Costs of Production 4 Nov 2010 Costs of

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Costs of Production 4 Nov 2010

Costs of Production 4 Nov 2010

Costs of Production � Costs are a critical concept � Costs represent a burden

Costs of Production � Costs are a critical concept � Costs represent a burden sustained to carry out activities ◦ Carry out production ◦ Meet certain goals � Costs determine production and pricing � Understand costs and you will understand the supply curve

Review � Profit = Total Revenue – Total Cost � Total Revenue = Price

Review � Profit = Total Revenue – Total Cost � Total Revenue = Price x Quantity � Total Costs = Explicit Costs + Implicit Costs � Implicit Costs ◦ Value of owner’s time (entrepreneurial value) �Difficult to quantify ◦ Opportunity cost of invested capital �Interest rates foregone � Economic Profit= Total Revenue – Opportunity Costs � Opportunity Costs = Implicit + Explicit Costs

Production and Costs Examination of Production Process and the Total Cost

Production and Costs Examination of Production Process and the Total Cost

Production Function (Starbucks) Workers Output Marginal Product of Labor Cost of Facility Cost of

Production Function (Starbucks) Workers Output Marginal Product of Labor Cost of Facility Cost of Total Cost Employees (per hour) 0 0 0 $50 1 12. 5 $50 $10 $60 2 37. 5 25 $50 $20 $70 3 75 37. 5 $50 $30 $80 4 125 50 $40 $90 5 168. 75 43. 75 $50 $100 6 206. 25 37. 5 $50 $60 $110 7 237. 5 31. 25 $50 $70 $120

Output OUTPUT 250 Number of Drinks 200 Inflection Point 150 OUTPUT 100 50 0

Output OUTPUT 250 Number of Drinks 200 Inflection Point 150 OUTPUT 100 50 0 0 1 2 3 4 5 6 7 8 Number of workers

Marginal Product of Labor 60 50 40 30 Marginal Product of Labor 20 10

Marginal Product of Labor 60 50 40 30 Marginal Product of Labor 20 10 0 0 1 2 3 4 5 6 7 8

Total Cost Curve Total Cost $140 $120 $100 $80 Total Cost $60 $40 $20

Total Cost Curve Total Cost $140 $120 $100 $80 Total Cost $60 $40 $20 $0 0 50 100 150 200 250 Output

Behavior of Total Costs and Variable Costs

Behavior of Total Costs and Variable Costs

Measures of Costs � Fixed Costs ◦ Costs that do not vary with the

Measures of Costs � Fixed Costs ◦ Costs that do not vary with the quantity of output � Variable Costs ◦ Costs that vary with the quantity of output produced � In our previous example ◦ Fixed Cost: $50 per hour for the Starbucks facility ◦ Variable Cost: $10 per hour wage

Average and Marginal Costs � How do costs vary as the level of production

Average and Marginal Costs � How do costs vary as the level of production varies? � How much does it cost to run the store? much does it cost when I increase the number of drinks/output?

Average and Marginal Costs � Average Total Cost � Average Fixed Cost � Average

Average and Marginal Costs � Average Total Cost � Average Fixed Cost � Average Variable Cost ◦ Total cost / output ◦ Fixed cost/output ◦ Variable cost/output � Marginal Cost ◦ Increase in total cost that arises from one more unit �MC = (TC 2 -TC 1) / (Q 2 -Q 1)

Average and Marginal Costs (Starbucks) Number of Drinks Total Cost Fixed Cost 0 $50.

Average and Marginal Costs (Starbucks) Number of Drinks Total Cost Fixed Cost 0 $50. 00 $0. 00 $65. 00 $50. 00 $84. 00 12. 5 37. 5 75 125 Variable Cost Average Fixed Costs Average Variable Costs Average Total Cost Marginal Cost 0 0 $15. 00 $4. 00 $1. 20 $5. 20 $1. 20 $50. 00 $34. 00 $1. 33 $0. 91 $2. 24 $0. 76 $107. 00 $50. 00 $57. 00 $0. 67 $0. 76 $1. 43 $0. 61 $134. 00 $50. 00 $84. 00 $0. 40 $0. 67 $1. 07 $0. 54 $0. 30 $0. 68 $0. 98 $0. 71 $0. 24 $0. 73 $0. 97 $0. 93 $0. 21 $0. 80 $1. 01 $1. 25 168. 75 $165. 00 $50. 00 $115. 00 206. 25 $200. 00 $50. 00 $150. 00 237. 5 $239. 00 $50. 00 $189. 00 $0. 00 0

