Unformatted text preview: Laura Miller Economics 101 Prelim #2 Chapter 13: The Costs of Production Total Revenue: the amount a firm received for the sale of its output Total Cost: the market value of inputs a firm uses in production o Includes implicit and explicit costs if thinking like an economist Profit: total revenue minus total cost Costs as Opportunity Costs Explicit Costs: input costs that require an outlay of money by the firm o Example: Helen hires workers to make cookies in her bakery and thus she/the firm is required to pay out some money Implicit Costs: input costs that do not require an outlay of money by the firm o Example: Helen could be working as a computer programmer earning $100/hour but instead she is working more time at the bakery. She therefore gives up this $100/hour income and it is a part of her costs. o Opportunity costs! The total cost of Helen's business is the sum of the explicit costs and the implicit costs Economists include both implicit + explicit costs in order to determine and analyze how firms make production and pricing decisions Accountants on the other hand just consider the explicit costs because they keep track of the money that flows in and out of a firm The Cost of Capital as an Opportunity Cost Economists would see an opportunity cost (a form of implicit cost) as a part of the total costs Accountants would not see an opportunity cost as a part of the total costs because no money flows out of the business to pay for it Economic Profit vs. Accounting Profit Economic Profit: total revenue minus total cost, including both explicit and implicit costs o Important because it is what motivates the firms that supply goods and services o Example: Joe quits his $10,000 job as a pants presser and opens his own dry cleaning store. His financial report for the past year shows the following: Market value of the shop (beginning and end of the year) Sales revenue of the shop Operating expenses o $50,000 o $25,000 o $5,000 If the market interest rate is 10%, an economist would say his profits were: $5,000. Economic Profit--TR TC, including both explicit and implicit costs TC= operating expenses + opportunity cost (salary) + 10% interest rate of market value 25,000 5,000 10,000 5,000 = $5,000 Accounting Profit: total revenue minus total explicit cost o Usually larger than economic profit o accounting profit > economic profit o To be successful from an economists' standpoint, TR > explicit + implicit costs Production and Costs We assume the size of factories is fixed and that we can vary the quantity of output produced only by changing the number of workers this is realistic in the short run but not in the long run. CAPITAL IS FIXED IN THE SHORT RUN YOU CAN ONLY CHANGE THE AMOUNT OF PEOPLE YOU HIRE! Production Function: the relationship between quantity of inputs used to make a good and the quantity of output of that good Marginal Product: the increase in output that arises from an additional unit of input o Example: when workers go from 1 to 2, cookie output goes from 50 to 90. So the marginal product for the second worker is 40. Diminishing Marginal Product: the property whereby the marginal product of an input declines as the quantity of the input increases o output/ labor o Each additional worker contributes less to the production of goods o In the cookie example, this could be because the kitchen is relatively small and so the additional bakers get in each others' way. o Slope in the production function will become flatter From Production Function to the TotalCost Curve Total Cost Curve: shows the relationship between the quantity produced and the total cost o Gets steeper as the amount produced rises (whereas the production function gets flatter as production rises) o In Helen's bakery, when the kitchen is crowded because there are more bakers, producing an additional cookie requires a lot of additional labor and thus is very costly. Therefore, when the quantity produced is large, the totalcost curve is relatively steep o It becomes steeper as the quantity produced rises, which reflects the diminishing marginal product. The Various Measures of Cost Fixed Costs: costs that do not vary with the quantity of output produced o Incurred even if the firm produces nothing at all o Example: rent, bookkeeper (these costs are the same regardless of how much money the firm makes) Variable Costs: costs that do vary with the quantity of output produced o Example: for the lemonade stand, the costs of lemons, sugar, paper cups, straws etc. Because the more lemonade is made, the more of these items the stand will need. Total Cost: the sum of the fixed costs and variable costs Average Total Cost: total cost divided by the quantity of