Welker's Wikinomics: 1 · •Profit maximization in terms of total revenue and total costs, and in...

AP/IB Economics Unit 2.3.1 Costs of Production

Welker's Wikinomics: http://welkerswikinomics.com/blog 1

Unit 2.3.1 - Introduction to Market Structures and Cost Theory

Intro to Market Structures• Pure competition• Monopolistic competition• Oligopoly• Monopoly

Cost theory• Types of costs: fixed costs, variable costs • Total, average and marginal costs• Accounting costs = opportunity costs = economic costs

Short-run• Law of diminishing returns• Total product, average product, marginal product• Short-run cost curves

Long-run• Economies of scale• Diseconomies of scale• Long-run cost curves

Revenues• Total revenue• Marginal revenue• Average revenue

Profit• Distinction between normal (zero) and supernormal (abnormal) profit• Profit maximization in terms of total revenue and total costs, and in terms of marginal revenue and marginal cost• Profit maximization assumed to be the main goal of firms but other goals exist (sales volume maximization, revenue maximization, environmental concerns)

Unit 2.3 - Theory of the FirmUnit Overview



2.3.2 - Perfect competition• Assumptions of the model• Demand curve facing the industry and the firm in perfect competition• Profit-maximizing level of output and price in the short-run and long-run• The possibility of abnormal profits/losses in the short-run and normal profits in the long-run• Shut-down price, break-even price• Definitions of allocative and productive efficiency• Efficiency in perfect competition

2.3.3 - Monopoly• Assumptions of the model• Sources of monopoly power/barriers to entry• Natural monopoly• Demand curve facing the monopolist• Profit-maximizing level of output• Advantages and disadvantages of monopoly in comparison with perfect competitionEfficiency in monopoly• Price discrimination >>Definition >>Reasons for price discrimination >>Necessary conditions for the practice of price discrimination >>Possible advantages to either the producer or the consumer

2.3.4 - Monopolistic competition• Assumptions of the model• Short-run and long-run equilibrium• Product differentiation• Efficiency in monopolistic competition

2.3.5 - Oligopoly• Assumptions of the model• Colusive and non-collusive oligopoly• Cartels• Kinked demand curve as one model to describe interdependent behavior (IB HL only)• Importance of non-price competition• Theory of contestable markets (IB HL only)

Unit 2.3 - Theory of the FirmUnit Overview



Unit 2.3 - Theory of the FirmIntroduction to the Four Market Structures

Pure (or Perfect)Competition

Monopolistic competition

Oligopoly Monopoly

VERY large number of firms

Each firm is so small that changes in its own output do not affect market price, i.e. firms are price takers

Firms all produce identical products, with no differentiation

Completely free entry and exit from the industry, i.e. NO barriers to entry.

All producers and consumers have perfect knowledge of prices, costs, and quality and availability of products

Only ONE firm. The firm IS the industry!

Significant barriers to entry exist, preventing new firms from entering and competing with the monopolist

the Monopolist can maintain significant profits due to the lack of competition.

Changes in the firm's output cause changes in the price, i.e. the firm is a price-maker!

Fairly large number of firms

Firms are small relative to the industry, meaning changes in one firms output have only a slight impact on market price

Products are slightly differentiated. Firms will advertise to try and further differentiate product. Branding! Advertising!

No barriers to entry, firms can enter or leave easily

A few large firms dominate an industry

A change in one firm's output has significant impact on the market price, firms are price-makers.

Products can be identical (such as oil) or differentiated (such as Macs and Dells)

There are significant barriers to entry

Firms will likely use advertising to try and differentiate their products from competitors'

Most competition Least competition



Pure Competition

Monopolistic competition

Oligopoly Monopoly

Unit 2.3 - Theory of the FirmIntroduction to the Four Market Structures

Examples of different market structures: Based on the characteristics of the different market structures, brainstorm examples of each.

Practice: Different types of Market Structure - Rainbow book Activity 24

SMART Notebook



Costs of ProductionBig Ideas

Big ideas:

What is productivity and how does it change as resources are added to production?

What are the different costs faced by firms in the short-run and the long-run?

What is the relationship between the productivity of its resources and the costs faced by a firm?

Why does understanding productivity and costs matter to firms?

1)

2)

3)

4)

Discussion Question: What is productivity, and why do firms care about it?



Costs of ProductionLaw of Diminishing Returns

Understanding Productivity:

Productivity: The amount of output attributable to a unit of input.

Examples of productivity: "Better training has increased the productivity of workers""The new robot is more productive than older versions""Adding fertilizer has increased the productivity of farmland"

Total product (TP) is the total output of a particular firm

Example of TP: "After hiring more workers the firm's total product increased."

Marginal product of labor (MPL) is the change in total product resulting

from each additional worker.

