13 Producer Choices and Constraints

13 Producer Choices and Constraints
Notes and teaching tips: 8, 16, 19, 37, 40, 44 and 66. To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button. To advance to the next slide, click anywhere on the full screen figure. 13 Producer Choices and Constraints

After studying this chapter, you will be able to
Explain the firm’s economic problem and function Explain the relationship between a firm’s output and its inputs in the short run Derive and explain a firm’s short-run cost curves Explain the relationship between a firm’s output and costs in the long run and derive a firm’s long-run average cost curve

What do a big electricity supplier, Origin Energy, and Sam’s T-Shirts, a small (fictional) producer, have in common? Like every firm, They must decide how much to produce. How many people to employ. How much and what type of capital equipment to use. How do firms make these decisions?

The Firm and Its Economic Problem
A firm is an institution that hires factors of production and organises them to produce and sell goods and services. The Firm’s Goal A firm’s goal is to maximise profit. If the firm fails to maximise its profit, the firm is either eliminated or taken over by another firm that seeks to maximise profit.

Accounting Profit Accountants measure a firm’s profit to ensure that the firm pays the correct amount of tax and to show its investors how their funds are being used. Profit equals total revenue minus total cost. Accountants use rules based on standards established by the accounting profession.

Economic Accounting Economists measure a firm’s profit to enable them to predict the firm’s decisions, and the goal of these decisions is to maximise economic profit. Economic profit is equal to total revenue minus total cost, with total cost measured as the opportunity cost of production.

A Firm’s Opportunity Cost of Production A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production. A firm’s opportunity cost of production is the sum of the cost of using resources Bought in the market Owned by the firm Supplied by the firm's owner Another day; another dollar profit—or 15 cents, after implicit costs. Emphasise the difference between accounting profit and economic profit when a firm owner is using cost information to make business decisions. Point out that only economic profit reflects the full opportunity cost of making a business decision and it is vital for assessing the true financial health of a firm. Stress that accountants are limited in their ability to interpret and report the costs of production: All accounting costs must either be documented with a receipt or estimated according to strict, generally accepted accounting procedures. Point out the principal-agent problem that arises when firm managers can exploit the limitations of accounting profit calculations to under-report costs and over-report revenues to paint an artificially rosy financial picture for the firm—to the detriment of the firm owners. Enron and Arthur Andersen: When is a cost really a cost? The Enron fiasco brought the subject of accuracy and completeness in cost assessment to the attention of investors everywhere. Suddenly, the validity of financial information on any financial statement issued by any publicly held company was under scrutiny. The implicit cost shuffle: Some subversive tools of the accounting trade. A very useful news article, written by financial reporter Ken Brown, appeared in the Wall Street Journal on Feb. 2, He summarised many popular ways to use accounting costs to understate opportunity costs on a financial statement while technically satisfying generally accepted accounting procedures: For example, his list includes: i) Understating the capital asset depreciation by failing to record recent declines in the true market valuation of the capital (rather than from physical decay); ii) using off-the-books agreements to hide debt and credit risk by partnering with another company to share liabilities (which was a key element of Enron’s ill-fated ploy); iii) capitalising operating expenses, which allows current operating costs to be allocated over future time periods as if it were a capital depreciation expense.

Resources Bought in the Market The amount spent by a firm on resources bought in the market is an opportunity cost of production because the firm could have bought different resources to produce some other good or service.

Resources Owned by the Firm If the firm owns capital and uses it to produce its output, then the firm incurs an opportunity cost. The firm incurs an opportunity cost of production because it could have sold the capital and rented capital from another firm. The firm implicitly rents the capital from itself. The firm’s opportunity cost of using the capital it owns is called the implicit rental rate of capital.

The implicit rental rate of capital is made up of 1. Economic depreciation 2. Interest forgone Economic depreciation is the change in the market value of capital over a given period. Interest forgone is the return on the funds used to acquire the capital.

Resources Supplied by the Firm’s Owner The owner might supply both entrepreneurship and labour. The return to entrepreneurship is profit. The profit that an entrepreneur can expect to receive on average is called normal profit. Normal profit is the cost of entrepreneurship and is an opportunity cost of production.

