Econ Dept, UMR Presents

TheThe SupplySupply SideSide ofof thethe MarketMarket inin ThreeThree Parts:Parts: I.I. AnAn IntroductionIntroduction toto SupplySupply andand ProducerProducer SurplusSurplus II.II. TheThe ProductionProduction FunctionFunction III.III. CostCost FunctionsFunctions StarringStarring uSupplySupply vProductionProduction vCostCost uProducerProducer surplussurplus FeaturingFeaturing

uThe Law of Diminishing Marginal Product uThe MP/P Rule uEconomic vs. Accounting Cost uEconomic vs. Accounting Profit uThe Unimportance of PartPart III:III: CostCost FunctionsFunctions LinkingLinking ProductionProduction toto CostsCosts u Each production relationship has a cost counterpart v TP:variable input -- variable cost v AP:variable input -- average variable cost v MP:variable input -- v Fixed inputs -- fixed (or sunk) cost v MP/P rule -- equal MC rule u The production function and the MP/P rule tells us the minimum cost of producing any level of output, q: cost = input times inputs required = P*R Short Run First by definition we have Fixed Costs that do not vary with output

FC = iK ; where i is the price of the fixed input, capital (K)

FC

q/t q0 q1 q2 q3 Often fixed costs are also sunk costs. Sunk costs are costs already incurred and are beyond recovery. TC Second, we have Short variable cost. Run TVC + FC = TC Adding TVC and FC Costs gives Total Costs TVC Fixed Costs

TVC = wL where w is the price of the variable input, labor (L) FC

q/t q0 q1 q2 q3

Notice the vertical distance between TC and TVC is Fixed Cost Short TC Run TVC Costs Notice the curvature of TC and TVC is the Fixed Costs same. The slope of both at any output is marginal cost

At q3, slope of TC = slope of TVC = MC FC MC = (ÎTC/ Îq) q/t = (ÎTVC/ Îq) q0 q1 q2 q3 The rise over the run is the change in cost, total or variable, divided by the change in output Short TC

Run TVC Costs Tangency’s to show minimum AVC and ATC •q1 min AVC

•q2 min ATC Note, q2 > q1 as long as fixed costs are present. That is the FC output at which AVC is minimized is q/t less than the output q q q q 0 1 2 3 at which ATC is (TVC/q) = AVC; (TC/q) = ATC minimized as long as FC > 0 Short TC

Run TVC Costs

Inflection Points •q0 min MC

At q0, the law of diminishing marginal returns sets in

FC

q/t q0 q1 q2 q3 At the Inflection Point, TC and TVC stop increasing at a decreasing rate and start increasing at an increasing rate.

MC falls up to q0 then starts to increase. Short TC EverythingEverything TogetherTogether Run TVC Costs Tangency’s to show Fixed Costs minimum AVC and Inflection Points ATC

•q0 min MC

•q1 min AVC FC •q2 min ATC •q slope of TC q/t 3 q0 q1 q2 q3 = slope of TVC = MC at q3 TVC + TFC = TC = wL + iK PerPer UnitUnit ShortShort RunRun CostsCosts u Let’s look now at costs on a per unit basis v Average fixed cost, AFC = FC/q v Average variable cost, AVC = TVC/q v Average , ATC = TC/q v Marginal cost, MC = ÎTC/Îq = ÎTVC/Îq AFC = FC/q Short Run Per Unit Costs First, Average Fixed Costs declines throughout the range of output. This is because you are dividing a constant, FC, with an ever increasing quantity.

AFC q/t q0 q1 q2 Short Run In the short run, the average curves take on a “U” shape Per Unit driven by the law of diminishing Costs marginal returns ATC

AVC

Notice the vertical distance between ATC and AVC is AFC AFC q q q q/t AFC = FC/q 0 1 2 AVC = TVC/q Also note, q2 > q1 as long as fixed costs are present ATC = AFC + AVC = TC/q AFC is not very important, so Short Run it is often not drawn with the Per Unit other per unit curves Costs ATC

AVC Notice the minimum

AVC at q1, occurs when the average product of the variable input is maximized q/t q0 q1 q2 AVC = TVC/q ATC = AFC + AVC = TC/q Notice MC is “U” shaped too with its Short Run Short Run minimum point, at q0, coinciding with Per Unit the output where the marginal Costs product of the variable input is maximized MC ATC

AVC

q/t q0 q1 q2 MC = ÎTC/Îq = ÎTVC/Îq Short Run EverythingEverything Per Unit TogetherTogether Costs MC ATC

