If the daily interest rate is 50%, what is the present value of an apple delivered 2 days from now?

Of an apple delivered 3 days from now?

1/(1+r)ⁿ where r is interest rate and n is = days in future

.44 apples today 1/(1+.5)²

.30 apples today

Suppose that your bank account pays 8% interest on your money and that inflation is 5%.

What nominal interest rate are you earning?

What real interest rate are you earning?

nominal 8%

real 3%

r=i-pie or 3%=8%-5%

Formula for current price?

What is the same formula but in terms of P1?

What about if the marginal costs are negligible?

P_o = MC + (P₁-MC)/(1+r)

P₁ = P_o X (1+r) - r X MC

P₁ = P_o X (1+r)

P₁ - Future Price; P_o - Current Price; r-interest rate; MC - Marginal Cost

1. The manager of a firm receives an engineering report claiming that an additional hour of capital would increase output twice as much as would an additional hour of labor. According to the firm’s management information system, an additional hour of capital costs three times more than an additional hour of labor. Is the firm behaving optimally? Why or why not? Explain. Suppose the firm is under a contractual obligation to keep its output at the current level. What long-run adjustment—if any—should the manager make in the firm’s employment of labor and capital?

2. A businessman says, “Of course sunk costs matter. People who pay $20,000 to join a golf club play golf more frequently than people who play on public golf courses.” Discuss.

3. Define the terms marginal cost and marginal benefit. What action should a firm take if its marginal revenue exceeds its marginal cost? Explain.

Marginal cost = the change in total cost when output is increased a little. (Or it is derivative of total cost with respect to output.) Marginal revenue = the change in total revenue when output is increased a little. (Or it is derivative of total revenue with respect to output.) If MR is > than MC, assuming it is worth producing at all, the firm should increase output.

4. Do the following comments reflect sound economic reasoning? Explain why or why not.

A.    “I paid $200.00 for this economics course. Therefore, I am going to attend the lectures even if they are useless and boring.”

B.     “Since we own rather than rent, housing does not cost us anything.”

C.     “I own 100 shares of stock that I can't afford to sell until the price goes up enough for me to get back at least my original investment.”

D.    “It costs to produce private education, whereas public schooling is free.”

A. No. Sunk cost.

          B. No. Opportunity cost of housing price, or cost of renting the house. (Answer is “no” whether or not there is a mortgage.)

          C. No. Sunk cost.

          D. No. Public has to pay for schooling, ultimately with taxes.

Not necessarily. These are average costs. We want to allocate output such that marginal costs are equal. (It is possible for the lower-average cost plant to have a higher marginal cost at current output levels.)

6. The management of Franklin National Bank made what fundamental mistake? What should it have done?

7. When Wang Corp. started losing sales to PC-makers, its average cost rose. To cover its higher average cost, Wang raised its price.  Was this a good decision? Why or why not? Explain.

---

---

No. Price and quantity should be affected—if it’s worth producing any output at all—only by marginal cost. Using average cost increased Wang’s problems.

8. In 1965 Gordon Moore, the co-founder of Intel, predicted that the number of transistors per square inch on integrated circuits, and thus the computing speed of a given size microprocessor, would continue to double every year for the foreseeable future. In subsequent years the pace has slowed, but computing speed has continued to double approximately every 18 months. This is known as Moore’s Law. Does Moore’s Law contradict the Law of Diminishing Marginal Returns? Explain

Suppose the government increases the annual cost of the liquor permit that a tavern needs to serve alcohol. What effect will this increased cost have on the tavern’s production and pricing decisions?

A.    In the short run, none—the tavern will maintain its current prices.

B.     The tavern will cut its prices to increase its sales.

C.     The tavern will immediately raise its prices to cover the higher cost of the permit.

D.    The tavern will begin advertising more.

E.     If the tavern is in a perfectly competitive industry, it will raise price.

None of the above

10. Why does a firm’s short run marginal cost normally increase as the firm increases its level of output? Explain carefully.

11. A driver always buys a carwash with gasoline. The carwash costs $0.90 if he buys 14 or less gallons of gas at $1.10 each; however, if he buys 15 gallons, the carwash is free. What is the driver’s marginal cost of the fifteenth gallon?  Why?

Use the definition of marginal cost: change in total cost divided by change in output. Going from the 14^th gallon to the 15^th gallon, total cost increases by $1.10, but the driver saves the $.90 for the carwash. So, MC = $.20 divided by 1, or $.20.

12. You are the CEO of a small pharmaceutical company that makes generic aspirin. You can sell as much aspirin as you want at the market price of $10 per case, but your plant capacity limits your production to a maximum of 1000 cases per day. You have the plant working at full capacity Monday through Saturday; you currently close the plant on Sunday. Each week the firm incurs fixed costs of $1,000 (property tax and insurance). No matter how many cases per day you manufacture, the cost of materials and supplies is $4 per case. The cost of labor is $5 per case, except on Sundays, when the cost of labor would be $10 per case.

      Your firm now wins a long-term contract to manufacture a brand-name aspirin. The cost of making the brand-name aspirin is identical to the costs of making the generic aspirin. Ignore any cost involved in switching from production of generic to name brand aspirin. Your contract calls for 1,000 cases per week and you will get $30 per case. (You cannot buy aspirin from another manufacturer to satisfy the brand-name contract.)

       Your V.P. of Marketing suggests that the plant start to manufacture on Sunday. But your plant foreman thinks that that would be a bad idea. They come to you to resolve the dispute. What do you say? Why? You must give details of your reasoning for any credit.