In addition to supplying entrepreneurship, the owner might supply labour but not take a wage. The opportunity cost of the owner’s labour is the wage income forgone by not taking the best alternative job. Economic Accounting: A Summary Economic profit equals a firm’s total revenue minus its total opportunity cost of production. The example in Table 13.1 on the next slide summarises the economic accounting. Figure

The Firm’s Constraints Two features of a firm’s environment impose constraints that limit the profit that it can make. They are: Technology constraints Market constraints

Decision Time Frames The firm makes many decisions to achieve its main objective: profit maximisation. Some decisions are critical to the survival of the firm. Some decisions are irreversible (or very costly to reverse). Other decisions are easily reversed and are less critical to the survival of the firm, but still influence profit. All decisions can be placed in two time frames: The short run The long run The big picture Stand back from the details of this chapter and be sure that your students learn two big ideas: A firm’s production costs depend on the freedom to choose all inputs. 1. Long-run flexibility enables firms to produce at a lower cost than is possible in the short run when some inputs are fixed. 2. In the short run, with one or more fixed inputs, production costs vary with output in a predictable way because they are directly linked to input productivity. Also, preview where we are heading. We want to be able to predict firm’s decisions. To do so, we need to know about the influences on their costs and revenues. 1. Cost conditions are similar for all firms. That’s what we study here. 2. Revenue conditions depend on the market constraints. That’s what we study in the three chapters that follow. Emphasise that what the student learns here about cost is a vital prerequisite for understanding firms in perfect competition, monopoly, monopolistic competition, and oligopoly.

The Short Run The short run is a time frame in which the quantity of one or more resources used in production is fixed. For most firms, the capital, called the firm’s plant, is fixed in the short run. Other resources used by the firm (such as labour, raw materials, and energy) can be changed in the short run. Short-run decisions are easily reversed.

The Long Run The long run is a time frame in which the quantities of all resources—including the plant size—can be varied. Long-run decisions are not easily reversed. A sunk cost is a cost incurred by the firm and cannot be changed. If a firm’s plant has no resale value, the amount paid for it is a sunk cost. Sunk costs are irrelevant to a firm’s current decisions.

Short-Run Technology Constraint
To increase output in the short run, a firm must increase the amount of labour employed. Three concepts describe the relationship between output and the quantity of labour employed: 1. Total product 2. Marginal product 3. Average product Lots of definitions and terminology can cloud the primary message Make good use of the glossary of productivity and cost terms provided in Table 13.3 but don’t get mired down in reciting productivity and cost measure definitions! Emphasise to the students that they must learn these definitions. But don’t spend a lot of class time on them. Focus on why productivity measures and cost measures are vital for decision making. Managers must frequently make quick decisions with little information. If managers have knowledge of a useful relationship between input measures (which are relatively easy to get) and production cost measures (which are much more difficult to get—especially marginal cost figures) they can use their understanding of this link to make inferences about how production costs will change when the firm’s output changes.

Product Schedules Total product is the total output produced in a given period. The marginal product of labour is the change in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same. The average product of labour is equal to total product divided by the quantity of labour employed.

Table 13.2 shows a firm’s product schedules. As the quantity of labour employed increases: Total product increases. Marginal product increases initially but eventually decreases. Average product increases initially but eventually decreases.

Product Curves Product curves show how the firm’s total product, marginal product, and average product change as the firm varies the quantity of labour employed.

Total Product Curve Figure 13.1 shows a total product curve. The total product curve shows how total product changes with the quantity of labour employed.

The total product curve is similar to the PPF. It separates attainable output levels from unattainable output levels in the short run.

Marginal Product Curve Figure 13.2 shows the marginal product of labour curve and how the marginal product curve relates to the total product curve. The first worker hired produces 4 units of output.

The second worker hired produces 6 units of output and total product becomes 10 units. The third worker hired produces 3 units of output and total product becomes 13 units. And so on.

The height of each bar measures the marginal product of labour. For example, when labour increases from 2 to 3, total product increases from 10 to 13, … so the marginal product of the third worker is 3 units of output.

To make a graph of the marginal product of labour, we can stack the bars in the previous graph side by side. The marginal product of labour curve passes through the midpoints of these bars.

Almost all production processes are like the one shown here and have: Increasing marginal returns initially Diminishing marginal returns eventually

Increasing Marginal Returns Initially, the marginal product of a worker exceeds the marginal product of the previous worker. The firm experiences increasing marginal returns.

Diminishing Marginal Returns Eventually, the marginal product of a worker is less than the marginal product of the previous worker. The firm experiences diminishing marginal returns.

Increasing marginal returns arise from increased specialisation and division of labour. Diminishing marginal returns arises because each additional worker has less access to capital and less space in which to work. Diminishing marginal returns are so pervasive that they are elevated to the status of a “law.” The law of diminishing returns states that: As a firm uses more of a variable input with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes.