AVC

AFC q/t q0 q1 q2 AFC = TFC/q MC = ÎTC/Îq AVC = TVC/q = ÎTVC/Îq ATC = AFC + AVC = TC/q BeforeBefore GoingGoing toto thethe LongLong RunRun u Review what we mean by “costs” v Costs are opportunity costs v Or, costs are benefits foregone-the benefits of the next best alternative given up v are often good measures of opportunity costs OpportunityOpportunity CostCost u In economics, costs are always the of the benefits given up-- u Sometimes these opportunity costs are monetary, e.g., paid labor u Sometimes these opportunity costs are nonmonetary, e.g., Value of time used EconomicEconomic CostsCosts

u Total cost (TC) - the total opportunity cost of all resources used in production v TC = monetary costs + Nonmonetary costs EconomicEconomic vs.vs. AccountingAccounting ConceptsConcepts ofof CostsCosts andand ProfitsProfits u In economics costs are opportunity costs u In accounting costs are defined according to accepted accounting rules designed for tax and public disclosure purposes u Since the definitions of cost differ so do the definitions of profits v Economic profit = total revenue - opportunity costs v Accounting profit = total revenue - accounting costs IllustrationIllustration ofof AccountingAccounting ProfitProfit vs.vs. EconomicEconomic ProfitProfit Assume: Monetary costs (explicit costs) for a month =$15,000 Non-monetary costs for a month = $ 4,000 Total costs =$19,000 Economic profit = total revenue (TR) - total costs (TC) If total revenue for this month is equal to $19,000 then: there is no economic profit, but there would be a $4,000 accounting profit. Accounting profit does not count non-monetary costs as a cost thus profit would be reported as $4,000 Suppose:Suppose: u Monthly costs include: v Owner’s time and expertise $2,000 v Land already owned but could $3,000 be rented v Payroll expenses $9,000 v bills $1,000 u Total economic costs $15,000 u Total accounting costs $10,000 The difference between accounting and economic costs are non-monetary costs are not included in the accounting costs EconomicEconomic ProfitProfit OverviewOverview u TR = TC the opportunity costs are covered and there is no economic profit u TR > TC revenue exceeds opportunity costs and there is an economic profit u TR < TC opportunity costs exceed revenues and there is economic loss ConsiderConsider HooeyHooey andand Dewie,Dewie, WhoWho OpenedOpened aa BusinessBusiness SellingSelling TurquoiseTurquoise BeltsBelts inin thethe DenverDenver Airport.Airport. u Display Cart Costs $10,000 and Is Paid by Withdrawing Hooey and Dewie’s That Was Earning 5% Per Year. The Cart Will Last One Year and Has No Salvage Value. u Belts Cost $20.00 Each From the Supplier. u Sales Are Estimated to Be 1,000 Belts Per Year. u The Price of the Belts Is $60.00. u The Cart Clerk Is Paid $14,000. u Hooey and Dewie Will Put in 2000 Hours of Labor During the Year. QUESTION: Is This Business Going to Make a Profit, or Should Hooey and Dewie Move Back in With Uncle Donald? HooeyHooey andand DewieDewie HaveHave aa TotalTotal RevenueRevenue ofof $60,000$60,000 forfor thethe YearYear

