MNOTES2

Chapter 7 - The Production Process: The Behavior of Profit-Maximizing Firms

Objectives:1. Student must understand the assumptions of perfect competition.

2. The student should be able to differentiate between accounting profit and economic profit.

3. The student should be able to differentiate between the long run and the short run.

4. The student must be able to apply the law of diminishing marginal returns.

5. The student should understand how the entrepreneur answers the question of "how".

┌──────── Product Markets ────────┐│ (D&S) │

Output Supply Output Demand

│ ┌─ Firms│ │ │ │ Households │ │ │ │ │ │ Labor Demand Labor Supply │ │ └──────── Input Markets ────────────┘Investment (D&S) │ │ Labor │ │ Natural Resources │ └───────────────── Capital ────────────── Savings

Accounting Profit = Total Revenue - Total Direct Cost of Operation

Assume Vincent can make $25,000 per year making blue jeans.

1. [Is this enough to keep Vincent in business?]

2. [If not, how much profit is required to keep your group producing blue jeans?] This last question only Vincent can answer.

3. [What are some factors that would determine the minimum (normal rate of return pg 137)profit necessary for your group to continue to produce blue jeans?]

Vincent estimates that he could earn $30,000 per year if he gave up his business and looked for a job in management.

4. [Do you think Vincent will sell his business for a management job? Assume the competitive conditions apply]

5. [Is it possible that Vincent would continue to operate

Vincent Enterprises even if he could earn $30,000 in the labor market?]

6. [Assume Vincent can sell his business for a profit of $50,000. How would this knowledge affect Vincent's decision to continue as a entrepreneur?]

7. [If Vincent continues to operate his business, what would be the minimum he values owning and operating his own business?]

8. [Assume Vincent cannot easily exit (he would have to sell his business at a considerable loss) the jeans business. How would this violation of the competitive conditions affect Vincent's decision?]

Now assume: 1) Vincent can sell his business for $50,000 profit, 2) the market interest rate is 8%(normal rate of return), 3) Vincent places no value on owning and operating his own business, and 4) Vincent can make $30,000 as a manager for another company. If Vincent is a rational entrepreneur, he would require an average profit of $34,000 per year to continue operating his own business. This is calculated by using table I below:

Table I

1. Opportunity costs of Vincent's labor ----- $30,000

2. Opportunity costs of Vincent's capital and land ----- $ 4,000

3. Intrinsic value of Vincent's business ------ $ 0 TOTAL ------ $34,000

If Vincent actually earned $34,000 this year, his economic profit would be zero. Economic profit is determined by taking the opportunity cost of doing business and subtracting accounting

profit. The equation is represented in equation 1 below:Equation #1

Economic Profit = Accounting Profit - Opportunity Cost (TR - AC) = TR - Economic Costs

AC= accounting or direct costsOC=opportunity costAC+OC = economic costs

Economic Costs - The full costs of production including 1) a normal rate of return on investment, and 2) the opportunity cost of each factor of production. Pg 137

9. [ Determine the accounting cost and economic costs of each of the following: You go to Wal-Mart to purchase a roll of tape that costs .69, You go to the D.M.V. to get your license renewed, You go to Wal-Mart to purchase an computer table that needs assemble for $59., You go to lunch the cost is $5.99]

10. [Is there always an opportunity cost?]

The amount of exit and entry for an industry is determined by the amount of economic profit in that industry. If economic profit is positive, individuals will stay in the industry and other people will enter. The assumption other people make is they will be able to earn economic profit if someone else in the industry is earning economic profit. This assumption of, "if someone else can do it, I can do it too" is usually false. People have vastly different skills. The skills of a successful business manager should never be taken for granted. If economic profit is negative, some people but not all will leave the industry. If economic profit is perceived to be zero by individuals in the market place, there should be no change in the number of firms in the industry. Because information is not perfect about the market and about themselves people make incorrect decisions i.e. enter when they should not and leave when they should not.

11. [How can individuals misinterpret information about themselves? How do people assess their own abilities?]

12. [How can people misinterpret market signals that may indicate positive economic profits?]

