Unformatted text preview: Principles of Economics I
Economics 101 Announcements Readings: Chapter 10: Production, Technology and Costs Chapter 16: Markets for Labor and other Factors of Production Discussion Sections this week New assignment available on Ctools this afternoon A Two Input Model Production uses labor (L) and capital (K) Price of labor = W (wage) Price of capital = R (rental rate) Production function: Q = f(K, L) Implied tradeoff between K and L Different combinations of K and L generate the same level of output A Two Input Model Optimal labor usage: MPL = W/P or P = W/MPL W/MPL = number of dollars required to increase output by 1 unit (using labor) Optimal capital usage: MPK = R/P or P = R/MPK R/MPK = number of dollars required to increase output by 1 unit (using capital) Profit maximization implies: W/MPL = R/MPK or W/R = MPL/MPK Example: Light bulb manufacturing GE owns light bulb plants around the world, including: Austintown, Ohio Budapest, Hungary (Tungsram, purchased in 1989) Plants have access to the same technology Plants do not look similar Owned by the same firm Hungarian plant looks like something out of the 1950s Why? Example: Light bulb manufacturing Production is relatively labor intensive where ever labor is relatively inexpensive Minimum Wages In Ohio $7/hour In Hungary HUF 69,000 per month
Approx $420/month Approx $1020/month (160 hours/month) If costs of capital are similar then labor is relatively inexpensive in Hangary i.e. capital is relatively expensive in Hungary Question Suppose Hungary becomes a full member of the EU and wages soon rise to equal US wages Are we likely to see Hungary manufacturing as capital intensively as the US?
Depends on the relative costs of capital The location with the lower cost of capital will display higher capital intensity Assessing the costs of capital Cost of capital is usually associated with the rental price Capital owners forgo the rental price in any given period if they use the capital (opportunity cost) Varies between locations based on trade/transactions distortions Also depends on Cost of financing Relative tax treatment "Cost of capital" in a given environment usually refers to the cost of raising funds e.g. selling bonds requires a promise to make interest payments E.g. depreciation allowances lower costs of capital Factor Demand and Output Supply Recall, cost minimization implied: where: W/MPL = R/MPK W/MPL = extra $ / extra unit of output = marginal cost (when using only L) R/MPK = extra $ /extra unit of output = marginal cost (when using only K) Therefore MC = W/MPL = R/MPK Factor Demand and Output Supply MC = W/MPL = R/MPK MPL = W/P MPK = R/P Then MC = P Example Suppose K and L inputs are chosen so that MPL = 10 and MPK = 20 Given W = $100, R = $200 Then hiring the extra unit of L creates 10 units of output and costs $100 Hiring the extra unit of K creates 20 units of output and costs $200 At the margin, the extra units of output cost $10 each (W/MPL = $10) At the margin, the extra units of output cost $10 each (R/MPK = $10) Regardless of HOW the extra units are produced, MC = $10 Is output the efficient level? Depends on P If P > $10, increase output If P < $10, reduce output If P = $10, profits are maximized (i.e. P = MC) Marginal Cost Characterized in two ways: Marginal Opportunity Cost Value of other goods forgone when using resources to produce the marginal unit Dollar cost of purchasing resources required to complete the production Marginal Production Cost These concepts are equivalent when factor markets are competitive Prices of purchased resources are equal to the value of the alternative goods they could have been used to produce Marginal Cost Marginal Production Cost Dollar cost of purchasing resources required to complete the production E.g. MCi = W/MPLi Labor market equilibrium implies that the value of the output created by the marginal unit of labor is the same for all uses of the labor Therefore Marginal Production Cost is identical to the value of the output of ANY alternative product that could have been produced with that labor Conclusion: Marginal production cost is equal to the marginal opportunity cost concept we introduced at the beginning of the course Marginal Cost Some Intuition Suppose it will cost a producer $100 to increase output by 1 unit $100 buys various factors of production (e.g. labor, capital, land) This is marginal production cost In equilibrium, the value of that unit of output is $100 If those inputs had been used in another industry, they would produce output that is also worth $100 Guaranteed by labor market equilibrium This is marginal opportunity cost Therefore marginal production cost = marginal opportunity cost Flexibility of the Firm In a 2input production model, profit maximization implies: W/MPL = P = R/MPK Presumes that ALL factors are chosen optimally Optimal choice depends only on Output price Factor prices Technology Not always feasible to vary all input quantities Firms may be unable to vary some factor usage at will Choice of inputs/output will depend upon TIME FRAME Flexibility of the Firm Over a given time frame, factors of production may be categorized as Variable factors i.e. usage of these inputs will vary with the output level selected by the firm Reducing output to zero implied that none of these factors are employed Fixed factors i.e. usage of these inputs does not vary with the output level selected by the firm Reducing output to zero does not change the fact that the firm must