Note: This transcription document is a text version of the upGrad videos present in this session.

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Speaker: Chris Oates

Welcome, in this session we're going to talk about consumers and producers and how they
make their decisions to try to maximise their own utility.

In this segment, we’re going to start with consumers. Now, how does a consumer
maximize his or her own utility? Well, let's just start with me, for example. Let's say that I
have a budget of $1000 that I want to spend going to sports games this year. Now, there's
two teams where I live that I’d like to go to, the Boston Celtics, they play basketball and
the New England Revolution, they play soccer. Now I want to go to see both of them and
I’ve got a budget of $1000, I’m willing to allocate. Well, obviously they cost slightly
different amounts of money.

The Celtics are pretty popular, they play in a smaller arena, so tickets are $100 each. The
Revolution is cheaper, I can go to a game for about $50. So if we were just to say how
much, how many games can I go to for each based on my budget, you could say I could go
to 10 games of the Celtics for $1000 or I can go to 20 games of the Revolution for $1000.

Obviously, I could go to a combination of the two of them and the combinations could be
drawn in a straight line between 10 games for basketball and 20 games for soccer, and
that line would be my budget line. That budget line is basically what combination I can
afford on my budget. Anything on the line is something that would use up all my $1000
dollars, anything below it would leave me with money left over, anything above it is
something I cannot afford. So I can go to one basketball game and one soccer game and
have a lot of money left over. I could not afford to go to a thousand basketball games and a
thousand soccer games, but any combination on that line is something that I would just be
able to afford and use up all of my budget.

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So we've got the first part of the equation, which is the budget. How much money do I have
to spend? The second part of any consumer decision is what do I want to spend it on. Now
most people do not have equal preference for different products. I mean I know I certainly
don't. The Celtics are a really great team this year. They’re on public transportation, I can
get to them easily. I would much rather go to a basketball game than a soccer game. But I
also, you know, want to go to as many sports games as I can see. So that's kind of my
trade-off. So for me, if I went to 10 soccer games and one basketball game that would
equal the enjoyment I would get out of four basketball games and one soccer game. So 10
soccer games, one basketball game, I get to go to 11 matches overall, I’m really happy.
That’s a lot of time out of the house, watching sports. Four basketball games, one soccer
game, it’s only five matches overall, but I’m really enjoying each one a lot because most of
it is basketball. There's also other combinations that would work for me. So six soccer
games and two basketball games or four soccer games and three basketball games,
different numbers of total games and different combinations, but to me they're all the
same. I would be indifferent between those combinations and if we plot those out, if we
plot all those lines and we plot all those dots and we draw a line between them that would
be considered my indifference curve.

Any dot on that line, I am indifferent between, it would give me the same amount of utility.
Now like a budget line, anything below that curve would be worse for me, anything above
it would be better for me. So one basketball game and one soccer game would be worse
than what's on this indifferent curve and a thousand basketball games, a thousand soccer
games would be much better for me on that curve. So the curve is everything that's equal
in utility for me. Anything below it is less utility, anything above it is more utility. Now the
indifference curve for most goods is convex. If I’m going to go from two basketball games a
year to one basketball game, I really need a lot of soccer to make that up to me, because
I’m losing half of my basketball that year and I really like basketball and so most will be a
kind of a convex shape.

Now most indifference curves are curves. It is possible for there to be in a different curve
that is a straight line that is when they are perfect substitutes. So I have no preference
between basketball or soccer, all I care about is seeing sports then it would be a straight
line. There’d be no adjustment between the two. If a good is a perfect complement, then
the indifference curve would be L shape. There would be a right angle between them.
Take, for example, doors and door knobs. Now, if I have five doors, I need five door knobs.
If I have seven door knobs that doesn't do me any better, because I can still only use five of
them. If I have seven doors and five door knobs again, those two extra doors don't really

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matter for me. So perfect substitutes, indifference curve will be a straight line. Perfect
complements, indifference curves will be L shaped. Most indifference curves for normal
goods are convex and why this matters and how it combines with a budget line is at the
heart of many consumer decisions and we're going to get to that in the next segment.

Speaker: Chris Oates

In the previous video, we talked about two lines that can help show how a consumer
makes decisions. The first was the budget line, which shows the constraints that they're
operating under financially speaking and the other is the indifference curve that's about
what they want and what combinations of goods are equally valuable to them.

