Module 5: Production and costs

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1 Module 5: Production and costs 5.2.1: Demonstration - production of tennis balls Production of anything is essentially a three step process: Inputs are combined Production process Output is produced Activity in live class introduces concept of production Tennis balls produced when a student grabs one from the bucket and passes it along the production line to another bucket. To be counted, the ball must be touched by all workers and cannot be dropped. Start with 2 workers 8 balls produced With 4 workers 11 balls With 6 11 balls With 8 13 balls With balls, but 2 are broken (dropped) With balls (several dropped) The question: Are we better off with 2 workers or with 12? 5.2.2: Production process at a glance Let s look at how the previous example fits into the production process. Our inputs are: workers we changed the number each time, so these are a variable input. buckets these didn t change, so they are a fixed input (We re leaving out the tennis balls here, since they re also outputs) Inputs at the Black Dog: Electric bill fixed Building/kitchen space fixed Mike could open a second store, or expand space but both would cost time, money and other resources Staff variable Goal is 20% of costs, but can run a little high because building setup doesn t allow for full efficiency Labor fluctuates with number of sandwiches sold. Started with 2 cooks; at some point, realized 3rd would move food (and tables) faster. Can t go any higher because there s not room. Whether an input is fixed or variable can depend on the time frame. Long run time in which some inputs are fixed Short run time in which all inputs are variable Kitchen could become variable input if he has time to change it in the long run, essentially, all inputs are variable and there are no fixed inputs Terms economists tend to use: labor in reference to variable inputs (often associated with staffing)

2 capital in reference to fixed inputs (often associated with plant, place, machinery, etc. things that take longer to purchase) 5.2.3: A numerical example - cooks in the kitchen Mike, owner of the Black Dog: As we got busier, determined we d need 3 servers all the time (and sometimes 4) adding more would make it too crowded. Each server gets 4 5 tables. Started with 2 cooks, later added a 3rd, but not space for any more Added folks in the back to do prep work so people on the line can work faster Big consideration is balancing the number of workers against the limited space. As you increase the number of workers and have a fixed input, you run into that fixed input s limitations, which affects productivity. Let s look at one scenario for the Black Dog: The total product curve at the right reflects the schedule of cooks/sandwiches gained that I couldn t get to play nicely with the chart After a point (cook #2), the gains from adding additional cooks become smaller. The Y axis is the marginal product of labor, or MP L. If we followed this chart a little farther, adding more cooks (labor), we d see productivity start to decrease forming an inverted U shape Now let s add in the marginal product how many more sandwiches we add with each cook. MP L = Δ Q Δ L We see a diminishing margin of product for the variable output at some point, you have too many cooks.

3 5.3.1: Fixed, variable and total costs Let s assume Mike has two inputs cooks = \$80/day per worker (variable input) grill = \$100/day (fixed input loan must be paid even if no sandwiches produced or restaurant is closed) Variable costs = # workers x \$80; fixed cost = \$100 Total costs = fixed cost + variable cost (TC = FC + VC) So our table looks like this: # cooks # sandwiches Marginal product Fixed costs Variable costs Total costs \$100 \$0 \$ \$100 \$80 \$ \$100 \$160 \$ \$100 \$240 \$ \$100 \$320 \$ * \$100 \$400 \$ * \$100 \$480 \$580 *Videos list these as 0, possibly for simplification purposes This will produce a chart that looks something like the one at right. This is the total cost curve. Increases slightly at beginning, but shoots up a lot as you go further out. This is because your costs increase steadily, but the gains in number of sandwiches produced are getting smaller. It s a mirror image of the total product curve we flipped the axes. The slope of this curve is called the marginal cost of production tells you how much the cost of production goes up with each additional cook : Marginal costs Marginal costs the additional costs required to produce one more of an item. MC = Δ TC Δ Q

4 # cooks # sandwiches Marginal product Fixed costs Variable costs Total costs Marginal costs \$100 \$0 \$ \$100 \$80 \$180 \$ \$100 \$160 \$260 \$ \$100 \$240 \$340 \$ \$100 \$320 \$420 \$ * \$100 \$400 \$500 \$ * \$100 \$480 \$580 \$40 *Videos list these as 0, presumably for simplification purposes As the marginal product of labor decreases, the marginal costs increase : Cost curves # cooks # sandwiches Average fixed cost (AFC) Average variable cost (AVC) Average total cost (ATC) Marginal cost (MC) \$2.50 \$2 \$4.50 \$ \$1.11 \$1.78 \$2.89 \$ \$0.83 \$2 \$2.83 \$ \$0.74 \$2.37 \$3.11 \$ \$0.71 \$2.86 \$3.57 \$ \$0.70 \$3.38 \$4.08 \$40 Calculating per unit basis for fixed costs ( average fixed cost ) Average fixed costs = fixed costs/output (AFC = FC/Q) Higher at the beginning, but goes down as output increases Calculating average variable cost Average variable cost = variable cost/output (AVC = VC/Q) Will go up at some point because more workers are being paid the same money, regardless of how productive they are Average total cost per unit (ATC) = AVC + AFC Same as TC/Q