pay for these factors Example: Electricity Generation Inputs: Labor Coal (i.e. raw materials) Generators (i.e. capital) Demand for electricity changes seasonally Ideally, output and inputs will also vary seasonally Is the firm likely to be fully flexible? Coal and labor are variable inputs Capital (i.e. Generators) is a fixed input Generators cannot appear immediately, nor do they disappear Even if no electricity were produced, the firm must make repayments on the loan for installing the generator Over a longer time frame, capital stock may be variable Example: Debbie Does Web Design Inputs: Debbie's time (labor) Debbie's computer (capital) Debbie's skills/knowhow (human capital) If Debbie wants to increase output, she can work more hours (i.e. increase variable labor input); buy more powerful/more computers (i.e. increase variable capital input) But Human capital (i.e.training) is a fixed input E.g. She will need to undertake training in order to develop JAVA skills The time dimension and firm flexibility Varying levels of some factor inputs is not possible within some time frames
Considering longer and longer time frames allows the firm greater flexibility in input selection Contrast: Short run responses (where the firm is constrained it its responses) Long run responses (where the firm has greater flexibility) A new interpretation of the two input production model Production Function Q = F(L, K) L: labor is a variable factor at all times K: capital takes time to install, and so is a fixed factor in the short run Long Run Short Run a time frame over which both inputs can be adjusted a time frame over which labor may be adjusted, but capital cannot Three Classes of Costs Variable costs Fixed but avoidable costs Costs that vary with output Reducing output to zero entails reducing these costs to zero Costs that do not vary with output May be totally avoided if the firm ceases to operate at all Costs that do not vary with output Cannot be avoided, even if the firm shuts down Sunk Costs Examples Labor costs: Extra workers can be hired easily Workers can be laid off easily If the firm chooses to produce no output, these costs can be reduced to zero by firing all the workers These are variable costs Examples Costs of Transferable Capital: Difficult to install new capital quickly Unlikely to destroy capital when reducing output If the firm chooses to produce no output, they must continue to make payments for installed capital If the firm chooses to shut down, the capital can be sold and the costs avoided In the short run, these capital costs are fixed but avoidable Examples Costs of Firmspecific Capital: Difficult to install new capital quickly Unlikely to destroy capital stock when reducing output If the firm chooses to produce no output, they must continue to make payments for installed capital If the firm chooses to shut down, the capital cannot be sold easily These capital costs are sunk Three classes of costs These different costs will impact on the firm's decisions in different ways Costs that have already been sunk by the firm are totally irrelevant to all decisions Costs that are fixed but avoidable are not relevant to the firm's marginal decisions, but will impact whether the firm wishes to remain in an industry Costs that are variable are always relevant Cost Relationships TC = Total Cost FC = Fixed Cost VC = Variable Cost ATC = Average Total Cost AFC = Average Fixed Cost AVC = Average Variable Cost TC = FC + VC TC/Q = FC/Q + VC/Q ATC = AFC + AVC Unit Cost Curves
AC, MC ($) MC ATC = AFC + AVC AVC AFC Q* AFC Q AC vs. MC If AC > MC, then AC must be falling as output increases If AC < MC, then AC must be rising as output increases If AC = MC, then AC must be at a minimum Production Model Production Function Q = F(L, K) L: labor can be varied at any time K: capital can be varied in the long run Short Run: Labor is a variable factor (so labor costs are variable costs) Capital is a fixed factor (so capital costs are fixed costs) Capital may or may not be an avoidable cost: Is there a long term contract that must be honored? Are there penalties for breaking the long term contract? If the capital is owned, can it be transferred? Can it be resold? For simplicity: let all fixed costs be sunk in the short run MC and AC in the Long and Short Run Short run that period of time over which we cannot vary capital inputs To vary output levels in short run: Vary only L input To vary output levels in the long run: Vary both L and K inputs Implication: For any output level, costs will be no higher in the long run than in the short run Long Run and Short Run AC
MC, AC ($) ACSR(K1) MCLR ACLR ACSR(K2) ACSR(K0) QL Q1 QL H Q0 QH Q2 Output Long Run and Short Run MC
MC, AC ($) MCSR MCLR ACLR Q2 Q0 Q1 Output What does profit maximization mean now? We know that firms look to choose output so that P = MC But which MC? Obviously it depends on the time frame we are talking about Responses to a price change in the long and short run MC, AC ($) MCSR Long Run Profit P1 MCLR ACLR AC1 P0 Q0 QSR QLR Output Responses to a price change in the long and short run MC, AC ($) MCSR ACSR AC1 Min AC = P0 AVC1 P1 AVC1 Avoidable loss ACLR MCLR AVC Short run loss Output QSR Q0 Additional losses incurred if firm shuts down Lessons In the long run In the short run If P > min ACLR then choose Q so that = P If P < min AC then shut down LR If P > min AVC then choose Q so that = P If P < min AVC then shut down MC MC ...
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