Working with Supply and Demand • • • • • • • Price Ceilings, Price Floors Price Elasticity of Demand Elasticity and Total Revenue Determinants of price elasticity of demand Income Elasticity of Demand Cross-Price Elasticity of Demand Determinants of price elasticity of supply 1 Price Ceilings • Government-imposed maximum price that prevents the price of a good from rising above a certain level in a market • Short side of the Market – Smaller of quantity supplied and quantity demanded at a particular price – When quantity supplied and quantity demanded differ, short side of market will prevail • Price ceiling creates a shortage and increases the time and trouble required to buy the good – While the price decreases, the opportunity cost may rise • Black Market – A market created by unintended consequences of government intervention • Goods are sold illegally at a price above the legal ceiling 2 Figure 1: A Price Ceiling in the Market for Maple Syrup 5. With a black market, the lower quantity sells for a higher price than initially. Price per Bottle 3. and decreases quantity supplied. 4. The result is a shortage – the distance between S R and V. T $4.00 3.00 R 2.00 E V 2. increases quantity demanded D 40,000 50,000 60,000 1. A price ceiling lower than the equilibrium price . . . Number of Bottles of Maple Syrup per Period 3 Price Floors • Government imposed minimum amount below which price is not permitted to fall – Price floors for agricultural goods are commonly called price support programs • When sellers produce more of the good than buyers want at the price floor – Remaining goods become a surplus that no one wants at the imposed price • Government responds by maintaining price floors – Uses taxpayer dollars to buy up entire excess supply of the good in question – Prevents excess supply from doing what it would ordinarily do • Drive price down to its equilibrium value 4 Figure 2: A Price Floor in the Market for Nonfat Dry Milk Price per Pound 2. decreases quantity demanded . . . 1. A price floor higher than the equilibrium price . . . 3. and increases quantity supplied. S J K $0.81 A 0.65 4. The result is a surplus the – distance between K and J – which government must buy. D 180 200 220 Millions of Pounds 5 Limiting Surplus • A price floor creates a surplus of goods – In order to maintain price floor, government must prevent surplus from driving down market price • Government often accomplishes this goal by purchasing surplus with taxpayers dollars. USDA spent $500 million to buy 636 million pounds of surplus nonfat dry milk. • Price floors often get government deeply involved in production decisions – Rather than leaving them to the market – Example: U.S. government developed a complicated management system to control the production and sale of milk to manufacturers and processors. 6 Benefits and costs of price floor for diary product • Benefits: help farmer when they are in need. Many farmers who benefit from price floors are wealthy or powerful who don’t need assistance. • Costs: (1) taxpayers’ money (2) consumers pay higher price ($10.4 billion from 1986 to 2001) (3) cost of health effect (calcium and protein deficiencies) More cost effective if given directly to those truly in need. 7 The Problem with Rate Change • For a particular good, when price rises by $1, quantity demanded falls by 500 units per period. (1)chocolate bars purchases in U.S. (2)private jets purchased in U.S. • Rate of change of quantity demanded compared to the change in price is not a good measure of price sensitivity – Doesn’t tell whether a change in price or a change in quantity demanded is a relatively large or relatively small change • Relative means compared to value of price or quantity before change 8 The Elasticity Approach • Elasticity approach improves on the problems with rate of change – By comparing percentage change in quantity demanded with percentage change in price • Price elasticity of demand (ED) for a good is percentage change in quantity demanded divided by percentage change in price %Q ED D %P • – Will virtually always be a negative number – Tells us percentage change in quantity demanded for each 1% increase in price Price elasticity of demand tells us percentage change in quantity demanded caused by a 1% rise in price as we move along a demand curve from one point to another 9 Calculating Price Elasticity of Demand • When calculating elasticity base value for percentage changes in price or quantity is always midway between initial value and new value – When price changes from any value P0 to any other value P1, we define the percentage change in price as % Change in Price ( P1 P 0 ) ( P1 P 0 ) 2 – When quantity demanded changes from Q0 to Q1, percentage change is calculated as % Change in Quantity Demanded (Q1 _ Q0 ) Q Q 0 1 2 10 Figure 3: Calculating Price Elasticity of Demand Price per Laptop $3,500 3,000 D C 2,500 2,000 1,500 