Understanding Markets

Transcription

1 Understanding Markets EC8005 Lecture Michael King 1

2 Revision: Consumer Theory 1. Qd = f(p,ps, Pc, Y, T, O) 2. Sd = f(p, T, I, G, Tx, Sy, O) 3. Types of goods 4. Shift along v s shift in demand/supply curves 5. Equilibrium 6. Price ceilings v price floors 7. 3 Elasticities of demand (and 1 elasticity of supply) 8. Marginal Utility Analysis 9. Indifference curves and budget line Comparative statics 10. Consumer surplus 2

3 Existence of a Giffen Good? Irish Potato Famine Recent Chinese History See: ge/2007/07/as_price_goes_up_so_does_d eman 3

4 Course Outline 1. Course Introduction 2. Demand and Supply 3. Market Equilibrium and Applications 4. Elasticity and its Applications 5. The Consumer and Demand 6. The Firm and Supply 7. Market Structures 8. Markets and States 9. Microeconomic Policy Issues in Ireland 4

5 Topic 6: The Firm and Supply Focus: More rigorous explanation of the theory of supply. How do firms behave? Structure: 1. Objectives of the Firm 2. Production and Time 3. Costs and Profit 4. Long-run Costs 5. Producer Surplus

6 1. The Objective of the Firm A firm s behaviour depends largely on its aims. Traditionally, economists assume that the objective of a firm is to maximise profits. We talk about profit maximising firms. This is the dominant microeconomic assumption. However, there are other objectives suggested by: (i) managerial model of the firm (ii) the behavioural model of the firm

7 Managerial Model Emphasis on the differences between ownership (shareholders) and control (managers), otherwise known as the principal-agent problem. Shareholders likely to want max profits. Managers may aim for other things: max revenue; mkt share; salaries; easy life Behavioural Model Assumes that firm is comprised of groups/coalitions who each pursue their own objectives (no longer a black box). Workers = better conditions and pay; owners = max profits; consumers = lower prices; government = less pollution

8 2. Production & Time Production = the transformation of inputs into output Inputs in 4 categories also know as Factors of Production (FoPs): land labour (L) capital (K) enterprise Relationship often expressed as a production function: TP = f (L, Land, K, Enterprise)

9 When considering production we distinguish between two time periods: (i) (ii) short run long run Definitions: The short run is a period of time where there is at least one factor of production that cannot change. The long run is a period of time when all the factor of production can be varied in quantity. Discussion: How long is the short run? Ryanair vs. Intel Google and Facebook

10 Short-run Example: Key Chain Production Per Week (1) Workers (2) K (3) Total Product (TP) (4) Average Product (AP) (5) Marginal Product (MP)

11 Key Definitions Total Product (TP): Total amount of units produced. Average Product (AP): The total output divided by the number of units of the variable input utilised. AP = TP/Qv Marginal Product (MP): The change in total output obtained from using an additional unit of a variable input, holding other inputs constant. MP = ΔTP/ΔQv 11

12 Increasing Marginal Returns Occurs when an additional unit of a variable factor adds more to total product than the previous unit. Specialisation of labour (Law of) Diminishing Marginal Returns if at least one factor of production is fixed a point is reached where an additional unit of a variable factor adds less to total product than the previous unit applies only in the short-run (e.g. labour from 4 to 5 units) John Stuart Mill agric production double labour does not double output

13 Key Chain Production: total product, average product and marginal product Non-labour factors of production are held constant. The TP curve divides the graph into attainable and unattainable output. MP L rises sharply until 4 units, with the addition of the fifth worker MP L begins to fall, before eventually becoming negative. Evidence of increasing and decreasing returns to scale. When the MP L curve is rising, the TP curve is becoming steeper and when the MP L curve is falling the TP curve is becoming less steep. When the MP L cuts the horizontal (becomes negative), TP begins to fall. When MP L is higher than AP, AP is rising and vice versa.

14 The Long-run Three possible relationships between inputs and outputs are possible: Increasing returns to scale: Increases in output is proportionately greater than the increase in inputs. Constant returns to scale: Increases in output are proportional to increases in inputs. Double inputs and output also doubles. Decreasing returns to scale: Increase in output is smaller than increase in inputs. Discussion: Examples from industry. 14

15 3. Costs and Profit Costs are payments for the use of the FoPs labour = wages land = rent capital = interest enterprise = profit ( is this a cost??) Economic Profit v Accounting Profit Economists see firms as experiencing two forms of costs: explicit and implicit Explicit: inputs Implicit: opportunity costs wages/interest forgone

16 Two perspectives on profit Economic Profit = TR TC (including both explicit and implicit costs) Accounting Profit = TR Total Explicit Costs Economists View Accountants View Economic Profit Implicit Costs Explicit Costs Accounting Profit Explicit Costs