Table II

1. Opportunity costs of Vincent's labor ----- $ 30,000

2. Opportunity costs of Vincent's capital and land ----- $ 4,000

3. Intrinsic value of Vincent's business ------$ -10,000 TOTAL ------$ 24,000

Now assume: 1) Vincent can sell his business for $50,000, 2) the market interest rate is 8%, 3) Vincent places the value of owning and operating his own business at $10,000, and 4) Vincent can make $30,000 as a manager for another company. Vincent's opportunity cost is now only $24,000 shown in table II above. The intrinsic value of Vincent's business is shown as a negative value because if Vincent sold his business he would lose $10,000 worth of satisfaction, but gain $34,000 in revenue. The net gain to Vincent from selling his business is only $24,000.

13. [What is the minimum accounting profit Vincent has to make to continue to operate? Is Vincent an Entrepreneur?]

14. [Today Michael sold 20 pairs of jeans at $25/pair. Michael hired 2 workers at $100/day each, bought raw materials which cost $5/pair, and rented a building for $50 per day. Michael just recently turned down a wage offer of $160 per day. Determine Michael=s accounting and economic profit.]

15. [Should Michael stay or leave this business?]

16. [Total revenue is $200,000 and accounting costs are $50,000. Should this person stay are leave this business?]

The relationship between inputs and the maximum obtainable output is called the production function. - Pg 140

A production function exists for the short run and long run. The short run is any length of time where some of the factors of production are fixed and cannot be changed. Anne Marie is a baker and she has decided to bake more donuts tomorrow. Anne Marie faces some constraints because she has only four ovens, a small shop and she is the sole owner. Tomorrow she cannot increase the amount of land, capital or entrepreneurship available to her. She can however hire her next door neighbor who said she would help out if needed. Anne Marie is in the short run when labor is the sole variable in the production process. She estimates that to buy a new oven and have it installed would take about one month. It would take about six months to buy a larger bakery and move all her equipment. The long run for Anne Marie would be at least six months. The long run is defined as any length of time when all factors of production can be changed.

17. [Assume there is a large family gathering (40 people) at your home for supper and you have to make dinner. 1. List resources you will need to accomplish the task. 2. How will the resources listed above differ from the resources needed for a normal family meal? 3. List some other combination of resources that could be used to produce this meal.]

18. [Assume the family meal is over and now the dishes need to be washed. You have 1 sink, 1 dish rag, and 1 towel complete the table below:

The law of diminishing returns - When additional units of a variable input are added to fixed inputs after a certain point, the marginal product of the variable input declines. - Pg 141

Labor Dishes Washed Dried and Put away

1234567 ]

Assume 30 minutes of time. Also assume only dishes and pots and pans are washed no utensils.

19. [Is this production function for clean dishes washing

in the short or long run?]

20. [List the fixed and variable resources for the above problem.]

Table III

LABOR OUTPUT A.P.L M.P.L BLUE JEANS PER DAY

0 0 0 01 3 3.0 32 7 3.5 43 12 4.0 54 16 4.0 45 19 3.8 36 21 3.5 27 22 3.14 18 22 2.75 0

TOTAL OUTPUTA.P.L. = Average product of labor = ----------------

LABOR

CHANGE IN TOTAL OUTPUTM.P.L. = Marginal product of labor -------------------------

CHANGE IN LABOR

21. [How does average productivity of labor relate to technical efficiency?]

Average product of labor determines how much each person on average contributed to the production process. Marginal product of labor determines how much the last person hired contributed to the production process. Average is one indicator of efficiency. Vincent Enterprises is the most efficient when operating with 3 or 4 workers given its capital equipment. Vincent Enterprises has only one cutting, one sewing machine and one loading dock that requires labor. Once these positions are filled efficiency will decline. Efficiency will not decline until the fifth worker is added however, the fourth worker can do some office work and substitute for people when breaks are taken.

22. [Problems 4,7, and 9]

ALL FIRMS MUST MAKE THREE DECISIONS - Pg 1551. How much to produce?2. How to produce that output?

3. How much of each input to use?

Choice of Technology - Pg 146Table IV

Technology* Units of Units of Cost if Cost ifCapital Labor Pl = $1 Pl = $5

Pk = $1 Pk = $1---------------------------------------------------------------A 2 10 $12 $52B 3 6 $ 9 $33C 4 4 $ 8 $24D 6 3 $ 9 $21E 10 2 $12 $20----------------------------------------------------------------*Each combination of capital and labor will produce 100 units of output.

23. [Find the combination of inputs the will be technically efficient for Pk = $5, and Pl = $1.]

24. [List some implicit assumptions you have made with your answer to 15d.]

