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Unit 2 Unit 2 Presentation Transcript

  • Theory of the Firm Section 2.3 HL Discuss the following with the person next to you: •What is the difference between profit and revenue? •Come up with concrete examples of: - Monopolies - Oligopolies - Monopolistic Competition - Perfect Competition • What is the goal of a firm?
  • Unit 2.3 - Theory of the Firm Introduction to the Four Market Structures Most competition Least competition Pure (or Perfect) Monopolistic Oligopoly Monopoly Competition competition VERY large number of firms A few large firms Only ONE firm. The Fairly large number of dominate an industry firm IS the industry! firms Each firm is so small that changes in its own output do A change in one firm's Significant barriers to Firms are small relative to not affect market price, i.e. output has significant entry exist, the industry, meaning firms are price takers impact on the market preventing new firms changes in one firms price, firms are price- from entering and output have only a slight Firms all produce identical makers. competing with the impact on market price products, with no monopolist differentiation Products can be iden- Products are slightly tical (such as oil) or differentiated. Firms will the Monopolist can Completely free entry and differentiated (such as advertise to try and maintain significant exit from the industry, i.e. Macs and Dells) further differentiate profits due to the lack NO barriers to entry. product. Branding! There are significant of competition. Advertising! All producers and barriers to entry consumers have perfect Changes in the firm's No barriers to entry, firms knowledge of prices, costs, Firms will likely use output cause changes can enter or leave easily and quality and availability advertising to try and in the price, i.e. the of products differentiate their firm is a price-maker! products from competitors'
  • Unit 2.3 - Theory of the Firm Introduction to the Four Market Structures Examples of different market structures: Based on the characteristics of the different market structures, brainstorm examples of each. Pure Monopolistic Oligopoly Monopoly Competition competition Practice: Different types of Market Structure - NCEE Activity 24 View slide
  • Unit 2.3 - Theory of the Firm Unit Overview Unit 2.3.1 - Introduction to Market Structures Long-run and Cost Theory ·Economies of scale ·Diseconomies of scale Intro to Market Structures ·Long-run cost curves ·Pure competition ·Monopolistic competition Revenues ·Oligopoly ·Total revenue ·Monopoly ·Marginal revenue ·Average revenue Cost theory ·Types of costs: fixed costs, variable costs ·Total, average and marginal costs Profit ·Accounting costs = opportunity costs = economic ·Distinction between normal (zero) and costs supernormal (abnormal) profit ·Profit maximization in terms of total revenue Short-run and total costs, and in terms of marginal ·Law of diminishing returns revenue and marginal cost ·Total product, average product, marginal product ·Profit maximization assumed to be the main ·Short-run cost curves goal of firms but other goals exist (sales volume maximization, revenue maximization, environmental concerns) Blog posts: “Economies of Scale” Blog posts: "Costs of Production" Blog posts: "Productivity" Blog posts: “Law of Diminishing Returns” View slide
  • Unit 2.3 - Theory of the Firm Unit Overview 2.3.2 - Perfect competition Efficiency in monopoly ·Assumptions of the model ·Price discrimination ·Demand curve facing the industry and the firm in >>Definition perfect competition >>Reasons for price discrimination ·Profit-maximizing level of output and price in the >>Necessary conditions for the practice of price short-run and long-run discrimination ·The possibility of abnormal profits/losses in the >>Possible advantages to either the producer or short-run and normal profits in the long-run the consumer ·Shut-down price, break-even price ·Definitions of allocative and productive efficiency 2.3.4 - Monopolistic competition ·Efficiency in perfect competition ·Assumptions of the model ·Short-run and long-run equilibrium 2.3.3 - Monopoly ·Product differentiation ·Assumptions of the model ·Efficiency in monopolistic competition ·Sources of monopoly power/barriers to entry ·Natural monopoly 2.3.5 - Oligopoly ·Demand curve facing the monopolist ·Assumptions of the model ·Profit-maximizing level of output ·Colusive and non-collusive oligopoly ·Advantages and disadvantages of monopoly in ·Cartels comparison with perfect competition ·Kinked demand curve as one model to describe interdependent behavior (IB HL only) ·Importance of non-price competition ·Theory of contestable markets (IB HL only)
