The Supply Side of the Market The Supply Side of the Market in in - - PDF document

The Supply Side of the Market The Supply Side of the Market in in Three Parts: Three Parts:

• I. An Introduction to Supply and
• I. An Introduction to Supply and

Producer Surplus Producer Surplus

• II. The Production Function
• II. The Production Function
• III. Cost Functions
• III. Cost Functions

Econ Dept, UMR Presents

Starring Starring

N NSupply

Supply

O OProduction

Production

O OCost

Cost

N NProducer surplus

Producer surplus

Featuring Featuring

N NThe Law of Diminishing Marginal Product

The Law of Diminishing Marginal Product

N NThe MP/P Rule

The MP/P Rule

N NEconomic Cost vs. Accounting Cost

Economic Cost vs. Accounting Cost

N NEconomic Profit vs. Accounting Profit

Economic Profit vs. Accounting Profit

N NThe Unimportance of Sunk Cost

The Unimportance of Sunk Cost

Part III: Cost Functions Part III: Cost Functions

Linking Production to Costs Linking Production to Costs

N N Each production relationship has a cost

Each production relationship has a cost counterpart counterpart

O O TP:variable input

TP:variable input

• - variable cost

variable cost

O O AP:variable input

AP:variable input

• - average variable cost

average variable cost

O O MP:variable input

MP:variable input

• - marginal cost

marginal cost

O O Fixed inputs

Fixed inputs

• - fixed (or sunk) cost

fixed (or sunk) cost

O O MP/P rule

MP/P rule

• - equal MC rule

equal MC rule

N N The production function and the MP/P rule

The production function and the MP/P rule tells us the minimum cost of producing any tells us the minimum cost of producing any level of output, q: cost = input price times level of output, q: cost = input price times inputs required = P*R inputs required = P*R

FC q/t

FC = iK ; where i is the price FC = iK ; where i is the price

• f the fixed input, capital (K)
• f the fixed input, capital (K)

q0 q1 q2 q3

Short Run Costs

First by definition we have Fixed Costs that do not vary with output Often fixed costs are also sunk costs. Sunk costs are costs already incurred and are beyond recovery.

FC Fixed Costs TVC TC q/t

TVC + FC = TC TVC + FC = TC

q0 q1 q2 q3

Short Run Costs

Second, we have variable cost. Adding TVC and FC gives Total Costs Notice the vertical distance between TC and TVC is Fixed Cost Notice the vertical distance between TC and TVC is Fixed Cost TVC = wL where w is the price of the variable input, labor (L)

FC Fixed Costs TVC TC q/t

MC = ( MC = (˛ ˛ TC/ TC/ ˛ ˛ q) q) = ( = (˛ ˛ TVC/ TVC/ ˛ ˛ q) q)

q0 q1 q2 q3

Short Run Costs

Notice the curvature of TC and TVC is the

• same. The slope of

both at any output is marginal cost The rise over the run is the change in cost, total or The rise over the run is the change in cost, total or variable, divided by the change in output variable, divided by the change in output At q3, slope of TC = slope of TVC = MC

FC TVC TC q/t

(TVC/q) = AVC; (TC/q) = ATC (TVC/q) = AVC; (TC/q) = ATC

Tangency’s to show minimum AVC and ATC q0 q1 q2 q3

• q1 min AVC
• q2 min ATC

Short Run Costs

Note, q2 > q1 as long as fixed costs are

• present. That is the
• utput at which

AVC is minimized is less than the output at which ATC is minimized as long as FC > 0

FC TVC TC q/t Inflection Points q0 q1 q2 q3

• q0 min MC

Short Short Run Run Costs Costs

At the Inflection Point, TC and TVC stop increasing at a At the Inflection Point, TC and TVC stop increasing at a decreasing rate and start increasing at an increasing rate. decreasing rate and start increasing at an increasing rate. MC falls up to q MC falls up to q0

