COST AND PRODUCTION THEORY

COST THEORYPRODUCTION THEORY April 28, 2011

QUIZ For #s 1-3, indicate whether the statement describes an INCOME EFFECT or SUBSTITUTION EFFECT if the PRICE OF GOOD X FALLS: 1. You buy more of good X since you feel richer. 2. You buy more of both good X and Y.

QUIZ 3. Get more good X for every good Y you give up. 4. T or F: The income effect is a movement to a higher IC resulting from a change in income. 5. T or F: The substitution effect is the movement in the same IC but with higher MRS.

QUIZ BONUS: DTI announced an increase in prices of basic commodities due to an increase in the prices of raw materials. What kind of inflation is this? (Hint: Cost-push or demand-pull)

INCOME AND SUBSTITUTION EFFECTS MILK TEA Draw your initial BL1 and IC1 The initial optimum level is at point A A IC1 WAFFLES BL1

INCOME AND SUBSTITUTION EFFECTS MILK TEA Due to a decrease in P of milk tea, BL1 shifts to BL2 BL2 WAFFLES BL1

INCOME AND SUBSTITUTION EFFECTS MILK TEA Draw a new IC2 tangent to your BL2 Label the new optimum as point C BL2 C IC2 WAFFLES

INCOME AND SUBSTITUTION EFFECTS MILK TEA Draw an imaginary BL3 parallel to your BL2 Draw it tangent to IC1 Label the new optimum as point B BL3 B IC1 WAFFLES

INCOME AND SUBSTITUTION EFFECTS MILK TEA AB: subs effect Same IC1 BC: inc effect Different IC AC total effect C B A WAFFLES

INCOME AND SUBSTITUTION EFFECTS MILK TEA YELLOW – income effect GREEN – subst. effect C B A WAFFLES

AC total effect,[object Object]

DERIVING THE DEMAND CURVE Graph the different optimal points in the Price and Quantity axes Since there was a change in price, demand also changes

DEMAND CURVE P – price Y – per capita income PR – price of related goods T – Tastes N – population

DEMAND FORECASTING a0 to a6 are parameters Represent the change of consumer demand per unit change in each determinant If any parameter is 0, no effect from that determinant Plug in values to parameters  get demand forecast

DEMAND FORECASTING a0 – autonomous consumption a1 – ΔQD per P1 change in price a2 – ΔQD per P1000 change in per capita income a3 – ΔQD per P1 change in P of rel. good a4 – ΔQD per P1 change per year a1 – ΔQD per P1M change of population

COST THEORY Every production has a cost Goal of each firm is to maximize profits

TERMS Revenue = PQ (goods bought) Total Cost = PQ (inputs bought) Profit = TR – TC Accounting Cost = explicit costs Econ Cost = explicit + implicit costs

TERMS Explicit Cost = exchange of money Implicit Cost = No money given out Accounting Profit = TR – TC TR – explicit costs Econ Profit = TR – TC TR – explicit costs – implicit costs

PRODUCTION Transformation of inputs into goods and services Production Function – Relationship between Q of inputs (workers) and Q of outputs (bread)

MARGINAL PRODUCT Increase in output (bread) resulting from an additional unit of input (workers) LAW OF DIMINISHING MARGINAL PRODUCTIVITY – Marginal product of an input decreases as Q of input increases

PROD’N FXN AND TOTAL COST Production Function Flatter as number of workers increase Kitchen is more crowded, each additional worker adds less to prod’n Total-Cost Curve Steeper as number of workers increase Producing addt’l bread requires addt’l worker, thus each addt’l bread is more costly

MEASURES OF COST FIXED COSTS (FC) – Costs that do not vary with the quantity of output produced Incurred even without production Ex: Rent AVE. FIXED COST (AFC) – FC/Q ,[object Object]

As Q increases, cost per unit decreases,[object Object]

MEASURES OF COST VARIABLE COST (VC) – Costs that vary with Q of output produced More output = more inputs, more costs AVE. VAR COST (AVC) = VC/Q TOTAL COST (TC) = FC + VC AVE. TOTAL COST (ATC) = TC/Q Cost of a typical unit

MEASURES OF COST Marginal Principle – every addt’l unit MARGINAL COST (MC) – increase in TC as a result of extra output produced How much it costs to increase production by 1 more unit MC = ΔTC/ ΔQ

COST CURVES AND THEIR SHAPES MC

RISING MARGINAL COST MC rises with Q Reflects LDMP With low production Few workers, equipment not used MP per worker large, MC per output is low High Production Many workers, all equipment used MP per worker low, MC per output large

COST CURVES AND THEIR SHAPES MC ATC

U-SHAPED AVE TOTAL COST ATC = AVC + AFC AFC goes down as Q rises AVC goes up as Q rises Low level of output ATC high (AVC low, AFC high) High level of output ATC high (AFC low, AVC high)

MC and ATC MC < ATC  ATC falling (low Q) MC > ATC  ATC rising (high Q) Ex: ATC = QPI, MC =Ec102 Grade If Ec102 < QPI, QPI falls If Ec102 > QPI, QPI increases MC crosses ATC at minimum ATC

COST CURVES AND THEIR SHAPES MC ATC AVC

COST CURVES AND THEIR SHAPES MC ATC AVC AFC

TYPICAL COST CURVES MP increases, then decreases Low levels of output Increasing MP, MC falls High levels of output Diminishing MP, MC increases AVC  U-shaped

TYPICAL COST CURVES MC eventually rises with Q output ATC u-shaped MC crosses ATC at minimum of ATC

LONG-RUN ATC (LRATC) Cost depends on time horizon Short-run – can’t change size of factories (fixed cost) Long-run – more flexible to changes (variable cost)

ECONOMIES OF SCALE (EOS) EOS: LRATC falls as quantity of output increases Diseconomies of Scale – LRATC rises as Q output increases Constant Returns to Scale (CRTS) – LRATC is constant as Q output changes

MARKET STRUCTURES Group of buyers and sellers Type of market structure influences how a firm behaves: Pricing Supply Barriers to Entry Efficiency Competition

MARKET STRUCTURES Competitive Perfect Monopolistic Monopoly Oligopoly Monopsony

DETERMINANTS OF MARKET STRUCTURES Freedom of entry and exit Nature of the product – homogenous (identical), differentiated Control over supply/output Control over price Barriers to entry

COST AND PRODUCTION THEORY

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