25. [Problems 5 and 12]

Two things determine the cost of production: (1) technologies that are available and (2) input prices. Pg 146

The basis of business decision making Pg 1401. The market price of output2. The techniques of production3. The prices of inputs.

CHAPTER 8 - Short-Run Costs and Output Decisions

OBJECTIVES:1. The student should be able to distinguish between the short run and long run.

2. The student should understand the application of marginal cost.

3. The student should be able to relate the marginal cost curve to the supply curve.

4. The student should be able to determine the profit maximizing quantity of output by using the total profit approach, and marginal approach.

5. The student should be able to explain how perfectly competitive firms maximize efficiency, equity and liberty.

In the short run some factors of production are fixed and as a result some costs are fixed. Anne Marie took out a loan to buy the bakery. The loan is amortized over 25 years and costs her $1,225 per month. The loan payment remains constant regardless of how many donuts Anne Marie makes each month. Fixed costs are costs that do not vary with the production process. Variable costs are costs that vary with the quantity produced. Some examples of Anne Marie's variable costs are: sugar, flour, wages and electricity.

26. [List other variable costs for Anne Marie.]

This concept of fixed and variable costs can be applied to any production process. Everyday each of us produces transportation by combining land, labor, capital and entrepreneurship. Every time you drive yourself or someone else you are producing transportation that has fixed and variable costs associated with it. Some of the variable costs when you drive a car are gas and maintenance. The more car trips you produce the more gas you will need and more frequent maintenance. Some of the fixed costs of driving a car are car insurance and the monthly car payment. No matter how many miles you drive tomorrow your car insurance and car payment this monthwill remain unchanged. If we look at fixed costs on a graph in relationship to output it would look like a horizontal line. Graph I illustrates insurance and car payments in relationship to miles traveled.

Graph ICost per │

Month │ │ │ │ $80 ├──────────────────────────Insurance+ Loan Payment │ │ │ │ │ └───────────────────────────── Miles Traveled

27. [When you decide to make a car trip which costs do you consider before producing that trip?]

28. [At home you may produce meals list some fixed and variable costs when making meals.]

29. [You plan to paint a few spots that are peeling on your house. List the fixed and variable costs of painting. How would the fixed and variable costs change if you were going to use an airless paint sprayer?]1

30. 111/25/08 What It Costs an Airline to Fly Your Lugguage WSJ D1 List the fixed and variable costs of moving lugguage.]

Vincent estimates it takes $5 in raw materials(cloth, thread and dye) to produce a par of blue jeans and labor cost is about $40 per day.

31. [Are the cost of raw materials listed above fixed or variable costs?]

Vincent estimates the capital costs(loans and mortgage) average about $20 per day.

32. [List some capital costs of Vincent Enterprises. Are

these fixed or variable costs?]33. [Which company has the larger fived costs Netflix or

Blokbuster? Why?]

The total cost of producing blue jeans is a combination of fixed and variable costs shown in equation II below:

Equation IITotal Costs = Fixed Costs + Variable costs - Pg 156

(Sunk costs) TC = FC + VC

34. [Using table IV which technology has the highest fixed costs?]

Variable costs can be divided up between labor costs and raw material costs and equation III would result.

Equation IIITotal Costs = Fixed Costs + Variable Costs*

TC = T.F.C + (T.L.C + A.O.C.)TC = TOTAL COST OF PRODUCTION

T.F.C. = TOTAL FIXED COST OF PRODUCTION T.L.C. = TOTAL LABOR COST OF PRODUCTION A.O.C. = ALL OTHER COSTS** A.O.C. include depreciation of the capital equipment and

power costs to heat the plant and operate the equipment.

Table V shows the total cost, average cost, and marginal cost for Vincent to produce blue jeans.

[QUATTRO FILE:TBL620.WKQ]

From Table III Table VLabor Output F.C V.C. T.C. A.C. M.C.0 0 $20 $ 0 $ 20 -1 3 $20 $ 55 $ 75 $25.00 $18.332 7 $20 $115 $135 $19.29 $15.00 3 12 $20 $180 $200 $16.67 $13.004 16 $20 $240 $260 $16.25 $15.005 19 $20 $295 $315 $16.57 $18.336 21 $20 $345 $365 $17.38 $25.007 22 $20 $390 $410 $18.64 $45.00

35. [Given the data above determine if accounting costs or economic costs are being computed.]

36. [Reproduce the computations for F.C., V.C., T.C., and

A.C.]

