Costs of the firm and costs to society: the case of pollution

Costs to a private firm can sometimes differ from full social costs when the firm's production activities create unwanted by-products — external costs. Suppose an iron smelting firm belches foul-smelling smoke into the air and dumps toxic wastes into streams. The same process that produces goods and services demanded by society also imposes costs on society in health hazards and pollution. What, if anything, is to be done about the costs to society of reducing or eliminating the costly pollution.

It will help to visualize the difference between firm costs and social costs, which we present in Figure 8.

Figure 8. Costs to the Firm, Costs to Society

In the case of an iron-smelting firm the marginal social costs (MSC) exceed the marginal private costs (MFC) of production. The marginal social cost curve includes all of the firm s private costs of production plus the costs to society of the firm s pollution. In the case of the polluting firm MSC is greater than MPC and “too much” Q_p of the good is produced at “too low” a price P_p. If all costs are accounted for including external or social costs a lower output, Q_s, would be produced at a higher price P_s.

Summary:

1. Costs result from the fact that resources have alternative uses. An opportunity cost is the value of resources in their next-best uses.

2. Explicit costs are like accounting costs, they are the bills that the firm must pay for the use of inputs. Implicit costs are the opportunity costs of resources owned by the firm. The total cost of production is the sum of explicit and implicit costs.

3. Private costs are payments for the use of inputs by the firm. External costs arise when the firm uses an input without paying for its services. The sum of private and external costs is social cost.

4. The short run is a period of economic time when some of the firm's inputs are fixed. The long run is a period over which all inputs, including the size of the firm's plant, can be varied.

5. The law of diminishing marginal returns states that when adding units of a variable input to a fixed amount of other resources beyond some point the resulting additions to output will start to decline.

6. The law of diminishing marginal returns implies that the marginal cost curve of the firm will ultimately rise. As the firm adds more variable inputs to its fixed plant diminishing marginal returns set in at some point, and marginal cost will start to raise as the firm approaches its short run capacity.

7. Short-run costs are:

(a) fixed costs—costs that do not vary with the firm's output,

(b) variable costs—the costs of purchasing variable inputs,

(c) total costs—the sum of fixed and variable costs,

(d) marginal costs—the change in total cost with respect to a change in output. These costs can be expressed in total or average (unit) terms. The short run average total cost curve is U shaped. When marginal cost is below average total cost, the latter fells. When it is above average total cost, the latter rises.

8. Long run average total cost shows the lowest-cost plant for producing output when the firm can choose among all possible plant sues. It is the planning curve of the firm; it helps the firm pick the right sized plant for long-run production.

9. A U-shaped long run average total cost curve results from economies and diseconomies of scale. Economies of scale cause long-run unit costs to fall and diseconomies of scale cause long run unit costs to rise as output is expanded.

10. Economic or opportunity costs are the expected future costs of forgoing alternative uses of resources. Accounting or historical costs are costs that have been incurred in the past. Sunk costs are historical costs and not relevant to present decisions.

LECTURE 9: FACTORS OF PRODUCTION

 

1. Derived demand

2. Productivity

3. Marginal revenue product

4. Changes in resource demand

5. The substitution and output effects

6. Optimum resource mix for the firm

 

Derived demand

The demand for these goods and services is sometimes called final demand. Examples of final demand would be the demand for cars, TVs, haircuts, medical services, or gasoline.

Now we'll look at derived demand, which is the demand for resources. There are four resources: land, labor, capital, and entrepreneurial ability. The demand for those resources is derived from the demand for the final products.

Example:

The demand for land on which to grow corn is derived from the demand for corn, and the demand for labor with which to produce cars is derived from the demand for cars.

A change in the demand for the final product brings about a change in derived demand.

Productivity

 

In addition to the demand for the final product, two other factors influence the demand for the productive resources (land, labor, capital, and entrepreneurial ability):

1. Productivity of the resource;

2. Relative prices of substitutable resources.

Productivity of the resource

Productivity is output per unit of input.

Inputs measure the four resources — land labor, capital, and entrepreneurial ability. Thus a unit of input might be an hour of labor, an acre of land, or an automobile assembly line.

The more productive a resource is, the more it will be in demand.