Firm The and Costs
Econ 425, Summer I 2008
The Firm
Central element of any industry.
- 84% of GNP in U.S. (2002)
Organization that transforms inputs into outputs. Do firms maximize profits? What determines a firms boundaries? Why are firms different?
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Do firms maximize profits?
We assume that firms maximize profits.
- Profit = Revenue - Costs
However, managers objectives may differ from those of owners.
- 20% of firms in U.S. are corporations, but represent 87% business sales (2002)
So, is profit maximization a plausible assumption? - Management incentive contracts - Reputation - Competition from rivals - Threat of takeover (mergers and acquisitions)
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What determines a firms boundaries?
Horizontal dimension largely determined by costs. Vertical dimension results from balance between investment and performance incentives. - Specific assets and hold-up problem
e.g. Fish Body and GM 1. Wooden era: GM bought car bodies from Fish Body (SR contracts) 2. Metal era: specific investments required (LR contracts) 3. GM eventually acquired Fish Body
- Performance issues - Tapered integration, franchising
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Why are firms different?
Most U.S. firms are small.
- 6 million companies, 89% employed less than 20 people (1999)
Firm performance varies a great deal.
- Only 20% of variation in profit rates due to firm size and industry type (Schmalensee ,1989)
What about the other 80%? - impediments to imitation; - firm strategy; - historical events.
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Costs
Economic decisions should be based on the concept of economic cost. Economic cost includes opportunity costs and excludes sunk costs. Opportunity cost (OC): foregone benefit of not using resource in the best alternative use. - What is your OC of attending this class? - What is the OC of a restaurant which owns the establishment where it operates?
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Costs (2)
Sunk cost: an expenditure that cannot be recovered. Sunk costs should not be taken into consideration in economic decisions.
Example: 1. A dam was built at a very high cost. 2. Estimated cost of energy produced by dam is $10 per unit ($5 correspond to amortization and $5 to variable costs). 3. After completion of investment, new energy source discovered with a cost of $7 per unit. 4. Should the dam be abandoned in favor of this alternative use?
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Cost measures
Fixed costs (F): costs that do not vary with output (q). Variable costs (VC): costs that change with the level of output, VC(q). Total costs: sum of fixed and variable costs, C(q) = F + VC(q). Marginal cost (MC): cost of expanding output by one unit, MC (q ) = Average cost (AC): cost per unit of output, AC ( q ) = Average variable cost (AVC): Average fixed cost (AFC):
AVC ( q ) = AFC ( q ) = F q VC ( q ) q
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dC ( q ) dq
C (q) q
Costs in the Short Run (SR)
$ MC
AC AVC
AFC Output, q
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Economies of scale
In SR, shape of cost curves determined primarily by diminishing In returns. LR, shape of cost curves determined by economies of scale. Economies of scale: output can be doubled by less than doubling costs. - at low output levels, why? Diseconomies of scale: output can be doubled by more than doubling costs. - at high output levels, why?
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Costs in the Long Run (LR)
$
LMC LAC
- If s = LAC/LMC > 1, economies of scale exist; - If s = 1, constant returns to scale exist; - If s < 1, diseconomies of scale exist.
q1
Output, q
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SR vs. LR cost curves
LAC curve is the envelope of the SAC curves.
SAC4
- If firm expects to produce q0, build small-sized plant. - If firm expects to produce q2, build medium-sized plant. - What if firm ends up producing q1?
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Economies of scale and number of plants
Importance of considering other types of costs in decision taking, besides production costs. e.g. transportation costs, monitoring costs Economies of scale in production does not mean that it is more efficient for a firm to have only one plant. - The more important economies of scale in production, the more likely that production is concentrated. - The greater the transportation costs (and dispersion of customers), the more likely that production is decentralized.
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Economies of scope
Many firms produce more than one product. e.g. automobiles: compact cars, trucks, SUVs Economies of scope: when is cheaper to produce two products together than separately. Degree of economies of scope (SC)
SC = C(q1 ,0 ) + C( 0, q2 ) C(q1,q2 ) C(q1,q2 )
No direct relationship between economies of scope and economies of scale.
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Exercise 1
You are considering opening your own restaurant. To do so, you will have to quit your current job which pays $46 thousand per year and cash in your life savings of $200 thousand to purchase equipment for your restaurant, which have been in a certificate of deposit paying 6% per year. You also estimate that you will have to spend $4 thousand during the year to maintain the equipment so as to preserve its market value at $200 thousand. Fortunately, you own a building suitable for the restaurant. You currently rent out this building for $2,500 per month. You anticipate that you will spend $50 thousand for food, $40 thousand for extra help, and $14 thousand for utilities and supplies during the first year of operations.
What are the economic costs of operating the restaurant during the first year?
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Exercise 2
A firm can choose between two production technologies for a new product line. If it installs technology 1, its yearly costs will be C1(q) = 3,600 + 65q + 36q2. If it installs technology 2, they will be C2(q) = 900 + 900q + q2. a. What is the optimal plant size under each technology? b. Which technology would the firm prefer (purely from a cost standpoint) if it expected to sell 30 units in summer and 10 units in winter each year?
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End of Chapter
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