1 Econ 1000: Mod 3, Lecture 5 C.L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008.

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Econ 1000: Mod 3, Lecture 5

C.L. Mattoli

(C) Red Hill Capital Corp., Delaware, USA 2008

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Before we move on If we change price, we move along a supply or

demand curve. Supply and demand curves are just schedules or

intentions of sellers and buyers of things to sell or buy certain quantities of a good or service, depending on price.

Markets, the coming together of supply and demand, work towards an equilibrium quantity and price at the intersection of supply and demand schedules.


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Before we move on Equilibrium price and quantity will remain until

there is a change in either the whole supply curve or the whole demand curve, a shift or change to a whole new curve.

Moreover, if one changes, either the supply or demand curve, the equilibrium will change by moving along the unchanged curve towards the new equilibrium at the intersection of the new one curve with the old other.

We demonstrate these concepts in the next slide.(C) Red Hill Capital Corp.,

Delaware, USA 2008

4

Before we move on A change in a non-price

factor causes demand to increase: the demand curve shifts into a new curve.

As a result, there is a movement up along the old supply curve to a new equilibrium price and quantity.

Change in non-price

Increase in demand

D1 D2P

Increase in price

Increase in quantity supplied

Quantity


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Elasticity We use percentage change, sometimes, in

economics because it gives a better basis for comparison.

Elasticity is, then, percentage change in quantity with respect to percentage change in another variable, such as price, income, or the price of another related good or service.


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Elasticity E = [ΔQ/Q]/[ΔX/X] = [(Q1 – Q0)/Q0]/](X1 –

X0)/X0] = %ΔQ/%ΔX, or the mid-point definition which uses the mid-points (Q1+Q0)/2 and (X1 +X0)/2 in the denominators of the percentage change calculations.

If something is elastic, that means that the quantity will be very sensitive to changes in the other variable.

If something is inelastic, quantity will not be very responsive to price.


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Elasticity calculations Elasticity equals percent change divided by

percent change. If we have raw numbers for both variables, we

can calculate % changes and then calculate elasticity.

If we know percentage changes, we can calculate elasticity directly as the ratio of the % changes.

If we know elasticity and one of the % changes, we can calculate the other % change.


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Elasticity Logic and Psychology. Quantity demanded or supplied will depend, at

least, on prices. It can also depend on income. Elasticity takes a deeper look at the

responsiveness of quantity change with respect to changes in some variables.

For example, if there are substitutes for something, and the price rises, people will just switch to an alternative. The good will have high elasticity.


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Elasticity Logic and Psychology. If something goes with something else, i.e.,

compliments it, like tires for automobile, a change in price of one will affect quantity demanded for the other. The good will have cross-elasticity.

If something is a large part of a person’s total budget, their spending allowance constraints, the change in price will have a larger affect on quantity than on a good that is a small part of a budget. Salt is more inelastic than automobiles.


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Elasticity Logic and Psychology. When income rises, people will buy better clothing,

better restaurants, better cars. So, rise in income will have positive (E>0) elasticity for nicer things (normal or so-called luxury goods) and negative elasticity (E<0) for lower quality and less expensive things (inferior goods).

While price elasticity of demand will always be a negative number because quantity will decrease as price increases, elasticity of supply will always be a positive number because quantity supplied is an increasing function of price (direct relationship).


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Elasticity Logic and Psychology. Income and cross-elasticities can be

either positive or negative numbers depending on the type of good.

The elasticity concept is also intimately connected with change in revenues versus changes in price, so it is an interesting piece of information for suppliers to have.


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Elasticity Logic and Psychology. When a good or service is elastic, total

revenue will rise with a decrease in price but fall for a price increase.

When a good is inelastic, total revenue will rise and fall with rising and falling prices.

If it is unit elastic, changes in price will have no affect at all on total revenues.


Elasticity and Taxation Governments add excise

taxes on things, like gasoline and cigarettes.

Adding a tax to a product shifts the supply curve up since a cost is added for every quantity, so every quantity comes at a higher price in the new supply schedule as shown:

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Tax cost


Elasticity and Taxation

In the case of perfect inelastic demand, the extra cost is born totally by the buyer because the equilibrium quantity is the same before and after the tax is added but the price paid is higher by exactly the extra cost tax.

