Costs and the Supply of Goods

  1. Introduction

    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.

  2. Organization of the Business Firm
    1. What Does the firm do?
      1. Purchases resources from individuals and other firms
      2. Transforms these resources into a product
      3. Offers this product for sale to individuals
    2. Incentives, cooperation, and the nature of the firm.
      1. Most firms are privately owned in capitalist countries. The owners are the residual claimants.

        As the residual claimant, the owners receive any profits that the firm makes (if any).

      2. Business firms rely on 2 organizational methods--team production and contracting.
        1. Team Production -- employees work under the supervision of the owner or the owner's representative.
        2. Contracting -- for each service the firm uses it must:
          1. determine what is required
          2. search out potential suppliers
          3. negotiate and enforce contracts
        3. Team Production reduces the transactions costs associated with contracting.
        4. Contracting reduces the cost of monitoring employees.
      3. The owner must direct workers' efforts, provide incentives, and prevent shirking.
        1. Shirking occurs when output is reduced due to less than a normal rate of productivity.
        2. The principal-agent problem: The incentive problem that arises when the interests of the agent (usually the seller of a service) conflict with those of the principal (the buyer of the service). It occurs when the purchaser of a service lacks information about how well the agent performs the purchased services. It may reduce the efficiency of the corporate business structure.

          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:

          Executive/stock holder:

    3. Proprietorships comprise 73 percent of all business firms in 1993 but only 6% of revenues.

      Sole Proprietorship: a firm owned and operated by one person.

    4. Partnerships account for 8 percent of the total number of firms and 4 percent of business receipts.

      Partnership: business formed by two or more people combining resources.

    5. Corporations comprise 19 percent of all business firms and account for 90 percent of business receipts. Stockholder liability is limited; ownership can be easily transferred.

      Corporations: firms sanctioned by state laws and considered legal entities separate and distinct from their owners.

  3. The Role of Costs
    1. Costs indicate the desire of consumers for other goods.
      1. The demand for a product can be thought of as the voice of consumers instructing suppliers to produce a good.
      2. In contrast, costs of production represent the voice of consumers indicating that other items which could be produced with the resources are also desired.
    2. Calculating economic costs and profits.
      1. Opportunity costs may be either explicit or implicit.


        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.

      2. Economic profit requires an above normal rate of return, a rate of return greater than the opportunity cost of capital.
      3. Accounting profit is not the same as economic profit--firms earning zero economic profit are earning exactly the market rate of return.
    3. Three major factors promote cost efficiency and limit the power of corporate managers to pursue their interest at the expense of cost efficiency.
      1. Corporations must compete for investment funds and customers.
      2. Managerial compensation is linked to profitability.
      3. High costs make firms vulnerable to a corporate takeover.
  4. Short Run and Long Run
    1. A firm cannot adjust its output instantaneously.
    2. Since time plays an important role there is a need to distinguish between the short run and the long run in the production process.

      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.

  5. Costs in the Short Run


    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.

    Numerical Example:

    Law of Diminishing Returns
    Units of Variable Resources (Labor per day) Total Product or Output Marginal Product Average Product
    0 0
    1 8 8 8
    2 20 12 10
    3 34 14 11.3
    4 46 12 11.5
    5 56 10 11.2
    6 64 8 10.7
    7 70 6 10
    8 74 4 9.3
    9 75 1 8.3
    10 73 -2 7.3

    Once diminishing returns are confronted, more of the variable factors will be needed to expand output. Thus, short-run marginal cost will rise.

  6. Costs in the Long Run

    The long-run average total cost curve reflects the cost of production for plants of various sizes.

    1. In the long run, firms may alter the size of their plant, and vary all other factors of production.
    2. The planning curve of a firm is the long run average cost curve at each output level for various plant sizes. (Exhibit 8)
    3. Size of firm (output) and factors that affect the firm's per unit cost.
      1. Adoption of mass production techniques.
      2. Specialization.
      3. Learning by doing.
    4. Economies and diseconomies of scale are present in the long run.

      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.

  7. What Factors Cause the Firm's Cost Curves to Shift?

    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.

    1. Prices of resources.
    2. Taxes.
    3. Technology.
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This page was last modified Monday, January 27, 1997.