u Total revenues...... $60,000 v P*q = $60*1,000 HooeyHooey andand DewieDewie HaveHave AccountingAccounting CostsCosts ofof $44,000$44,000 forfor thethe YearYear Total Revenues...... $60,000 Total Accounting Costs (Monetary Cost) Belts From Supplier...... $20,000 Clerk Cost ...... 14,000 Cart Cost...... 10,000 $44,000 Acct’ing Profit = Total Revenue – Acct’ing Costs = 60,000 - 44,000 = $16,000 (And We Are Ignoring Taxes) ButBut HooeyHooey andand DewieDewie HaveHave nonmonetarynonmonetary CostsCosts TooToo Total Revenues $60,000 Total Accounting Costs (Monetary Cost) Belts From Supplier $20,000 Clerk Cost 14,000 Cart Cost 10,000 $44,000 Total Nonmonetary Cost Foregone on $10,000 $ 500 Opportunity Cost of 2000 Hours X Economic Costs $44,500 + X Economic Profits = Total Revenue - Economic Costs = 60,000 - 44,500 - X = $15,500 - X HooeyHooey andand DewieDewie’’ss AdventureAdventure u Did they make a profit? u It depends on the value they place on their time, the 2000 hours v They cleared $16,000 according to the accountant and would be asked to pay taxes on this amount (after figuring loopholes) v But the opportunity cost of their savings and time were not taken into account u $500 for foregone interest lowers profit by $500 u If they value their time less than $7.50 per hour (= $15,500/2000) they made a profit otherwise, they didn’t and should move back in with uncle Donald BeforeBefore MovingMoving toto thethe LongLong Run,Run, LetLet’’ss ReviewReview u Total cost concepts u Per unit cost concepts u The shape of cost curves v Due to the law of diminishing marginal returns u The relationship between marginal and average u Efficiency in getting what we want TotalTotal CostCost ConceptsConcepts u Total fixed cost (FC) - costs which do not vary with output v The costs of fixed inputs, e.g., Capital u Total variable costs (TVC) - any cost that varies with the quantity of output produced v The costs of variable inputs, e.g., Labor u Total cost (TC) - sum of all costs of production v TC = fixed costs + total variable costs PerPer UnitUnit CostCost ConceptsConcepts u Marginal cost (MC) - the additional cost of producing one more unit of output v MC = DTC / Dq u Average variable cost (AVC) = TVC/q u Average fixed cost (AFC) = FC/q u Average total cost (ATC) = TC/q ShapeShape ofof CostCost CurvesCurves u Total cost and total variable cost v Eventually steeper due to law of diminishing marginal returns u Marginal cost v Eventually upward sloping due to law of diminishing marginal returns u Average fixed cost v Downward sloping always: a fixed number (FC) is divided by increasing q as output rises u Average total cost and average variable cost v “U” shaped but eventually upward sloping due to law of diminishing marginal returns LawLaw ofof DiminishingDiminishing MarginalMarginal ReturnsReturns andand CostCost CurvesCurves u If each unit of labor produces less additional output eventually, then in order to produce each additional unit of output we need to hire increasing amounts of inputs (labor) eventually (law of diminishing marginal returns) v Tells us total product eventually gets flatter and marginal product eventually declines v Tells us total costs eventually gets steeper and marginal costs eventually rise AverageAverage--marginalmarginal RuleRule u The marginal cost and curves have to obey the average-marginal rule u The average-marginal rule says that if marginal is above average, then average must be rising u If marginal is below average, then average falling u This implies the MC curve crosses the ATC and AVC curves at the bottom of both, and that the MP curve must cross the AP curve at the top of AP AverageAverage--marginalmarginal RuleRule u For example, your grade point average (GPA) is an average. The marginal grade is the next grade you get u If your next grade (marginal grade) is above your average (GPA), then your GPA rises u If your next grade (marginal grade) is below your average (GPA), then your GPA falls MinimumMinimum CostCost ConditionCondition u We saw earlier the rationale of the MP/P rule: to minimize cost of any level of activity, a supplier must mix variable inputs in such a way their marginal product divided by their price are equal u If input and output prices are taken as given, and suppliers are profit maximizers, the marginal costs of suppliers will be equal (MC1 = MC2 = … = MCj for all j suppliers). This is a necessary condition for insuring industry output is produced at minimum cost NowNow WeWe MoveMove toto CostsCosts inin thethe LongLong RunRun u Long run - period of time in which all inputs are variable u Capital and labor, all inputs, can change u Think of the long run as a planning period v Firm can estimate costs based on various plant sizes, number of machines, etc v Once it makes a decision and builds the plant, buys the machines, etc., It moves into the short run and are stuck with their decision for a while CostsCosts inin thethe LongLong RunRun u Long run average total cost (LRATC) - ATC of producing a given level of output when all inputs can vary u LRATC curve is constructed as an envelope of all possible short run cost curves u NOTE - no AFC in long-run v In long run all inputs are variable, so no fixed costs v LRATC is equal to long run AVC since all costs are variable LongLong RunRun andand ShortShort RunRun ATCATC u Consider what happens to the short run ATC curve when we increase fixed costs: v The average cost of making a small amount of product rises v The average cost of making a large amount goes down v For instance, we increase the size of an assembly line - the ATC of making 1000 cars is now higher, but the ATC of 250,000 cars is less LongLong RunRun ATCATC CurveCurve

$ SRATC1

Higher ATC with higher SRATC2 Fixed Cost (Higher Fixed Costs)