No.    MR of producing on Sunday = $10,000 (10 * $1000).

          MC of producing on Sunday = $4000 materials

                                                           5000 straight-time labor cost

                                                           5000 overtime pay

                                                       $14000

Therefore, MR < MC.

(Produce the special contract sometime during Monday through Saturday.)

Find the Q such that MR = MC. MR = dQ/dL times dTR/dQ, or (4.5 - .6L)*5. (If you can’t find the derivative—but you really should be able to—setting up the problem completely would get you substantial partial credit.) MC = 4.50. Setting the two quantities equal and solving for L, we get L*=6. (And we should check that that is a better solution than L=0, which it is.)

The airports can be resold, so Mr. Leone doesn’t have to “earn back” his investment. All he should try to do is earn the highest rate of return (risk-adjusted) on the $2.2 billion investment.

18. When should a firm increase its production?

A.    When it is earning a positive economic profit.

B.     When its revenues are too low to cover the firm’s fixed costs.

C.     When there is a fall in the price of its product.

D.    When its marginal revenue is greater than its marginal cost.

E.     All of the above.

F.      None of the above.

The same thing "revenue". It can be computed by the formula

Revenue= Price x Quantity

Variable cost divided by the quantity of output

AVC = VC /  Q

Total Cost divided by the quantity of output.

AC = TC/Q

The set of all technically efficient ways to produce one unit of output

Iso = "equal or same"

Quant = "Quantity of Output"

Assumption is that there is some substitutability b/w inputs generally

3 Responses for why we learn Perfect Competition

& Potential Problem

1) Cast light on role of price - power importance of prices

2) Develop the Industry Supply Curve - useful for certain shifts (rudimentary calculations)

3) Developed some ideas in course of learning that are applicable to other applications.  i) equimarinal principle ii) law of diminishing marginal returns iii) equilibrium

Potential problem - At full equilibrium turns out if you have a perfectly competitive market, all the production is occuring at lowest possible cost (no slack, waste, etc.).  2nd is what goods would be produced (Scarcity)  - answer is goods that are most highly valued by consumers. ex: people want right and left shoes that is what they get -consumer demand.  All firms are earning 0 profits - no excess profits. (making just enough to the penny to stay in the industry). No restrictions on entry or exit (no legal barriers such as patents, financial barriers, licenses)

We assume that firms act to maximize profits. This implies that they will act in accordance with the equimarginal principal; that is, they will engage in any activity up to the point where marginal cost equals marginal benefit.

When the firm sells goods in the marketplace, it chooses the profit maximizing quantity. In accordance with the equimarginal principle, thi is the quantity at which marginal cost equals marginal revenue. The firm sells this quantity at a price determined by the demand cureve for its product.

The total revenue derived from selling a given quantity is given by the formula Revenue=PriceXQuantity, where the price is read off the demand curve. Thus, the total revenue curve, and consequently the marginal revenue curve, are determined by the demand curve for the firm's product.

A change in the firm's fixed costs, because it affects nothing marginal, will not affect the quantity or price of the firm's output. There is one exception: A sufficiently large increase in fixed costs will cause the firm to shut down or leave the industry entirely.

A change in marginal costs can lead to a change in the firm's behavior. So can a change in marginal revenue. Any change in the demand curve facing the firm can lead to a change in marginal revenue. For example, a change in the availability of competing products can affect demand and, consequently, marginal revenue and, consequently, the behavior of the firm.

The role of the firm is to convert inputs into outputs. The cost of producing a given level of output depends on the technology availble to the firm (which determines the quantities of inputs the firm will need) and the prices of the inputs.

In the short run, the firm is committed to employing some inputs in fixed amounts. In the long run, it is free to vary its employment of every input, always producing at the lowest possible cost.

For illustrative puposes, we consider a firm that employs labor and capital, with capital fixed in the short run. The options available to the firm are then illustrated its total product (TP) curve, also called its short-run production function. From the TP curve, we can derive the marginal product of labor (MPL) curve by computing the additional output derived from each addtional unit of labor: The value of MPL is the slope of TP.

The average product of labor (APL) is defined to be TP/L, where L is the amount of labor employed. At low levels of output (the first stage of production), each additional worker increases the productivity of his colleagues. Therefore, marginal product exceeds average product and average product is rising. At higher levels of output (the second stage of production), each additional worker reduces the prodductivity of his colleagues. Therefore, marginal product is below average product and average product is falling. The average product curve has the shape of an inverted U, with the marginal product curve cutting through it at the highest point.

For a given level of output, the firm faces a fixed cost (FC), which is the cost of renting capital, and a variable cost (VC), which is the cost of hiring label. FC can be computed as P_k * K, where P_k is the price of capital and K is the firm's (fixed) capital usage. VC can be computed as P_L * L, where P_L is the wage rate of labor and L is the quantity of labor needed to produce the desired output; the value of L that corresponds to a given quantity of output can be found by examining the TP curve.

The firm's total cost (TC) is the sum of FC and VC. Its average cost (AC) is TC/Q, where Q is the quantity of its output. Its average variable cost (AVC) is VC/Q. Its marginal cost is the increment to the total cost attributable to the last unit of output.

Typically, the average, average variable, and marginal costs curves are U-shaped. MC cuts through both AC and AVC at their minimum points.