0 then starts to increase.

then starts to increase. At q0, the law of diminishing marginal returns sets in

FC Fixed Costs TVC TC q/t

TVC + TFC = TC = wL + iK

Tangency’s to show minimum AVC and ATC Inflection Points q0 q1 q2 q3

• q0 min MC
• q1 min AVC
• q2 min ATC
• q3 slope of TC

= slope of TVC = MC at q3

Short Short Run Run Costs Costs

Everything Everything Together Together

Per Unit Short Run Costs Per Unit Short Run Costs

N N Let

Let’

’s look now at costs on a per unit basis

s look now at costs on a per unit basis

O O Average fixed cost, AFC = FC/q

Average fixed cost, AFC = FC/q

O O Average variable cost, AVC = TVC/q

Average variable cost, AVC = TVC/q

O O Average total cost, ATC = TC/q

Average total cost, ATC = TC/q

O O Marginal cost, MC =

Marginal cost, MC = ˛ ˛ TC/ TC/˛ ˛ q = q = ˛ ˛ TVC/ TVC/˛ ˛ q q

AFC = FC/q AFC = FC/q AFC q/t q0 q1 q2

Short Run Short Run Per Unit Per Unit Costs Costs

First, Average Fixed Costs declines throughout the range of output. This is because you are dividing a constant, FC, with an ever increasing quantity.

AFC = FC/q AFC = FC/q AVC = TVC/q AVC = TVC/q ATC = AFC + AVC = TC/q ATC = AFC + AVC = TC/q

ATC AFC AVC q/t q0 q1 q2

Short Run Short Run Per Unit Per Unit Costs Costs

In the short run, the average curves take on a “U” shape driven by the law of diminishing marginal returns Notice the vertical distance between ATC and AVC is AFC Also note, q2 > q1 as long as fixed costs are present

AVC = TVC/q AVC = TVC/q ATC = AFC + AVC = TC/q ATC = AFC + AVC = TC/q

ATC AVC q/t q0 q1 q2

Short Run Per Unit Costs

AFC is not very important, so it is often not drawn with the

• ther per unit curves

Notice the minimum AVC at q1, occurs when the average product of the variable input is maximized

MC ATC AVC q/t q0 q1 q2

Short Run Short Run Per Unit Per Unit Costs Costs

MC = MC = ˛

˛ TC/

TC/˛

˛ q

q = = ˛

˛ TVC/

TVC/˛

˛ q

q Notice MC is “U” shaped too with its minimum point, at q0, coinciding with the output where the marginal product of the variable input is maximized

AFC = TFC/q AFC = TFC/q AVC = TVC/q AVC = TVC/q ATC = AFC + AVC = TC/q ATC = AFC + AVC = TC/q

MC ATC AFC AVC q/t q0 q1 q2

Everything Everything Together Together

Short Run Short Run Per Unit Per Unit Costs Costs

MC = MC = ˛

˛ TC/

TC/˛

˛ q

q = = ˛

˛ TVC/

TVC/˛

˛ q

q

Before Going to the Long Run Before Going to the Long Run

N N Review what we mean by

Review what we mean by “costs” “costs”

O O Costs are opportunity costs

Costs are opportunity costs

O O Or, costs are benefits foregone

Or, costs are benefits foregone-

• the benefits

the benefits

• f the next best alternative given up
• f the next best alternative given up

O O Market prices are often good measures of

Market prices are often good measures of

• pportunity costs
• pportunity costs

Opportunity Cost Opportunity Cost

N N In economics, costs are always the value

In economics, costs are always the value

• f the benefits given up
• f the benefits given up--
• -opportunity
• pportunity

cost cost

N N Sometimes these opportunity costs are

Sometimes these opportunity costs are monetary, e.g., Wages paid labor monetary, e.g., Wages paid labor

N N Sometimes these opportunity costs are

Sometimes these opportunity costs are nonmonetary, e.g., Value of time used nonmonetary, e.g., Value of time used