output o A firm produces 2 glasses of lemonade per hour and its total costs is $3.80. the cost of the typical glass is $3.80/2, or $1.90. o The sum of the average fixed costs + average variable costs o AFC+AVC= ATC Average Fixed Cost: fixed costs divided by the quantity of output Average Variable Cost: variable costs divided by the quantity of output o Example: From the information in the table below, what is average variable cost when output is 50 units? Output 0 10 20 30 40 50 Total Cost 40 60 90 130 180 240 Answer: $4.00 Fixed cost = $40 Variable cost for 50 units = $200 AVC= VC/Q AVC= 200/50 = $4.00 Marginal Cost: the increase in total cost that arises from an extra unit of production o How much total cost rises when the firm increases production by one unit output o TC/ Q o Diminishing marginal product is closely related to increasing marginal cost. o Example: Tubby pays all his workers the same wage and labor is his only variable cost. Tubby's marginal cost: Worker 1 2 3 4 5 6 7 Marginal Product 3 5 8 7 5 2 1 MP increases therefore MC decreases MP decreases therefore MC increases *declines as output increases from 0 to 16, but increases after that* Total Product: 3, 8, 16, 25.... Term Explicit Costs Definition Costs that require an outlay of money by the firm Costs that o not require and outlay of money by the firm Costs that do not vary FC with the quantity of output produced Costs that do vary with the quantity of output produced The market value of all VC Mathematical Description Implicit Costs Fixed Costs Variable Costs Total Cost TC= FC+VC the inputs that a firm uses in production Average Fixed Costs Average Variable Cost Average Total Cost Marginal Cost Fixed costs divided by the quantity of output AFC= FC/Q Variable costs divided by AVC= VC/Q the quantity of output Total cost divided by the quantity of output ATC= TC/Q The increase in total cost MC= TC/Q that arises from an extra unit of production Cost Curves and Their Shapes Rising Marginal Cost o o o o o Reflects the property of diminishing product Always hits AVC at its lowest point Always hits ATC at its lowest point MC starts to rise as MP starts to fall The MC curve crossed the ATC curve at: The efficient scale The minimum point on the ATC curve A point where the MC curve is rising UShaped ATC o ATC is the sum of FC and VC o AFC always declines as output rises because FC is getting spread over a larger number of units o AVC typically rises as output increases because of diminishing marginal product o The bottom of the U shape occurs at the quantity that maximizes ATC the quantity is called the efficient scale for the firm Relationship between MC and ATC o Whenever MC < ATC, ATC is falling o Whenever MC > ATC, ATC is rising o The marginal cost curve crosses the average total cost curve at its minimum Because at low levels of output, MC is below ATC, so ATC is falling. But after the two curves cross, MC rises above ATC Market Price: horizontal line because the firm is a price taker Typical Cost Curves (UShaped because there is initially an increasing marginal product, followed by a decreasing marginal product) Diminishing marginal products Rising marginal costs Some firms may experience a decreasing MC before an increasing MC because the team of workers can divide tasks and work more productively than a single worker up until a certain point The combination of increasing then diminishing marginal product also makes the AVC curve Ushaped MC eventually rises with the quantity of output The ATC curve is Ushaped The MC curve crosses the ATC curve at the minimum of ATC Costs in the Short Run and Long Run CAPITAL IS FIXED IN THE SHORT RUN! CAPITAL IS VARIABLE IN THE LONG RUN! Ex: a car company cannot adjust the number or size of its factories over night, it can only produce additional cars by hiring more workers its factories already have o SR: cost of these factories is a fixed cost o LR: cost of these factories is a variable cost Long Run ATC curve is a much flatter Ushape than the short run ATC curve All SR curves lie on or above the LR curve These properties arise because firms have greater flexibility in the LR in essence, in the LR, the firm gets to choose which shortrun curve it wants to use. But in the SR, it has to use whatever SR curve it has in the past. Short Run Long Run Fixed Capital Diminishing Returns Fixed Costs Variable Costs Total Costs All Factors Vary Choose Capital or Labor Technological Efficiency Economic Efficiency Returns to Scale Economies and Diseconomies of Scale Economies of Scale: the property whereby longrun ATC falls as the quantity of output increases o Often arise because higher production levels allow specialization among workers, which permits each