PGP I Term I

Broad types of businesses organizations

Proprietorship

Partnership
Corporations

What is a firm?
Specialized organization devoted to managing the process of production
Produce goods or services Raise resources Manage and coordinate production process

Why do firms exist?

Transaction cost (Ronald Coase, 1937)-specific assets, contractual issues, hold up problems Horizontal and vertical boundaries of firms

Firms objectives
1. Produce maximum output from given level of inputs (technical efficiency) 2. Produce at least cost (cost efficiency), given
The output level Price of inputs
3. Supply output that maximize profit

Production function

Cost min. subject to output level

Production with one variable input

Production with one variable input

Labour(L) 0 Total output 0 AP MP -

1 2 3 4 5 6 7 8 9 10

10 30 60 80 95 108 112 112 108 100

10 15 20 20 19 18 16 14 12 10

10 20 30 20 15 13 4 0 -4 -8

Product curves
Output
112 80

D C B A
2 3 4

60 30 AP, MP

Labour

Stage I

Stage II

Stage III

Labour

Relationship between AP and MP

Technology improvement/Change in K

Output Q3 Q2 Q1 A B C

L1 L2

L3

Labour

Returns to scale (all inputs are variable)

Which cost matters and which does not?

Opportunity cost matters in economic decision making. Sunk cost-Should be ignored; opportunity cost is zero

Fixed versus variable cost

Fixed cost versus sunk cost Marginal and average cost

Short run costs

Relationship between short run production and short run costs

The shapes of the cost curves

Cost Total cost B A Fixed cost Output Variable cost

The shapes of the cost curves

Cost

MC

ATC
AVC

AFC

Output

Relationship between AC and MC

Relationship between Average and Marginal costs

If MC > ATC, then ATC is rising. If MC = ATC, then ATC is at its low point. If MC < ATC, then ATC is falling.
If MC > AVC, then AVC is rising. If MC = AVC, then AVC is at its low point. If MC < AVC, then AVC is falling.

Long run cost curves

Cost

LRMC

LRAC

Output

Economies of scale
Long run AC falls if economies of scale Long run AC rises if diseconomies of scale

Reasons for economies of scale:

Specialization and IRS Cheaper inputs, loans Lower advertising cost/marketing cost

Reasons for diseconomies of scale

Inefficient management and coordination issue Bulk effect disappears Specialization effect disappears and DRS

Cost elasticity and economies of scale

Returns to scale and cost

IRS: LRAC exhibits economies of scale CRS: LRAC is constant as output increases DRS: LRAC exhibits diseconomies of scale

Exercise
1. Assume that the

marginal cost of production is increasing. Can you determine whether the average variable cost is increasing or decreasing? Explain. 2. Assume that the marginal cost of production is greater than the average variable cost. Can you determine whether the average variable cost is increasing or decreasing? Explain.

3. If the firms average cost curves are U-shaped, why does its average variable cost curve achieve its minimum at a lower level of output than the average total cost curve?