MNOTES2
Chapter 7 - The
Profit-Maximizing Firms
Production
Process:
The
Behavior
of
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
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
TOTAL
------ $
0
------ $34,000
3
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 costs
OC=opportunity cost
AC+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?]
4
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
TOTAL
------$ -10,000
------$ 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
5
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
1
2
3
4
5
6
7
Dishes Washed
Dried and Put away
]
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.]
6
Table III
LABOR
0
1
2
3
4
5
6
7
8
OUTPUT
BLUE JEANS
PER DAY
0
3
7
12
16
19
21
22
22
A.P.L. = Average product of labor =
M.P.L. = Marginal product of labor
21.
[How does average
technical efficiency?]
A.P.L
M.P.L
0
0
3.0
3
3.5
4
4.0
5
4.0
4
3.8
3
3.5
2
3.14
1
2.75
0
TOTAL OUTPUT
---------------LABOR
CHANGE IN TOTAL OUTPUT
------------------------CHANGE IN LABOR
productivity
of
labor
relate
to
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 155
1. How much to produce?
2. How to produce that output?
3. How much of each input to use?
7
Choice of Technology - Pg 146
Technology*
Units of
Capital
Table IV
Units of
Labor
Cost if
Cost if
Pl = $1
Pl = $5
Pk = $1
Pk = $1
--------------------------------------------------------------A
2
10
$12
$52
B
3
6
$ 9
$33
C
4
4
$ 8
$24
D
6
3
$ 9
$21
E
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 140
1. The market price of output
2. The techniques of production
3. 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.
8
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 month
will 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.
9
Cost per
Month
$80
Graph I
│
│
│
│
│
├──────────────────────────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?]
30.
11/25/08 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?]
10
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 II
Total 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 III
Total 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
Vincent to produce blue jeans.
for
[QUATTRO FILE:TBL620.WKQ]
From Table III
Table V
Labor
Output
F.C
V.C. T.C. A.C.
M.C.
0
0
$20
$ 0 $ 20 
1
3
$20
$ 55 $ 75 $25.00 $18.33
2
7
$20
$115 $135 $19.29 $15.00
3
12
$20
$180 $200 $16.67 $13.00
4
16
$20
$240 $260 $16.25 $15.00
5
19
$20
$295 $315 $16.57 $18.33
6
21
$20
$345 $365 $17.38 $25.00
7
22
$20
$390 $410 $18.64 $45.00
35.
[Given the data above determine if accounting costs or
economic costs are being computed.]
11
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
Average Cost (A.C.) = --------------=
Quantity produced
(T.C.)
----(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
Average Costs =
per unit
Capital
Labor
Raw Materials
T.F.C.
T.L.C.
A.O.C.
-------- + ------ + -----Q
Q
Q
DECLINES DECLINES
CONSTANT
OR
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 157
Average 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.
12
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).
TOTAL
LABOR COST
($40/DAY
0
40
80
120
160
200
240
280
320
LABOR
0
1
2
3
4
5
6
7
8
Table VI
OUTPUT
BLUE JEANS
PER DAY
0
3
7
12
16
19
21
22
22
A.P.L
A.L.C
0
3.0
3.5
4.0
4.0
3.8
3.5
3.14
2.75
0
13.33
11.43
10.00
10.00
10.52
11.42
12.73
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.
0
200
1
2
3
4
F.C.
A.V.C.
A.T.C.
M.C.
100
87.5
50
125
13
5
6
600
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.
Total Profit
Total Revenue
-
T.C.
Total Cost
Price/unit x Units
Output
0
3
7
12
16
19
21
22
T.R.
0
$ 45
$105
$180
$240
$285
$315
$330
Table VII
F.C. V.C. T.C. A.V.C. A.C.
$20 $ 0 $ 20


$20 $ 55 $ 75 $18.33 $25.00
$20 $115 $135 $16.42 $19.29
$20 $180 $200 $15.00 $16.67
$20 $240 $260 $15.00 $16.25
$20 $295 $315 $15.52 $16.57
$20 $345 $365 $16.42 $17.38
$20 $390 $410 $17.72 $18.63
M.C
$18.33
$15.00
$13.00
$15.00
$18.33
$25.00
$45.00
π
$-30
$-30
$-20*
$-20*
$-30
$-50
$-80
*Loss minimizing quantity of output if the product price is $15 per
unit.
14
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 5.9
Operating Costs
1. labor cost ($5.25 per hour x 8) = $42.00
2. electricity and raw materials
= $ 5.00
3. 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
15
and pollution.
Table VIII below illustrate overall
Enterprises at various product prices.
profit
for
Vincent
Table VIII
Output
0
3
7
12
16
19
21
22
Pp
$13.00
$15.00
$18.50
$25.00
$45.00
M.C
$18.33
$15.00
$13.00
$15.00
$18.33
$25.00
$45.00
π
$-44
$-20
$ 36.50
$160.00
$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:
16
Output
0
3
7
12
16
19
21
22
T.R.
0
$ 45
$105
$180
$240
$285
$315
$330
Table IX
F.C. V.C. T.C. A.V.C. A.C.
