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Cost and Production Theory

Cost and Production Theory

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  • 1. COST THEORYPRODUCTION THEORY
    April 28, 2011
  • 2. 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.
  • 3. 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.
  • 4. 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)
  • 5. INCOME AND SUBSTITUTION EFFECTS
    MILK TEA
    Draw your initial BL1 and IC1
    The initial optimum level is at point A
    A
    IC1
    WAFFLES
    BL1
  • 6. INCOME AND SUBSTITUTION EFFECTS
    MILK TEA
    Due to a decrease in P of milk tea, BL1 shifts to BL2
    BL2
    WAFFLES
    BL1
  • 7. 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
  • 8. 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
  • 9. 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
  • 10. INCOME AND SUBSTITUTION EFFECTS
    MILK TEA
    YELLOW – income effect
    GREEN – subst. effect
    C
    B
    A
    WAFFLES
  • 11.
  • TO GRAPH
    Graph IC1 tangent to BL1
    Increase BL1 to BL2 (decrease in P)
    Draw a new IC2 tangent to BL2
    Draw an imaginary BL3 against IC1, parallel to BL2
    AB is substitution effect
    BC is income effect
  • 16. 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
  • 17. DEMAND CURVE
    P – price
    Y – per capita income
    PR – price of related goods
    T – Tastes
    N – population
  • 18. 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
  • 19. 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
  • 20. COST THEORY
    Every production has a cost
    Goal of each firm is to maximize profits
  • 21. TERMS
    Revenue = PQ (goods bought)
    Total Cost = PQ (inputs bought)
    Profit = TR – TC
    Accounting Cost = explicit costs
    Econ Cost = explicit + implicit costs
  • 22. 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
  • 23. PRODUCTION
    Transformation of inputs into goods and services
    Production Function – Relationship between Q of inputs (workers) and Q of outputs (bread)
  • 24. PRODUCTION FUNCTION
  • 25. PRODUCTION FUNCTION
  • 26. TOTAL COST FUNCTION
  • 27. 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
  • 28. 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
  • 29. PRODUCTION FUNCTION
  • 30. TOTAL COST FUNCTION
  • 31. MEASURES OF COST
  • 32. 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
    • As production increases, average fixed cost decreases
    • 33. As Q increases, cost per unit decreases
  • MEASURES OF COST
  • 34. 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
  • 35. MEASURES OF COST
  • 36. 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
  • 37. MEASURES OF COST
  • 38. COST CURVES AND THEIR SHAPES
    MC
  • 39. 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
  • 40. COST CURVES AND THEIR SHAPES
    MC
    ATC
  • 41. 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)
  • 42. 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
  • 43. COST CURVES AND THEIR SHAPES
    MC
    ATC
    AVC
  • 44. COST CURVES AND THEIR SHAPES
    MC
    ATC
    AVC
    AFC
  • 45. 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
  • 46.
  • 47. TYPICAL COST CURVES
    MC eventually rises with Q output
    ATC u-shaped
    MC crosses ATC at minimum of ATC
  • 48. 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)
  • 49. LONG-RUN ATC (LRATC)
  • 50. 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
  • 51. LONG-RUN ATC (LRATC)
  • 52. MARKET STRUCTURES
    Group of buyers and sellers
    Type of market structure influences how a firm behaves:
    Pricing
    Supply
    Barriers to Entry
    Efficiency
    Competition
  • 53. MARKET STRUCTURES
    Competitive
    Perfect
    Monopolistic
    Monopoly
    Oligopoly
    Monopsony
  • 54. 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
  • 55. PERFECTLY COMPETITIVE MARKET
    Many buyers and sellers
    Homogenous products (identical)
    Each buyer and seller is a price taker
    Firms can freely enter or exit the market
    • Perfect information available to buyers and sellers
  • ADVANTAGES OF PCM
    High degree of competition helps allocate resources to most efficient use
    Price = marginal costs
    Normal (econ) profit made in the long run (TR-TC)
    Firms operate at maximum efficiency
    Consumers benefit
  • 56. REVENUE
    Example: Nicole’s Bakery
    TR = PQ; P = determined by market
    If P = P2, Q = 1000, TR = P2000
    If Nicole’s Bakery increases production to Q = 2000, TR = P4000
    TR is proportional to amount of output