See the figure:

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Tax

DS1

S0


Elasticity and Taxation When demand is other than

perfectly elastic (vertical) it will have a downward slope.

Because of the downward slope, the burden will shift from totally on the buyer to a split between buyer and seller.

Thus, of T = Tax, the added cost, the part that is shifted to the buyer is the difference between what he paid before and what he is paying now, which change in price is less than the added cost = T

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BuyerSeller

Change in market price = ΔP

T – ΔP

TotalTax = T


Elasticity and Taxation In the diagram, we also

show what happens when supply is more inelastic (blue lines). Then, the part of the tax shifted to the buyer is less, the more inelastic the supply for the same tax.

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BuyerSeller

Change in market price = ΔP

T – ΔP

TotalTax = T


Elasticity and Taxation

Limiting cases are, thus:

1. Inelastic demand: all tax to consumer.

2. Perfect elastic demand: all cost to seller.

3. Perfect inelastic supply: all cost to seller.

4. Perfect elastic supply: all cost to buyer

17(C) Red Hill Capital Corp.,

Delaware, USA 2008

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This week

Chapter 6: Production costs


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Learning objectives

On successful completion of this module, you should be able to:

Explain the concepts of ‘explicit’ and implicit’ costs

Define the terms ‘economic profit’, ‘accounting profit’ and ‘normal’ profit

Use the law of diminishing returns to explain and illustrate the short-run production function


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Learning objectives

Explain the relationship between short run costs and output in terms of total, average, and marginal cost curves

Explain the relationship between marginal and average cost and between marginal product and marginal cost

Explain the construction and shape of the firm’s long run average cost curve.


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Where we are coming from

We have looked at concepts of supply and demand, and we have examined the underlying psychological factors involved on both sides.

A fundamental driver of economic people is self-interest.

We usually assume that self-interest is enlightened, but the fact that people would pollute the environment to produce goods and services proves otherwise.


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Where we are coming from Demand is driven by wants, tempered by

people’s 1) limited financial resources, 2) a desire to pay less rather than more, and 3) a tendency to be slow to accept change.

Thus, people have unlimited wants but limited personal resources with which to get what they want.

They can trade their time, and make their own clothing, or they get a job and trade their time to earn money to buy things from others.


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Where we are coming from They give up one opportunity, their time and

their money, to make a choice and take another opportunity.

Indeed, most people try to find a comparative advantage for their time, and they get a job. They trade their time for the intermediary of transactions: money.

Some might give up a paying job to start a business. Then, their opportunity cost will be money from another job.


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Where we are coming from Once in business, their might be several

business opportunities that they have to weigh against one another: to make more forks or to grow more corn.

Suppliers and producers have taken initiative to take on risk to fulfill the needs and wants of others. They are motivated by profits.

People are competitive, at least because of self-interest, whether it is to win a basketball game or an on-line auction for a computer.


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Where we are coming from That natural competitive tendency

helps make competitive markets in the economy.

However, just as self-interested profit seeking can lead to undesirable results, such as pollution, it can lead to other undesirable economic behavior, like anti-competitive or collusive behavior, in the marketplace.


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Where we are coming from The demand side is also complicated.

People will take substitutes. People can be stubborn. People are concerned about their incomes and the prices of the things that they buy, along with other personal welfare issues.

We have seen, in our study of elasticity, that the interaction of price and quantity, on the demand side of the equation, can have an affect on total revenues.


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Where we are coming from Total revenues can be sensitive to

changes in price, perhaps decreasing when prices are raised beyond a certain level.

A rise in price will help unit profit margins, but a decrease in revenues will also affect overall margins.

That is a limitation on the situation for suppliers, originating on the demand side.


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Where we are coming from We looked at production on a larger

scale in the PPF. There we found a maximum capacity output line for simultaneous production of a number of goods.

Then, we can figure out, for example, that the opportunity to produce 10,000 more tons of corn will mean giving up the opportunity to make 50,000 forks, so the cost is 5 forks per ton of corn.


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Where we are coming from In looking at the PPF, we discovered that

substitutes are also available to suppliers: they can be attracted to one business or another.

Their decision is based on opportunity costs.

Next, we shall look more closely at the cost side of the production function, in order to examine limitations on profits.