COST CURVES FOR STARBUCKS $6. 00 $5. 00 $4. 00 Average Fixed Costs Average

COST CURVES FOR STARBUCKS $6. 00 $5. 00 $4. 00 Average Fixed Costs Average Variable Costs $3. 00 Average Total Cost Marginal Cost $2. 00 $1. 00 $0. 00 0 50 100 150 200 250

Economies of Scale � The increase in efficiency of production as the number of

Economies of Scale � The increase in efficiency of production as the number of goods being produced increases. � Typically, a company that achieves economies of scale lowers the average cost per unit through increased production ◦ fixed costs are shared over an increased number of goods.

Economies of Scale

Economies of Scale

Competitive Markets Decisions Behind the Supply Curve

Competitive Markets Decisions Behind the Supply Curve

Conditions of Competitive Markets � Many buyers and sellers - individual firms have little

Conditions of Competitive Markets � Many buyers and sellers - individual firms have little effect on the price. � Goods offered are very similar - demand is very elastic for individual firms. � Firms can freely enter or exit the industry no substantial barriers to entry.

Revenue in a Competitive Market � Market Price (P) is given ◦ Firms are

Revenue in a Competitive Market � Market Price (P) is given ◦ Firms are “Price Takers” � Profit = Total Revenue (TR) – Total Cost (TC) � How much does the Firm receive for a “typical unit”? ◦ AVERAGE REVENUE �Total Revenue / Quantity Sold

Average Revenue � TR/Q = (P x Q)/Q = Price � TR/Q = PRICE

Average Revenue � TR/Q = (P x Q)/Q = Price � TR/Q = PRICE

Economists Think at the Margin � How much additional revenue does the firm get

Economists Think at the Margin � How much additional revenue does the firm get if it sells one more unit? ◦ MARGINAL REVENUE �Change in Total Revenue/ Change in Quantity �MARGINAL REVENUE IS ALSO EQUAL TO PRICE!! �SEE NEXT SLIDE

Michelin Hydro. Edge Tires Quantity (Q) Total Revenue (TR = P X Q) Price

Michelin Hydro. Edge Tires Quantity (Q) Total Revenue (TR = P X Q) Price (P) Average Revenue AR = TR/Q Marginal Revenue = CHANGE IN TR/CHANGE IN Q 1 $131. 00 2 $131. 00 $262. 00 $131. 00 3 $131. 00 $393. 00 $131. 00 4 $131. 00 $524. 00 $131. 00 5 $131. 00 $655. 00 $131. 00 6 $131. 00 $786. 00 $131. 00 7 $131. 00 $917. 00 $131. 00 8 $131. 00 $1, 048. 00 $131. 00 9 $131. 00 $1, 179. 00 $131. 00 10 $131. 00 $1, 310. 00 $131. 00

Tim’s Tire Store QUANTITY TOTAL REVENUE TOTAL COST PROFIT (TR-TC) MARGINAL REVENUE (CHANGE TC/

Tim’s Tire Store QUANTITY TOTAL REVENUE TOTAL COST PROFIT (TR-TC) MARGINAL REVENUE (CHANGE TC/ CHANGE IN Q) MARGINAL COST CHANGE IN PROFIT MR- MC 0 $0. 00 $15. 00 -$15. 00 $131. 00 1 $131. 00 $115. 00 $16. 00 $131. 00 $100. 00 $31. 00 2 $262. 00 $219. 00 $43. 00 $131. 00 $104. 00 $27. 00 3 $393. 00 $327. 00 $66. 00 $131. 00 $108. 00 $23. 00 4 $524. 00 $439. 00 $85. 00 $131. 00 $112. 00 $19. 00 5 $655. 00 $555. 00 $100. 00 $131. 00 $116. 00 $15. 00 6 $786. 00 $675. 00 $111. 00 $131. 00 $120. 00 $11. 00 7 $917. 00 $799. 00 $118. 00 $131. 00 $124. 00 $7. 00 8 $1, 048. 00 $927. 00 $121. 00 $131. 00 $128. 00 $3. 00 9 $1, 179. 00 $1, 059. 00 $120. 00 $131. 00 $132. 00 -$1. 00 10 $1, 310. 00 $1, 195. 00 $115. 00 $131. 00 $136. 00 -$5. 00

Profit Maximization � Profit is Maximized where Marginal Revenue is equal to Marginal Cost

Profit Maximization � Profit is Maximized where Marginal Revenue is equal to Marginal Cost � Marginal Cost is always rising � When MR > MC ◦ Revenue is increasing faster than costs ◦ Firm should increase production � When MR < MC ◦ revenue from the additional unit is less than additional cost ◦ the firm should decrease production.

