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day7 - PADP 6950 Founda1ons of Policy Analysis Theory of...

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Unformatted text preview: PADP 6950: Founda1ons of Policy Analysis Theory of the Firm Angela Fer1g, PhD The Firm A firm is an organiza1on that transforms inputs into outputs in order to earn profits Inputs include labor, capital, land, and any other raw materials used in the produc1on process Profit = total revenue total cost = TR TC The firm's objec1ve is to maximize profits 1 Significance of the Firm The decisions made by firms are important because most of the goods and services we consume are produced by firms. Understanding how firms behave is essen1al for a comprehensive knowledge of how markets work Many government policies are aimed at regula1ng or affec1ng firm behavior Understanding firm behavior is essen1al for crea1ng effec1ve business and industrial policies Firms and the government Many public agencies and non-profit organiza1ons resemble firms in that they use inputs to produce outputs (they even some1mes sell their outputs for a price) The main difference is that public and non-profit organiza1ons do not have the goal of maximizing profits They some1mes have goals and mandates to minimize cost so some of the results from producer theory apply to them also 2 Short-run vs. Long-run An important dis1nc1on to understand before we begin is that there are 2 1me frames: The short run is a 1me frame sufficiently short that some of the firm's inputs are in fixed supply Usually we assume that capital is fixed in the short run, but that labor is variable The long run is a 1me frame sufficiently long that all inputs are in variable supply The firm is free to choose whatever amount of each input it wishes E.g. the difference between short-run and long-run is the 1me it takes to build a new factory. Short-run Produc1on Func1on The firm's ability to turn inputs into outputs in the short-run is described by the short-run produc/on func/on The short-run produc1on func1on is wri\en Q=f(L,K*) Thus the short-run produc1on func1on shows the rela1onship between labor and output for a fixed amount of capital Q is output L is labor K* is the fixed amount of capital in the short run f is the produc1on func1on, which tells you the maximum output that can be produced with each possible combina1on of K and L. 3 Short run produc1on func1on graph (only 1 input is variable) Long run produc1on func1on graph (2 inputs are variable) 4 Usual assump1ons about produc1on func1ons Monotonic: if you increase the amount of at least one of the inputs, it should be possible to produce at least as much output as you were producing originally Free disposal: if the firm can costlessly dispose of any inputs, having extra inputs around can't hurt it Convex: if there are 2 ways to produce an output, then their weighted average will also be feasible Diminishing Marginal Product Diminishing Technical Rate of Subs/tu/on Diminishing Marginal Product Marginal product is the amount of addi1onal output produced by an addi1onal unit of input (holding other inputs fixed): MP of labor = Q / L Because of monotonicity, if L goes up, Q goes up Diminishing MP means that the marginal product of an input will diminish as we get more and more of that input, i.e., Q will go up by less and less with each addi1onal L as L gets larger This is why short-run produc1on func1on is curved 5 Diminishing Technical Rate of Subs1tu1on Technical rate of subs/tu/on measures the rate at which the firm will have to subs1tute one input for another in order to keep output constant Diminishing TRS means that the slope of the isoquant (in absolute value) must decrease as we move along the isoquant TRS is the slope of the isoquant This is why the isoquant has a convex shape Compared to producing with about equal amount of K and L, when we produce with a lot of K and a li\le L, we'd give up a lot of K to get another unit of L and keep the same output level, and vice-versa Firm Profit Profit = Total Revenue Total Cost 6 Revenues from produc1on The revenues from produc1on are what the firm receives from selling its output in the market: Total Revenue = Price * Quan1ty Sold TR=PQQ TR=PQf(K,L) where Q=f(K,L) is determined by the firm's produc1on func1on Costs of produc1on The cost of produc1on is what the firm must pay to the owners of its labor and capital inputs The total produc1on cost is given by: Total Cost = Capital Cost + Labor Cost TC = PKK+PLL 7 Economic Profit Economic profit is the difference between total revenue and total cost (including both direct and opportunity costs) The firm's capital cost includes the opportunity cost of owner- supplied inputs (the value of 1me, financial resources and material resources that the owner could have used elsewhere) Accoun1ng profits do not subtract the opportunity costs, so they are always higher than economic profits In contrast, accoun/ng profit is the difference between total revenue and direct costs Nega/ve profit: If a firm has nega1ve accoun1ng profit, they are losing money; if a firm has nega1ve economic profit, the owner is earning less than what s/he could elsewhere Profit maximiza1on Let's look at how a firm maximizes its profit in a specific situa1on: Compe11on in the output and input markets This means that the firm is small and its choices do not affect the market price for the good it produces (its output) or the prices for the inputs it needs for produc1on PQ, PK, and PL are all given by the market In a couple of weeks, we will learn about profit max if you can affect the output price This means that the fixed inputs cannot be adjusted K is fixed at some exis1ng level K* In a minute, we will do profit max in the long-run In the short run 8 Profit Max Problem Want to choose the quan1ty of L (the only variable input in the short-run) that gives us the most profit, given fixed K*, PQ, PK, and PL: max pQ f (L,K * ) - pL L - pK K * L How to solve the problem (without calculus) Here's the thought process: Should you hire one more person? Yes if the revenue generated by that person exceeds their costs profits would go up if hired him: PQ*MPL > PL where MPL = Q/L (MPL = marginal product of labor) Yes if the revenue generated by that person is less than their costs profits would go up if fired him: PQ*MPL < PL Should you reduce L by one person? Profit-maximizing level of L is when PQ*MPL = PL 9 Profit Max in the Long Run Same problem as in short run except you have to choose all inputs (not just variable ones) max p f (L,K) - pL L - pK K L,K Q Solu1on: PQ*MPL = PL PQ*MPK = PK 10 ...
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