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Where we are coming from In the case of the consumer and demand,

we found the concept of marginal utility. We will find the law of diminishing returns

on the supply side of the market. These are concepts that involve marginal

thinking. We will use further marginal concepts, like

marginal costs, which will lead to another: marginal product.

Our study of the limitations on producers will give us an idea of how much suppliers can supply.


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Mathematically: total revenue & elasticity Total revenue equals price times quantity

demanded: RT = QxP The variation of total revenues with

respect to price is given by: Δ RT /ΔP = P x[ΔQ/ΔP] + QxΔP/ΔP = P x[ΔQ/ΔP] + Q

If we want to find the condition for increasing total revenue that means that the change in revenue should always be a positive number. In algebra, we require: ΔRT /ΔP > 0.


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Mathematically: total revenue So, Δ RT /ΔP = P x[ΔQ/ΔP] + Q >0 Rearranging the symbols in the

equation, we get ΔQ/(ΔP/P) > – Q Or, (ΔQ/Q)/(ΔP/P) = %ΔQ/%ΔP =

ED> – 1 So, if P is increasing, and E is

inelastic (absolute value less than 1) We shall also take a closer look at

revenues, in this module.(C) Red Hill Capital Corp.,

Delaware, USA 2008

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Costs and the supply curve We have discussed shifts in the supply curve. A shift up or to the left is called a decrease in

supply because in the new supply less quantity will be supplied at each price versus the old curve.

Such a shift can, for example, come from some type of cost increase. In that case, any quantity will come at a higher price than before the change in cost, which is the same as less quantity will be supplied at any price.

We show the two ways of looking at up and left shifts in the next slide.


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Costs and the supply curve A decrease in supply is a

shift up or left of the supply curve.

A higher price is charged for each quantity supplied,

or Less quantity is supplied

at each price.

S1S2

P

P

Q


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Costs and the supply curve: prior examples We have discussed various reasons, so

far, that supply curves can shift. New technology introduced into an

industry can substantially reduce costs and shift the supply curve down or right.

Increases in labor costs can shift it up or left.


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Costs and the supply curve: prior examples Another type of cost that can shift it

up or left are taxes, like excise taxes on “sin” products or taxes on pollution.

In this module we shall examine, more closely, the issue of costs versus revenues and profits in shaping the supply curve.


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Costs and Profits


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Profit motive It is a basic tenet of economics that the

motivation for business is profit maximization.

Revenues will depend on demand: quantity demanded times price.

To get to profits we must understand costs. Before we do that, we must understand

how economists define costs and profits versus how those concepts are defined in accounting and finance.


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Explicit and implicit costs Explicit costs are costs paid to non-

owners of the firm for resources. That includes things, like labor costs, electricity, raw materials, rentals of PP&E.

Implicit cost are the opportunity costs associated with using firm resources one way versus another.

Thus, we find opportunity costs entering our economic analysis, again.


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Explicit and implicit costs We first found that opportunity costs

enter consumers’ decisions to purchase: If I buy an expensive lunch, I might not

have enough money to go to the movies. A company decides whether to buy a machine to produce candles or a jet to ferry its executives around the world.

Then, we encountered opportunity costs when we looked at production possibilities.


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Explicit and implicit costs We considered that to produce more

of good A, we had to give up a certain amount of production of good B, and we called the trade-off: opportunity costs.

Now, we extend that thinking to directly apply to our accounting for costs and profits.


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Explicit and implicit costs We can pay money for more laborers or

we can buy an expensive machine to lessen our dependence on labor but might also increase our dependence on energy, like electricity or oil.

Trade labor for machinery and electricity A building, for example, might be used for

warehousing of one product or manufacture of another. There is an opportunity trade-off for its use.


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Explicit and implicit costs Moreover, even the owner of the

business might better use his or her time and money in another business.

We, therefore, must think about the other opportunities for his time and his money.

Then, economics defines the total opportunity cost as the sum of all explicit and implicit costs.


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Profits Given an economic definition of costs, we

also have to revise our concept of profits. Our standard notion of profits is what

economists refer to as accounting profits. Accounting profits = Total revenues –

Total explicit costs In contrast, economists define economic

profits as total revenues less all costs; thus Economic profits = Total revenues –

Total opportunity costs


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Profit example Assume that Craig decides to quit his job at

Starbucks to start his own coffee business. He already has store space on a busy street

in Guangzhou that he could use to house the business and he has some savings that he can use for business startup costs.