  • Costs of Production Big Ideas Important questions: 1) What is productivity and how does it change as resources (LAND, LABOR, CAPITAL) are added to production? 2) What are the different costs faced by firms in the short-run and the long-run? 3) What is the relationship between the productivity of its resources and the costs faced by a firm? 4) Why does understanding productivity and costs matter to firms? Discussion Question: What is productivity, and why do firms care about it? Blog posts: "Productivity"
  • Costs of Production Law of Diminishing Returns Understanding Productivity: Productivity (OUTPUT) : The amount of output attributable to a unit of input. Examples of productivity: "Better training has increased the productivity of workers" "The new robot is more productive than older versions" "Adding fertilizer has increased the productivity of farmland" Total prod. (TP or TO) is the total output of a particular firm Example of TP: "After hiring more workers the firm's total product increased." Marginal prod. of labor (MPL) is the change in total product resulting from each additional worker. >>MPL = ∆TP/∆L Average prod. of labor (APL) is the output, on average, by each worker >>APL = TP/units of L
  • Costs of Production Law of Diminishing Returns Law of Diminishing Returns:states that as additional units of a variable resource are added to fixed resources, beyond some point the marginal product of the variable resource will decline. HUH? Let's illustrate this with an example Example: Paper Chain Factory Instructions: 1) Use inputs (land, labor and capital) to create a product (paper chains) 2) Labor is the only variable resource. Land and capital are fixed. 3) Production rounds last one minute 4) Record production data in a data table LAND (fixed) LABOR (variable) CAPITAL (fixed)
  • Costs of Production Law of Diminishing Returns Units of labor TP MP AP One worker has one minute to make the longest chain possible. 0 A volunteer is needed to 1 record output data in the 2 table to the right. 3 As more workers are added, TP, MP and AP will 4 be calculated and recorded. 5 MP = ∆TP/∆L L 6 AP = TP/units of L L 7 8
  • Costs of Production Law of Diminishing Returns MP/ 9 Marginal/Average Product AP 8 7 Data: 6 Units of labor TP MP AP 5 4 0 3 2 1 1 2 0 -1 1 2 3 4 5 3 -2 4 TP 18 Total Product 16 5 14 12 6 10 7 8 6 8 4 2 0 1 2 3 4 5 Units of Labor
  • Costs of Production Law of Diminishing Returns Marginal/Average Product MP/AP Observations: Diminishing returns sets in Describe what happens to TP as more and more labor is added to a fixed amount of capital and land TP increases at an increasing rate as workers' MP AP increases, at a decreasing rate as MP falls, and declines as MP becomes negative. MP What is the relationship between TP and MP? 0 10 20 30 40 50 Units of Labor MP is the rate of increase in TP TP Total Product What is the relationship between MP and AP? When MP is greater than AP, AP increases. MP intersects AP at its highest point, and when MP is TP less than AP, AP decreases MP becomes negative, TP begins to fall Why does a producer care about the productivity of i workers and other resources? Because firms’ average and marginal costs in 0 10 20 30 40 50 the short-run are inversely related to the Units of Labor productivity of its workers
  • Costs of Production Law of Diminishing Returns Conclusions: ·Explanation of increasing returns : ·Explanation of diminishing returns: ·Negative marginal product and implications: ·Implications of diminishing marginal returns to producers: Blog posts: “Law of Diminishing Returns”
  • Costs of Production Marginal/Average Product Law of Diminishing Returns MP/ 9 Posters for Econ. AP 8 7 Data: 6 Units of labor TP MP AP 5 0 0 4 3 1 6 2 1 2 14 0 -1 1 2 3 4 5 3 21 -2 4 24 TP 18 Total Product 16 5 20 14 12 10 8 6 4 2 Fill in the chart and the graphs above. 0 1 2 3 4 5 Where is the law of diminishing Units of Labor returns?
