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# Ec102 April 28

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Cost and Production Theory

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### Ec102 April 28

1. 1. COST THEORYPRODUCTION THEORY<br />April 28, 2011<br />
2. 2. QUIZ<br />For #s 1-3, indicate whether the statement describes an INCOME EFFECT or SUBSTITUTION EFFECT if the PRICE OF GOOD X FALLS:<br />1. You buy more of good X since you feel richer.<br />2. You buy more of both good X and Y.<br />
3. 3. QUIZ<br />3. Get more good X for every good Y you give up.<br />4. T or F: The income effect is a movement to a higher IC resulting from a change in income.<br />5. T or F: The substitution effect is the movement in the same IC but with higher MRS.<br />
4. 4. QUIZ<br />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)<br />
5. 5. INCOME AND SUBSTITUTION EFFECTS<br />MILK TEA<br />Draw your initial BL1 and IC1<br />The initial optimum level is at point A<br />A<br />IC1<br />WAFFLES<br />BL1<br />
6. 6. INCOME AND SUBSTITUTION EFFECTS<br />MILK TEA<br />Due to a decrease in P of milk tea, BL1 shifts to BL2<br />BL2<br />WAFFLES<br />BL1<br />
7. 7. INCOME AND SUBSTITUTION EFFECTS<br />MILK TEA<br />Draw a new IC2 tangent to your BL2<br />Label the new optimum as point C<br />BL2<br />C<br />IC2<br />WAFFLES<br />
8. 8. INCOME AND SUBSTITUTION EFFECTS<br />MILK TEA<br />Draw an imaginary BL3 parallel to your BL2<br />Draw it tangent to IC1<br />Label the new optimum as point B<br />BL3<br />B<br />IC1<br />WAFFLES<br />
9. 9. INCOME AND SUBSTITUTION EFFECTS<br />MILK TEA<br />AB: subs effect<br />Same IC1<br />BC: inc effect<br />Different IC<br />AC total effect<br />C<br />B<br />A<br />WAFFLES<br />
10. 10. INCOME AND SUBSTITUTION EFFECTS<br />MILK TEA<br />YELLOW – income effect<br />GREEN – subst. effect<br />C<br />B<br />A<br />WAFFLES<br />
11. 11. <ul><li>AB: subs effect
12. 12. Same IC1
13. 13. BC: inc effect
14. 14. Different IC
15. 15. AC total effect</li></li></ul><li>TO GRAPH<br />Graph IC1 tangent to BL1<br />Increase BL1 to BL2 (decrease in P)<br />Draw a new IC2 tangent to BL2<br />Draw an imaginary BL3 against IC1, parallel to BL2<br />AB is substitution effect<br />BC is income effect<br />
16. 16. DERIVING THE DEMAND CURVE<br />Graph the different optimal points in the Price and Quantity axes<br />Since there was a change in price, demand also changes<br />
17. 17. DEMAND CURVE<br />P – price<br />Y – per capita income<br />PR – price of related goods<br />T – Tastes<br />N – population <br />
18. 18. DEMAND FORECASTING<br />a0 to a6 are parameters<br />Represent the change of consumer demand per unit change in each determinant<br />If any parameter is 0, no effect from that determinant<br />Plug in values to parameters  get demand forecast<br />
19. 19. DEMAND FORECASTING<br />a0 – autonomous consumption<br />a1 – ΔQD per P1 change in price<br />a2 – ΔQD per P1000 change in per capita income<br />a3 – ΔQD per P1 change in P of rel. good<br />a4 – ΔQD per P1 change per year<br />a1 – ΔQD per P1M change of population<br />
20. 20. COST THEORY<br />Every production has a cost<br />Goal of each firm is to maximize profits<br />
21. 21. TERMS<br />Revenue = PQ (goods bought)<br />Total Cost = PQ (inputs bought)<br />Profit = TR – TC<br />Accounting Cost = explicit costs<br />Econ Cost = explicit + implicit costs<br />
22. 22. TERMS<br />Explicit Cost = exchange of money<br />Implicit Cost = No money given out<br />Accounting Profit = TR – TC<br />TR – explicit costs<br />Econ Profit = TR – TC<br />TR – explicit costs – implicit costs<br />
23. 23. PRODUCTION<br />Transformation of inputs into goods and services<br />Production Function – Relationship between Q of inputs (workers) and Q of outputs (bread)<br />
24. 24. PRODUCTION FUNCTION<br />
25. 25. PRODUCTION FUNCTION<br />
26. 26. TOTAL COST FUNCTION<br />
27. 27. MARGINAL PRODUCT<br />Increase in output (bread) resulting from an additional unit of input (workers)<br />LAW OF DIMINISHING MARGINAL PRODUCTIVITY – Marginal product of an input decreases as Q of input increases<br />
28. 28. PROD’N FXN AND TOTAL COST<br />Production Function <br />Flatter as number of workers increase<br />Kitchen is more crowded, each additional worker adds less to prod’n<br />Total-Cost Curve<br />Steeper as number of workers increase<br />Producing addt’l bread requires addt’l worker, thus each addt’l bread is more costly<br />
