COSTS OF PRODUCTIONChapters 11

Short-Run vs. Long Run• Firms typically have several types of inputs that they can

adjust to adjust production.• Long-run - When firms are able to adjust all of their inputs

including physical plant.• Short-run – When firms are able to adjust only some of

their inputs (usually energy, labor, and raw material costs).

Productivity• Average Productivity of Labor is output per work.

• Marginal Productivity of Labor is the extra production that is obtained from an extra unit of labor.

Total ProductAPL

Labor

TPMPL

Labor

Short Run Production Function

TPMPL

Labor

ΔLabor

ΔTP

ΔLaborΔTP

Total

Product

MPL is the slope of the production function which gets flatter as labor is added.

Labor

Production in the Short-Run• Given a set of fixed inputs (like plant and capital equipment),

a firm can vary other inputs (typically labor) and to vary production.

• Typically, as you add workers, you get more output.

• Up to a point each additional worker adds synergy and adding more workers leads to more and more extra pay-off.

• But at some point, capacity constraints bind, diminishing returns sets in, and the addition of extra workers will generate less and less extra production.

0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 100

0

5

10

15

20

25

30

35

Bakery

Hours

Lo

av

es

Productivity• Labor productivity depends on the number of workers

• First, increasing, then, decreasing• Average product of labor begins decreasing when

marginal product of labor drops below average.

Note: Marginal Product crosses through average product at the peak of average product.

As long as the next worker adds more product than the average worker, they will increase the average.

Once diminishing returns set in, additional workers may add less to output than the average worker, reducing the overall average.

MPL, APL

L

MPLAPL

Small Scale Schedule

Average MarginalHours Loaves Product Product

0 00.10

2 0.20 0.100.32

4 0.83 0.210.58

6 2 0.331

8 4 0.53

10 10 1

Large Scale ScheduleAverage Marginal

Hours Output Product Product0 0

110 10 1

0.33333340 20 0.5

0.290 30 0.333333

0.142857160 40 0.25

0.111111250 50 0.2

0.090909360 60 0.166667

Fixed Costs vs. Variable Costs• In short-run, we distinguish between the costs that are

adjustable as production is adjusted (variable costs) and costs that are unchanged regardless of production (fixed costs).• Variable costs (Wages of production workers, supply and raw

materials costs)• Fixed costs (Depreciation costs, Financial costs, wages of non-

production workers).

Types of Costs• Total Fixed Costs – Invariant to the number of goods

produced (in the short-run)• Average Fixed Costs – Decreasing in the number of goods

produced.

• Total Variable Costs- Increasing in the number of goods produced.

• Total Costs: Fixed Costs + Variable Costs

Cost Shares Various 4 Digit Industry

(USA, 1991-1996)

Production NonproductionIndustry Workers Energy Materials Workers Labor IntensityCement 9.02% 17.83% 43.21% 4.23% 34.00%Typesetting 28.17% 0.96% 18.96% 13.07% 51.50%Oil Refinery 1.65% 2.62% 83.80% 1.07% 20.09%Automobiles 5.41% 0.37% 71.97% 1.06% 23.38%Furniture 18.03% 1.62% 47.86% 5.56% 46.68%Mens Clothes 20.20% 1.23% 40.08% 7.67% 47.49%

NBER Productivity Database

Bakery: Wages $10 per Worker, $5 Wheat per Loaf

Output Fixed Workers Bakers Wheat Variable Total(Loaves) Costs Wages Costs Costs

2.00 1000 6 60 10.00 70.00 1070.00

10.00 1000 10 100 50.00 150.00 1150.00

20.00 1000 40 400 100.00 500.00 1500.00

30.00 1000 90 900 150.00 1050.00 2050.00

40.00 1000 160 1600 200.00 1800.00 2800.00

50.00 1000 250 2500 250.00 2750.00 3750.00

60.00 1000 360 3600 300.00 3900.00 4900.00

Total Variable Costs are increasing at an accelerating rate.