$20 $ 0 $ 20


$20 $ 55 $ 75 $18.33 $25.00
$20 $115 $135 $16.42 $19.29
$20 $180 $200 $15.00 $16.67
$20 $240 $260 $15.00 $16.25
$20 $295 $315 $15.52 $16.57
$20 $345 $365 $16.42 $17.38
$20 $390 $410 $17.72 $18.63
π
M.C
$18.33
$15.00
$13.00
$15.00
$18.33
$25.00
$45.00
$-30
$-30
$-20*
$-20*
$-30
$-50
$-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.
Output
Table X
Pp
A.V.C.
M.C
π
17
0
Supply Curve
Short Run
3
7
12 $13.00
┌──── 16 $15.00
│
19 $18.50
│
21 $25.00
│
22 $45.00
$18.33 $18.33
$16.42 $15.00
$15.00 $13.00 $-44
$15.00 $15.00 $-20
$15.92 $18.33 $ 36.50
$16.42 $25.00 $160.00
$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
Code
A
8
1.0
B
5
5.0
C
10
.5
D
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?]
18
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 ------ $ .75
Double cheeseburger $1.50
McLiska 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
cost
11/27/10
The Secret to the Best Gifts WSJ Life/Style
Synthesis
53.
[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.]
19
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]
20
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
BLUE JEANS
PER DAY #1
0
0
1
3
2
7
3
12
A.P.L. M.P.L
OUTPUT
A.P.L
M.P.L
#1
#1
#BLUE JEANS #2
#2
PER DAY#2
0
3.0
3
3
3.0
3
3.5
4
7
3.5
4
4.0
5
12
4.0
5
21
4
5
6
7
8
9
10
16
19
21
22
22
21
19
4.0
3.8
3.5
3.14
2.75
2.33
1.9
LABOR OUTPUT
A.P.L.
BLUE JEANS
#5
PER DAY #5
0
0
1
3
3.0
2
7
3.5
3
12
4.0
4
28
7.0
5
46
9.2
6
66
11.0
7
118
16.86
8
171
21.38
9
225
25.00
10
280
28.0
11
336
30.55
12
393
32.75
13
451
34.69
14
530
37.86
15
590
39.33
16
630
39.75
17
650
38.23
18
660
36.67
19
665
35.00
20
666
33.3
4
3
2
1
0
-1
-2
28
46
66
84
94
102
107
7.0
9.2
11.0
12.0
11.75
11.3
10.7
16
18
20
18
10
8
5
M.P.L
#5
3
4
5
16
18
20
52
53
54
55
56
57
58
59
60
40
20
10
5
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 $40
Raw material $5
Fixed cost plant #1 $20
61. [Why do fixed costs increase with plants one, two and
22
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.
67.
[How will building costs affect your location decision?]
[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.]
23
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 III
Long Run Average Costs page 186-190
24
Cost per unit
Economies of scale
Diseconomies of
scale
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
25
Sources of Economies of Scale
1. Increased size allows for specialization of capital and
labor
2. Increased size allows for volume discounts for raw
materials especially in transport costs
Examples
1sq ft
Brush
clean up 5 min
paint 1/100
time 1 minute
Total Cost
Fees
0.0833
0.01
20.00
25.00
0.0167
20.00
0.0833
10
16
20
25
20
fees
2
1.6667
0.2500
0.3333
4.25
30
sec
Sprayer
0.5
0.01
75
10
0.25
0.0083
0.166667
85.41667
Sprayer
0.5
10
2
75
10
250
40
375
AC
10,000 sq ft
Brush
clean up 5 min
paint 10 gals
time 16 hours
Total cost
2
1.666
250
320
573.67
2 hrs
Paint 1 square foot with a brush of Industrial paint sprayer
List 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
26
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 201
P* = 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
efficiency. The correct amount of resources
the production of this good or service i.e.
or surpluses. The right goods produced. Pg
is called allocative
are being allocated to
there are no shortages
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
Economies of Scale
ADo lean Times Mean Fighting Machines Will Be Built for Less?@, WSJ
11/18/96 Economies of Scale
3/3/97 AAcquisitive Companies Set Out to >Roll Up= Fragmentation
Industries@ WSJ Economies of Scale - technical efficiency
3/31/97 ACellular-Phone Boom Lures Foreign Firms To Brazilian
Sell-Off@ WSJ Is the phone industry a natural monopoly?
10/8/97 The Wal-Mart Way Sometimes Gets Lost in Translation Overseas@
WSJ
12/1/97 AU.S. agriculture: Challenges for the twenty-first century@
Large farms are expanding, Fed of Chicago letter
1/6/00 “Car Wars 2000: Sales Surge, Prices Drop in Battle for Market
Share” WSJ
1/6/00 “Virtual Utilities Peddle Power Over the Web” WSJ
27
8/3/06
“Big Steel” WSJ A6 Economies of scale
Diminishing Marginal Returns
5/13/96 AAirlines Are Grappling With a Complex Task: Avoiding
Catastrophe@ WSJ
Marginal Cost Pricing
4/19/95 ACalifornia=s Three Strikes Law Strikes Out@ WSJ marginal
cost and crime
11/30/95 ADespite Deregulation Rural Phone Subsidies Are Likely to
Survive@ WSJ average versus marginal cost pricing-efficiency versus
equity
4/15/96 AFree Airline Miles Become a Potent Tool For Selling
Everything@ Marginal Cost pricing WSJ
9/3/96 ABaby Bells Profit by Tapping Phone Paranoia@, WSJ Market
Place marginal cost pricing