econ think

We economists believe that customers

(demanders of goods and services) attempt to
maximize their satisfaction (what we call utility).
Econ 101 We also believe that firms will maximize their
profit.
– That is, people and firms act rationally…
Fall 2010 – Such is the basis of neo-classical economics
Production and the Supply Curve

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The Firm
• Y=Af(HK, PK, L, NR)
or, sometimes the more simpler version
• Y=Af(K,L)
• This is the “story” of the firm…
• Inputs go in (K,L) and stuff comes out, Y
Technology

La L
bo
r

Kapital The Firm Output K f() Y

es
urc NR
so
Re

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detour The Production Function
• From Wikipedia: In economics, the Cobb-Douglas functional form of
• Economic formula, like Y=Af(HK,PK,L,NR) have a production functions is widely used to represent the relationship of an output
tendency to return, over and over (and show up on to inputs. It was proposed by Knut Wicksell, and tested against statistical
evidence by Paul Douglas and Charles Cobb in 1928.
exams) • For production, the function is Y = ALαKβ Where:
Y = output
• These formulae may, in fact, be related to zombies. L = labour input
K = capital input
• To protect yourself you should learn what the elements A, α and β are constants determined by technology.
mean • If α plus β = 1, the production function has constant returns to scale (if L and
K are increased by 20%, Y increases by 20%). If α plus β is less than 1,
– Y=production returns to scale are decreasing, and if they are greater than 1 returns to
– scale are increasing. Assuming perfect competition, α and β can be shown
A=technology to be labor and capital's share of output.
– HK=human capital • Cobb and Douglas were influenced by statistical evidence that appeared to
show that labor and capital shares of total output were constant over time in
– PK=physical capital developed countries, they explained this by statistical fitting
– NR=natural resources least-squares regression of their production function. There is now doubt
over whether constancy over time exists.

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about this production function
• you are what you do, Y=f(L)
• you are what you know, Y=f(HK)
• you are what you have, Y=f(PK,NR)
• Where are you today? Y=f(L)
• Why are you going to school? Y=f(HK,L)
• Let your production, Y, equal your wages, then
wages=f(education, ability)
what is the production function for a brewery
• Y=Af(HK,PK,L,NR)
• NR=resources: malt, hops, water, yeast, bottles
• L=brew crew, bottle crew, biologist, brewer, ops
manger, cellar manager
• PK=brew tanks, lager tanks, bright tanks, bottle
machine, kegs, plant…
• HK=how to brew, how to bottle, accounting,
economics, management, how to fix pumps,
wire, plumb, market, pr …

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what the production function for a teacher
• Things that go into a firm can be
– Fixed inputs (things that don’t change in the short run)
student achivement = Y = Af ( HK teacher , PK , L, R) but – Variable inputs (things that may change in the short
HK teacher = h(a + n, t )φ e f ( s ) + g ( a − s ) run)
• In the long run all variables may be changed
student achivement = f (h(a + n, t )φ e f ( s ) + g ( a − s ) , PK , L, R)
• In the short run at least one variable may be changed
?
• What comes out of the firm is production, more
often called product, or total product
• We can plot the product of a firm, and the plot is
called the total product curve
– It is output plotted against input
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the wheat farm

• We have plotted the marginal
product of labor; the additional
productivity of one more unit
of input
mpl=∆Q/∆L

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diminishing returns combining costs and marginal product
• There are diminishing returns to an input when an • To produce a firm must spend money, costs
increase in the quantity of that input, holding the levels of • It must make decisions (op costs), and must
all other inputs fixed, leads to a decline in the marginal wisely use its inputs (b/c of diminishing returns
product of that input. of inputs)
• The mythical man month
• The inside of a firm from the eye of an
– The idea of diminishing marginal returns is a new idea for
management economist is a bunch of cost curves
– IBM was trying to build a new computer – Total cost
– It was behind schedule, so more engineers were thrown on the – Fixed cost
project. If a project takes 100man months, well (thought IBM), – Variable cost
that is one person for 100 months or 100 people for one month.
– Average costs
– They ignored the diminishing marginal product of labor
– Marginal costs
– IBM=itsy bitsy mentality ?

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Looking Inside The Firm Profit and Economic Profit

(this gets uggggly)

• Definitions • If not this business then what? That would be the

– The consumer – an economic agent that demands
goods (services) because they give that agent some
satisfaction.
– The firm – another economic agent that brings goods
to the market. It transforms resources into product.
– perfect competition
• Large number of buyers and sellers
• No one buyers can influence price
• Firms have perfect information
• All product is the same
• The market is in equilibrium
next best thing we could be doing, the Opportunity
Cost (maybe invest the money in T-bills).
• So this thing… the business we are in… must earn
at least the Opportunity Cost (must earn the interest
paid on that T-bill).
• Anything more is Economic Profit (the monies
earned greater than what a T-bill would provide).