He borrows funds to cover initial investment requirements, and he opens the business.

In the next slide, we show a comparison of accounting and economic profits for his first year of business.


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Profits exampleCraig’s Coffee Clutch

Accounting Profit Economic Profit

Revenue $500,000 $500,000Less explicitWages 40,000 40,000Materials 50,000 50,000Interest paid 10,000 10,000Other 10,000 10,000Less implicitSalary forgone Not included 70,000Rent forgone Not included 10,000Interest forgone Not included 5,000Profits $30,000 – $55,000


Profits example

The table shows economic and accounting profits.

While accounting profit is positive, economic profit is negative after accounting for lost opportunities: $70,000 Craig could have earned at his old job, rental income that he could have gotten from renting his space, and the interest he could have earned on his savings.


Delaware, USA 2008

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Zero Profit: the proper economic goal In the above example, Craig is failing to

cover his opportunity costs, so his resources would be put to better use and could earn a higher return if used elsewhere.

In other words, by comparing all of his opportunities to make money, he can choose among them based on total opportunity costs and, thereby, maximize his intrinsic worth.


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Zero Profit: the proper economic goal In that manner, he will be able to choose

the right career path. In economic terms, zero economic

profits are called normal profits. Normal profits are the minimum profit

necessary to justify keeping a firm in business.

When normal profits are equal to zero it is the state in which there is just enough revenue to cover all costs, including opportunity costs.


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Zero Profit: the proper economic goal In other words, at that minimum, there is no

benefit from reallocating resources to another use.

We can now better appreciate the discussion of opportunity costs in looking at the PPF.

There, we quantified costs in terms of how much of one good we gave up to produce another. That is output or revenue.

Now, we find that opportunity costs must be taken into account for calculating profits.


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Zero Profit: the proper economic goal Thus, they will affect decisions of where

actual production might occur on the PPF. For example, if a company can produce

napkins or parachutes, it will decide how to divide its labor and machinery to producing each.

That decision will be based on how much it gives up in producing one to produce more of the other.

It can reallocate production from one to the other until its incremental economic profits are zero.


Choice and Opportunity Costs Economics is a socio-psychologically, logical

theory of business transactions. Thus, money is not what most often enters

analysis. Money is just an intermediate thing that

allows us to buy many different things. However, costs are better measured in terms

of opportunities: what they are worth, in terms of other available options.

We give up a hotdog to have a hamburger at lunch: opportunity costs are that simple.


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Choice and Opportunity Costs We go to college and spend 4 years of

earning no money and giving up time. We become a financial analyst instead of a

brain surgeon. Then, we decide how production should be

allocated to a number of different possibilities, depending on our perceived opportunities created by choices in demand made in the markets.

In the end, the whole economy lands somewhere in its production possibilities set.


Delaware, USA 2008

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Short-run Production


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Short-run versus long-run? Economists do not distinguish between the

short and long terms on an arbitrary basis of time. Time only has meaning in terms of what you can do with it.

In economics, the line between short and long run is drawn in terms of the ability to vary the quantity of inputs of resources, factors of production, in the production process.

To analyze the question, we must distinguish between fixed and variable inputs.


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Short-run versus long-run? Fixed inputs are resources for which the

quantity cannot be changed during the period of time under consideration.

Fixed inputs include things, like the size of a firm’s physical plant or the capacity of a machine to produce output.

Such things cannot be changed in a short period of time.

They must remain fixed while managers decide upon other ways to vary output…the variable inputs.


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Short-run versus long-run? Then, there are variable inputs, over

which managers do have some control, given the fixed inputs.

A simple example of variable input is the number of employees and employee hours in a given period of time.

Of course, at some point even employee and machine hours will max out.


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Short-run versus long-run? Given those concepts, we can finally make

a proper distinction between short-run and long-run.

The short-run is the period during which there is at least one fixed input.

The short-run is, for example, the period in which a firm can hire more employees, variable input, while it cannot change the size of its physical plant, fixed input.


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Short-run versus long-run?

The long-run is the period of time that is sufficient to allow for changes in fixed inputs.

In the long-run a firm can build new plant and buy more equipment.

In the long-run, new firms can enter the business and old firms might exit, changing the supply curve.