Reason: Diminishing returns to variable inputs.

2.00 10.00 20.00 30.00 40.00 50.00 60.000

1000

2000

3000

4000

5000

6000

Cost Schedule

Fixed Costs Variable Costs Total Costs

Costs: Average vs. Marginal• Total Costs are the sum of all relevant costs for a firm.• Average Costs: Costs per unit of output.• Marginal Cost: Extra Cost per Extra Unit of Output.

Cost Schedules

Output Average Average Average Total Fixed Variable Total Marginal

(Loaves) Costs Costs Costs Costs Costs

2.00 1070.00 500 35 53510.00

10.00 1150.00 100 15 11535.00

20.00 1500.00 50 25 7555.00

30.00 2050.00 33.33333 35 6875.00

40.00 2800.00 25 45 7095.00

50.00 3750.00 20 55 75115.00

60.00 4900.00 16.66667 65 82

Average and Marginal CostsAverage Fixed Costs decreases as production increases

AVC, ATC, MC all increase as diminishing returns kick in

2.00 10.00 20.00 30.00 40.00 50.00 60.00

AFC NaN 100 50 33.3333333333333

25 20 16.6666666666667

AVC 35 15 25 35 45 55 65

ATC NaN 115 75 68.3333333333333

70 75 81.6666666666667

MC 35 10 35 55 75 95 115

10

30

50

70

90

110

130

Cost Curve

$

MC equals AVC and ATC when each of the latter are at their minimum level.

Long Run Costs• In the short-run, the size of a firms physical plant is a fixed

factor. • Over-time, the plant size can adjust. • In the bakery example, extra ovens can be added.

Minimizing Costs in the Long Run• Consider average total cost schedules at different

numbers of ovens. • Each oven will have a production level that generates the

minimum average total cost. • To minimize average costs in the long-run, choose the

number of ovens which will have the lowest, minimum average total cost.

10

20

30

40

50

60

70

80

90

10

0

11

0

12

0

48

68

88

108

128

148

168

188

208

228

1 Oven

2 Ovens

3 Ovens

4 Ovens

5 Ovens

6 Ovens

7 Ovens

8 Ovens

Output

Connect the Dots Long Run Average Total Costs

If we adjust capital scale continuously, the collection of minimum points is the Long Run Average Total cost cuve

LR ATC

Short-run ATC

Economies of Scale• When firms are able to adjust all of their inputs, they can choose a size that will minimize costs.

• If a firm is able to achieve some economies of scale, increasing size will reduce the average total cost.

• Sources of Economies of Scale• Production requires major expenditure on items needed to

produce even zero products• Ex. Software, pharmaceuticals

• Production requires many specific steps which can be most efficiently done through specialization• Ex. Airplanes, automobiles

Long Run ATC increasing returns to scale.

Output

Costs

LR ATC

Economies of Scale

Returns to Scale• Scale Economies is not always likely to characterize production.

• If each production unit can act autonomously with identical costs then we may experience constant returns to scale.

• Firms at some point experience diseconomies of scale or increasing long run average total costs.

• Sources of diseconomies of scale• Limits of managerial attention. • Limits of some other fixed resource.

Long Run ATC decreasing returns to scale.

Output

Costs

LR ATC

Constant Returns Scale

Diseconomies

Overall Cost Function

LR ATC

Minimum Efficient Scale

MES and Market Structure• If MES is relatively large in comparison with the market

demand:

$

Q

D

LRAC

The market is most efficiently served by a single firm---natural monopoly!

MES and Market Structure• If MES is relatively small in comparison with market

demand:

$

Q

Many “small” firms in the market.

Learning OutcomesStudents should be able to • Define and calculate various types of economic costs.• Fixed, variable, total, average, marginal.

• Describe the shape of various relevant cost curves• Average Total (in LR and SR), Average Fixed, Marginal Costs

• Describe the relationship between production, productivity (marginal and average) and the law of diminishing returns.