worker to become better at his or her assigned tasks o At low levels of production, the firm benefits from increased sized because it can take advantage of greater specialization o When a firm's longrun average cost curve exhibits economies of scale, the longrun average cost curve is downward sloping. "Economies" is a term that means lower per unit costs. o Downward sloping Diseconomies of Scale: the property whereby longrun ATC rises as the quantity of output increases o Can arise because of coordination problem that are inherent in any large organization o At high levels of production, the benefits of specialization have already been realized, and coordination problems become more sever as the firm grows larger o If a producer's longrun average cost rises as its scale of operations increases, the producer is experiencing a diseconomy of scale. The term "diseconomies" refers to increasing per unit costs as the size of the firm increases. o In the long run, when marginal cost is above average total cost, the average total cost curve exhibits diseconomies of scale MC> ATC o Increasing the size of a business does not always result in lower costs per unit. Sometimes a business can get too big! Diseconomies of scale occur when a business grows so large that the costs per unit increase. Diseconomies of scale occur for several reasons, but all as a result of the difficulties of managing a larger workforce. o Upward sloping Constant Returns to Scale: the property whereby longrun ATC stays the same as the quantity of output changes o A production process is said to have constant returns to scale if, when all inputs are changed by given proportion, output changes by the same proportion REMEMBER: Supply curve is always upward sloping in the SR
Returns to Scale Constant Factor Costs Constant Increasing Decreasing Constant Increasing Increasing Decreasing Constant Decreasing Increasing Decreasing Economies of Scale None Diseconomies Economies Economies ? Economies Diseconomies Diseconomies ? o Examples: If a firm has decreasing returnsto scale and increasing factor costs, then: a. its supply curve is downward sloping in the shortrun but may be upward sloping in the longrun. b. its supply curve is upward sloping in the shortrun but may be downward sloping in the longrun. c. its supply curve is upward sloping in the shortrun but downward sloping in the longrun. d. its supply curve is upward sloping in both the shortrun and the longrun. e. its supply curve is downward sloping in both the shortrun and the longrun. Since the 1980s, WalMart stores have appeared in almost every community in America. WalMart buys its goods in large quantities and, therefore, at cheaper prices. WalMart also locates its stores where land prices are low, usually outside of the community business district. Many customers shop at WalMart because of low prices. Local retailers, like the neighborhood drug store, often go out of business because they lose customers. This story demonstrates that: a. there are economies of scale in retail sales. b. consumers are boycotting local retailers whose prices are relatively higher. c. there are diseconomies of scale in retail sales. d. there are diminishing returns to producing and selling retail goods. The longrun supply curve of an industry with a constant returnstoscale production function and increasing factor costs is: a. upward sloping b. c. horizontal. initially downward sloping but eventually upward sloping. initially upward sloping but eventually downward sloping. e. downward-sloping. The supply curve of an industry with a decreasing returnsto scale production function and constant factor costs is: Horizontal Initially downward sloping but eventually upward sloping Initially upward sloping but eventually downward sloping Upward sloping Downward sloping d. If a firm has increasing returns to scale, then: Its supply curve is upward sloping in the short run but maybe downward sloping in the longrun If a firm has a constant returns to scale production function, then: Its marginal costs are increasing in the short run, and may be increasing in the long run ** supply curve is the marginal cost curve!!! The longrun average total cost curve is always flatter than the shortrun average total cost curve, but not necessarily horizontal The short run supply curve is always upward sloping regardless of whether it's and economy or diseconomy of scale. This is because capital is fixed in the SR Chapter 14: Firms in Competitive Markets Competitive Market: a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker o (1) there are many buyers and many sellers in the market o (2) the goods offered by various sellers are largely the same o (3) firms can freely enter or