In the long run, the firm's technology is embodied in its production function, which is illustrated by the isoquant diagram. The slope of an isoquant is equal to the marginal rate of technical substitution between labor and capital. We expect MRTS_LK to decrease as we move down and to the right along the isoquant, with the result that isoquants are convex.

In the long run, the firm minimizes costs for a given level of output, which leads it to choose a point of tangency between an isocost and an isoquant.

Alternatively, we can think of the firm as maximizing output for a given expenditure on inputs; this reasoning also leads to the conclusion that the firm operates at a tangency. The set of all such tangencies forms the firm's expansion path.

To compute the long-run total cost for Q units of output, find the tangency of the Q-unit isoquant with an isocost, and compute the price of the corresponding input basket.

Long-run average and marginal costs can be computed from long-run total cost.

The long-run average cost curve is downward sloping, flat, or upward sloping, depending on whether the firm experiences increasing, constant, or decreasing returns to scale.  Weexpect increasing returns (decreasing average cost) at low levels of output because of the advantages of specialization. At higher levels of output, there will be constant returns to scale unless some factor is fixed even in teh long run; however, this case is very common because of limits on things like skills and supervisory ability of the entrepreneur. Therfore, we often draw the long-run average cost curve increasing at high levels of output, making the entire curve U-shaped. (That is, we assume decreasing returns to scaleat highh levels of outputs.) Long-run marginal cost cuts through long-run average cost at the bottom of the U.

The same isoquant diagram that is used to derive long-run total cost can be used to derive short-run total product and total cost curves as well. Each possible plant size for the firm results in a different short-run total cost curve and consequently a different short-run average cost curve. The short-run cost curves never dip below the long-run cost curves. The short-run total cost curve associated with a given plant size touches the long-run total cost curve only at that quantity for which the plant size is optimal; the same is true for average cost curves.

A perfectly competitive firm is one that faces a horizontal demand curve for its product; that is, it can sell any quantity it wants to at the going market price. The total revenue curve for such a firm is a straight line though the origin, and the marginal revenue curve is a horizontal line at the going market price. Thus, the marginal revenue curve is identical to the demand curve.

Like any producer, competitive or not, the competitive firm produces, if it produces at all, where marginal cost equals marginal revenue. Because marginal revenue equals price for a competitive firm, we can say that such a firm produces, if it produces at all, where marginal cost equals price. To see what the firm will produce in the short run, we use its short-run marginal cost curve; and to see what it will produce in the long run, we use its long-run marginal cost curve.

In the short run, the firm operates only if its revenue exceeds its variable costs. This is the same as saying that the firm operates only if the market price exceeds its average variable cost. Thus, the firm's short-run supply curve is that portion of its marginal cost curve that lies above average variable cost.

A competitive industry is on ein which all firms are competitive.

To derive the short-run industry supply curve, we assume a fixed number of firms and add their quantities supplied at each price.

The competitive industry operates at the point where supply and demand are equal, because each individual firm maximizes profits at this point. In compeitive equilibrium, the total cost of producing any quantity of output is minmied. This is because each firm has the same marginal cost (equal to the market price).

In the long run, the firm oerates where price is equal to long-run marginal cost, provided that it earns positive profits. If profits are negative (which happens when price falls below average cost) the firm leaves the industry. Therefore, the firm's long-run suppply curve is that part of its long-run marginal cost curve that lies above its long-run average cost curve.

To study long-run equilibrium, we must account for the possibility of entry and exit. Entry and exit are driven by profit. If all firms are identical, the all firms must earn zero profit in long-run equilibrium.

In the simplest analysis, we assume that ll firms share a single break-even price, and that the break-even price is unaffected by entry and exit. In that case, the break-even price is the only price that can prevail in long-run equilibrium; therefore, the long-run supply curve is flat at the break-even price.

A second possibility is that the industry is increasing-cost, which means that the break-even price for new entrants increases as the industry expands. This could happen either because new entrants are less efficient than existing firms or because new entrants bid up the price of inputs, causing everyone's costs to increase. In this case, the industry supply curve slopes upward.

A third possibility is that the industry is decreasing-cost, which means that the break-even price for new entrants falls as the industry expands. For example, when the industry reaches a certain size, specialized sub-industries can be formed. In this case, there is a downward-sloping long-run supply curve.

The price of an item reflects the value of that item to some potential user. It also provides an incentive for others to act on that information. If the item is valuable elsewhere, the high price will tell potential users to search for substitutes.

Prices allow complex economies to be coordinated in ways that take account of vast amounts of knowledge. This knowledge includes what Hayek called the "particular circumstances of time and place." Each individual producer and consuer has access to special information that is not available to anyone else, and prices lead him to use this information in deciding how to allocate resources. A social planner without access to all of this information will allocate resources less efficiently.

The conventional measures of social welfare that were introduced in Chapter 8 make the implicit assumption that all goods are produced by the low-cost producers and distributed to the consumers who value them the most. In the absence of a price system, this assumption may be unjustified, in which case the usual measures of social welfare are overly optimistic.

An efficient market is one in which prices fully reveal all available information. Markets for financial assets appear to provide examples.

When the informational content of prices is diluted, as by an inflation that makes it difficult for people to distinguish absolute from relative price changes, resources are alloated less efficiently. This provides one possible explanation of why the level of employment will change in response to an unexpected inflation but not to an expected one.

When information is distributed asymmetrically, surprising and sometimes inefficient outcomes can result. Examples include signaling equilibria, adverse selection, moral hazard, and prinicipal-agent problems.