1,000 B A D 100,000 200,000 300,000 400,000 500,000 600,000 Quantity of Laptops 11 An Example: Calculating Price Elasticity of Demand • Now let’s calculate an elasticity of demand for laptop computers using data in Figure 3 from point A to point B % Change in Quantity Demanded % Change in Price (500,000 600,000) 100,000 0.182, or 18.2 percent 550,000 (500,000 600,000) 2 ($1,500 $1,000) $500 0.400, or 40.0 percent ($1,500 $1,000) $1,250 2 • Use percentage changes for price and quantity to calculate price elasticity of demand (ED) ED 0.182 0.46 0.400 12 Elasticity and Straight-Line Demand Curves • As we move upward and leftward along a straight-line demand curve – Same absolute increment in price will correspond to smaller and smaller percentage increments in price • Because base price used to calculate percentage changes keeps rising • As we move upward and leftward along a straight-line demand curve – Same absolute decrease in quantity corresponds to larger and larger percentage decreases in quantity • As we move upward and leftward by equal distances, percentage change in quantity rises – Percentage change in price falls • Elasticity of demand varies along a straight-line demand curve – Demand becomes more elastic as we move upward and leftward 13 Calculating Price Elasticity of Demand from Point C to Point D (100,000 200,000) 0.667, or 66.7 % (100,000 200,000) 2 ($3,500 - $3,000) % Change in Price Demanded 0.154, or15.4% $3,250 - 66.7% Elasticity of Demand 4.33 15.4% % Change in Quantity Demanded 14 Figure 4: Elasticity and StraightLine Demand Curves Price Since equal dollar increases (vertical arrows) are smaller and smaller percentage increases . . . 3 2 and since equal quantity decreases (horizontal arrows) are larger and larger percentage decreases . . . 1 demand becomes more and more elastic as we move leftward and upward along a straight-line demand curve. D Quantity 15 Categorizing Goods by Elasticity • Inelastic Demand – Price elasticity of demand between 0 and -1 % Change in Quantity Demanded Inelastic Demand 1.0 % Change in Price |% Change in Quantity Demanded| < |% Change in Price| • Perfectly Inelastic Demand: Price elasticity of demand equal to 0 Examples: – Drug ‘insulin’ for diabetics to control their blood sugar. No substitutes. ‘Antibiotics’. – Addicts. Necessities. 16 Categorizing Goods by Elasticity • Elastic Demand – Price elasticity of demand with absolute value > 1 Elastic Demand % Change in Quantity Demanded 1 % Change in Price |% Change in Quantity Demanded| > |% Change in Price| • Examples: Luxury goods • Perfectly (infinitely) Elastic Demand – Price elasticity of demand approaching minus infinity • Unitary Elastic Demand – Price elasticity of demand equal to -1 17 Figure 5: Extreme Cases of Demand (a) Price per Unit (b) Price per Unit D $4 3 2 $4 Perfectly Inelastic Demand 1 3 Perfectly Elastic Demand 2 D 1 20 40 60 80 100 Quantity 20 40 60 80 100 Quantity 18 Elasticity and Total Revenue • Total revenue (TR) of all firms in the market is defined as • TR = P x Q • When two numbers are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes – Applying this to total revenue • % Change in TR = % Change in Price + % Change in Quantity Demanded • Assume demand is unitary elastic and Q rises by 10% – % Change in TR = 10% + (-10%) = 0 19 Elasticity and Total Revenue • If demand is inelastic, a 10% rise in price will cause quantity demanded to fall by less than 10% – % change in TR = 10% + (something less negative than –10%) > 0 • If demand is elastic, so that Q falls by more than 10% – TR will fall • % Change in TR = 10% + (something more negative than -10%) < 0 20 Elasticity and Total Revenue • Where demand is inelastic, total revenue moves in same direction as price • Where demand is elastic, total revenue moves in opposite direction from price • Where demand is unitary elastic, total revenue remains the same as price changes • At any point on a demand curve sellers’ total revenue (buyers’ total expenditure) is the area of a rectangle – Width equal to quantity demanded – Height equal to price 21 Figure 6: Elasticity and Total Expenditure Price per Laptop $3,500 3,000 2,500 2,000 1,500 1,000 2. At point B, revenue is $750 million. 1. At point A , where price is $1,000 and 600,000 laptops are demanded, revenue is $600 million. 