Short-run versus long-run? Thus, the difference between SR & LR can

vary for different businesses or even for the same business at different times.

An airplane manufacturer will have certain fixed plant capacity, and to increase it might take a year or more to build new buildings and to order and install new equipment.

It might only take a few months to build a repair shop for old airplanes.

(C) Red Hill Capital Corp., Delaware, USA 2008 60

Short-run versus long-run? A clothing sales chain might take several

months to find space for a new store and to build it out.

If it want to begin sales in another country, it might take a year or more to do all of the paper work and find international shippers for its international aspirations.

Thus, SR & LR will depend on the particular business and situation.


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Break time

Please, take a 10 minute break


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The Production Function Model The next step is to look at the transformation of

inputs into output. This is done using the production function, the

relationship giving the maximum output that can be produced using varying quantities of the various inputs to production.

In production function theory, as presented herein, ceteris paribus is that technology remains unchanged since changes in technology would change the output that can be achieved with given inputs and would, therefore, change the production function.


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Production function example: Chateau Mattoli Vineyards. Consider a business that grows grapes to

produce wine. The input for the business is labor, and we

assume all potential laborers have equal job skills.

The land, number of vines, the machinery, and all other inputs are categorized as fixed.

Thus, our production model description is in the short run.


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Production function example: Chateau Mattoli Vineyards. Output will vary with employment: the

more employees, the more man hours, the higher the maximum output.

Output begins at zero when zero employees are employed.

With only one employees, maximum daily output is 1 ton.

However, there is a lot of wasted time with only one employee.


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Production function example: Chateau Mattoli Vineyards. She has to:

1. pick the grapes and put them in a cart,

2. she has to transport the cart to the shed, then, press the grapes,

3. make the wine and store it in casks, and

4. follow up with the aging process and final bottling, labeling, and boxing of the wine.

It is very inefficient.(C) Red Hill Capital Corp.,

Delaware, USA 2008

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Production function example: Chateau Mattoli Vineyards. The addition of a second employee adds

efficiency. The 2 can save time by dividing tasks that

might overlap. After a cart is filled with grapes, the second

employee could have brought a second cart to start on, and she can take the first cart back to the press to begin the next step, while the first continues to fill up the next cart.


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Production function example: Chateau Mattoli Vineyards. They can process 2.2 tons per day, together. Thus, they produce more than 2 times the

amount that can be produced with only one employee.

Adding a third employee increases production to 3.3 tons per day.

However, by the time we have increased the employees to 6, production is only to up 5 tons.

See the next slide for graphical details.


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Production function example: Chateau Mattoli Vineyards.

Total Output versus Employees

Employees Production

0 0

1 1

2 2.2

3 3.3

4 4.2

5 4.8

6 5

Total Output

0

1

2

3

4

5

6

0 2 4 6 8

Tons

Em

plo

yees


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Marginal Product

The example points out an interesting phenomena: adding labor increases output, first, at a magnified rate and, later, as more employees are added, at a shrunken rate.

We define marginal product as the change in total output (TO) per unit change in labor (L): ΔTO/ΔL


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Marginal Product

It is the slope of the total output curve, at any point along the curve.

For Chateau Mattoli, marginal product is equal to 1 when the first employee is added, 1.2 for the second, 1.1 for the third, and is down to 0.2 by the time that the 6th employee is hired.

We show the figures in the next slide.(C) Red Hill Capital Corp.,

Delaware, USA 2008

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Marginal Product: Chateau Mattoli

Marginal Product

0.0

0.5

1.0

1.5

0 2 4 6 8

Employees

Mar

gina

l Pr

oduc

t

Marginal Product

Employees Marginal Product

0 0.0

1 1.0

2 1.2

3 1.1

4 0.9

5 0.6

6 0.2


Marginal product decreases because the slope of the output curve is decreasing

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Law of diminishing returns What is at work in the preceding analysis

is another law of economics: the law of diminishing returns.

The law of diminishing returns states that, beyond a certain point, the addition of a unit of variable factor to a fixed factor will result in decreasing marginal product.

Since the law assumes that there is a fixed factor, it is necessarily a short-run law.


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Law of diminishing returns At first, additional employees use the fixed

resources more efficiently by working together’

But as more employees are added to the fixed inputs, their sharing begins to decrease the initial efficiency of dividing tasks.