If we overlay those two lines, we can start to understand what decision a consumer will
make to maximise their utility. So these two curves in this graphic that you're seeing are
the lines that I mentioned in the previous segment. So I have a budget line of a $1000.
Basketball tickets are $100, soccer tickets are $50. We have an indifference curve that
shows what games I want to go see. So I would like to see 10 soccer games and one
basketball game to me that would be equal to four basketball games and one soccer game
because I prefer basketball games to soccer games. And so we can overlay them and then
see what my decision will be.

Now you might notice that the indifference curve here exists entirely within the budget
line. What that means is that the indifference curve we mentioned is completely
affordable to me. I can afford not only any one of those points, but I can also afford other
points on that chart. So I mentioned 10 soccer games and one basketball game, well I can
afford more than that. So what this means is that I can have an indifference curve that is
superior to the one that we've just drawn on this chart. Now something that's important to
note is that indifference curves, even though this is how we're drawing it on the chart, they
exist kind of infinitely across this. So that’s the shape of the curve, but we could shift it
downwards and to the left, and that would be a worse indifference curve. Every point of
that line would be equal to each other and it would be slightly worse than the one before
or we could shift it up into the right and we get more utility.

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So, for example, yes, I’d be happy with 10 soccer games and one basketball game. I'd also
be happy with 20 soccer games and two basketball games. That to me is a better point on
the indifferent space because I’m getting more utility out of it. So the indifference curve
and this is something important to note, it shows everything that's equal to those dots, but
let's remember you always as a consumer want to be getting something more. You don't
want to just find what’s equal, you want to find something superior and probably you want
to find what is optimal to you. So we can shift my indifference curve into a better one. So
we can find a superior indifference curve and we have it right here and this one intersects
with my budget line.

Now in this chart, we've pushed my indifference curve upwards. So we've taken my
indifference curve, we've realized that we can afford it, and so we've increased it, and now
this indifference curve intersects with my budget line. So the combinations are the same
between basketball and soccer. We just now have more of them because I can afford more,
I have more options. What we have here is that it intersects with the budget line and that
means that there are two combinations that for me lie on that indifference curve that I can
afford with that budget. But if you notice there are points above that indifference curve
that are still within my budget. So in the middle where the indifference curve dips below
the budget line, well that is an inferior indifference point to anything to the right of it and
there's quite a few of them still below my budget line. So I can actually push the
indifference curve more. What we're looking to find when we do this exercise with the
budget line in indifference curve is where the curve just touches the budget line that is
considered to be the consumer's optimum. It is a point on the indifference curve where
you can just barely afford it. So you're within your budget line, but that is the maximum
utility you're going to get out of it. You can't push the indifference curve anymore to the
right without going into something that you can't afford.

So we take this soccer and basketball dilemma that I have with a budget of $1000 and with
the constraints that I’ve said with my indifference curve are, I found that my personal
consumer optimum is six basketball games and eight soccer games. That’s the
combination that I can afford and that gets me the most enjoyment. So any other
combination that would be the same utility would push me over my budget and any other
combination within my budget would be less utility, so be below my indifference curve.
Now there are a number of applications for this principle in business. Let’s say that you are
an automobile dealership in the Boston area and you know that your customers are sports
fans and you have a $1000 in promotional budget for each car that you want to sell. Now,
how do you use that promotional budget? Should you offer the customer 20 soccer tickets
if they buy a car at your dealership, should you offer them 10 basketball tickets. Well,
maybe you do some market research and you find that I am like the typical customer and

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my indifference curve is that of the typical customer. Well, if you say, come and buy a car
at our dealership and we'll give you six basketball tickets and eight soccer tickets, I’m
gonna say, hey, that's a better deal for me than the place down the street that’s only
offering 20 soccer tickets or the other place down the street that's only offering 10
basketball tickets. You will be offering me more utility for the same amount of money and
therefore I’m going to come to your business. And this principle is behind a lot of
consumer decision making or at least how we analyse consumer decision making.

And so it's a really important principle at least in concept to start to apply. What do our
consumers want, what’s the combination they want it, and how do we maximize what they
can get out of a fixed budget.

Speaker: Chris Oates

In the last segment, I talked about how budget lines and indifference curves can be
combined to find the consumer optimum, to find the combination of goods that the
consumer is going to buy. Now obviously these lines are not static in the real world.
They’re often changing.

Let’s say the budget line, let's take that. Imagine I get a raise at work and I’m going to
spend $2000 a year on sports tickets rather than just $1000 dollars a year. Well for most
goods, I’m just gonna buy more of them. There are some exceptions, there's a category
called inferior goods, which is that once you get more money, you buy less of it. So imagine
really cheap clothing brands, for example, you're not gonna buy more cheap clothing as
you get more money, most people will just go into higher quality or more luxury products,
and so maybe this happens for me. Maybe I think that, you know, it's the basketball that's a
real quality game here and the soccer tickets are kind of an inferior good. So, as I get more
money, I’m gonna buy less soccer tickets. That could happen.