17 Total Cost (TC) Cost Definitions How much it costs to produce the output. Divided into two elements in the case of a cake store: Total Fixed Costs: Rent on Bakery Total Variable Costs: Labour, flour etc Note, in the LR there are no fixed costs as all inputs are variable. Marginal Cost (MC) The change in total cost as a result of producing the last unit. e.g. If from 1 to 2 units of output, and TC go from 12 to 22 ; then the MC is 10 for the second unit. Average Cost (AC) The TC divided by the number of units produced. e.g. If TC is 300 and TP is 6 units; then AC = 50. In the short-run it is possible to calculate SAFC and SAVC.

18 Revenue Definitions Total Revenue (TR) calculated as P x Qty e.g. sell 100 units at 5 each TR = 500 Marginal Revenue (MR) the change in TR as a result of producing / selling the last unit MR as sales why?

19 Profit Definitions Normal profit the amount (or %) of profit which the entrepreneur requires to supply entrepreneurship the implicit cost need to make this to stay in business otherwise, better off leaving Supernormal profit (i.e. Economic profit) this is the difference between revenue and economic costs over and above the normal

20 Short-run cost curves for Key Chains Ltd STC = SFC + SVC SATC = SAFC + SAVC SMC = ΔSTC/ΔQ

21 In the Key Chains example: SAFC: Falls throughout as overheads are spread over more units produced. SAVC: Falls initially and then rises because of increasing and then decreasing returns to scale (for labour in this case). Remember VC per unit is not falling but AVC is. With the addition of each of the first four workers, MP L increases, and thus the marginal cost to produce key chains falls. When the marginal cost is below the average, the average cost falls and vice versa (the SMC intersects both the SATC and SAVC curves at the lowest points). 21

22 4. Long-run Costs In the long run firms can change all their inputs. Therefore don't differentiate between fixed and variable costs. Three key definitions: Long-run total cost (LTC): the lowest cost of making each output level when a firm can fully adjust Long-run marginal cost (LMC): the in LTC if output by one unit Long-run average cost (LAC): is the LTC divided by the level of output

23 The slope of the long-run average cost curve Long-run average cost curve is thought to be a combination of all three (decreasing, constant and increasing returns to scale) DRTS: Fixed costs, specialisation and machinery ITRS: Managerial diseconomies and geography

24 The U-shaped long-run average cost curve Minimum cost production level

25 The Envelope Curve The LAC curve is said to envelope the SATC curves. Each point on LAC curve is a point of tangency with one SATC curve. Only the minimum point on LAC is also a minimum point on SATC curve. x Note: slightly different abbreviations in this graph. 25

26 5. Profit-Maximising Output Level To decipher this there are two approaches: 1. Using total revenue (TR) and total cost (TC) for each level of production, the profit maximising output level is found where the difference between total revenue and total cost is the largest. 2. The profit maximising output level found where marginal cost equal marginal revenue. Marginal revenue (MR) is the change in total revenue resulting from a one unit change in output. MR = ΔTR/ΔQ

27 Example: Organic Potato Production (1) Q (tons) (2) TR (3) MR (4) TC (5) MC (5) Profit (6) MR- MC (7) Output decision Increase Increase Increase Increase Increase Increase Increase No change Decrease Decrease 27

28 Profit maximisation with total revenue and total cost, marginal revenue and marginal cost When the marginal revenue (MR) is greater than marginal cost (MC), the level of output should be increased and when MR is less than MC, output should be reduced. The graphs shows that the output level associated with the maximum distance between TR and TC is equivalent to the output level associated with the intersection of the MC and MR curves. 28

29 Output decision in short run 1 st condition: MR = SMC (as discussed). 2 nd condition: Firm must at least cover variable costs (P SAVC) where price is sometimes called average revenue. If P>SATC supernormal profits results. If P is between SATC and SAVC the firm is operating at a loss but is covering variable costs and some contribution to fixed costs. If P<SAVC the firm will close. 29

30 Output decision in long run 1 st condition: MR = LMC (as discussed). 2 nd condition: Firm must cover total costs in long run (P SATC). If P>LATC supernormal profits results and firm will stay in business. If P=LATC normal profits result and firm will stay in business. If P<LATC the firm will close. 30

31 6. Producer Surplus Producer surplus is the excess in revenue that a producer receives for a product over the minimum revenue that the producer would have accepted for that product. Long-run: PS is equivalent to economic profit (supernormal profit). Short-run: PS is difference between total revenue and total variable cost and is not equal to equal to economic profit as fixed costs are not taken into consideration. 31

32 Any questions? 32