Profit Maximization �A firm maximizes profits when MR = MC.

Profit Maximization �A firm maximizes profits when MR = MC.

Profit Maximization Costs/ Rev MC ATC P=AR=MR Q* Quantity

Profit Maximization Costs/ Rev MC ATC P=AR=MR Q* Quantity

Tim’s Tire Store $160. 00 $140. 00 $120. 00 $100. 00 MR $80. 00

Tim’s Tire Store $160. 00 $140. 00 $120. 00 $100. 00 MR $80. 00 MC ATC $60. 00 $40. 00 $20. 00 $0. 00 0 2 4 6 8 10 12

Marginal Cost Curve is the Supply Curve? � Since MC is upward sloping, as

Marginal Cost Curve is the Supply Curve? � Since MC is upward sloping, as price increases, quantity produced will increase too. � As price falls, quantity produced falls. � In each case, the marginal cost curve determines how much the firm is willing to produce at each price ◦ So it translates into the supply curve

Shutting Down (Temporary) Total Costs = Variable Costs + Fixed Costs If a business

Shutting Down (Temporary) Total Costs = Variable Costs + Fixed Costs If a business shuts down it will only incur FIXED COSTS (it will not have any revenue either)

Shutting Down (Temporary) � Company should produce if it can cover its variable costs

Shutting Down (Temporary) � Company should produce if it can cover its variable costs � Total Revenue > Total Variable Costs ◦ Or how about…. AR > AVC �It means the same thing, we are just adjusting the inequality for quantity � Shut down would occur if/when Price falls below the level of the Average Variable Cost ◦ Rember: PRICE is also AVERAGE REVENUE

Short Run Supply COSTS MC ATC AVC Shut down: P < AVC QUANTITY

Short Run Supply COSTS MC ATC AVC Shut down: P < AVC QUANTITY

Long Run Decisions � In � If the long run, all costs are variable

Long Run Decisions � In � If the long run, all costs are variable Total Revenue is less than Total Costs ◦ Or if Average Revenue is less than Average Total Cost ◦ Firm will shut down

Long Run Supply Curve COSTS MC ATC P = AR QUANTITY

Long Run Supply Curve COSTS MC ATC P = AR QUANTITY

Parting Thoughts � In the long run, a firm will enter or exit the

Parting Thoughts � In the long run, a firm will enter or exit the market until profit is zero � Profit = TR – TC � Total Cost includes all the opportunity costs of the firm � ZERO PROFIT is EQUILIBRIUM CONDITION ◦ Even if profit is zero, the firm has met satisfaction of opportunity costs

Monopoly Monopolistic Competition

Monopoly Monopolistic Competition

What is a monopoly? � One and only one firm that produces a good

What is a monopoly? � One and only one firm that produces a good (or offers a unique service) � Characteristics ◦ Barriers to entry ◦ No close substitutes

Monopolies are… � PRICE � Recall MAKERS! from our previous discussion that competitive firms

Monopolies are… � PRICE � Recall MAKERS! from our previous discussion that competitive firms are price takers

Examples � De. Beers Diamonds � ALCOA (Aluminum) � The cable company � Utilities

Examples � De. Beers Diamonds � ALCOA (Aluminum) � The cable company � Utilities (gas, electric, etc) � Morton Salt

Monopoly Quirks � Monopoly’s power exists in its power to sell ◦ In other

Monopoly Quirks � Monopoly’s power exists in its power to sell ◦ In other words, its profits depend upon DEMAND ◦ The market demand company demand curve are one and the same � Like a competitive firm, a monopoly’s profits are maximized where ◦ MR = MC � However, monopoly price will be well above the point where MR = MC

Monopoly Example MC ATC PROFIT MAX DEMAND MR

Monopoly Example MC ATC PROFIT MAX DEMAND MR

Antitrust � Government regulation to attack efficiency loss of monopoly � Break up monopolies

