Economics 101: Principles of Economics

1
Economics 101 Principles of Economics

• Lectures on Perfect Competition

2
Short-Run Costs of Production

• A firms production costs equal explicit
  implicit costs (i.e., the opportunity cost of
  their resources -- their value in their next best
  use)
• Economic cost Accounting cost
• Labor explicit cost (w) current expenses
• Capital implicit cost (r) historical price
  depreciation
• Measures of Short-Run Costs
• Total Fixed Costs (TFC) are costs that dont
  depend on level of output
• Costs they cant adjust in short-run (plant and
  equipment)
• Even if they shut-down, they have to pay their
  Fixed costs
• Total Variable Costs (TVC) are costs that do
  depend on level of output
• These can be adjusted in short-run (workers,
  electricity, raw materials)
• More output leads to greater TVC
• Total Cost TFC TVC at each output level
• Because TVC increases with Q, so does TC
• Marginal Cost ?TC/?Q
• How much will cost increase if we make one more
  unit of output?
• How much will a firm save if it makes one fewer
  unit of output?

3
Measures of Average Cost

• Average Fixed Cost (AFC) TFC/Q
• As output increases, AFC decreases.
• Average Variable Cost (AVC) TVC/Q
• Average Total Cost (ATC) TC/Q
• ATC AFC AVC

4
Short-Run Cost Curves

• We typically reverse the axes, so TC curve has
  the shape shown.
• TFC is horizontal line.
• TVC is same distance below TC at all output
  levels.

TC

TVC
49
40
18
TFC

• MC curve is derived from TC curve and is U-shaped
  due to diminishing marginal returns.
• MC ?TVC/?Q
• ?Lw/?Q
• w/MPL
• Under diminishing marginal returns, each extra
  worker adds less to Q ? each extra unit of Q
  requires more workers ? each extra unit of Q will
  cost more

4
Q

MC
Q
4
5
Short-Run Cost Curves

• There are 3 average cost curves
• AVC TVC/Q wL/Q w/APL
• Recall that APL rises to a maximum and then falls
  ? AVC will fall then rise.
• AVC is slope of ray from origin to a point on the
  TVC curve

TC

TVC
49
40
18
TFC
Q

• AFC TFC/Q and declines over the entire range of
  Q
• Fixed costs are spread over more Q

4
ATC

MC
AVC

• ATC AVC AFC
• Its minimum is to right of AVCs because when AVC
  is lowest, AFC still falling, but soon the rising
  AVC overtakes falling AFC
• Vertical distance between ATC and AVC is AFC,
  which becomes smaller smaller as Q increases

AFC
Q
4
6
Marginal-Average Relationships
TC

TVC
49
40
18
TFC
Q

• If Marginal lt Average, Avg is falling
• If Marginal gtAverage, Avg is rising
• ? MC AC at ACs minimum

4
ATC

MC
AVC
Q
4
7
Market Structures

• Continuum of market structures
• Competition Monopolistic Competition
  Oligopoly Monopoly
• many firms/buyers many smaller firms
  small of bigger firms 1 supplier
• free entry/exit free entry/exit
  difficult to enter barriers to entry
• product homogeneity differentiated
  products same or different Q one
  product
• perfect information perfect info
  imperfect info imperfect info
• Examples
• Farmers market fast food, clothes,
  steel , cars, cell phones, local cable
• cereals, aspirin, colas
  ABC/NBC/CBS/Fox local utility
• Microsoft?

8
Demand Curve of a Competitive Firm

• ?-maximization perfect competition
• Price of the product is determined by market S
  D
• Since output is tiny of market output, no
  effect on Pmkt
• Competitive firms D-curve is horizontal ? price
  taker
• ?x,Px ?
• AR TR/Q PQ/Q P
• MR ?TR/ ?Q ?(PQ)/ ?Q P
• When AR is constant, MR AR
• The price can change, not due to one firms
  actions, but due to changes in Income,
  Technology, tastes

9
Short-run Profit Maximization

• Total Revenue (TR) curve is new
• Profit TR - TC
• Implicit (like owners time) explicit costs
  are included
• ? lt 0 even if shut down (Q 0)
• ?max occurs where MR MC

TR
TC
TFC
?

