Economics for CED

1. Economics for CED Noémi GiszpencSpring 2004Lecture 3: Micro: Supply February 24, 2004

2. First, a little expansion of Demand From Lecture 2:The proximate causes of demand Tastes: A Effective Demand Prices: B Economics for CED: Lecture 3, Noémi Giszpenc

3. From Lecture 2: longer causal chains Tastes: A1 A2 A3 Effective Demand Prices: B1 B2 B3 Other: (e.g.laws) C1 C2 C3 Economics for CED: Lecture 3, Noémi Giszpenc

4. A bigger picture Commercial persuaders Wants and desires Effective demands Prices Marketers’ perspective Economics for CED: Lecture 3, Noémi Giszpenc

5. An even bigger picture Nature, Law, Culture, Home & School, other persuaders Commercial persuaders Wants and desires Effective demands Provident or improvident uses of the environment Prices Environmentalists’ perspective Economics for CED: Lecture 3, Noémi Giszpenc

6. Deprivation, anxiety, unhappiness, bad behavior An even bigger picture Nature, Law, Culture, Home & School, other persuaders Unsatisfied desires Commercial persuaders Wants and desires Effective demands=satisfied desires Fit or misfit between wants generated and wants satisfied Prices Sociologists’, social psychologists’ perspective Economics for CED: Lecture 3, Noémi Giszpenc

7. Deprivation, anxiety, unhappiness, bad behavior An even bigger picture Few households own capital Unsatisfied desires Commercial persuaders Wants and desires Bargaining strengths Effective demands Incomes HH rewards =firms’ costs of production Prices Many households contribute labor Left economists’ perspective Economics for CED: Lecture 3, Noémi Giszpenc

8. Nature, Law, Culture, Home & School, other persuaders Deprivation, anxiety, unhappiness, bad behavior Few households own capital Unsatisfied desires Commercial persuaders Fit or misfit between wants generated and wants satisfied Wants and desires Bargaining strengths Effective demands Incomes HH rewards =firms’ costs of production Prices Provident or improvident uses of the environment Many households contribute labor Broad economists’ perspective Economics for CED: Lecture 3, Noémi Giszpenc

9. Can even that picture be broadened? “Sixto Roxas, a Filipino economist, argues that the main problem with conventional economics is that it focuses its analysis on the interests of the individual and the firm rather than those of the family and the community. ‘Neo-classical economics is not just a mathematical framework or analytical guideline to facilitate the understanding of reality: it is a full-fledged ideology and design for remaking the world,’ he says… People are reduced to flesh-and-blood machines that earn wages and salaries and generate profits but whose non-economic existence is not recognized.” [emphasis added] Economics for CED: Lecture 3, Noémi Giszpenc

10. Now, on to supply • Who produces for the market? Firms. • Households and Government are also producers, but not for the market • Relations between producers: • Organized relations (within-firm) • Market relations (beyond firm) • Ex: Restaurant owner organizes menu, shoppers, cooks, and waiters • But goes to market for meat, vegetables supplied by farmers, truckers, and shopkeepers Economics for CED: Lecture 3, Noémi Giszpenc

11. Firms’ purposes (1) • Maximize profit, silly • Remember, profits = revenue - costs • Or π = PxQ - C(Q) • Assume firm’s Q has no effect on P (for now) • So main focus is effect of Q on C Economics for CED: Lecture 3, Noémi Giszpenc

12. Another way to see profit Rev=3Q Cost=5+Q2/4 And π=Rev-Cost At what point is profit maximized? What is the slope of the cost curve? Economics for CED: Lecture 3, Noémi Giszpenc

13. Firms’ costs • (Do not include all costs--i.e., external) • In the “short run” means during the time that you cannot replace existing fixed K • What is the most economical way to use existing fixed K (capital): or, how to produce goods at least cost? • A dual problem: productivity (subject to diminishing marginal returns) and costs Economics for CED: Lecture 3, Noémi Giszpenc

14. First, costs: a few simple definitions • Total costs • All the accrued costs of producing • Average cost • Total cost divided by number of units produced • Marginal cost • Additional cost of producing the last unit Economics for CED: Lecture 3, Noémi Giszpenc

15. Let’s produce some widgets! • Typical good produced in economics classes. • Nobody knows what they are, really. • At left, a drawing of a widget by Leonardo da Vinci. Economics for CED: Lecture 3, Noémi Giszpenc

16. A numerical example Economics for CED: Lecture 3, Noémi Giszpenc

17. The example graphed Economics for CED: Lecture 3, Noémi Giszpenc

18. Marginal cost drives TC and AC • Marginal cost is always positive: total cost is always rising • If marginal cost < average cost, then marginal cost is pulling average cost down • If marginal cost > average cost, then marginal cost is pulling average cost up Economics for CED: Lecture 3, Noémi Giszpenc

19. What happens to profits? • Assume the price for output sold is $6 Economics for CED: Lecture 3, Noémi Giszpenc

20. Information from Costs • All three cost measures show that biggest total profit comes from producing 4 units. • Only marginal cost shows when firm is actually losing, and how much. • Rule: Produce until MC = price • This will give us the supply curve Economics for CED: Lecture 3, Noémi Giszpenc

21. Types of costs • Fixed: can’t be altered at short notice • Factory, equipment, salaried staff • Also called sunk costs, overheads • Predictable economies of scale • average fixed cost per unit output declines w/ Q • Variable: can vary w/ Q of output • Raw materials, fuel, temp workers • May not vary evenly Economics for CED: Lecture 3, Noémi Giszpenc