Economic Costs Economic Costs

N N Total cost

Total cost (TC) (TC) -

• the total opportunity

the total opportunity cost of all resources used in production cost of all resources used in production

O O TC = monetary costs + Nonmonetary costs

TC = monetary costs + Nonmonetary costs

Economic vs. Accounting Economic vs. Accounting Concepts of Costs and Profits Concepts of Costs and Profits

N N In economics costs are opportunity costs

In economics costs are opportunity costs

N N In accounting costs are defined according to

In accounting costs are defined according to accepted accounting rules designed for tax accepted accounting rules designed for tax and public disclosure purposes and public disclosure purposes

N N Since the definitions of cost differ so do the

Since the definitions of cost differ so do the definitions of profits definitions of profits

O O Economic profit = total revenue

Economic profit = total revenue -

• opportunity
• pportunity

costs costs

O O Accounting profit = total revenue

Accounting profit = total revenue -

• accounting

accounting costs costs

Illustration of Accounting Illustration of Accounting Profit vs. Economic Profit Profit vs. Economic Profit

Assume: Assume: Monetary costs (explicit costs) for a month =$15,000 Monetary costs (explicit costs) for a month =$15,000 Non Non-

• monetary costs for a month = $ 4,000

monetary costs for a month = $ 4,000 Total costs Total costs =$19,000 =$19,000 Economic profit = total revenue (TR) Economic profit = total revenue (TR) -

• total costs (TC)

total costs (TC) If total revenue for this month is equal to $19,000 then: If total revenue for this month is equal to $19,000 then: there is no economic profit, but there would be a there is no economic profit, but there would be a $4,000 accounting profit. Accounting profit does not $4,000 accounting profit. Accounting profit does not count non count non-

• monetary costs as a cost thus profit would

monetary costs as a cost thus profit would be reported as $4,000 be reported as $4,000

Suppose: Suppose:

N N Monthly costs include:

Monthly costs include:

O O Owner’s time and expertise

Owner’s time and expertise $2,000 $2,000

O O Land already owned but could

Land already owned but could $3,000 $3,000 be rented be rented

O O Payroll expenses

Payroll expenses $9,000 $9,000

O O Utility bills

Utility bills $1,000 $1,000 N N Total economic costs

Total economic costs $15,000 $15,000

N N Total accounting costs $10,000

Total accounting costs $10,000

The difference between accounting and economic costs are non-monetary costs are not included in the accounting costs

Economic Profit Overview Economic Profit Overview

N N TR = TC the opportunity costs are

TR = TC the opportunity costs are covered and there is no economic profit covered and there is no economic profit

N N TR > TC revenue exceeds opportunity

TR > TC revenue exceeds opportunity costs and there is an economic profit costs and there is an economic profit

N N TR < TC opportunity costs exceed

TR < TC opportunity costs exceed revenues and there is economic loss revenues and there is economic loss

Consider Hooey and Dewie, Who Consider Hooey and Dewie, Who Opened a Business Selling Turquoise Opened a Business Selling Turquoise Belts in the Denver Airport. Belts in the Denver Airport.

N N Display Cart Costs $10,000 and Is Paid by Withdrawing

Display Cart Costs $10,000 and Is Paid by Withdrawing Hooey and Dewie Hooey and Dewie’ ’s Savings That Was Earning 5% Per s Savings That Was Earning 5% Per

• Year. The Cart Will Last One Year and Has No Salvage
• Year. The Cart Will Last One Year and Has No Salvage

Value. Value.

N N Belts Cost $20.00 Each From the Supplier.

Belts Cost $20.00 Each From the Supplier.

N N Sales Are Estimated to Be 1,000 Belts Per Year.

Sales Are Estimated to Be 1,000 Belts Per Year.

N N The Price of the Belts Is $60.00.

The Price of the Belts Is $60.00.

