Costs are the major determinant of the shape and position of the supply curve for a good. In this chapter we will discuss the general characteristics of a firm's costs which we will use to determine supply in Chapters 8 and 9.
As the residual claimant, the owners receive any profits that the firm makes (if any).
Examples: Doctor / patient relationship--The patient is the principal and the doctor is the agent. Are we sure that the doctor acts in patients interest or is the doctor acting in the doctor's interest? Since we have a difficult time determining whether the doctor is giving us his best possible care, we are subject to the principal agent problem.
Auto mechanic/car owner:
Sole Proprietorship: a firm owned and operated by one person.
Partnership: business formed by two or more people combining resources.
Corporations: firms sanctioned by state laws and considered legal entities separate and distinct from their owners.
Total Cost--The implicit and explicit costs incurred by the firm.
Implicit Cost--Opportunity cost of resources owned by the firm. One of the most important implicit costs incurred by the firm is its opportunity cost of capital. This is the rate of return that investors in the firm can earn on another investment of similar risk. If the investors do not earn what is normal for given risk, they will take their money out of the firm and invest it elsewhere.
Explicit cost--Money paid by the firm to purchase productive resources.
Short-run--A time period so short that the owner of the firm cannot vary all of the resources he commands. At least one input is fixed in the short-run. For instance, the firm can't change the size of its plant in the short-run.
Long-run--A time period long enough to allow the firm to vary all factors of production.
Fixed Cost--A cost that does not vary with the amount of output produced by the firm. These costs can only be avoided if the firm goes out of business.
Variable Cost--A cost that varies with the output of the firm. Examples: Wages and payments for raw materials.
Marginal Cost--The change in total cost required to produce one more unit of output.
Average Fixed Cost--Total fixed costs divided by the number of units produced. It always declines as output increases.
Average Variable Cost--The total variable cost divided by the number of units produced.
Average Total Cost--Total cost divided by the number of units produced.
Law of Diminishing Marginal Returns--As more units of a variable resource are added to a fixed amount of other resources, output will eventually begin to increase by smaller and smaller amounts. In terms of the variable input's effect on output, the marginal returns will begin to diminish.
Marginal Product--The increase in output resulting from the addition of one more unit of variable resources.
|Law of Diminishing Returns|
|Units of Variable Resources (Labor per day)||Total Product or Output||Marginal Product||Average Product|
Once diminishing returns are confronted, more of the variable factors will be needed to expand output. Thus, short-run marginal cost will rise.
The long-run average total cost curve reflects the cost of production for plants of various sizes.
Economic theory suggests that, at least initially, larger firms have lower per unit costs--they realize economies of scale.
Economies of Scale--Describes the case when per unit cost (long-run average costs) fall as the size of the firm expands.
Constant Returns to Scale--Unit costs are constant as the scale of the firm expands.
Diseconomies of Scale--In this case, the larger the firm gets, the higher its unit costs become.
In outlining the general shape of a firm's cost curves in both the short run and long run, we assume certain other factors remain constant. When these other factors change, the firm's cost curves will shift.
This page was last modified Monday, January 27, 1997.