Average cost is defined as the total cost of producing blue jeans divided by the total quantity of blue jeans produced. The formula is shown in equation IV below:

Equation IV

Total Cost (T.C.)Average Cost (A.C.) = --------------- = -----

Quantity produced (Q)

This average cost formula can be modified by using equation 8.4 above and is shown in equation V below.

Equation V T.F.C. + T.L.C. + A.O.C.Average Cost (A.C.) = ------------------------

Quantity Produced (Q)

Equation V can be restated as equation VI below. Average total cost of production per unit is equal to average fixed cost of production per unit plus average labor cost of production per unit plus the average of other operating costs per unit.

Equation VI

Capital Labor Raw Materials T.F.C. T.L.C. A.O.C.

Average Costs = -------- + ------ + ------ per unit Q Q Q

DECLINES DECLINES CONSTANTOR

INCREASES

When production increases average fixed costs per unit (T.F.C./Q) decline because now more units are being produced and fixed costs remain constant. - Pg 157Average labor costs per unit decline (T.L.C./Q) per unit decline at first because labor productivity is increasing as the plant moves closer to the optimal capital to labor ratio. Average labor costs per unit will start to increase as the plant increases production in the short run by moving beyond the optimal capital to labor ratio. This is shown below in table VI. The average of all the other operating expenses per unit of output besides labor (A.O.C./Q) are fixed by the production function and remain

constant at $5.00 per unit. An increase in the productivity of labor (Q/L) must result in a decrease in average total costs (ceteris paribus).

Table VITOTAL LABOR OUTPUT A.P.L A.L.CLABOR COST BLUE JEANS($40/DAY PER DAY

0 0 0 0 0 40 1 3 3.0 13.33 80 2 7 3.5 11.43 120 3 12 4.0 10.00 160 4 16 4.0 10.00 200 5 19 3.8 10.52 240 6 21 3.5 11.42 280 7 22 3.14 12.73 320 8 22 2.75 14.56

36. [Use the information for Vincent Enterprises to compare the average cost of producing 12 units with 3 workers and an increase in labor productivity so now 3 workers can produce 16 pairs of blue jeans.]

Total cost, fixed cost and variable costs for Vincent Enterprises are shown on graph I. Average and marginal costs are shown in graph II.

Total cost, fixed cost and variable costs for Vincent Enterprises are shown on the graph I. Average and marginal costs are shown in graph II.

Equation VII T.V.C.

M.C. = --------- Pg 160 Q

37. [Out T.C. F.C. A.V.C. A.T.C. M.C.0 2001 1002 87.53 504 1255 6006 116.66 ]

excel:notes#33

This is a very typical relationship between total cost of production and the quantity produced for any business in the short run. The first few units produced results in rapidly rising costs. The entrepreneur must acquire the building(land), machinery (capital equipment), and labor to start the business. Once the capital and land is purchased the business is in the short run and these costs do not increase as the quantity produced increases. In the area between 7 to 16 units of production, costs rise very slowly. Cost start to rise at an increasing rate after 16 units of production. Table VI shows the amount of labor needed to produce 19 blue jeans is 5 workers. Vincent Enterprises has only one cutting, one sewing machine and one loading dock. Five workers is more than the optimal amount of labor for this plant size (capital equipment) and as a result productivity declines and production costs rise at an increasing rate.

38. [If there is only one cutting, one sewing and one loading dock how can Vincent Enterprises use more than three workers?]

Equation VIII π = T.R. - T.C.

Total Profit Total Revenue Total Cost

Price/unit x Units

Table VIIOutput T.R. F.C. V.C. T.C. A.V.C. A.C. M.C π

0 0 $20 $ 0 $ 20 - 3 $ 45 $20 $ 55 $ 75 $18.33 $25.00 $18.33 $-30 7 $105 $20 $115 $135 $16.42 $19.29 $15.00 $-30 12 $180 $20 $180 $200 $15.00 $16.67 $13.00 $-20*16 $240 $20 $240 $260 $15.00 $16.25 $15.00 $-20*19 $285 $20 $295 $315 $15.52 $16.57 $18.33 $-3021 $315 $20 $345 $365 $16.42 $17.38 $25.00 $-5022 $330 $20 $390 $410 $17.72 $18.63 $45.00 $-80

*Loss minimizing quantity of output if the product price is $15 per unit.

The loss minimizing quantity of production is 12 or 16 pairs of blue jeans.

39. [Should Vincent Enterprises close down?]

