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# Chapter v

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### Chapter v

1. 1. 5/27/2014 1 MSc Le Thanh Thuy CHAPTER V: THE THEORY OF PRODUCER’S BEHAVIOR 2 This topic will give you a better understanding of what decisions lie behind the supply curve in a market 3 Why the behaviors of different firm are so STRANGE????
2. 2. 5/27/2014 2 I. Theory of production 1. Production function a. Definitions:  Production function: – Relationship between • Quantity of inputs used to make a good • And the quantity of output of that good – Gets flatter as production rises Cobb-Douglas function Q = f(K,L) = aKαLβ Returns to scale: Rate at which output increases as inputs are increased proportionately Return to Scale 6  How does firm decide, in long run, best way to improve output? Can change scale of production by increasing all inputs in proportion If double inputs, output will most likely increase but by how much?
3. 3. 5/27/2014 3 7  Economies of scale  Output increases at a higher rate than the increased rate of inputs  Increasing specialization  Constant returns to scale  Output increases at a same rate as the increased rate of inputs Costs in Short Run and in Long Run 8  Diseconomies of scale  Output increases at a lower rate than the increased rate of inputs  Increasing coordination problems Note: f(nK,nL) > nf(K,L): Economies of scale f(nK,nL) < nf(K,L): Diseconomies of scale f(nK,nL) = nf(K,L): Constant returns to scale What is the rule for Return to Scale in Cobb- Douglas production function??? - α+β < 1: Cobb-Douglas function presents diseconomies of scale - α+β > 1: Cobb-Douglas function presents economies of scale - α+β = 1: Cobb-Douglas function presents constant returns to scale
4. 4. 5/27/2014 4 2. Production in short-term 2.1 Definitions - Short-term refers to a production which has at least one unchanged input In Microeconomics we suppose there are 2 inputs (Capital – K and Labor – L).  Which of these two input can not be changed in short-term??? IT DEPENDS  Assumptions:  Technology during the production is supposed to be unchanged  Each labor provides same kind of service - Total quantity (Q): refers to the output of production using inputs of capital (K) and labor (L) - Average Physical Product (APP) refers to output per unit of input using in the production
5. 5. 5/27/2014 5 - Marginal Physical Product (MPP) or Marginal Product (MP) is a measurement of productivity. It refers to the additional output brought by an additional in the input 2.2 Diminishing marginal product  Marginal product of an input declines as the quantity of the input increases  As input use increases with other inputs fixed, resulting additions to output eventually decrease  When labor use is small and capital fixed, output increases since workers specialize; MP of labor increases  When labor use is large, some workers become less efficient; MP of labor decreases 15
6. 6. 5/27/2014 6  Diminishing marginal product 16 2.3 Relationship between MPP and APP: MPP intersect with APP at the maximum point of APP II. Theory of Production Cost (Short-run)  All firms, from Delta Air Lines to your local deli, incur costs as they make the goods and services that they sell.  As we will see in the coming chapters, a firm’s costs are a key determinant of its production and pricing decisions. Establishing what a firm’s costs are, however, is not as straightforward as it might seem
7. 7. 5/27/2014 7 What are Costs?  Costs as opportunity costs  The cost of something is what you give up to get it  Firm’s cost of production  Include all the opportunity costs  Making its output of goods and services 19 What are Costs?  Costs as opportunity costs  Explicit costs  Input costs that require an outlay of money by the firm  Implicit costs  Input costs that do not require an outlay of money by the firm 20 What are Costs?  The cost of capital as an opportunity cost Implicit cost Interest income not earned On financial capital  Owned as saving  Invested in business Not shown as cost by an accountant 21
8. 8. 5/27/2014 8 What are Costs?  Economic profit Total revenue minus total cost Including both explicit and implicit costs  Accounting profit Total revenue minus total explicit cost Which profit is expected to be larger? 22  Sunk Cost  Expenditure cannot be recovered should not influence firm’s future economic decisions 23 1. The Various Measures of Cost  Fixed costs (FC)  Do not vary with the quantity of output produced  Variable costs (VC)  Vary with the quantity of output produced  Total cost (TC) = FC + VC  Total-cost curve  Relationship between quantity produced and total costs  Gets steeper as the amount produced rises
9. 9. 5/27/2014 9 A production function and total cost: Caroline’s cookie factory 1 25 Number of workers Output (quantity of cookies produced per hour) Marginal product of labor Cost of factory Cost of workers Total cost of inputs (cost of factory + cost of workers) 0 1 2 3 4 5 6 0 50 90 120 140 150 155 \$30 30 30 30 30 30 30 \$0 10 20 30 40 50 60 \$30 40 50 60 70 80 90 50 40 30 20 10 5 Total Cost 50 40 30 20 10 80 70 60 \$90 Quantity of Output (cookies per hour) 100 80 60 40 20 160 140 120 Caroline’s production function and total-cost curve 2 26 (a) Production function - The production function gets flatter as the number of workers increases, which reflects diminishing marginal product. - The total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product. (b) Total-cost curve Number of Workers Hired 0 1 2 3 4 5 6 Production function Total-cost curve Quantity of Output (cookies per hour) 0 20 40 60 80 100 120 140 160 2. Average costs  Average fixed cost (AFC)  Fixed cost divided by the quantity of output  Average variable cost (AVC)  Variable cost divided by the quantity of output  Average total cost (ATC) ATC = AFC + AVC  Total cost divided by the quantity of output  Average total cost = Total cost / Quantity ATC = TC / Q