3. Moving from A to B, expenditure increases, so demand must be inelastic over that range. B A D 500 100,000 200,000 300,000 400,000 500,000 600,000 Quantity of Laptops 22 Table: Some Short-Run Price Elasticities of Demand Specific Brands Narrow Categories Tide Detergent -2.79 Transatlantic Travel -1.3 Pepsi -2.08 Tourism in Thailand -1.2 Coke -1.71 Ground Beef -1.02 Pork -0.78 Milk -0.54 Cigarettes -0.45 Electricity -0.40 to -0.50 Beer -0.26 Eggs -0.26 Gasoline -0.20 Oil -0.15 Broad Categories Recreation -1.09 Clothing -0.89 Food -0.67 Imports -0.58 Transportation -0.56 23 Availability of Substitutes • Demand is more elastic – If close substitutes are easy to find and buyers can cut back on purchases of the good in question • Demand is less elastic – If close substitutes are difficult to find and buyers can not cut back on purchases of the good in question 24 Narrowness of Market • More narrowly we define a good, easier it is to find substitutes – More elastic is demand for the good • More broadly we define a good – Harder it is to find substitutes and the less elastic is demand for the good • Different things are assumed constant when we use a narrow definition compared with a broader definition 25 Necessities vs. Luxuries • The more “necessary” we regard an item, the harder it is to find a substitute – Expect it to be less price elastic • The less “necessary” (luxurious) we regard an item, the easier it is to find a substitute – Expect it to be more price elastic 26 Table: Adjustments after a rise in the price of gasoline Short Run (a few months Long Run (a year or or few) more) Use public transit more often Arrange a car pool Drive more slowly on the highway Eliminate unnecessary trips If there are two cars, use the more fuel-efficient one Buy a more fuel-efficient car Move closer to your job Switch to a job closer to home Mover to a city where less driving is required 27 Time Horizon • Short-run elasticity – Measured a short time after a price change • Long-run elasticity – Measured a year or more after a price change • Usually easier to find substitutes for an item in the long run than in the short run – Therefore, demand tends to be more elastic in the long run than in the short run 28 Importance in the Buyer’s Budget • The more of their total budgets that households spend on an item – The more elastic is demand for that item – Example: housing, transatlantic air travel • The less of their total budgets that households spend on an item – The less elastic is demand for that item – Example: salt 29 Using Price Elasticity of Demand: The War on Drugs • Every year U.S. Government spends about $20 billion on efforts to restrict the supply of drugs • Figure 9(a) – Market for heroin without government intervention • Figure 9(b) – Result of government efforts to restrict supply (current policy) • Figure 9(c) – Results of an effective policy of reducing demand 30 Figure 7a: The War on Drugs (a) Price per Unit S1 A P1 D1 Q1 Quantity 31 Figure 7b: The War on Drugs (b) Price per Unit S2 B S1 P2 A P1 D1 Q2 Q1 Quantity A rise in price will increase the total expenditure of drug users. Many drug users Support themselves through crime. Total revenue for illegal drug industry increases too. 32 Figure 7c: The War on Drugs (c) Price per Unit S1 A P1 P3 C D2 D1 Q3 Q1 Quantity Heavier advertisement against drug use, and greater availability of treatment Centers for addicts. 33 Income Elasticity of Demand • Percentage change in quantity demanded divided by the percentage change in income – With all other influences on demand—including the price of the good—remaining constant EY % change in Quantity Demanded % Change in Income • Interpret this number as percentage increase in quantity demanded for each 1% rise in income 34 Income Elasticity of Demand • Income elasticities vs. price elasticities of demand – Price elasticity of demand • Measures effect of change in price of good – Assumes that other influences on demand, including income, remain unchanged – Income elasticity • Measures effect on demand we would observe if income changed and all other influences on demand—including price of the good—remained the same • Instead of letting price vary and holding income constant, now we are letting income vary and holding price constant 35 Income Elasticity of Demand • Another difference between price and income elasticity of demand – Price elasticity measures sensitivity of demand to price as we move along a demand curve from one point to another – Income elasticity tells us relative shift in demand curve—increase in quantity demanded at a given price • While a price elasticity is virtually always negative – Income elasticity can be positive or negative – Normal goods and Inferior goods 36 Some Income Elasticities Narrow Categories Income Elasticities Broad Categories Income Elasticities Fresh fruit Computers Transatlantic Air Travel College Education Cigarettes Chicken Pork Fresh Vegetables Tooth Extraction Ground Beef Bread Potatoes 1.99 1.71 1.4 0.55 0.50 0.42 0.34 0.26 -0.13 ~ 0.47 -0.20 -0.42 -0.81 Imports Transportation Recreation Clothing Food 2.73 1.79 1.07 1.02 0.60-0.85 37 Income and Spending on Economic Necessities and Economic Luxuries Income Spending on Food Percent of Spending on % of income Income Spent on Transportation spend on Food Transportation $10,000 $6,000 60% $1,000 10% $20,000 $96,000 48% $2,800 14% $40,000 $15,360 38% $7,840 20% $80,000 $24,576 30% $21,952 27% 38 Income Elasticity of Demand • Economic necessity – Good with an income elasticity of demand between 0 and 1 • Economic luxury – Good with an income elasticity of demand greater than 1 • An implication follows from these definitions – As income rises, proportion of income spent on economic necessities will fall • While proportion of income spent on economic luxuries will rise • But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior – Not by our judgment of a good’s importance to human survival – Example: Cigarettes 39 Cross-Price Elasticity of Demand • Cross-price elasticity of demand – Percentage change in quantity demanded of one good caused by a 1% change in price of another good • While all other influences on demand remain unchanged EXZ % Change in Quantity of X Demanded % Change in Price of Z • While the sign of the cross-price elasticity helps us distinguish substitutes (positive) and complements (negative) among related goods • Its size tells us how closely the two goods are related – A large absolute value for EXZ suggests that the two goods are close substitutes or complements – While a small value suggests a weaker relationship 40 Some Cross-Price Elasticities Products Cross-Price Elasticity Margarine with price of butter Pepsi with price of Coke Coke with price of Pepsi Ground beef with price of poultry Electricity with price of natural gas Theater with price of all other lively arts Entertainment with price of food 1.53 0.80 0.61 0.24 0.20 0.12 -0.72 41 Price Elasticity of Supply • Percentage change in quantity of a good supplied that is caused by a 1% change in the price of the good – With all other influences on supply held constant % Change in Quantity Supplied ES % Change in Price 42 Price Elasticity of Supply • When do we expect supply to be price elastic, and when do we expect it to be price inelastic? – Ease with which suppliers can find profitable activities that are alternatives to producing the good in question • Supply will tend to be more elastic when suppliers can switch to producing alternate goods more easily (produce orange to orange juice) – When can we expect suppliers to have easy alternatives? Depends on » Nature of the good itself (Envelope v.s. microprocessor chips) » Narrowness of the market definition—especially geographic narrowness (the market of orange in Iowa v.s. the market of orange in U.S.A.) » Time horizon—longer we wait after a price change, greater the supply response to a price change 43 Price Elasticity of Supply • Extreme cases of supply elasticity – Perfectly inelastic supply curve is a vertical line • Many markets display almost completely inelastic supply curves over very short periods of time • Example: the supply of fresh-caught tuna – Perfectly elastic supply curve is a horizontal line The supply of IBM Stock when the price of IBM stock at Pacific Stock Exchange rises even the tiniest bit above the price in other markets 44 Figure 8: Extreme Cases of Supply (a) (b) Price per Unit Price per Unit S P2 Perfectly Inelastic Supply Perfectly Elastic Supply S P1 Quantity per Period Quantity per Period 45 The Tax on Airline Travel: Taxes and Market Equilibrium • A tax on a particular good or service is called an excise tax – Shifts market supply curve upward by amount of tax • For each quantity supplied, the new, higher curve tells us firms’ gross price, and the original, lower curve tells us the net price • Who really pays excise taxes? – Buyers and sellers share in the payment of an excise tax • Called tax shifting – Process that causes some of tax collected from one side of market (sellers) to be paid by other side of market (buyers) 46 Figure 9a: The Tax on Airline Travel Price per Ticket (a) 4. and then find the minimum price needed for the market to supply that quantity. SBefore Tax $300 $260 1. One way to use the supply curve is to start with the price . . . 3. But another way is to start with a quantity . . . A 7 10 Millions of Tickets per Year 2. and then find the quantity supplied at that price. 47 Figure 9b: The Tax on Airline Travel Price per Ticket (b) SAfter Tax $360 A' SBefore Tax $300 A 3. But another way is to start with a quantity . . . 10 Millions of Tickets per Year 4. and then find the minimum price needed for the market to supply that quantity. 