• Now use per-unit cost curves
• ATC AVC AFC
• ATCmin gt AVCmin
• Vertical distance becomes smaller
• Competitive firms D-curve is horiz.
• ?max occurs where MR MC
• Profit (AR - AC)(Q) green box
• (avg profit per unit)( units sold)
• ?max rule does not mean the firm intentionally
  sets P MC price-taker ?adjust Q til MR MC

Output
Q
MC
/unit
ATC
P
PMRAR
AVC
Q
Q
10
Operating at a Loss in the Short-run

• It might be in the best interests of the firm to
  incur a loss
• If P lt ATC , but P gt AVC
• Can either shut down or operate
• Ceasing production may be only temporary until D
  picks up again
• Loss if Q Q2 is yellow rectangle
• Loss if Q 0 is yellow green
• (note that were only using the Q2 level to
  compare at same output)

MC
ATC
/unit
P1
AVC
P2MRAR
P2
Output
Q2
Q1
MC
ATC
/unit

• Loss if Q Q3 is yellow area
• Loss if Q 0 is purple area
• Shutdown point is the minimum of the AVC curve
  since for any price below that it will be more
  profitable (less unprofitable) to stop producing

AVC
P3MRAR
P3
Output
Q3
11
Perfectly Competitive Industries

• Short-run vs. Long-run effects of
  increases/decreases in Demand for
• Increasing-cost industry
• Decreasing-cost industry
• Constant-cost industry

12
Long-Run Costs of Production

• All inputs are variable
• Firms costs can be represented by an Iso-Cost
  line, which identifies all the combinations of
  (L,K) that can be purchased for a given total
  cost.
• TC wL rK
• Rewrite to get K (-w/r)L (TC/r)
• Y-intercept is TC/r
• X-intercept is TC/w
• Slope indicates the relative prices of the inputs
  (slope -2 says hiring 1 more L, means must buy
  2 less K)
• Analogy with consumers budget line
• Exception?
• Consumers are stuck with feasible set
• Firms can increase TC by hiring more inputs and
  paying for them by selling more output

• Assumptions
• Homogeneous labor and capital
• Perfectly competitive input markets

13
Least Cost/Max Output

• At the tangency point, slope of the isoquant
  slope of the isocost line
• MPL/ MPK w/r
• Two ways to interpret
• 1. Least-cost way to produce a given Q
• If firm decides to produce Q2, the
  cost-minimizing way is TC2.
• 2. Maximum output possible for a given TC
• If firm decides to spend TC1, Q1 is the most
  they can produce.

Capital (K)
TC3/r
TC2/r
slope -w/r
TC1/r
Q39
A
Q26
Q13
TC1/w
TC3/w
Labor
TC2/w
14
Output Maximization

• Lets rearrange the equation MPL/ MPK w/r as
  follows
• MPL MPK
• w r
• This says that the firm should use K L in such
  a way that the additional output per dollar spent
  on L additional output per dollar spent on K
• Firm decides to spend TC2. Whats the most Q
  they can make?
• At point A
• MPL 100 widgets, w 20 MPK 25 widgets, r
  25
• MPL/w 5 widgets/dollar
• MPK/r 1 widget/dollar

Capital (K)
TC2/r
A
M
Q2
Q1
Labor
TC2/w

• Firm can increase Q and keep the same total
  cost A ? M
• Spend 1 less on K ? lose 1 widget
• Spend 1 more on L ? gain 5 widgets

15
Cost Minimization

• Interpretation 2, rearrange another way w
  r
• MPL MPK
• This says that the last widget made using L
  should cost the same as the last widget made
  using K.
• Firm decides to make Q1 widgets. Whats the
  least-cost way to do it?
• MPL 10 widgets, w 20 MPK 8 widgets, r
  10
• w/MPL 2/ widget
• r/MPK 1.25/ widget
• Firm can decrease TC and still produce Q1
  widgets B ? N

Capital (K)
TC2/r
TC1/r
N
B
Q1
Labor
TC2/w
TC1/w

• Produce 1 less widget using L ? save 2
• Produce 1 more widget using K ? costs only
  1.25 more

16
Why the Necks are Thicker in New Haven

• Yale vs. Harvard in college hockey
• Harvard recruits small, scrawny, wimps who can
  skate fast
• Yale opts for bigger, huskier, smarter players ?
  who skate a bit more slowly (so what, they got
  skills)
• Rink characteristics are important.
• Harvards pond is larger the arena colder (for
  faster ice).
• Assume there are two inputs to winning speed
  brawn
• Optimization requires that MPspeed/
  Pspeed MPbrawn/Pbrawn
• Playing at Ingalls rink in New Haven, MPspeed ?
  and MPbrawn?

17
Hire the Most Productive Worker?

• Why is the answer sometimes No?
• Lets suppose a firm wants to hire another
  worker. It can hire a higher-skilled or
  low-skilled worker.
• MPhigh skilled 2 MPlow skilled
• But productivity is not the only consideration
• Phigh skilled 3Plow skilled
• Optimization requires that MPhigh /
  Phigh MPlow/Plow
• However, MPhigh / Phigh lt MPlow/Plow
• Therefore, the firm should hire the lower-skilled
  worker because he or she has higher output per
  dollar.