40. [Marie's Hamburger Palace (M.H.P.) has a mortgage payment of $800 due each month. Marie is currently open from 7 a.m. to 11 p.m., but she is considering keeping MHP open 24 hours a day. Marie's estimated costs of the third shift are shown in table 5.9.

Table 5.9Operating Costs

1. labor cost ($5.25 per hour x 8) = $42.00 2. electricity and raw materials = $ 5.003. capital costs per day ($800/30)*= $26.67

TOTALS = $73.67 PER DAY*$800 per month with approximately 30 days in a month

Marie estimates the income from the third shift to be approximately $55.00. Should Marie keep the hamburger palace open 24 hours a day? Application]

41. [Use table VI determine if profit will be rising if the product price is $20 per unit and the entrepreneur is considering producing 16 pairs of blue jeans. What does the total approach indicate about profit?]

Everyone uses marginal analysis to make decisions. A student is deciding to spend another hour studying economics or watch E.R.. The student quickly assesses the benefits of one more hour of study (marginal benefits) and compares then to the additional costs of one more hour of study (marginal costs).

42. [List the benefits and costs of one more hour of study to you last night. At the time you stopped studying the marginal costs of additional study time exceeded the marginal benefits]

Marginal analysis can lead to inaccurate decisions if information about cost and benefits is not complete or inaccurate. Should a steel mill produce one more ton of steel? The additional cost of producing that ton of steel is $100 and the additional revenue from selling that steel is $125. The steel maker decides that profit will rise if the steel is produced. This decision was based on the variable costs of steel production (labor fuel, and raw materials) but the true variable costs to society are: labor, fuel, raw materials and pollution.

Table VIII below illustrate overall profit for Vincent Enterprises at various product prices.

Table VIII

Output Pp M.C π 0 -

3 $18.33 7 $15.00

12 $13.00 $13.00 $-4416 $15.00 $15.00 $-2019 $18.50 $18.33 $ 36.5021 $25.00 $25.00 $160.0022 $45.00 $45.00 $580.00

If the product price is fifteen dollars, marginal cost equals marginal benefit(product price) at 16 units of production. If product price(marginal benefit) exceeds marginal costs of production, profits should be rising or losses falling. If product price(marginal benefit) is less than marginal costs of production profits, should be falling or losses increasing. The production decision is answered by the relationship between price(marginal benefits) and marginal costs.

43. [Use table VII to determine the appropriate course of action if: 1) the product price is $18.50 and the firm is producing 22 units, 2) the product price is $15.00 and the firm is producing 12 units, 3) the product price is $18.50 and the firm is producing 19 units.]

44. [Determine actual profit levels for parts 1, 2, and 3 above.]

If the product price falls to below $13.00 per pair, Vincent would likely shut down immediately unless: 1) he expected a very rapid increase in price or 2) there are substantial shut down and start up costs. When the product price is less than $15.00 per day Vincent looses more than his fixed costs because he cannot cover his variable costs. Table IX below:

Table IXOutput T.R. F.C. V.C. T.C. A.V.C. A.C. M.C π

0 0 $20 $ 0 $ 20 - 3 $ 45 $20 $ 55 $ 75 $18.33 $25.00 $18.33 $-30 7 $105 $20 $115 $135 $16.42 $19.29 $15.00 $-30 12 $180 $20 $180 $200 $15.00 $16.67 $13.00 $-20*16 $240 $20 $240 $260 $15.00 $16.25 $15.00 $-20*19 $285 $20 $295 $315 $15.52 $16.57 $18.33 $-3021 $315 $20 $345 $365 $16.42 $17.38 $25.00 $-5022 $330 $20 $390 $410 $17.72 $18.63 $45.00 $-80

Any firm that can cover its average variable costs (A.V.C.) of production can minimize losses by continuing to operate. As soon as the firm cannot cover its average variable costs (product price is lower than average variable costs) the firm should consider shutdown. Remember the shutdown decision is made based on variable not fixed costs, and the most important variable cost is average variable cost. If a firm can cover its average variable costs of production, it should pay to operate at least in the short run. If a firm can cover it's variable costs of production, it is no worse off than if it did not operate because in both cases the firm must still cover fixed costs. If Vincent Enterprises is producing 16 pairs of blue jeans, the average variable cost is $15.00 per pair. Fifteen dollars per pair covers all raw materials, labor, and other operating costs. If Vincent can charge at least $15.00 per pair, he would be no worse off than not operating at all. The short run supply curve is shown in bold print in table X, and graph 2. Remember, the law of supply states, quantity supplied of a good or service by a producer will be directly related to its price, everything else remaining constant (ceteris paribus). The first two columns of table X below show the quantity supplied of blue jeans by Vincent Enterprises is directly related to its price, while holding everything else constant.

