9 Producer Theory PDF - Principles Of Microeconomics

Intro Econ cost Time frames SR output SR cost LR cost Scale Principles of Microeconomics Economics 1021A Lecture 9: Output and cost Fall 2024...

Intro Econ cost Time frames SR output SR cost LR cost Scale Principles of Microeconomics Economics 1021A Lecture 9: Output and cost Fall 2024 1/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Output and cost Time to build deeper producer theory underlying supply Distinguish economic and accounting definitions of costs and profits. Explain, derive, and differentiate short- and long-run cost schedules. Discuss broader economic significance of understanding production costs. 2/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Firms First things first... Firm: institution that hires factors of production and organizes them to produce and sell goods and services. Our goal is to predict firm behaviour. Critical assumption: firms maximize profit and minimize costs. Otherwise they would be eliminated or taken over by more profitable entrepreneur. 3/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Profit Profit always equals revenue minus cost. Two types of cost =⇒ two types of profit: 1 Accounting profit: total revenue net of accounting cost. Ignores opportunity cost. 2 Economic profit: total revenue net of total economic cost. Includes opportunity cost. Key difference: accounting profit ignores opportunity cost (constrained to measured costs like wages, materials, etc.) 4/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Firm opportunity costs Opportunity cost of production is the value of the best alternative use of the resources that a firm uses. It is the total economic cost of using resources that are: Bought in the market. Supplied by the firm’s owner. Owned by the firm. 5/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Opp cost of purchased inputs Opportunity cost of production includes cost of using resources bought in the market: Firm could have bought different resources. Includes raw materials, employees’ wages, leased capital, financing costs,... 6/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Opp cost of inputs supplied by owner Opportunity cost of inputs supplied by firm’s owner includes their entrepreneurship and labour: Average return to entrepreneurship is called normal profit and is the opportunity cost of entrepreneurship. Wage in next best alternative job is the opportunity cost of owner’s labour. 7/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Opp cost of inputs owned by firm Opportunity cost of using capital the firm owns includes: Economic depreciation (degrades in quality). Measurable as change in the market value of capital during use. Interest forgone (could have loaned it out). Measurable as funds used to acquire capital. Often called capital’s implicit rental rate. Capital-owning firm implicitly rents the capital from itself. Could sell or rent out capital, so forgone rents on owned capital are an opportunity cost. 8/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Short-run and long-run Important to separate short-run and long-run decisions Key distinction: what (not when) we’re choosing: What’s fixed What’s flexible Persistence of a decision’s consequences Short-run and long-run are not precise measures of time. 9/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Short run Short run: time span when the quantity of one or more resources used in production (i.e. capital stock) is fixed Variable inputs (i.e. labour, raw materials, energy,...) are adjustable in the short run Short-run decisions don’t affect future options, so cannot sell/buy capital or exit/enter market in the short run 10/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Long run Long run: time span when the quantities of all resources (including capital stock/plant size) are adjustable Long-run decisions are not easily reversed, affect future options, and can become sunk costs Sunk cost: a cost incurred in the past that cannot be undone Example: amount paid for a computer with no resale value Sunk costs you have incurred in the past are irrelevant to current decisions 11/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Sunk cost fallacy Sunk cost fallacy: believing that sunk investments justify further expenditures Finish a book that’s still boring half way through, go to a baseball game in the rain because you already paid for the tickets,... Concorde fallacy: British and French governments continued funding the (insane) supersonic passenger jet even after it became apparent there was no longer an economic case for it 12/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Short-run constraint Short-run output decisions compare variable costs (wages, energy prices,...) and benefits (revenue) Focus on a simplified model with two-inputs: labour (adjustable in short-run) and capital (adjustable in long-run) Then, increasing output in short-run requires employing more labour and short-run decisions compare labour’s costs (additional wages) and benefits (additional output and revenue) 13/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Short-run output Three important output concepts: 1 Total product (TP): total output produced in a given period 2 Marginal product (MP) of labour: change in total product from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same 3 Average product (AP) of labour: output per unit of labour employed (total output divided by quantity of labour) 14/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Short-run output As the quantity of labour em- ployed increases: Total product increases Marginal and average product increase initially... but eventually decrease 15/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Total product curve Like the PPF, the total product curve separates attainable and unattainable output levels We can also use total product to determine marginal and average product 16/45 Intro Econ cost Time frames SR output SR cost LR