N N The Cart Clerk Is Paid $14,000.

The Cart Clerk Is Paid $14,000.

N N Hooey and Dewie Will Put in 2000 Hours of Labor

Hooey and Dewie Will Put in 2000 Hours of Labor During the Year. During the Year. QUESTION: Is This Business Going to Make a Profit, or QUESTION: Is This Business Going to Make a Profit, or Should Hooey and Dewie Move Back in With Uncle Should Hooey and Dewie Move Back in With Uncle Donald? Donald?

Hooey and Dewie Have a Hooey and Dewie Have a Total Revenue of $60,000 for Total Revenue of $60,000 for the Year the Year

N N Total revenues.............................$60,000

Total revenues.............................$60,000

O O P*q = $60*1,000

P*q = $60*1,000

Hooey and Dewie Have Hooey and Dewie Have Accounting Costs of Accounting Costs of $44,000 for the Year $44,000 for the Year

Total Revenues. . . . . . . . . . . . . . . . . . . . . . . . Total Revenues. . . . . . . . . . . . . . . . . . . . . . . .$60,000 $60,000 Total Accounting Costs (Monetary Cost) Total Accounting Costs (Monetary Cost) Belts From Supplier. . . . . . . .$20,000 Belts From Supplier. . . . . . . .$20,000 Clerk Cost . . . . . . . . . . . . . . . 14,000 Clerk Cost . . . . . . . . . . . . . . . 14,000 Cart Cost. . . . . . . . . . . . . . . . . Cart Cost. . . . . . . . . . . . . . . . . 10,000 10,000 $44,000 $44,000 Acct’ing Acct’ing Profit = Total Revenue Profit = Total Revenue – – Acct’ing Acct’ing Costs Costs = 60,000 = 60,000 -

• 44,000 = $16,000

44,000 = $16,000 (And We Are Ignoring Taxes) (And We Are Ignoring Taxes)

But Hooey and Dewie Have But Hooey and Dewie Have nonmonetary Costs Too nonmonetary Costs Too

Total Revenues Total Revenues $60,000 $60,000 Total Accounting Costs (Monetary Cost) Total Accounting Costs (Monetary Cost) Belts From Supplier Belts From Supplier $20,000 $20,000 Clerk Cost Clerk Cost 14,000 14,000 Cart Cost Cart Cost 10,000 10,000 $44,000 $44,000 Total Nonmonetary Cost Total Nonmonetary Cost Interest Foregone on $10,000 Interest Foregone on $10,000 $ 500 $ 500 Opportunity Cost of 2000 Hours Opportunity Cost of 2000 Hours X X Economic Costs Economic Costs $44,500 + X $44,500 + X Economic Profits = Total Revenue Economic Profits = Total Revenue -

• Economic Costs

Economic Costs = 60,000 = 60,000 -

• 44,500

44,500 -

• X = $15,500

X = $15,500 -

• X

X

Hooey and Hooey and Dewie’s Dewie’s Adventure Adventure

N N Did they make a profit?

Did they make a profit?

N N It depends on the value they place on their

It depends on the value they place on their time, the 2000 hours time, the 2000 hours

O O They cleared $16,000 according to the accountant

They cleared $16,000 according to the accountant and would be asked to pay taxes on this amount and would be asked to pay taxes on this amount (after figuring loopholes) (after figuring loopholes)

O O But the opportunity cost of their savings and time

But the opportunity cost of their savings and time were not taken into account were not taken into account

N N $500 for foregone interest lowers profit by $500

$500 for foregone interest lowers profit by $500

N N If they value their time less than $7.50 per hour

If they value their time less than $7.50 per hour (= $15,500/2000) they made a profit otherwise, (= $15,500/2000) they made a profit otherwise, they didn they didn’

’t and should move back in with uncle

t and should move back in with uncle Donald Donald

Before Moving to the Long Before Moving to the Long Run, Let Run, Let’

