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 • 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 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 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 • 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

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 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. • 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 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 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 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 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 • 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 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 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 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 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 • Chapter 6: • Production costs (C) Red Hill Capital Corp., Delaware, USA 2008

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

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

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

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 • 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 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 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

Econ 1000: Mod 3, Lecture 5