The Firm s Objective A Firm s Profit The economic goal of the firm is to maximize profits Total Revenue The amount that the firm receives for the sale of its output Total Cost The amount that the firm pays to buy inputs Profit Total revenue Total cost Costs as Opportunity Costs Economic Profit versus Accounting Profit A firm s cost of production includes all the opportunity costs of making its output of goods and services Explicit costs involve a direct money outlay for factors of production Implicit costs do not involve a direct money outlay Economic Profit versus Accounting Profit How an Economist Views a Firm How an Accountant Views a Firm Economic profit Accounting profit Revenue Implicit costs Explicit costs Revenue Total opportunity costs Economists measure a firm s economic profit as total revenue minus all the opportunity costs explicit and implicit Accountants measure the accounting profit as the firm s total revenue minus only the firm s explicit costs In other words they ignore the implicit costs Production Profit maximization is the firm s objective Firms can earn profit by making stuff and selling it We will first focus on the production process AND costs associated with production Explicit costs 1 Production Class Production Function Example The production function shows the relationship between quantity of an input used to make a good and the quantity of output of that good Number of Workers 0 1 2 3 4 5 6 7 8 The marginal product of any input in the production process is the increase in the quantity of output obtained from an additional unit of that input Class Production Function Marginal Product of Labor 2 2 3 5 4 3 2 1 Diminishing Marginal Product Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases 25 Number of Foldits Produced Number of Paperfoldits Produced 0 2 4 7 12 16 19 21 22 20 15 Example As more and more workers are hired at a firm each additional worker contributes less and less to production because the firm has a limited amount of equipment 10 5 0 0 1 2 3 4 5 6 7 8 Number of Workers The Various Measures of Cost Total costs TC of production may be divided into fixed costs and variable costs Total fixed costs TFC are those costs that do not vary with the quantity of output produced Total variable costs TVC are those costs that do change as the firm alters the quantity of output produced Class Production Function Example Number of Number of Paperfoldits Workers Produced 0 0 1 2 2 4 3 7 4 12 5 16 6 19 7 21 8 22 Total Total Total Cost Fixed Cost Variable Cost 18 18 18 18 18 18 18 18 18 4 8 12 16 20 24 28 32 18 22 26 30 34 38 42 46 50 Marginal Cost of an Additional Paperfoldits 2 2 1 33 0 80 1 1 33 2 4 TC TFC TVC 2 Total Cost Curve Average Costs Average costs can be determined by dividing the firm s costs by the quantity of output produced 55 50 45 Total Cost 40 35 The average cost is the cost of each typical unit of product 30 25 20 15 10 0 5 10 15 20 25 Number of Foldits Produced Family of Average Costs Family of Average Costs Number of Paperfoldits Produced 0 2 4 7 12 16 19 21 22 Fixed cost FC AFC Quantity Q AVC Variable cost VC Quantity Q ATC Total cost TC Quantity Q Average Cost Curves 18 18 18 18 18 18 18 18 18 4 8 12 16 20 24 28 32 18 22 26 30 34 38 42 46 50 Average Average Average Fixed Cost Variable Cost Total Cost 9 00 4 50 2 57 1 50 1 13 0 95 0 86 0 82 2 00 2 00 1 71 1 33 1 25 1 26 1 33 1 45 11 00 6 50 4 29 2 83 2 38 2 21 2 19 2 27 Marginal Cost 12 00 Marginal cost MC measures the amount total cost rises when the firm increases production by one unit 10 00 Average Costs Total Total Total Cost Fixed Cost Variable Cost 8 00 6 00 Marginal cost helps answer the following question 4 00 2 00 0 00 0 5 10 15 20 25 How much does it cost to produce an additional unit of output Number of Foldits Produced Average Fixed Costs Average Variable Costs Average Total Costs 3 Marginal Cost MC Marginal Cost Change in total cost Change in quantity TC Q Average Cost and Marginal Cost Curves Number of Number of Paperfoldits Workers Produced 0 0 1 2 2 4 3 7 4 12 5 16 6 19 7 21 8 22 Total Total Total Cost Fixed Cost Variable Cost 18 18 18 18 18 18 18 18 18 4 8 12 16 20 24 28 32 18 22 26 30 34 38 42 46 50 Marginal Cost of an Additional Paperfoldits 2 2 1 33 0 80 1 1 33 2 4 Average Cost and Marginal Cost Curves 12 00 3 50 3 00 8 00 2 50 6 00 Costs Average Costs 10 00 4 00 MC 2 00 ATC AVC 1 50 2 00 1 00 0 00 0 5 10 15 20 25 Number of Foldits Produced Average Fixed Costs Average Variable Costs Average Total Costs Marginal Cost Cost Curves and Their Shapes Marginal cost rises with the amount of output produced This reflects the property of diminishing marginal product 0 50 AFC 0 00 0 2 4 6 8 10 12 Quantity of Output glasses of lemonade per hour Cost Curves and Their Shapes The average total cost curve is U shaped At very low levels of output average total cost is high because fixed cost is spread over only a few units Average total cost declines as output increases Average total cost starts rising because average variable cost rises substantially 4 Cost Curves and Their Shapes The bottom of the U shape occurs at the quantity that minimizes average total cost This quantity is sometimes called the efficient scale of the firm Three Important Properties of Cost Curves Marginal cost eventually rises with the quantity of output The average total cost curve is U shaped The marginal cost curve crosses the averagetotal cost curve at the minimum of average total cost Average Total Cost in the Short and Long Runs Average Total Cost ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory Relationship Between Marginal Cost and Average Total Cost Whenever marginal cost is less than average total cost average total cost is falling Whenever marginal cost is greater than average total cost average total cost is rising The marginal cost curve crosses the averagetotal cost curve at the efficient scale Costs in the Long Run For many firms the division of total costs between fixed and variable costs depends on the time …