5 Note that average total cost goes down for the first three cooks, then starts to rise again. The lowest point on the average total cost curve (\$2.83) is the minimum cost output the lowest cost per sandwich we can achieve. This is the most efficient use of resources the best possible way of doing this. The marginal cost curve crosses the average total cost curve at this point. This isn t coincidence, but a mathematical property. When the marginal is higher than the average, your average will go up. When the marginal s lower than the average, your average will go down. Module 6: Competitive output 6.2.1: The maximizing profit assumption Probably best explained in the greed is good speech from Wall Street Greed is what drives the economy, what drives people to innovate ultimately means more jobs, food on the table, etc. For our purposes, we ll assume any company, manager, etc. is driven by greed that their only goal is to get the highest possible profit (though in reality, there are lots of other reasons one might start a company). Profit = Revenue Cost (or π = R TC) We use π for profit because P = price, and TC = total cost 6.2.2: The profit equation Let s say you own a BBQ sandwich joint, and at current production levels, your economic profits are zero. Which of the following should you do? Continue to operate your business Get out of the business Expand operations Reduce operations Economic theory says you should keep doing what you re doing if your economic profits are zero, you re actually doing pretty well. This differs from most people s knee jerk response, which is to reduce operations or to cut and run. To understand why, you must understand the difference between economic profits and accounting profits.

7 Let s go back to our table from last week, with profits added: # cooks # sandwiches Average fixed cost (AFC) Average variable cost (AVC) Average total cost (ATC) Marginal cost (MC) Profits ( π) \$2.50 \$2 \$4.50 \$2 \$ \$1.11 \$1.78 \$2.89 \$1.60 \$ \$0.83 \$2 \$2.83 \$2.70 \$ \$0.74 \$2.37 \$3.11 \$5.30 \$ \$0.71 \$2.86 \$3.57 \$16 \$ \$0.70 \$3.38 \$4.08 \$40 \$556 With the table in front of us, it s clear that reducing output from 142 to 140 would let you get rid of a cook, raising profits from \$556 to \$620. Knowing that, our answer to the first question is that we should reduce output. We could not answer that question without knowing the marginal cost change. The chart also indicates that the best output for maximizing profits is 135 sandwiches (\$660 profits). What happens if we produce a different output? Say you have 4 cooks (for maximum profits) and decide to add a 5th anyway. change in Q = 5 ATC = (\$3.57 \$3.11) = \$0.46 Hiring another worker increases cost for each of those 5 extra sandwiches from \$5.30 to \$16 while you re getting just \$8 in revenue per sandwich. What if you re using 3 cooks and making 120 sandwiches, and are looking to go to 4 cooks/135 sandwiches? change in Q = +15 Marginal cost of those sandwiches rises from \$2.70 to \$5.30, which is still lower than the revenue being brought in per sandwich. π = R C = \$2.70 in profits Profits will rise as long as revenue rises more than costs. If MR > MC of last unit you should produce more If costs rise more than revenue, profits will go down. If MR < MC of last unit you should reduce output If MR = MC, that s the highest profits the rule we were looking for earlier.

9 Profits will probably be negative no matter how many cooks you hire. Whether your store stays open or not, fixed costs (such as loans) must be paid. So the real question is: Should you hire cooks and produce sandwiches, or just close? Even though you re still in the red, producing 135 sandwiches results in less of a loss than producing just 40 ( \$40 vs. \$560). The short run is the period of time in which you can t get rid of certain fixed costs. Decision is essentially shutdown or no : Shut down and not incur variable costs Incur variable costs to help cover some of the fixed costs If P < AVC (price is less than average variable cost), you should shut down. Otherwise, you should continue operating in the short term, even if you have losses. So why are the losses less when you sell 135 sandwiches? Revenue per unit is more than variable cost per unit Q = 135 R = 135 x \$8 = \$1,080 VC = 4 x \$80 = \$320 \$1,080 \$320 = \$760 left over to put toward fixed costs FC = \$800 \$760 = \$40 If the store hadn t opened, you wouldn t have that \$760 to cover at least some of the fixed costs : Long-run competitive output Say Mike s BBQ sandwich business is doing really well (with lines of people waiting at all hours) in a perfectly competitive environment. What do we expect to happen to the price of BBQ sandwiches in the Urbana area in the long term? To answer that, we have to understand a little bit about the market. In the long run, Mike will face more competition. If other entrepreneurs see Mike s doing really well for himself, there s incentive for them to try to enter the market and compete with him. In the long run, companies have time to buy locations and enter the market. And even Mike s considering competing with himself by opening a second location which could split his customer base in half. The increased competition will put downward pressure on the price (which is good for consumers). This will last however long BBQ sandwich places continue to do well and competitors keep entering the market. It ends when profits are eliminated (P = ATC). At this point, companies will be operating at most efficient output.