In chapter 11, a detailed analysis of the labor market tells how to decide on the right number of employees.


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Law of diminishing returns We shall not cover those details, in

this course. For now, we only say that a firm would

never hire an employee who has marginal product of zero or less.

The law is a simple statement of the reality of business organization.

Eventually, too many cooks spoil the soup.


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Short-run cost formulas


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Total cost curves For a business to make a decision to

produce a product, in the long or short runs, it must first determine the costs associated with producing various quantities.

For example, in Mattoli Vineyards, we saw that output was varied by adding employees.

In the short run, costs are divided between total fixed costs and total variable costs.


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Total cost curves Fixed costs (TFC), like mortgage or

rent, interest on loans, and insurance, must be paid even if there is nothing produced.

Variable costs (TVC) will vary with the output.

Variable costs will include labor, materials for production, and the like.


Total cost curves You rent or buy a space for a dress store. You have to pay rent, no matter if you have

business or not. You have to pay interest on borrowings

whether you have sold any dresses or not. You have to have the lights and climate

control on whether or not you make sales. You can vary the amount of inventory that

you purchase and the hours that you have people work at the store.


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Total cost curves In the simple example of Mattoli’s

Vineyards, we assumed that the only variable cost was labor. We also assume that each employee is equally skilled and that they are all paid the same wage rate.

Then, total cost (TC) will be the sum of fixed and variable costs, TC = TFC + TVC.

In the next slide we show cost data for another mythical business: MAT ATM machines (Mattoli’s automatic teller bank machines).


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MAT ATM Data

The quantity versus cost data for MAT ATM

MAT ATM's

Q TFC + TVC = TC

0 100 0 100

1 100 50 150

2 100 84 184

3 100 108 208

4 100 127 227

5 100 150 250

6 100 180 280

7 100 218 318

8 100 266 366

9 100 325 425

10 100 400 500

11 100 495 595

12 100 612 712

Cost vs. Quantity

0100200300400500600700800

0 5 10 15

Quantity

Cos

t ($

)


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Average cost curves Costs are nice to look at but more interesting to a

manager are costs per unit of product produced, or average costs.

Like prices, average costs are stated on a per unit basis.

Thus, we have the following definitional formulae:AFC = FC/QAVC = VC/Q

ATC = AFC + AVC = FC/Q + VC/Q = (FC+VC)/Q = TC/Q

Note: there is a mistake in the book on page 153 for ATC; book says ATC = TVC/Q


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Connection with marginal cost Marginal cost is, basically, the change in

cost when one additional unit is produced. In terms of our new equation definitions, we

can say marginal cost is the change in total cost per change in unit output. Moreover, since fixed cost never changes, we can write an equation for MC as:

MC = ΔTC/ΔQ = ΔTVC/ΔQ In the next slide, we show average and

marginal costs in table and graph forms.


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AC & MC Data Average and marginal

costs are shown for MAT ATM’s.

MAT ATM's

Q MC AFC AVC AC

1 50 100.00 50.00 150.00

2 34 50.00 42.00 92.00

3 24 33.33 36.00 69.33

4 19 25.00 31.75 56.75

5 23 20.00 30.00 50.00

6 30 16.67 30.00 46.67

7 38 14.29 31.14 45.43

8 48 12.50 33.25 45.75

9 59 11.11 36.11 47.22

10 75 10.00 40.00 50.00

11 95 9.09 45.00 54.09

12 117 8.33 51.00 59.33

Average and Marginal Costs vs. Output

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

0 2 4 6 8 10 12 14

Quantity

Uni

t Cos

t($)

AVC

AFC

ATC

MC


Details TC = TFC+TVC; MC(n+1) = TC(n+1) – TC(n);

ATC = TC/n for Q = n units


Q TFC + TVC = TC MC =ΔTC/ΔQ AFC = FC/Q AVC = VC/Q AC = TC/Q0 100 0 100 01 100 50 150 50 100.00 50.00 150.002 100 84 184 34 50.00 42.00 92.003 100 108 208 24 33.33 36.00 69.334 100 127 227 19 25.00 31.75 56.755 100 150 250 23 20.00 30.00 50.006 100 180 280 30 16.67 30.00 46.677 100 218 318 38 14.29 31.14 45.438 100 266 366 48 12.50 33.25 45.759 100 325 425 59 11.11 36.11 47.22

10 100 400 500 75 10.00 40.00 50.0011 100 495 595 95 9.09 45.00 54.0912 100 612 712 117 8.33 51.00 59.33

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Cost curve analyses Average fixed cost is an ever decreasing

value versus output since the total cost is spread over more and more units.