  • Costs of Production Productivity and costs Productivity and Costs: As worker productivity increases, firms get "more for their money", meaning per-unit and marginal costs decrease. When productivity decreases, costs increase. Discussion: When productivity of workers is Costs and Productivity rising, firms costs are falling, since they're getting more output for workers while paying MC them the same wages. Product/costs ·When marginal product is increasing (increasing returns) marginal cost is falling AP ·When MP is at its maximum, MC is at its minimum AC ·When diminishing returns set in, MP begins falling and MC begins rising ·MP intersects average product at its highest MP point, and MC intersects average total cost at its lowest point Units of Labor/ units of output Summary: Increasing marginal returns is reflected in a declining marginal cost, and diminishing marginal returns in a rising marginal cost!
  • Costs of Production Short-run Costs of Production What is the short-run? "the fixed-plant period" The short-run is the period of time over which a firm's plant size is fixed. Capital cannot and land cannot be varied, labor is the only variable resource. To increase output in the short-run, a firm can only increase inputs of labor, not the other resources. Total Costs: Total fixed costs (TFC): These are the costs a firm faces that do not vary with changes in short-run output. Could include rent on factory space, interest on capital (already acquired). Total variable costs (TVC): These are the costs a firm faces which change with the level of output in the short-run. Could include payment for raw materials, fuel, power, transportation services, wages for workers, etc... Total cost:TFC + TVC at each level of output
  • Costs of Production Short-run Costs of Production Resource costs in the short-run: Rent - the payment for land: Rent is fixed in the short-run since firms cannot add this resource to production. Rents must be paid regardless of the level of the firm's output. Interest - the payment for capital: Interest is fixed in the short-run since firms cannot add this resource to production. Interest must be paid on loans regardless of the level of the firm's output. Wages - the payment for labor: Wages are variable in the short-run, since firms can hire or fire workers to use existing land and capital resources. Wage costs increase when new workers are hired, and decrease when workers are laid off. Normal profit:the minimum level of profit needed just to keep an entrepreneur operating in his current market. If he does not earn normal profit, an entrepreneur will direct his skills towards another market. Normal profit is a cost because if a firm does not earn normal profit, it is not covering its costs and may shut down. Other short-run variable costs of production: ·Transportation costs: Firms pay lower transport costs at lower levels of output. ·Raw material costs: vary with the level of output ·Manufactured inputs: fewer parts are needed from suppliers when a firm lowers output.
  • Costs of Production Short-run Costs of Production Graphing total costs: TFC: Notice that regardless of the level of output, TFC remains constant. This is because these are costs that do not vary with output. TVC: Notice that when output is zero, TVC is zero, because you do not need to hire any workers or use any raw materials if you're not producing anything. As output increases, TVC continues to increase TC: Notice that when output is zero, TC = TFC. But once the factory begins pumping out products, TC rises with TVC. TC is the sum of TFC and TVC, since both fixed and variable costs make up total cost. TC Diminishing returns: Costs TVC ·Notice that TC and TVC increase at a decreasing rate at first. This is when marginal product is increasing as more labor is employed (firms get "more for their money") ·However, beyond some point, costs begin 100 TFC to increase at an increasing rate. This is where diminishing returns set in and MP is decreasing. The firm is getting less 0 Point at which Q of output additional output from each worker hired, diminishing returns sets in but must pay the same wages regardless. (The firm gets "less for its money")
  • Costs of Production Short-run Costs of Production Average Costs: Average fixed cost:AFC=TFC/Q AFC will decline as output rises, never increases. This is because the fixed cost (which never goes up) is “spread out” as output goes up. This is called “spreading the overhead” Average variable cost:AVC = TVC/Q For simplicity, we will assume that labor is the only variable input, the labor cost per unit of output is the AVC Average total cost:ATC = TC/Q Sometimes called unit cost or per unit cost. ATC also equals AFC + AVC Marginal Cost = the additional cost of producing one more unit of output. MC = ∆TVC/∆Q.
  • Theory of the Firm Section 2.3 HL Price Quantity of output Draw a graph to represent revenue and explain it.