>>MPL = ∆TP/∆L

Average product of labor (APL) is the output, on average, by

each worker

>>APL = TP/units of L



Example: Paper Chain Factory Instructions:

1) Use inputs (land, labor and capital) to create a product (paper chains)2) Labor is the only variable resource. Land and capital are fixed. 3) Production rounds last one minute4) Record production data in a data table

Law of Diminishing Returns: states that as additional units of a variable resource are added to fixed resources, beyond some point the marginal product of the variable resource will decline.


HUH? Let's illustrate this with an example

LAND (fixed) LABOR (variable) CAPITAL (fixed)



Units of labor TP MP AP

0

1

2

3

4

5

6

7

8


One worker has one minute to make the longest chain possible.

A volunteer is needed to record output data in the table to the right.

As more workers are added, TP, MP and AP will be calculated and recorded.

MPL = ∆TP/∆L

APL = TP/units of L




Total Product

Units of Labor

TP

0 1 2 3 4 5

20

18

16

14

12

10

8

6

4

2

MP/AP

Marginal/Average Product

1 2 3 4 5

10

9

8

7

6

5

4

3

2

1

0

-1

-2

Data:

Units of labor TP MP AP

0

1

2

3

4

5

6

7

8



0 10 20 30 40 50

Units of Labor

0 10 20 30 40 50

TP Total Product

Units of Labor

MP/A

P

Marginal/Average Product

TP

AP

MP

Diminishing returns sets in

MP becomes negative, TP begins to fall


Describe what happens to TP as more and more labor is added to a fixed amount of capital and land

What is the relationship between TP and MP?

What is the relationship between MP and AP?

Why does a producer care about the productivity of its workers and other resources?

Observations:

TP increases at an increasing rate as workers' MP increases, at a decreasing rate as MP falls, and declines as MP becomes negative.

MP is the rate of increase in TP

When MP is greater than AP, AP increases. MP intersects AP at its highest point, and when MP is less than AP, AP decreases

Because firms average and marginal costs in the short-run are inversely related to the productivity of its workers



Conclusions:

• Explanation of increasing returns :

• Explanation of diminishing returns:

• Negative marginal product and implications:

• Implications of diminishing marginal returns to producers:


Practice Diminishing Returns: Rainbow book Activity 25

SMART Notebook



Productivity and Costs: As worker productivity increases, firms get "more for their money", meaning per-unit and marginal cost decrease. When productivity decreases, costs increase.

Discussion: When productivity of workers is rising, firms costs are falling, since they're getting more output for workers while paying them the same wages.

• When marginal product is increasing (increasing returns) marginal cost is falling

• When MP is at its maximum, MC is at its minimum

• When diminishing returns set in, MP begins falling and MC begins rising

• MP intersects average product at its highest point, and MC intersects average total cost at its lowest point

Costs of ProductionProductivity and costs

Product

/cost

s

AP

MP

Costs and Productivity

Units of Labor/units of output

Summary: Increasing marginal returns is reflected in a declining marginal cost, and diminishing marginal returns in a rising marginal cost!

In the graph below, fill in the marginal and average cost curves using the marginal and average product curves to guide you.

AC

MC



Costs of ProductionShort-run Costs of Production

Total fixed costs (TFC): These are the costs a firm faces that do not vary with changes in short-run output. Could include rent on factory space, interest on capital (already acquired).

Total variable costs (TVC): These are the costs a firm faces which change with the level of output in the short-run. Could include payment for raw materials, fuel, power, transportation services, wages for workers, etc...

Total cost: TFC + TVC at each level of output

Total Costs:

What is the short-run? "the fixed-plant period"The short-run is the period of time over which a firm's plant size is fixed. Capital cannot and land cannot be varied, labor is the only variable resource. To increase output in the short-run, a firm can only increase inputs of labor, not the other resources.




Resource costs in the short-run:

Rent - the payment for land: Rent is fixed in the short-run since firms cannot add this resource to production. Rents must be paid regardless of the level of the firm's output.

Interest - the payment for capital: Interest is fixed in the short-run since firms cannot add this resource to production. Interest must be paid on loans regardless of the level of the firm's output.

Wages - the payment for labor: Wages are variable in the short-run, since firms can hire or fire workers to use existing land and capital resources. Wage costs increase when new workers are hired, and decrease when workers are laid off. Normal profit: the minimum level of profit needed just to keep an entrepreneur operating in his current market. If he does not earn normal profit, an entrepreneur will direct his skills towards another market. Normal profit is a cost because if a firm does not earn normal profit, it is not covering its costs and may shut down.

Other short-run variable costs of production: • Transportation costs: Firms pay lower transport costs at lower levels of output.• Raw material costs: vary with the level of output• Manufactured inputs: fewer parts are needed from suppliers when a firm lowers output.



Graphing total costs: TFC: Notice that regardless of the level of output, TFC remains constant. This is because these are costs that do not vary with output.