18
Economics of Raising Razing Buildings

• Sometimes its the Price, rather than MP, that
  changes from one location to another
• Parking garage construction uses two inputs
  Concrete Land
• Initially equating MPC/ PC MPLand/Pland in
  suburban America
• If producing parking in downtown urban areas,
  PLand higher, ceteris paribus ?
• MPC/ PC gt MPLand/Pland
• Builder shifts toward Concrete and we see
  high-rise parking structures in cities

• Building demolition dynamite vs. axes
• MPDynamite/ PDynamite ? MPLabor/PLabor
• Which method in Hong Kong vs. USA?
• Plabor much lower in Hong Kong ? Hong Kong
  demolition firms substitute toward L

19
Firms Short-run Supply Curve

• A perfectly competitive firms SR supply curve is
  the same as its MC curve (above min AVC!)
• It shows how much they will supply at any given
  price
• Lower the price ? MR lt MC
• Only above the shutdown point
• At P1, produce Q1 ( ? gt 0 )
• At P2, produce Q2 ( ? gt 0 )
• At P3, produce Q3 ( ? gt 0 )
• At P4, produce Q4
• ( ? lt 0, but better to still operate )
• At P5, produce Q5 0
• ( ? lt 0, but better to shut down)

/unit
MC
SS
P1
P2
ATC
AVC
P3
P4
P5
Output
Q4
Q1
Q2
Q3
Q5
20
Changes in the Firms Supply

• What effects SR supply?
• 1. Changes in price of the product
• P2 to P3, produce less
• 2. Changes in input prices (cost of making the
  product)
• if the price of labor or capital falls, then MC
  falls
• at Q4, MC was 10 per unit (MR)
• After ?wage, at Q4, MC now 6.
• MR gt MC ? increase output and expand along new
  MC curve until MR MC again at Q3
• Capture the profit in the blue triangle

/unit
MC
MC
P2
P3
P MR
10
6
Output
Q4
Q2
Q3
21
Industry Short-run Supply Curve

• A perfectly competitive firms SR supply curve is
  the same as its MC curve (above min AVC!)
• The industry supply curve is found by
  horizontally summing quantity supplied at
  different prices
• Below P0, nobody produces
• At P0, firm C jumps in
• At P1, firm A jumps in
• At P2, firm B jumps in
• Short-run Industry supply slopes up because the
  MC curves slope up ( they slope up because?)
• Put in Industry Demand? equil.
• If greater D ? higher price causes firms to
  supply more (moving up along MCA,B,C , along
  Industry S)

MCB
MCA
/unit
MCC
P3
P2
P1
P0
Output
QC
QB
QA
22
Long-run vs.Short-run Cost curves
/unit
SAC1
SAC7
LAC
SAC3
SAC6
Output

• Long-run is a planning horizon. Under
  uncertainty about future demand, the firm chooses
  which size plant to build, thus determining their
  short-run costs, until its time to build again.
• Pick an output level and build the plant size
  allowing lowest avg cost
• LAC is the lowest average cost attainable when
  all inputs are variable
• If only 7 plant sizes available, LAC is a
  wave-line.
• If lots and lots of plant sizes possible, LAC is
  the smooth line

23
Shape of Long-run AC curves
/unit
LAC
LAC
Output

• Many are U-shaped, but some are L-shaped
• L-shape ? IRS/economies of scale are quickly
  exhausted, CRS exist over a wide range of
  output
• Result both small large firms can exist in
  same industry
• LAC of small hospitals is 29 more than for large
  ones ? declining LAC

• Industry LACsm/LAClg
• hospitals 129
• electric power 112 banking 102
• airlines 100
• trucking 95
• Result small banks big banks exist

24
Market Structure Long-run AC curves
/unit
D industry
LAC tech 1
LAC tech 2
30K
.05Qtotal
Output
.5Qtotal
Qtotal

• Minimum Efficient Scale is the production scale
  at which ATC is a minimum.
• This will vary by industry because production
  technology differs and technology is in part
  responsible for declining LAC.
• Key question Where does LAC reach minimum
  compared to total demand?
• If very low (.05Qtotal), then lots of firms in
  that industry.
• If relatively high (.5Qtotal), then very few
  firms in that industry.
• LAC tech 1 coffee shops, breweries LAC tech 2
  cars, law firms, cola, planes

25
Long-run Equilibrium
/unit
LMC
SMC1
SAC1
P MR AR
12
? short-run
LAC
SAC5
? long-run
LR Supply Curve
7
q1
q5
q2
Output

• Short-run ?-maximizing equilibrium is only
  temporary
• If Price stays at 12, then they start making
  plans to build larger plant (q5)

• If price is expected to fall to 7 in the
  long-run, most profitable output is q2
• What is ? at this output?
• We call this zero economic profit, because LAC
  includes opp. costs of using the inputs in some
  other endeavor. The firm is getting a normal
  rate of return on its inputs. There is positive
  accounting profit.

• LR Supply curve is FLAT when firms face same
  costs. Upward-sloping?