Economics 101: Principles of Economics

Economics 101: Principles of Economics • Any questions? • Read Ch. 13 and 14 • PS #4 on website. Due this Friday. Quiz Friday on Ch. 13 only. 4. Learning Excel … Extra session tomorrow in Chambers 337 computer lab

Diminishing Marginal Returns • Diminishing Marginal Returns is an empirical observation about how output responds to more inputs. • It means that as the amount of some input is increased (in equal increments), the changes in output will become smaller after some point. • Key points: 1. It says the MPL begins to decrease after some point, not that it becomes negative. Malthus’ prediction: “With fixed land and diminishing MPL, food supplies will become insufficient”. What did he miss? 2. Ceteris paribus. i.e., other inputs are held constant: K, energy, raw materials, & technology. If you find a better way to produce, that shifts your entire TP curve!

In the long-run, all inputs are variable. The long-run and short-run will be different time spans for different industries and firms. e.g., Khakis vs. Cadillacs Long-Run Production K (units of capital) • Isoquant depicts the possible combinations of K and L which produce the same level of output. f(K,L) = Q0(Q0 is efficient or max level) A Q3 = 500 Q2 = 200 B Q1 = 100 Properties of Isoquants: (1) isoquants are downward-sloping MPL > 0 and MPK > 0 L (units of labor) (4) isoquants are convex to the origin The absolute value of the slope gets smaller from left to right. (2) isoquants do not intersect (3) higher isoquants are associated with higher levels of Q (MPL > 0, MPK > 0)

Slope of an Isoquant • Slope measures the amount by which a firm can reduce K and use 1 more unit of L, maintaining the same Q • Gain in output from Y to X = L * MPL • Loss in output from Y to X = K * MPK • Same isoquant  L * MPL + K * MPK =0 • A little algebra yields the slope: K/ L= - MPL/ MPK • We call this the Marginal Rate of Technical Substitution, the rate at which L can be substituted for K, holding Q constant • Slope is flat when lots of L, little K (easier for K to replace L), but steeper when little L & lots of K (harder to replace worker with machines) K Y X Q = 500 L

What relationship exists between inputs and outputs in the Long-Run? All Inputs are:OutputProduction exhibits Doubled Doubles Constant Returns to Scale Doubled < doubles Decreasing Returns to Scale Doubled > doubles Increasing Returns to Scale However, different factors lead to different outcomes. Increasing Returns to Scale Decreasing Returns to Scale (“the Dilbert effect” – inefficiency of large operations) Constant Returns to Scale Graphical representation of IRS, CRS, & DRS Returns to Scale

Short-Run Costs of Production • A firm’s production costs equal explicit + implicit costs (i.e., the opportunity cost of their resources -- their value in their next best use) • Economic costAccounting cost Labor explicit cost (w) current expenses Capital implicit cost (r) historical price & depreciation • Measures of Short-Run Costs: • Total Fixed Costs (TFC) are costs that don’t depend on level of output • Costs they can’t adjust in short-run (plant and equipment) • Even if they shut-down, they have to pay their Fixed costs • Total Variable Costs(TVC) are costs that do depend on level of output • These can be adjusted in short-run (workers, electricity, raw materials) • More output leads to greater TVC • Total Cost = TFC + TVC at each output level • Because TVC increases with Q, so does TC • Marginal Cost = TC/Q • How much will cost increase if we make one more unit of output? • How much will a firm save if it makes one fewer unit of output?

