Introductory Microeconomics (ES10001)

Introductory Microeconomics (ES10001) Topic 3: Production and Costs

I. Introduction • We now begin to look behind the Supply Curve • Recall: Supply curve tells us: • Quantity sellers willing to supply at particular price per unit; • Minimum price per unit sellers willing to sell particular quantity • Assumed to be upward sloping

I. Introduction • We assume sellers are owner-managed firms (i.e. no agency issues) • Firms objective is to maximise profits • Thus, supply decision must reflect profit-maximising considerations • Thus to understand supply decision, we need to understand profit and profit maximisation

Figure 1: Optimal Output q* Costs of Production Revenue ‘Optimal’ Output

II. Profit • Profit = Total Revenue (TR) - Total Costs (TC) • Note the important distinction between Economic Profit and Accounting Profit • Opportunity Cost (OC) - amount lost by not using a particular resource in its next best alternative use. • Accountants ignore OC - only measure monetary costs

II. Profit • Example: self-employed builder earns £10 and incurs £3 costs; his accounting profit is thus £7 • But if he had the alternative of working in MacDonalds for £8, then self-employment ‘costs’ him £1 per period. • Thus, it would irrational for him to continue working as a builder

II. Profit • Formally, we define accounting profit as: • where TCa = totalaccountingcosts. We define economic profit as: • where TC = TCa + OC denotes total costs

II. Profit • Thus: • Thus, economists include OC in their (stricter) definition of profits

II. Profit • Define Normal (Economic) Profit • That is, where accounting profit just covers OC such that the firm is doing just as well as its next best alternative.

II. Profit • Define Super-normal (Economic) Profit: • Supernormal profit thus provides true economic indicator of how well owners are doing by tying their money up in the business

III. The Production Decision • Optimal (i.e. profit-maximising) q (i.e. q*) depends on marginal revenue (MR) and marginal cost (MC) • Define: MR = ΔTR / Δq MR = ΔTC / Δq • Decision to produce additional (i.e. marginal) unit of q (i.e. Δq = 1) depends on how this unit impacts upon firm’s total revenue and total costs

III. The Production Decision • If additional unit of qcontributes more to TR than TC, then the firm increase production by one unit of q • If additional unit of qcontributes less to TR than TC, then the firm decreases production by one unit of q • Optimal (i.e. profit maximising) q (i.e. q*) is where additional unit ofq changesTR and TC by the same amount

III. The Production Decision • Strategy: • MR > MC=>Increase q • MR < MC=>Decrease q • MR = MC=>Optimal q (i.e. q*) • Thus, two key factors: • Costs firm incurs in producing q • Revenue firm earns from producing q • We will look at each of these factors in turn.

III. The Production Decision • Revenue affected by factors external to the firm. essentially, the environment within which it operates • Is it the only seller of a particular good, or is it one of many? Does it face a single rival? • We will explore the environments of perfect competition, monopoly and imperfect competition • But first, we explore costs

IV. Costs • If the firm wishes to maximise profits, then it will also wish to minimise costs. • Two key factors determine costs of production: • Cost of productive inputs • Productive efficiency of firm • i.e. how much firm pays for its inputs; and the efficiency with which it transforms these inputs into outputs.

IV. Costs • Formally, we envisage the firm as a production function: q = f(K, L) • Firm employs inputs of, e.g., capital (K) and labour (L) to produce output (q) • Assume cost per unit of capital is r and cost per unit of labour is w

Figure 2: The Firm as a Production Function smoke r K q = f(K, L) L w Inputs Output

IV. Costs • Assume for simplicity that the unit cost of inputs are exogenous to the firm • Thus, it can employ as many units of K and L it wishes at a constant price per unit • To be sure, if w = £5, then one unit of L would cost £5 and 6 units of L would cost £30 • Consider, then, productive efficiency

V. Productive Efficiency • We describe efficiency of the firm’s productive relationship in two ways depending on the time scale involved: • Long Run: Period of time over which firm can change all of its factor inputs • Short Run: Period of time over which at least one of its factor is fixed. • We describe productive efficiency in: • Long Run: ‘Returns to Scale’ • Short Run: ‘Returns to a Factor’

VI. Returns to Scale • Describes the effect on q when all inputs are changed proportionately • e.g. double (K, L); triple (K, L); increase (K, L), by factor of 1.7888452 • Does not matter how much we increase capital and labour as long as we increase them in the same proportion