PERFECT COMPETITIONChapter 12

Costs and Supply Decisions

• How much should a firm supply?• Firms and their managers should attempt to maximize profits

(Profits = Revenues – Costs)• Select a pricing strategy that induces a demand for a product that

generates highest revenue relative to the cost of production of that level of supply.

• Profits depends on response of revenues to changes in production quantities.

Perfect Competition/ Price Taking• We think of some markets as characterized by perfect

competition• In competitive markets, no firm has the market power to set their

own price.

• Firms in perfectly competitive markets take their price as given.

China Price Download

Characteristics of Competitive Markets• Non-differentiated goods• Large number of firms• All firms are small relative to the market• Free entry and exit.

Name some competitive markets in HK

Name some uncompetitive markets

MES and Market Structure

• If MES is relatively small in comparison with market demand:

$

Q

Many “small” firms in the market.

• Non-differentiated goods• Large number of firms• All firms are small relative to the market• Free entry and exit.

Revenues and Perfect Competition

• Revenues = Price * Quantity• Average Revenue = Price• Marginal Revenue is the extra revenue generated by

selling an extra good. • If production by a firm doesn’t shift the price, marginal revenue is

the price.

Profit Maximization: Short Run

• In the short-run, firm may only have a limited number of avenues along which they may vary production.

• Cost of producing each good is likely to increase. But as long as the extra revenue that the good brings in exceeds the extra cost, it will be profitable to produce it.

• Maximize profits by producing up to that point that price is equal to marginal cost. Beyond that, producing more goods only subtracts from profits.

Accounting vs. Economic Profits

• Profits are revenues less costs.• Economic profits are revenues less explicit and implicit costs.• Economic profits attract competition so they typically

don’t last.

• Accountants do not fully incorporate all implicit costs including cost of equity capital or owner’s contribution of time or expertise. • Accountants do incorporate some implicit costs (such

as depreciation) into their profit& loss statements.

Revenues are price × quantity Q

P

ATC

MC

P

Q*

Revenues

Increase Production until marginal cost reaches the price level.

Profits

Costs

Profits = Revenues - Costs

Profit Maximization: Price is 80Output Average

Total Marginal Marginal(Loaves) Costs Costs Revenues Revenues Profits

2.00 535 160.00 -910.0015.00 80.00

10.00 115 800.00 -350.0035.00 80.00

20.00 75 1600.00 100.0055.00 80.00

30.00 68 2400.00 350.0075.00 80.00

40.00 70 3200.00 400.0095.00 80.00

50.00 75 4000.00 250.00115.00 80.00

60.00 82 4800.00 -100.00

What if prices drop?

Q

P

ATC

MC

P

Q**

-Profits

Revenues

P'

Breakeven point

Q*

Costs

• The average total cost of production (when marginal cost equals price) is above the new lower price. • If the firm sets production at a level such that price equals marginal cost,

but that is the best they can do in the short run. • Firms only decision is to vary production costs along those dimensions

that are available.

• Should the firm shut down?• No. The firm has paid costs which cannot be retrieved [SUNK COSTS].

Since the firm cannot change this, they should ignore these sunk costs in making their marginal decision.

• As long as prices exceeds variable costs, produce.

Profit Maximization: Price is 60Output Average Average

Total Variable Marginal Marginal(Loaves) Costs Costs Costs Revenues Revenues Profits

2.00 535 35 120.00 -950.0010.00 60.00

10.00 115 15 600.00 -550.0035.00 60.00

20.00 75 25 1200.00 -300.0055.00 60.00

30.00 68 35 1800.00 -250.0075.00 60.00

40.00 70 45 2400.00 -400.0095.00 60.00

50.00 75 55 3000.00 -750.00115.00 60.00

60.00 82 65 3600.00 -1300.00

When should the firm stop production in the short-run?

