Supply: The Costs of Doing Business

1
Chapter 8

• Supply The Costs of Doing Business

2
Firms and Production

• The quantity of resources a firm uses and the
  amount spent on selling activities depends on how
  much they contribute to the value of the firm.
• In general, the more the firm wants to supply the
  more resources it must have.
• Output and Resources
• Supply is the quantities of output that sellers
  are willing and able to offer for sale at every
  price.
• To determine how much to supply at any given
  price, sellers must know how much it costs to
  supply each quantity.

3
Diminishing Marginal Returns

• The law of diminishing marginal returns
• When successive equal amounts of a variable
• resource (L) are combined with a fixed amount
• of another resource (say, K), marginal physical
• output due to the variable input (MPL?Q/?L)
• increases but will eventually decline as more
• of a variable input is added.

4
Short Vs Long Run in Production

• Short-run (SR) Qf( L,K), i.e. only these inputs
  are a
• constrain. But assume K is fixed, so that the
  production
• function, Qf(L), expresses various amounts of L
  
• combined with fixed K Idea in SR, management
  has
• limited flexibility in controlling costs since K
  is fixed only L
• is variable.
• Implication TC (w x L) (r x K) VC FC
• Long-run (LR) Qf( L,K), i.e. only these inputs
  are a
• constraint on a firms profit-maximizing
  objective. Now K is variable, so
• that the production function, Qf(L,K) ?
  flexibility for management to
• combine various L K to minimize costs profit
  maximization.
• Implication TC (w x L) (r x K) VC. There
  are no FC in the LR.

5
Average Total Costs

• Average Total Costs ATC TC/Total Output
• Average total cost (ATC) the per unit cost
  derived by dividing total cost by the quantity of
  output.
• Plotting the cost on the vertical axis and
  quantity of output on the horizontal axis
  generates the ATC curve.

6
Marginal Costs

• MC?TC/ ?Q ?VC/?Q since ?FC/ ?Q0
• When MCgtATC -gtATC?
• When MCltATC -gtATC?
• Upwards-sloping MC cuts the ATC at its minimum

7
Average and Marginal Costs
8
Definition of Costs Qf( L), K is fixed

• Total Costs (TC) -- the expenses a business has
  in supplying goods and/or services.
• Total Fixed Costs (TFC) -- payments to resources
  whose quantities can not be changed during a
  fixed period of time the short run e.g. TFC
  r x K
• Total Variable Costs (TVC) -- payments for
  additional resources used as output increases
  e.g. TVC w x L
• Average Fixed Cost -- the total fixed cost
  divided by total output AFC TFC/Q
• Average total Cost (SRATC) -- the total cost of
  production divided by the total quantity of
  output produced when at least one resource is
  fixed SRATC (TFCTVC)/Q
• Average Variable Cost -- total variable cost
  divided by total output e.g. AVC TVC/Q

9
Costs for the Airline Industry

• Suppose TC TFC TVC Fuel Costs New
• Seat Technology
• In response to higher fuel (fixed) costs, airline
  carriers are taking advantage of new seat
  technology (variable costs). e.g. Airbus seats
• By using the stronger, lighter materials for
  seats, airlines have been able to add as many as
  12 extra seats to the coach section of their
  planes, adding millions of dollars to their
  annual revenues.
• Result Higher revenues but dissatisfied coach
  fliers

10
Time in Economics Short vs. Long Run

• The short run refers to any period of time during
  which at least one resource can not be changed.
• In the long run, everything is variable nothing
  is fixed.
• The most important difference between the short
  run and the long run is that the law of
  diminishing marginal returns does not apply when
  all resources are variable.
• Economics of Scale Scale means size.
• Economies of scale the decrease in per unit
  costs as the quantity of production increases and
  all resources are variable
• Diseconomies of scale the increase in per unit
  costs as the quantity of production increases and
  all resources are variable
• Constant returns to scale unit costs remain
  constant as the quantity of production is
  increased and all resources are variable

11
Short-Run and Long-Run Average-Cost Curves

• Economies of Scale and Long-Run Cost Curves
• In the long run, a firm has many sizes to choose
  from.
• The short run requires that scale be fixed only
  one or a few resources can be changed.

12
Long-Run Average Total Cost

• Long-run average total cost (LRATC) the
  lowest-cost combination of resources with which
  each level of output is produced when all
  resources are variable.
• The long-run average total cost curve gets its
  shape from economies and diseconomies of scale.
• Shape of LRATC
• If producing each unit of output becomes less
  costly there are economies of scale.
• If producing each unit of output becomes more
  costly there are diseconomies of scale.
• If unit costs remain constant as output rises
  there are constant returns to scale.

13
Long-Run and Short-Run Cost Curves (1)
14
Long-Run and Short-Run Cost Curves (3)
15
Minimum Efficient Scale

• Most industries experience both economies and
  diseconomies of scale.
• The minimum efficient scale (MES) is the minimum
  point of the long-run average-cost curve the
  output level at which the cost per unit of output
  is the lowest.
• The MES varies considerably across industries.