BUSS1040 W2 - Lecture notes PDF

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BUSS1040 – Economics for Business Decision Making, Semester 2, 2019 Lecture 2: Firm Behaviour: Production, Costs and Firm Supply

Dr. Kadir Atalay School of Economics, Faculty of Arts and Social Sciences

Notification Online Quiz 1 – week 3 › Access on BUSS1040 Blackboard › Starts Monday 19 August 16:00 – keep an eye on email and Canvas › Closes on Monday 26 August 12:00 (noon) › 10 multiple choice questions, covering material from weeks 1-2 › Shortly after the quiz closes, correct answers will be available on Canvas › Schedule enough time to work through the quiz! › All questions appear on one page. › As long as you have saved (but not submitted) your answers, you can return to the quiz and change your answers – once submitted your answers are FINAL! › Make sure you submit your answers before end of the quiz, otherwise NO marks (zero). › Important: once submitted, you should see a message confirming you submitted. You will not see your mark, neither what you got right/wrong. Your mark will be available in MyGrades after the quiz closes. Questions with answers will be posted on Canvas after the quiz closes. ADVICE: save a screenshot before submitting your answers. RMIT University©1/08/2019

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Outline › Outline 1 The Firm 2 Production Function 3 The Costs of Production Short-run Costs Long-run Costs 4 Technology and Economic Efficiency 5 Firm Supply

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Introduction › Now we focus on how firms operate. o

We want to describe firm behaviour with a view on understanding firm and market supply

› First, we examine the ideas of short and long run for a firm's production process; o

In the short run the firm has at least one fixed input of production, whereas in the long run all inputs can be adjusted if the firm wishes to.

› Second, we analyse the relationship between a firm's inputs and its outputs – that is, its production function. › Third, we examine how a firm's output is related to its costs in the short run and in the long run.

© 2016 Bonnie Nguyen and Andrew Wait

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Economic profit versus accounting profit › We assume that firms aim to maximise profits, where

profit = Economic profit

› Economic profit may differ from accounting profit › Accounting profits are revenues minus all explicit costs › Economic profits are revenues minus total opportunity cost

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Economic profit Profit: total revenue minus total costs

 = TR – TC Total revenue : the amount a firm receives for the sale of its output Total cost : the amount a firm pays to buy the inputs of production + forgone opportunities = total opportunity cost of producing goods/services o Opportunity costs include  explicit costs (that are not sunk) = direct payments for inputs or factors of production  implicit costs (value of foregone opportunities) e.g. forgone wages, interest earnings Example: Helen uses $300000 of savings, interest rate at 5 %. Thus Helen gives up $15000 per year in interest 6

Not an explicit cost – but it is an opportunity cost while she is running the firm, so needs to be included in costs (and measures of economic profit). Zero economic profit – revenues just cover opportunity costs BUSS1040 - lecture 2

Profit maximisation › › › ›

Firm’s goal is to maximise profit where profit = economic profit Economic profit may differ from accounting profit Accounting profits are revenues minus all explicit costs Economic profits are revenues minus total opportunity cost

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Economic Profit – Example Q1. pingo.upb.de (Session 155787) Bazza recently opened a restaurant. This requires Bazza to (temporarily) give up a job working as a lecturer at the university that pays $20 000 a year. The restaurant is located in a house he inherited from his grandmother, of which he is the sole owner. The house would otherwise be rented out at a price of $30,000 a year. This year, the restaurant has revenue of $200 000, personnel costs of $50 000 and costs of food inputs of $20 000. What is Bazza’s economic profit of running his restaurant this year? (a)

$80 000

(b)

$90 000

(c)

$110 000

(d)

$130 000

(e)

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The short run and long run › What is a firm? - A firm, using the available technology, converts inputs – labour, machinery (often called capital), natural resources (typically called land) – into output that is sold in the marketplace. o

Typically, a firm will require more than one input to produce its final output.

› We define the short run and the long run of a firm in relation to whether or not any of the factors of production (inputs) are fixed o

An input is ‘fixed’ if it cannot be changed regardless of the output produced

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Short and long run › The short run is the period of time during which at least one of the factors of production is fixed o for example, the size of a factory might not be able to be changed.

› In the long run, all factors of production are variable (that is, not fixed). o Therefore, in when the firm's lease of the factory ends, the firm is free to decide whether or not to renew the lease for that factory.

› The short run and the long run is not defined in relation to a set period of time, but rather in relation to how long it takes for all of a firm's inputs to become variable – this will differ between industries.