Comparable Worth – Background

 

Became Federal Law:

1) Equal Pay Act of 1963 (Equal Pay for Equal Work)

2) Title VII of Civil Rights Act of 1964 prohibit discrimination against women. 

 1.     Women earned only about 60% of men. 

2.     Proposed answer is to raise wage of lower-paying occupations to that of higher-paying occupations.  Comparable worth—equal pay for jobs of equal “worth”.

Earnings differentials: Two hypotheses

(Comparable Worth)

1) Crowding

2) Choice

1.     “Crowding” or discrimination:  entry barriers in some occupations (corp. execs, science, engineering, law):  implies wages in others will be lower. (Barriers to being corp. execs., science, engineering?).  Woman discouraged from certain jobs.

2.     Choice (due to Mincer and Polachek, 1974; Polachek, 1981): non-pecuniary compensating differentials. Women might want ease of entry and exit, where skills don’t depreciate, with flexible hours and there is no need to relocate. June O’Neill: “The expectation of withdrawals from the labor force and the need to work fewer hours during the week are likely to influence the type of occupations that women train for and ultimately pursue.”

- Choice = choosing to be in a lower paying job.  a) women looked for jobs geographically flexible.  Their career was 2nd to their spouse.  b) women anticipate leaving job for some time due to children.

 Some empirical evidence seems to be inconsistent with discrimination (Choice) hypothesis (Fischel and Lazear)

(comparable worth)

1.   Never-married women have 90-100% salary of never-married men. (More flexible, have more choices)

2.     Larger the # of children, greater their spacing, larger the differential.  (The wage gap increases with more children)

3. Differential increases up to about age 40 then declines.  (Is 40 just a coincidence?) - No, most women have less children responsibility by that age. 

Law that attempts to change the market wage w/out shifting the curve.  Similar to the min wage law. 

4 costs associated:

1) Qty of labor will decrease

2) Price control lowers quality

3) Complications of law will increase (similar to rent control)

4) Distribution effects - overtime the people you are trying to help will change.

1) If problem is discrimination - attach discrimination

2) Shift the curves

     a.  restrict supply (ie: need license/certification for job)

     b.  Increase demand (ie: subsidies, govt hire)

Present Value Analysis

Basic idea: $1 today is not worth $1 one year from now because $1 today can earn interest (or a non-monetary return).

Essentially, cash flows that occur in the future should be given less weight than past or present. Why?  $ in hand is more valuable - you can do something with it.

A.  We assume no inflation, no uncertainty, no taxes. Basic idea still holds. (restrictive)

B.          Frequently investment decisions have a very complicated series of revenue and cost flows over time. We need a way to put those cash flows on an equal basis, to compare apples to apples.

C.         Answer is to convert all cash flows to their present value. Then they can be directly compared.

Present value assumptions and terms

A.  Assumptions

1.       Continue to assume no inflation and no uncertainty. (And no taxes.)

2.       Assume initially that cash flows are only received in lump sums at the end of a period, one year.

3.       Assume also that interest computed and paid only once a year, at the end of a year.

4.       Assume interest rate constant over time.

B.          FV = PV (1 + r)t where t = the number of years from the present the cash flow occurs and r is an annual opportunity interest rate. (r = annual interest rate)

C.         Therefore, have basic formula: PV = . (+ for inflows, – for outflows)

D.         1/(1+r)t is called the discount factor because for r > 0, is less than 1; we are discounting future cash flows to reflect that they are worth less than present dollars.

E.          Interest rate to use is roughly the opportunity interest rate: rate of interest or return could earn on best alternate use of funds

1.       For consumer, look at how you are using your money.

2.       For publicly held firm, must consider opportunity cost of marginal investor’s funds (who is assumed diversified); should consider costs of debt and preferred stock, as well as common equity. More complicated, leave to finance course.

A.         Maintain earlier assumptions but add:

1.       Assume cash flows are exactly the same each and every period: $X.

2.       Cash flows continue forever.

B.          Then PV of stream of cash flows is .

C.         If number of time periods is 30 or more, formula is a good approximation.

"Demand For Fear" -   Psychometricians have identified factors of risk perception that many people share and that can deepen individual fears. Among these factors:

1. Control vs. no control. Less afraid of statistically riskier driving than flying because with driving feel in control.

2.       Catastrophic vs. chronic. More afraid of risks that could kill or cause serious injury quickly—like plane crash—than risks, like lung cancer, which will take longer.

3.       Natural vs. man-made. Less afraid of sun’s radiation than radiation from power lines, cell phone towers, cell phones.

4.       Imposed vs. voluntary. Risks we choose are less scary.

Production technology (Foundations for Cost Functions: Production Functions)

A.         Where we’re going: to understand demand function, we looked at preferences and market prices. To understand supply function, we look at firm’s cost function, which in turn depends on the production function and factor prices.

B) Firm takes inputs, factors of production (land, labor, capital, energy) and converts into outputs, products.

1)  Sunk Costs - costs that can no longer be changed or avoided.  Should not affect choice of x at all.  They should always be ignored!

2) Fixed Costs - costs which don't change once x > 0.  Should affect choice in only one way.  Helps you determine if x* is = 0 or x* > 0.  (ie: property taxes, licensing fee).  Key driver - costs can change but not as a result of output.

3) If activity is worthwhile to undertake at all (x*>0) then only Marginal Costs should affect the activity level, NOT Average Costs.