’s Review

s Review

N N Total cost concepts

Total cost concepts

N N Per unit cost concepts

Per unit cost concepts

N N The shape of cost curves

The shape of cost curves

O O Due to the law of diminishing marginal

Due to the law of diminishing marginal returns returns

N N The relationship between marginal and

The relationship between marginal and average average

N N Efficiency in getting what we want

Efficiency in getting what we want

Total Cost Concepts Total Cost Concepts

N N Total fixed cost

Total fixed cost (FC) (FC) -

• costs which do not vary

costs which do not vary with output with output

O O The costs of fixed inputs, e.g., Capital

The costs of fixed inputs, e.g., Capital

N N Total variable costs

Total variable costs (TVC) (TVC) -

• any cost that

any cost that varies with the quantity of output produced varies with the quantity of output produced

O O The costs of variable inputs, e.g., Labor

The costs of variable inputs, e.g., Labor

N N Total cost

Total cost (TC) (TC) -

• sum of all costs of

sum of all costs of production production

O O TC = fixed costs + total variable costs

TC = fixed costs + total variable costs

Per Unit Cost Concepts Per Unit Cost Concepts

N N Marginal cost

Marginal cost (MC) (MC) -

• the additional cost

the additional cost

• f producing one more unit of output
• f producing one more unit of output

O O MC =

MC = ∆ ∆TC / TC / ∆ ∆q q

N N Average variable cost

Average variable cost (AVC) = TVC/q (AVC) = TVC/q

N N Average fixed cost

Average fixed cost (AFC) = FC/q (AFC) = FC/q

N N Average total cost

Average total cost (ATC) = TC/q (ATC) = TC/q

Shape of Cost Curves Shape of Cost Curves

N N Total cost and total variable cost

Total cost and total variable cost

O O Eventually steeper due to law of diminishing

Eventually steeper due to law of diminishing marginal returns marginal returns

N N Marginal cost

Marginal cost

O O Eventually upward sloping due to law of

Eventually upward sloping due to law of diminishing marginal returns diminishing marginal returns

N N Average fixed cost

Average fixed cost

O O Downward sloping always: a fixed number (FC) is

Downward sloping always: a fixed number (FC) is divided by increasing q as output rises divided by increasing q as output rises

N N Average total cost and average variable cost

Average total cost and average variable cost

O O “U”

“U” shaped but shaped but eventually upward sloping due to eventually upward sloping due to law of diminishing marginal returns law of diminishing marginal returns

Law of Diminishing Marginal Law of Diminishing Marginal Returns and Cost Curves Returns and Cost Curves

N N If each unit of labor produces less additional

If each unit of labor produces less additional

• utput eventually, then in order to produce
• utput eventually, then in order to produce

each additional unit of output we need to hire each additional unit of output we need to hire increasing amounts of inputs (labor) increasing amounts of inputs (labor) eventually (law of diminishing marginal eventually (law of diminishing marginal returns) returns)

O O Tells us total product eventually gets flatter and

Tells us total product eventually gets flatter and marginal product eventually declines marginal product eventually declines

O O Tells us total costs eventually gets steeper and

Tells us total costs eventually gets steeper and marginal costs eventually rise marginal costs eventually rise

Average Average-

• marginal Rule

marginal Rule

N N The marginal cost and average cost curves

The marginal cost and average cost curves have to obey the average have to obey the average-

• marginal rule

marginal rule

N N The average

The average-

• marginal rule says that if

marginal rule says that if marginal is above average, then average must marginal is above average, then average must be rising be rising

N N If marginal is below average, then average

If marginal is below average, then average falling falling

N N This implies the MC curve crosses the ATC

This implies the MC curve crosses the ATC and AVC curves at the bottom of both, and and AVC curves at the bottom of both, and that the MP curve must cross the AP curve at that the MP curve must cross the AP curve at the top of AP the top of AP

