Supply & Costs of Production

Supply & Costs of Production

Diminishing Marginal Returns As more and more of a variable input is added to a fixed input, the resulting additional output eventually decreases.

If there were not diminishing marginal returns, we could feed the world from a single flower pot. Here’s why...

We have • fixed inputs: the flower pot and the soil • variable inputs: seeds and fertilizer We start with a few seeds and a little fertilizer. We get some food from the plant. Then we double the amount of seeds and fertilizer. We get more food but probably not twice as much as before.

If there were not diminishing marginal returns, we could just keep adding more seeds and fertilizer until eventually we have enough to feed the world.

Accounting Costs Costs as defined by accountants are explicit costs. Explicit costs: the value of resources used in production for which explicit payments are made.

Economic Costs Costs as defined by economists include both explicit and implicit costs. Implicit costs: the value of resources used in production for which noexplicit payments are made.

Examples of Implicit Costs • the salary that the owners would have made if they worked for someone else. • the interest the owners would have made if they had invested their money elsewhere instead of using it to start up the company.

Accounting Profits & Economic Profits Accounting Profits = Total Revenue - Accounting Costs = Total Revenue - Explicit Costs Economic Profits = Total Revenue - Economic Costs = Total Revenue - (Explicit and Implicit Costs)

Zero Accounting Profits & Zero Economic Profits Zero Accounting Profits means that revenues are just covering explicit costs. Zero Economic Profits means that revenues are just covering all explicit and implicit costs.

Normal Accounting Profits Suppose that a typical firm earns $100,000 per year in accounting profits. Then we say that a normal accounting profit is $100,000 per year.

the firm is doing no better and no worse than other firms. In other words, a zero economic profit is equivalent to a normal accounting profit. When a firm has zero economic profits,

Positive and Negative Economic Profits If a firm has positive economic profits, the firm is doing better than other firms. It is making more than a normal accounting profit. If a firm has negative economic profits, the firm is doing worse than other firms. It is making less than a normal accounting profit.

Short Run and Long Run Short run: a time period in which some inputs are fixed. For example, you can’t build a factory overnight. Long run: a time period long enough for all things to change. All inputs are variable in the long run. You can sell off a business and start up a new one if you have enough time.

Short Run Equilibrium and Long Run Equilibrium Recall equilibrium means no tendency to change. Things are in balance. Previously discussed equilibrium condition: quantity demanded = quantity supplied. This condition is sufficient for short run equilibrium. For long run equilibrium, we need more. Note: In the following discussion, we assume that barriers to entering a industry are minimal.

Positive Profits Suppose firms in industry A have positive economic profits. That means that those firms are making more than the normal accounting profit. They are doing better than other industries.

Then people will want to leave the other industries and enter industry A. In the short run, firms have leases and other commitments that prevent them from leaving an industry. In the long run, however, firms can be closed down and new ones started.

When people start to enter the more profitable industry A, prices in A will fall, and profits will fall as well. People will continue to enter A until economic profits fall to zero. Then there will no longer be an incentive for people to move.

Positive Economic Profit normal accounting profit (zero economic profit) more than normal accounting profit (positive economic profit)

Negative Profits: Suppose firms in industry B have negative economic profits (or losses). That means that those firms are making less than the normal accounting profit. They are doing worse than other industries.

Then people will want to leave industry B and enter other industries. In the long run, when people can start to leave industry B, prices in B will rise, and profits will rise as well. People will continue to leave B until economic profits rise to zero. Then there will no longer be an incentive for people to move.

Negative Economic Profit less than normal accounting profit (negative economic profit) normal accounting profit (zero economic profit)

Zero Profits: Suppose firms in all industries have zero economic profits. That means that everyone is making the normal accounting profit. No one is doing any better or worse than anyone else. There is no incentive for anyone to change industries.

Zero Economic Profit normal accounting profit (zero economic profit) normal accounting profit (zero economic profit)

Long Run Equilibrium Conditions: (1) Quantity Demanded = Quantity Supplied (no tendency for price to change) (2) Zero Economic Profits (no tendency for firms to start up or close down)

The Long Run ATC Curve(or the planning curve) shows the least per unit cost at which any output can be produced after the firm has had time to make all appropriate adjustments in its plant size.

Cost SRATC1 At a relatively low output level, in the short run, the firm might have SRATC1 curve as its short run average cost curve. Quantity of output

Cost SRATC2 At a slightly higher output level, in the short run, the firm might have SRATC2 curve as its short run average cost curve. Quantity of output

Cost SRATC3 At a still higher output level, in the short run, the firm might have SRATC3 curve as its short run average cost curve. Quantity of output

Cost LRATC SRATC1 SRATC5 SRATC2 SRATC4 SRATC3 In the long run, the firm can pick any appropriate plant size. At each output level, the firm picks the plant that has the SRATC curve with the lowest value. So, the LRATC curve is made up of segments of the SRATC curves. Quantity of output

In many industries, the number of possible plant sizes is virtually unlimited. Then the long-run ATC curve is made up of points of tangency of the theoretically unlimited number of short-run ATC curves. Then the long run ATC curve is smooth.

Cost LRATC SRATC1 SRATC5 SRATC2 SRATC4 SRATC3 Quantity of output

Why is the downward-sloping section of the Long Run ATC curve downward-sloping? Economies of Scale

Economies of Scale: As plant size increases, there are factors which lead to lower average costs of production. • Labor Specialization: Jobs can be subdivided and workers performing very specialized tasks can become very efficient at their jobs. • Managerial Specialization: Management can also specialize in a larger firm (in areas such as marketing, personnel, or finance). • Equipment that is technologically efficient but only effectively utilized with a large volume of production can be used.

Why is the upward-sloping section of the Long Run ATC curve upward-sloping? Diseconomies of Scale

Diseconomies of Scale: As plant size increases, there are factors which lead to higher average costs of production. • Expansion of the management hierarchy leads to problems of communication, coordination, and bureaucratic red tape, and the possibility that decisions will fail to mesh. (“The left hand doesn’t seem to know what the right hand is doing.”) The result is reduced efficiency. 2. In large facilities, workers may feel alienated and may shirk (not work as much as they should). Then additional supervision may be required and that adds to costs.

Constant Returns to Scale when long-run ATC is constant

Minimum Efficient Scale (MES) the smallest level of output at which a firm can minimize long-run average costs.

Some Industry Possibilities

When there is an extended range of constant returns to scale, we may find the industry populated by firms of many different sizes. Cost LRATC Minimum efficient scale MES Quantity of output

Cost When economies of scale continue up to a very high level of output, average cost may be minimized by having a single firm produce all of the output. This is called natural monopoly. LRATC Quantity of output

Cost When economies of scale are few and diseconomies are quickly encountered, MES occurs at a small level of output. We would then see a large number of small firms. LRATC Minimum efficient scale MES Quantity of output

Comment Industry structure does not depend on cost conditions alone. Other factors, such as government policies, geographic size of a market, and managerial ability may influence the structure of an industry.

Supply & Costs of Production