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Production › A firm requires inputs or factors of production (labour, capital, land, etc.) in order to produce its final output (i.e. goods or services). › A production function shows the relationship between quantity of inputs used and the (maximum) quantity of output produced, given the state of technology.

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Example of a production function › Jonathan owns a factory that makes umbrellas. › Assume the factory size cannot be changed – that is, we are in the short run. › Jonathan chooses how many workers to use o

with one worker, he can make 60 umbrellas; with two workers, 110 umbrellas; three workers, 150 umbrellas; four workers, 180 umbrellas.

› The relationship between inputs (number of workers) and output (number of umbrellas) is the production function. › Often a production function is represented using an equation. o

For example, q=f(L) where q is the level of output and L the amount of labour.

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Example of a production function

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Typical production function

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Marginal product › The marginal product (MP) is the change in output when one more input is used. › In the umbrella example above: o

Hiring one worker (rather than having no workers at all) allows 60 umbrellas to be made rather than 0 – the MP of the first worker is 60.

o

If Jonathan has one worker and hires one additional worker, output increases from 60 to 110 – the MP of the second worker is 110 - 60 = 50.

o

If Jonathan has three workers and hires one additional worker, is output will increase from 150 to 180; the MP of the fourth worker is 30 umbrellas.

› MP is the slope of the production function.

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Diminishing MP › MP of an input changes as we increase the use of that input. › If the MP becomes progressively smaller, this is called diminishing marginal product. o In

the example above concerning Jonathan's umbrellas, the marginal products of the second, third and fourth workers respectively are 50, 40 and 30, indicating diminishing marginal product;

o that

is, each additional worker contributes less to output than the worker before.

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Diminishing MP › Diminishing MP is very common oIn the short run there is a fixed input of some kind which creates a capacity constraint; othis will mean that each additional worker will contribute to output less and less than those hired before. › Crucially, diminishing MP is a short-run concept oIt relies on the idea that at least one input (like the factory) is fixed. oThink of it as initially, the first few workers have a lot of space to do productive work. However, the more workers are added, the more crowded the factory becomes and the less productive each additional worker is as they do not have enough space to do productive work. BUSS1040 - lecture 2

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Production function – Helen’s cakes Number of Output workers (q, cakes per hour) 0

0

1

50

2

90

3

120

4

140

5

150

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Marginal product of labour

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Production function – Helen’s cakes Number of Output workers (q, cakes per hour)

Marginal product of labour

0

0

1

50

50

2

90

40

3

120

30

4

140

20

5

150

10

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ProductionfunctionforHelen’scakes

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ProductionfunctionforHelen’scakes Output

PF

140

120

Notehowthefunction becomesflatter 90

50

No.ofworkers

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Production function

Qofoutput

Outputincreasesasinputs Increase,butatadecreasing Rate(eventually) Thisisduetodiminishing Marginalproduct

Unitsoflabour

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Production in the LONG RUN › Allow all inputs into the production process to be variable. o

In our umbrella manufacturing example, Jonathan can now vary all inputs in production process; he can choose the factory size as well as the amount of labour utilized.

› Given all factors of production are variable, we are in the long run. › We are interested in how the quantity of output changes when we change the quantity of all of the factors of production. o production function in the LR: q = f (L,K)

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Returns to scale – production in the long run › Returns to scale refers to how the quantity of output changes when there is a proportional change in the quantity of all inputs. o If output increases by the same proportional change, there are constant returns to scale – if we double the quantity of all the inputs and output also doubles in quantity. o If output increases by more than the proportional increase in all inputs, we have increasing returns to scale. o If output increases by less than the proportional increase in all inputs, there are decreasing returns to scale.

› Note, it is possible that a firm has diminishing MP in the short run, and still has increasing returns to scale in the long run!

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Production and Cost › The production function relates inputs and outputs › The firm’s cost function relates the total cost of production and output › There is a one-to-one relationship between the production function and cost function › The production function and the cost function ‘tell the same story’ › They are two sides of the same coin

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SHORT-RUN costs › A cost function is an equation that links the quantity of output with its associated production cost. - For example, TC = f(q), where TC represents total cost and q represents the quantity of output.

› Example: Helen’s cakes, wage for a worker is $10.

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TotalcostandoutputofHelen’scakes

Number of workers 0

Total cost

Output

30

0

1

40

50

2

50

90

3

60

120

4

70

140

5

80

150

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Total cost curve of Helen’s cakes total cost

total cost curve

Note how the curve becomes steeper

q of output

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A typical short-run total cost function

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A typical short-run cost curve › Several points are worth noting: › When output is zero, total cost is positive o this is because, in the short run, some factors of production are fixed and must be paid for.