4) Economic costs should pay attention to opportunity costs.

1) Identify which costs matter (marginal - ignore everything else)

2) Estimate price sensitivity for your buyers (price elasticity)

3) Competition (careful on price cutting and price matching)

4) Look for subgroups of customers (segmentation).  Ideally charge multiple prices.

4)

A.         But customers determine what product can sell for not costs. Need to recognize tradeoff between price and sales.

B.          “Assurance” of cost-plus pricing is illusionary; will cover costs and make profit only if sales forecast is accurate. (Need forecast of Q to know average cost.) Given knowledge of customer’s demands, so will incremental pricing approach.

C.         Note, though, that cost-plus pricing is used frequently in business, and that under some circumstances it approximates sound economic pricing. We will return to this after chapter 10.

1.         average-cost-plus pricing tends to overprice when demand is weak (“death-spiral”)(AC > MC), but tends to underprice when demand is strong (MC > AC)

Assumptions of perfect competition model

A.         Large number of potential sellers (and buyers); each seller supplies only a tiny % of market output.

B.          Homogenous output; product of one seller is a perfect substitute for product of another seller. 

1.       Only price matters. 

2.       Not quality, durability, esthetic appeal, etc.

C.         Consumers have perfect knowledge of market opportunities.

D.         Resources are freely mobile.  No resource restrictions such as patents, licensing, etc.

E.          Continuous divisibility of inputs and outputs.  (For example, not “cars”, but “car services”.)

Principle of zero-profit-for-marginal-firm in action

Application: suppose we gave tips to busboys?

A.         Surprising they don’t benefit if there are no specialized skills in being a busboy; that is, if busboys are perfectly elastically supplied.

B.          If their total compensation goes up, enough people enter to reduce total compensation back to the “zero profit” level in the long run.

C.         Restaurant owners now have lower wage costs for busboys. So the supply curve shifts out.

1.       In short run: customers and restaurant owners share gross benefits of the reduced wages, depending on elasticities.

2.       But customers pay tip so on net are worse off.

D.         In long run depends on whether restaurant owners identical or not.

1.       If are, restaurant supply curve is perfectly elastic and shifts down by full amount of busboy tips. Diners get back tip in form of lower meal prices.

2.       If restaurant supply is upward sloping, restaurant owners benefit some and diners get some of their tip—not all—back in form of lower prices.

Barney article on Corporate Strategy

A.         This article representative of a “UCLA” approach to strategy

B.          Whenever the implementation of a strategy requires the acquisition of resources, a strategic factor market develops

 (Sustainable competitive advantage above normal profits.  Companies are looking to do this - real trick is to sustain!)

C.         Importance for strategies - only 2 ways to make above profits - 1) Need to out forecast the market (out perform) 2) do external analysis - need to look outside the firm.

Market prices need to be efficient.  Efficiency does not mean that prices are correct - just that it is the best forecast.

D.         Conclusions:  Barney wants to shift analysis to internal analysis.  Still need to do both, but in order to forecast, most likely needs to be done from within (external info most likely to be public available to all people).

Perfectly competitive firms

A.         Definition: faces a perfectly elastic demand curve.

1.       Most likely to occur when firm is very small relative to market

2.        Wheat farmers probably a good real-world example (see Exhibit 7-1)

B.          For such firms, MB = MR = P for all units of output.

A. SR Supply for perfectly competitive firm

B.    SR supply for perfectly competitive industry

C.         LR supply for perfectly competitive firm

D.         LR supply for perfectly competitive industry (most complicated)

Production and costs in the short run

A.         Short run/long run and fixed cost/variable cost and inputs distinction

B.          Product curves (see Exhibit 6-1, p. 147)

1.       Hold K fixed, can look at total product as L increases.

2.       Of particular interest is marginal product of L, delta q/delta L.

a)   Marginal product typically rises and then falls (may stay constant over some fairly large, relevant range), may even turn negative. That it eventually does decline is Law of Diminishing Marginal Returns. Not theoretical, empirical stylized fact. (Law holds at least one input and

C.         With knowledge of input prices and product curves, can map out cost curves.

1.       Multiply L by wage of L = variable cost and change axes: VC on vertical and q on horizontal, have firm’s total variable cost curve. (Exhibit 6-3, p. 150)

a)   Rises at increasing rate as L gets large due to diminishing MP of L.

b)   TC curve higher by amount of fixed cost.

2.       Can look at average total cost = total cost/q = Fixed Cost/q + Variable Cost/q and at AVC = Variable Cost/q.

3.       See Ex. 6-4 (p. 152) for these curves. Three important principles:

a)   MC falls, but eventually rises (in vicinity of plant capacity).

b)   ATC and AVC are U-shaped.

c)   MC intersects minimum point of both AVC and ATC. (Min AVC lower and to left of minimum ATC.)

Production Function

Firm in the Short Run

Production Function equation symbols

Q = function (K,L)

Q = output

K = capital

L = labor

f = function (it is the mathematical mapping of capital & labor and how much output they can produce).

**Always measured in physical units, not $$.

As long as one input is being held constant, as you add additional inputs, the marginal return must decline.

Need to keep technology constant.  Law does not have to hold if change in science, technology, etc.

*To have law observed - need to have one input fixed & technology constant

 Competitive firm’s long-run supply curve

A.         Now will never produce unless P covers entire AC (not just AVC). Labeled “exit price.”

B.          Fixed factors now adjusted to new price level. Therefore, supply response is more elastic.

Competitive industry supply in short run

A.         Definition: all firms are perfectly competitive and no firms can enter or exit (because capital is fixed in SR).