  • Costs of Production Short-run Costs of Production Graphing Average and Marginal Costs: AFC: it declines as output increases. This is called "spreading the overhead". ATC and AVC: At first they are declining as output increases. This is during the stage when MP is increasing, since new labor is making better use of capital and beginning to specialize. AVC: When AVC is at its minimum, average product is at its maximum, meaning workers are producing the most output per worker. As more workers are added, average product begins to go down, and AVC begins to rise. Costs Short-run Costs Things to notice: ·the vertical distance between ATC and AVC equals the AFC at each level of MC output. ATC ·MC intersects both AVC and ATC at their minimum. This is because if the last unit AVC produced costs less than the average, then the average must be falling, and vis versa (just like your test scores!) AFC ·MC is at its minimum when MP is at its Point at which Q maximum, because beyond that point diminishing returns sets in diminishing returns sets in and the firm starts getting less for its money!
  • Costs of Production Short-run Costs of Production Labor is the only variable resource and the wage = $200 / week Rent and interest are fixed costs, and = $400 / week QL TP (Q TFC TVC TC AFC AVC ATC MC supplied ) 0 0 400 1 10 2 25 3 45 4 70 5 90 6 105 7 115 8 120 Describe and explain what happens to each of the following as output increases: 1) TFC 2) TC 3) AFC 4) AVC and ATC 5) MC
  • Costs of Production Short-run Costs of Production Labor is the only variable resource and the wage = $200 / week Rent and interest are fixed costs, and = $400 / week QL TP (Q TFC TVC TC AFC AVC ATC MC supplied ) 0 0 400 1 10 2 25 3 45 4 70 5 90 6 105 7 115 8 120 Describe and explain what happens to each of the following as output increases: 1) TFC 2) TC 3) AFC 4) AVC and ATC 5) MC
  • Costs of Production Short-run Costs of Production Costs Short-run Costs Discussion Questions: Short-run Costs MC ATC AVC 1) State the law of diminishing returns and explain how it determines the AFC shape of the marginal cost curve. Q TC Costs TVC 2) Explain the relationship between the marginal cost curve and the average variable and average total cost curves. 3) What determines the distance TFC between the ATC and the AVC at a Point at which particular level of output. Q diminishing returns sets in
  • Costs of Production Short-run vs. Long-run costs Long-run is the variable plant period, meaning that firms can open up new plants, add capital to existing plants, or close plans and remove capital if need be. Economies of scale: are the cost advantages that a business obtains due to expansion. As new plants open, ATC declines. WHY? ·better specialization, division of labor, bulk buying, lower interest on loans, lower per unit transport costs, larger and more efficient machines, etc... Also called "Increasing returns to scale" Minimum Efficient Scale (MES): The minimum level of output a firm must achieve to achieve the lowest average total cost. Diseconomies of Scale: When a firm becomes "too big for its own good" it experiences diseconomies of scale. Continuing to add plants and increase output causes ATC to rise. WHY? Mostly due to control and communications problems, trying to coordinate production across a wide geographic area may make firm less efficient. Also called "Decreasing returns to scale" Blog posts: “Economies of Scale”
  • Theory of the Firm Section 2.3 HL Define economies of scale in your own words and explain why they are possible. You may use your notes but not your book.
  • Costs of Production Short-run vs. Long-run costs Graphing long-run ATC: The gray curves represent all the SR ATC curves the firm experiences as it opens new plants. As it opens its first 10 plants, ATC declines, while for plants 11-16 ATC remains constant. Costs Beyond 16 plants the firm's ATC begins to rise, indicating it has gotten too big. ATC LR Economies Diseconomies of scale of scale Constant returns to scale MES Q Blog posts: "Economies of Scale"
  • FIXED COST (FC) VARIABLE COST (VC) Costs TOTAL COST (TC) Quantity of output
  • AFC AVC MC Costs ATC Quantity of output
  • TP (TO) WHAT GOES HERE? WHAT GOES HERE?
  • AP (AO) MP (MO) WHAT GOES HERE? WHAT GOES HERE?
  • TC TR COSTS $ Quantity of Output
  • MC MR COSTS $ Quantity of Output
  • LRAC (LRATC) COSTS $ Quantity of Output