› The total cost curve rises as output increases o costs increase when more inputs are required

› The total cost curve rises at an increasing rate o this captures diminishing MP: as output increases, a greater quantity of inputs is needed to increase output by the same amount.

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Fixed and variable costs › In the short run, some inputs will be fixed and some inputs will be variable; as a consequence, a firm will have some fixed costs and some variable costs. › Fixed costs (FC) are costs that do not vary with output. When output is zero, all the costs are fixed costs. › By contrast, Variable costs (VC) are costs that vary with output. All costs that are not fixed costs will be variable costs. VC = TC – FC › And hence Total costs (TC) consist of fixed and variable costs: TC = VC + FC

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Short-run Costs TC Costs (dollars)

TVC Fixed Cost

Total Cost

Variable Cost TFC

TFC

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Q of output TC 0

3.00

1

3.30

2

3.80

3

4.50

4

5.40

FC

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VC

AFC AVC

ATC MC

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Average costs

› Average fixed cost (AFC) is fixed cost per unit of output: AFC = FC/q o

Note that the AFC curve is always downward-sloping – why?

› Average variable cost (AVC) is variable cost per unit of output: that is, AVC = VC/q o

Because of diminishing MP, the AVC curve will eventually be upward-sloping.

› Average total cost (ATC) is total cost per unit of output; ATC = TC/q o

As ATC = AFC + AVC, its shape is affected by both.

o

At very low levels of output, ATC is usually the decline in AFC dominates, but at higher levels of output, it is usually upward sloping because the increasing AVC dominates.

o

Together, this will give the ATC curve a U-shape (i.e. initially decreasing, but eventually increasing with output).

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Marginal cost › Marginal cost (MC) is the increase in total cost from an extra unit of output. › Due to diminishing MP, a typical MC curve will eventually be increasing in output; MC often has a positive slope. o

In our umbrella example, each worker costs the same to hire but produces progressively less than the previous hire (diminishing MP).

o

The extra cost of producing another unit of output (MC) must go up.

o

In the short run diminishing MP implies increasing MC.

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Q of output TC

FC

VC

AFC AVC

0

3.00 3.00 0.00 -

1

3.30 3.00 0.30

2

3.80 3.00 0.80

3

4.50 3.00 1.50

4

5.40 3.00 2.40

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-

ATC MC -

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Q of output TC

FC

VC

AFC AVC

ATC MC

0

3.00 3.00 0.00 -

-

-

1

3.30 3.00 0.30 3.00

0.30

3.30

0.30

2

3.80 3.00 0.80 1.50

0.40

1.90

0.50

3

4.50 3.00 1.50 1.00

0.50

1.50

0.70

4

5.40 3.00 2.40 0.75

0.60

1.35

0.90

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Average costs › Average fixed cost (AFC) is fixed cost per unit of output: AFC = o

Note that the AFC curve is always downward-sloping.

TFC Q

› Average variable cost (AVC) is variable cost per unit of output: that is, › AVC =

TVC Q

› Because of diminishing MP, the AVC curve will eventually be upward-sloping – the more output, the more variable costs incurred as a greater quantity of inputs is needed to increase output by the same amount. › Average total cost (ATC) is total cost per unit of output; › ATC =

TC  AFC  AVC Q

› As ATC = AFC + AVC, its shape is affected by both. o

At very low levels of output, ATC is usually downward sloping as AFC dominates, but at higher levels of output, it is usually upward sloping because the increasing AVC dominates.

o

Together, this will give the ATC curve a U-shape (i.e. initially decreasing, but eventually increasing with output). © 2016 Bonnie Nguyen and Andrew Wait

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Marginal cost › Marginal cost (MC) is the increase in total cost from an extra unit of output. › Due to diminishing MP, a typical MC curve will eventually be increasing in output; MC often has a positive slope. o

In our umbrella example, each worker costs the same to hire but produces progressively less than the previous hire (diminishing MP).

o

The extra cost of producing another unit of output (MC) must go up.

o

In the short run diminishing MP implies increasing MC.

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Short-run Costs › Marginal Cost: the additional cost when producing an extra unit of output TC TC TVC   Q Q Q Short-run average costs (dollars)

› MC =

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MC

ATC

AVC ATC

AVC

AFC Qty

AFC 40

Short-run Costs › AFC declines as Q increases. Why? (hint: think about the TFC) › AVC declines initially, reaches a minimum , and then increases again. It looks like an U shape. Why? › MC also declines sharply, reaches a minimum and then rises rather sharply. Why? (think about t...