Ch. 19, R.A. Arnold, Economics 9th Ed Production and Costs Ch. 19, R.A. Arnold, Economics 9th Ed

Business (Firms) In this chapter we study the economic actor: Business (Firm) and the activity it undertakes i.e. Production. Production is the transformation of resources or factors of production into goods or services. E.g. Golpea Burger (a business) in our cafeteria makes burger (the good) using: bread, beef patty and cheese (the resources or inputs).

Why Businesses (Firms) Exist? Alchian and Demsetz (Dec 1972) provided a theory suggesting that firms exist because of the benefits of working as a team. Sum of team production > Sum of individual production E.g. Person A, B and C can make 10 burgers each per hour (individually). So sum of individual production = 30 burgers per hour. But together (as a team) they may be able to make 40 burgers per hour. Why? Can a theory or concept from Ch. 2 explain this. Remember: Specialization. If A, B, C divide the task of making a burger and each specialize in the task they are good at. E.g. A specializes in beef patty and B makes bread and C makes cheese. Together they may be able to produce more burger. Hence, they get together and open a burger shop

Continued There are benefits of working as a team but there are problems as well. One problem of team production is shirking (when workers put less effort than they are supposed to). Chances of shirking are higher in a team since costs of shirking are lower. How? If someone misses work someone else covers for him or her which is not possible in individual production. Solution? The Monitor (Manager) in a firm reduces the amount of shirking by firing shirkers and rewarding the productive members of the firm (an incentive for not shirking).

The Firm’s Objective: Maximizing Profit Q: Why do firms undertake the activity of production? A: To maximize profit (it is the incentive for production) Profit = Total Revenue (TR) – Total Cost (TC) Ch. 17, TR = Price (P) x Quantity (Q) E.g. if 40 burgers are sold at 100 BDT each. TR = 100 x 40 = 4,000 BDT Cost can be divided into two categories: explicit cost and implicit cost. Explicit cost: A cost for which an actual monetary payment was made e.g. cost of labour, capital etc. Implicit cost: A cost for which no monetary payment was made. E.g. the opportunity cost of starting a business.

Continued If a burger shop produces 1000 burgers per month and sells each at 50 taka. Then, TR = 50 x 1000 = 50, 000 taka Let’s assume, the shop spends 40, 000 taka on - meat, cheese, bread, paying employees (labour) and renting shop – per month. This is the explicit cost. In accounting we consider the explicit cost only. So, Accounting profit = TR – Explicit Cost = 50, 000 – 40, 000 = 10, 000 In economics we consider the implicit cost as well. Here, instead of opening a burger shop the owner (entrepreneur) could have worked at a office earning 10, 000 taka per month. This is the opportunity cost of the owner’s decision to start a business and hence we include it as the the implicit cost. You could say it is the cost of entrepreneurship. But no actual monetary payment is being made for this resource. So it is an implicit cost. Economic Profit = TR – (Explicit + Implicit Cost) = 50, 000 – (40, 000 + 10, 000) = 0

Continued Economic profit = 0. This situation is called ‘zero economic profit’. A business will continue production even if it’s earning zero economic profit. Why? As we can see the owner’s opportunity cost (the implicit cost of 10, 000 taka) – the salary he could have earned at the next best line of employment (office job) – is equal to the accounting profit. Hence, he may decide to continue the business instead of working at a office. What if the economic profit is negative e.g. – 5000 taka. In that case the accounting profit is 5000. Will the business continue production? Why?

Production and Cost Production – transformation of inputs (or resources) into goods the inputs the burger shop uses – meat, cheese, bread, labour, a shop. Let’s assume the owner has leased (rented on contract) the shop for 1 year. Hence, for 1 year he has to keep the shop, whether he stops production (no output) or continues production (some output). So this input (the shop) does not vary with the output. Hence it is a fixed input. But the other inputs – meat, ... and labour will vary as the production (and output) varies. If we produce more burger we need more meat, cheese,... Hence these are all variable inputs.

Continued The inputs (fixed and variable) are the source of cost for any business. Hence, Total cost = total fixed cost + total variable cost Here, we assume - the business uses only labour (variable input) and capital (the shop: the fixed input) - to simplify the following analysis . Short run: A period of time during which at least one input in the production process is fixed. Here the shop is leased (fixed) for 1 year. So 1 year is the short run. After 1 year the owner may decide to shift to a different shop. So this input is no longer fixed after 1 year. Long run: A period of time during which all inputs may be varied. In this case after 1 year.

