Lecture 3 Basic Micro: production and exchange

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Lecture 3Basic Micro production and exchange

• Introductory Economics for the Treasury
• Dr. Paul Frijters
• http//econrsss.anu.edu.au/frijters

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Production

• Key terms in this lecture
• 1. Inputs resources production factors
• 2. Outputs sold production outcomes
• 3. Complementarity and substitution
• 4. Costs of production.
• 5. Increasing, constant, and decreasing returns
  to scale
• 6. Comparative advantage and exchange
• 7. Basic competition

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Recap Factors of production

These two are known as the basic factors of
production. The other factors of production are
essentially a form of conserved labour.
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Recap basic forms of sold output

• 1. Final consumption good anything that can be
  directly consumed, i.e. that is valued for
  itself. E.g. a sigar.
• 2. Intermediary production good something that
  is itself already a combination of basic
  production factors but serves as an input into
  the production of final consumption goods. E.g.
  shredded tobacco leaves, or stationary.
• 3. Services intangible goods that are valued for
  themselves. E.g. security or entertainment.
• Note that unsold production is a pure loss, i.e.
  waste.

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Complements or substitutes?

• In production
• Two inputs are seen as complements when one input
  raises the productivity of the other input.
  Examples a computer and a worker, a sales
  department and a production department, a soldier
  and a gun, nuts and bolts, income tax laws and
  tax collectors, tertiary education systems and
  RD.
• Two inputs are seen as substitutes when one input
  reduces or has the same function as the other
  input. Examples a computer and a typewriter, a
  combine harvester or low-skilled labour.

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Rules of thumb

• 1. High-skilled labour and capital are generally
  complements. Implication high-skilled labour
  profits from a low price of capital.
• 2. Low-skilled labour and capital are
  substitutes. Implication low-skilled labour
  suffers from a low price of capital.
• 3. Different specialisations are generally
  complements. Implication a higher degree of
  specialisation increases production.

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Complement or substitute?

• In Consumption
• - two goods are said to be complements if the
  consumption value of one increases with the
  other. Examples a pipe and tobacco, a cd and a
  cd-player.
• - two goods are said to be substitutes if the
  consumption value of the one decreases with
  consumption of the other. Examples two soft
  drinks, a car and a motorbike.

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Basic terms Costs of production

• Total Costs
• A firm organises the manufacture of a good or
  service. An industry is made up of all those
  firms producing the same commodity. The amount
  spent on producing a given amount of a good is
  called total cost, TC, and is found by adding
  together variable and fixed costs.

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Variable Costs

• Variable costs, VC, are the costs that depend on
  how many goods are being made (output). If just
  one more unit is made then total variable costs
  rise. Variable costs include the following
• Weekly wages paid to the shop floor workers.
• The cost of buying raw materials and components.
• The cost of electricity and gas.

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Fixed Costs

• Fixed costs, FC, are totally independent of
  output. Fixed costs have to be paid out even if
  the firm stops production. Fixed costs include
  the following
• monthly salaries paid to managers
• rent paid for the use of premises
• rates paid to the council
• any interest paid on loans
• insurance payments in case of accidents
• money put aside to replace work-out machines and
  vehicles sometime in the future (depreciation).

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Average and Marginal Cost

• Average cost, AC or unit is the cost of producing
  one item and is calculated by dividing total
  costs by total sold output.
• Marginal cost, MC is the (long-run) cost of
  producing one extra unit and is calculated by
  dividing the change in total costs by the change
  in output.
• Profit maximisation principle you choose your
  level of output such that the marginal revenue
  you obtain from the last good sold equals your
  marginal cost. If you cannot manipulate the
  price, you produce until marginal costs equals
  price.

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Economies of scale

• Increasing returns to scale when the unit costs
  go down with the scale of production. These occur
  when mass producing a good results in lower
  average cost.
• Main example when these occur when fixed costs
  are high and variable costs are low.
• Economies of scale occur within an firm
  (internal) or within an industry (external).

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Internal economies of scale of firms

• These are economies made within a firm as a
  result of mass production. As the firm produces
  more and more goods, so average cost begin to
  fall because of
• Technical economies made in the actual production
  of the good. For example, large firms can use
  expensive machinery, intensively.
• Managerial economies made in the administration
  of a large firm by splitting up management jobs
  and employing specialist accountants, salesmen,
  etc.
• Financial economies made by borrowing money at
  lower rates of interest than smaller firms.
• Marketing economies made by spreading the high
  cost of advertising on television and in national
  newspapers, across a large level of output.
• Commercial economies made when buying supplies in
  bulk and therefore gaining a larger discount.
• Research and development economies made when
  developing new and better products.

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External economies to scale

• External Economies of Scale
• These are economies made outside the firm as a
  result of its location and occur when
• A local skilled labour force is available.
• Specialist local back-up forms can supply parts
  or services.
• An area has a good transport network.
• An area has an excellent reputation for producing
  a particular good. For example, Sydney is
  associated with tourism.

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Internal Diseconomies of Scale

• These occur when the firm has become too large
  and inefficient. As the firm increases
  production, eventually average costs begin to
  rise because
• Management becomes out of touch with the shop
  floor and some machinery becomes over-manned.
• Decisions are not taken quickly and there is too
  much form filling.
• Lack of communication in a large firm means than
  management tasks sometimes get done twice.
• Poor labour relations may develop in large
  companies.

