ECON 110 Introductory Microeconomics

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ECON 110Introductory Microeconomics

• Lecture 10
• Fall, 2009
• William Chow

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Highlights

• Background of Firms Problem
• Constraints firms face
• Short and Long Run
• Product Curves

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The Firm

• A firm is an institution that hires factors of
  production and organizes them to produce and sell
  goods and services.
• The Firms Goal - A firms goal is to maximize
  profit.
• If the firm fails to maximize profit, it is
  either eliminated or bought out by other firms
  seeking to maximize profit.

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The Firm

• Relationship between firms and markets
• Firms coordinate production when they can do so
  more efficiently than a market.
• Four key reasons might make firms more efficient.
• Lower transactions costs
• Economies of scale
• Economies of scope
• Economies of team production

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The Firm

• Transactions costs are the costs arising from
  finding someone with whom to do business,
  reaching agreement on the price and other aspects
  of the exchange, and ensuring that the terms of
  the agreement are fulfilled.
• Economies of scale occur when the cost of
  producing a unit of a good falls as its output
  rate increases.
• Economies of scope arise when a firm can use
  specialized inputs to produce a range of
  different goods at a lower cost than otherwise.
• Firms can engage in team production, in which the
  individuals specialize in mutually supporting
  tasks.

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The Firm

• The above can be easily understood by imagining a
  society with no firms but only individual
  entities.
• Suppose we have 2 tailors and 2 farmers, then
  resources will be better used and cost saved if
  we organize them into 1 clothing company and 1
  agricultural company. Overall efficiency will
  therefore be enhanced.

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The Firm

• In pursuing profit maximization, the firm also
  faces constraints
• Technology
• Information
• Market
• We will look at this objective and constraints
  separately.

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Economic Profit

• A firms decisions respond to opportunity cost
  and economic profit.
• Note that they differ from accounting cost and
  accounting profit.
• Opportunity cost includes both
• Explicit costs - costs paid directly in money,
  e.g. wages you paid your employees.
• Implicit costs - costs incurred when a firm uses
  its own capital or its owners time for which it
  does not make a direct money payment, e.g.
  forgone value of using your managerial skills.

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Economic Profit

• Economic Profit
• Total Revenue Opportunity Cost
• Total Revenue (Implicit Cost Explicit
  Cost)
• Accounting Profit
• Total Revenue Accounting Cost
• Total Revenue Explicit Cost
• Thus Economic Profit is usually smaller than
  Accounting Profit.
• It still makes sense for firms to operate under
  situation where economic profit 0 ----- Why?

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Implicit Cost

• Capital
• The firm can rent capital and pay an explicit
  rental cost reflecting the opportunity cost of
  using the capital.
• The firm can also buy capital and incur an
  implicit opportunity cost of using its own
  capital, called the implicit rental rate of
  capital.
• The implicit rental rate of capital is made up
  of
• Economic depreciation
• Interest forgone

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Implicit Cost

• Economic depreciation is the change in the market
  value of capital over a given period.
• Interest forgone is the return on the funds used
  to acquire the capital.
• Owners entrepreneurial ability and labor
  expended in running the business
• The opportunity cost of entrepreneurial ability
  is the average return from this contribution that
  can be expected from running another firm. This
  return is called a normal profit.

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Implicit Cost

• The opportunity cost of the owners labor spent
  running the business is the wage income forgone
  by not working in the next best alternative job.
• Normal profit is part of the firms opportunity
  costs, so economic profit is profit over and
  above normal profit.

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Example
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The Firms Constraints

• Technology Constraints
• Technology is any method of producing a good or
  service.
• Technology advances over time.
• Using the available technology, the firm can
  produce more only if it hires more resources,
  which will increase its costs and limit the
  profit of additional output.

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The Firms Constraints

• Information Constraints
• A firm never possesses complete information about
  either the present or the future.
• It is constrained by limited information about
  the quality and effort of its work force, current
  and future buying plans of its customers, and the
  plans of its competitors.
• The cost of coping with limited information
  limits profit.