B.          Note terminological difference between shutdown (SR) and exit (LR)

C.         Short-run industry supply

1.       Given short run firm supply curves can construct industry curve. Each firm is in the industry (no entry or exit in the short run), but may they may have differences in shutdown prices. Leads to an upward sloping SR supply curve.

2.       If an industry comprises a substantial fraction of the demand for one of its inputs, have a factor price effect

a)   If the factor price effect is “positive”, industry expansion drives up the cost of the input.

b)   Industry supply is therefore less elastic than sum of firm supply curves. See exhibit 7-9.

c)   Conceivably could have negative factor price effect and industry supply would be more elastic than sum of firm supply curves.

A.         Entry and zero economic profits condition for marginal firm

1.       Economic profits not equal to accounting profits. For one thing, economic profits would subtract opportunity cost of capital invested.

2.       This condition is analogous to condition we saw earlier, that in equilibrium, marginal worker must be indifferent among careers.

B.          Simplest case: all firms have identical cost curves, no factor price effects. Page 190.

1.       Landsburg labels such industries constant-cost industries. The firm’s breakeven output stays the same as industry output expands.

2.       Identical firms plausible if skills and assets in industry relatively unspecialized (sidewalk flower vendor). Less plausible if specialized (world-class orchid grower).

3.       If skills and assets in industry relatively unspecialized, also plausible no factor price effect. Industry can expand without changing price of input because even entire industry is just small part of demand for input. But if skill or asset specialized, more likely to be factor price effect.

4.       With identical firms there is just one price that allows zero economic profits: break-even price. All firms earn zero economic profits, supply curve is horizontal at that price. Entry and exit of firms maintains equilibrium.

 Production and costs in the long run

A.         Choosing a production process

1.       Isoquants, analogous to individual’s indifference curves: minimum combinations of inputs that can produce a given q. [Iso- prefix for equal or same, -quant for quantity of output.] Assumption is that there is some substitutability between inputs generally. (Though can have limiting case of fixed proportions.)

2.       Suppose the firm wants to spend a given amount, E, on inputs. Wants to maximum output given E. E determines an isocost line, Pk x K + Pl x L = E. |Slope| = MPl/MPk = Pl/Pk.

3.       Optimal input mix is where isocost line is tangent to isoquant. Explanation in words:

a)   Equimarginal principle says should choose K and L such that MPk/Pk = MPl/Pl; rearrange and get MPl/MPk = Pl/Pk. Left side is MRTS, absolute value of slope of isoquant; right side is absolute value of slope of isocost line.

b)   Suppose isoquant steeper than isocost: MPl/MPk > Pl/Pk, means marginal product per $ on L greater than on K. Spend additional dollar on L, move down isocost.

4.       Expansion path is set of tangencies over which firm can freely choose—unlike consumer who has given income level. Can’t determine optimum point on expansion path until know about MR in product market.

B.          Long-run cost curves

1.       Can use the firm’s expansion path to construct long-run cost curves.

2.       See Ex. 6-11; now in long run firm hires any combination of K and L it wants.

3.       Similar to SR curves, can construct long-run versions of MC and AC curves from the total cost curve. (Exhibit 6-12.)

Firm short-run supply curve

A.         To maximize profits, given Q* > 0, must have MR = MC. For competitive firm, this implies setting q such that P = MC. (Follows from Equimarginal Principle.)

B.          If worth producing at all, firm’s short-run supply curve is given by rising portion of MC curve above the shutdown price (see point D below).

C.         Notice that fixed costs are sunk in the short run, so they are irrelevant in determining output in the short run.

D.         Regarding point B, have to determine whether it is worth producing at all: shutdown price.

1.       Variable costs are avoidable. If total revenue not covering these—if TR < VC—can minimize loss by shutting down. That is, if TR < VC, firm loses less by shutting down.

2.       So shut down if TR/Q < VC/Q; this is the same as P < AVC.

3.       That implies firm should operate only if P > AVC. Thus, competitive firm’s short-run supply curve is MC above AVC.

E.          Supply curve is upward sloping because MC is upward sloping due to diminishing marginal returns

Where marginal cost is upward sloping.  important that it intersects at min points of ATC and AVC curves.

ATC = Avg Total Cost

AVC = Avg Cost

Equal quantity, any point along the production curve.  An isoquant produces the same output. 

Also has similar properties of indifference curve:

1) Negatively sloped

2) Property has at least one isoquant

3) No 2 isoquants can intersect

4) bend in towards arch

note:  they do not have to be parallel.

Price of Labor = (P labor * labor) + P capital * capital) = Expenditure

As long as there is a tangency, teh best combo of K & L and best output for a given expenditure.

1) Enormous # of sellers and buyers

2) Strip out all considerations of quality

3) assume customers have perfect knowledge on sellers & offering prices.  Will look for lowest price.

4) on sellers side, no barries to enter or exit.

1) Firm, Short Run

2) Industry, Short Run

3) Firm, Long Run

4) Industry, Long Run

A.         What it can be used for:

1.       To show role of prices in coordinating decentralized economy. Adam Smith’s day they wondered whether central coordination was essential.