All other curves fall, initially, hit a minimum, and, then, begin to rise.

Notice, also, that the MC curve intersects with both the AVC and ATC curves at their minimums. It is no accident, and we shall take a closer look and find that it is a general result.


87

Marginal Relationships The marginal-average rule is a relationship

that applies to any marginal versus average variables.

The marginal-average rule states that as long as the marginal variable is below the average, the average curve will be falling. When marginal is above the average, the average will be rising. Thus, the average will be equal to the marginal at the minimum of the average.

Thus, both AVC and ATC will obey the rule


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Marginal average example To understand the average marginal

rule in more familiar territory, let us consider average class grades.

If the average grade of 20 students is 80% and another person’s grade is added to the average, if the grade is above 80%, it will increase the average. If it is below average, it will pull the average down.


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Marginal average example Take 20x80%, then, add the new grade,

and divide by 21. As you can easily understand, the new

average will be below 80%, if you add a grade below 80%, and conversely, if you add a grade above 80%.

Thus, the marginal-average rule holds for average grades or any other average-marginal relationship.


90

Marginal Costs versus Marginal Product

The marginal cost declines if the marginal product is increasing when the price of a variable input is constant.

Marginal cost begins to increase when marginal product is on the decline.

It is only logical. As long as marginal product is increasing,

we will get more and more efficient use of variable inputs and lower our average costs.


91

Marginal Costs versus Marginal Product When marginal product hits it peak, we

begin to lose benefits, and average costs begin to increase.

The result also shows that marginal cost begins to rise at the point of diminishing returns, so it is a result of the law.

We return to Mattoli Vineyards for an example look at the relationship of MC and MP, in the next slide.


92

Chateau Mattoli Marginals Assume that Chateau Mattoli

pays its employees $100/day. Each worker is equally skilled

and equally paid.MP vs. MC

0

100

200

300

400

500

600

0 2 4 6

Output

Co

st (

$)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

MP

Labor MP Output TVC MC/unit

0 0.0 0 0

1 1.0 1 100 100.00

2 1.2 2.2 200 83.33

3 1.1 3.3 300 90.91

4 0.9 4.2 400 111.11

5 0.6 4.8 500 166.67

6 0.2 5 600 500.00


93

Chateau Mattoli Marginals In the example, marginal cost begins

at $100 for the first employee, and hits a low at $83 with the second.

After that there are diminishing returns from hiring more employees.

As you can see in the graphs, the minimum MC is at the maximum MP.

MC and MP are inversely related. (C) Red Hill Capital Corp.,

Delaware, USA 2008

94

Long run production costs


95

Long run average cost curves The long run, as previously stated, is a period

of time long enough to change the quantities of all fixed input that was fixed in the short run.

In the long run, a business can change the size of its physical plant, larger or smaller. It can change the machinery capacity.

Whenever a business makes a change in fixed inputs it puts itself back in the short run again.

In the next slides, we look at the decision for MAT ATM’s on the proper size of a plant, given only 3 choices of size.


96

MAT’s Choices MATATM has 3 choices of factory sizes. Each has its own cost curve.

Cost curves for 3 factories

0

10

20

30

40

50

60

0 2 4 6 8 10 12 14 16

Quantity of output

Un

it c

ost

s


97

Size matters to MAT The previous slide shows graphs of short run

average total cost curves (SRATC) for three factory sizes.

If MAT thought that it will produces 6 machines a week for the foreseeable future. Then, it would be better off with the smaller size plant represented by the curve on the right.

If MAT thought that it will be producing 9 machines a week, it will choose the mid-size plant.


98

Size matters to MAT If it believes that it will produce 12

machines a week it will choose the large plant.

In all 3 factory sizes, it can produce at a number of levels.

Although the graph does not show it, production possibilities for all size plants will range from 0 up to some maximum output.


99

Size matters to MAT However, all three sizes will have maximum

outputs that are different: the larger the factory, the larger the maximum output.

