Economics 308

1. Economics 308 Chapter 5 and 6 Production and Cost Market Structure

2. Administrative Details The Aplia.com assignment due on April 17th has been moved to April 10th. The Second Exam has been scheduled for Tuesday April 17th.

3. Plan of Action: Production and Supply

4. Efficient production in the multiple input case. If a firm is going to produce a certain quantity of a good, what is the best, i.e. most efficient method of production. Consider the two input case, where two inputs, capital and labor are used to produce a given quantity of a good. Will use three theoretical constructs� production function, iso-cost curve and iso-output curve.

5. Production Functions A production function specifies maximum output from given inputs:

6. Returns to Scale Defined: The relation between output and a proportional variation of all inputs together. If the firm doubled all inputs would output double, less than double or more than double. Consider the following production function and ask the question: what would happen to output if inputs of K and L doubled? Increasing returns to scale (doubling inputs more than doubles output): Q=KL Q=1*1=1 Q=2*2=4 Decreasing returns to scale (doubling inputs less than doubles output): : Q=K1/3L1/3 Constant returns to scale (doubling inputs exactly doubles output): : Q=K1/2L1/2

7. Returns to a Factor Returns to a Factor refer to the relation between output and variation in only one input while the amount of other inputs is kept constant. Can measure Returns to a Factor in different ways. Total product Given the amount of capital the firm has, how much output will the firm produce with different amounts of labor. Average product Q/L Marginal product ?Q/?L

8. Iso Cost Curves An isocost curve shows combinations of two inputs (labor and capital) that can be purchased for a given amount. Similar to Budget Line.

9. Isocost Curve: $10,000 budget, Price of Labor =$50, Price of Capital=$25

10. Position of the Isocost curve represents Total Cost: Consider an increase in expenditures on inputs to $15,000. How will this shift the iso-cost curve?

11. Slope of the iso-cost curve represents the Relative Price of Inputs: Consider an increase in the price of labor to $100. How will this shift the iso-cost curve?

12. Iso output Curves An iso-output curve shows combinations of two inputs (labor and capital) that produce the same amount of the good. Similar to an Indifference Curve.

13. Movement along the iso-output curve represents a change in the way goods are produced.

15. Position of the iso output curve represents the amount of the good produced: the farther out from the origin, the greater the output produced.

16. Slope of the iso output curve represents the how easily one factor can be substituted for another factor in the production process.

17. Efficient Production. Once the firm has chosen how much to produce, it will produce that amount in the most efficient way. Efficient production can be described two alternative but equivalent ways: The firm is producing efficiently if the firm is producing at a point where the iso-output and iso-cost curve is tangent. The firm is producing efficiently if it is on the highest iso-output curve that has at least one point in common with an iso cost curve. Examine the intuition behind each way of describing efficient production.

18. Efficient Production

19. Efficient Production: Cost Minimization

20. Efficient Production: Output Maximization

21. Efficient Production Revisited. A firm is producing efficiently if it is: Minimizing costs for the amount of the good it is producing. Maximizing output for the amount it is expending on inputs.

22. Using iso-cost and iso-output curves to analyze two changes. Suppose the price of an input changed. How would this affect the production decision of the firm? Suppose there was a change in technology. How would this affect the production decision of the firm?

23. Analyzing a change in the price of inputs.

24. Adjusting to a change in the price of inputs: Cost Minimization

25. Adjusting to a change in the price of inputs: Output Maximization

26. Analyzing a change in technology.

27. Analyzing a different change in technology.

28. Production and Supply-Progress

29. Variable and Fixed Costs Iso-cost and iso-output curves can be used to analyze the difference between fixed and variable costs. The short and long run. The short run is period so short that the amount of some inputs cannot be changed,i.e. some inputs are fixed. The long run is a period long enough that all inputs are changed i.e. all inputs become variable. Consider how a firm adjusts production to vary input in the short and long run. For the lecture examples, capital is the fixed input and labor is the variable input.

30. Changing output in the short and long run.

31. Changing output in the short and long run.

32. Cost Curves and the Output Decision of the Firm To properly make the decision how much to produce (as opposed to the question of how to produce) the firm must measure the unit cost of production in four ways. Average Short Run Total Cost Average Long Run Total Cost Average Variable Cost Marginal Cost Each of these measures of unit cost can be derived using iso-cost/iso-output analysis. A firm can use these measures of unit cost to decide how much to produce in a competitive market.