22. Costs = Fixed + Variable • Total Costs: C(Q) = F + V(Q) • Average Costs: AC = (F + V(Q) ) ÷ Q • Average Fixed costs = F ÷ Q • Average Variable costs = V(Q) ÷ Q • Marginal Costs: MC = d(F+V(Q))/dQ • Fixed costs have no effect on MC Economics for CED: Lecture 3, Noémi Giszpenc

23. Some cost curves TC TC VC AC MC=AC=1 MC=AVC AFC F = 0, V(Q) = Q F = 1, V(Q) = Q Economics for CED: Lecture 3, Noémi Giszpenc

24. Another cost curve: “U-shaped” V(Q)=(Q/3-2)2 Economics for CED: Lecture 3, Noémi Giszpenc

25. Yet another cost curve: very high fixed costs, low MC TC F=100V(Q)=Q/100 MC Economics for CED: Lecture 3, Noémi Giszpenc

26. A counter-intuitive result • If a firm has fixed costs, and if it can keep meeting its variable costs, it should keep producing regardless of whether it is making a loss. • Making a little toward meeting fixed costs is better than making nothing at all • Explains success of early railroads despite lack of profitability--they just kept chugging! Economics for CED: Lecture 3, Noémi Giszpenc

27. Now, productivity: diminishing returns • Holding other factor(s) of production fixed, increasing a factor eventually adds less and less output • Not all producers encounter rising costs and diminishing returns as output increases • Some producers don’t get demand for that level of volume • Some factors of production have fixed capacity • Beyond limit, no production at all • Some factors of production are variable (can vary in proportion to each other) Economics for CED: Lecture 3, Noémi Giszpenc

28. Production Function • In general, Production is the transformation of inputs into outputs. • Inputs are the factors of production -- land, labor, and capital -- plus raw materials and business services. • A production function -- f(L,K, etc.)=q -- describes how combinations of inputs produce output (given a certain technology) • We saw a production function in first class Economics for CED: Lecture 3, Noémi Giszpenc

29. Average and marginal productivity • Productivity is ratio of output to input • Average productivity is total output divided by total input • Marginal productivity is increase in output with addition of last unit of input • With all other inputs held steady (cet. par.) Economics for CED: Lecture 3, Noémi Giszpenc

30. A numerical example: farmer Ted Economics for CED: Lecture 3, Noémi Giszpenc

31. Output Diagram • As the variable input increases, output increases at a decreasing rate. • This is the Law of Diminishing Marginal Productivity Economics for CED: Lecture 3, Noémi Giszpenc

32. Average and marginal productivity • Marginal productivity is decreasing and pulling average productivity down. Economics for CED: Lecture 3, Noémi Giszpenc

33. What happens to profits? • Assume: • cost of variable input fixed (wage rate of farmer=opportunity cost of working elsewhere), and • price of good produced fixed (price of wheat determined by world markets) • Profits ≈ revenue - costs = PxQ - C(Q) =Pxf(L,K) - C(L,K) for given L,K Economics for CED: Lecture 3, Noémi Giszpenc

34. The relationship will look like this • As labor input increases, output does not increase as fast. • Cost of labor input goes up steadily but return, or value of marginal product slows down Economics for CED: Lecture 3, Noémi Giszpenc

35. How to maximize Profit • What does one additional labor unit add to cost? w = wage • What does one additional labor unit add to revenue? p*MP = value of marginal product • Profit is max’ed when p*MP = w Economics for CED: Lecture 3, Noémi Giszpenc

36. Costs and types of firms • Natural monopolies • Ex: power & gas, water & sewerage, canals & RR • Continually increasing returns to scale • Big firms out-compete small firms • Ex: steel, machine-making, petro-chemicals • U-shaped costs • Medium-sized firms • Ex: house-building, furniture-making, textiles Economics for CED: Lecture 3, Noémi Giszpenc

37. Costs and types of firms • Constant unit costs • Can be big or small • Ex: book publishing, brewing, wineries • Diseconomies of scale • Small firms have lower unit costs than big • Ex: tailoring, repair, individual arts, some farming • Each type of industry has different temptations and remedies Economics for CED: Lecture 3, Noémi Giszpenc

38. Firms’ purposes (2) • Working and managing for owners • When firms were mostly sole propietorships • Maximizing profit or return on equity • Directors’ purposes • In 20th C., more separation of ownership and control • Adolf A. Berle and Gardner C. Means, The modern corporation and private property (1932) • What are the directors going to do? Economics for CED: Lecture 3, Noémi Giszpenc

39. Berle and Means: 3 alternatives • Directors maximize owners’ π • but own π motive weakened • Manage for their own benefit • Just enough π paid out to comply with law, attract K • Keeps π motive but leads to corp. plunder • Manage for good of all society • Purely neutral technocracy Economics for CED: Lecture 3, Noémi Giszpenc

40. “The state seeks in some aspects to regulate the corporation, while the corporation, steadily becoming more powerful, makes every effort to avoid such regulation.” Berle and Means (1932) Economics for CED: Lecture 3, Noémi Giszpenc

41. Firms are responsible to… • (Can’t survive without any of the below) • Owners • Creditors • Employees • Customers • Community • Local & National government Economics for CED: Lecture 3, Noémi Giszpenc

42. Firms’ policy choices • Profit: maximize, moderate, or (for tax purposes) minimize? • Short, medium, or long-term profit? • How to divide profit between dividends and reinvestment in growth? • Aim for big revenue, market share, profit, profit/sales, profit/equity? • Stability or growth? Safety or risk? • Working conditions? Neighborliness? • Sketchiness: offshore taxes, unsavory partners, bribery? Economics for CED: Lecture 3, Noémi Giszpenc