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The Firms Constraints

• Market Constraints
• What a firm can sell and the price it can obtain
  are constrained by its customers willingness to
  pay and by the prices and marketing efforts of
  other firms. (Even if you are the sole producer,
  you cant force people to buy.)
• The resources that a firm can buy and the prices
  it must pay for them are limited by the
  willingness of people to work for and invest in
  the firm.
• The expenditures a firm incurs to overcome these
  market constraints will limit the profit the firm
  can make.

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Technology and Economic Efficiency

• Technological efficiency occurs when a firm
  produces a given level of output by using the
  least amount of inputs.
• There may be different combinations of inputs to
  use for producing a given level of output.
  (Similar to the idea of indifference curves in
  consumption choices this time we consider
  combining different inputs to produce a fixed
  amount of output.)
• If it is impossible to maintain output by
  decreasing any one input, holding all other
  inputs constant, then production is
  technologically efficient.

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Technology and Economic Efficiency

• Economic efficiency occurs when the firm produces
  a given level of output at the least cost.
• The difference between technological and economic
  efficiency is that technological efficiency is
  concerned with the quantity of inputs used in
  production for a given level of output, whereas
  economic efficiency is concerned with the cost of
  the inputs used.

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Example Technological Efficiency
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Example Economic Efficiency
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Information

• A firm organizes production by combining and
  coordinating productive resources using a mixture
  of two systems
• Command systems - commands pass downward through
  the managerial hierarchy and information
  (feedback) passes upward.
• Incentive systems - uses market-like mechanisms
  to induce workers to perform in ways that
  maximize the firms profit.

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Information

• Most firms use a mix of command and incentive
  systems to maximize profit.
• They use commands when it is easy to monitor
  performance or when a small deviation from the
  ideal performance is very costly.
• They use incentives whenever monitoring
  performance is impossible or too costly to be
  worth doing.

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The Principal-Agent Problem

• The principal-agent problem is the problem of
  devising compensation rules that induce an agent
  to act in the best interests of a principal.
• For example, the stockholders of a firm are the
  principals and the managers of the firm are their
  agents.
• Also, the Enron Incident.
• Three ways of coping with the principal-agent
  problem are
• Ownership
• Incentive pay
• Long-term contracts

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The Principal-Agent Problem

• Ownership, often offered to managers, gives the
  managers an incentive to maximize the firms
  profits, which is the goal of the owners, the
  principals.
• Incentive pay links managers or workers pay to
  the firms performance and helps align the
  managers and workers interests with those of
  the owners, the principals.
• Long-term contracts can tie managers or workers
  long-term rewards to the long-term performance of
  the firm. This arrangement encourages the agents
  to work in the best long-term interests of the
  firm owners, the principals.

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Decision Time Frames

• The Short Run
• The short run is a time frame in which the
  quantity of one or more resources used in
  production is fixed.
• For most firms, the capital, called the firms
  plant, is fixed in the short run.
• Other resources used by the firm (such as labor,
  raw materials, and energy) can be changed in the
  short run.
• Short-run decisions are easily reversed.

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Decision Time Frames

• The Long Run
• The long run is a time frame in which the
  quantities of all resourcesincluding the plant
  sizecan be varied.
• Long-run decisions are not easily reversed.
• A sunk cost is a cost incurred by the firm and
  cannot be changed.
• If a firms plant has no resale value, the amount
  paid for it is a sunk cost.
• Sunk costs are irrelevant to a firms decisions.

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Short Run Technology Constraint

• To increase output in the SR, a firm must
  increase the amount of labor employed (since
  capital is held fixed in the SR).
• Three concepts describe the relationship between
  output and the quantity of labor employed
• Total product is the total output produced in a
  given period.
• The marginal product of labor is the change in
  total product that results from a one-unit
  increase in the quantity of labor employed, with
  all other inputs remaining the same.
• The average product of labor is equal to total
  product divided by the quantity of labor employed.

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Short Run Technology Constraint

• Total product Q
• Marginal product ?Q/?L
• Average product Q/L

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Total Product Curve

• The total product curve shows how total product
  changes with the quantity of labor employed.
• It separates attainable output levels from
  unattainable output levels in the short run.