39. The Firm�s Unit Cost Curves

40. Production and Supply-Progress

41. Output Level The previous discussion has shown how the firm, once it has decided how much to produce, determines how (the combination of capital and labor) it will produce that output� efficient production. Turn now to a discussion of how the firm decides how much to produce. Will assume that the firm is a price taker in a competitive market i.e. it assumes that it can sell as much or as little as it desires at the prevailing market price. The firm is in a perfectly competitive market.

42. Profit Maximization for the Competitive Firm The goal of a competitive firm is to maximize profit. The firm in a competitive market can maximize profits by applying the 3-part output rule of a price taking firm. Shutdown Decision: Should if produce at all? Short Run Output Decision: If the firm is going to produce how much should it produce in the short run? Long Run Entry and Exit Decision: In the long run, should the firm stay in business? Examine each of these three decisions in detail.

43. The Firm�s Shut Down Decision The firm should shutdown in the short run, i.e. produce nothing if the price is below the minimum AVC of production. If the price is below the min. AVC, the firm would lose less by shutting down. If the firm shutdown, it would lose only its� fixed costs. If it produced, it would lose its� fixed costs and a portion of its� variable costs. Therefore, it would lose less in the short run by shutting down. If the price is between the min. AVC and the min. ATC, the firm should produce even though it loses money by doing so. The price it is getting is sufficient to cover its variable costs and a portion of its� fixed costs. Therefore the firm will lose less by producing than it would be shutting down. If the price is above the min. ATC, the the firm can produce at a profit. The price it is getting is sufficient to cover all of its� costs.

44. Example of Shutdown Decision Gas Station: Cost of pumps, building, bullet proof cashiers station, etc--$500,000. Labor cost to keep gas station open-$10/hr. and gasoline has a wholesale cost of $1/ gallon. Gasoline sells for $1.50 per gallon. If the gas station is opened for one day (24 hours), they will sell 500 gallons. Should the shutdown? Compare shutting down vs. opening. Shutdown-Lose $500,000 Open-$750 revenue, $240 labor costs, $500 gasoline costs. Price exceeds the variable cost of producing so the firm loses less by producing�only lose $499,990. They are still producing at a loss, but lose less by producing than by shutting down. Suppose if the gas station opened for one day, they will sell 400 gallons. Should the station shut down? Shutdown-Lose $500,000 Open- $600 revenue, $240 labor costs, $400 gasoline costs-lose $500,040. The immigrant�s ladder of economic success. The immigrant�s ladder of economic success.

45. The Economic Ladder of the FOB Immigrant

46. The Firm�s Decision to Shut Down

47. Short Run Output Decision Once the firm has made the shutdown decision and decided not to shutdown, the next decision the firm must make is how much to produce. The firm can determine the profit maximizing (or loss minimizing) level of output by setting P=MC. An alternative way of determining the profit maximizing level of output is to use the following rule: If P>MC increase output. If P<MC decrease output. If P=MC leave output unchanged.

48. Profit Maximization for the Competitive Firm

49. Profit Maximization for the Competitive Firm

50. Profit Maximization for the Competitive Firm

51. Profit Maximization for the Competitive Firm

52. Profit Maximization for the Competitive Firm

53. Profit Maximization for the Competitive Firm

54. Profit Maximization for the Competitive Firm

55. An Application of the Short Run Output Rule and the Importance of Marginal Thinking Many �business problems� can be solved by using a specific type of logic�marginal thinking or thinking at the margin. Thinking �at the margin� means asking and answering the following question: Given what has already happened, what will happen if a firm engages in one more unit of an activity. This type of logic can be applied to most �business problems.� Simple cost/benefit analysis is an example of marginal thinking. How late should a store stay open? Should an amusement park build an additional ride? Should carmakers provide additional options on a car-4 doors/2doors/targa top/hatchback.

56. Thinking at the Margin in Action. While the idea of Thinking at the Margin principle can be stated simply, applying it in real life can be quite complex and involved. In some lines of business, hundreds of employees and the MIS of the company are designed around the implementation of the equimarginal principle. Example: The comping system at Las Vegas casinos. What is the goal of the casino? Maximize profits. What is the main source of casino revenue? Player losses. Profits=Player Losses-Costs How does the casino get players to come to their casino and gamble, e.g. lose? Attractions, entertainment, restaurants, etc Giving away free stuff. Rooms, airplane tickets, shows, food, etc. Business problem: who gets the free stuff an how much?