But let's just assume right now that it's a normal good, basketball and soccer ticket to me.
Ideally I’d be at every season of the game, I can’t afford that. So I will want as much game
time as I possibly can, and so for me, the more money I have to spend on the games, the
more I’m going to want to go to them. So they're a normal good. So what happens if I get
more money? Well assume that I just get more money and so I now have $2000 to spend,
I’m just going to apply the same principle as I did in the last session, but with a higher
budget line, my indifference curve will shift. It’ll probably say the same. So if at $1000 I’m

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buying six basketball and eight soccer tickets, at $2000 I’m going to be buying 12
basketball and 16 soccer tickets. So I’m just gonna double it and everything will otherwise
stay the same. But what happens if the price of one of the products changes? Let’s say, for
example, that the soccer team

is kind of struggling this year, so they decided to cut the price of their tickets in half. They
used to be $50 a ticket, now they’re $25 a ticket. Well, that's going to change my budget
line because I have $1000 to spend. Still for basketball it’s the same, that’s 10 tickets of
basketball tickets because they're $100 each, but now with soccer tickets being only $25,
I’d go to 40 games. So my budget line has now shifted, so what am I going to do now? Will I
buy just more soccer and basketball tickets as I would if I get a raise because, you know, I
have more money to spend now, soccer tickets are cheaper, so that means that's more
money in my pocket or do I change the combination of what I buy, because soccer has
become relatively cheaper

compared to my basketball tickets? Previously, I could buy two soccer tickets for the price
of one basketball ticket. Now I can go to four soccer games for the price of one basketball
ticket.

The first idea that I’m going to buy more because I have more income in my pocket or my
income goes further is called the income effect and the second idea that there's now a
different marginal rate between the two is the substitution effect. These two effects will
be combined when I do my new calculation. Now I do know that I’m going to buy more
soccer tickets. The income effect means that I have effectively more money, so I want to
buy more soccer tickets and the substitution effect means that soccer tickets are cheaper,
so I should want more of them. So the income effect means I’m going to buy more soccer
tickets. The substitution effect because soccer is cheaper means I’m going to buy more
soccer tickets. For basketball, it’s a different question. I have more money effectively, so
the income effect would say that I would buy more basketball tickets, but basketball is
now more expensive than soccer tickets on relative terms, so the substitution effect would
go the other way. The combination of those two will determine whether or not I buy
basketball tickets and that will have to do with kind of what my indifference curve is,
where is my curve, how is it shaped, and how does this new budget line intersect with it.

In this case if you look at this graph with my new budget line, I’m actually going to buy
fewer basketball tickets. My budget line is different and it intersects with a different point
on the indifference curve than it's a higher indifference curve. So I’m getting more utility.
So in this case, I will be buying more soccer tickets and I’m going to be buying a lot more
soccer tickets, but I’m actually going to be buying fewer basketball tickets, because now
one basketball ticket is relatively more expensive than soccer tickets. I now can get four

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soccer tickets for the price of one basketball ticket. So in terms of utility, when I go to a
basketball game, I’m giving up the chance to go to four soccer games. If you're interested
in the math on this particular one, it used to be that my optimum was six basketball and
eight soccer. It’s now three basketball and 28 soccer. So you can see the real impact that
the soccer team cutting their prices had on me as a consumer and where I was going to go.

One additional thing this shows is how the demand for soccer tickets fluctuates according
to its price. When they cost $50, I was willing to go to eight games. When they cost $25, I
was willing to go to 28 games and that's actually how the demand curve, you know, in at
least in theoretical terms, that’s how it's constructed. The demand curve is every
individual consumer, price versus quantity demanded how that interacts. So, if you're
trying to think of how the demand curve kind of emerges, just think about how every
single consumer would trade-off different goods and we isolate on that one good and we
go price versus quantity demanded. Now one of the most important principles that this
idea shows us as a business person is that what you're selling is always dependent on what
the consumer could otherwise be buying.

So let's say you work for the Boston Celtics. Basketball team is doing well. You know,
you're doing your job really well and then suddenly you see that your consumers aren't
going to as many games. There's not as many tickets being bought. You haven't done
anything, you haven't changed anything. What happened was that a different team in the
area cut their prices and your customers, given the choice between basketball and soccer,
have now made a decision to buy a lot more soccer tickets. What you're selling as any kind
of business is often going to be in competition with others. It may not even be in
competition in the same exact market, but if it's coming from the same budget line of a
consumer or the same bucket of money that they've set aside for some purpose, you're
going to be in competition with them because they have to decide do I spend my money on
what this person's selling or what this other person is selling. Even if they're slightly
different, if they're close enough to be considered substitutes, they're in competition with
each other.