45. [What variables were held constant in determining the supply curve in table X?] Hint: Go back to chapter 4 and examine the definition of a supply curve.

Table XOutput Pp A.V.C. M.C π

0 - - 3 $18.33 $18.33

7 $16.42 $15.00

12 $13.00 $15.00 $13.00 $-44 ┌──── 16 $15.00 $15.00 $15.00 $-20

Supply Curve │ 19 $18.50 $15.92 $18.33 $ 36.50Short Run │ 21 $25.00 $16.42 $25.00 $160.00

│ 22 $45.00 $17.92 $45.00 $580.00

The short run supply curve for a firm in perfect competition is its short run marginal cost curve above the minimum point on the average variable cost curve. - Pg 171-172

46. [Why must the short run supply curve begin at the minimum point on the average variable cost curve?]

47. [Problem 3,4,5,6 and 10]

Increasing marginal cost of a product is the result of diminishing marginal returns. The producer must charge a price at least equal to the cost of the last unit (assuming marginal cost is rising)or that unit will not be produced. Marginal cost pricing, when marginal costs are rising, is allocatively efficient. Marginal cost pricing allows the market to equate the marginal cost of the product to society to the marginal benefit to society. Marginal benefit is equal to product price in perfect competition.

48. [Remember problem 19 in the first set of notes. Four individuals employed by a business that produces computers and software. The computers require assembly and the software requires programming of computer code. Use the following information to construct a production possibilities frontier for this company:

Employees Computers CodeA 8 1.0B 5 5.0C 10 .5D 1 10.0

Use the production possibilities frontier to make a supply schedule for assembling computers. Assume a wage of $100 per day then determine the supply schedule for the 10th, 18th, 23rd, and 24 fourth computer.]

49. [Would one-day pass to Disney World be an example of average or marginal-cost pricing?]

We can now look at the incremental costs of producing different products. Question 34 shows the McLiska menu.

50. [The McLiska menu is listed below:Hamburger --------- $ .50

Cheeseburger ------ $ .75Double cheeseburger $1.50McLiska Deluxe ---- $3.00

Is this menu based on incremental or average cost pricing?]

51. [Assume the incremental cost to produce a cheeseburger from a hamburger is twenty cents. If McLiska believes the going price of cheeseburgers is 75 cents, should McLiska produce cheeseburgers? If McLiska produces cheeseburgers, will profit increase?

Marginal cost to fly your luggage WSJ 11/25/08

52. [Recently an advertisement for Domino=s pizza read, AExtra Large 1 Topping Pizza $8.99. Add a 2nd Xtra Large 1 topping for only $8. How does this ad relate to marginal analysis?]3/17/10 Who Could Eat All This? WSJ D1

Marginal decision making versus decision making based on fixed cost11/27/10 The Secret to the Best Gifts WSJ Life/Style

Synthesis53. [How does question 34 relate to the

competitive firm=s profit- maximizing rule of marginal revenue must equal marginal cost?

54. [Give an example of how McLiska would average-cost price its menu.]

55. [Would the choice of marginal- or average-cost pricing affect allocative efficiency? List any important assumptions.]

WSJ

Many states have a three strikes and your out law. The U.S. Supreme Court said certain repeat offenders may be locked up for long periods for relatively minor crimes. The court also said a term of 50 years to life is not out of bounds for a small-time thief who shoplifted videotapes from Kmart Wis. State Journal 3/6/03.

56. [Use marginal analysis to determine how this three strikes law might affect the decision making of a criminal with 2 strikes. Evaluation]

The marginal cost of producing electric power during peak periods is much higher than during non-peak periods. During peak periods(in the short run), the electric power producer must meet the demand by buying additional power from outside sources which will increase the cost of producing electric power to the utility.

57. [What long run question will a utility have to answer if it continually needs to buy power from an outside source? Analysis]

58. [What happens to allocative efficiency when people who put extra burdens on the electric producer during peak hours pay less than marginal cost? Evaluation]

59. [What would happen to allocative efficiency if everyone paid the average cost of electric power? Evaluation]

Chapter 9 - Costs and Output Decisions in the Long Run

OBJECTIVES:1. The student should be able to differentiate between the long run profit maximization point and the short run profit maximization point.