Q

P

ATC

MC

P

Q**

P'

Breakeven point

AVC

Dropout point

Profit Maximization: Price is < 10Output Average Average

Total Variable Marginal Marginal(Loaves) Costs Costs Costs Revenues Revenues Profits

2.00 535 35 20.00 -1050.0010.00 10.00

10.00 115 15 100.00 -1050.0035.00 10.00

20.00 75 25 200.00 -1300.0055.00 10.00

30.00 68 35 300.00 -1750.0075.00 10.00

40.00 70 45 400.00 -2400.0095.00 10.00

50.00 75 55 500.00 -3250.00115.00 10.00

60.00 82 65 600.00 -4300.00

Dropout!

Adjustment in the Long Run• In the longer run, firms are able to adjust the size of their plant. (adjust the number of machines in the factory, adjust the number of oil rigs).

• If profits are positive. Firms will seek to build new equipment as they compete for profits.

• If profits are negative, firms will shut down equipment and sell it, or possibly go out of business.• Firms will adjust their physical plant until they are

making profits again.

Profit maximization and the supply curve• In the short-run, firms produce up to that point

where price equal marginal cost.• Supply curve is the sum of the supply curves of the different firms in the market.

• In the long-run, capacity will be adjusted to the point where profits are zero (i.e. where marginal cost equals average total cost).

• Long run ATC curve is collection of points where MC = ATC and is the long-run supply curve.

Firm Level Supply Curve: Short Run

Output

SR ATC

MC

P

P*

SFirm 1

In the short run, MC curve is the relationship between firm price and production

Firm Level Supply Curve: Short Run

Output

SR ATC

MC

P

P*

SFirm 2

Industry Level Supply Curve:Short Run

Output

P

SFirm 1

In the short run, the sum of the MC curves is the relationship between price and industry production

+SFirm 2 +SFirm 3SIndustry

Short Run Response to Increase in DemandIncrease Variable Inputs

SIndustry

Output

PD

Q*

P* D'

Q**

P**

1

2

Firm Level Supply Curve: Short Run

Output

SR ATC

MC

P

P*

SFirm 1

In the short run, MC curve is the relationship between price and firm production

P**

q* q**

1

2

Profits

Short-run profits attract new entrants

New Entrants in the Long RunSupply Increases and Price Drops

SIndustry

Output

PD

Q*

P* D'

Q**

P**

+SFirm N+ 1

P***

Q***

1

2

3

Firm Level Response to New Entrants: Reduce Output

Output

SR ATC

MC

P

P*

SFirm 1

But as long as price is above minimum of ATC, there will still be profits and entry.

P**

q* q**

P***

q***

1

2

3

Profits

New Entrants as Long as Profits at MESSupply Increases and Price Drops

SIndustry

Output

PD

Q*

P* D'

Q**

P**

+SFirm N+ 1

P**

Q***

+…+SFirm N+ J

Q****

1

2

3

4

Firm Level Response to New Entrants: Reduce Output

Output

SR ATC

MC

P

P*

SFirm 1

In the short run, MC curve is the relationship between firm price and production

P**

q* q**

P***

q***

1,4

2

3

Long Run, Supply is Flat along MES of New Entrants

SIndustry

Output

PD

Q*

P* D'

Q**

P**

P**

Q***

+SIndustry

Q****

SLR

1

2

4

Long Run Supply Curve• If all firms are exactly the same, then new firms have

same MES as old firms and supply curve is flat.• In some cases, like oil drilling, new firms may have higher

MES than old firms and supply curve is upward sloping.• Long run supply curve is flatter, more elastic than short-

term supply curve.

Long Run Equilibrium• Firms are making zero profits.• Firms will be producing at their minimum efficient scale

and at a minimum of ATC

Learning Outcomes

Students should be able to • Characterize a perfectly competitive market.• Calculate total revenue, marginal revenue and profit for a firm in a competitive market.

• Describe the supply curve in a competitive market in both the short and long run.

MONOPOLYChapter 13

Market Power• Market power is the ability of a firm to affect the market price of a good to their advantage. In declining order.