Average Average-

• marginal Rule

marginal Rule

N N For example, your grade point average

For example, your grade point average (GPA) is an average. The marginal (GPA) is an average. The marginal grade is the next grade you get grade is the next grade you get

N N If your next grade (marginal grade) is

If your next grade (marginal grade) is above your average (GPA), then your above your average (GPA), then your GPA rises GPA rises

N N If your next grade (marginal grade) is

If your next grade (marginal grade) is below your average (GPA), then your below your average (GPA), then your GPA falls GPA falls

Minimum Cost Condition Minimum Cost Condition

N N We saw earlier the rationale of the MP/P rule:

We saw earlier the rationale of the MP/P rule: to minimize cost of any level of activity, a to minimize cost of any level of activity, a supplier must mix variable inputs in such a supplier must mix variable inputs in such a way their marginal product divided by their way their marginal product divided by their price are equal price are equal

N N If input and output prices are taken as given,

If input and output prices are taken as given, and suppliers are profit maximizers, the and suppliers are profit maximizers, the marginal costs of suppliers will be equal marginal costs of suppliers will be equal (MC (MC1

1 = MC

= MC2

2 =

= … … = MC = MCj

j for all j suppliers).

for all j suppliers). This is a necessary condition for insuring This is a necessary condition for insuring industry output is produced at minimum cost industry output is produced at minimum cost

Now We Move to Costs in the Now We Move to Costs in the Long Run Long Run

N N Long run

Long run -

• period of time in which

period of time in which all all inputs are variable inputs are variable

N N Capital and labor, all inputs, can change

Capital and labor, all inputs, can change

N N Think of the long run as a planning

Think of the long run as a planning period period

O O Firm can estimate costs based on various

Firm can estimate costs based on various plant sizes, number of machines, etc plant sizes, number of machines, etc

O O Once it makes a decision and builds the

Once it makes a decision and builds the plant, buys the machines, etc., It moves into plant, buys the machines, etc., It moves into the short run and are stuck with their the short run and are stuck with their decision for a while decision for a while

Costs in the Long Run Costs in the Long Run

N N Long run average total cost

Long run average total cost (LRATC) (LRATC) -

• ATC of producing a given level of

ATC of producing a given level of

• utput when all inputs can vary
• utput when all inputs can vary

N N LRATC curve is constructed as an

LRATC curve is constructed as an envelope of all possible short run cost envelope of all possible short run cost curves curves

N N NOTE

NOTE -

• no AFC in long

no AFC in long-

• run

run

O O In long run all inputs are variable, so no

In long run all inputs are variable, so no fixed costs fixed costs

O O LRATC is equal to long run AVC since all

LRATC is equal to long run AVC since all costs are variable costs are variable

Long Run and Short Run ATC Long Run and Short Run ATC

N N Consider what happens to the short run

Consider what happens to the short run ATC curve when we increase fixed ATC curve when we increase fixed costs: costs:

O O The average cost of making a small amount

The average cost of making a small amount

• f product rises
• f product rises

O O The average cost of making a large amount

The average cost of making a large amount goes down goes down

O O For instance, we increase the size of an

For instance, we increase the size of an assembly line assembly line -

• the ATC of making 1000

the ATC of making 1000 cars is now higher, but the ATC of 250,000 cars is now higher, but the ATC of 250,000 cars is less cars is less

Long Run ATC Curve Long Run ATC Curve

$ q/t SRATC1 SRATC2

Higher ATC with higher Fixed Cost (Higher Fixed Costs) Lower ATC with higher Fixed Cost

The Shape of the LRATC The Shape of the LRATC

N N We draw the LRATC as

We draw the LRATC as “U” “U” shaped shaped similar to the similar to the “U” “U” shape of the short run shape of the short run average cost curves average cost curves

N N But the AVC and ATC were

But the AVC and ATC were “U” “U” shaped shaped due to the law of diminishing marginal due to the law of diminishing marginal returns which doesn returns which doesn’ ’t apply in the long t apply in the long run (all inputs are variable) run (all inputs are variable)

N N What gives?