One of the best examples I’ve seen for this is in the leisure and entertainment field. So
most people have a fixed entertainment budget or at least relatively fixed, and either they
go out to a restaurant or they go to a movie theatre or they go to a sports game, but it's
kind of mentally coming from the same amount of money. So if you're in that field, you not
only have to be worried about how your product is doing, how your customers are liking it,
but what other people in the entertainment field are doing that might eat into your
market. You know in the United States, casinos are a great example of how this works in
practice. Casinos have been proliferating across the United States. A lot of states are

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legalising gambling because they see it as a big way to get revenue without raising taxes.
The problem is that casinos are not just competing with each other, so you know if one
state opens a casino right next to another state's casino, they're probably both going to
suffer as they divide up their market share, but also casinos are in competition with every
other form of entertainment that is now so much easier to get.

You know, if you're building a casino and you're trying to project what the revenues will
be, you're trying to project what the value is, you have to think to yourself not only what's
the casino industry going to be like in five years, but also our streaming services going to
make home movies much easier, is online gambling going to be much simpler? , will video
games be more entertaining and more social, will people want more outdoors adventures.
How are they going to be spending their entertainment dollars? Because what you might
find is that, even though your product is just the same price, just as good as it once was,
everything else that is a substitute for it gets cheaper and therefore consumers they start
shifting their budget lines that starts intersecting at a different point on their indifference
curves and you find that you are losing customers to things that you didn't even realise
you were in competition with.

Speaker: Chris Oates

Let’s turn now to the other side of the economy from consumers to producers. How much
of something should a producer produce, especially if there's options about what they
could produce? One way to measure this is the production possibilities curve.

Now, let's say that I'm in my bakery and I’m now gonna make some lunch options for
people. I’m either gonna make sandwiches or I can make pizza. Now sandwiches are a lot
easier, so I could either make 100 sandwiches or 50 pizzas per day. You can draw a curve
between that and then obviously all the combinations of possibilities within them and get
something that looks like this, which is how much I could produce. Anything on the line is
me producing the absolute maximum I can, anything below the line is me being inefficient,
and anything above the line is not something I can do with the resources I have right now.
Now this production possibilities frontier is really useful for a business to think about how
it's deploying its resources and is it doing it so effectively. Now you might have a sales
team that you want to assign some marketing duties to, and you say, you know, you're
doing a lot of sales and you're doing a great job, why don't you just do some extra

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marketing work as well. Well, if all you're thinking about is that my sales team could also
do this, you might be missing the fact that it's a choice your sales team has to make
between making sales calls and doing marketing work and there's only so much time in the
day for them, there's only so much effort they can put in. So, if you're telling, if they're
working flat out on sales and you say do marketing, well they're going to decrease the
amount of sales work that they do, that seems kind of obvious. And if their marketing work
is not as productive as not as revenue driving as their sales work, you're going to be taking
resources away from your sales team, putting it to something that is not as useful, and as
we said in the first segment of the module a lot of economics is about trade-offs, about
measuring the trade-offs, the different incentives that people have.

This production possibilities curve can help you illustrate what those trade-offs are
between two options that you could do with the same limited amount of resources.
Another way to model production is with something called the production function, and
this looks at how much you can make of something with different levels of inputs. So let's
say that I'm gonna make pizza at this restaurant. Sandwiches are too difficult, they’re not
lucrative enough, so I’m gonna make pizza and to do that I need to, you know, I need to buy
the dough, the toppings, the tomato sauce, and I need to hire some workers, and my
question is how many workers should I hire to make pizza. So let's assume that I set it all
up myself. I’ve got all the food in the back room, I’ve got the pizza oven set-up, I’ve got the
storefront, and I’m going to just do it myself, because I just opened up this store and just
me, I can make a 100 pizzas per day with just one person working there I can make 100
pizzas per day.