VI. Returns to Scale • Increasing Returns to Scale: Equi-proportionate increase in all inputs leads to a more than equi-proportionate increase in q • Decreasing Returns to Scale: Equi-proportionate increase in all inputs leads to a less than equi-proportionate increase in q • Constant Returns to Scale: Equi-proportionate increase in all inputs leads to same equi-proportionate increase in q

VI. Returns to Scale • What causes changes in returns to scale? • Economies of Scale: Indivisibilities; specialisation; large Scale / better machinery • Diseconomies of Scale: Managerial diseconomies of Scale; geographical diseconomies • Balance of two forces is an empirical phenomenon (see Begg et al, pp. 111-113)

VI. Returns to Scale • How do returns to scale relate to firm’s long run costs? • Efficiency with which firm can transform inputs into output in the long run will affect the cost of producing output in the long run • And this, will affect the shape of the firms long run total cost curve

Figure 3: LTC & Constant Returns to Scale c LTC 15 10 5 q 0 10 20 30

Figure 4: LTC & Decreasing Returns to Scale c LTC 25 12 5 q 0 10 20 30

Figure 5: LTC & Increasing Returns to Scale c LTC 10 8 5 q 0 10 20 30

VI. Returns to Scale • LTC tells firm much profit is being made given TR; but firm wants to know how much to produce for maximum profit. • For this it needs to know MR and MC • So can LTC tell us anything about LMC? • Yes!

VI. Returns to Scale • Slope of line drawn tangent to LTC curve at particular level of q gives LMC of producing that level of q • i.e.

Figure 6a: LTC & LMC c LTC x q 0 q0q1 Tan x = LTC / q

Figure 6b: LTC & LMC c LTC x q 0 q0q1 Tan x = LTC / q

Figure 6c: LTC & LMC c LTC x q 0 q0q1 Tan x = LTC / q

Figure 6d: LTC & LMC c LTC x q 0 q0 Tan x = LMC(q0)

Figure 6e: IRS Implies Decreasing LMC c LTC q 0 q0 q1

Figure 7: IRS Implies Decreasing LMC c LMC q 0 q0 q1

VI. Returns to Scale • Similarly, slope of line drawn from origin to point on LTC curve at particular level of q gives LAC of producing that level of q • i.e.

Figure 8: LTC & LAC c LTC x q 0 q0 Tan x = LAC(q0)

Figure 9: IRS Implies Decreasing LAC c LTC x z q 0 Tan x = LAC(q0)

Figure 10: IRS Implies Decreasing LAC c LAC q 0 q0 q1

VI. Returns to Scale • Generally, we will assume that firms first enjoy increasing returns to scale (IRS) and then decreasing returns to scale (DRS) • Thus, there is an implied ‘efficient’ size of a firm • i.e. when it has exhausted all its IRS • qmes - ‘minimum efficient scale’

Figure 11: IRS and then DRS c LTC q 0 qmes

VI. Returns to Scale • Note the relationship between LMC and LAC: q < qmes LMC < LAC q = qmes LMC = LAC q > qmes LMC > LAC

Figure 12a: IRS and then DRS c LTC LMC < LAC q 0

Figure 12b: IRS and then DRS c LTC LAC =LMC LMC < LAC q 0

Figure 12c: IRS and then DRS c LTC LMC > LAC LAC =LMC LMC < LAC q 0

Figure 12d: IRS and then DRS c LTC LMC > LAC LAC =LMC LAC > LMC q 0 qmes

VI. Returns to Scale • Thus: LAC is falling if: LMC < LAC LAC is flat if: LMC = LAC LAC is rising if: LMC > LAC

Figure 13: IRS Implies Decreasing LAC c LTC 0 q LMC LAC q 0 qmes

VII. Returns to a Factor • Returns to a factor describe productive efficiency in the short run when at least one factor is fixed • Usually assumed to be capital • Short-run production function:

VII. Returns to a Factor • Increasing Returns to a Factor: Increase in variable factor leads to a more than proportionate increase in q • Decreasing Returns to a Factor: Increase in variable factor leads to a less than proportionate increase in q • Constant Returns to a Factor: Increase in variable factor leads to same proportionate increase in q

Figure 14: Returns to a Factor q IRF CRF DRF L 0 Short-Run Production Function:

Introductory Microeconomics (ES10001)