2.       To study effects of exogenous supply and demand shocks.

3.       Pedagogical purpose; important ideas covered

a)   Equimarginal principle

b)   Law of Diminishing Marginal Returns

c)   Market equilibrium—marginal firm earns zero economic profits

B.          Socially desirable properties of perfectly competitive equilibrium sometimes lead people to want to use it as a benchmark (recall discussion of Pareto efficiency)

1.       Consumptive efficiency: given initial distribution of income, a given quantity of a good goes to the people who value it the most.

2.       Consumer sovereignty: goods which consumers want most are ones produced.

3.       Productive efficiency: goods are produced at lowest possible cost.

4.       Zero excess profits for businesses.

5.       Decentralized power and freedom of opportunity.

C.       But applying benchmark to actual policy can be as foolish as thinking that because physics uses frictionless model, we should coat all real-world surfaces with oil and grease.

D.         Problems with perfectly competitive model

1.       Assumes consumer information costs are zero.

2.       Doesn’t talk at all about internal structure of firms. How to organize production, how to compensate employees, etc.

3.       Doesn’t consider tradeoff between static efficiency (the “snapshot”) and dynamic efficiency (the “movie”). Consider patents.

E.          Schumpeter article

1.       Capitalism is an evolutionary process: Its fundamental impulse is toward new consumer goods, new methods of production and transportation, new markets, new forms of business organization. “Creative destruction” the essence of capitalism.

2.       More important than price competition important: new markets, organizational forms, etc. Assembly line at Ford, divisional structure at GM, Wal-Mart.

3.       Must judge economic performance over time, not at a point in time. Example: patents.

4.       Practices must be understood against “perennial gale of creative destruction.”

5.       These other forms of competition give not marginal advantages but decisive advantages that can destroy competitors.

a)   So much more powerful than price competition, it matters little how effective price competition is. Intel?

b)   This powerful competition does not have to be in evidence for it to be effective: “It disciplines before it attacks.”

Theory: Firm, Short Run

Perfect Model Competition

Uses cost curves AVC, ATC, MC.

What is optimal output?

Where do you start?  Equimarginal Principle

P = MC

* if P is equal or > AVC, S = MC Curve

If P <AVC, S = 0

If P< AVC -> Firm should Shut Down!

If price is below avg variable cost, best output is zero.

Theory: Industy, Short Run

Perfect Model Competition

# of firms cannot change, it is fixed.

Need to add up all of the firm curves.  We'll call this "Sigma" Curve.

"Sigma" Curve

(book does not have name)

It is the supply curve if there is no factor of price effect.

The Sigma curve will be more elastic than the average firm curves.

Cost curves wold all move if industry had to incease price of labor.

Is labor specialized?  If not, labor rate should not have to rise.

1.       Decision-maker doesn’t have to know conditions in specific market, only needs to know that price is higher.

2.       Prices coordinate information and bring about solution that a single mind might have arrived at had it possessed all the dispersed information.

3.       Suppose valuable new use of tin is discovered or that one of the sources of supply of tin is eliminated. What happens?

a)   Users begin to bid up the price.

b)   Other users, who get relatively less value and have easier substitution, switch, freeing up tin for the valuable new use.

c)   Suppliers try to produce more.

d)   Tin flows from less valuable uses to more valuable users. Automatically, without central control. No central authority could gather at reasonable cost all the information about tin’s uses, its substitutes, its sources, its methods of production and distribution.

4.       Individuals need understand very little. (Civilization advances by the number of operations people can perform without conscious control.) Can react to conditions in faraway markets without knowing cause and without explicit orders.

Summary: prices

A.         Aggregate and transmit information from all sources.

1.       Demanders’ offer prices indicate individuals’ relative value for goods and services.

2.       Sellers’ offer prices indicate opportunity cost of resources.

3.       Are easily transmitted and cheap to observe. Allow market participants who are miles away and have no specialized knowledge ready access to important information. (See Hayek.)

B.          Offer market participants the proper incentives to act according to what is in best interest of society.

1.       Induce suppliers to produce goods and services most highly valued by demanders and to send them where they are wanted most.

2.       Discourage wasteful use of scarce resources by demanders.

Maurice and Smithson excerpts about Doomsday Myth

What will happen if we run out?

Policy Impication - let's postpone it from happening.  How?  Tax it!

What happens economically?  Demand Increasing, supply is not, causes prices to continue going up.

Demanders would substitute, Suppliers would look for alternatives.

Firm, Long Run

Theory - Perfect Model Competition

What is optimal output?

MC = MR = price

if Q* > 0

if P < ATC, firm should produce 0.

Long run change is when price = ATC

This is Exit, not shutdown in Long Run.  Want to leave when P<ATC

Industy, Long Run

Theory - Perfect Model Competition

The marginal firm must earn 0 economic profits.

Constant Cost Industry = Think about 2 questions

1) Do we want to think of firms as identical?  Yes - all have same cost & supply curve.

2) Do we think ther eis a factor price effect?  No

Flat Supply curve, p[rice will be flat at P = Min AC

1) Perfect Comp. Model casts light on role of prices

2) Can be used to develop industry supply curve

3) Learning - Development of Ideas

       - Equimarginal Principles

       - Law of Diminishing Returns

       - Equilibrium

All full equilibriums

1) Lowest possible cost

2) What goods to be produced?

3) All firms equal 0 economic profits (no excess)

In the model - no restrictions to entrance or exit in the industry

1) Assumes no customer issues (trust, satisfaction, behavior)

2) No discussion about teams, set-up, compensation

3) Issue between static vs. dynamic analysis

We can't say if perfect competion would be ideal for innovation...not clear.

