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| CHAPTER OUTLINE |
I. Explain and distinguish between the economic and accountingmeasures of a firm’s cost of production and profit.
A. TheFirm’s Goal
B. AccountingCost and Profit
C. Opportunity Cost
1. ExplicitCosts and Implicit Costs
D. EconomicProfit
2. Explain the relationship between a firm’soutput and labor employed in the short run.
A. TheShort Run: Fixed Plant
B. TheLong Run: Variable Plant
C. TotalProduct
D. MarginalProduct
1. IncreasingMarginal Returns
2. DecreasingMarginal Returns
E. AverageProduct
n What’s New in this Edition?
Chapter 14 is similar to Chapter 13 inthe fifth edition but the entire chapter has been updated. The economies ofscale section has been rewritten. The definitions of “economies of scale,” ”diseconomies of scale,” and “constant returns to scale” have been changed. Economiesof scale are defined as: Features of a firm’s technology that make averagetotal cost fall as output increases;diseconomies of scale are defined as: Features of a firm’s technology that makeaverage total cost rise as outputincreases; and constant returns to scale are defined as: Features of a firm’stechnology that keep average total cost constant as output increases.
n Where We Are
In this chapter, we define economic costsand profits. We examine the relationship between inputs, costs, and production.This chapter lays the groundwork for the profit-maximizing decisions that aremade by firms, which we study in the next several chapters.
n Where We’ve Been
We defined what economics means in termsof scarcity, opportunity cost, choice, and efficient use of resources. We’veexplored the interactions of supply and demand that bring about the efficientuse of resources and the role of government intervention in market efficiency.We’ve discussed the rationale behind the downward-sloping demand curve usingmarginal utility analysis.
n Where We’re Going
After thischapter, we look at the demand and marginal revenue curves for firms indifferent industry structures. By combining cost, demand, and revenue curves,we will see the profit-maximizing operating decisions made by firms.
IN THECLASSROOM
nClass Time Needed
This chapter can be completed in two to threeclass sessions. However, this material lays a foundation for the next four chapters,so do not short change it. If you judge from your class’s reaction that youneed more time, take it!
Anestimate of the time per checkpoint is:
· 14.1 Economic Cost andProfit—15 to 20 minutes
· 14.2 Short-Run Production—40 to60 minutes
· 14.3 Short-Run Cost—40 to 60minutes
· 14.4 Long-Run Cost—30 to 40minutes
Classroom Activity This chapter is one more place where an in-class experiment has ahuge payoff and is definitely recommended. The experiment teaches studentsabout the product curves, and a related assignment that we describe laterteaches them about the short-run cost curves. Allow 30 to 40 minutes for thisproduction experiment. This experiment motivates the students to go beyondmemorizing the cost and productivity definitions by getting them directlyinvolved with generating their own data and productivity and cost measures.This is a fun exercise that will illustrate the concept of diminishing returnsto labor, as well as how short run productivity measures and cost measures arerelated. Students genuinely enjoy and learn from this exercise, even though itmight seem childish. You have two inputs:
Capital: A table (of which theclass must have an unobstructed view), some tear-off scratch pads with about500 sheets of paper, a fully loaded stapler, and a back-up stapler (also fullyloaded).
Labor: Provided by yourstudents.
Thecapital and labor are used to produce “widgets.” A widget is a piece of paper,torn from a pad, folded twice very carefully so that the corners of the paperalign, and stapled. The first fold bisects the paper along its long side andthe second fold is at right angles to the first. Once folded, a staple is usedto hold the folds in place. A widget is fragile and breaks if it falls off thetable.
Startthe experiment by hiring a manager from your class and appointing an auditor.Get the manager to hire a quality controller, an accountant, and some workers.Tell the manager that he or she must produce widgets as efficiently as possibleand that he or she can discuss the process with his workers and with the class.Define a day as lasting 1 minute. Get the class to keep time. On day 1, have 1worker produce widgets. On day 2, have 2 workers, and so on. You’ll probablyrun for 10 to 12 days before you get to almost zero marginal product. Recordthe inputs and outputs in a table on the board. Have some fun with qualitycontrol, shirking, and cheating. The auditor must ensure that old widgets andpartly made widgets don’t get used in a subsequent day. Each day must startclean.
Nowcomes the assignment (Stage 1): Get the students to calculate marginal productand average product from the total product numbers that you’re recorded on theboard. Get them to make graphs of the total product, marginal product, andaverage product curves. Get them to describe the curves and to explain theirsimilarities with and differences to the curves for smoothies in the textbook.
Ifyou want, you can extend the experiment with another assignment (Stage 2): Usethe data from your widget production experiment. Tell the students the cost ofthe capital and the wage rate of a worker. (Make up the numbers. Any will do.)Tell the students to calculate total cost, marginal cost, and average cost. Getthem to make graphs of the total cost, marginal cost, and average cost curves.Get them to describe the curves and to explain their similarities with anddifferences to the curves for smoothies in the textbook. This assignment andthe previous one make an outstanding assignment for credit or extra credit.
CHAPTER LECTURE
n 10.1 Economic Cost and Profit
Lecture Launchers: This chapter is incredibly important because it serves as thebasis for the next four chapters. You know this fact, I know this fact, butyour students don’t know this fact. You must tell them this fact becausewithout it you will definitely lose some of the class. How so? They won’trealize that this chapter is critical until they are unable to grasp the next fourchapters. At that point, several possibilities exist, all unpleasant: Thesestudents flunk the course, these students drop the course, or these studentscamp out in your office. Most likely no one would be happy with any of theseoutcomes, so launch your lecture by motivating your students with the importantinformation that Chapter 14 is truly a key to Chapters 15, 16, 17, and 18!