2. The student should understand economies of scale and external economies.

3. The student should understand the difference between the long run supply curve and the short run supply curve.

4. The student should be able to explain how perfectly competitive firms maximize efficiency, equity and liberty in the short run and the long run.

PROFITS IN THE LONG RUN

Vincent is considering adding a second cutting and a second sewing machine to his plant. As soon as Vincent decides to adjust his capital he is in the long run. The long run is defined as any length of time when all factors of production can be changed and all costs are variable. As Vincent decides to expand his plant he can now build any size plant he thinks is most profitable. In this planning stage Vincent is in the long run because all costs are variable. Once Vincent buys the desired capital equipment he is again in the short run.

Table XI

LABOR OUTPUT A.P.L. M.P.L OUTPUT A.P.L M.P.L BLUE JEANS #1 #1 #BLUE JEANS #2 #2 PER DAY #1 PER DAY#2

0 0 - - 0 - - 1 3 3.0 3 3 3.0 32 7 3.5 4 7 3.5 43 12 4.0 5 12 4.0 54 16 4.0 4 28 7.0 165 19 3.8 3 46 9.2 186 21 3.5 2 66 11.0 207 22 3.14 1 84 12.0 188 22 2.75 0 94 11.75 109 21 2.33 -1 102 11.3 8

10 19 1.9 -2 107 10.7 5

LABOR OUTPUT A.P.L. M.P.L BLUE JEANS #5 #5 PER DAY #5

0 0 - - 1 3 3.0 3 2 7 3.5 4 3 12 4.0 5 4 28 7.0 16 5 46 9.2 18 6 66 11.0 20 7 118 16.86 52 8 171 21.38 53 9 225 25.00 54 10 280 28.0 55 11 336 30.55 56 12 393 32.75 57 13 451 34.69 58 14 530 37.86 59 15 590 39.33 60 16 630 39.75 40 17 650 38.23 20 18 660 36.67 10 19 665 35.00 5 20 666 33.3 1

Table XI illustrate the total output, average product and marginal product of three blue jean plants. Plant #1 has one cutting and one sewing machine, Plant #2 has two cutting and two sewing machines and Plant #5 has five cutting and five sewing machines.

60. [What additional information would you need to compute average costs for plants 1,2, and 5 use equation VI?]

Labor cost $40Raw material $5Fixed cost plant #1 $20

61. [Why do fixed costs increase with plants one, two and five?]

62. [What quantity of production will minimize average

total cost for each plant?]Graph of long run costs on quattro file.

- QUATTRO FILE TBL621.WKQ

63. [Which plant is more efficient to produce 7 pairs of blue jeans a day? Remember efficiency is defined as lowest average cost of production. Assume labor costs is $100 per day and raw material cost is $5 per pair]

64. [Which plant is the most efficient to produce 46 pairs of blue jeans per day?]

65. [Which plant is the most efficient to produce 280 pairs of blue jeans per day?]

At some point as capital equipment continues to increase the average cost curves of these large plants will begin to rise. If a corporation has 10,000 cutting and sewing machines in three plants around the country, fixed costs may increase dramatically. The fixed costs of this plant maybe more than 100 times the fixed cost of a plant which has only 100 cutting and sewing machines. Since three plants are needed in three states the cost of building these three plants will not be all the same.

66. [How will building costs affect your location decision?]

67. [Are building costs a long or short run decision?]

The cost of large quantities of land may increase if you need 20 or 30 acres as opposed to one acre. Now you need quality control equipment and personnel to keep the quality of the blue jeans in the plants equal. You will need additional communications equipment between plants that would not be necessary with only one plant. The plant size that can be built before all these additional costs set in is the most efficient plant possible. This plant produces the lowest cost per pair of blue jeans humanly possible with the existing technology.

68. [What size plant would you build? Remember in a perfectly competitive product market you are guaranteed to sell every pair of blue jeans that is produced.]

69. [What factors determine what size farm should be built?]

70. [Would this decision change in a less than perfectly competitive market place i.e. imperfect information and less than perfectly elastic demand schedule?]