48 Figure 10: Effect of Excise Tax on Airlines 2. The $60 tax shifts the supply curve up by $60. Price per Ticket SAfter Tax B $340 3. In the new equilibrium, buyers pay $340. SBefore Tax $300 A 1. Before the tax, the supply curve is SBefore Tax and the price is $300. $280 4. And, net of the tax, sellers receive $280. D Millions of Tickets per Year 49 Tax Incidence and Demand Elasticity • In most cases excise tax will be shared by both buyer and seller – For a given supply curve, the more elastic is demand, the more of an excise tax is paid by sellers – The more inelastic is demand, the more of the tax is paid by buyers 50 Figure 11: Tax Incidence and Demand Elasticity (a) Price per Ticket D (b) Price per SAfter Tax Ticket SAfter Tax SBefore Tax SBefore Tax B $360 $300 A 10 $300 Millions of Tickets per Year B A 2 10 D Millions of Tickets per Year 51 Tax Incidence and Supply Elasticity • Although there are extreme cases of supply elasticity, in general the following is true – For a given demand curve, the more elastic is supply, the more of an excise tax is paid by buyers – The more inelastic is supply, the more of the tax is paid by sellers 52 Figure 12: Tax Incidence and Supply Elasticity (a) Price per Ticket (b) SBefore and After Tax Price per Ticket $360 $300 A $240 B SAfter Tax A $300 D 10 Millions of Tickets per Year SBefore Tax D 8 10 Millions of Tickets per Year 53 Health Insurance and the Market for Health Care • Health insurance has definite benefits to our society • Our current health care system keeps patients from facing the full opportunity cost of their health care decisions – Can cause people to over consume health care • Health insurance reduces buyers’ incentives to monitor their health care expenditures closely or to shop around for high-quality low-cost care 54 Figure 14: The Market For Health Care With Coinsurance Price per D After Insurance Examination $100 S DBefore Insurance B 70 50 A 100,000 150,000 Examinations per Year 55 The Nature of the Firm • What is a business firm? – An organization, owned and operated by private individuals, that specializes in ___________. • Production is _________________________________. • The firm must deal with a variety of individuals and organizations – Owners, Customers, Input suppliers, and government. • Where does the revenue go? – Much of it goes to __________________ • The total of all of these payments makes up the firm’s costs of production – When costs are deducted from revenue, what remains is the firm’s _______ » The firm’s profit (after taxes) accrues to ________ who provided the firm’s initial financing. 56 The Nature of the Firm • Every firm must deal with the government – Pays ____ to the government – Must obey government ___________ – Receive valuable services from the government • Public capital • Legal systems • Financial systems 57 Fig. 1 The Firm and Its Environment Owners Initial Financing Profit After Taxes Input Costs Input Suppliers Taxes The Firm (Management) Inputs Output Government Government Services Government Regulations Revenue Customers 58 Types of Business Firms • There are more than 25 million business firms in United States—each of them falls into one of three legal categories – A _________________ • A firm owned by a single individual – A _________________ • A firm owned and usually operated by several individuals who share in the profits and bear personal responsibility for any losses – Both of the above face • Unlimited liability – Each owner is held personally responsible for the obligations of the firm • The difficulty of raising money to expand the business – Each partner bears full responsibility for the poor judgment of any one of them 59 Types of Business Firms • A __________ – Owned by those who buy shares of stock and whose liability is limited to the amount of their investment in the firm – Ownership is divided among those who buy shares of stock – Each share of stock entitles its owner to a share of the corporation’s profit • Some of this is paid out in _________ • If the corporation needs additional funds it may sell more stock • Offers the stockholder _____ liability • However, stockholders suffer double taxation 60 Figure 2: Forms of Business Organization Percent of Firms Percent of Total Sales Corporations 20% Partnerships 7% Corporations 90% Sole Proprietorships 73% Partnerships 4% Sole Proprietorships 6% 61 Why Employees? • Most firms have employees • Each of us could operate our own oneperson firms as independent contractors – So why don’t more of us do this? – The advantages of employment ______________ ______________ ______________ 62 Further Gains From Specialization • Independent contractor must – – – – Design the good Make the good Deal with customers Advertise services • At a factory each of these tasks would be performed by different individuals who would work full time at their activity 63 Lower Transaction Costs • Transaction costs are time costs and other costs required to carry out market exchanges • In a firm with employees many supplies and services can be produced inside the organization – Firm can enjoy significant savings on transaction costs 64 Reduced Risk • Large firm with employees offers opportunities for everyone involved to reduce risk through – ______________ • Process of reducing risk by spreading sources of income among different alternatives • With large firms, two kinds of diversification are possible – Within the firm – Among firms • These advantages help it attract customers, workers, and potential owners 65 The Limits to the Firm • You might be tempted to