1. The variable cost (VC) is always increasing, because more output requires more labor and hence higher costs.
2. The total cost (TC) curve is determined by the forumla TC=FC+VC, where FC (fixed cost) is constant. Therefore, it has exactly the same shape as the VC curve.
3. The marginal cost (MC) curve is U-shaped.
4. The average cost (AC) and average variable cost (AVC) curves are also U-shaped.
5. When marginal cost is below average variable cost, average variable cost is falling. To see why, consider a situation where you've already produced 10 items at an average variable cost of $12 apiece. If the 11th item has a marginal cost below $12 (that is, if MC is below AVC), then it will lower the average variable cost below $12 (that is, if MC is below AVC), then it will lower the average variable cost below $12 (that is, average cost falls as the quantity increases from 10 to 11).
6. When marginal cost is above average variable cost, average variable cost is rising.
7. Marginal cost crosses average variable cost at the bottom of the average variable cost "U". This is a geometric consequence of points 5 and 6. When marginal cost is just equal to average variable cost, average variable cost is just changing from falling to rising.
8. The analogs of points 5, 6 and 7 hold when average variable cost is replaced by average cost, and they hold for the same reasons. Thus when marginal cost is below average cost, average cost is falling; when marginal cost is above average cost, average cost is rising; marginal cost crosses average cost at the bottome of the average cost U.
9. The shapes of the cost curves are releated to the shapes of the product curves. For example, we have AVC=P_L/APL and MC=P_L/MPL, where P_L (the wage rate of labor) is a constant. These formulas convert the inverted U shapes of APL and MPL to the U shapes of AVC and MC.

Marginal rate of Technical Substitution of labor for capital (K=Capital)

EX: Suppose that a construction firm produces 1 house per day by employing 100 carpenters and 10 power tools. Then it is reasonable to think when a carpenter calls in sick, the firm can maintain its level of production through a small increase in power tool usuage. On the other hand if the same firm only employes 10 carpenters and 100 power tools, we expect it need a much larger increase in tool usage to compensate for the same absent carpenter. In other words, when much labor and little capital are employed to produce a unit of output, MRTS_LK, is large. Geometrically, this means that at points far to the southeast, the isoquant (downward sloping) is shallow, while at points to the northwest it is steep. Thiat is, the isoquant is convex.

Critical difference between the consumer (who seeks tangency between his budget line and an indifference curve) and the firm (which seeks a tangency between an isocost and an isoquant) is a consumer has a given income to divide among consumption gods, whereas a firm can choose its level of expenditure on inputs.  Put another way, a consumer is constrained to only one budget line, whereas a firm has a whole family of isocosts (one for eeach leve of expenditure). Unlike an individual a firm has no budget constraint, individuals pursue consumption, wheras firms pursue profits.

Tangencies b/w isocosts and isoquants lie along a curve called the firm's expansion path.

1. Horizontal

2. Downward Sloping

Flat

Ex: $50 per unit and for every unit Marginal revenue is additional $50

The Firm's Supply Decision

A competitive firm, if it produces anything at all, produces a quantity where:

Supply

Marginal Cost

TR (Total Revenue) - TC (Total Costs) > -FC (Fixed Costs)

or

TR>VC

or P>AVC

In other words, the firm continues to operate in the short run, if at the profit-maximizing quantity, the price of output exceeds the average variable cost.

Elasticity = Percentage change in quantity demanded / PErcentage change in price

Elasticity of supply is positive because an increase in price brings forth an increase in the quantity supplied. Given two supply curves through the same point, the flatter one has the higher elasticity

1. Some costs that are fixed in the short run become variable in the long run
2. Firms can enter or exit from the industry in the long run

Economic

Total revenue minus all costs, including the opportunity cost of being in another industry

Cost Minimization

When a competitive firm breaks even, it produces at the lowest possible average cost

1. You should begin by drawing supply and demand curves for both the industry an the firm. industry supply curve is always upward sloping in the short run and in the long run  either flat (if industry is constant-cost) or upward sloping (if industry is increasing cost).  Demand curve should always be drawn flat at the price determined by the industry wide equilibrium

Using the Competitive Model

Fundamental principles to keep in mind in analyzing a change in equilibrium

1. Shifts in the Firm's Supply Curve: Firm's supply curve coincides with its marginal cost curve. Therefore, only a change in marginal costs can affect it. A cost is marginal only if it varies with output. In the short run, marginal costs include labor and raw materials.
2. Shifts in the Short-Run Industry Supply: In the short run, the industry supply curve is the sum of the individual firms supply curves. Therefore, it shifts only if there is a change in supply at the individual firms.
3. Shifts in teh Long-Run Industry Supply Curve: The long-run industry supply curve shifts in response to any change in profitability - unless the change in profitability is due to a change in the price of output, in which case it is reflected by a movement along, rather than of, the long run supply curve. However remember that sunk costs are sunk, son only future costs are relevant.
4. The Individual Firm's Exit Decision: The Constant-Cost Case:   In a constant-cost industry, every firm is completely indifferent about whether to remain in the industry. Thus, anything that reduces profits at just one firm must drive that firm from the industry.
5. Demand Curves: After shifting the firm's and the industry's supply curves, and after deciding whether the firm remains in teh industry, determine whether there is any shift in the industry demand curve. Then if there has been a shift in industry equilibrium (due to shifts in either industry supply, industry demand or both) draw the new firm demand curve as horizontal at the new industry equilibrium price.