What gives? A: A: returns to scale returns to scale

Returns to Scale Returns to Scale

N N Changing all inputs in the same proportion is

Changing all inputs in the same proportion is a a “scale” “scale” change, e.g., increase all by 10%, change, e.g., increase all by 10%, decrease all by 5% decrease all by 5%

N N The

The “U” “U” shape of the LRATC is due to the shape of the LRATC is due to the possibility of three types of returns to scale: possibility of three types of returns to scale:

O O Increasing returns to scale: %

Increasing returns to scale: %˛ ˛ q>% q>%˛ ˛ r r

O O Constant returns to scale: %

Constant returns to scale: % ˛ ˛ q=% q=%˛ ˛ r r

O O Decreasing returns to scale: %

Decreasing returns to scale: %˛ ˛ q<% q<%˛ ˛ r (where R is r (where R is all resources) all resources)

N N Cost curves in the long run are based on the

Cost curves in the long run are based on the underlying production technology, i.e., underlying production technology, i.e., Returns to scale Returns to scale

Returns to Scale, Examples Returns to Scale, Examples

N N IRTS: doubling all inputs leads to an

IRTS: doubling all inputs leads to an increase of 125% in q (LRATC falls) increase of 125% in q (LRATC falls)

N N DRTS: an increase in all inputs by 5%

DRTS: an increase in all inputs by 5% leads to a 3% increase in q (LRATC rises) leads to a 3% increase in q (LRATC rises)

N N CRTS: a decrease in all inputs by 10%

CRTS: a decrease in all inputs by 10% lead to a 10% fall in q (LRATC is lead to a 10% fall in q (LRATC is constant) constant)

N N If all inputs are decreased by 5% and

If all inputs are decreased by 5% and

• utput falls by 7%, %
• utput falls by 7%, %˛

˛ q>% q>%˛ ˛ r, therefore r, therefore IRTS IRTS

What If All Inputs Change but What If All Inputs Change but Not in the Same Proportion? Not in the Same Proportion?

N N If the %

If the %˛ ˛ q>% q>%˛ ˛ costs we use the term costs we use the term economies of scale economies of scale

N N If the %

If the %˛ ˛ q<% q<%˛ ˛ costs we use the term costs we use the term diseconomies of scale diseconomies of scale

N N IRTS implies economies of scale but

IRTS implies economies of scale but economies of scale do not imply IRTS economies of scale do not imply IRTS

N N The same is true for the relationship

The same is true for the relationship between diseconomies of scale and DRTS between diseconomies of scale and DRTS

N N Reasons for economies and diseconomies

Reasons for economies and diseconomies

• f scale are given in Part II
• f scale are given in Part II

Linking the Short Run to the Linking the Short Run to the Long Run Long Run

N N Suppose you have four choices for a stock

Suppose you have four choices for a stock

• f fixed inputs, e.g., 4 different sizes of
• f fixed inputs, e.g., 4 different sizes of
• ffice buildings to build or lease
• ffice buildings to build or lease

N N There are tradeoffs apparent:

There are tradeoffs apparent:

O O Smaller fixed costs are associated with higher

Smaller fixed costs are associated with higher variable costs variable costs

O O Economies and diseconomies of scale are

Economies and diseconomies of scale are apparent apparent

N N The output you expect to sell is

The output you expect to sell is paramount, but that depends on demand paramount, but that depends on demand conditions we will consider next chapter conditions we will consider next chapter

Four Short Run ATC Curve Four Short Run ATC Curve Choices Choices

$ q/t

SRATC1 SRATC2 SRATC3 SRATC4

q4 q1 q2 q3

Selection of Fixed Input Stock Selection of Fixed Input Stock

N N If you expect business to support

If you expect business to support

• utput q
• utput q1

1 you select the input stock

you select the input stock associated with associated with SRATC SRATC1

1

N N And so on, e.g., If you expect to sell q

And so on, e.g., If you expect to sell q3

3

then you will select the input stock then you will select the input stock associated with associated with SRATC SRATC3

