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Econ 1000: Mod 3, Lecture 5. C.L. Mattoli. Before we move on. If we change price, we move along a supply or demand curve. Supply and demand curves are just schedules or intentions of sellers and buyers of things to sell or buy certain quantities of a good or service, depending on price.

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Econ 1000: Mod 3, Lecture 5

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Econ 1000 mod 3 lecture 5

Econ 1000: Mod 3, Lecture 5

C.L. Mattoli

(C) Red Hill Capital Corp., Delaware, USA 2008


Before we move on

Before we move on

  • If we change price, we move along a supply or demand curve.

  • Supply and demand curves are just schedules or intentions of sellers and buyers of things to sell or buy certain quantities of a good or service, depending on price.

  • Markets, the coming together of supply and demand, work towards an equilibrium quantity and price at the intersection of supply and demand schedules.

(C) Red Hill Capital Corp., Delaware, USA 2008


Before we move on1

Before we move on

  • Equilibrium price and quantity will remain until there is a change in either the whole supply curve or the whole demand curve, a shift or change to a whole new curve.

  • Moreover, if one changes, either the supply or demand curve, the equilibrium will change by moving along the unchanged curve towards the new equilibrium at the intersection of the new one curve with the old other.

  • We demonstrate these concepts in the next slide.

(C) Red Hill Capital Corp., Delaware, USA 2008


Before we move on2

Before we move on

  • A change in a non-price factor causes demand to increase: the demand curve shifts into a new curve.

  • As a result, there is a movement up along the old supply curve to a new equilibrium price and quantity.

Increase in

demand

Change in non-price

Increase

in price

Increase in

quantity supplied

P

D1

D2

Quantity

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity

Elasticity

  • We use percentage change, sometimes, in economics because it gives a better basis for comparison.

  • Elasticity is, then, percentage change in quantity with respect to percentage change in another variable, such as price, income, or the price of another related good or service.

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity1

Elasticity

  • E = [ΔQ/Q]/[ΔX/X] = [(Q1 – Q0)/Q0]/](X1 – X0)/X0] = %ΔQ/%ΔX, or the mid-point definition which uses the mid-points (Q1+Q0)/2 and (X1 +X0)/2 in the denominators of the percentage change calculations.

  • If something is elastic, that means that the quantity will be very sensitive to changes in the other variable.

  • If something is inelastic, quantity will not be very responsive to price.

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity calculations

Elasticity calculations

  • Elasticity equals percent change divided by percent change.

  • If we have raw numbers for both variables, we can calculate % changes and then calculate elasticity.

  • If we know percentage changes, we can calculate elasticity directly as the ratio of the % changes.

  • If we know elasticity and one of the % changes, we can calculate the other % change.

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity logic and psychology

Elasticity Logic and Psychology.

  • Quantity demanded or supplied will depend, at least, on prices.

  • It can also depend on income.

  • Elasticity takes a deeper look at the responsiveness of quantity change with respect to changes in some variables.

  • For example, if there are substitutes for something, and the price rises, people will just switch to an alternative. The good will have high elasticity.

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity logic and psychology1

Elasticity Logic and Psychology.

  • If something goes with something else, i.e., compliments it, like tires for automobile, a change in price of one will affect quantity demanded for the other. The good will have cross-elasticity.

  • If something is a large part of a person’s total budget, their spending allowance constraints, the change in price will have a larger affect on quantity than on a good that is a small part of a budget. Salt is more inelastic than automobiles.

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity logic and psychology2

Elasticity Logic and Psychology.

  • When income rises, people will buy better clothing, better restaurants, better cars. So, rise in income will have positive (E>0) elasticity for nicer things (normal or so-called luxury goods) and negative elasticity (E<0) for lower quality and less expensive things (inferior goods).

  • While price elasticity of demand will always be a negative number because quantity will decrease as price increases, elasticity of supply will always be a positive number because quantity supplied is an increasing function of price (direct relationship).

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity logic and psychology3

Elasticity Logic and Psychology.

  • Income and cross-elasticities can be either positive or negative numbers depending on the type of good.

  • The elasticity concept is also intimately connected with change in revenues versus changes in price, so it is an interesting piece of information for suppliers to have.

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity logic and psychology4

Elasticity Logic and Psychology.

  • When a good or service is elastic, total revenue will rise with a decrease in price but fall for a price increase.

  • When a good is inelastic, total revenue will rise and fall with rising and falling prices.

  • If it is unit elastic, changes in price will have no affect at all on total revenues.

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity and taxation

Elasticity and Taxation

  • Governments add excise taxes on things, like gasoline and cigarettes.

