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Microeconomics Lecture 4-5

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Title: Microeconomics Lecture 4-5


1
Microeconomics Lecture 4-5
Mónika Kis-Orloczki Assistant lecturer orloczki.mo
nika_at_uni-miskolc.hu
2
  • production The process by which inputs are
    combined, transformed, and turned into outputs.
  • firm An organization that comes into being when
    a person or a group of people decides to produce
    a good or service to meet a perceived demand.
    Most firms exist to make a profit.

3
The Three Decisions That All Firms Must Make
  • 1. How much output to supply
  • 2. Which production technology to use
  • 3. How much of each input to demand
  • The bases of decision making
  • 1. The market price of output
  • 2. The techniques of production that are
    available
  • 3. The prices of inputs
  • Output price determines potential revenues. The
    techniques available tell me how much of each
    input I need, and input prices tell me how much
    they will cost. Together, the available
    production techniques and the prices of inputs
    determine costs.

4
Determining the Optimal Method of Production
optimal method of production The production
method that minimizes cost.
5
Time Horizons for Decision Making
  • The short run is a period of time in which some
    of the firms factors of production are fixed.
    Typically capital is fixed in the short run.
  • Fixed factor An input whose quantity cannot be
    changed in the short run.
  • Variable factor An input whose quantity can be
    changed over the time period under
    consideration.
  • The long run is the length of time over which all
    of the firms factors of production can be
    varied, but its technology is fixed.
  • The very long run is the length of time over
    which all the firms factors of production and
    its technological possibilities can change.

6
1. The Short-run Production Process
  • Production function A numerical or mathematical
    expression of a relationship between inputs and
    outputs. It shows units of total product as a
    function of units of inputs.
  • Total product of labour total quantity of output
    produced with a given quantity of a variable
    input.
  • TP or Q f (L)
  • where
  • TP or Q total product or quantity of output
  • L quantity of labor input
  • (quantity of capital input is fixed)

7
  • Marginal product the additional output produced
    with an additional unit of variable input
  • MP ?TP / ?L ?Q / ?L
  • Average product amount of output per unit of
    variable input. The productivity of an individual
    worker
  • AP TP / L or Q / L

8
C
110
90
B
Output, q, Units per day
56
A
11
6
4
L, Workers per day
a
MP
L
20
,
AP
b
15
Average product, APL
Marginal product, MPL
c
11
6
4
L, Workers per day
9
Between zero and b, MP curve lies above AP curve,
causing AP curve to increase. Below b, MP curve
is below AP curve, causing AP curve to
decrease. Therefore, MP curve must intersect AP
curve at maximum point of AP curve.
TP increases rapidly up to level of labor input A
then increases at a slower rate as labor input
increases. TP curve becomes flatter and flatter
until it reaches maximum output level at C. Curve
implies that marginal product of labor first
increases rapidly then decreases, eventually
becoming zero or less.
10
  • Increasing marginal returns region where MP
    curve is positive and increasing
  • Law of diminishing returns region where marginal
    product curve is positive but decreasing
  • Negative marginal returns region where product
    curve is negative so that TP is decreasing
  • Law of Diminishing Returns
  • Occurs because capital input and technologies are
    held constant
  • Additional output generated by additional units
    of variable input (MP)
  • Production becomes less constrained

11
  • Elasticity of production
  • The Relationship between Marginal and Average
    Product




11
12
2. Long-run decisions
  • In the long run, all inputs are variable.
  • Relationship between a flow of inputs and the
    resulting flow of output where all inputs are
    variable
  • Q f (L, K)
  • where
  • Q quantity of output
  • L quantity of labor input (variable)
  • K quantity of capital input (variable)
  • both inputs are variable

13
Technical versus Economic Efficiency
  • Technical efficiency Obtaining the greatest
    possible production of goods and services from
    available resources. In other words, resources
    are not wasted in the production process.
  • Technical efficiency is not enough for firms to
    maximize profits. The firm must choose among the
    technically efficient options to produce a given
    level of output at the lowest cost Economic
    efficiency

14
Profit Maximization and Cost Minimization
  • For any level of output, maximizing profits
    requires firms to choose their inputs to minimize
    total costs.
  • A firm is not minimizing costs if it is possible
    to substitute one factor for another to keep
    output constant while reducing total cost
  • ? The firm should substitute one factor for
    another factor as long as the marginal product of
    one factor per dollar spent on it is greater than
    the marginal product of the other factor per
    dollar spent on it.

15
  • Labor-intensive method process that uses large
    amounts of labor relative to other inputs
  • Capital-intensive method process that uses large
    amounts of capital equipment relative to other
    inputs
  • Input substitution degree to which one input can
    be substituted for another
  • Can occur in small-scale or large-scale business
  • Some processes may not be conducive to
    substitution
  • Issue is whether the same quality output is being
    produced with input substitution
  • Factors influencing input substitution
  • Technology
  • Prices of inputs
  • Incentives facing a given producer

16
  • Isoquant A graph that shows all the combinations
    of capital and labor that can be used to produce
    a given amount of output.

K
Input Labour Labour Labour Labour Labour
Capital 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120
5
3
Q75
1
2
L
17
  • Properties of Isoquants
  • The farther an isoquant is from the origin, the
    greater the level of output.
  • Isoquants do not cross.
  • Isoquants slope downward
  • Marginal rate of technical substitution (MRTS)
    The slope of an isoquant, or the rate at which a
    firm is able to substitute one input for another
    while keeping the level of output constant.