3

N N With only 4 possible input stock sizes,

With only 4 possible input stock sizes, the LRATC is the heavy sections of the the LRATC is the heavy sections of the short run curves outlined in blue on the short run curves outlined in blue on the next slide next slide

Four Short Run ATC Curve Four Short Run ATC Curve Choices and Their LRATC Choices and Their LRATC

$ q/t

SRATC1 SRATC2 SRATC3 SRATC4

q4 q1 q2 q3

LRATC Curve When There Are LRATC Curve When There Are Many Input Stocks to Select From Many Input Stocks to Select From

$ q/t

SRATC1 SRATC2 SRATC3 SRATC4

LRATC : Minimum SRATC : Tangency of SRATC and LRATC q1 q2 q3 q4

Reviewing the Shape of LRATC Reviewing the Shape of LRATC

N N Explained by economies and

Explained by economies and diseconomies of scale diseconomies of scale

N N Typically firms will make efforts to

Typically firms will make efforts to expand to take advantage of economies expand to take advantage of economies

• f scale and take caution not to get too
• f scale and take caution not to get too

big so as to experience diseconomies of big so as to experience diseconomies of scale scale

N N We find for most industries, firms

We find for most industries, firms

• perating at constant ATC over a
• perating at constant ATC over a

considerable range of output considerable range of output

Long Run ATC Curve Long Run ATC Curve (Economies of Scale) (Economies of Scale)

$ q/t

Economies of Scale

Long Run ATC Curve Long Run ATC Curve (Diseconomies of Scale) (Diseconomies of Scale)

$ q/t

Diseconomies of Scale

Long Run ATC Curve Long Run ATC Curve (Constant Average Costs) (Constant Average Costs)

$ q/t

Constant Average Costs

Typical LRATC Typical LRATC

$ q/t

Constant Average Total Costs

Sort of like a Frying Pan

What If a Mistake Is Made? What If a Mistake Is Made?

N N You select SRATC

You select SRATC1

1, expecting to sell q

, expecting to sell q1

1

per period, but things are better than per period, but things are better than expected, you sell q expected, you sell q2

2

N N Your ATC are higher than they need have

Your ATC are higher than they need have been (represented by a level rather been (represented by a level rather than shown on a couple of slides back) than shown on a couple of slides back)

N N But your decision has been made and you

But your decision has been made and you have to live with it for now have to live with it for now

N N It is important to learn that sunk costs are

It is important to learn that sunk costs are not important (if your fixed inputs can be not important (if your fixed inputs can be sold their costs are not sunk) sold their costs are not sunk)

Sunk Cost Sunk Cost

N N Sunk costs are fixed costs, but FC may

Sunk costs are fixed costs, but FC may not be sunk if there are valuable not be sunk if there are valuable

• alternatives. If the capital equipment
• alternatives. If the capital equipment

may be sold then the capital cost is not may be sold then the capital cost is not sunk sunk

N N Economics has an important message

Economics has an important message about sunk cost about sunk cost--

• -they don’t matter

they don’t matter

N N The proverb to remember is

The proverb to remember is “ “let bygones let bygones be bygones be bygones” ”

Sunk Costs Sunk Costs

N N A good poker player

A good poker player “ “knows when to knows when to hold hold’

’em

em, knows when to fold , knows when to fold’

’ em

em” ”--

• -the

the money in the pot is not important money in the pot is not important

N N You ought not stay in a major because

You ought not stay in a major because you have almost completed the degree you have almost completed the degree--

• the decision must be based on expected

the decision must be based on expected benefits and costs of the change, not benefits and costs of the change, not costs already experienced costs already experienced

The End The End