david bryce © 1996-2002 adapted from baye © 2002 production and supply manec 387 economics of...

David Bryce © 1996-2002Adapted from Baye © 2002


Production and SupplyProduction and Supply

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

David J. BryceDavid J. Bryce



The Structure of IndustriesThe Structure of Industries

Competitive Rivalry

Threat of newEntrants

BargainingPower of

Customers

Threat ofSubstitutes

BargainingPower of Suppliers

From M. Porter, 1979, “How Competitive Forces Shape Strategy”



Production and SupplyProduction and Supply

• Firms acquire inputs from suppliers• Economics of production determines

demand for inputs • Inputs are transformed into outputs

through a productivity relationship defined by the “production function”

• For example, consider the Cobb-Douglas production function:

Q = f(L,K) = ALK

• Firms acquire inputs from suppliers• Economics of production determines

demand for inputs • Inputs are transformed into outputs

through a productivity relationship defined by the “production function”

• For example, consider the Cobb-Douglas production function:

Q = f(L,K) = ALK



Total ProductThe Cobb-Douglas Production FunctionTotal ProductThe Cobb-Douglas Production Function

Q = f(K,L) = K0.5L0.5

• Assume that in the very short run, capital (K) is fixed at 16 units

• Short run production function:Q = 160.5 L0.5 = 4 L0.5

• What is total product (output) when we use 100 employees?

Q = 4 (1000.5) = 4 (10) = 40 units

Q = f(K,L) = K0.5L0.5

• Assume that in the very short run, capital (K) is fixed at 16 units

• Short run production function:Q = 160.5 L0.5 = 4 L0.5

• What is total product (output) when we use 100 employees?

Q = 4 (1000.5) = 4 (10) = 40 units



Product of LaborProduct of Labor

• Marginal product of labor – MPL = Q/L– Measures the output produced by the last

worker– Slope of the production function

• Average product of labor – APL = Q/L– Measures the output of an “average” worker

• Marginal product of labor – MPL = Q/L– Measures the output produced by the last

worker– Slope of the production function

• Average product of labor – APL = Q/L– Measures the output of an “average” worker



Productivity in StagesProductivity in Stages

QQ

LL

Q=F(K,L)Q=F(K,L)

IncreasingMarginalReturns

IncreasingMarginalReturns

DiminishingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

NegativeMarginalReturns

MPMP

APAP



Optimal Choice of Input LevelsHow much of an input do I need?Optimal Choice of Input LevelsHow much of an input do I need?

• Use enough input such that marginal benefit equals marginal cost

• Logic – if one more unit provides more value (PQQ) than it costs (PLL), firm is better off – use another unit

• Use enough input such that marginal benefit equals marginal cost

• Logic – if one more unit provides more value (PQQ) than it costs (PLL), firm is better off – use another unit

TVPTVP

Input LInput L

PLLPLL

PQQPQQ

L*L*

Q*Q*

Tangency means MVP=MCTangency means MVP=MC



Marginal Rate of Technical Substitution – Cobb-Douglas

Marginal Rate of Technical Substitution – Cobb-Douglas

• Isoquants represent the combinations of inputs that produce a particular level of output

• Slope of isoquant gives the rate at which we can trade one input for another leaving output unchanged – marginal rate of technical substitution (MRTS)

• Isoquants represent the combinations of inputs that produce a particular level of output

• Slope of isoquant gives the rate at which we can trade one input for another leaving output unchanged – marginal rate of technical substitution (MRTS)

Input KInput K

Input LInput L

Q3Q3

Q2Q2

Q1Q1

Q1 < Q2 < Q3Q1 < Q2 < Q3



Linear IsoquantsPerfect substitutes – Perfect ComplementsLinear IsoquantsPerfect substitutes – Perfect Complements

Q3Q3Q2Q2Q1Q1

LL

KK

Q3Q3

Q2Q2

Q1Q1

LL

KK

Leontief (fixed proportion) technologyLeontief (fixed proportion) technology



Optimal Choice of Input CombinationsOptimal Choice of Input Combinations

• Choose optimal inputs Choose optimal inputs such that marginal such that marginal rate of technical rate of technical substitution equals substitution equals the price ratiothe price ratio

• LogicLogic – if MRTS > price – if MRTS > price ratio, you can get ratio, you can get more production/$ more production/$ from L than from K. from L than from K. Add more L until its Add more L until its marginal contribution marginal contribution equals that of Kequals that of K

• Choose optimal inputs Choose optimal inputs such that marginal such that marginal rate of technical rate of technical substitution equals substitution equals the price ratiothe price ratio

• LogicLogic – if MRTS > price – if MRTS > price ratio, you can get ratio, you can get more production/$ more production/$ from L than from K. from L than from K. Add more L until its Add more L until its marginal contribution marginal contribution equals that of Kequals that of K

Input KInput K

Input LInput L

Tangency means MRTS = price ratio

Tangency means MRTS = price ratio

L*L*

K*K*

PL/PKPL/PK



Input Factor DemandsHow much do we need from suppliers?Input Factor DemandsHow much do we need from suppliers?