cost Scale From the total product to the marginal product curve Build marginal product curve from changes in total product: First worker’s marginal product is 4 units Second worker’s marginal product is 10 - 4 = 6 units... Bar height = marginal product 17/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Marginal product curve Marginal product curve repre- sents changes in total product between quantities of inputs by arranging bars from last slide side-by-side 18/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Marginal product curve: increasing at first Expect increasing marginal re- turns to labour at low levels At first, the marginal product of next worker exceeds that of last worker Think of this as synergies from teamwork and benefits of specialization kicking in 19/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Marginal product curve: diminishing eventually Expect diminishing marginal re- turns to labour at high levels Eventually, marginal product of next worker less than that of last worker We’re in the short-run, so the amount of capital is fixed and more workers are sharing a fixed amount of tools 20/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Average product curve Average product is total product divided by quantity of labour Important relationship between average and marginal product: MP > AP, AP is growing MP < AP, AP is falling MP = AP, average product at maximum 21/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Short-run cost Now that we have a model of short-run output, we can build important notions of short-run costs of production: 1 Total cost (TC): economic cost of all inputs used to produce a given amount of output 2 Marginal cost (MC): increase in total cost from a one-unit increase in output 3 Average cost (AC): cost per unit output (total cost divided by total product) 22/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Short-run total cost: breakdown Total cost is the sum of: Total fixed cost (TFC): cost fixed inputs and does not change with output Total variable cost (TVC): cost of variable inputs and increases with output Total cost = Total variable cost + Total fixed cost 23/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Cost curves reflect output curves Total product steeper at low output and flatter at high output because of labour’s diminishing marginal product And variable cost is the wage times the quantity of labour So variable cost will grow as labour requirements grow 24/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Cost curves reflect output curves Total product steeper at low output and flatter at high output because of labour’s diminishing marginal product And variable cost is the wage times the quantity of labour So variable cost will grow as labour requirements grow 24/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Short-run cost curves Cost curves plot costs against output quantities: To get cost on y-axis, flip last slide’s TVC graph Then, re-insert total fixed cost Add up curves to find a convex total cost curve Diminishing marginal product of labour and constant wage mean total cost curve gets steeper as output grows 25/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Marginal cost Marginal cost (MC): increase in total cost that results from a one-unit increase in total product Incremental cost of increasing output quantity Over the output range with increasing marginal product, marginal cost falls as output increases Over the output range with diminishing marginal product, marginal cost rises as output increases 26/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Average cost Average cost measures costs per-unit of output produced and can be derived from total cost measures: Average fixed cost (AFC): total fixed cost per unit of output Average variable cost (AVC): total variable cost per unit of output Average total cost (ATC): total cost per unit of output TFC TVC Bringing everything together: ATC = AFC + AVC = Q + Q 27/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Average cost curve shapes Average cost curve’s shapes will be important for studying profit and competition: As output increases, average fixed cost (AFC = TFC/Q) decreases But average variable cost (AVC = TVC/Q) falls to a minimum and then increases 28/45 Intro Econ cost Time frames SR output SR cost LR cost Scale U-shaped average variable cost AVC curve is U-shaped because marginal product declines Remember that increasing short-run output means hiring labour: Initially, marginal worker more productive than average And MC of output is lower than AVC Small TVC increase is offset by output increase and AVC falls Eventually, marginal worker less productive than average And MC of output is greater than AVC Large TVC increase offsets output increase and AVC grows AVC reaches minimum when MC equals AVC 29/45 Intro Econ cost Time frames SR output SR cost LR cost Scale U-shaped average total cost The ATC curve is U-shaped for two reasons: 1 Diminishing marginal product and U-shaped AVC 2 Spread fixed costs across larger output so AFC falls as output grows When output is big, fixed costs per unit are small so reason 2 eventually becomes less important and ATC starts increasing 30/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Cost curve shifts Movement of cost curves is just as important for movement along cost curves. Factors that shift cost curves include: Technology, which affects both the product curves and the cost curves Prices of factors of production, which only affect cost curves 31/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Cost curve shifts: input prices Prices of factors of production shift cost curves but not product curves: Price increase of fixed input shifts the total cost (TC) and average total cost (ATC) curves upward but does not shift the marginal cost (MC) curve Price increase of variable input shifts the total cost (TC), average total cost (ATC), and marginal cost (MC) curves upward 