Average Product Curve Figure 13.3 shows the average product curve and its relationship with the marginal product curve. When marginal product exceeds average product, average product increases. The marginal pulls (but cannot not push) the average Don’t let the students fall into the trap of thinking that if the marginal measure rises (falls) with the level of an activity, then the average measure must also rise (fall). This is a sloppy statement of the relationship between marginal and average measures. Use the tried-and-true average mark example used in the text. Explain that if their average mark is a 60%, and their next marginal mark is 80%, their average rises to 70%. But if the next marginal market is 60%, this marginal grade will not pull the average mark up. Conceptually, the students should understand that the marginal value can’t “push” the average measure higher when it is, itself, lower than the average measure. The marginal measure must be higher (lower) than the average value if the average value is to rise (fall) with the level of activity, thereby “pulling” the average from its position of either higher or lower than the average.

When marginal product is below average product, average product decreases. When marginal product equals average product, average product is at its maximum.

Short-Run Cost To produce more output in the short run, the firm must employ more labour, which means that it must increase its costs. Three cost concepts and three types of cost curves are: Total cost Marginal cost Average cost Explain the intuition behind each cost measure. For example, explain why the relationship between marginal product and marginal cost is worth understanding. Point out that although separating fixed and variable components of cost help us understand why unit cost of production is U-shaped in the short run and why fixed costs don’t matter in a firm’s output decision.

Short-Run Cost TC = TFC + TVC Total Cost
A firm’s total cost (TC) is the cost of all resources used. Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output. Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output. Total cost equals total fixed cost plus total variable cost. That is: TC = TFC + TVC

Short-Run Cost Figure 13.4 shows a firm’s total cost curves.
Total fixed cost is the same at each output level. Total variable cost increases as output increases. Total cost, which is the sum of TFC and TVC also increases as output increases.

Short-Run Cost The AVC curve gets its shape from the TP curve.
The TP curve becomes steeper at small output levels and then less steep at larger output levels. In contrast, the TVC curve becomes less steep at small output levels and steeper at larger output levels. Emphasise that the TP curve graph has labour on the x-axis and output on the y- axis, while the TVC curve has output on the x-axis and total variable cost on the y-axis. So, each graph has output on one of the axes.

Short-Run Cost To see the relationship between the TVC curve and the TP curve, let’s look again at the TP curve. But let us add a second x-axis to measure total variable cost. 1 worker costs $25; 2 workers cost $50; and so on, so the two x-axes line up.

Short-Run Cost We can replace the quantity of labour on the x-axis with total variable cost. When we do that, we must change the name of the curve. It is now the TVC curve. But it is graphed with cost on the x-axis and output on the y-axis.

Short-Run Cost Redraw the graph with cost on the y-axis and output on the x-axis, and you’ve got the TVC curve drawn the usual way. Put the TFC curve back in the figure, … and add TFC to TVC, and you’ve got the TC curve.

Short-Run Cost Marginal Cost
Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product. Over the output range with increasing marginal returns, marginal cost falls as output increases. Over the output range with diminishing marginal returns, marginal cost rises as output increases.

Short-Run Cost ATC = AFC + AVC. Average Cost
Average cost measures can be derived from each of the total cost measures: Average fixed cost (AFC) is total fixed cost per unit of output. Average variable cost (AVC) is total variable cost per unit of output. Average total cost (ATC) is total cost per unit of output. ATC = AFC + AVC.

Short-Run Cost Figure 13.5 shows the MC, AFC, AVC and ATC curves.
The AFC curve shows that average fixed cost falls as output increases. The AVC curve is U-shaped. As output increases, average variable cost falls to a minimum and then increases.

Short-Run Cost The ATC curve is also U-shaped.
The MC curve is very special. For the output range over which AVC is falling, MC is below AVC. For the output range over which AVC is rising, MC is above AVC. At minimum AVC, MC equals AVC.

Short-Run Cost Similarly, for the output range over which ATC is falling, MC is below ATC. For the output range over which ATC is rising, MC is above ATC. At the minimum ATC, MC equals ATC.

Short-Run Cost The AVC curve is U-shaped because:
Initially, MP exceeds AP, which brings rising AP and falling AVC. Eventually, MP falls below AP, which brings falling AP and rising AVC. The ATC curve is U-shaped for the same reasons. In addition, ATC falls at low output levels because AFC is falling quickly.