Measures of Average Cost • Average Fixed Cost (AFC) = TFC/Q • As output increases, AFC decreases. • Average Variable Cost (AVC) = TVC/Q • Average Total Cost (ATC) = TC/Q • ATC = AFC + AVC

Short-Run Cost Curves • We typically reverse the axes, so TC curve has the shape shown. • TFC is horizontal line. • TVC is same distance below TC at all output levels. TC $ TVC 49 40 18 • MC curve is derived from TC curve and is U-shaped due to diminishing marginal returns. • MC = TVC/Q = L*w/Q = w/MPL • Under diminishing marginal returns, each extra worker adds less to Q  each extra unit of Q requires more workers  each extra unit of Q will cost more TFC 4 $ Q MC 4 Q

Short-Run Cost Curves • There are 3 average cost curves • AVC = TVC/Q = wL/Q = w/APL • Recall that APL rises to a maximum and then falls  AVC will fall then rise. • AVC is slope of ray from origin to a point on the TVC curve TC $ TVC 49 40 18 TFC • AFC = TFC/Q and declines over the entire range of Q • Fixed costs are spread over more Q Q 4 ATC $ MC • ATC = AVC + AFC • Its minimum is to right of AVC’s because when AVC is lowest, AFC still falling, but soon the rising AVC overtakes falling AFC • Vertical distance between ATC and AVC is AFC, which becomes smaller & smaller as Q increases AVC AFC 4 Q

Marginal-Average Relationships TC $ TVC 49 40 18 TFC Q • If Marginal < Average, Avg is falling • If Marginal >Average, Avg is rising •  MC = AC at AC’s minimum 4 ATC $ MC AVC 4 Q

Market Structures • Continuum of market structures CompetitionMonopolistic CompetitionOligopolyMonopoly many firms/buyers many smaller firms small # of bigger firms 1 supplier free entry/exit free entry/exit difficult to enter barriers to entry product homogeneity differentiated products same or different Q one product perfect information perfect info imperfect info imperfect info • Examples: Farmer’s market fast food, clothes, steel , cars, cell phones, local cable cereals, aspirin, colas ABC/NBC/CBS/Fox local utility Microsoft?

Demand Curve of a Competitive Firm • -maximization & perfect competition • Price of the product is determined by market S & D • Since output is tiny % of market output, no effect on P*mkt • Competitive firm’s D-curve is horizontal  price taker • x,Px = ? • AR = TR/Q = P*Q/Q = P • MR = TR/ Q = (P*Q)/ Q = P • When AR is constant, MR = AR • The price can change, not due to one firm’s actions, but due to changes in Income, Technology, tastes

Short-run Profit Maximization • Total Revenue (TR) curve is new • Profit = TR - TC • Implicit (like owner’s time) & explicit costs are included •  < 0 even if shut down (Q = 0) • max occurs where MR = MC $ TR TC TFC  • Now use per-unit cost curves • ATC = AVC + AFC • ATCmin > AVCmin • Vertical distance becomes smaller • Competitive firm’s D-curve is horiz. • max occurs where MR = MC • Profit = (AR - AC)*(Q) [green box] • (avg profit per unit)*(# units sold) • max rule does not mean the firm intentionallysets P = MC; price-taker adjust Q ‘til MR = MC Output Q* MC $/unit ATC P P=MR=AR AVC Q* Q

It might be in the best interests of the firm to incur a loss If P < ATC , but P > AVC Can either shut down or operate Ceasing production may be only temporary until D picks up again Loss if Q = Q2* is yellow rectangle Loss if Q = 0 is yellow + green (note that we’re only using the Q2* level to compare at same output) Operating at a Loss in the Short-run MC ATC $/unit P1 AVC P2=MR=AR P2 Q2* Q1* Output MC ATC $/unit • Loss if Q = Q3* is yellow area Loss if Q = 0 is purple area • Shutdown point is the minimum of the AVC curve since for any price below that it will be more profitable (less unprofitable) to stop producing AVC P3=MR=AR P3 Q3* Output

Perfectly Competitive Industries • Short-run vs. Long-run effects of increases/decreases in Demand for • Increasing-cost industry • Decreasing-cost industry • Constant-cost industry