10. 10. 5/27/2014 10  Marginal cost (MC)  Increase in total cost  Arising from an extra unit of production  Marginal cost = Change in total cost / Change in quantity MC = ΔTC / ΔQ = TC’(Q) The various measures of cost: Conrad’s coffee shop 2 29 Quantity of coffee (cups per hour) Total Cost Fixed Cost Variable Cost Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost 0 1 2 3 4 5 6 7 8 9 10 \$3.00 3.30 3.80 4.50 5.40 6.50 7.80 9.30 11.00 12.90 15.00 \$3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 \$0.00 0.30 0.80 1.50 2.40 3.50 4.80 6.30 8.00 9.90 12.00 - \$3.00 1.50 1.00 0.75 0.60 0.50 0.43 0.38 0.33 0.30 - \$0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1.20 - \$3.30 1.90 1.50 1.35 1.30 1.30 1.33 1.38 1.43 1.50 \$0.30 0.50 0.70 0.90 1.10 1.30 1.50 1.70 1.90 2.10 3. Cost curve and their shapes  Rising marginal cost Because of diminishing marginal product  AFC – always declines as output rises  AVC – typically rises as output increases Diminishing marginal product  U-shaped average total cost: ATC = AVC + AFC
11. 11. 5/27/2014 11  Relationship between MC and ATC When MC < ATC: average total cost is falling When MC > ATC: average total cost is rising The marginal-cost curve crosses the average- total-cost curve at its minimum Conrad’s average-cost and marginal-cost curves 4 32 Costs 1.25 1.00 0.75 0.50 0.25 2.00 1.75 1.50 2.25 2.50 2.75 3.00 3.25 \$3.50 This figure shows the average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC) for Conrad’s Coffee Shop. All of these curves are obtained by graphing the data in Table 2. These cost curves show three features that are typical of many firms: (1) Marginal cost rises with the quantity of output. (2) The average-total-cost curve is U-shaped. (3) The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. Quantity of Output (cups of coffee per hour) 0 1 2 3 4 5 6 7 8 9 10 AVC AFC ATC MC Cost curves for a typical firm 5 33 Costs 1.00 0.50 2.00 1.50 2.50 \$3.00 Many firms experience increasing marginal product before diminishing marginal product. As a result, they have cost curves shaped like those in this figure. Notice that marginal cost and average variable cost fall for a while before starting to rise. Quantity of Output 0 2 4 6 8 10 12 14 MC ATC AVC AFC
12. 12. 5/27/2014 12 Questions: - Comments on the vertical distance between TC and VC - Comments on the vertical distance between ATC and AVC III. Theory of Profit  Total revenue Amount a firm receives for the sale of its output  Total cost Market value of the inputs a firm uses in production  Profit Total revenue minus total cost 35  How to maximize profit MR = MC  How to maximize revenue MR = 0
13. 13. 5/27/2014 13 Exercise Firm A faces with demand function as follows: (D): P = 640 – Q Marginal cost: MC = 2Q + 8, FC = 500\$ Determine P, Q for: a. Profit maximizing b. Total revenue maximizing. Calculate the profit in this case If products C and D are close substitutes, an increase in the price of C will:  Tend to cause the price of D to fall  Shift the demand curve of C to the left and the demand curve of D to the right  Shift the demand curve of D to the right  Shift the demand curve of both goods to the right  Shift the demand curve of both goods to the left Which of the following statements is CORRECT?  An increase in the price of C will decrease the price of complementary product D  A decrease in income will decrease the demand for an inferior good  An increase in income will reduce the demand for a normal good  A decline in the price of X will increase the price of substitute product Y
14. 14. 5/27/2014 14 Which of the following statements is NOT correct:  If the relative change in price is greater than the relative change in the quantity demanded associated with it, demand is inelastic  In the range of prices in which demand is elastic, total revenue will diminish as price decreases  Total revenue will not change if price varies within a range where the elasticity coefficient is unity  Demand tends to be elastic at high prices and inelastic at low prices Other things being equal, which of the following might shift the demand curve for gasoline to the left?  The discovery of vast new oil reserves in Alberta  The development of a low-cost electric automobile  An increase in the price of train and air transportation  A large decline in the price of automobile Which of the following would NOT shift the demand curve for beef?  A widely publicized study that indicates beef increases one’s cholesterol  A reduction in the price of cattle feed  An effective advertising campaign by pork producers  A change in the incomes of beef consumers
15. 15. 5/27/2014 15 Which of the following statements is INCORRECT:  If demand increases and supply decreases, equilibrium price will rise  If supply increases and demand decreases, equilibrium price will fall  If demand decreases and supply increases, equilibrium price will rise  If supply declines and demand remains constant, equilibrium price will rise If the supply and demand curves for a product both decrease, we can say that equilibrium:  Quantity must fall and equilibrium price must rise  Price must fall, but equilibrium quantity may either rise, fall or remain unchanged  Quantity must decline, but equilibrium price may either rise, fall or remained unchanged  Quantity and equilibrium price must both decline