• Monopoly – A single producer without competition• Oligopoly Power – A small number of producers sometimes acting in concert.

• Monopolistic Competition – Firms selling differentiated products.

Price effects• There is a demand curve relating the quantity of a product

that can be sold at a given price. • Invert the concept: For each quantity, there is a price that

the market may bear.• Change the quantity and change that price• Marginal revenue

Marginal Revenue

• For price taking firm, marginal revenue is equal to price.• For a firm with market power, marginal revenue must

include the change in the price that results from a change in quantity.

PMR P Q P

Q

1 1(1 ) (1 )D

PPMR P P P P eQ Demand ElasticityQ

Example Demand, Revenue, Marginal Revenue

Output Price Revenue Marginal Revenue

10,000.00 33.0 330,000.013.7

20,000.00 23.3 466,690.510.5

30,000.00 19.1 571,576.88.8

40,000.00 16.5 660,000.07.8

50,000.00 14.8 737,902.47.0

60,000.00 13.5 808,331.66.5

70,000.00 12.5 873,097.96.0

80,000.00 11.7 933,381.05.7

90,000.00 11.0 990,000.05.4

100,000.00 10.4 1,043,551.6

Example

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

10 20 30 40 50 60 70 80 90

Q

P

Price Marginal Revenue

Demand

MR

Monopolist• Maximize Revenues by choosing an output level such that

marginal revenue equals marginal cost.• Price will exceed marginal cost. Monopolists will make

greater profits than a competitive firm. • Monopolists will charge higher prices and produce less output than a

competitive industry. • Profits should attract new entrants to the market.

• Monopoly can only survive if there are some barriers to entry.

Monopolist: Constant Cost

MC = ATC

MR

D

QMono

P*

QPC

Price

Output

Revenues

Cost

Profit

Marginal MarginalPrice Revenue Revenue Cost Cost Profit

10,000 33.0 330000 80000 25000013.66905 8

20,000 23.3 466690.5 160000 306690.510.48863 8

30,000 19.1 571576.8 240000 331576.88.842323 8

40,000 16.5 660000 320000 3400007.790243 8

50,000 14.8 737902.4 400000 337902.47.042918 8

60,000 13.5 808331.6 480000 328331.66.476632 8

70,000 12.5 873097.9 560000 313097.96.028302 8

80,000 11.7 933381 640000 2933815.661905 8

90,000 11.0 990000 720000 270000

Monopolist: General CaseMC

ATC

MR

D

Q*

P*

Price

Output

Costs

RevenuesProfits

Monopolist’s Schedule• The more elastic the demand curve, the higher the market

power.• The greater the market power, the greater the markup.• Firm has more pricing power if good has fewer

substitutes.

Barriers to Entry• Total Control over Vital Resource

• Alcoa in the aluminum market• DeBeers in Diamond market

• Patents or Secret Formula: • Xerox: Controlled photocopying

• Regulations: Jockey Club, SDTM• Gambling is a legally restricted monopoly

• Returns to Scale: • TownGas is an regulated monopoly supplier of a particular type of

piped natural gas (may have competition from LNG)

Price Discrimination• Demand curve is the price customers are willing to pay. • Some customers are willing to pay a very high price. If

monopolists could tailor a price to each customer they could make maximum profits.

Monopolist: Price Discriminatation

MC

MRD

Q1

P1*

Price

Output

Profit

MR2

+Q2

P2*Profit

Natural Monopoly

• In markets with a natural monopoly there may be one firm.• Economies of scale indicate that at marginal cost pricing

firms make a loss.• Efficient production involves 1 firm. Firm will naturally charge

markup and earn profits.

Monopolist: High Fixed Costs

MC

MR

D

QMono

P*

QPC

ATC

Price

Output

Profits

Profits under Monopoly

Under perfect competition, price equals marginal cost and the firm incurs losses.

Losses

Regulation• Government may step in, usually to put a maximum price level. Should be minimum amount necessary to get the firm to operate small decisions that lead to a competitive outcome.