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That Economic Profit Thing Again… Short Run and Long Run
The firm’s revenues • How we analyze the firm varies with time
TR > TC Economic Profit exceed all costs,
including opportunity • Think about a brewery
costs. – In the short run little could be changed: number of
tanks fixed… size of bottling line fixed, distribution
The firm’s revenues
equal its costs, system fixed..
TR = TC Normal Profit
including opportunity – In the long run many things can change: add or sell
costs. tanks, resize the bottling line, release distributors from
contracts, contract new distributors
The firms’ revenues
TR < TC Economic Loss do not cover all of its • In the short run only some resources can be
costs, including changed
opportunity costs.
• In the long run all resources can be changed.
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The Firm & Profits from production to costs

• The firm’s objective is to maximize profits
• Profits are the firm’s revenues less costs
profit = TR - TC This is a small
10acre wheat farm
• Total Revenue, TR is = quantity sold, Q, times
TC=FC+VC
the price of the product, P Let
TR = P x Q FC=$400
VC=$200
• Total Costs include fixed costs and variable per worker
costs
TC = TFC + TVC

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Using FC and VC we can figure MC
• Note that the curve slopes, and
• Review: Each time a worker is added, the acreage is divided to
that slope keeps changing
accommodate that new worker • The slope changes because
• Each worker then provides some additional marginal product of labor, MPL output for each additional
• MPL is the change is output, Q, due to the change in labor, L worker is slightly less (why?)
• We call this, the marginal
product of labor
MPL = ∆Q/∆L
• Every time we add another
worker, the product we get
out of him/her is less than
the previous hire

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Another way of looking at the diminishing

returns to an input (in this case, diminishing A bigger farm … better Production Curves, Better Marginal Product Curves
returns to labor)
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Review: Total Cost = TFC + TVC Again,
• Profit=TR-TC
We assume the farm has a • TC=FC+VC
fixed cost, FC, of $400 • Output and total cost are related by marginal cost,
And we assume that each MC=∆TC/∆Q
worker adds $200 VC

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Assume a small
tomato farm.
• TAKE NOTE: we are done with wheat. The FC are $14.
Our next example uses tomatoes Other costs are
shown in the table…

Assume a price of
$18 (and P=MR,
optimal Q is where
MC=MR)

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 A plot of the marginal costs...
total revenue, price, and quantity
• Recall, profit=TR-TC
• And TC=FC+VC and MC=∆TC/∆Q
• Production also figures into revenue
TR=price*quantity
TR=P*Q
• And there is a marginal revenue too,
MR=∆TR/∆Q

For our farm, assume a bushel of tomatoes sells for $18

Q 0 1 2 3 4 5 6 7
MC 16 6 8 12 16 20 24
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MR=MC is key to optimal production. Note too that it is where we

maximize profit... • Marginal revenue is the change in total revenue
generated by an additional unit of output.
• The optimal output rule says that profit is maximized by
producing the quantity of output at which the marginal
cost of the last unit produced is equal to its marginal
revenue,
MR=MC

We use MARGINAL ANALYSIS to get a better idea how this farm (any
business) is working.

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a firm in a competitive market is a price taker short run marginal costs and marginal revenues

• If we assume this farm is in a competitive market

(many buyers, many sellers, all products are
substitutes), then MR is the price.
• You have no choice about P, therefore P=MR

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• First step of the business: should we enter the

market (either/or)
• If yes, then take the second step
• Second step of the business: how much should
we make
• Answer, make Q at MR=MC

This marginal analysis along with average costs tells us when our
business is profitable, and when we should shut it down.
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opportunity costs profit vs profitability
• A firm’s decision whether or not to stay in a given • A business’ profitability is whether the market
business depends on its economic profit—a measure price is more or less than the farm’s minimum
based on the opportunity cost of resources used in the
average total cost.
business.
profit = tr − tc = tr − fc − vc
• To put it a slightly different way: in the calculation of
profit, a firm’s total cost incorporates implicit costs—the profit tr fc vc
= − −
benefits forgone in the next best use of the firm’s q q q q
resources—as well as explicit costs in the form of actual but tr = p × q ∴ tr = p
cash outlays. q
• We will assume that TC=FC+VC+OC and that the OC is and fc = afc
accounted for in the TC; that is, TC=FC+VC q
and vc = avc
q
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so, are we profitable?

• If p>atc, we are profitable
• If p=atc, we are at breakeven
• If p<atc, we are losing money

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but we said price, P=$18 what if price drops to $10?

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when should the firm shut down?

• We have looked at
– Profit
– Total costs
– Total revenues
– Marginal costs and marginal revenues
– Average costs and average revenues
– Discovered how we can combine all these numbers to
help us understand the cost functions of a firm.
• But we assumed a competitive market
– Many buyers many sellers
– No one buyer or seller controls the price
– Our products are close substitutes
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Are our markets Perfectly Competitive?
• The answer, nope. That ain’t the reality.
• Many (most?) of our businesses are monopolies
or oligopolies.
• Too bad, it looked like we had a good handle on
how businesses work.
• So we study competition and non-competitive
markets and Inefficiency next.
• A production function is the relationship between the quantity of inputs a firm uses
•
and the quantity of output it produces.
A fixed input is an input whose quantity is fixed and cannot be varied.
• A variable input is an input whose quantity the firm can vary.
•
•
The long run is the time period in which all inputs can be varied.
The short run is the time period in which at least one input is fixed.
• The total product curve shows how the quantity of output depends on the quantity of
the variable input, for a given amount of the fixed input.
• The marginal product of an input is the additional quantity of output that is produced
by using one more unit of that input.
• There are diminishing returns to an input when an increase in the quantity of that
input, holding the levels of all other inputs fixed, leads to a decline in the marginal
product of that input.
• A fixed cost is a cost that does not depend on the quantity of output produced. It is
the cost of the fixed input.
• A variable cost is a cost that depends on the quantity of output produced. It is the
cost of the variable input.
• The total cost of producing a given quantity of output is the sum of the fixed cost and
the variable cost of producing that quantity of output.
• The total cost curve shows how total cost depends on the quantity of output.
• Marginal revenue is the change in total revenue generated by an additional unit of
output.
• The optimal output rule says that profit is maximized by producing the quantity of
output at which the marginal cost of the last unit produced is equal to its marginal
revenue.

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