Input KInput K

Input LInput LL0L0

K0K0

PL/PKPL/PK

L1L1

K1K1

When the price of labor rises, firm demand for labor falls and demand for capital rises

When the price of labor rises, firm demand for labor falls and demand for capital rises



Input Factor DemandInput Factor Demand

LL

KK

$$

LL

DLDLP1P1

L0L0 L1L1

The firm’s demand for an input (from a supplier) is derived from each new equilibrium point found on the isoquant as the price of the input is varied.

The firm’s demand for an input (from a supplier) is derived from each new equilibrium point found on the isoquant as the price of the input is varied. P0P0



Elements of CostFirms Incur Costs Using InputsElements of CostFirms Incur Costs Using Inputs

• Total cost is an (always) increasing function of output and assumes that firms produce efficiently.

• Variable cost is the cost of variable inputs (e.g., direct labor, raw materials, sales commissions) and varies directly with output.

• Fixed costs remain constant as output increases

• Total cost is an (always) increasing function of output and assumes that firms produce efficiently.

• Variable cost is the cost of variable inputs (e.g., direct labor, raw materials, sales commissions) and varies directly with output.

• Fixed costs remain constant as output increases

QQ

TC(Q) = VC(Q) + FCTC(Q) = VC(Q) + FC

VC(Q)VC(Q)

FCFC

$$



Properties of CostProperties of Cost

• The properties of cost are determined by the shape of total cost function

• Average cost (AC(Q)) is the average cost per unit (TC(Q)/Q)

• Marginal cost (MC(Q)) is the cost of the last unit and defines the rate at which cost changes as quantity changes

• The properties of cost are determined by the shape of total cost function

• Average cost (AC(Q)) is the average cost per unit (TC(Q)/Q)

• Marginal cost (MC(Q)) is the cost of the last unit and defines the rate at which cost changes as quantity changes

$$

QQ

ATCATC

AVCAVC

AFCAFC

MCMC



Fixed CostFixed Cost

$$

QQ

ATCATC

AVCAVC

MCMC

ATCATC

AVCAVC

Q0Q0

AFCAFC Fixed CostFixed CostFixed CostFixed Cost

Q0(ATC-AVC)

= Q0 AFC

= Q0(FC/ Q0)

= FC

Q0(ATC-AVC)

= Q0 AFC

= Q0(FC/ Q0)

= FC



Variable CostVariable Cost

$$

QQ

ATCATC

AVCAVC

MCMC

AVCAVC

Q0Q0

Variable CostVariable CostVariable CostVariable Cost

Q0AVC

= Q0 [VC(Q0)/Q0]

= Q0(FC/ Q0)

= VC(Q0 )

Q0AVC

= Q0 [VC(Q0)/Q0]

= Q0(FC/ Q0)

= VC(Q0 )

ATCATC



Total CostTotal Cost

$$

QQ

ATCATC

AVCAVC

MCMC

AVCAVC

Q0Q0

TotalTotalCostCostTotalTotalCostCost

Q0ATC

= Q0 [TC(Q0)/Q0]

= TC(Q0 )

Q0ATC

= Q0 [TC(Q0)/Q0]

= TC(Q0 )

ATCATC



Time and CostTime and Cost

• Once a firm commits to a technology, it cannot immediately change scale – costs are more fixed in the short-run

• In the long-run, firms can change technology and scale – costs are more variable

• The long-run average cost is the minimum of all short-run cost curves over time.

• Once a firm commits to a technology, it cannot immediately change scale – costs are more fixed in the short-run

• In the long-run, firms can change technology and scale – costs are more variable

• The long-run average cost is the minimum of all short-run cost curves over time.

SRAC1

SRAC5SRAC

3

LRAC

QuantityQuantity

CostCost



Decision-Making and CostDecision-Making and Cost

• Accounting costs inform external constituents.

• Economic costs inform internal decision makers and include opportunity costs.

• Sunk costs have already been incurred and cannot be avoided.– Economic decisions depend on avoidable costs.– When fixed costs can be redeployed or sold, they

are not entirely sunk.– Sunk costs are the basis for strategic commitment.

• Accounting costs inform external constituents.

• Economic costs inform internal decision makers and include opportunity costs.

• Sunk costs have already been incurred and cannot be avoided.– Economic decisions depend on avoidable costs.– When fixed costs can be redeployed or sold, they

are not entirely sunk.– Sunk costs are the basis for strategic commitment.

david bryce © 1996-2002 adapted from baye © 2002 production and supply manec 387 economics of...

Documents

qatcavcafcmcfixed cost

inputstotal cost

cost of variable inputs

inputs inputs

price of labor

function of output

unit tcqqmarginal cost

input kinput ll0k0plpkl1k1when