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# 2.3 theory of the firm - web version

## by Andrew McCarthy, Teacher at Education on Nov 29, 2010

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## 2.3 theory of the firm - web versionPresentation Transcript

• IB Economics Econ 2.3 Theory of the Firm (HL only) Extract from Powerpoint Notes ISS International School Singapore Andrew McCarthy ©
• Diminishing returns for a producer
• The short run is defined as period of time in which some resources used in the production process are fixed and cannot be changed.
• In the long run all factors are variable including level of capital employed.
• Law of Diminishing Marginal Returns Concepts
• Total product This is the quantity of output produced by a given number of workers over a given period of time. Remember the amount of capital (or machines) is fixed.
• Average product This is the quantity of output per unit of input. In this model, the input is labour. In other words, we are dealing with the output per worker, on average.
• Marginal product The addition to total output produced by one extra unit of input (again, labour). It is the extra output produced at the margin (i.e. by adding a marginal unit of labour).
• Law of Diminishing Returns Example
• Law of Diminishing Returns Example
• Law of increasing costs
• Any situation where the law of diminishing returns operates so does law of increasing costs .
• To gain an extra unit of output will require a greater increase in the amount of inputs As a greater number of inputs are required you will have to pay for them.
• Diminishing Marginal Returns Law of Diminishing Costs
• The returns from extra inputs are falling
• The costs of gaining extra output are increasing
Add one more worker | gain less marginal output Gain extra output | will cost more workers For each increase in output| the marginal cost will increase
• Law of increasing costs Definitions
• Total cost (TC). This is the total cost to the firm of producing a given number of units. This can be sub-divided. Total cost = total fixed costs + total variable costs (or TC = TFC + TVC). A cost is either fixed or variable. There is no third group. If a cost is not fixed, then, by definition, it must vary with output.
• Average cost (AC). This is the cost, on average, per unit of output produced. If a firm made 100 bars of chocolate at a total cost of £10, then the cost, on average, per bar of chocolate produced, is 10p. So, algebraically: It also follows that average cost = average fixed cost + average variable cost (AC = AFC + AVC). This is derived by simply dividing both sides of the total cost equation by Q. Average cost is often called average total cost so as to distinguish it from AFC and AVC.
• Marginal cost (MC). This is the additional cost incurred by a firm as a result of producing one more unit of output. It is the extra cost at the margin (i.e. by producing the marginal unit of output).
• Graphing output and costs COSTS PRODUCT Data and Graphs and Definitions – sourced from http://www.s-cool.co.uk/alevel/economics.html
• Cost Curves Bob the Builder example
• Total Costs
• To employ Bob to work the firm needs to pay \$420
• Every additional worker also cost \$420
• Cost Curves Bob the Builder example
• Total Product
• When Bob begins laying bricks he adds 70 to the wall
• When a second friend begins the total product increases to 210 bricks. Worker 6 adds less bricks
• Cost Curves Bob the Builder example
• Average Costs
• Because Bob is not very productive by himself the cost per brick is very high at \$6
• By adding extra workers the average cost per brick falls due to increased efficiencies. Division of labour, specialisation etc.
• Cost Curves Bob the Builder example
• Marginal Costs
• If Bob ’ s boss wants to add one more brick to the fence he has to pay a small amount. This is called the marginal cost.
MC per brick \$ = (Total Cost now – Total Cost previous) / Marginal Product MC (2) = (840 - 420) / 140 = \$3 per brick This is the cost of adding one more brick in dollars, at two workers
• Cost Curves Bob the Builder example
• Marginal Costs
• If Bob ’ s boss wants to add one more brick to the fence he has to pay a small amount. This is called the marginal cost.
MC per brick \$ = (Total Cost now – Total Cost previous) / Marginal Product MC (2) = (840/420) / 140 = \$3 per brick This is the cost of adding one more brick in dollars, at two workers
• Fixed Costs
• The firm where Bob works needs to pay some costs regardless of the level of building that is occurring.
• This are sometimes called sunk costs
• Bobs firm must pay these fixed costs.
• General Managers salary
• Lease the digger and crane
• Pay insurance
• Pay for a phone rental
Cost Curves Bob the Builder example
• Average Fixed Costs
• These are calculated by dividing fixed costs by the output of the firm. If Bobs firm makes two fences the AFC is \$60
Cost Curves Bob the Builder example
• Average Variable Costs
• These are the costs that increase as output increases.
• As quantity produced increases ….variable costs increase
• Bills that relate directly to level of output
• Eg. Cost of raw materials, wages, electricity bills, petrol
• Output / Variable Cost = Average Variable Cost
• Average Total Costs
• This is the sum of Variable Costs and Fixed Costs
• TC = FC + VC
• ATC = AFC + AVC
• ATC = TC / Output
Cost Curves Bob the Builder example
• Cost Curves Bob the Builder example
• Bringing it all together… what do costs look like?
FC = constant VC = increases with output TC = increases with output AFC = decreases with output AVC = u shaped ATC = u shaped MC = u shaped but very steep at end
• Cost Curves Bob the Builder example
• Bringing it all together… what do costs look like?
• Cost Curves Bob the Builder example
• Marginal Cost curves… !!
Where does MC cross? Cuts AVC at minimum Cuts ATC at minimum Increasing returns from 0 – 4 mean that MC must fall Decreasing returns after 4 mean than MC must rise
• Data and Graphs – sources from Geoff Evans (NZ Economics Textbook)