Production Costs Microeconomic Analysis Tuesday September 15 th 2009

2 Today Recap Practice questions Production Excercice Cost structure of the firm

3 Practice Question In an attempt to decrease the amount of drinking on college campuses, state legislators decide to raise the price of beer by 10%. If beer has a price elasticity of demand of 2, by what percent will the quantity of beer demanded decrease as a response to the price increase?

4 Practice Question You are the manager of a small city and are trying to find a way to make your city bus system take in more revenue. Your staff recommends raising the bus fare to increase revenue. However, after looking at the demand curve for bus service your undergraduate intern (who happens to be an economics major) claims that reducing, instead of increasing, the fare would increase revenue. Assuming that the econ major is correct, which of the following best characterizes the shape of the demand curve for bus service? 1. downward sloping, elasticity =.6 2. Almost vertical 3. Almost horizontal 4. Upward sloping 5. downward sloping, elasticity = 1

5 Practice Question Your consulting firm has been hired to investigate the way in which female smokers respond to an increase in cigarette prices. On your first day on the job, you observe that a pack of cigarettes costs $4.60 and that 15,000 packs are sold to women each day. A month later, you observe that after a state imposed “sin tax” that raises the price of cigarettes to $6.00, 15,000 packs are still sold. This is not an example of an upward sloping demand curve and it is not because of new smokers. Based on these figures, determine the price elasticity of demand for cigarettes. Is this demand elastic or inelastic?

Production costs

7 Introduction Nature and goals of the firm Short/Long Run distinction Costs: Opportunity cost Sunk costs Economies of scale

8 The firm A firm: An organization which transforms inputs into output. Goal of a firm: To maximize its profit Profit (π) = Revenue – Costs

9 The production process Factors of production (or inputs): Capital (K): Durable material resources  Examples: machines, computers,... Labor (L): Employee resources  Examples: workers,... Materials (M):Resources to be transformed in the production process  Examples: weat, iron, ink,... Product (or output) : Goods or services destined to be sold Examples : newspaper,...

10 Short run v. Long run Example: A new restaurant realizes that its popularity exceeds its expectations. What are its options? …in the short-run (in the following weeks/months)? Hire more workers, increase food production... …in the long run (in the following years)? Open new restaurants, get new ovens,...

11 In the long run, the use of inputs is not constrained (e.g.: the size of a plant, contracts with providers, etc..): Enough time passes so that all inputs are variable. Short run v. Long run

What costs to include? 1. Opportunity cost

13 A business decision You are contemplating starting your own business. Your estimate: revenue of $80,000 per year Estimated costs (by accountant): $25,000 per year What would your profit be? 55K$ Should you start this business? YES!

14 Opportunity cost How would your answer change if you were currently employed at $60,000 per year? Opportunity cost: the value of the best alternative use of a resource. Accounting π = Revenue – Accounting Costs Economic π = Revenue – Economic costs Accounting costs + Opportunity cost

What costs to include? 2. Sunk costs

16 What price should you accept? You designed and made 1000 funny t-shirts, at a cost of $15 each. Unfortunately, nobody likes them, and no one is willing to buy them for $15 each. Should you accept to lower your price below $15?

17 Sunk costs Sunk costs are related to irreversible decisions which have already been made. Therefore, sunk costs are irrelevant for current decision making!

What costs to include? 3. Fixed costs

19 Fixed costs Necessary costs in order to serve the first customer. They include: Opportunity costs R&D costs “Production” costs (e.g.: music album, film, etc.) Distribution costs (cable, electricity, water,…) Etc.

20 Remark on LR fixed costs Even though enough time passes for all inputs to be variable in the long run… …it does not imply that there are no fixed costs in the long run.

21 Cost curves Fixed costs (F): independent of output (= set-up costs) Variable costs (VC): vary with output Total Cost: C = F + VC

22 AC= C/q = F/q + VC/q = AFC + AVC Interpretation: Useful for determining the profitability of the firm Average cost (AC)

23 MC= ∆C/∆q(discrete case) = C’ (continuous case) Interpretation: Useful for the firm’s pricing decision Marginal cost (MC)

24 Economies of scale Help determine the optimal size of the firm: No economies of scale: Constant AC Economies of scale: Falling AC Diseconomies of scale: Rising AC

25 Sources of economies of scale Sources of economies of scale: Specialization; Large quantities of inputs necessary to operate; When a fusion can eliminate the duplication of set- up costs Sources of diseconomies of scale: Management made difficult as size gets too large. Internal communication problems.

26 Typical cost curve Typically, firms experience both types of economies of scale. $/q AC q

QuantityTC ($)FC ($)VC ($)ATC ($)AVC ($)MC ($) 010XXXXXX

QuantityTC ($)FC ($)VC ($)ATC ($)AVC ($)MC ($) XXXXX /

29 OutputFVCCMCAFCAVCAC 0500___n/a 150 ___ 25078___ 35098___ ___ ___ ___ ___ ___ ___ ___ ___

Explain why: 1.AC increases when MC > AC 2.AC decreases when MC < AC 3.MC = AC where AC is minimum Similarly for AVC q $ VC C F 50 $/q q MC AC AVC

Short-run cost curves In the short-run, some inputs are fixed (because there is too little time to adjust) Hence, less flexibility  short-run costs are larger than long-run costs. $/q AC LR q AC SR

32 Conclusions Inner workings of a firm: production and costs Economic costs ≠ accounting costs  The difference is the opportunity cost Next: Decision-making in a competitive industry.