57. Making the Comping Decision: An Example of Marginal Thinking or the Equimarginal Principle in Action.

58. The Rating Slip

59. Computing the Player�s Rating Lexicon of Gambling RFB Comp Run of the House Black player Green player Whale

60. Computing Player Rating (2) Casino will give back in comps roughly 50% of the expected loss. $50 rating-$240 expected loss ?$120 of comps. $100 rating-$480 expected loss?$240 of comps. $200 rating-$980 expected loss? $480 of comps. How much must you bet to get a room comp at a various casinos. A-Hotels--$200+ rating: MGM, Bellagio, Treasure Island, Mirage. B-Hotels--$100+ rating: Luxor, Venetian, Monte Carlo, New York, New York. C-Hotels---$50+ rating: Excalibur, Circus Circus, Stardust.

61. How to get a free weekend in Las Vegas? The job of the Casino Host. How do you establish yourself on a casino VIP list? Comp City by Max Rubin

62. Getting a free weekend in Las Vegas?

63. The Long-Run Decision to Enter or Exit an Industry The long-run is period of time long enough that a firm can control/avoid both its� variable and fixed costs, i.e. they can exit or enter an industry. In the long-run, the firm exits if the revenue it would get from producing is less than its total cost. Exit if P<min ATC. New firms will enter the industry if such an action would be profitable. Enter if P >min ATC

64. The Competitive Firm�s Supply Curve

65. Profit as the Area Between Price and Average Total Cost

66. Profit as the Area Between Price and Average Total Cost

67. Profit as the Area Between Price and Average Total Cost

68. Loss as the Area Between Price and Average Total Cost

69. Loss as the Area Between Price and Average Total Cost

70. Loss as the Area Between Price and Average Total Cost

71. Review: The 3-part output rule of firm in a competitive market. Once the firm knows it�s unit costs (ATC, AVC, and MC) at each level of output and the prevailing market price, a price taking firm can determine the profit maximizing level of output by applying the 3-part output rule. Shutdown if the P < min AVC. Explain. If the firm is going to produce in the short run, produce the Q where P=MC even if it means losing money. Explain. In the long run, exit if P < min ATC. Explain.

72. Production and Supply-Progress

73. Market Supply in a Competitive Market Market supply equals the sum of the quantities. supplied by the individual firms in the market. Market Supply with a Fixed Number of Firms (Short Run Supply Curve). For any given price, each firm supplies a quantity of output so that price equals its marginal cost. The market supply curve reflects the individual firms� marginal cost curves. Market Supply with Entry and Exit (Long Run Supply Curve). Firms will enter or exit the market until profit is driven to zero. In the long-run, price equals the minimum of average total cost. The long-run market supply curve is horizontal at this price (constant cost industry).

74. Initial Condition: Long Run Equilibrium

75. Short-Run Response to an increase in Demand

76. Short-Run Response to an increase in Demand

77. Short-Run Response to an increase in Demand

78. Increase in Demand in the Long Run Over time, the short-run supply curve shifts as profits encourage new firms to enter the market. Price falls as new firms enter the market In the new long-run equilibrium profits return to zero and price returns to minimum average total cost. The market has more firms to satisfy the greater demand.

79. Long-Run Response

80. Long-Run Response

81. Long-Run Response

82. Increase in Demand in the Short and Long Run

83. Shape of the LR Supply Curve The nature of the industry determines the shape of the long run supply curve. Is the min. ATC of potential entrants higher, lower, or the same as existing firms? Slope of the long run supply curve. Upward sloping-increasing cost industry. Downward sloping-decreasing cost industry. Flat-constant cost industry.

84. Market for Fatburgers. What is takes to own a Fatburger. Net Worth of $250,000 with $150,000 in liquid assets. $30,000 franchise fee. $370,000-$730,000 startup costs. 25% of startup costs funded from personal resources. Pay 5% of net sales. Example of business in a box. Invest $500,000 and earn $200,000 in first year profits.

85. Long Run Supply Curve in Fatburger Market.

86. Basics of Oil Exploration

94. Long Run Supply Curve in Fatburger Market.

95. Shape of the LR Supply Curve The shape of the long run supply curve is determined by the min ATC of potential entrants. If potential entrants have higher costs than existing firms, the LR supply curve will be upward sloping (oil industry example). If potential entrants have the same costs as existing firms, the LR supply curve will be flat (business in a box example). A constant cost industry is an industry where potential entrants face the same unit costs as existing firms. Example: Business in a box. An increasing cost industry is an industry where potential entrants face higher unit costs than existing firms. Example: Oil Industry

96. Production and Supply-Progress

100. Example outsourcing. Example outsourcing.

101. Example outsourcing. Example outsourcing.