32/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Cost curve shifts: technology Technological change affects both the product curves and the cost curves: An increase in productivity shifts all the product curves upward and all the cost curves downward But relationships between product and cost curves remain the same If technological advances make a firm use more capital and less labour, their fixed costs increase and variable costs decrease 33/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Long-run Cost Now we consider long-run costs, which differ from short-run costs because all inputs are variable The production function is especially important for behaviour of long-run cost Firm’s production function is a formula that gives the maximum output they can produce from a bundle of inputs 34/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Production function Example: a sweater manufacturer’s long-run production function The firm can choose from many plant types, each with different amounts of capital Plants can increase output by hiring more workers, but experience diminishing marginal product of labour Short-run decision minimizes cost at a given plant, long-run minimizes cost by choosing a plant size 35/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Diminishing marginal product of capital Production function exhibits diminishing marginal returns to labour (for a given plant) as well as diminishing marginal returns to capital (for a given quantity of labour) The marginal product of capital is the increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labour employed Just like the marginal product of labour, we expect the firm to have a diminishing marginal product of capital This leads to an optimal mix of capital and labour in the long run 36/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Capital decisions and long-run cost: high-level Long-run capital decisions affect short-run cost curves, use this fact to consider capital investment decisions Average cost of producing a given output quantity at a plant depends on capital installed Installing more capital means paying a higher fixed costs in exchange for lower variable costs So big plants are only justified by high output, and this trade-off guides capital decisions 37/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Capital decisions and long-run cost: high-level In the long run, firm chooses level of capital to minimize average total cost: For each level of capital, there is a set of short-run cost curves Long-run capital decision is a cost-minimizing production plan that anticipates output quantity and chooses best short-run cost curves Long-run average total cost (LRATC) traces minimum of short-run average total cost (SRATC) curves across levels of capital 38/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Capital decisions and long-run cost: example Plants have different amounts of capital, and different cost curves ATC1 is the ATC curve for a plant with 1 machine 39/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Capital decisions and long-run cost: example Plants have different amounts of capital, and different cost curves Plant 2 has more capital, meaning higher fixed costs in exchange for lower variable costs at any given quantity 39/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Capital decisions and long-run cost: example Plants have different amounts of capital, and different cost curves ATC3 is the ATC curve for a plant with 3 machines, it has even higher fixed costs and even lower variable costs at any given quantity 39/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Capital decisions and long-run cost: example Plants have different amounts of capital, and different cost curves ATC4 is the ATC curve for a plant with 4 machines, it has the highest fixed cost and the lowest variable cost 39/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Long-run average cost: example In the long-run, choose plant with lowest average cost at required output quantity: How many machines gives the lowest possible cost of making 13 sweaters? 40/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Long-run average cost In the long-run, the firm chooses the capital investment that leads to the lowest average cost at the required output quantity: LRAC curve is lower envelope of all possible short-run ATC curves. 41/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Long-run average cost Long-run average cost curve: relationship between output quantity and the lowest attainable average total cost when both capital and labour are adjustable Planning curve that tells firm the capital investment that minimizes the cost of producing a given output quantity Once the firm has chosen its capital, it is stuck with the corresponding short-run cost curves and can change output by adjusting labour in the short-run 42/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Scale economies Economies and diseconomies of scale affect production decisions, market structure, and supply curves: Economies of scale: falling long-run average cost as output increases Diseconomies of scale: rising long-run average cost as output increases Constant returns to scale: constant long-run average cost as output increases. Economies of scale depend on features of firm’s technology, input markets, and production process. 43/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Scale economies U-shaped average cost curve means economies of scale at low output levels and diseconomies of scale as output grows: 44/45 Intro Econ cost Time frames SR output SR cost LR cost Scale Minimum efficient scale Minimum efficient scale: lowest quantity of output that minimizes long-run average cost A firm with U-shaped LRATC curve experiences economies of scale up to some output level, which we call the efficient scale Expanding output beyond efficient scale moves the firm into the region of diseconomies of scale, where two smaller firms might be able to produce at lower costs 45/45