  • Adding a tax to a product shifts the supply curve up since a cost is added for every quantity, so every quantity comes at a higher price in the new supply schedule as shown:

Tax cost

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity and taxation1

Elasticity and Taxation

  • In the case of perfect inelastic demand, the extra cost is born totally by the buyer because the equilibrium quantity is the same before and after the tax is added but the price paid is higher by exactly the extra cost tax.

  • See the figure:

S1

D

Tax

S0

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity and taxation2

Elasticity and Taxation

Change in

market price

= ΔP

  • When demand is other than perfectly elastic (vertical) it will have a downward slope.

  • Because of the downward slope, the burden will shift from totally on the buyer to a split between buyer and seller.

  • Thus, of T = Tax, the added cost, the part that is shifted to the buyer is the difference between what he paid before and what he is paying now, which change in price is less than the added cost = T

T – ΔP

Buyer

Seller

Total

Tax = T

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity and taxation3

Elasticity and Taxation

Change in

market price

= ΔP

  • In the diagram, we also show what happens when supply is more inelastic (blue lines). Then, the part of the tax shifted to the buyer is less, the more inelastic the supply for the same tax.

T – ΔP

Buyer

Seller

Total

Tax = T

(C) Red Hill Capital Corp., Delaware, USA 2008


Elasticity and taxation4

Elasticity and Taxation

  • Limiting cases are, thus:

  • Inelastic demand: all tax to consumer.

  • Perfect elastic demand: all cost to seller.

  • Perfect inelastic supply: all cost to seller.

  • Perfect elastic supply: all cost to buyer

(C) Red Hill Capital Corp., Delaware, USA 2008


This week

This week

  • Chapter 6:

  • Production costs

(C) Red Hill Capital Corp., Delaware, USA 2008


Learning objectives

Learning objectives

On successful completion of this module, you should be able to:

  • Explain the concepts of ‘explicit’ and implicit’ costs

  • Define the terms ‘economic profit’, ‘accounting profit’ and ‘normal’ profit

  • Use the law of diminishing returns to explain and illustrate the short-runproduction function

(C) Red Hill Capital Corp., Delaware, USA 2008


Learning objectives1

Learning objectives

  • Explain the relationship between short run costs and output in terms of total, average, and marginal cost curves

  • Explain the relationship between marginal and average cost and between marginal product and marginal cost

  • Explain the construction and shape of the firm’s long run average cost curve.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from

Where we are coming from

  • We have looked at concepts of supply and demand, and we have examined the underlying psychological factors involved on both sides.

  • A fundamental driver of economic people is self-interest.

  • We usually assume that self-interest is enlightened, but the fact that people would pollute the environment to produce goods and services proves otherwise.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from1

Where we are coming from

  • Demand is driven by wants, tempered by people’s 1) limited financial resources, 2) a desire to pay less rather than more, and 3) a tendency to be slow to accept change.

  • Thus, people have unlimited wants but limited personal resources with which to get what they want.

  • They can trade their time, and make their own clothing, or they get a job and trade their time to earn money to buy things from others.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from2

Where we are coming from

  • They give up one opportunity, their time and their money, to make a choice and take another opportunity.

  • Indeed, most people try to find a comparative advantage for their time, and they get a job. They trade their time for the intermediary of transactions: money.

  • Some might give up a paying job to start a business. Then, their opportunity cost will be money from another job.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from3

Where we are coming from

  • Once in business, their might be several business opportunities that they have to weigh against one another: to make more forks or to grow more corn.

  • Suppliers and producers have taken initiative to take on risk to fulfill the needs and wants of others. They are motivated by profits.

  • People are competitive, at least because of self-interest, whether it is to win a basketball game or an on-line auction for a computer.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from4

Where we are coming from

  • That natural competitive tendencyhelps make competitive markets in the economy.

  • However, just as self-interested profit seekingcan lead to undesirable results, such as pollution, it can lead to other undesirable economic behavior, like anti-competitive or collusive behavior, in the marketplace.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from5

Where we are coming from

  • The demand side is also complicated. People will take substitutes. People can be stubborn. People are concerned about their incomes and the prices of the things that they buy, along with other personal welfare issues.

  • We have seen, in our study of elasticity, that the interaction of price and quantity, on the demand side of the equation, can have an affect on total revenues.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from6

Where we are coming from

  • Total revenues can be sensitive to changes in price, perhaps decreasing when prices are raised beyond a certain level.

  • A rise in price will help unit profit margins, but a decrease in revenues will also affect overall margins.