TVC: Notice that when output is zero, TVC is zero, because you do not need to hire any workers or use any raw materials if you're not producing anything. As output increases, TVC continues to increase

TC: Notice that when output is zero, TC = TFC. But once the factory begins pumping out products, TC rises with TVC. TC is the sum of TFC and TVC, since both fixed and variable costs make up total cost.

Diminishing returns: • Notice that TC and TVC increase at a decreasing rate at first. This is when marginal product is increasing as more labor is employed (firms get "more for their money")

• However, beyond some point, costs begin to increase at an increasing rate. This is where diminishing returns set in and MP is decreasing. The firm is getting less additional output from each worker hired, but must pay the same wages regardless. (The firm gets "less for its money")


TFC

Costs

Q of outputPoint at which diminishing returns sets in

TVC

TC

100

0



Average fixed cost: AFC=TFC/QAFC will decline as output rises, never increases. This is because the fixed cost (which never goes up) is “spread out” as output goes up. This is called “spreading the overhead”

Average variable cost: AVC = TVC/QFor simplicity, we will assume that labor is the only variable input, the labor cost per unit of output is the AVC

Average total cost: ATC = TC/QSometimes called unit cost or per unit cost. ATC also equals AFC + AVC

Average Costs:

Marginal Cost = the additional cost of producing one more unit of output.

MC = ∆TVC/∆Q.




Things to notice:• the vertical distance between ATC and AVC equals the AFC at each level of output.

• MC intersects both AVC and ATC at their minimum. This is because if the last unit produced cost less than the average, then the average must be falling, and vis versa (just like your test scores!)

• MC is at its minimum when MP is at its maximum, because beyond that point diminishing returns sets in and the firm starts getting less for its money!

Cost

s

QPoint at which diminishing returns sets in

AFC

AVCATC

MC

Short-run Costs

Graphing Average and Marginal Costs:AFC: it declines as output increases. This is called "spreading the overhead".

ATC and AVC: At first they are declining as output increases. This is during the stage when MP is increasing, since new labor is making better use of capital and beginning to specialize.

AVC: When AVC is at its minimum, average product is at its maximum, meaning workers are producing the most output per worker. As more workers are added, average product begins to go down, and AVC begins to rise.




QL TP (Q supplied) TFC TVC TC AFC AVC ATC MC

0 0 400

1 10

2 25

3 45

4 70

5 90

6 105

7 115

8 120

Labor is the only variable resource and the wage = $200 / weekRent and interest are fixed costs, and = $400 / week


Describe and explain what happens to each of the following as output increases:1) TFC 2) TC 3) AFC 4) AVC and ATC 5) MC



Cost

s

Q

AFC

AVCATC

MC

Short-run Costs

TFC

Cost

s

QPoint at which diminishing returns sets in

TVC

TC


Discussion Questions: Short-run Costs

State the law of diminishing returns and explain how it determines the shape of the marginal cost curve.

1)

Explain the relationship between the marginal cost curve and the average variable and average total cost curves.

2)

What determines the distance between the ATC and the AVC at a particular level of output.

3)



When MC is below ATC and AVC, what is happening to the average costs curve? Why?

How is the law of diminishing returns reflected in the shape of the MC curve?

How is Average fixed cost implied in your diagram without even having to draw it?

Relationships between MC, ATC and AVC

Costs of ProductionProductivity and costs

Cost

s

Quantity of output

Illustrate the relationship b/w Total Fixed Cost, Total Variable Cost, and Total Cost

Cost

s

Quantity of output

Illustrate the relationship b/w Average Fixed Cost, Average Variable Cost, Averate Total Cost and Marginal Cost



Economies of scale: the range of plant size over which increasing output leads to lower and lower average total cost. As new plants open, ATC declines. WHY? • better specialization, division of labor, bulk buying, lower interest on loans, lower per unit transport costs, larger and more efficient machines, etc...

Also called "Increasing returns to scale"

Long-run is the variable plant period, meaninig that firms can open up new plants, add capital to existing plants, or close plans and remove capital if need be.

Costs of ProductionShort-run vs. Long-run costs

Diseconomies of Scale: When a firm becomes "too big for its own good" it experiences diseconomies of scale. Continuing to add plants and increase output causes ATC to rise. WHY? Mostly due to control and communications problems, trying to coordinate production across a wide geographic may make firm less efficient.

Also called "Decreasing returns to scale"

Minimum Efficient Scale (MES): The minimum level of output a firm must achieve to achieve the lowest average total cost.



Cost

s

QMES

Economiesof scale

Constant returns to scale

Diseconomies of scale

Graphing long-run ATC: The gray curves represent all the SR ATC curve the firm experiences as it opens new plants. As it opens its first 10 plants, ATC declines, while for plants 11-16 ATC remains constant. Beyond 16 plants the firm's ATC begins to rise, indicating it has gotten too big.

ATCLR

Costs of ProductionShort-run vs. Long-run costs

Attachments

APMicroUnit3.jnt

SMART Notebook

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