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 problem set available on Ctools Fixed and Variable Inputs Fixed Inputs: Quantity of such inputs does not vary with the quantity produced Variable Inputs: Quantity of such inputs varies with quantity produced Inputs are likely to be fixed over short periods, and variable over longer time horizons 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 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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