conclude that bigger is always better – The larger the firm, the greater will be the cost savings • However, there are limits 66 Thinking About Production • Outputs • Inputs include resources – – – – – – Labor Human Capital Physical Capital Land Raw materials Other goods and services provided by other firms • Way in which these inputs may be combined to produce output is the firm’s _________ 67 Thinking About Production • A firm’s technology is treated as a given – Constraint on its production – For each different combination of inputs, the production function tells us ___________________ a firm can produce over some period of time 68 Figure 3: The Firm’s Production Function Alternative Input Combinations Production Function Different Quantities of Output 69 The Short Run and the Long Run • Useful to categorize firms’ decisions into – Long-run decisions—involves a time horizon long enough for a firm to vary all of its inputs – Short-run decisions—involves any time horizon over which at least one of the firm’s inputs cannot be varied • To guide the firm over the next several years – Manager must use the long-run lens • To determine what the firm should do next week – Short run lens is best 70 Production in the Short Run • When firms make short-run decisions, there is nothing they can do about their _________ – Stuck with whatever quantity they have – However, can make choices about their variable inputs • Fixed inputs •Outputs – An input whose quantity must remain constant, regardless of how much output is produced • Variable input – An input whose usage can change as the level of output changes • Total product – Maximum quantity of output that can be produced from a given combination of inputs 71 Production in the Short Run • Marginal product of labor (MPL) is the change in total product (ΔQ) divided by the change in the number of workers hired (ΔL) ΔQ MPL ΔL – Tells us the rise in output produced when one more worker is hired 72 Figure 4: Total and Marginal Product Units of Output Total Product 196 184 161 Q from hiring fourth worker 130 Q from hiring third worker 90 Q from hiring second worker 30 Q from hiring first worker 1 increasing marginal returns 2 3 4 5 6 Number of Workers diminishing marginal returns 73 Marginal Returns To Labor • As more and more workers are hired – MPL first increases – Then decreases • Pattern is believed to be typical at many types of firms 74 Increasing Marginal Returns to Labor • The marginal product of labor ______ as employment rises – Each time a worker is hired, total output rises by more than it did when the previous worker was hired – The additional worker not only produces some additional output as an individual, but also makes all other workers more productive. 75 Diminishing Returns To Labor • The marginal product of labor is ________ – Output rises when another worker is added so marginal product is ________ – But the rise in output is ___________ with each successive worker • Law of diminishing (marginal) returns states that as we continue to add more of any one input (holding the other inputs constant) – Its marginal product will eventually _______ 76 Thinking About Costs • A firm’s total cost of producing a given level of output is ______________ – Everything they must give up in order to produce that amount of output – At the core of economist’s thinking about costs. – Help us understand which costs matter and which don’t. 77 The Irrelevance of Sunk Costs • Sunk cost is one that already has been paid, or must be paid, regardless of any future action being considered • Should not be considered when making decisions • Even a future payment can be sunk – If an unavoidable commitment to pay it has already been made 78 Explicit vs. Implicit Costs • Types of costs – Explicit (involving actual payments) • Money actually paid out for the use of inputs – Implicit (no money changes hands) • The cost of inputs for which there is no direct money payment 79 Costs in the Short Run • Costs for a time horizon during which at least one of the firm’s inputs is fixed. • Fixed costs – Costs of a firm’s ____ inputs – Remains the same no matter what the level of output • Variable costs – Costs of obtaining the firm’s ______ inputs – Rise as output increases 80 Measuring Short Run Costs: Total Costs • Types of total costs – Total fixed costs • Cost of all inputs that are fixed in the short run – Total variable costs • Cost of all variable inputs used in producing a particular level of output – Total cost • Cost of all inputs—fixed and variable • TC = TFC + TVC 81 Figure 5: The Firm’s Total Cost Curves Dollars TC $435 375 TVC TFC 315 255 195 135 TFC 0 30 90 130 161 184 196 Units of Output 82 Average Costs • Average fixed cost (AFC) – Total fixed cost divided by the quantity of output produced AFC TFC Q • Average variable cost (TVC) – Total variable cost divided by the quantity of output produced TVC AVC Q • Average