Short-Run Cost Why the Average Total Cost Curve Is U-Shaped
The ATC curve is the vertical sum of the AFC curve and the AVC curve. The U-shape of the ATC curve arises from the influence of two opposing forces: Spreading total fixed cost over a larger output—AFC curve slopes downward as output increases. Eventually diminishing returns—the AVC curve slopes upward and AVC increases more quickly than AFC is decreasing.

Short-Run Cost Cost Curves and Product Curves
The shapes of a firm’s cost curves are determined by the technology it uses: MC is at its minimum at the same output level at which MP is at its maximum. When MP is rising, MC is falling. AVC is at its minimum at the same output level at which AP is at its maximum. When AP is rising, AVC is falling.

Short-Run Cost Figure 13.6 shows these relationships.

Short-Run Cost Shifts in the Cost Curves
The position of a firm’s cost curves depends on two factors: Technology Prices of factors of production

Short-Run Cost Technology
Technological change influences both the product curves and the cost curves. An increase in productivity shifts the product curves upward and the cost curves downward. If a technological advance results in the firm using more capital and less labour, fixed costs increase and variable costs decrease. In this case, average total cost increases at low output levels and decreases at high output levels.

Short-Run Cost Prices of Factors of Production
An increase in the price of a factor of production increases costs and shifts the cost curves. An increase in a fixed cost shifts the total cost (TC ) and average total cost (ATC ) curves upward but does not shift the marginal cost (MC ) curve. An increase in a variable cost shifts the total cost (TC ), average total cost (ATC ), and marginal cost (MC ) curves upward.

Long-Run Cost In the long run, all inputs are variable and all costs are variable. The Production Function The behaviour of long-run cost depends upon the firm’s production function. The firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labour. The firm’s transition between the short run and long run revolves around the commitments made by the firm Be sure the students realise that accurate forecasting of market demand for a firm’s product is key to profitability, since it must make the proper long-run commitment to a given plant size. Show the students that if faulty market analysis causes a firm to commit to a plant that is too small (too large) when the required range of production is actually relatively high (relatively low), the firm will suddenly be locked into a much less competitive production cost situation with potentially dire consequences.

Long-Run Cost Table 13.4 shows a firm’s production function.
As the size of the plant increases, the output that a given quantity of labour can produce increases. But for each plant, as the quantity of labour increases, diminishing returns occur.

Long-Run Cost Diminishing Marginal Product of Capital
The marginal product of capital is the increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labour employed. A firm’s production function exhibits diminishing marginal returns to labour (for a given plant) as well as diminishing marginal returns to capital (for a quantity of labour). For each plant, diminishing marginal product of labour creates a set of short run, U-shaped costs curves for MC, AVC, and ATC.

Long-Run Cost Short-Run Cost and Long-Run Cost
The average cost of producing a given output varies and depends on the firm’s plant. The larger the plant, the greater is the output at which ATC is at a minimum. The firm has 4 different plants: 1, 2, 3, or 4 sewing machines. Each plant has a short-run ATC curve. The firm can compare the ATC for each output at different plants.

Long-Run Cost ATC1 is the ATC curve for a plant with 1 sewing machine.

Long-Run Cost ATC2 is the ATC curve for a plant with 2 sewing machines.

Long-Run Cost The long-run average cost curve is made up from the lowest ATC for each output level. So, we want to decide which plant has the lowest cost for producing each output level. Let’s find the least-cost way of producing a given output level. Suppose that the firm wants to produce 13 T-shirts a day.

Long-Run Cost 13 T-shirts a day cost $7.69 each on ATC1.

Long-Run Cost The least-cost way of producing 13 T-shirts a day is to use 2 sewing machines, the fixed factor of ATC2.

Long-Run Cost Long-Run Average Cost Curve
The long-run average cost curve is the relationship between the lowest attainable average total cost and output when both the plant and labour are varied. The long-run average cost curve is a planning curve that tells the firm the plant that minimises the cost of producing a given output range. Once the firm has chosen its plant, the firm incurs the costs that correspond to the ATC curve for that plant.

Long-Run Cost Figure 13.8 illustrates the long-run average cost (LRAC) curve.

Long-Run Cost Economies and Diseconomies of Scale
Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output increases. Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output increases. Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases.

Long-Run Cost Figure 13.8 illustrates economies and diseconomies of scale.

Long-Run Cost Minimum Efficient Scale
A firm experiences economies of scale up to some output level. Beyond that output level, it moves into constant returns to scale or diseconomies of scale. Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its lowest level. If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale output level.

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