Unit Theory of the Firm Unit Overview

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1 Unit Introduction to Market Structures and Cost Theory Intro to Market Structures Pure competition Monopolistic competition Oligopoly Monopoly Cost theory Types of costs: fixed costs, variable costs Total, average and marginal costs Accounting costs = opportunity costs = economic costs Short-run Law of diminishing returns Total product, average product, marginal product Short-run cost curves Long-run Economies of scale Diseconomies of scale Long-run cost curves Revenues Total revenue Marginal revenue Average revenue Unit Theory of the Firm Unit Overview Profit Distinction between normal (zero) and supernormal (abnormal) profit Profit maximization in terms of total revenue and total costs, and in terms of marginal revenue and marginal cost Profit maximization assumed to be the main goal of firms but other goals exist (sales volume maximization, revenue maximization, environmental concerns) Welker's Wikinomics: 1

2 Perfect competition Assumptions of the model Demand curve facing the industry and the firm in perfect competition Profit-maximizing level of output and price in the short-run and long-run The possibility of abnormal profits/losses in the short-run and normal profits in the long-run Shut-down price, break-even price Definitions of allocative and productive efficiency Efficiency in perfect competition Monopoly Assumptions of the model Sources of monopoly power/barriers to entry Natural monopoly Demand curve facing the monopolist Profit-maximizing level of output Advantages and disadvantages of monopoly in comparison with perfect competition Efficiency in monopoly Price discrimination >>Definition >>Reasons for price discrimination >>Necessary conditions for the practice of price discrimination >>Possible advantages to either the producer or the consumer Monopolistic competition Assumptions of the model Short-run and long-run equilibrium Product differentiation Efficiency in monopolistic competition Unit Theory of the Firm Unit Overview Oligopoly Assumptions of the model Colusive and non-collusive oligopoly Cartels Kinked demand curve as one model to describe interdependent behavior (IB HL only) Importance of non-price competition Theory of contestable markets (IB HL only) Welker's Wikinomics: 2

3 Most competition Pure (or Perfect) Competition VERY large number of firms Each firm is so small that changes in its own output do not affect market price, i.e. firms are price takers Firms all produce identical products, with no differentiation Completely free entry and exit from the industry, i.e. NO barriers to entry. All producers and consumers have perfect knowledge of prices, costs, and quality and availability of products Unit Theory of the Firm Introduction to the Four Market Structures Monopolistic competition Fairly large number of firms Firms are small relative to the industry, meaning changes in one firms output have only a slight impact on market price Products are slightly differentiated. Firms will advertise to try and further differentiate product. Branding! Advertising! No barriers to entry, firms can enter or leave easily Oligopoly A few large firms dominate an industry A change in one firm's output has significant impact on the market price, firms are pricemakers. Products can be identical (such as oil) or differentiated (such as Macs and Dells) There are significant barriers to entry Firms will likely use advertising to try and differentiate their products from competitors' Least competition Monopoly Only ONE firm. The firm IS the industry! Significant barriers to entry exist, preventing new firms from entering and competing with the monopolist the Monopolist can maintain significant profits due to the lack of competition. Changes in the firm's output cause changes in the price, i.e. the firm is a price-maker! Welker's Wikinomics: 3

4 AP/IB Economics Unit Costs of Production Unit Theory of the Firm Introduction to the Four Market Structures Examples of different market structures: Based on the characteristics of the different market structures, brainstorm examples of each. Pure Competition Monopolistic competition Oligopoly Monopoly Practice: Different types of Market Structure - Rainbow book Activity 24 Welker's Wikinomics: 4

5 Big ideas: 1) Big Ideas What is productivity and how does it change as resources are added to production? 2) 3) 4) What are the different costs faced by firms in the shortrun and the long-run? What is the relationship between the productivity of its resources and the costs faced by a firm? Why does understanding productivity and costs matter to firms? Discussion Question: What is productivity, and why do firms care about it? Welker's Wikinomics: 5

6 Understanding Productivity: Law of Diminishing Returns Productivity: The amount of output attributable to a unit of input. Examples of productivity: "Better training has increased the productivity of workers" "The new robot is more productive than older versions" "Adding fertilizer has increased the productivity of farmland" Total product (TP) is the total output of a particular firm Example of TP: "After hiring more workers the firm's total product increased." Marginal product of labor (MP L ) is the change in total product resulting from each additional worker. >>MP L = TP/ L Average product of labor (AP L ) is the output, on average, by each worker >>AP L = TP/units of L Welker's Wikinomics: 6

