Economics for CED

Economics for CED

Noémi GiszpencSpring 2004

Lecture 3: Micro: SupplyFebruary 24, 2004

2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc

2

First, a little expansion of Demand From Lecture 2:

The proximate causes of demand

AB

Tastes:Prices: Effective

Demand


3

A1 A2 A3

B1 B2 B3

Tastes:Prices:

Effective Demand

Other: (e.g.laws)

C1 C2 C3

From Lecture 2: longer causal chains


4

A bigger picture

Wants and desires

Prices

Effective demands

Commercial persuaders

Marketers’ perspective


5

An even bigger picture

Wants and desires

Prices

Effective demands


Environmentalists’ perspective

Nature, Law, Culture, Home & School, other persuaders

Provident or improvident uses of the environment


6


Wants and desires

Prices

Effective demands=satisfied desires


Sociologists’, social psychologists’ perspective


Fit or misfit between wants generated and wants satisfied

Unsatisfied desires

Deprivation, anxiety, unhappiness, bad behavior


7


Wants and desires

Prices

Effective demands


Left economists’ perspective

Unsatisfied desires

Deprivation, anxiety, unhappiness, bad behaviorFew

households own capital

Bargaining strengths

Many households contribute labor

HH rewards =firms’ costs of production

Incomes


8

Wants and desires

Prices

Effective demands


Broad economists’ perspective

Unsatisfied desires

Deprivation, anxiety, unhappiness, bad behaviorFew

households own capital

Bargaining strengths

Many households contribute labor

HH rewards =firms’ costs of production

Incomes


Fit or misfit between wants generated and wants satisfied

Provident or improvident uses of the environment


9

Can even that picture be broadened?“Sixto Roxas, a Filipino economist, argues that the main problem with conventional economics is that it focuses its analysis on the interests of the individual and the firm rather than those of the family and the community. ‘Neo-classical economics is not just a mathematical framework or analytical guideline to facilitate the understanding of reality: it is a full-fledged ideology and design for remaking the world,’ he says… People are reduced to flesh-and-blood machines that earn wages and salaries and generate profits but whose non-economic existence is not recognized.” [emphasis added]


10

Now, on to supply

• Who produces for the market? Firms.– Households and Government are also producers,

but not for the market• Relations between producers:

– Organized relations (within-firm)– Market relations (beyond firm)

• Ex: Restaurant owner organizes menu, shoppers, cooks, and waiters

• But goes to market for meat, vegetables supplied by farmers, truckers, and shopkeepers


11

Firms’ purposes (1)

• Maximize profit, silly• Remember, profits = revenue - costs• Or π = PxQ - C(Q)• Assume firm’s Q has no effect on P

(for now)• So main focus is effect of Q on C


12

Another way to see profit

-10-505

101520253035

0 1 2 3 4 5 6 7 8 9 10

revenuecostprofit

At what point is profit maximized? What is the slope of the cost curve?

Rev=3QCost=5+Q2/4And π=Rev-Cost


13

Firms’ costs

• (Do not include all costs--i.e., external)• In the “short run” means during the time

that you cannot replace existing fixed K– What is the most economical way to use

existing fixed K (capital): or, how to produce goods at least cost?

• A dual problem: productivity (subject to diminishing marginal returns) and costs


14

First, costs: a few simple definitions

• Total costs– All the accrued costs of producing

• Average cost– Total cost divided by number of units

produced• Marginal cost

– Additional cost of producing the last unit


15

Let’s produce some widgets!

• Typical good produced in economics classes.

• Nobody knows what they are, really.

• At left, a drawing of a widget by Leonardo da Vinci.


16

A numerical example

Quantity produced Total cost Average

cost

Marginal cost of last

unit0 5 - -1 8 8 32 10 5 23 12 4 24 16 4 45 $25 $5 $9


17

The example graphed

$0

$5

$10

$15

$20

$25

$30

0 1 2 3 4 5

Total CostAverage CostMarginal Cost


18

Marginal cost drives TC and AC

• Marginal cost is always positive: total cost is always rising

• If marginal cost < average cost, then marginal cost is pulling average cost down

• If marginal cost > average cost, then marginal cost is pulling average cost up


19

What happens to profits?

• Assume the price for output sold is $6

units Total cost

Sell for

Total π

Avg. cost

Sell for

Avg π/uni

t

Add’l cost

Add’l rev.

Add’l π

3 12 18 6 4 6 2 2 6 4

4 16 24 8 4 6 2 4 6 2

5 25 30 5 5 6 1 9 6 -3


20

Information from Costs

• All three cost measures show that biggest total profit comes from producing 4 units.

• Only marginal cost shows when firm is actually losing, and how much.