  • That is a limitation on the situation for suppliers, originating on the demand side.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from7

Where we are coming from

  • We looked at production on a larger scale in the PPF. There we found a maximumcapacity output line for simultaneous production of a number of goods.

  • Then, we can figure out, for example, that the opportunity to produce 10,000 more tons of corn will mean giving up the opportunity to make 50,000 forks, so the cost is 5 forks per ton of corn.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from8

Where we are coming from

  • In looking at the PPF, we discovered that substitutes are also available to suppliers: they can be attracted to one business or another.

  • Their decision is based on opportunity costs.

  • Next, we shall look more closely at the cost side of the production function, in order to examine limitations on profits.

(C) Red Hill Capital Corp., Delaware, USA 2008


Where we are coming from9

Where we are coming from

  • In the case of the consumer and demand, we found the concept of marginal utility.

  • We will find the law of diminishing returns on the supply side of the market.

  • These are concepts that involve marginal thinking.

  • We will use further marginal concepts, like marginal costs, which will lead to another: marginal product.

  • Our study of the limitations on producers will give us an idea of how much suppliers can supply.

(C) Red Hill Capital Corp., Delaware, USA 2008


Mathematically total revenue elasticity

Mathematically: total revenue & elasticity

  • Total revenue equals price times quantity demanded: RT = QxP

  • The variation of total revenues with respect to price is given by: Δ RT /ΔP = P x[ΔQ/ΔP] + QxΔP/ΔP = P x[ΔQ/ΔP] + Q

  • If we want to find the condition for increasing total revenue that means that the change in revenue should always be a positive number. In algebra, we require: ΔRT /ΔP > 0.

(C) Red Hill Capital Corp., Delaware, USA 2008


Mathematically total revenue

Mathematically: total revenue

  • So, Δ RT /ΔP = P x[ΔQ/ΔP] + Q >0

  • Rearranging the symbols in the equation, we get ΔQ/(ΔP/P) > – Q

  • Or, (ΔQ/Q)/(ΔP/P) = %ΔQ/%ΔP = ED> – 1

  • So, if P is increasing, and E is inelastic (absolute value less than 1)

  • We shall also take a closer look at revenues, in this module.

(C) Red Hill Capital Corp., Delaware, USA 2008


Costs and the supply curve

Costs and the supply curve

  • We have discussed shifts in the supply curve.

  • A shift up or to the left is called a decrease in supply because in the new supply less quantity will be supplied at each price versus the old curve.

  • Such a shift can, for example, come from some type of cost increase. In that case, any quantity will come at a higher price than before the change in cost, which is the same as less quantity will be supplied at any price.

  • We show the two ways of looking at up and left shifts in the next slide.

(C) Red Hill Capital Corp., Delaware, USA 2008


Costs and the supply curve1

Costs and the supply curve

  • A decrease in supply is a shift up or left of the supply curve.

  • A higher price is charged for each quantity supplied,

  • or

  • Less quantity is supplied at each price.

P

S2

S1

P

Q

(C) Red Hill Capital Corp., Delaware, USA 2008


Costs and the supply curve prior examples

Costs and the supply curve: prior examples

  • We have discussed various reasons, so far, that supply curves can shift.

  • New technology introduced into an industry can substantially reduce costs and shift the supply curve down or right.

  • Increases in labor costs can shift it up or left.

(C) Red Hill Capital Corp., Delaware, USA 2008


Costs and the supply curve prior examples1

Costs and the supply curve: prior examples

  • Another type of cost that can shift it up or left are taxes, like excise taxes on “sin” products or taxes on pollution.

  • In this module we shall examine, more closely, the issue of costs versus revenues and profits in shaping the supply curve.

(C) Red Hill Capital Corp., Delaware, USA 2008


Costs and profits

Costs and Profits

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Profit motive

Profit motive

  • It is a basic tenet of economics that the motivation for business is profit maximization.

  • Revenues will depend on demand: quantity demanded times price.

  • To get to profits we must understand costs.

  • Before we do that, we must understand how economists define costs and profits versus how those concepts are defined in accounting and finance.

(C) Red Hill Capital Corp., Delaware, USA 2008


Explicit and implicit costs

Explicit and implicit costs

  • Explicit costs are costs paid to non-owners of the firm for resources. That includes things, like labor costs, electricity, raw materials, rentals of PP&E.

  • Implicit cost are the opportunity costs associated with using firm resources one way versus another.

  • Thus, we find opportunity costs entering our economic analysis, again.