And then I’m getting a little overworked, so I decide to hire another person. They're pretty
efficient, but you know occasionally they have to wait for me to move out of the way, my
pizza's in the oven. They need to hold on for few seconds. So they're making a lot of pizzas,
but they're only making another 90 pizzas per day. So together we're making 190 pizzas.
Let’s say then, I hire another worker and again they're very productive, but again
occasionally they have to wait for someone to get out of the way or the pizzas ovens in
use, so they bring us an extra additional 80 pizzas. So, between the three of us we're
making 270 pizzas per day. Now eventually, if we keep doing this, if we keep adding more
workers and people keep bumping into each other and they keep getting it away, we're
going to be adding less and less pizza per worker and eventually we'll hit the limit of the
store, we can't make any more. Well if we map out those workers and how many pizzas
they can make, we can develop our production function. So this is how much of the good
you can make based on your input cost. In this case, how many pizzas we can make based
on the number of workers that we hire? Now you might be seeing an issue with this curve.
As I’m hiring more and more workers, they're producing less and less extra pizza. My first

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worker, just me, can make 100 pizzas in a day, by the time I’m hiring my 10th or 11th
worker they're only giving us an extra few pizzas.

This illustrates the concept of the diminishing marginal product. So each additional unit
we put into our store less than the one before it. So my first worker was the most efficient
or the most productive. My second worker was a little less productive than the first. My
third was a little less productive than the second. My fourth was a little less productive
than the third. This helps us get into the question of how to maximise profits given that,
you know, we want to make as much profit as possible, and so it's probably not smart to
hire a 20th worker for this store if they're only going to make one pizza a day, but should
we hire 15, should we hire 10, 5, 3, what’s the right number to make sure that we can make
as much money as possible that’s something we're going to get to in a future segment.

Speaker: Chris Oates

In this segment, we’re going to talk about the cost structure of firms and how firms
manage because they have in order to maximise profits.

So in my pizza parlour, I've abandoned my bakery and I’m trying to get into pizza parlour,
I’ve variety of costs. I have rent that I have to pay on my store and let's just say to keep out
all the things around numbers, I have spent $100 a day on rent. So that’s a fixed cost. As
soon as I move into the store, I’m spending $100 on rent every single day that does not
change. I also have some variable cost. So I’ve things that change depending on how much
pizza I sell. One is food inputs. So I’ve to buy dough and tomato sauce and toppings and
we’re going to say that, that is basically constant. So for every hundred pieces I sell, it’s
going to cost me an extra $25 in food cost.

Then finally I had to pay my workers who make the pizza. Now let's say that for every
hundred pieces made, there is $50 in labour cost that goes into it. Well as you might
remember from the previous video, workers have a diminishing marginal product. So each
additional worker I add will cost the same, but will produce a little bit less or if we want to
flip that equation around for each increase in pizza by the same amount my worker costs
are going to increase. So for the first hundred pizzas, it cost me $50 for a worker. For the
next hundred pizzas to go from 100 to 200, it's gonna cost me $60 in worker costs. Now
breaking cost down into this can help illustrate how our cost will change as production
increases. So our fixed cost is going to be the same.

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The fixed cost is the same no matter how many pizzas we’re making, but the variable costs
will go up the more pizzas we make because of that diminishing marginal product. Now if
you plot this out let's just say in this chart here we go out to 2000 pizzas per day, we can
not only see what are total costs, but we can start to see what is the average cost per
pizza. So the fixed cost, the average fixed cost per pizza made goes down the more pieces
we make. Think about it, if we have to spend $100 a day on rent, it’s much better for us to
spread that $100 out over 2000 pizzas then on just one pizza. We are spending the same
amount of money, but we are selling a lot more so we can kind of spread out those costs
over each unit. So the average cost per pizza that comes from our fixed costs will go down
the more we make. Our average variable cost will go up. So remember because workers
have a diminishing marginal product, the variable costs on each pizza is going up the more
and more we are making. So on average, the variable cost will go up.

What you can see here is that the average total cost has a curve. So the average total cost
is extremely high for our first pizza because there's a lot of fixed costs on that first pizza
that’s all been concentrated there, but the variable costs aren’t that much, just one pizza.
Once we get to say 2000 pizzas, our average costs are again high and this is not because of
the fixed cost they have been spread out to virtually nothing per pizza bases, but our
variable costs are really high. And there is a point where that curve drops and where we
have a pretty low average total cost per pizza. Now let's say that, you know, with these
numbers, we are selling pizzas for a $50, we would be losing money if we made less than
100 pizzas or if we make more than 1500 pizzas, because below hundred pizzas our fixed
costs are so high we can't make any money selling pizzas for only $50 each. Our average
total cost on each pizza is higher than that. Above 1500 pizzas per day, we are losing
money because we are hiring so many workers that are efficient at those high-ends that
our variable costs are higher than a dollar for each.

The fact is, a lot of businesses conceptualize this in terms of sunk costs versus operating
cost.