Antitrust � Government regulation to attack efficiency loss of monopoly � Break up monopolies ◦ AT&T � Prevent mergers? � Fining companies that collude or price discriminate ◦ Walmart

Monopolistic Competition � More than one buyer/sellers (several…could be numerous) � Differentiated products (substitutes)

Monopolistic Competition � More than one buyer/sellers (several…could be numerous) � Differentiated products (substitutes) � Firms have sufficient knowledge (do not act as if in a vacuum) � Free entry and exit

Monopolistic Competition (Short Run) � Limited competition at first � Products that are in

Monopolistic Competition (Short Run) � Limited competition at first � Products that are in the market are close, but not exact substitutes � “Every firm has a monopoly of its own product” (British Economist Joan Robinson) � Example: Portable Media PLayer ◦ i. POD AAC m. P 4 ◦ 80% market share

Monopolistic Competition (Short Run) MC Costs ATC D = AR MR Quantity

Monopolistic Competition (Short Run) MC Costs ATC D = AR MR Quantity

Monopolisitically Competitive (Long Run) � Firms that produce close substitutes enter market ◦ There

Monopolisitically Competitive (Long Run) � Firms that produce close substitutes enter market ◦ There is a profit to be made ◦ As long as: ◦ �P > MR=MC P > ATC!

Monopolistic Competition (Long Run) MC ATC D = AR MR ZERO ECONOMIC PROFIT P

Monopolistic Competition (Long Run) MC ATC D = AR MR ZERO ECONOMIC PROFIT P = ATC

Problems with Monopolistic Competition � Inefficiency ◦ Price is always greater than marginal cost

Problems with Monopolistic Competition � Inefficiency ◦ Price is always greater than marginal cost � Excess capacity ◦ Firm not producing at bottom of ATC ◦ Underserving market � Advertising/non-Price Competition ◦ Advertises to attract customers rather than cutting price ◦ Advertising is seen as wasteful

Oligopoly Few Sellers/Similar or Identical Products

Oligopoly Few Sellers/Similar or Identical Products

At the Heart � Game Theory ◦ Psychologists call it theory of social situations

At the Heart � Game Theory ◦ Psychologists call it theory of social situations �After all, Economics is a social science ◦ Cooperative Game Theory ◦ Non-Cooperative Game Theory

Cooperative Game � Rules are enforced within the group � Groups of firms form

Cooperative Game � Rules are enforced within the group � Groups of firms form coalitions and collude � Ever watch “Survivor”?

Non-Cooperative Game � Players make decisions independently � Cooperation is self-enforcing � Does not

Non-Cooperative Game � Players make decisions independently � Cooperation is self-enforcing � Does not exist

Prisoner’s Dilemma SUSPECT 1/SUSPECT 2 Not Confess RAT 5, 5 -4, 10 10, -4

Prisoner’s Dilemma SUSPECT 1/SUSPECT 2 Not Confess RAT 5, 5 -4, 10 10, -4 1, 1 Not Confess RAT

Dominant Strategy in Prisoners Dilemma � “Ratting” � It is the best strategy to

Dominant Strategy in Prisoners Dilemma � “Ratting” � It is the best strategy to pursue, individually, regardless of the strategies pursued by the other player(s)

Prisoner’s Dilemma and Public Goods Issue � Construction of a Bridge � Great for

Prisoner’s Dilemma and Public Goods Issue � Construction of a Bridge � Great for society! � Best for each individual as long as someone else builds the bridge

Firm Behavior and Prisoners Dilemma � It would be great for both firms to

Firm Behavior and Prisoners Dilemma � It would be great for both firms to set a high price ◦ (e. g. , not confess) � The firm who “cheats” by undercutting his competitor with a lower price gets a high payoff

Nash Equilibrium �A Nash Equilibrium is a set of mixed strategies for finite, non-cooperative

Nash Equilibrium �A Nash Equilibrium is a set of mixed strategies for finite, non-cooperative games between two or more players ◦ No player can improve his or her payoff by changing their strategy. ◦ Each player's strategy is an 'optimal' response based on the anticipated rational strategy of the other player(s) in the game. � Nash equilibrium does not necessarily mean the best cumulative payoff for all the players involved

Nash Equilibrium and Prisoner’s Dilemma � Neither suspect confesses ◦ Each derives one (1)

Nash Equilibrium and Prisoner’s Dilemma � Neither suspect confesses ◦ Each derives one (1) measure of utility

Questions?

Questions?