(C) Red Hill Capital Corp., Delaware, USA 2008


Explicit and implicit costs1

Explicit and implicit costs

  • We first found that opportunity costs enter consumers’ decisions to purchase:

  • If I buy an expensive lunch, I might not have enough money to go to the movies. A company decides whether to buy a machine to produce candles or a jet to ferry its executives around the world.

  • Then, we encountered opportunity costs when we looked at production possibilities.

(C) Red Hill Capital Corp., Delaware, USA 2008


Explicit and implicit costs2

Explicit and implicit costs

  • We considered that to produce more of good A, we had to give up a certain amount of production of good B, and we called the trade-off: opportunity costs.

  • Now, we extend that thinking to directly apply to our accounting for costs and profits.

(C) Red Hill Capital Corp., Delaware, USA 2008


Explicit and implicit costs3

Explicit and implicit costs

  • We can pay money for more laborers or we can buy an expensive machine to lessen our dependence on labor but might also increase our dependence on energy, like electricity or oil.

  • Trade labor for machinery and electricity

  • A building, for example, might be used for warehousing of one product or manufacture of another. There is an opportunity trade-off for its use.

(C) Red Hill Capital Corp., Delaware, USA 2008


Explicit and implicit costs4

Explicit and implicit costs

  • Moreover, even the owner of the business might better use his or her time and money in another business.

  • We, therefore, must think about the other opportunities for his time and his money.

  • Then, economics defines the total opportunity cost as the sum of all explicit and implicit costs.

(C) Red Hill Capital Corp., Delaware, USA 2008


Profits

Profits

  • Given an economic definition of costs, we also have to revise our concept of profits.

  • Our standard notion of profits is what economists refer to as accounting profits.

  • Accounting profits = Total revenues – Total explicit costs

  • In contrast, economists define economic profits as total revenues less all costs; thus

  • Economic profits = Total revenues – Total opportunity costs

(C) Red Hill Capital Corp., Delaware, USA 2008


Profit example

Profit example

  • Assume that Craig decides to quit his job at Starbucks to start his own coffee business.

  • He already has store space on a busy street in Guangzhou that he could use to house the business and he has some savings that he can use for business startup costs.

  • He borrows funds to cover initial investment requirements, and he opens the business.

  • In the next slide, we show a comparison of accounting and economic profits for his first year of business.

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Profits example

Profits example

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Profits example1

Profits example

  • The table shows economic and accounting profits.

  • While accounting profit is positive, economic profit is negative after accounting for lost opportunities: $70,000 Craig could have earned at his old job, rental income that he could have gotten from renting his space, and the interest he could have earned on his savings.

(C) Red Hill Capital Corp., Delaware, USA 2008


Zero profit the proper economic goal

Zero Profit: the proper economic goal

  • In the above example, Craig is failing to cover his opportunity costs, so his resources would be put to better use and could earn a higher return if used elsewhere.

  • In other words, by comparing all of his opportunities to make money, he can choose among them based on total opportunity costs and, thereby, maximize his intrinsic worth.

(C) Red Hill Capital Corp., Delaware, USA 2008


Zero profit the proper economic goal1

Zero Profit: the proper economic goal

  • In that manner, he will be able to choose the right career path.

  • In economic terms, zero economic profits are called normal profits.

  • Normal profits are the minimum profit necessary to justify keeping a firm in business.

  • When normal profits are equal to zero it is the state in which there is just enough revenue to cover all costs, including opportunity costs.

(C) Red Hill Capital Corp., Delaware, USA 2008


Zero profit the proper economic goal2

Zero Profit: the proper economic goal

  • In other words, at that minimum, there is no benefit from reallocating resources to another use.

  • We can now better appreciate the discussion of opportunity costs in looking at the PPF.

  • There, we quantified costs in terms of how much of one good we gave up to produce another. That is output or revenue.

  • Now, we find that opportunity costs must be taken into account for calculating profits.

(C) Red Hill Capital Corp., Delaware, USA 2008


Zero profit the proper economic goal3

Zero Profit: the proper economic goal

  • Thus, they will affect decisions of where actual production might occur on the PPF.

  • For example, if a company can produce napkins or parachutes, it will decide how to divide its labor and machinery to producing each.

  • That decision will be based on how much it gives up in producing one to produce more of the other.

  • It can reallocate production from one to the other until its incremental economic profits are zero.

(C) Red Hill Capital Corp., Delaware, USA 2008


Choice and opportunity costs

Choice and Opportunity Costs

  • Economics is a socio-psychologically, logical theory of business transactions.

  • Thus, money is not what most often enters analysis.

  • Money is just an intermediate thing that allows us to buy many different things.