10 And now, a visual. Left chart is the typical firm in this competitive market, which has no barriers to entry. All firms have same cost structure Firm quantity (q) replaces market quantity (Q) on horizontal axis. If you have 10 firms, market quantity is the output of whatever each of those firms make. Right chart is the market. The firm will operate as best it can given the price set in the market (market equilibrium). We know that a firm maximizes revenue when marginal revenue = marginal cost. In a perfectly competitive industry, marginal revenue is the same as price (MR = P) If TR = PQ and P is always the same, every increase in output will increase TR. (This is q1 on left chart.) The area between MC and ATC at q1 is profits (P (ATC)q). If MC is higher than ATC at that point, the firm is making profits As more companies enter the market, the supply curve shifts right this drives down prices, which in turn reduces profits. If the supply curve is driven far enough right that the market price hits the lowest point on the ATC curve, each firm is going to produce a little less than Mike was producing. Equilibrium occurs when P = MC = ATC at that point, companies are making zero profits Survival of the fittest in play the firms that are most efficient will survive in the long run, when competition boils down to whose costs are lowest : Using the long-run equilibrium model Now let s try some examples with the long run equilibrium model:

11 Here, we have another set of firm and market charts for BBQ sandwiches. P1 is the equilibrium price set by the market, equal to market revenue. Firms are competing, so they can t change the price. The marginal cost curve and average total cost intersect at P1, meaning the firm is making zero profits. This company is operating on long run equilibrium there s no incentive for firms to enter or leave the market. Let s say demand picks up for BBQ sandwiches the demand curve shifts right (D2) That increases the market price for BBQ sandwiches (P2), so firms can charge more. In the short term, this firm is now making profits MC exceeds ATC (q2). Companies have incentive to enter the market or expand, increasing the supply (S2) and eliminating profits. This puts us back at the original equilibrium. But the quantity of BBQ sandwiches remains higher (Q3). This can also be explained intuitively: The demand for BBQ sandwiches in the area increased, and stores saw this as a positive they increased the prices to make more revenue and a lot more profits. In the long term, entrepreneurs seize on this opportunity and enter the market, ultimately wiping out those short term profits. Once this process settles down, the market has returned to the equilibrium price but now has a much higher quantity of sandwiches. Say the market for haircuts in a community is perfectly competitive and that the market is initially in long run equilibrium. An increase* in population increases the demand for haircuts. In the short run, we expect that the market price will and the output of a typical firm will. (Options: rise/rise, rise/fall, fall/rise, fall/fall, not change/fall) Rise/rise. Scenario is very similar to that from the previous question.

12 Now let s diagram it: * Note: The video is confusing in that it starts out with decrease but changes to increase thereafter. If it were decrease, the answer would be fall/fall seen in red on the diagram above : The long-run supply curve So far, we ve been laboring under a fairly strong assumption: that the lowest point of the average total cost curve doesn t change in response to changes in the market. Let s relax that assumption and look at three situations possible in the long run: In a constant cost industry like the scenario in our previous examples the long run supply curve is a flat line between points A and B (Q1 and Q2). In increasing cost industries, increased competition results in increasing average production cost the long run supply curve is upward sloping. As more firms enter the market, the price will continue to increase. Examples: oil or anything involving limited resources that are difficult to extract. In decreasing cost industries, increased competition results in decreasing average production cost the long run supply curve is downward sloping. As more firms enter the market, the price will continue to increase. Examples: computers or other industries in which companies can take advantage of things like economies of scale.

= AFC + AVC = (FC + VC)

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Guns Butter 200 0 175 75 130 125 70 150 0 160 What it shows: the maximum combinations of two goods an economy can produce with its existing resources and technology; an economy can produce at points on