I recently heard a pretty interesting podcast by someone who owns a restaurant and bar
that also has a bowling alley arcade attached to it and he was talking about how those four
different businesses have slightly different business models that can really complement
each other. So, for example, a restaurant, bars or separate restaurants especially have
relatively high operating costs. You know, you have to buy the food, you have to buy pretty

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frequently so it doesn’t go bad. You have to pay for waiters, you have to pay for the kitchen
staff, you have to pay for dishwashers. If you're opening a restaurant, you have a lot of
costs that are associated with every single hour or day that it is open. A bowling alley or an
arcade is a very different proposition. They cost a lot of money to get them up and run. You
know, for a bowling alley, you need to install all the floors, buy all the balls, get the
machines that set the pins, you have to buy all that stuff. For an arcade, you have to buy
every single game, but then the operating costs are actually pretty low. For an arcade, you
just need to pay for the electricity to run the games, maybe an attendant or 2 to empty out
the coins. For a bowling alley, you just need an attendant to sell the shoes and disinfect
them after each use. So for a bowling alley or arcade, you have really have fixed costs at
the beginning, really low operating costs as you are operating. For a restaurant, it’s slightly
differently. The operating costs are much more of an issue than the fixed cost. As you can
see in this chart, the cost in a bowling alley is really high if you don't have a lot of
customers. For a bowling alley, you want to maximize the customers in there to make sure
that you can spread out those fixed costs over a number of people, you can get the prices
down. The restaurant will have much lower fixed costs, but the variable cost will keep
driving upwards.

The business application is that if you have a business with really high sunk costs or fixed
cost and really low operating cost, you can afford to give a big discount. If it takes me
almost nothing to keep a bowling alley open on a Tuesday afternoon, I can then afford to
give 90% off tickets to a bowling alley on a Tuesday afternoon. All I care about is getting a
customer who can pay a little bit more than the operating cost. You can also use that low
operating costs as a way of enticing people into your high operating cost operation.

So let's say there's a deal by a meal restaurant and you get to bowl for free. That makes
sense because I'm driving people towards that business that costs a lot to stay open.One
final concept to know about cost is that you also always have to be aware of what your
opportunity costs are. So imagine if Lionel Messi decided to leave Barcelona and work at
that bowling alley. Now, he might really like it and he might have big businesses at that
bowling alley, but he is probably not making as much money as if he were playing football.

He is Lionel Messi. Every hour that he is playing football is really valuable and every hour
that he is at the bowling alley is not nearly as valuable. Even a really efficient bowling alley
is not a good use of Leo Massey’s time. For your own business, you should always be
thinking what are we not doing because of what we're doing now, what don’t we have time
to do, what don't we have the resources to do because of our current operations. It could
be that there's a big opportunity you are missing because you are too focused on what
you're doing now, but there is a business line that you could be getting into that would be

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much more profitable. Whether it’s a decision that could be made that is better than the
one you're either making now or not even realize that you could make.

You can see where businesses are located. You know, imagine you are a used car
dealership and you're in an area that is becoming wealthier and wealthier. Well your used
car dealership might be making good money, but it could be making good money 5 miles
out of town and the land you're sitting on is becoming more and more valuable by the day.
So from an opportunity cost perspective, you should sell that land to developer, make a lot
of money off it, get to a slightly verse location, but much cheaper and you got the money
from the land sale and now you are still running your business, or you might be working at
a beverage company that is thriving and someone says hey we should also have a fashion
line and again it might be a good idea, but maybe that's gonna take you away from your
core business of beverages, that is what you do is what you do better than anyone else,
and profession is just going to be waste to money. So by looking at the cost structure of
business, we can see is, not only are you a business that is more about fixed costs or
variable costs, sunk costs or operating costs, but also what is your opportunity cost and
these can help guide some of your decisions.

Speaker: Chris Oates

In the previous video, I talked about running a pizza parlour and how my costs will go up
the more pizzas I make, because each additional worker I hire has a diminishing marginal
product, but what if, instead of making pizzas, I were making automobiles. Now I can tell
you that making a car in a store big enough to run a pizza parlour is not going to be that
efficient. You need space to make a car, you need parts to make a car, you need a lot of
specialized workers to make a car. There's a reason that cars are made in really large
factories and the reason is that when increased productivity means that you become more
efficient, it’s said that you have an economy of scale, that your product is subject to
economies of scale.

Economies of scale are when your long run average costs decrease as your production
increases. So imagine an automobile factory, if you were in a small studio, building a car
just by yourself, it would take days and days of work to get all the parts together, to hire
the workers to come in one at a time to do the jobs that they know how to do. If you're in a
giant factory, it's actually much easier to do. You can churn out hundreds of thousands of

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cars every single year from a factory if you are specialized. In fact, the automobile industry
is one of the best examples of this.