7 Law of Diminishing Returns Law of Diminishing Returns: states that as additional units of a variable resource are added to fixed resources, beyond some point the marginal product of the variable resource will decline. HUH? Let's illustrate this with an example Example: Paper Chain Factory Instructions: 1) Use inputs (land, labor and capital) to create a product (paper chains) 2) Labor is the only variable resource. Land and capital are fixed. 3) Production rounds last one minute 4) Record production data in a data table LAND (fixed) LABOR (variable) CAPITAL (fixed) Welker's Wikinomics: 7

8 Law of Diminishing Returns One worker has one minute to make the longest chain possible. A volunteer is needed to record output data in the table to the right. As more workers are added, TP, MP and AP will be calculated and recorded. MP L = TP/ L AP L = TP/units of L Units of labor TP MP AP Welker's Wikinomics: 8

9 MP/ AP Marginal/Average Product Law of Diminishing Returns Data: Units of labor TP MP AP TP Total Product Units of Labor Welker's Wikinomics: 9

10 Law of Diminishing Returns MP/AP TP Marginal/Average Product Diminishing returns sets in Units of Labor Total Product AP MP Observations: Describe what happens to TP as more and more labor is added to a fixed amount of capital and land TP increases at an increasing rate as workers' MP increases, at a decreasing rate as MP falls, and declines as MP becomes negative. What is the relationship between TP and MP? MP is the rate of increase in TP Units of Labor TP MP becomes negative, TP begins to fall What is the relationship between MP and AP? When MP is greater than AP, AP increases. MP intersects AP at its highest point, and when MP is less than AP, AP decreases Why does a producer care about the productivity of its workers and other resources? Because firms average and marginal costs in the short-run are inversely related to the productivity of its workers Welker's Wikinomics: 10

11 AP/IB Economics Unit Costs of Production Law of Diminishing Returns Conclusions: Explanation of increasing returns : Explanation of diminishing returns: Negative marginal product and implications: Implications of diminishing marginal returns to producers: Practice Diminishing Returns: Rainbow book Activity 25 Welker's Wikinomics: 11

12 Productivity and costs Productivity and Costs: As worker productivity increases, firms get "more for their money", meaning per-unit and marginal cost decrease. When productivity decreases, costs increase. In the graph below, fill in the marginal and average cost curves using the marginal and average product curves to guide you. Product/costs Costs and Productivity MC AP AC Discussion: When productivity of workers is rising, firms costs are falling, since they're getting more output for workers while paying them the same wages. When marginal product is increasing (increasing returns) marginal cost is falling When MP is at its maximum, MC is at its minimum When diminishing returns set in, MP begins falling and MC begins rising Units of Labor/ units of output MP MP intersects average product at its highest point, and MC intersects average total cost at its lowest point Summary: Increasing marginal returns is reflected in a declining marginal cost, and diminishing marginal returns in a rising marginal cost! Welker's Wikinomics: 12

13 Short-run What is the short-run? "the fixed-plant period" The short-run is the period of time over which a firm's plant size is fixed. Capital cannot and land cannot be varied, labor is the only variable resource. To increase output in the short-run, a firm can only increase inputs of labor, not the other resources. Total Costs: Total fixed costs (TFC): These are the costs a firm faces that do not vary with changes in short-run output. Could include rent on factory space, interest on capital (already acquired). Total variable costs (TVC): These are the costs a firm faces which change with the level of output in the short-run. Could include payment for raw materials, fuel, power, transportation services, wages for workers, etc... Total cost: TFC + TVC at each level of output Welker's Wikinomics: 13

14 Short-run Resource costs in the short-run: Rent - the payment for land: Rent is fixed in the short-run since firms cannot add this resource to production. Rents must be paid regardless of the level of the firm's output. Interest - the payment for capital: Interest is fixed in the short-run since firms cannot add this resource to production. Interest must be paid on loans regardless of the level of the firm's output. Wages - the payment for labor: Wages are variable in the short-run, since firms can hire or fire workers to use existing land and capital resources. Wage costs increase when new workers are hired, and decrease when workers are laid off. Normal profit: the minimum level of profit needed just to keep an entrepreneur operating in his current market. If he does not earn normal profit, an entrepreneur will direct his skills towards another market. Normal profit is a cost because if a firm does not earn normal profit, it is not covering its costs and may shut down. Other short-run variable costs of production: Transportation costs: Firms pay lower transport costs at lower levels of output. Raw material costs: vary with the level of output Manufactured inputs: fewer parts are needed from suppliers when a firm lowers output. Welker's Wikinomics: 14

