Economics 101: Principles of Economics

1. Economics 101: Principles of Economics • Lectures on Perfect Competition

2. 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?

3. 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

4. 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

5. 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

6. 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

7. 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?

8. 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

9. 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

10. 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

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

12. 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

13. 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

14. 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

15. 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

16. “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

17. 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.

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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?