When cars were first invented, when the automobile first started to take-off, they were
made in small shops, small garages. Then, when the Ford motor company introduced the
assembly line, they were made in relatively large factories and they found that that
assembly line and all that equipment and infrastructure really made it cheap to make cars.
Then, with the rise of automation, factories got a little bit bigger and now there's actually a
plant in Wolfsburg, Germany with Volkswagen that is one of the largest factories in the
world. It makes 815,000 cars every single year and in fact they make their own sausages
there because they realized that that was more efficient making sausages for their
workers than it was to just to buy sausage and bring them in from the outside.

So economies of scale represent your long run to average cost decreasing as your
production ramps up. Now you should get to a point where those average costs start to
flatten up. So maybe it's true that going from one car a day to thousand cars a day really
helps your economies of scale, really helps your costs go down because that one car to a
thousand cars means that you're going from a small store to a large factory with
specialized workforce, but then maybe after a thousand cars a day to two thousand cars a
day, you're not really saving much more money. You’re being more productive, you're
making more cars, but the average cost for every car is basically the same. You know, once
you get that factory up and running, it's pretty much the same cost for a car. So that's the
second stage in production. Usually you start off and you have some economies of scale at
the beginning, then you reach a point where the average costs remain constant and that is
what we call constant returns to scale.

Eventually though, you should hit a point where you start to have your average cost rise as
your production increases. Now we don't often talk about this, because most companies
are operating still at that level where they're trying to achieve economies of scale, but it's
certainly theoretically true. You know, imagine that plant in Germany, if it were three
times as large. It may be the case that once you build the largest factory in the world and
you triple it in size that the cost it takes to keep that factory standing, to keep the
electricity running, to keep the heat or the air conditioning going, it becomes
exponentially higher. Maybe to afford the real estate to have a factory of that size, you
need to put it way out in the middle of nowhere, and so you have to pay more to your
workers to get them to live out there. What you can see is that coordination costs would
go up. One of the times that we see diseconomies of scale in practice is whenever a
company breaks up.

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Let’s say there's a large conglomerate that effectively has 15 or so different business lines
within it and they're all pretty different. You know, it makes beverages, it makes clothes, it
makes TV components, something as different as that. There‘s a good chance that the
management team of that conglomerate is so torn between all the different business lines,
it doesn't have the time to give to each one to make sure it's doing better. So there is value
in the business that is not being fully captured. If you ever hear of a business that is
breaking up and the constituent parts are becoming valued more than the old
conglomerate used to be, that means that it likely had or at least it's estimated by financial
analysts that there were diseconomies of scale working in that firm.

One of the best examples of this is the merger between America Online and Time Warner.
This was the largest merger at the time. It was a $350 billion deal. America Online was an
internet provider and so that was new media. Time Warner was a traditional media
company, so that was old media, and it was assumed that there would be great economies
of scale once they merged. It was assumed that that company would become more
valuable than they two had been apart, which is why they merged and as it turned out it
was a giant bust. There were no economies of scale.

Arguably, the amount of time it took for the two companies to coordinate with each other
meant that there became diseconomies of scale. So as a business, you're much more likely
to be at that first stage of the cost curve where you're trying to achieve economies of
scale, but it's something to remember if you're at a large company or if you're at a
conglomerate, that a move to expand into a new area rather than giving you a new
business line, giving you a new set of revenue could actually introduce diseconomies of
scale and make everything you do more inefficient and more costly.

Speaker: Chris Oates

In this segment, I’m going to talk a little bit about digital goods and products, mainly
because they're often seen to not follow many of the same laws that affect production of
other more traditional goods. On the one hand this makes sense.

So let's say I make an app, it takes me a lot of time to make that app or I write a song and it
takes me a lot of time to write that song. Well, if the app or the song gets downloaded
once, it took me the same amount of time to produce it. If it gets downloaded a million
times, again it took me the same amount of time to produce it. The production of the song
or app is not affected by the number of downloads. So in that sense the app that's

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downloaded once and the app downloaded million times has the same costs, but
nonetheless we can still look at many of these digital goods and products and use the same
microeconomic models to understand what’s going on with them.