exit the market o Firms have little ability to influence market prices o A firm's goal in a competitive market is to maximize profit Price takers: buyers and sellers in competitive markets must accept the price the market determines, therefore, are said to be price takers Market Power: if a firm is able to influence the market price of the goods it sells Revenue: P*Q Average Revenue: total revenue/the quantity sold o For all firms, average revenue equals the price of the good Marginal Revenue: change in total revenue from the sale of each additional unit of output o For competitive firms, marginal revenue equals the price of the goods The demand curve faced by a firm in perfect competition is perfectly elastic at all quantities Profit Maximization and the Competitive Firm's Supply Chain If marginal revenue is greater than marginal costs, then you should increase the production of your product because it will put more money in your pocket (marginal revenue) than it takes out (marginal cost) o MR > MC, then production If marginal revenue is less than marginal costs, you should decrease production o MR< MC, then production At the profitmaximizing level of output, marginal revenue and marginal cost are exactly equal The MarginalCost Curve and the Firm's Supply Decision Marginal Cost Curve: upward slopping Average Total Cost Curve: Ushaped and crosses the MC curve at it the minimum of ATC curve Market Price: horizontal line because the firm is a price taker o The price of the firm's output is the same regardless of the quantity that the firm decides to produce o For a competitive firm, the price equals both its average revenue and its marginal revenue o P = AR and MR o PERFECTLY ELASTIC!!! Because a competitive firm is a price taker, its marginal revenue equals the market price o MR= Price For any given price, the competitive firm's profit maximizing quantity of output is found by looking at the intersection of the price (MR) with the Marginal Cost (MC) curve o MR=MC = Qoptimal Because the firm's marginalcost curve determines the quantity of the good the firm is willing to supply at any price, the marginal cost curve is also the competitive firm's supply curve Costs and Revenue The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC
If MR < MC (as it is here at Q2), a firm can increase profit by decreasing production MC2 ATC P = MR 1 = MR 2 AVC P = AR = MR MC1
If MR>MC, firm can maximize profits by increasing production from Q1 Qmax 0 Q1 Q MAX Q2 Quantity The Firm's Short Run Decision to Shut Down Shutdown: shortrun decision not to produce anything during a specific period of time because of current market conditions Exit: longrun decision to leave the market SHORT RUN : differs from long run decisions because most firms cannot avoid their fixed costs in the short run but can do so in the long run o A firm that shuts down has to pay its fixed costs, whereas a firm that exits the market does not have to pay any costs at all A firm shuts down if the revenue that it would get from producing is less than its variable costs of production o Shut down if: TR<VC Firm shuts down if Price < AVC o If the price of the products wont cover the AVC, the firm might as well shut down You are comparing the TR to the AVC and VC because the FCs are gone and thus not a part of the decision The firm will lose money when it shuts down (it still has to pay fixed costs) but it would lose more money staying open The competitive firm's shortrun supply curve is the portion of its marginal cost curve that lies above average variable cost (AVC) Sunk Costs: a cost that has already been committed and cannot be recovered o Because nothing can be done about them, you ignore them when making decisions about various aspects of life, including business strategy o A firm's fixed costs are sunk in the short run o Example: you place a $10 value on seeing a movie. You bought a ticket for $7 before the show but lost it. Should you go home and refuse to pay $14 to see the movie or should you buy another ticket for $7? Answer: you should buy another ticket. The benefit of seeing the movie ($10) still exceeds the opportunity cost (the $7 for the second ticket). The $7 you paid for the first ticket is a sunk cost and you should ignore it. The Firm's Long Run Decision to Exit or Enter a Market If a firm exits, it loses revenue from sales of the product but will save its variable costs AND fixed costs (shutting down just saves variable costs) The firm exits the market if the revenue it would get from producing is less than its total costs o Exit if TR<TC Exit if P< ATC Enter if P>ATC The competitive firm's long run supply curve is the portion of its marginal cost curve that lies above ATC Measuring Profit in Our Graph for the Competitive Firm Profit= TRTC Profit= (PriceATC)*Q Positive profit= price is above ATC Losses= price is less than ATC (a) A Firm with Profits
