs: The payments a firm
makes to purchase the goods and
services of productive resources.
2. Implicit Costs: The opportunity costs
associated with the firm’s use of
resources that it owns
ex. Foregone interest, foregone rent
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Calculating Economic Costs and
Profits
3. Total Costs (TC): The costs (both
explicit and implicit) of all of the
resources used by the firm
includes the normal rate of return for the
firms equity capital.
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Economic vs. Accounting Profit
Economic Profit: The difference between
the firms total revenue and its total costs
(including both explicit and implicit costs)
Accounting Profit: The sales revenue
minus the expenses of the firm (does not
usually include implicit costs)
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Normal Profit Rate
Normal Profit Rate: Zero economic profit,
the competitive rate of return on the
capital and labor of the owners
*Note: Zero economic profit does NOT
mean the business is failing
≠
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Short Run vs. Long Run
Short Run: A time period so short that a
firm is unable to vary some of its factors
of production.
Long Run: A time period long enough to
allow the firm to vary all of its factors of
production.
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Lets Throw a Party!
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What do we need?
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Categories Of Costs
Total Fixed Costs (TFC): The sum of the
costs that do not vary with output
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Fixed costs will remain unchanged as
output rises or falls in the short run
Ex. Insurance premiums, property taxes,
etc.
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Categories Of Costs
Average Fixed Costs (AFC): Total Fixed
Costs divided by the number of units
produced
AFC = TFC / Q
average fixed costs always declines with
output
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Categories Of Costs
Total Variable Costs (TVC): The sum of
those costs that change with output
Ex. wages, raw materials
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Categories Of Costs
Average Variable Costs (AVC): Total
variable costs divided by the number of
units produced
AVC = TVC / Q
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Categories Of Costs
One can get Total Costs (TC) by adding
together Total Fixed Costs (TFC) and Total
Variable Costs (TVC)
TC = TFC + TVC
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Categories Of Costs
Average Total Costs (ATC): Total Cost divided
by the number of units produced
ATC = TC / Q
or
ATC = AFC + AVC
The ATC curve is U-shaped because Average Total
Cost will be high for both an under-utilized plant
(AFC is high) and an over-utilized plant (MC is
high)
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Categories Of Costs
Marginal Costs (MC): The change in total
costs required to produce an additional
unit of output.
To increase profits: one only produces if the
additional revenue from one more unit is
greater than the marginal cost of that unit
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Diminishing Returns and
Production
Law of Diminishing Returns: As more
and more units of a variable resource are
applied to a fixed amount of other
resources, output will eventually increase
by smaller and smaller amounts
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Diminishing Returns and
Production
Total Product (TP): The total output of a
good at a given rate of input
Marginal Product (MP): the change in
total product associated with each
additional unit of labor
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Diminishing Returns and
Production (pg. 181)
Average Product (AP): The total product divided
by the number of variable units (labor) used to
get that total product
AP = TP / Q
*Note: Average product increases as long as
marginal product is greater than the average
product
Ex. Your GPA
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The Cost Curves!
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2.
3.
Remember that ATC is U-shaped
Remember that AFC falls with output
AVC is a small part of ATC when output is small
and a LARGE part of ATC when output is
LARGE
4.
5.
MC curve may decrease at first, but then rises
MC < AVC (ATC) → AVC (ATC) decreases
MC > AVC (ATC) → AVC (ATC) increases
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Output and Costs in the Long Run
The Long Run Average Total Cost
Curve (LRATC): shows the minimum
average cost of producing each output
level when the firm is free to choose
among all possible plant sizes
Outlines the possibilities available in the
planning stage.
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Economies of Scale (pg. 188)
Economies of Scale: Occurs when the
firm’s per-unit costs decrease as output
increases (Q↑ → LRATC↓)
Diseconomies of Scale: Occurs when the
firm’s per-unit costs increase as output
increases (Q↑ → LRATC↑)
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Economies of Scale
Constant Economies of Scale: Occurs when the
firms per-unit costs do not change as output
changes.
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Economies and diseconomies of scale are long
run concepts (where all factors are variable).
Increasing and diminishing returns are short run
concepts (where at least one factor of
production is fixed).
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Production: Economies of Scale
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Shifting The Cost Curves
Shifters of the Cost Curves
1.
2.
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4.
Price of resources
Taxes
Regulations
Technology
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Sunk Costs
Sunk Costs: Costs that have already been
incurred as a result of past decisions
Sunk costs should be ignored
Ex. Painting your room
Ex. Taking a class
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Review
1.
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5.
Understand the principle-agent problem
Know the difference between economic
profits and accounting profits and what
we mean by the normal rate of profit
Know the difference between the short
run and the long run
Be able to fill in the cost table
Be able to recognize the cost curves and
why they slope the way they do
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Review
6.
7.
8.
Know the law of diminishing returns
Know what we mean by economies and
diseconomies of scale.
Understand the idea of sunk costs.
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