There are also overlaps. For example, 9 machines per week could be produced with all factory sizes.

However, the mid-sized factory can produce 9 machines per week with the lowest cost for not only that size but for all sizes.

Thus, we construct a LR curve, using the better parts of the three SR curves, as in the next slide.


100

Long run average cost curves Referring back to the last set of graphs, the long run cost

curve for MAT ATM is the combination of the lower connected parts of the three graphs.

Cost curves for 3 factories

0

10

20

30

40

50

60

0 2 4 6 8 10 12 14 16

Quantity of output

Un

it c

ost

s


101

Long run average cost curves We might imagine a more comprehensive case of more

possibilities in the long run, as shown in the graph below.


Long run average cost curves

In constructing the LR curve, we no longer just connect the better parts of a few SR curves.

In this case, we imagine an infinite number of possible factory sizes.

Then, we construct the LR continuous curve as the set of points of tangents of the SR curves to that line, as shown in the figure, above.


103

Scales of production Again, even the long run cost curve

decreases, hits a minimum, then, rises, just like the short run cost curves.

The law of diminishing returns is not responsible in this case because diminishing returns is a short run, fixed-input phenomenon.

Firms starting out small face decreasing long run average cost curves because of economies of scale.


104

Reasons for economies of scale First, when the size of the firm increases,

there is more chance for division of labor and specialization.

In that case, each person can specialize and become proficient in one small tack instead of being jack-of-all-trades.

The classic example is Henry Ford’s assembly line for automobile manufacturing, which substantially reduced the cost of automobiles and ushered in a new era or mass production.


105

Reasons for economies of scale A second factor is greater efficiency of capital. A machine with a capacity of 1000 units/day

might cost $100,000 while a $400,000 machine might have capacity of 8000 units/day, 8 times the output for 4 times the price.

A smaller company might find the second machine too large for its needs and cannot take advantage of the lower machine cost per unit of output.

In that regard newer companies are sometimes competing with older larger companies that have been able to take advantage of economies of scales.


106

Reasons for economies of scale Economies of scale might last up to a

certain level of output in the long-term average cost curve.

After that, there might be a region of output for which there are constant returns to scale. In that region the long-term average cost curve remains flat and increasing size of plant neither helps or hurts the business.


107

Reasons for economies of scale A final region of the average cost long term curve might begin to rise, again, and we say that there are diseconomies of scale.

After a certain size, a firm can become bulky to manage. The chain of command and communication becomes stretched out. The firm becomes laden with bureaucracy and red tape, and the result is increasing average cost with increasing output.


108

Long run Possibilities In the long run there can be economies of scale, constant returns to

scale, and even diseconomies of scale as size becomes too bulky and unmanageable.

0

5

10

15

20

25

30

35

0 20 40 60 80 100 120

Economies of scale

Constant returns to scale

Diseconomies of scale

Cost

Output(C) Red Hill Capital Corp., Delaware, USA 2008

Epilogue We have talked about costs in this lecture. The other half of the equation is revenues. You can’t be in business, just taking on costs

without making sales. The variable costs come from production and

increase with units produced. We make sales, incur costs, and, in the end,

we hope that Revenue – costs = Profits > 0. In the next lecture we will discuss these next

steps in the process of being in business.(C) Red Hill Capital Corp.,

Delaware, USA 2008 109

Exam-caliber QuestionsQuestion 22 The table below shows total output and total cost of

a CD manufacturing firm. Assume that the lease payment for the company’s machine is $40 per day, which must be paid whether the company makes any CDs or not. This payment is a fixed cost since it does not depend on the number of CDs per day the firm makes. Also assume that the only variable factor is labor.

If CDs sell for 35 cents each, calculate how many CDs should the firm produce each day to maximize profit? Show your working


Delaware, USA 2008

Exam-caliber Questions


Employeesper day

Output(CDs/day)

Total cost($/day)

0 0 40

1 80 52

2 200 64

3 260 76

4 300 88

5 330 100

6 350 112

7 362 124

112

Homework

Chapter 6 Questions 1-11 MC questions 1-19


113

Next week

We continue analyzing cost, revenue and supply curves in the case of perfect competition.

Textbook chapter 7.


114

END

END


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1 Econ 1000: Mod 3, Lecture 5 C.L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008.

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