Price MC Profit ATC P
ATC P = AR = MR 0 Quantity (profit-maximizing quantity) Q (b) A Firm with Losses
Price MC ATC ATC P Loss P = AR = MR 0 Q (loss-minimizing quantity) Quantity The Supply Curve in a Competitive Market The Short Run: Market Supply with a Fixed Number of Firms Market Supply= the sum of the quantities supplied by each of the individual firms in the market As long as price is above AVC, each firm's MC curve is its supply curve The Long Run: Market Supply with Entry and Exit If firms already in the market are profitable, then new firms will have an incentive to enter the market o This entry will expand the number of firms, increase the quantity of the good supplied and drive down prices and profits If firms in the market are making losses, then some existing firms will exit the market. o Their exit will reduce the number of firms, decrease the quantity of the good supplied, and drive up the prices and profits At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit Profit= (PriceATC)*Q When firm is profit maximizing (Price=MC=MR) and so profits are zero, new firms have no incentive to leave or enter the market. As a result, the LR market supply curve must be horizontal at this price (perfectly elastic supply curve!) The supply is perfectly elastic because there is only one price consistent with zero profit. Why Do Competitive Firms Stay in Business if They Make Zero Profit? In the zeroprofit equilibrium, the firm's revenue must compensate the owners for the time and money that they expend to keep their business going A Shift in Demand in the Short Run and Long Run (a) Initial Condition Firm Price Price Market MC P1 ATC P1 A Short-run supply, S1 Long-run supply Demand, D1 0 Quantity (firm) 0 Q1 Quantity (market) (b) Short-Run Response Firm Price Profit P2 P1 ATC P2 P1 A Long-run D2 supply D1 0 0 Q1 Q2 Price S1 Market MC B Quantity (firm) Quantity (market) (c) Long-Run Response Firm Price MC P1 Price S1 S2 C D2 D1 0 Quantity (firm) 0 Q1 Q2 Q3 Quantity (market) Long-run supply Market ATC P2 P1 A B Why the LongRun Supply Curve Might Slope Upward Page 305 Chapter 18: The Economics of Labor Markets Factor of Production: the inputs used to produce goods and services o The demand for a factor of production is a derived demand, derived from its decision to supply a good in another market o Ex: Gas station attendant (labor) a demand derived from the supply of gasoline. o Capital: the economy's stock of equipment and structures Demand for Labor Labor demand is a derived demand from the firm's primary goal of maximizing profit Inputs Production of goods and demand for labor! LINKED The Competitive Profit Maximizing Firm The Production Function and the Marginal Product of Labor o Marginal product of labor declines as more workers are hired, diminishing marginal product, so the production function becomes flatter The Value of the Marginal Product and the Demand for Labor o Value of the Marginal Product: the marginal product of an input times the price of the output o Because the market price is constant, the VMP diminishes over time o Also called marginal revenue product because it's the extra revenue the firm gets from hiring an additional unit of a factor of production o Marginal Profit: VMPLWage o To maximize profit, the firm hires workers up to the point where the market wage curve meets the VMP curve! Below this level of employment, the VMP exceeds this wage, so hiring another worker would increase profit Above this level, the VMP is less than the wage, so the marginal worker is unprofitable o Value of Marginal Product curve is the labor demand curve for a competitive, profitmaximizing firm What Causes Labor Demand to Shift? o The output price Increase price of apples: VMP, therefore labor demand from the firm that supplies apples Decrease price of apples: VMP and therefore decreases labor demand o Technological change Increases marginal product of labor, which in turn increases the demand for labor , can also decrease the demand for labor: robots are But labor saving technologies o Supply of other factors A fall in the supply of ladders will reduce the MP of apple pickers and thus reduce the demand for apple pickers The Supply of Labor The Tradeoff between Work and Leisure What Causes the LaborSupply Curve to Shift? Whenever people change the amount they want to work at a given wage Changes in Tastes o Ex: more women in the workforce because women now want to work increases the supply of labor Changes in Alternative Opportunities o If the wage earned by pear pickers suddenly