  • However, costs are better measured in terms of opportunities: what they are worth, in terms of other available options.

  • We give up a hotdog to have a hamburger at lunch: opportunity costs are that simple.

(C) Red Hill Capital Corp., Delaware, USA 2008


Choice and opportunity costs1

Choice and Opportunity Costs

  • We go to college and spend 4 years of earning no money and giving up time.

  • We become a financial analyst instead of a brain surgeon.

  • Then, we decide how production should be allocated to a number of different possibilities, depending on our perceived opportunities created by choices in demand made in the markets.

  • In the end, the whole economy lands somewhere in its production possibilities set.

(C) Red Hill Capital Corp., Delaware, USA 2008


Short run production

Short-run Production

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Short run versus long run

Short-run versus long-run?

  • Economists do not distinguish between the short and long terms on an arbitrary basis of time. Time only has meaning in terms of what you can do with it.

  • In economics, the line between short and long run is drawn in terms of the ability to vary the quantity of inputs of resources, factors of production, in the production process.

  • To analyze the question, we must distinguish between fixed and variable inputs.

(C) Red Hill Capital Corp., Delaware, USA 2008


Short run versus long run1

Short-run versus long-run?

  • Fixed inputs are resources for which the quantity cannot be changed during the period of time under consideration.

  • Fixed inputsinclude things, like the size of a firm’s physical plant or the capacity of a machine to produce output.

  • Such things cannot be changed in a short period of time.

  • They must remain fixed while managers decide upon other ways to vary output…the variable inputs.

(C) Red Hill Capital Corp., Delaware, USA 2008


Short run versus long run2

Short-run versus long-run?

  • Then, there are variable inputs, over which managers do have some control, given the fixed inputs.

  • A simple example of variable input is the number of employees and employee hours in a given period of time.

  • Of course, at some point even employee and machine hours will max out.

(C) Red Hill Capital Corp., Delaware, USA 2008


Short run versus long run3

Short-run versus long-run?

  • Given those concepts, we can finally make a proper distinction between short-run and long-run.

  • The short-run is the period during which there is at least one fixed input.

  • The short-run is, for example, the period in which a firm can hire more employees, variable input, while it cannot change the size of its physical plant, fixed input.

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Short run versus long run4

Short-run versus long-run?

  • The long-run is the period of time that is sufficient to allow for changes in fixed inputs.

  • In the long-run a firm can build new plant and buy more equipment.

  • In the long-run, new firms can enter the business and oldfirms might exit, changing the supply curve.

(C) Red Hill Capital Corp., Delaware, USA 2008


Short run versus long run5

Short-run versus long-run?

  • Thus, the difference between SR & LR can vary for different businesses or even for the same business at different times.

  • An airplane manufacturer will have certain fixed plant capacity, and to increase it might take a year or more to build new buildings and to order and install new equipment.

  • It might only take a few months to build a repair shop for old airplanes.

(C) Red Hill Capital Corp., Delaware, USA 2008


Short run versus long run6

Short-run versus long-run?

  • A clothing sales chain might take several months to find space for a new store and to build it out.

  • If it want to begin sales in another country, it might take a year or more to do all of the paper work and find international shippers for its international aspirations.

  • Thus, SR & LR will depend on the particular business and situation.

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Break time

Break time

  • Please, take a 10 minute break

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The production function model

The Production Function Model

  • The next step is to look at the transformation of inputs into output.

  • This is done using the production function, the relationship giving the maximum output that can be produced using varying quantities of the various inputs to production.

  • In production function theory, as presented herein, ceteris paribus is that technology remains unchanged since changes in technology would change the output that can be achieved with given inputs and would, therefore, change the production function.

(C) Red Hill Capital Corp., Delaware, USA 2008


Production function example chateau mattoli vineyards

Production function example: Chateau Mattoli Vineyards.

  • Consider a business that grows grapes to produce wine.

  • The input for the business is labor, and we assume all potential laborers have equal job skills.

  • The land, number of vines, the machinery, and all other inputs are categorized as fixed.

  • Thus, our production model description is in the short run.

(C) Red Hill Capital Corp., Delaware, USA 2008


Production function example chateau mattoli vineyards1

Production function example: Chateau Mattoli Vineyards.

  • Output will vary with employment: the more employees, the more man hours, the higher the maximum output.

  • Output begins at zero when zero employees are employed.

  • With only one employees, maximum daily output is 1 ton.

  • However, there is a lot of wasted time with only one employee.

(C) Red Hill Capital Corp., Delaware, USA 2008


Production function example chateau mattoli vineyards2

Production function example: Chateau Mattoli Vineyards.