The Firm’s Goal
· The firm’s goal is to maximize profit.
Accounting Cost and Profit versus OpportunityCost
· Accountants measure revenue and costusing accounting conventions in order to ensure that the firm pays the properamount of tax and to give creditors information. But the costs as measured by accountantsare the firm’s opportunity costs.
· The decisions the firm makes tomaximize its profit respond to opportunity cost and economic profit. Theopportunity cost of a firm’s use of resources is the highest-valued alternativeforgone. Opportunity costs include bothexplicit costs and implicit costs.
· Anexplicit cost is a cost paid inmoney. Explicit costs are opportunity costs.
· Animplicit cost is an opportunitycost incurred by a firm when it uses a factor of production for which it doesnot make a direct money payment. Implicit costs also are opportunity costs.
Normal Profit and Economic Profit
· A firm’s owner suppliesentrepreneurship by organizing the business and bearing the risk of running it.
· Normalprofit is the return to entrepreneurship. The normal ispart of a firm’s opportunity cost because it is the cost of persuading theentrepreneur of not running another business.
· Economicprofit is a firm’s total revenue minus its totalopportunity cost. An economic profit is a profit over and above the normalprofit.
qLandMine: Watch out for persistent confusion betweeneconomic profit and accounting profit. You can avoid some of this by thoroughlydrilling them in opportunity cost, so that they understand that non-money costis still cost.
n 10.2 Short-Run Production
Afirm owner’s decisions can be categorized as short run decisions and longrun decisions.
· Theshort run is a time frame inwhich the quantities of some resources are fixed. The fixed resources includethe firm’s management organization structure, level of technology, buildingsand large equipment. These factors are called the firm’s plant.
· Thelong run is a time frame inwhich the quantities of all resourcescan be varied. Long-run decisions are not easily reversed so usually a firmmust live with the plant size that it has created for some time.
Help the students to understand that thedifference between the long run and short run is not related to calendar time.Compare the street vendor, who is a firm owner operating out of a food truck,to the giant automaker firm, Ford. Ask them how long it would take for the foodvendor to double the size of his or her plant (truck, oven, etc.) versus Fordto double its plant size (factory buildings covering multiple blocks,sophisticated computerized assembly lines and robotics, etc.). They willrealize that the length of time covered by the long run differs among firms.
To increase its output in the shortrun, a firm must increase the quantity of labor employed. There are threerelationships between the quantity of labor and the firm’s output.
qLand Mine: If you do notcreate your own data using the experiment described in the ClassroomActivities, be sure that when you draw the curves in this chapter you usenumeric examples. Either make up your own numbers or use the table in the notesbelow, but make sure to provide your students with two things: a preprintedtable with the columns labeled (but not filled in) and preprinted handouts withgraphs on which the axes are labeled. If you can, draw the points (not theactual curves) on the graphs that will correspond to the data in the tables.
Thetable should provide a complete spreadsheet, with labor employment, capital employment,output, AP, MP, TC, TFC, TVC, ATC, AFC,AVC, and MC. Work through thefirst part of the table (capital and labor inputs, output, fixed, variable andtotal costs). Label and draw these graphs. Then turn back to the table,completing the data for the average and marginal cost columns. Finally draw andexplain the graphs that relate to these data. This exercise allows students tolisten to the intuition and follow the example without being distracted tryingto get the layout of the table and graphs correct. You’ll also be able to covermore material this way because you won’t be waiting for students to catch up.
Product Schedules
· Thetotal product is the total quantity of a goodproduced in a given period.
· The marginalproduct (MP)of labor is the increase in total product that results from a one-unit increasein the quantity of labor employed with all other inputs remaining the same.
· The averageproduct of labor is equal to the total product of labordivided by the quantity of labor.
· The table to the right has examples ofthese product schedules.
· The marginal product curve shows the additional output generated byeach additional unit of labor. The figure shows a typical marginal product oflabor curve (MP), with an upside-down U shape. The shape reflects thepoint that marginal product has increasing marginal returns initially anddecreasing marginal returns eventually.
· Increasingmarginal returns occurs when the marginal product ofan additional worker exceeds themarginal product of the previous worker. The marginal product curve has apositive slope. At low levels of employment, increasing marginal returns islikely because hiring an additional worker allows large gains fromspecialization. Eventually these gains become small or nonexistent and decreasing marginal returns set in.
· Decreasing marginal returnsoccur when the marginal product of an additional worker is less than the marginalproduct of the previous worker. The marginal product curve has a negativeslope. The lawof decreasing returns states that as a firm usesmore of a variable input, with a given quantity of fixed inputs, the marginalproduct of the variable input eventually diminishes.
· The average product curve shows the average product that is generatedby labor at each level of labor. The average product of labor curve (AP)has an upside-down U shape.
· As the figure shows, the marginalproduct curve and the average product curve are related: when the marginalproduct of labor exceeds the average product of labor, the averageproduct of labor increases; when the marginal product of labor is less than theaverage product of labor, the average product of labordecreases; and the marginal product of laborequals the average product of labor when the average product of labor is at itsmaximum.