total cost (TC) – Total cost divided by the quantity of output produced TC ATC Q 83 Marginal Cost • Marginal Cost – Increase in total cost from producing one more unit or output • Marginal cost is the change in total cost (ΔTC) divided by the change in output (ΔQ) ΔTC MC ΔQ – Tells us how much cost rises per unit increase in output – Marginal cost for any change in output is equal to shape of total cost curve along that interval of output 84 Figure 6: Average And Marginal Costs Dollars MC $4 3 AFC ATC AVC 2 1 0 30 90 130 161 196 Units of Output 85 Explaining the Shape of the Marginal Cost Curve • When the marginal product of labor (MPL) rises (falls), marginal cost (MC) ____ (____) • Since MPL ordinarily rises and then falls, MC will do the opposite—it will fall and then rise – Thus, the MC curve is _______ 86 The Relationship Between Average And Marginal Costs • At low levels of output, the MC curve lies below the AVC and ATC curves – These curves will slope downward • At higher levels of output, the MC curve will rise above the AVC and ATC curves – These curves will slope upward • As output increases; the average curves will first slope downward and then slope upward – Will have a U-shape • MC curve will intersect the minimum points of the AVC and ATC curves 87 Production And Cost in the Long Run • In the long run, costs behave differently – Firm can adjust all of its inputs in any way it wants • In the long run, there are no ___ inputs or ___ costs – All inputs and all costs are ______ – Firm must decide what combination of inputs to use in producing any level of output • The firm’s goal is to ___________ – To do this, it must follow ______________ • To produce any given level of output the firm will choose the input mix with the lowest cost Different ways to wash 196 cars per day Capital cost =$75 per day Labor cost = $60 per unit per day Method Quantity of Quantity of Cost Capital Labor A 0 9 B 1 6 C 2 4 D 3 3 Production And Cost in the Long Run • Long-run total cost – The cost of producing each quantity of output when the least-cost input mix is chosen in the long run • Long-run average total cost – The cost per unit of output in the long run, when all inputs are variable • The long-run average total cost (LRATC) – Cost per unit of output in the long-run LRTC LRATC Q Long-Run and Short-Run Costs for Spotless Car Wash Output TC($) LRTC($) 0 30 90 130 161 184 196 250 300 75 135 195 255 315 375 435 0 100 195 255 315 360 390 650 1,200 LRATC($) The Relationship Between Long-Run And Short-Run Costs • For some output levels, LRTC is ______ than TC • Long-run total cost of producing a given level of output can be less than or equal to, but never greater than, short-run total cost (LRTC ≤ TC) • Long-run average cost of producing a given level of output can be less than or equal to, but never greater than, short–run average total cost (LRATC ≤ ATC) Average Cost And Plant Size • Plant – Collection of fixed inputs at a firm’s disposal • Can distinguish between the long run and the short run – In the long run, the firm can change the size of its plant – In the short run, it is stuck with its current plant size • ATC curve tells us how average cost behaves in the short run, when the firm uses a plant of a given size • To produce any level of output, it will always choose that ATC curve—among all of the ATC curves available—that enables it to produce at lowest possible average total cost – This insight tells us how we can graph the firm’s LRATC curve Figure 7: Long-Run Average Total Cost Dollars ATC1 $4.00 ATC0 ATC2 3.00 C D B A 2.00 LRATC ATC3 E 1.00 0 30 Use 0 automated lines 90 130 161 184 175 196 Use 1 automated lines 250 Use 2 automated lines 300 Use 3 automated lines Units of Output Graphing the LRATC Curve • A firm’s LRATC curve combines portions of each ATC curve available to firm in the long run – For each output level, firm will always choose to operate on the ATC curve with ________________ • In the short run, a firm can only move along its current ATC curve • However, in the long run it can move from one ATC curve to another by varying the size of its plant – Will also be moving along its LRATC curve Economics of Scale • Economics of scale – Long-run average total cost _____ as output increases • When an increase in output causes LRATC to decrease, we say that the firm is enjoying economics of scale – The more output produced, the lower the cost per unit • When long-run total cost rises proportionately less than output, production is characterized by economies of scale – LRATC curve slopes ________ Figure 8: The Shape Of LRATC Dollars $4.00 3.00 LRATC 2.00 1.00 130 0 Economies of Scale 184 Constant Returns to Scale Diseconomies of Scale Units of Output Gains From Specialization • One reason for economies of scale is gains from specialization • The greatest opportunities for increased specialization occur when a firm is producing