Let's start on the consumer side. So let's say, I’m going to take a train ride and I’ve got an
hour to kill and I could either look at Twitter or I can look at Instagram. Now, even though
those apps are free to me, there is still a cost. They're free in the sense that they don't cost
me money, but using them does cost me time. One minute spent on Instagram is a minute I
can’t be doing anything else. One minute spent on Twitter is a minute I’m not spending on
Instagram or on anything else. So we can, in this case, draw a budget line for me. Now it
wouldn't be a budget line with money, it would be a budget line of time. I could either
spend 60 minutes on Twitter or I could spend 60 minutes on Instagram or I can do some
kind of combination of the two, you know 30, 30, 40, 20 that sort of thing.

We can also create an indifference curve. Maybe I like Instagram more than Twitter,
maybe I like Twitter more than Instagram. Maybe I want at least a little bit of Twitter and
more of Instagram, but you know we can draw an indifference curve about what I value in
the trade-off between those two products. We can then take the budget line, take
indifference curves, put them together and see what is my ideal distribution of time spent
on Twitter versus Instagram. So how does, what happens at the companies that make
these apps interact with that indifference curve, how do we model what they're doing?
Well in one sense, what they're doing might be to try to affect my budget line. Maybe
we're at the point where an app is running so smoothly that one minute on that app, I’m
getting as much content or I’m getting as much out of it as two minutes on another app
because it's just really well made. Maybe they're adding friction, so I don’t want to leave
the app. Once I’m on it, I want to keep scrolling and so that would kind of change the
indifference curve or maybe they're just making it a superior product. So again, they want
to shift my indifference curve more towards that. But even though all of this is free and all
of this is happening just within an app, there is still a way to model it for what the
consumer wants and what choices they're going to make.

Now how about from the producer side because again one download is the same cost as a
million downloads and that's true. But if we look at production not as the number of
downloads, but as what they're making, then the traditional model still applies. So if it's
Twitter, for example, you could probably make a really basic version of Twitter with just a
few people, but to make a really well developed app to have that 100th feature that
thousands feature to make it a little bit more secure, well then you're going to need a lot
more engineers. And so you're probably going to see in terms of the actual product you're

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making, the actual app or the number of features, then, yes there is that traditional
production function.

Now another thing you might be seeing, especially in the digital economy, but also
elsewhere, just in the start-up world, are companies that are taking huge amounts of
venture capital before they even sell a single product, and that might seem odd, but again
traditional models can still be applied. So let's imagine that it's my pizza parlour and we
look at the total cost I have for making pizza. We can see in this chart here that it's a
traditional standard curve. I have some fixed costs, I have variable costs. My variable cost
increases as my production goes up and so my total costs go up as well. So that's pretty
typical and that's what you would expect to see if I were making pizzas. But let's say
instead of a pizza parlour, this is a pizza research company and I’m trying to investigate the
next generation of pizza. Well, those pizzas that I have in this chart, let's assume they're
not pizzas, but they're units of research. They’re, say, each additional unit of research
produced. Well again, it will follow a traditional curve. There are fixed costs that I have to
go through, so the office space. There are variable costs, you know, my pizza scientists that
I’m hiring, their salaries, and they again have a diminishing marginal product and there
might be some economies of scale there. So maybe this curve wouldn't look precisely like
this, maybe it would be slightly different, but it would basically look the same if we went
long enough.

Now the difference between selling pizzas and a pizza start-up doing the next generation
pizzas is that I might not be able to sell anything until I’ve done those 2000 units of
research. Pharmaceutical companies are a great example. You can't sell a drug until you've
invented it and there's a lot of research that goes into it. So one way to look at all of those
upfront investments, all of those fixed and variable costs that just get into that first drug is
to treat them all as a fixed cost. Before you can sell one unit of your product, you have to
do all of the upfront investment. So what happens with a lot of start-ups or companies like
pharmaceutical companies that really depend on a lot of research is that their average
total cost curve is almost exactly the same as their average fixed cost curve, and that's
simply because their costs are weighted so heavily towards those upfront investments
and those fixed costs that need to be paid before they can start producing anything.

So that's one reason why you'll often hear about venture capital pouring in millions of
dollars to these companies even though they seem to be losing money or even they
haven't built anything yet it's because they've identified a product or a potential market
where to sell a single unit requires a huge amount of initial investment and initial fixed
cost before they can start to do that. So it's not necessarily that venture capital is acting
irrationally and they're throwing money at problems, although that is obviously

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sometimes the case. It also could be that they know that the fixed costs required for this
product are so high that you need to have that upfront investment, and hopefully you will
pay off as you start producing something. So there are certainly differences between
digital goods, traditional goods, between start-up, between an established company, but
these microeconomic models and these concepts that we've talked about over the course
of this module can usually be applied to nearly every single one of them and therefore can
help you in a business make better decisions and understand the forces that are operating
in your market even if your day-to-day work may not be focused solely on them.

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