  • She has to:

  • pick the grapes and put them in a cart,

  • she has to transport the cart to the shed, then, press the grapes,

  • make the wine and store it in casks, and

  • follow up with the aging process and final bottling, labeling, and boxing of the wine.

  • It is very inefficient.

(C) Red Hill Capital Corp., Delaware, USA 2008


Production function example chateau mattoli vineyards3

Production function example: Chateau Mattoli Vineyards.

  • The addition of a second employee adds efficiency.

  • The 2 can save time by dividing tasks that might overlap.

  • After a cart is filled with grapes, the second employee could have brought a second cart to start on, and she can take the first cart back to the press to begin the next step, while the first continues to fill up the next cart.

(C) Red Hill Capital Corp., Delaware, USA 2008


Production function example chateau mattoli vineyards4

Production function example: Chateau Mattoli Vineyards.

  • They can process 2.2 tons per day, together.

  • Thus, they produce more than 2 times the amount that can be produced with only one employee.

  • Adding a third employee increases production to 3.3 tons per day.

  • However, by the time we have increased the employees to 6, production is only to up 5 tons.

  • See the next slide for graphical details.

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Production function example chateau mattoli vineyards5

Production function example: Chateau Mattoli Vineyards.

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Marginal product

Marginal Product

  • The example points out an interesting phenomena: adding labor increases output, first, at a magnified rate and, later, as more employees are added, at a shrunken rate.

  • We define marginal product as the change in total output (TO) per unit change in labor (L): ΔTO/ΔL

(C) Red Hill Capital Corp., Delaware, USA 2008


Marginal product1

Marginal Product

  • It is the slope of the total output curve, at any point along the curve.

  • For Chateau Mattoli, marginal product is equal to 1 when the first employee is added, 1.2 for the second, 1.1 for the third, and is down to 0.2 by the time that the 6th employee is hired.

  • We show the figures in the next slide.

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Marginal product chateau mattoli

Marginal Product: Chateau Mattoli

Marginal product decreases because the slope of the output curve is decreasing

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Law of diminishing returns

Law of diminishing returns

  • What is at work in the preceding analysis is another law of economics: the law of diminishing returns.

  • The law of diminishing returns states that, beyond a certain point, the addition of a unit of variable factor to a fixed factor will result in decreasing marginal product.

  • Since the law assumes that there is a fixed factor, it is necessarily a short-run law.

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Law of diminishing returns1

Law of diminishing returns

  • At first, additional employees use the fixed resources more efficiently by working together’

  • But as more employees are added to the fixed inputs, their sharing begins to decrease the initial efficiency of dividing tasks.

  • In chapter 11, a detailed analysis of the labor market tells how to decide on the right number of employees.

(C) Red Hill Capital Corp., Delaware, USA 2008


Law of diminishing returns2

Law of diminishing returns

  • We shall not cover those details, in this course.

  • For now, we only say that a firm would never hire an employee who has marginal product of zero or less.

  • The law is a simple statement of the reality of business organization.

  • Eventually, too many cooks spoil the soup.

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Short run cost formulas

Short-run cost formulas

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Total cost curves

Total cost curves

  • For a business to make a decision to produce a product, in the long or short runs, it must first determine the costs associated with producing various quantities.

  • For example, in Mattoli Vineyards, we saw that output was varied by adding employees.

  • In the short run, costs are divided between total fixed costs and total variable costs.

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Total cost curves1

Total cost curves

  • Fixed costs (TFC), like mortgage or rent, interest on loans, and insurance, must be paid even if there is nothing produced.

  • Variable costs (TVC) will vary with the output.

  • Variable costs will include labor, materials for production, and the like.

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Total cost curves2

Total cost curves

  • You rent or buy a space for a dress store.

  • You have to pay rent, no matter if you have business or not.

  • You have to pay interest on borrowings whether you have sold any dresses or not.

  • You have to have the lights and climate control on whether or not you make sales.

  • You can vary the amount of inventory that you purchase and the hours that you have people work at the store.

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Total cost curves3

Total cost curves

  • In the simple example of Mattoli’s Vineyards, we assumed that the only variable cost was labor. We also assume that each employee is equally skilled and that they are all paid the same wage rate.

  • Then, total cost (TC) will be the sum of fixed and variable costs, TC = TFC + TVC.

  • In the next slide we show cost data for another mythical business: MAT ATM machines (Mattoli’s automatic teller bank machines).

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Mat atm data

MAT ATM Data

  • The quantity versus cost data for MAT ATM

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Average cost curves

Average cost curves

  • Costs are nice to look at but more interesting to a manager are costs per unit of product produced, or average costs.