• Rule: Produce until MC = price– This will give us the supply curve


21

Types of costs

• Fixed: can’t be altered at short notice– Factory, equipment, salaried staff– Also called sunk costs, overheads– Predictable economies of scale

• average fixed cost per unit output declines w/ Q

• Variable: can vary w/ Q of output– Raw materials, fuel, temp workers– May not vary evenly


22

Costs = Fixed + Variable

• Total Costs: C(Q) = F + V(Q)• Average Costs: AC = (F + V(Q) ) ÷ Q

– Average Fixed costs = F ÷ Q– Average Variable costs = V(Q) ÷ Q

• Marginal Costs: MC = d(F+V(Q))/dQ– Fixed costs have no effect on MC


23

0

2

4

6

8

10

12

0 1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

12

1 2 3 4 5 6 7 8 9 10 11

Some cost curves

MC=AC=1

F = 0, V(Q) = Q

TC

F = 1, V(Q) = Q

TC

VC

ACMC=AVC

AFC


24

Another cost curve: “U-shaped”

-2

-1

0

1

2

3

4

5

0 1 2 3 4 5 6 7 8 9 10

Fixed costvariable costtotal costaverage fixed costavg var costavg costmarg'l cost

V(Q)=(Q/3-2)2


25

0

20

40

60

80

100

120

0 1 2 3 4 5 6 7 8 9 10

Yet another cost curve: very high fixed costs, low MC

F=100V(Q)=Q/100

TC

MC


26

A counter-intuitive result

• If a firm has fixed costs, and if it can keep meeting its variable costs, it should keep producing regardless of whether it is making a loss. – Making a little toward meeting fixed costs

is better than making nothing at all– Explains success of early railroads despite

lack of profitability--they just kept chugging!


27

Now, productivity: diminishing returns

• Holding other factor(s) of production fixed, increasing a factor eventually adds less and less output– Not all producers encounter rising costs and

diminishing returns as output increases• Some producers don’t get demand for that level of

volume• Some factors of production have fixed capacity

– Beyond limit, no production at all• Some factors of production are variable (can vary in

proportion to each other)


28

Production Function

• In general, Production is the transformation of inputs into outputs.– Inputs are the factors of production -- land, labor,

and capital -- plus raw materials and business services.

• A production function -- f(L,K, etc.)=q -- describes how combinations of inputs produce output (given a certain technology)– We saw a production function in first class


29

Average and marginal productivity

• Productivity is ratio of output to input• Average productivity is total output

divided by total input• Marginal productivity is increase in

output with addition of last unit of input– With all other inputs held steady (cet. par.)


30

A numerical example: farmer TedHours of Labor Output: bushels

of wheatAverage

ProductivityMarginal

Productivity0 0 0 9.45

100 945 9.45 8.35200 1780 8.9 7.25300 2505 8.35 6.15400 3120 7.8 5.05500 3625 7.25 3.95600 4020 6.7 2.85700 4305 6.15 1.75800 4480 5.6 0.65900 4545 5.05 -0.45

1000 4500 4.5 0


31

Output Diagram

• As the variable input increases, output increases at a decreasing rate.

• This is the Law of Diminishing Marginal Productivity


32

Average and marginal productivity

• Marginal productivity is decreasing and pulling average productivity down.


33

What happens to profits?

• Assume: – cost of variable input fixed (wage rate of

farmer=opportunity cost of working elsewhere), and

– price of good produced fixed (price of wheat determined by world markets)

• Profits ≈ revenue - costs = PxQ - C(Q) =Pxf(L,K) - C(L,K) for given L,K


34

The relationship will look like this

• As labor input increases, output does not increase as fast.

• Cost of labor input goes up steadily but return, or value of marginal product slows down


35

How to maximize Profit

• What does one additional labor unit add to cost? w = wage

• What does one additional labor unit add to revenue? p*MP = value of marginal product

• Profit is max’ed when p*MP = w


36

Costs and types of firms

• Natural monopolies– Ex: power & gas, water & sewerage, canals & RR

• Continually increasing returns to scale– Big firms out-compete small firms– Ex: steel, machine-making, petro-chemicals

• U-shaped costs– Medium-sized firms– Ex: house-building, furniture-making, textiles


37

Costs and types of firms

• Constant unit costs– Can be big or small– Ex: book publishing, brewing, wineries

• Diseconomies of scale– Small firms have lower unit costs than big– Ex: tailoring, repair, individual arts, some farming

• Each type of industry has different temptations and remedies


38

Firms’ purposes (2)

• Working and managing for owners– When firms were mostly sole propietorships– Maximizing profit or return on equity

• Directors’ purposes– In 20th C., more separation of ownership and

control– Adolf A. Berle and Gardner C. Means, The

modern corporation and private property (1932)– What are the directors going to do?


39

Berle and Means: 3 alternatives

1. Directors maximize owners’ π • but own π motive weakened

2. Manage for their own benefit• Just enough π paid out to comply with law,

attract K• Keeps π motive but leads to corp. plunder

3. Manage for good of all society• Purely neutral technocracy


40

“The state seeks in some aspects to regulate the corporation, while the corporation, steadily becoming more powerful, makes every effort to avoid such regulation.”

Berle and Means (1932)


41

Firms are responsible to…

– (Can’t survive without any of the below)• Owners• Creditors• Employees• Customers• Community• Local & National government


42

Firms’ policy choices

• Profit: maximize, moderate, or (for tax purposes) minimize?

• Short, medium, or long-term profit?• How to divide profit between dividends and

reinvestment in growth?• Aim for big revenue, market share, profit, profit/sales,

profit/equity?• Stability or growth? Safety or risk?• Working conditions? Neighborliness?• Sketchiness: offshore taxes, unsavory partners,

bribery?

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