• Average cost pricing• Information Problem. A single decision maker may not have full access to enough information.

.

0

100

200

300

400

500

600

0 50 100 150 200 250

Q

P

MC

ATC

MR

DMonopoly

Competition

Average Cost Pricing

MONOPOLISTIC COMPETITION AND PRODUCT DIFFERENTIATIONChapter 14

Monopolistic Competition• Most firms produce a good that is (to a certain extent)

unique. No other good has the exact same properties.• Coke, Pepsi, President’s Choice

• To the extent that you are a unique producer, you will have some market power.

• Price elasticity of individual products are larger than total category. But not infinite as in the case of commodity goods.

Monopolistic Competition: Short-term

MC

ATC

MR

D

Q*

P*

Price

Output

Characteristics of Monopolistically Competitive Markets• Differentiated Products Download • Free Entry into very similar markets.• Fixed costs of setting up production• Individual firms face downward sloping demand curve and

a falling average total cost curve.• They would sell more if they could at the going rate but lowering

their prices to sell more would lead to losses.

No Barriers to Entry• What happens if new firms can enter?• If there are profits to be had, entrepreneurs will enter

markets to provide close substitutes for profit making goods.

• New goods splitting the market and better substitutes means lower, flatter demand curve.

Monopolistic Competition: Entry of Competitors

MC

ATC

MRD

Q*

P*

Price

Output

D′MR′

Q**

P**

Profits

Monopolistic Competition vs. Perfect Competition

• On a market-by-market basis, perfect competition will offer greater efficiency both in terms of minimizing deadweight losses and encouraging an efficient production scale.

• Monopolistic Competition only occurs with differentiated products. • Greater variety generated by this market may compensate for loss

of efficiency.

Monopolistic Competition: Long-term

MC

ATC

MR′′ D′′

Q*

P*

Price

Output

D′

MR′

Profits

Monopolistic Competition vs. Perfect Competition

• Similar: Both have many firms, both have zero profits and P = ATC.

• Different: • P > MC : On the margin, monopolistically competitive firms want

more customers. Greater variety generated by this market may compensate for loss of efficiency.

• MC < ATC: Firm is operating at a level that does not minimize total costs.

Variety and Monopolistic Competition• Given that most markets have the “feel” of monopolistic

competition, do we have too many firms or is variety it’s own reward?

• Does advertising create phony differentiation or provide information?

Monopolistic Competition and Entrepreneurship

• New markets are frequently developed. • For many goods, the only barriers to entry is imagination. • Entrepreneurs develop new ideas for new goods. The

pay-off for entrepreneurship are short-run monopoly profits. (Ted Turner and CNN). Only in rare cases will firms be able to make long-term monopolistic profits.

Unprofitable Monopolistic Competition:Short-term

MC

ATC

MRD

Q*

P*

Price

Output

Consequences of Market Power• One clear consequence of the existence of market power is

that prices are higher than marginal cost and output is smaller than perfect competition.

• Additional consequences of the presence of market power may be:• Complacency by firms managers (i.e. standard corporate governance

measures do not generate efficiency)• Rent-seeking: Firms may put effort into constructing artificial barriers

to entry rather than producing goods.

Learning Outcomes• Define marginal revenue. • Characterize the relationship between price, marginal

revenue, marginal cost, average total cost, and profits in a monopolistic market.

• Measure the degree of market power with the Lerner index.

• Describe 4 barriers to entry that may enable monopoly power.

Final Exam (TBA)• When: Sunday, February 8th. TBA.• Where: TBA• What: Cover Materials in lectures on Supply& Demand,

Macro Indicators, Exchange Rates, Loanable Funds, Business Cycles, Monetary Policy, Industrial Organization.

• How: Format similar to practice final.• Bring writing materials, calculator, 1 A4 paper with

handwritten notes on both sides. • Office Hours: Thursday, January 29th 7-8pm, Downtown

campus; February 7th, 12:30-2pm.