The long run average cost curve shows the lowest cost per unit of output if all costs of production are variable. The long run average cost curve is determined by varying capital, labor and raw materials in the optimum ratio to produce the lowest cost per unit of output. Here is another example of the importance of information in the market place. The long run average cost curve is unknown to entrepreneurs. Entrepreneurs are not sure if they double there capital equipment and labor force if average costs will go up or down. Most entrepreneurs are not sure if they are on point A, B or C on the long run average cost curve shown in figure 5 below. The point on the long run average cost curve between points A and B is called increasing returns to scale or economies of scale. Economies of scale exist whenever average cost per unit of output is falling as all inputs are increased proportionately. Diseconomies of scale exist whenever average cost per unit of output is raising when all inputs are increased proportionately. It is possible that average costs remain at a minimum for a period of time as inputs are increases and this is called constant returns to scale.

Inefficiency results as different individuals experiment with different plant sizes to find point B. Usually in a competitive industry you can gather this information by looking at different size firms in operation and looking at the success of these firms. Even observing the success of different size firms may not give you complete information on when diseconomies of scale start. Even observing economies of scale in other firms does not guarantee economies of scale if your firm expands. The only way to really determine if economies of scale are possible for a specific entrepreneur in a world were information is not perfect, is for that entrepreneur to expand. Each entrepreneur has individual talents and limitations. One may be better at managing larger firms and another at managing smaller firms. Here is another application of ceteris paribus. An entrepreneur could only determine when diseconomies of

Graph IIILong Run Average Costs page 186-190

Economies of scale Diseconomies of scale

Cost per unit

Units

scale start by observing other firms only if everything else, that includes the manager, is held constant.

71. [In question 29a determine the average fixed cost per square foot to paint using a brush and an airless sprayer to paint 1 square foot and 1200 square feet. Assume the brush cost $4.00 and it takes 15 minutes of clean-up. The sprayer cost $100 and it takes 30 minutes of clean-up.]

72. [If an entrepreneur observed ten different plant sizes, explain why you would need ceteris paribus before being certain about whether any economies or dis-economies of scale existed.]

73. [What could lower the long run and short run average cost curves?]

The minimum of the long run cost curve could go up or down depending on if external economies exist. Pg 198-200

Sources of Economies of Scale 1. Increased size allows for specialization of capital and labor2. Increased size allows for volume discounts for raw materials especially in transport costs

Examples1sq ft Fees feesBrush 2 Sprayer 75

clean up 5 min0.083

3 20.001.666

7 0.5 10

paint 1/100 0.01 25.000.250

0 0.01 0.25

time 1 minute0.016

7 20.000.333

330 sec 0.0083

0.166667

Total Cost 4.2585.4166

7

AC

10,000 sq ftBrush 2 Sprayer 75

clean up 5 min0.083

3 20 1.666 0.5 10paint 10 gals 10 25 250 10 250time 16 hours 16 20 320 2 hrs 2 40

Total cost573.6

7 375Paint 1 square foot with a brush of Industrial paint sprayerList cost of painting with a brush. Assume wage cost is $20

per hour.

74. Does this show economies of scale?

75. [Assume plant 3 in table XI is the optimum plant size. If raw material costs increase by $1.00 per pair a year over the next ten years determine the long run product price if nothing else changes by using excel file tbl621.]

76. [What would be some factors that would make the long run cost curve move up or down?]

Point B will produce the three policy objectives of efficiency, equity and liberty. Point B will produce efficiency because the minimum amount of resources are being consumed to produce this product i.e. average cost per unit of output is at a minimum. The consumer is getting the product at the lowest possible price as a result this improves equity. Capitalism will never have perfect equity, but the distribution of goods and services will likely be maximized in a competitive market. Remember the poor can acquire more goods and services by either raising their income or lowering prices of goods and services or both. Liberty is maximized in competitive markets since the

market decisions are being made by market participants i.e. people in our society.

Short run expansion to equilibrium - Pg 201P* = SRMC = SRAC = LRAC

77. [How does the above equation lead to both technical and allocative efficiency?]

Efficient markets both technically and allocatively efficient.

Technical efficiency implies: The least amount of resources are used in producing the good or service. Or the maximum amount of goods and services are produced with the existing resources.

The second principle of efficiency is called allocative efficiency. The correct amount of resources are being allocated to the production of this good or service i.e. there are no shortages or surpluses. The right goods produced. Pg 16

Long Run Supply Curve - Pg 199 External economies of scale and diseconomies.

References:Cross-subsidization, Incentives, and Outcomes in Professional Team Sports Leagues, Rodney Fort and James Quirk, JEL Sept. 1995

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