Long-Run Costs of Production Capital (K) TC3/r TC2/r slope = -w/r TC1/r TC1/w TC3/w Labor TC2/w • All inputs are variable • Firm’s costs can be represented by an Iso-Cost line, which identifies all the combinations of (L,K) that can be purchased for a given total cost. • TC = wL + rK • Rewrite to get: K = (-w/r)L + (TC/r) • Y-intercept is TC/r • X-intercept is TC/w • Slope indicates the relative prices of the inputs (slope = -2 says hiring 1 more L, means must buy 2 less K) • Analogy with consumer’s budget line • Exception? • Consumers are stuck with feasible set • Firms can increase TC by hiring more inputs and paying for them by selling more output • Assumptions • Homogeneous labor and capital • Perfectly competitive input markets

Least Cost/Max Output • At the tangency point, slope of the isoquant = slope of the isocost line • MPL/ MPK = w/r • Two ways to interpret: 1. “Least-cost way to produce a given Q” If firm decides to produce Q2, the cost-minimizing way is TC2. 2. “Maximum output possible for a given TC” If firm decides to spend TC1, Q1 is the most they can produce. Capital (K) TC3/r TC2/r slope = -w/r TC1/r Q3=9 A Q2=6 Q1=3 TC1/w TC3/w Labor TC2/w

Output Maximization • Let’s rearrange the equation MPL/ MPK = w/r as follows: MPL= MPK w r • This says that the firm should use K & L in such a way that the additional output per dollar spent on L = additional output per dollar spent on K • Firm decides to spend TC2. What’s the most Q they can make? • At point A: MPL= 100 widgets, w = $20 MPK= 25 widgets, r = $25 • MPL/w = 5 widgets/dollar MPK/r = 1 widget/dollar Capital (K) TC2/r A M Q2 Q1 TC2/w Labor • Firm can increase Q and keep the same total cost: A  M • Spend $1 less on K  lose 1 widget Spend $1 more on L  gain 5 widgets

Cost Minimization • Interpretation #2, rearrange another way: w = r MPL MPK • This says that the last widget made using L should cost the same as the last widget made using K. • Firm decides to make Q1 widgets. What’s the least-cost way to do it? • MPL= 10 widgets, w = $20 MPK= 8 widgets, r = $10 • w/MPL = $2/ widget r/MPK = $1.25/ widget • Firm can decrease TC and still produce Q1 widgets: B  N Capital (K) TC2/r TC1/r N B Q1 TC1/w TC2/w Labor • Produce 1 less widget using L  save $2 Produce 1 more widget using K  costs only $1.25 more

“Why the Necks are Thicker in New Haven” • Yale vs. Harvard in college hockey • Harvard recruits small, scrawny, wimps who can skate fast • Yale opts for bigger, huskier, smarter players  who skate a bit more slowly (so what, they got skills) • Rink characteristics are important. Harvard’s pond is larger & the arena colder (for “faster” ice). • Assume there are two inputs to winning: speed & brawn Optimization requires that MPspeed/ Pspeed = MPbrawn/Pbrawn • Playing at Ingall’s rink in New Haven, MPspeed  and MPbrawn

Hire the Most Productive Worker? • Why is the answer sometimes “No”? • Let’s suppose a firm wants to hire another worker. It can hire a higher-skilled or low-skilled worker. • MPhigh skilled = 2 MPlow skilled • But productivity is not the only consideration • Phigh skilled = 3Plow skilled • Optimization requires that MPhigh / Phigh = MPlow/Plow • However, MPhigh / Phigh < MPlow/Plow • Therefore, the firm should hire the lower-skilled worker because he or she has higher output per dollar.

Economics of Raising & Razing Buildings • Sometimes it’s the Price, rather than MP, that changes from one location to another • Parking garage construction uses two inputs Concrete & Land • Initially equating MPC/ PC = MPLand/Plandin suburban America • If producing parking in downtown urban areas, PLand higher, ceteris paribus  MPC/ PC > MPLand/Pland • Builder shifts toward Concrete and we see high-rise parking structures in cities • Building demolition: dynamite vs. axes MPDynamite/ PDynamite ? MPLabor/PLabor • Which method in Hong Kong vs. USA? Plabor much lower in Hong Kong  Hong Kong demolition firms substitute toward L