15 Graphing total costs: TFC: Notice that regardless of the level of output, TFC remains constant. This is because these are costs that do not vary with output. TVC: Notice that when output is zero, TVC is zero, because you do not need to hire any workers or use any raw materials if you're not producing anything. As output increases, TVC continues to increase TC: Notice that when output is zero, TC = TFC. But once the factory begins pumping out products, TC rises with TVC. TC is the sum of TFC and TVC, since both fixed and variable costs make up total cost. Costs Short-run TC TVC Diminishing returns: Notice that TC and TVC increase at a decreasing rate at first. This is when marginal product is increasing as more labor is employed (firms get "more for their money") Point at which diminishing returns sets in TFC Q of output However, beyond some point, costs begin to increase at an increasing rate. This is where diminishing returns set in and MP is decreasing. The firm is getting less additional output from each worker hired, but must pay the same wages regardless. (The firm gets "less for its money") Welker's Wikinomics: 15

16 Average Costs: Short-run Average fixed cost: AFC=TFC/Q AFC will decline as output rises, never increases. This is because the fixed cost (which never goes up) is spread out as output goes up. This is called spreading the overhead Average variable cost: AVC = TVC/Q For simplicity, we will assume that labor is the only variable input, the labor cost per unit of output is the AVC Average total cost: ATC = TC/Q Sometimes called unit cost or per unit cost. ATC also equals AFC + AVC Marginal Cost = the additional cost of producing one more unit of output. MC = TVC/ Q. Welker's Wikinomics: 16

17 Costs Short-run Graphing Average and Marginal Costs: AFC: it declines as output increases. This is called "spreading the overhead". ATC and AVC: At first they are declining as output increases. This is during the stage when MP is increasing, since new labor is making better use of capital and beginning to specialize. AVC: When AVC is at its minimum, average product is at its maximum, meaning workers are producing the most output per worker. As more workers are added, average product begins to go down, and AVC begins to rise. Things to notice: the vertical distance between ATC and Short-run Costs AVC equals the AFC at each level of output. MC AFC ATC AVC MC intersects both AVC and ATC at their minimum. This is because if the last unit produced cost less than the average, then the average must be falling, and vis versa (just like your test scores!) MC is at its minimum when MP is at its maximum, because beyond that point diminishing returns sets in and the firm starts getting less for its money! Point at which diminishing returns sets in Q Welker's Wikinomics: 17

18 Short-run Labor is the only variable resource and the wage = $200 / week Rent and interest are fixed costs, and = $400 / week Q L TP (Q supplied) TFC TVC TC AFC AVC ATC MC Describe and explain what happens to each of the following as output increases: 1) TFC 2) TC 3) AFC 4) AVC and ATC 5) MC Welker's Wikinomics: 18

19 Costs Costs Short-run Costs Short-run MC Q TC AFC TVC ATC AVC Discussion Questions: Short-run Costs 1) 2) State the law of diminishing returns and explain how it determines the shape of the marginal cost curve. Explain the relationship between the marginal cost curve and the average variable and average total cost curves. TFC What determines the distance 3) between the ATC and the AVC at a particular level of output. Point at which diminishing returns sets in Q Welker's Wikinomics: 19

20 Productivity and costs Relationships between MC, ATC and AVC Illustrate the relationship b/w Total Fixed Cost, Total Variable Cost, and Total Cost Illustrate the relationship b/w Average Fixed Cost, Average Variable Cost, Averate Total Cost and Marginal Cost Costs Costs Quantity of output When MC is below ATC and AVC, what is happening to the average costs curve? Why? How is the law of diminishing returns reflected in the shape of the MC curve? How is Average fixed cost implied in your diagram without even having to draw it? Quantity of output Welker's Wikinomics: 20

21 Short-run vs. Long-run costs Long-run is the variable plant period, meaninig that firms can open up new plants, add capital to existing plants, or close plans and remove capital if need be. Economies of scale: the range of plant size over which increasing output leads to lower and lower average total cost. As new plants open, ATC declines. WHY? better specialization, division of labor, bulk buying, lower interest on loans, lower per unit transport costs, larger and more efficient machines, etc... Also called "Increasing returns to scale" Minimum Efficient Scale (MES): The minimum level of output a firm must achieve to achieve the lowest average total cost. Diseconomies of Scale: When a firm becomes "too big for its own good" it experiences diseconomies of scale. Continuing to add plants and increase output causes ATC to rise. WHY? Mostly due to control and communications problems, trying to coordinate production across a wide geographic may make firm less efficient. Also called "Decreasing returns to scale" Welker's Wikinomics: 21

22 Short-run vs. Long-run costs Costs Graphing long-run ATC: The gray curves represent all the SR ATC curve the firm experiences as it opens new plants. As it opens its first 10 plants, ATC declines, while for plants ATC remains constant. Beyond 16 plants the firm's ATC begins to rise, indicating it has gotten too big. ATC LR Economies of scale MES Constant returns to scale Diseconomies of scale Q Welker's Wikinomics: 22

23 Attachments APMicroUnit3.jnt

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