18
Substitution Among Inputs

K
a
16
b
10
3
c
1
7
d
2
1
5
e
1
4
1
0
1
2
3
4
5
6
7
8
9
10
L
19
Substitutability of Inputs
Isoquants When Inputs Are Perfect Substitutes
Fixed-Proportions Production Function
20
Holding the amount of capital fixed at a
particular level (say 3), we can see that each
additional unit of labor generates less and less
additional output.
21
  • Isocost line A graph that shows all the
    combinations of capital and labor available for a
    given total cost.
  • Slope of isocost line
  • Movements of the isocost line
  • Change in the budget constraint
  • The price ratio of the two inputs changes

22
Finding The Least-cost Technology with Isoquants
and Isocosts
The firm will choose the combination of inputs
that is least costly. The least costly way to
produce any given level of output is indicated by
the point of tangency between an isocost line
(TC) and the isoquant (Q) corresponding to that
level of output.
23
Finding The Least-cost Technology with Isoquants
and Isocosts
  • At the point where a line is just tangent to a
    curve, the two have the same slope. At each point
    of tangency, the following must be true

Thus,
Dividing both sides by PL and multiplying both
sides by MPK, we get
24
Example
  • Suppose the marginal product of capital is 40
    units of output and the price of one unit of
    capital is 10. The marginal product of labor is
    20 units of output and the price of one unit of
    labor is 2.
  • In this case, the firm can reduce the cost of
    producing its current level of output by using
    more labor and less capital.

25
How does output respond to increases in all
inputs together?
  • Increasing returns to scale output increases
    more than in proportion to inputs as the scale of
    a firms production increases.
  • Constant returns to scale output increases in
    proportion to inputs as the scale of a firms
    production increases.
  • Decreasing returns to scale output increases
    less than in proportion to inputs as the scale of
    a firms production increases.

26
3. The Very Long Run Changes In Technology
  • In the very long run, there are changes in the
    available techniques and resources for firms.
    Such changes shifts the long-run cost curves.
  • Technological change refers to all changes in
    the available techniques of production.
  • Economists use the notion of productivity to
    measure the extent of technological change.
  • Faced with increases in the price of an input,
    firms may either substitute away (LR) or innovate
    away (VLR) from the input.
  • These two options can involve different actions
    and can have different implications for
    productivity.

27
Microeconomics Lecture 6
Mónika Kis-Orloczki Assistant lecturer orloczki.mo
nika_at_uni-miskolc.hu
28
  • Explicit costs payment to an individual that is
    recorded in an accounting system.
  • Implicit costs value of using a resource that is
    not explicitly paid out, is often difficult to
    measure, and partly not recorded in an accounting
    system.
  • Economic depreciation measured as the change in
    the market value of capital over a given period.
  • Normal profit is the return to entrepreneurship.
    A rate of return on capital that is just
    sufficient to keep owners and investors
    satisfied. For relatively risk-free firms, it
    should be nearly the same as the interest rate on
    risk-free government bonds. It is part of a
    firms economic cost because it is the cost of
    the entrepreneur not running another firm. It is
    the minimum level of profit required to keep the
    factors of production in their current use in the
    long run.

29
  • Total revenue The amount received from the sale
    of the product (Q x P).
  • Total cost (total economic cost) The total of
    explicit (out-of-pocket) and implicit costs.
  • Accounting profit difference between total
    revenue and accountable costs (explicit costs
    accountable implicit costs (for example
    depreciation).
  • Economic profit difference between total revenue
    and total cost, both implicit and explicit.
  • ? TR - TC

30
Implicit Costs versus Explicit Costs, an example
Pizza dough, tomato sauce, and other ingredients 20,000
Wages 48,000
Interest payments on loan to buy pizza ovens 10,000
Electricity 6,000
Lease payment for store 24,000
Foregone salary 30,000
Foregone interest 3,000
Economic depreciation 10,000
Total 151,000
31
Costs and revenues of the firm
32
Short-Run Costs and Output Decisions
  • Fixed cost (FC) Any cost that does not depend on
    the firms level of output. These costs are
    incurred even if the firm is producing nothing.
    There are no fixed costs in the long run.
  • Variable cost (VC) A cost that depends on the
    level of production chosen.
  • Total cost (TC) Fixed costs plus variable costs.

33
  • Average fixed cost (AFC) Total fixed cost divided
    by the number of units of output a per-unit
    measure of fixed costs.

Average variable cost (AVC) Total variable cost
divided by the number of units of output.
Average total cost (AC) Total cost divided by the
number of units of output.
34
  • Marginal cost (MC) The increase in total cost
    that results from producing one more unit of
    output. Marginal costs reflect changes in
    variable costs.

35
Because fixed costs do not vary with output, the
only part of TC that changes is the variable
cost.
The marginal cost (MC), average total cost (AC),
and average variable cost (AVC) curves are all U
shaped, and the marginal cost curve intersects
the average variable cost and average total cost
curves at their minimum points.
36
Relation of MP - MC and AP - AVC
37
Summary
Total fixed costs Costs that do not depend on the quantity of output produced. These must be paid even if output is zero. TFC
Total variable costs Costs that vary with the level of output. TVC
Total cost The total economic cost of all the inputs used by a firm in production. TC TFC TVC
Average fixed costs Fixed costs per unit of output. AFC TFC/Q
Average variable costs Variable costs per unit of output. AVC TVC/Q
Average total costs Total costs per unit of output. ATC TC/Q ATC AFC AVC
Marginal costs The increase in total cost that results from producing one additional unit of output. MC DTC/DQ
38
Long-run costs
  • Since all inputs are variable, all costs are
    variable in the long run.
  • Long-run average cost (LRAC) measures the
    long-run cost of producing one unit of output

39
The Relationship between Short-Run Average Cost
and Long-Run Average Cost
LRAC shows minimum average cost of producing any
level of output when all inputs are variable
40
Return to scale
what happens to LRAC as a firm increases its
plant size
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