  • Like prices, average costs are stated on a per unit basis.

  • Thus, we have the following definitional formulae:

    AFC = FC/Q

    AVC = VC/Q

    ATC = AFC + AVC = FC/Q + VC/Q = (FC+VC)/Q = TC/Q

    Note: there is a mistake in the book on page 153 for ATC; book says ATC = TVC/Q

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Connection with marginal cost

Connection with marginal cost

  • Marginal cost is, basically, the change in cost when one additional unit is produced.

  • In terms of our new equation definitions, we can say marginal cost is the change in total cost per change in unit output. Moreover, since fixed cost never changes, we can write an equation for MC as:

    MC = ΔTC/ΔQ = ΔTVC/ΔQ

  • In the next slide, we show average and marginal costs in table and graph forms.

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Ac mc data

AC & MC Data

  • Average and marginal costs are shown for MAT ATM’s.

MC

ATC

AVC

AFC

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Details

Details

  • TC = TFC+TVC; MC(n+1) = TC(n+1) – TC(n); ATC = TC/n for Q = n units

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Cost curve analyses

Cost curve analyses

  • Average fixed cost is an ever decreasing value versus output since the total cost is spread over more and more units.

  • All other curves fall, initially, hit a minimum, and, then, begin to rise.

  • Notice, also, that the MC curve intersects with both the AVC and ATC curves at their minimums. It is no accident, and we shall take a closer look and find that it is a general result.

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Marginal relationships

Marginal Relationships

  • The marginal-average rule is a relationship that applies to any marginal versus average variables.

  • The marginal-average rule states that as long as the marginal variable is below the average, the average curve will be falling. When marginal is above the average, the average will be rising. Thus, the average will be equal to the marginal at the minimum of the average.

  • Thus, both AVC and ATC will obey the rule

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Marginal average example

Marginal average example

  • To understand the average marginal rule in more familiar territory, let us consider average class grades.

  • If the average grade of 20 students is 80% and another person’s grade is added to the average, if the grade is above 80%, it will increase the average. If it is below average, it will pull the average down.

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Marginal average example1

Marginal average example

  • Take 20x80%, then, add the new grade, and divide by 21.

  • As you can easily understand, the new average will be below 80%, if you add a grade below 80%, and conversely, if you add a grade above 80%.

  • Thus, the marginal-average rule holds for average grades or any other average-marginal relationship.

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Marginal costs versus marginal product

Marginal Costs versus Marginal Product

  • The marginal cost declinesif the marginal product is increasing when the price of a variable input is constant.

  • Marginal cost begins to increase when marginal product is on the decline.

  • It is only logical.

  • As long as marginal product is increasing, we will get more and more efficient use of variable inputs and lower our average costs.

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Marginal costs versus marginal product1

Marginal Costs versus Marginal Product

  • When marginal product hits it peak, we begin to lose benefits, and average costs begin to increase.

  • The result also shows that marginal cost begins to rise at the point of diminishing returns, so it is a result of the law.

  • We return to Mattoli Vineyards for an example look at the relationship of MC and MP, in the next slide.

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Chateau mattoli marginals

Chateau Mattoli Marginals

  • Assume that Chateau Mattoli pays its employees $100/day.

  • Each worker is equally skilled and equally paid.

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Chateau mattoli marginals1

Chateau Mattoli Marginals

  • In the example, marginal cost begins at $100 for the first employee, and hits a low at $83 with the second.

  • After that there are diminishing returns from hiring more employees.

  • As you can see in the graphs, the minimum MC is at the maximum MP.

  • MC and MP are inversely related.

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Long run production costs

Long run production costs

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Long run average cost curves

Long run average cost curves

  • The long run, as previously stated, is a period of time long enough to change the quantities of all fixed input that was fixed in the short run.

  • In the long run, a business can change the size of its physical plant, larger or smaller. It can change the machinery capacity.

  • Whenever a business makes a change in fixed inputs it puts itself back in the short run again.

  • In the next slides, we look at the decision for MAT ATM’s on the proper size of a plant, given only 3 choices of size.

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Mat s choices

MAT’s Choices

  • MATATM has 3 choices of factory sizes.

  • Each has its own cost curve.

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Size matters to mat

Size matters to MAT

  • The previous slide shows graphs of short run average total cost curves (SRATC) for three factory sizes.

  • If MAT thought that it will produces 6 machines a week for the foreseeable future. Then, it would be better off with the smaller size plant represented by the curve on the right.

  • If MAT thought that it will be producing 9 machines a week, it will choose the mid-size plant.