rises, some apple pickers may choose to switch occupations. The supply of labor in the market of apple pickers falls. Immigration Equilibrium in the Labor Market Wage adjusts to balance the supply and demand for labor The wage equals the value of the marginal product of labor Any event that changes the supply or demand for labor must change the equilibrium wage and the VMP by the same amount because these must always be equal Shifts in Labor Supply Page 204 SUPPLY CURVE IS PERFECTLY ELASTIC IN THE INDUSTRY/ LABOR MARKET? Shifts in Labor Demand Popularity of apples : price , VMP , with a higher price of apples, hiring more apple pickers is now profitable. Demand for labor , equilibrium wage and equilibrium employment When price of apples rises, apple producers make greater profit and apple pickers earn higher wages Other Factors of Production: Land and Capital Factors of Production o Land o Labor o Capital: the stock of equipment and structures used for production. For the apple orchard, capital could be the ladders used to climb the trees, the trucks used to transport the apples, the buildings used to store the apples, etc. Equilibrium in the Markets for Land and Capital Purchase Price: the price a person pays to own that factor of production Rental Price: price a person pays to use that factor of production Linkages among the Factors of Production Page 409 Perfectly Competitive Markets. All entrepreneurs in perfectly competitive markets are price takers in both the product market (they face perfectly elastic demand curves) and in the factor market (they face perfectly elastic supply curves). What then decides the mix of capital and labor that they use in the production of that optimal output? Elasticity of substitution? Long Run Demand for Labor Capital is variable Labor is variable In the LR, a change in wage has two effects: Output Effect Substitution Effect: if labor becomes cheaper, firms will substitute labor for capital LR: Output Effect, Substitution Effect SR: ONLY Output Effect (because capital is fixed in the SR) Pk Sg , Dk , DL (Output Effect) Dk, DL (Substitution Effect) Pk Sg, Dk, DL (Output Effect) Dk, DL (Substitution Effect) PL Sg, Dk, DL (Output Effect) DL, DK (Substitution Effect) PL Sg, DL, Dk (Output Effect) DL, Dk (Substitution Effect) Minimum Wage Case:
PL (LowSkilled) : Sg , DL (Low Skilled) , DL (High Skilled) (Output Effect) : DL (High Skilled) , DL (Low Skilled) (Substitution Effect) The derived demand for labor will be more elastic the more price elastic is the demand for the product that labor produced The derived demand for labor will be more elastic the easier it is to substitute other productive factors The derived demand for labor will increase of decrease with a change in the price of an alternative factor depending on whether the output effect or substitution effect is greater o Example: a decrease in the price of capital used in the production of cars May increase or decrease the demand for car workers o Example: an increase in the price of labor used to produce airplanes Will increase the price of airplanes, and may increase the demand for capital used in airplane production o Example: workers employed in the beef industry would gain the most in the LR if the price of capital used to produce beef Decreased, if the output effect was greater than the substitution effect LABORERS WANT A BIG OUTPUT EFFECT IF THE PRICE OF K FALLS LARGER ELASTICITY OF DEMAND FOR PRODUCT = GREATER OUTPUT EFFECT o Example: A Union is more likely to fight the introduction of machines which are substitutes for workers The more elastic the demand for industry's product LARGER ELASTICITY OF DEMAND FOR PRODUCT = GREATER OUTPUT EFFECT Workers want a greater output effect because then they get more money o Example: In most cases, the elasticity of demand for labor with respect to change in wages will be The same in the LR as in the SR o Monopoly: o Monopoly firm produces less of the good than would a competitive firm o By reducing the Q, the monopoly firm moves along the product's demand curve, raising the price and also its profits o Reduces economic activity below the socially optimal level o Causes deadweight loss Monopsony: a market in which there is only one buyer o Hires fewer workers than would a competitive firm o By reducing number of job available, the monopsony firm moves along the labor supply curve, reducing the wage it pays and raising its profits o Reduces economic activity below the socially optimal level o Causes deadweight loss o Rare ...
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This note was uploaded on 12/13/2007 for the course ECON 1110 taught by Professor Wissink during the Fall '06 term at Cornell.
- Fall '06