Production in the short run Here we study the production of the burger shop (a business) in the short-run using a table (next slide). Rent of shop per month = 1000 taka & salary of a worker = 500 taka per month. If the business wants to increase the production of burger in the short run what should it do? Remember: It cannot change the fixed input (the shop); so the only option is to hire more labour (change the variable input) to make more burger. The owner may want to know, how many more additional burgers can a worker make? This answer is provided by: the marginal physical product of labour – the additional output obtained after employing one additional labour, ceteris paribus.

Fixed Input, Capital (Shop) Variable Input, Labour Quanity of Output, Q (number of burgers) Marginal physical product of labour (MPP) Total Fixed Cost (TFC) Total Variable cost (TVC) Total Cost (TC) Average total Cost, ATC ( TC ÷ Q) Marginal Cost 1 - 1000 500 1500 1.50 0.5 2 2500 2000 0.80 0.33 3 4000 0.63 4 5000 3000 0.60 5 5500 3500 0.64 6 5750 250 0.70

Continued In the table last slide, (fourth column) MPP of the 1st i.e. The additional burgers obtained after employing the first labour = 1000 – 0 = 1000. Similarly MPP of the 2nd labour i.e. additional burgers obtained after employing the 2nd labour = 2500 – 1000 = 1500. We are using column 3 (Quantity of output, Q) to calculate the MPP. We just need to find the change in Q to find the MPP. Something interesting can be observed when we study the MPP table. The MPP increases initially. Why? Remember team production > individual production. Specialization could explain this as well. But later as we add more labour, MPP falls. Why? Ans: The burger shop

Continued becomes overcrowded, workers get in the way of one another, shirking may increase, so the MPP falls. This is the law of diminishing marginal returns – as we combine larger amounts of a variable input with fixed input(s), eventually the marginal physical product of the variable input (in this case labour) declines. But the total output still increases (3rd column; Q) so the business may hire the 5th employee. In column 7, Total Cost = Total Fixed Cost + Total Variable Cost = Column 5 + Column 6 In column 8, Average Total Cost = TC ÷ Q = Column 6 ÷ Column 3

Continued In the last column, Marginal Cost (MC) means the additional cost of producing one additional unit of output (or burger). The additional cost here is the wage (W) = 500 taka. So to find marginal cost we can use, MC = (W / MPP). For example to find the marginal cost in 2nd row, 0.5 = (500 / 1000). This is how we obtain the values in the last column. Here the salary of every additional worker is 500 taka. So we can see as MPP increases, the MC decreases and when MPP decreases, MC increases. You can verify this by studying the table above. You may use, another formula for MC = (∆TC / ∆Q ). Here, ∆TC = W = 500 and ∆Q = MPP. Hence, we get the same result

Continued When we analyze the two last columns in the table we can see a interesting pattern. When, marginal cost < average total cost, then, average total cost ↓ When, marginal cost > average total cost, then, average total cost ↑ Hence, graphically, The MC curve intersects the ATC curve at its lowest point.

Analyzing Some Decision-Making of Businesses When should a business (or the burger shop) hire one more worker? Let us analyze this decision. The 1st worker employed adds 1000 cups of burger (MPP of 1st worker) to the production. Assuming the 1000 cups of burger can be sold at 50 taka each. The business can earn a total revenue of = 50, 000 taka from those 1000 burgers. The cost of hiring the worker = 500 taka. Here, the benefit of hiring the worker > cost (wage) of hiring the worker. So the business should definitely hire the 1st worker. The same analysis can be extended to any one of the workers. Generally, a firm (or business) should employ a labour if the additional goods obtained after employing him or her can be sold for a revenue greater than the wage or salary of that labour.

Continued Another decision: Should a business (or the burger shop) produce one more unit of output (or burger). Once again we compare the costs and benefits. The benefit of producing one more burger or output is called the marginal revenue - It is the additional revenue obtained from producing and selling one additional unit of output. What is cost of one additional unit of output? It is the marginal cost. If the marginal revenue (MR) > marginal cost (MC), then the output or good should be produced. Why? Revenue > Cost indicates positive profit so the business has an incentive to produce.

Maximizing Profit Finally, the million dollar question is, how many outputs (or burgers) should a business produce to ‘maximize profit’ (‘obtain the highest profit out of his business’)? Ans: The business should produce the number of outputs (Q) or burgers at which MR = MC (the profit maximizing condition). At this point a business (any business) will be maximizing profit. Why? Remember a business should produce a unit of good if MR > MC. But as they produce more units of good using more variable inputs MC increases (due to the law of diminishing marginal returns). And at one point MR = MC. At that point, the business should stop production. The business is now producing the profit maximizing level of output.