Lecture 9: Production and Costs of the Firm in the
Short Run
Outline:
1. Profit maximization
2. The meaning of cost
i. Opportunity cost
ii. Sunk cost
3. Economic profits versus accounting profits
4. Economic profits and resource allocation
i. Positive economic profits
ii. Zero economic profits
iii. Negative economic profits(Losses)
5. The production function
6. Time horizons for the firm's decision making
i. Short run
ii. Long run
iii. Very long run
1. Profit Maximization:
The assumption that neoclassical economists make about the behavior of firms is that the most important goal of the firm is to maximize profits.
Profit = Total Revenue - Total Cost
Note: In order to maximize profits the firm must minimize costs.
2. The Meaning of Cost:
* The firm purchases/hires inputs which it uses to produce output.
* The firm incurs costs associated with purchasing/hiring these inputs.
* Economists are interested in the opportunity cost of the inputs.
Opportunity Cost:
The opportunity cost of using an input is the benefit foregone by not using it in its best alternative use.
Economists measure the opportunity cost of the firm's inputs in the following way:
1. Purchased and hired factors of production:
The opportunity cost of these inputs is the price that the firm pays for them.
For example: if the firm hires a worker for $100 per day then the opportunity cost of hiring that worker is whatever else that $100 could buy.
2. Cost of the owner's capital:
If the owner of the firm already owns some factors of production there is no payment made for these inputs but they still have an opportunity cost - the owner of the firm could sell or hire them out to someone else.
For example: the owner of a firm invests $100,000 into her/his firm. S/he could have invested the money elsewhere and earned 7% or $7,000 in a year. The opportunity cost of putting the $100,000 into the firm is thus $7,000.
3. Economic profit versus accounting profit:
Accounting profit = Total Revenue - Opportunity Cost of purchased and hired inputs
Economic profit = Total Revenue - Opportunity cost of purchased and hired inputs - Opportunity cost of the owner's inputs
Positive economic profit = The firm is earning more than the opportunity cost of the owner's inputs.
The owner of the firm is doing better than s/he would do in her/his best alternative.
Zero economic profit = The firm is earning exactly the opportunity cost of the owner's inputs.
The owner of the firm is doing as well as s/he would do in her/his best alternative
Negative economic profit = The firm is earning less than the opportunity cost of the owner's inputs.
(Losses)
The owner of the firm is doing worse that s/he would do in her/his best alternative.
4. Economic profit and resource allocation
Question:
If the firms in a market are earning positive economic profits, would you expect to see resources flowing into the market, flowing out of the market, or neither flowing in or out of the market?
Question:
What about if the firms are earning zero economic profits? Negative economic profits?
5. The production function:
Definition:
The production function shows the maximum output that can be produced with the firm's inputs.
General: Q = F (L, K, R)
Simple: Q= F (L, K)
6. Time horizons for the firm's decision making:
* Firms know that there is a positive relationship between the amount of output they produce and their total costs.
* If demand for a firm's product increases the firm will have to decide how much more output it should produce at the higher price for its good.
* The firm's decisions regarding how much output to produce can be divided into three time horizons.
Short Run: How much should the firm produce with its existing plant and equipment?
Q=f(L) with K fixed, Technology fixed.
Definition:
The SR is the time period during which the quantity of a least one input cannot be increased. That input is called a fixed factor of production. Inputs that can be varied are called variable factors of production.
Long Run: How much should the firm produce when it can change its plant and equipment.?
Q=F(L, K) with Technology fixed.
Definition:
The LR is the time period during which all inputs may be varied but the state of technology is fixed.
Note: All inputs are variable factors of production in the long run.
Very Long Run: How much should the firm produce when all inputs may be varied and the firm may choose new technology?
Q= F(L, K) where F indicates that technology can be varied.
Definition:
The VLR is the time period during which the firm can vary all its inputs and the level of technology.