Lower ATC with higher Fixed Cost

0 q/t TheThe ShapeShape ofof thethe LRATCLRATC u We draw the LRATC as “U” shaped similar to the “U” shape of the short run average cost curves u But the AVC and ATC were “U” shaped due to the law of diminishing marginal returns which doesn’t apply in the long run (all inputs are variable) u What gives? A: ReturnsReturns toto ScaleScale u Changing all inputs in the same proportion is a “scale” change, e.g., increase all by 10%, decrease all by 5% u The “U” shape of the LRATC is due to the possibility of three types of returns to scale: v Increasing returns to scale: %Îq>%Îr v Constant returns to scale: % Îq=%Îr v Decreasing returns to scale: %Îq<%Îr (where R is all resources) u Cost curves in the long run are based on the underlying production technology, i.e., Returns to scale ReturnsReturns toto Scale,Scale, ExamplesExamples u IRTS: doubling all inputs leads to an increase of 125% in q (LRATC falls) u DRTS: an increase in all inputs by 5% leads to a 3% increase in q (LRATC rises) u CRTS: a decrease in all inputs by 10% lead to a 10% fall in q (LRATC is constant) u If all inputs are decreased by 5% and output falls by 7%, %Îq>%Îr, therefore IRTS WhatWhat IfIf AllAll InputsInputs ChangeChange butbut NotNot inin thethe SameSame Proportion?Proportion? u If the %Îq>%Îcosts we use the term u If the %Îq<%Îcosts we use the term diseconomies of scale u IRTS implies economies of scale but economies of scale do not imply IRTS u The same is true for the relationship between diseconomies of scale and DRTS u Reasons for economies and diseconomies of scale are given in Part II LinkingLinking thethe ShortShort RunRun toto thethe LongLong RunRun u Suppose you have four choices for a stock of fixed inputs, e.g., 4 different sizes of office buildings to build or lease u There are tradeoffs apparent: v Smaller fixed costs are associated with higher variable costs v Economies and diseconomies of scale are apparent u The output you expect to sell is paramount, but that depends on demand conditions we will consider next chapter FourFour ShortShort RunRun ATCATC CurveCurve ChoicesChoices

$ SRATC1 SRATC4 SRATC2

SRATC3

0 q1 q2 q3 q4 q/t SelectionSelection ofof FixedFixed InputInput StockStock

u If you expect business to support output q1 you select the input stock associated with SRATC1

u And so on, e.g., If you expect to sell q3 then you will select the input stock associated with SRATC3 u With only 4 possible input stock sizes, the LRATC is the heavy sections of the short run curves outlined in blue on the next slide FourFour ShortShort RunRun ATCATC CurveCurve ChoicesChoices andand TheirTheir LRATCLRATC

$ SRATC1 SRATC4 SRATC2

SRATC3

0 q1 q2 q3 q4 q/t LRATCLRATC CurveCurve WhenWhen ThereThere AreAre ManyMany InputInput StocksStocks toto SelectSelect FromFrom

$ SRATC1 SRATC 2 SRATC4 SRATC3

LRATC : Minimum SRATC : Tangency of SRATC and LRATC 0 q1 q2 q3 q/t q4 ReviewingReviewing thethe ShapeShape ofof LRATCLRATC u Explained by economies and diseconomies of scale u Typically firms will make efforts to expand to take advantage of economies of scale and take caution not to get too big so as to experience diseconomies of scale u We find for most industries, firms operating at constant ATC over a considerable range of output LongLong RunRun ATCATC CurveCurve (Economies(Economies ofof Scale)Scale) $

Economies of Scale

0 q/t LongLong RunRun ATCATC CurveCurve (Diseconomies(Diseconomies ofof Scale)Scale) $

Diseconomies of Scale

0 q/t LongLong RunRun ATCATC CurveCurve (Constant(Constant AverageAverage Costs)Costs) $

Constant Average Costs

0 q/t TypicalTypical LRATCLRATC

$ Sort of like a Frying Pan

Constant Average Total Costs

0 q/t WhatWhat IfIf aa MistakeMistake IsIs Made?Made? u You select SRATC1, expecting to sell q1 per period, but things are better than expected, you sell q2 u Your ATC are higher than they need have been (represented by a level rather than shown on a couple of slides back) u But your decision has been made and you have to live with it for now u It is important to learn that sunk costs are not important (if your fixed inputs can be sold their costs are not sunk) SunkSunk CostCost u Sunk costs are fixed costs, but FC may not be sunk if there are valuable alternatives. If the capital equipment may be sold then the capital cost is not sunk u Economics has an important message about sunk cost--they don’t matter u The proverb to remember is “let bygones be bygones” SunkSunk CostsCosts u A good poker player “knows when to hold’em, knows when to fold’ em”--the in the pot is not important u You ought not stay in a major because you have almost completed the degree-- the decision must be based on expected benefits and costs of the change, not costs already experienced TheThe EndEnd