at a relatively low level of output – With a relatively small plant and small workforce • Thus, economies of scale are more likely to occur at lower levels of output More Efficient Use of Lumpy Inputs • Another explanation for economies of scale involves the “lumpy” nature of many types of plant and equipment – Some types of inputs cannot be increased in tiny increments, but rather must be increased in large jumps • Plant and equipment must be purchased in large lumps – Low cost per unit is achieved only at high levels of output • Making more efficient use of lumpy inputs will have more impact on LRATC at low levels of output – When these inputs make up a greater proportion of the firm’s total costs • At high levels of output, the impact is smaller Diseconomies of Scale • Long-run average total cost _______ as output increases • As output continues to increase, most firms will reach a point where bigness begins to cause problems – True even in the long run, when the firm is free to increase its plant size as well as its workforce • When long-run total cost rises more than in proportion to output, there are diseconomies of scale – LRATC curve slopes ________________ • While economies of scale are more likely at low levels of output – Diseconomies of scale are more likely at higher output levels Constant Returns To Scale • Long-run average total cost is ______ as output increases • When both output and long-run total cost rise by the same proportion, production is characterized by constant returns to scale – LRATC curve is ___ • In sum, when we look at the behavior of LRATC, we often expect a pattern like the following – Economies of scale (decreasing LRATC) at relatively low levels of output – Constant returns to scale (constant LRATC) at some intermediate levels of output – Diseconomies of scale (increasing LRATC) at relatively high levels of output • This is why LRATC curves are typically U-shaped Using the Theory: Long Run Costs, Market Structure and Mergers • The number of firms in a market is an important aspect of market structure—a general term for the environment in which trading takes place • What accounts for these differences in the number of sellers in the market? – Shape of the LRATC curve plays an important role in the answer LRATC and the Size of Firms • The output level at which the LRATC first hits bottom is known as the minimum efficient scale (MES) for the firm – Lowest level of output at which it can achieve minimum cost per unit • Can also determine the maximum possible total quantity demanded by using market demand curve • Applying these two curves—the LRATC for the typical firm, and the demand curve for the entire market—to market structure – When the MES is small relative to the maximum potential market • Firms that are relatively small will have a cost advantage over relatively large firms • Market should be populated by many small firms, each producing for only a tiny share of the market LRATC and the Size of Firms • There are significant economies of scale that continue as output increases – Even to the point where a typical firm is supplying the maximum possible quantity demanded • This market will gravitate naturally toward monopoly • In some cases the MES occurs at 25% of the maximum potential market – In this type of market, expect to see a few large competitors • There are significant lumpy inputs that create economies of scale – Until each firm has expanded to produce for a large share of the market Figure 9: How LRATC Helps Explain Market Structure LRATCTypical Firm Dollars F $160 E 80 DMarket 0 1,000 3,000 100,000 Units per Month Figure 9: How LRATC Helps Explain Market Structure LRATCTypical Firm Dollars $160 80 DMarket 0 100,000 Units per Month Figure 9: How LRATC Helps Explain Market Structure Dollars LRATCTypical Firm H $200 F E 80 DMarket 0 25,000 100,000 Units per Month Figure 9: How LRATC Helps Explain Market Structure LRATCTypical Firm Dollars $160 E F 80 DMarket 0 1,000 10,000 100,000 Units per Month LRATC and the Size of Firms • The MES of the typical firm in this market is 1,000 units – Lowest output level at which it reaches minimum cost per unit – For firms in this market, diseconomies of scale don’t set in until output exceeds 10,000 units • Since both small and large firms can have equally low average costs with neither having any advantage over the other – Firms of varying sizes can coexist The Urge To Merge • If by doubling their output, firms could slide down the LRATC curve in Figure 9, and enjoy a significant cost advantage over any other, stillsmaller firm, they would – This is a market that is ripe for a merger wave • A sudden merger wave is usually set off by some change in the market • Market structure in general—and mergers and acquisitions in particular—raise many important issues for public policy – Low-cost production can benefit consumers—if it results in lower prices