Firm’s Short-run Supply Curve • A perfectly competitive firm’s SR supply curve is the same as its MC curve (above min AVC!) • It shows how much they will supply at any given price • Lower the price  MR < MC • Only above the shutdown point • At P1, produce Q1 (  > 0 ) At P2, produce Q2 (  > 0 ) At P3, produce Q3 (  > 0 ) At P4, produce Q4 (  < 0, but better to still operate ) At P5, produce Q5 = 0 (  < 0, but better to shut down) $/unit MC SS P1 P2 ATC AVC P3 P4 P5 Q5 Q4 Q3 Q2 Q1 Output

Changes in the Firm’s Supply • What effects SR supply? 1. Changes in price of the product • P2 to P3, produce less 2. Changes in input prices (cost of making the product) • if the price of labor or capital falls, then MC falls • at Q4, MC was $10 per unit (=MR) • After wage, at Q4, MC now 6. • MR > MC  increase output and expand along new MC’ curve until MR = MC again at Q3 • Capture the profit in the blue triangle $/unit MC MC’ P2 P3 P = MR $10 $6 Q4 Q3 Q2 Output

IndustryShort-run Supply Curve • A perfectly competitive firm’s SR supply curve is the same as its MC curve (above min AVC!) • The industry supply curve is found by horizontally summing quantity supplied at different prices • Below P0, nobody produces At P0, firm C jumps in At P1, firm A jumps in At P2, firm B jumps in • Short-run Industry supply slopes up because the MC curves slope up (& they slope up because?) • Put in Industry Demand equil. • If greater D  higher price causes firms to supply more (moving up along MCA,B,C , & along Industry S) MCB MCA $/unit MCC P3 P2 P1 P0 QA QB QC Output

Long-run vs.Short-run Cost curves $/unit SAC1 SAC7 LAC SAC3 SAC6 Output • Long-run is a planning horizon. Under uncertainty about future demand, the firm chooses which size plant to build, thus determining their short-run costs, until it’s time to build again. • Pick an output level and build the plant size allowing lowest avg cost • LAC is the lowest average cost attainable when all inputs are variable • If only 7 plant sizes available, LAC is a “wave”-line. • If lots and lots of plant sizes possible, LAC is the smooth line

Shape of Long-run AC curves $/unit LAC LAC Output • Many are “U-shaped”, but some are “L-shaped” • L-shape  IRS/economies of scale are quickly exhausted, & CRS exist over a wide range of output • Result: both small & large firms can exist in same industry • LAC of small hospitals is 29% more than for large ones  declining LAC • IndustryLACsm/LAClg hospitals 129% electric power 112 banking 102 airlines 100 trucking 95 • Result: small banks & big banks exist

Market Structure & Long-run AC curves $/unit D industry LAC tech 1 LAC tech 2 30K .05Qtotal .5Qtotal Qtotal Output • Minimum Efficient Scale is the production scale at which ATC is a minimum. • This will vary by industry because production technology differs and technology is in part responsible for declining LAC. • Key question: Where does LAC reach minimum compared to total demand? • If very low (.05Qtotal), then lots of firms in that industry. • If relatively high (.5Qtotal), then very few firms in that industry. • LAC tech 1: coffee shops, breweries LAC tech 2: cars, law firms, cola, planes

Long-run Equilibrium $/unit LMC SMC1 SAC1 P = MR = AR $12  short-run LAC SAC5  long-run LR Supply Curve $7 q1 q2 q5 Output • Short-run -maximizing equilibrium is only temporary • If Price stays at $12, then they start making plans to build larger plant (q5) • If price is expected to fall to $7 in the long-run, most profitable output is q2 • What is  at this output? • We call this zero economic profit, because LAC includes opp. costs of using the inputs in some other endeavor. The firm is getting a “normal” rate of return on its inputs. There is positive accounting profit. • LR Supply curve is FLAT when firms face same costs. Upward-sloping?

Economics 101: Principles of Economics