29. 29. PRODUCTION FUNCTION<br />
30. 30. TOTAL COST FUNCTION<br />
31. 31. MEASURES OF COST<br />
32. 32. MEASURES OF COST<br />FIXED COSTS (FC) – Costs that do not vary with the quantity of output produced<br />Incurred even without production<br />Ex: Rent<br />AVE. FIXED COST (AFC) – FC/Q<br /><ul><li>As production increases, average fixed cost decreases
33. 33. As Q increases, cost per unit decreases</li></li></ul><li>MEASURES OF COST<br />
34. 34. MEASURES OF COST<br />VARIABLE COST (VC) – Costs that vary with Q of output produced<br />More output = more inputs, more costs<br />AVE. VAR COST (AVC) = VC/Q<br />TOTAL COST (TC) = FC + VC<br />AVE. TOTAL COST (ATC) = TC/Q<br />Cost of a typical unit<br />
35. 35. MEASURES OF COST<br />
36. 36. MEASURES OF COST<br />Marginal Principle – every addt’l unit<br />MARGINAL COST (MC) – increase in TC as a result of extra output produced<br />How much it costs to increase production by 1 more unit<br />MC = ΔTC/ ΔQ<br />
37. 37. MEASURES OF COST<br />
38. 38. COST CURVES AND THEIR SHAPES<br />MC<br />
39. 39. RISING MARGINAL COST<br />MC rises with Q<br />Reflects LDMP<br />With low production<br />Few workers, equipment not used<br />MP per worker large, MC per output is low<br />High Production<br />Many workers, all equipment used<br />MP per worker low, MC per output large<br />
40. 40. COST CURVES AND THEIR SHAPES<br />MC<br />ATC<br />
41. 41. U-SHAPED AVE TOTAL COST<br />ATC = AVC + AFC<br />AFC goes down as Q rises<br />AVC goes up as Q rises<br />Low level of output<br />ATC high (AVC low, AFC high)<br />High level of output<br />ATC high (AFC low, AVC high)<br />
42. 42. MC and ATC<br />MC < ATC  ATC falling (low Q)<br />MC > ATC  ATC rising (high Q)<br />Ex: ATC = QPI, MC =Ec102 Grade<br />If Ec102 < QPI, QPI falls<br />If Ec102 > QPI, QPI increases<br />MC crosses ATC at minimum ATC<br />
43. 43. COST CURVES AND THEIR SHAPES<br />MC<br />ATC<br />AVC<br />
44. 44. COST CURVES AND THEIR SHAPES<br />MC<br />ATC<br />AVC<br />AFC<br />
45. 45. TYPICAL COST CURVES<br />MP increases, then decreases<br />Low levels of output<br />Increasing MP, MC falls<br />High levels of output<br />Diminishing MP, MC increases<br />AVC  U-shaped<br />
46. 46.
47. 47. TYPICAL COST CURVES<br />MC eventually rises with Q output<br />ATC u-shaped<br />MC crosses ATC at minimum of ATC<br />
48. 48. LONG-RUN ATC (LRATC)<br />Cost depends on time horizon<br />Short-run – can’t change size of factories (fixed cost)<br />Long-run – more flexible to changes<br />(variable cost)<br />
49. 49. LONG-RUN ATC (LRATC)<br />
50. 50. ECONOMIES OF SCALE (EOS)<br />EOS: LRATC falls as quantity of output increases<br />Diseconomies of Scale – LRATC rises as Q output increases<br />Constant Returns to Scale (CRTS) – LRATC is constant as Q output changes<br />
51. 51. LONG-RUN ATC (LRATC)<br />
52. 52. MARKET STRUCTURES<br />Group of buyers and sellers<br />Type of market structure influences how a firm behaves:<br />Pricing<br />Supply<br />Barriers to Entry<br />Efficiency<br />Competition<br />
53. 53. MARKET STRUCTURES<br />Competitive<br />Perfect<br />Monopolistic<br />Monopoly<br />Oligopoly <br />Monopsony<br />
54. 54. DETERMINANTS OF MARKET STRUCTURES<br />Freedom of entry and exit<br />Nature of the product – homogenous (identical), differentiated<br />Control over supply/output<br />Control over price<br />Barriers to entry<br />
55. 55. PERFECTLY COMPETITIVE MARKET<br />Many buyers and sellers <br />Homogenous products (identical)<br />Each buyer and seller is a price taker<br />Firms can freely enter or exit the market<br /><ul><li>Perfect information available to buyers and sellers</li></li></ul><li>ADVANTAGES OF PCM<br />High degree of competition helps allocate resources to most efficient use<br />Price = marginal costs<br />Normal (econ) profit made in the long run (TR-TC)<br />Firms operate at maximum efficiency<br />Consumers benefit<br />
56. 56. REVENUE<br />Example: Nicole’s Bakery<br />TR = PQ; P = determined by market<br />If P = P2, Q = 1000, TR = P2000<br />If Nicole’s Bakery increases production to Q = 2000, TR = P4000<br />TR is proportional to amount of output<br />