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Total Product Curve

• The height of each bar measures the marginal
  product of labor.
• For example, when labor increases from 2 to 3,
  total product increases from 10 to 13, so the
  marginal product of the third worker is 3 units
  of output.

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Marginal Product Curve

• To make a graph of the marginal product of labor,
  we can stack the bars in the previous graph side
  by side.
• The marginal product of labor curve passes
  through the mid-points of these bars.

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Marginal Product Curve
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Marginal Product Curve

• We observe from the previous slide the following
• Initially, when the marginal product of a worker
  exceeds the marginal product of the previous
  worker, the marginal product of labor increases
  and the firm experiences increasing marginal
  returns.
• Subsequently, when the marginal product of a
  worker is less than the marginal product of the
  previous worker, the marginal product of labor
  decreases and the firm experiences diminishing
  marginal returns.

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Marginal Product Curve

• Can we justify what we observed?
• Increasing marginal returns arise from increased
  specialization and division of labor.
• Diminishing marginal returns arises from the fact
  that employing additional units of labor means
  each worker has less access to capital and less
  space in which to work i.e. coordination and
  congestion problems.
• The law of diminishing returns states that as a
  firm uses more of a variable input with a given
  quantity of fixed inputs, the marginal product of
  the variable input eventually diminishes.

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Average Product Curve

• How can we derive the Average Product Curve?
• Note that AP by definition Q/L
• Thus, if you draw a straight line from the point
  of origin to a point on the Total Product Curve,
  the AP for that point will equal to the slope of
  that straight line you drew.
• By doing this successively, you obtain a
  hump-shaped Average Product Curve (The MP curve
  is also hump-shaped).

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AP and MP
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AP and MP

• Important Observation
• When marginal product exceeds average product,
  average product increases.
• When marginal product is below average product,
  average product decreases.
• When marginal product equals average product,
  average product is at its maximum.

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AP and MP

• Intuition with example
• Class Size 100
• Average midterm score for the other 99 students
  excluding yourself 70
• If your score, the marginal (100th) score, is
  80, then the average for the whole class
• (99 x 70) (1 x 80) / 100 70.1
• Thus when the marginal is greater than the
  average (80 gt 70), then the average must increase
  ( from 70 to 70.1)

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AP and MP

• If your score, the marginal (100th) score, is
  60, then the average for the whole class
• (99 x 70) (1 x 60) / 100 69.9
• Thus when the marginal is smaller than the
  average (60 lt 70), then the average must decrease
  ( from 70 to 69.9)
• It is easy to see that if the marginal score
  equals the existing average in this example,
  there will be no change in the average for the
  whole class.

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Practical Example

• Are all these observations valid from a practical
  perspective?
• Consider a logistic company before you can
  anchor any business, you have to invest in a
  warehouse, a team of vans, an office and other
  fixtures, office equipments, and a team of
  workers to handle the delivery of items.
• Some of these are obviously fixed in the SR.
  Initially, as you increase output, all you need
  is still one warehouse (provided it is big
  enough), one office, and a fixed number of
  vehicles.
• You can vary the amount of labor you employ even
  in the SR.
• Suppose we have the following hypothetical
  figures

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Practical Example
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Practical Example

• Note that MP stops increasing after the
  employment of the 3rd worker. Thereafter, MP is
  still positive but becomes smaller with further
  employment.
• This occurs because the number of trips that a
  van can make in any day and the corresponding
  load that it can carry will be limited.
• You can still produce more by hiring more workers
  to deliver parcels. The van will still make a
  fixed amount of trip each day, and drop off these
  workers at a drop-off point from which the
  workers are to deliver the parcels by hand.

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Practical Example

• With 3 workers, the 3rd worker will be more
  productive marginally since he only has to wait
  for 2 colleagues before the van can take off for
  the next destination.
• With 4 workers, the 4th worker will have to wait
  for 3 colleagues, resulting in a loss of time
  that can be used for other delivery job.
• Well see how TP, MP and AP are related to Total
  Cost, Marginal Cost and Average Cost in the next
  lecture.