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Size matters to mat1

Size matters to MAT

  • If it believes that it will produce 12 machines a week it will choose the large plant.

  • In all 3 factory sizes, it can produce at a number of levels.

  • Although the graph does not show it, production possibilities for all size plants will range from 0 up to some maximum output.

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Size matters to mat2

Size matters to MAT

  • However, all three sizes will have maximum outputs that are different: the larger the factory, the larger the maximum output.

  • There are also overlaps. For example, 9 machines per week could be produced with all factory sizes.

  • However, the mid-sized factory can produce 9 machines per week with the lowest cost for not only that size but for all sizes.

  • Thus, we construct a LR curve, using the better parts of the three SR curves, as in the next slide.

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Long run average cost curves1

Long run average cost curves

  • Referring back to the last set of graphs, the long run cost curve for MAT ATM is the combination of the lower connected parts of the three graphs.

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Long run average cost curves2

Long run average cost curves

  • We might imagine a more comprehensive case of more possibilities in the long run, as shown in the graph below.

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Long run average cost curves3

Long run average cost curves

  • In constructing the LR curve, we no longer just connect the better parts of a few SR curves.

  • In this case, we imagine an infinite number of possible factory sizes.

  • Then, we construct the LR continuous curve as the set of points of tangents of the SR curves to that line, as shown in the figure, above.

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Scales of production

Scales of production

  • Again, even the long run cost curve decreases, hits a minimum, then, rises, just like the short run cost curves.

  • The law of diminishing returns is not responsible in this case because diminishing returns is a short run, fixed-input phenomenon.

  • Firms starting out small face decreasing long run average cost curves because of economies of scale.

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Reasons for economies of scale

Reasons for economies of scale

  • First, when the size of the firm increases, there is more chance for division of labor and specialization.

  • In that case, each person can specialize and become proficient in one small tack instead of being jack-of-all-trades.

  • The classic example is Henry Ford’s assembly line for automobile manufacturing, which substantially reduced the cost of automobiles and ushered in a new era or mass production.

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Reasons for economies of scale1

Reasons for economies of scale

  • A second factor is greater efficiency of capital.

  • A machine with a capacity of 1000 units/day might cost $100,000 while a $400,000 machine might have capacity of 8000 units/day, 8 times the output for 4 times the price.

  • A smaller company might find the second machine too large for its needs and cannot take advantage of the lower machine cost per unit of output.

  • In that regard newer companies are sometimes competing with older larger companies that have been able to take advantage of economies of scales.

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Reasons for economies of scale2

Reasons for economies of scale

  • Economies of scale might last up to a certain level of output in the long-term average cost curve.

  • After that, there might be a region of output for which there are constant returns to scale. In that region the long-term average cost curve remains flat and increasing size of plant neither helps or hurts the business.

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Reasons for economies of scale3

Reasons for economies of scale

  • A final region of the average cost long term curve might begin to rise, again, and we say that there are diseconomies of scale.

  • After a certain size, a firm can become bulky to manage. The chain of command and communication becomes stretched out. The firm becomes laden with bureaucracy and red tape, and the result is increasing average cost with increasing output.

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Long run possibilities

Long run Possibilities

  • In the long run there can be economies of scale, constant returns to scale, and even diseconomies of scale as size becomes too bulky and unmanageable.

Cost

Economies of scale

Diseconomies of scale

Constant returns to scale

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Output


Epilogue

Epilogue

  • We have talked about costs in this lecture.

  • The other half of the equation is revenues.

  • You can’t be in business, just taking on costs without making sales.

  • The variable costs come from production and increase with units produced.

  • We make sales, incur costs, and, in the end, we hope that Revenue – costs = Profits > 0.

  • In the next lecture we will discuss these next steps in the process of being in business.

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Exam caliber questions

Exam-caliber Questions

Question 22

  • The table below shows total output and total cost of a CD manufacturing firm. Assume that the lease payment for the company’s machine is $40 per day, which must be paid whether the company makes any CDs or not. This payment is a fixed cost since it does not depend on the number of CDs per day the firm makes. Also assume that the only variable factor is labor.

  • If CDs sell for 35 cents each, calculate how many CDs should the firm produce each day to maximize profit? Show your working

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Exam caliber questions1

Exam-caliber Questions

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Homework

Homework

  • Chapter 6

  • Questions 1-11

  • MC questions 1-19

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Next week

Next week

  • We continue analyzing cost, revenue and supply curves in the case of perfect competition.

  • Textbook chapter 7.

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Econ 1000 mod 3 lecture 5

END

END

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