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External Diseconomies of Scale

• These occur for instance when too many firms have
  located in one area. Unit costs begin to rise
  because
• Local labour becomes scarce and firms now have to
  offer higher wages to attract new workers.
• Land and factories become scarce and rents begin
  to rise.
• Local roads become congested and so transport
  costs begin to rise.

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Economies of scale and size

• Basic point competition moves a system towards
  the point where the opportunities for economies
  of scale cease.
• Why? As long as there are still increasing
  economies of scale, a bigger organisation has
  lower average costs and can hence undercut /
  drive out smaller competitors.

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Implications

• 1. Without interference, if the economies of
  scale continue to outweigh the diseconomies (also
  known as decreasing returns to scale), everything
  moves towards a single organisation, called a
  natural monopoly.
• 2. From a cost-minimising perspective you want
  this to happen as long as you can control the
  power of the remaining organisation or trust this
  organisation to work in your interest.

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Rules of thumb

• 1. On the country level, production is generally
  believed to be constant returns to scale (i.e.
  there is no inherent reason why a small country
  is generally more or less productive than a
  bigger one).
• 2. Manufacturing, network industries (mobile
  phones, basic software), and communication
  vehicles (languages) are generally believed to
  have increasing returns to scale.
• Specialised professional services (accounting,
  law, consulting, engineering) are generally
  believed to quickly suffer from decreasing
  returns to scale.

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Economies of scale in the state

• 1. Economies of scale of information gathering
  it is very costly to set up an organisation that
  can continuously keep track of one person, but
  keeping track of the next persons becomes
  progressively easier.
• 2. Economies of scale of violence to be able to
  punish one person anywhere is costly. To be able
  to do so with many becomes cheaper.

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.

• 3. Economies of scale in expectation formation
  it is very difficult to make one person believe
  that all other persons behave/think a certain
  way. It is only marginally more difficult to make
  everyone believe everyone else behaves/thinks a
  certain way. Expectation formation is related to
  state loyalty (we all support the same team
  because we all support the same team).
• These are actually all examples of the economies
  of scale inherent in networks

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The basic point about networks

• First 4 points, 4 connections. Each point can
  travel to 3 others 12 point-destinations, 3
  point-destinations per node.

Second 5 point, 5 connections 20
point-destinations with only 1 More connection,
i.e. 8 point destination at a cost of 1 node more
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Implications

• 1. The state is the natural monopoly of violence,
  having defeated all other suppliers of violence
  with its lower cost.
• 2. The state has lower costs of anything
  involving the monitoring of large slices of the
  population or anything involving the punishment
  of individuals. Simply from a cost point-of-view
  it should hence undertake all those activities
  where the involuntary cooperation of many is very
  important.

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Examples of efficient state production

• 1) taxation in general,
• 2) organising education when young, whilst
  retrieving the cost in the form of taxes when
  old,
• 3) basic welfare insurance schemes and basic
  pension schemes where again the payment is tax,
• 4) The monitoring of laws on individuals and
  organisations,

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Comparative advantage and exchange

• Basic terms
• 1. The Production Possibilities Frontier (PPF) is
  a graph showing the various combinations of
  output that the economy can possibly produce
  given the available factors of production and
  technology.
• 2. A producer who requires smaller quantities of
  inputs to produce a good has an absolute
  advantage in the production of that good.
• 3. A producer who has lower opportunity costs of
  producing a good has a comparative advantage in
  the production of that good, i.e. is relatively
  more productive than another in this activity
  versus another one.

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Conclusion on basic exchange

• 1. Voluntary exchange allows each person (or
  country) to specialise in what they are
  relatively best at, leading to gains for both.
• 2. Preventing voluntary exchange in such a
  stylised environment, for instance via tariffs or
  quotas or even outright trade bans, leads to loss
  for both.

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Example of the interview

• Suppose you are in a country that exports wool to
  a specific other country and imports potatoes.
  Your country is particularly suited for producing
  wool and is particularly badly suited for making
  potatoes.

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.

• Nevertheless, a local farmer wants to start
  producing potatoes but cannot compete in price
  with the foreign import. He asks you to ban or
  restrict the import of potatoes. You do not fear
  reprisals of the other country if you would.
• What do you do and what is your reasoning?

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Standard economic answer

• A quota prevents specialisation into fields of
  comparative advantage (here wool) and hence
  leads to a loss for this country even in the
  absence of reprisals. Giving the farmer a subsidy
  to try potatoes merely impoverishes the taxpayers
  (the wool farmers)
• Equivalent formulations
• - the potato farmer can be put to better use you
  tell him to grow wool or look for something else
  to do.
• - consumers (i.e. the wool farmers) lose out when
  forced to consume home-grown potatoes.

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Distribution of answers

• - the majority (over 60) had roughly correct
  answers. Many added political considerations.
• - some 40 was susceptible to the belief that
  protecting your home industry improves the
  outcome for your own country, which in this
  stylised example is untrue the protected
  industry (home potatoes) gains at the expense of
  the other industry (wool) via higher potatoe
  prices. There is a net loss which is the gains
  from specialisation.

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Rules of thumb

• 1. The majority of trade is within small areas
  trade between specialists occurs mainly within
  villages, provinces, and countries.
• 2. One has comparative advantages in the
  production of things that require the factor of
  production (resource) you have most.
• 2a. For Australia that includes the production of
  things needing a lot of land.
• 2b. For China and India that means things whose
  production needs a lot of low-skilled labour.
• 2c. For the EU/US that means capital and
  skill-intensive production.

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Sneak preview of next week
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Competition with many suppliers basic intuition

• Sellers (cost)
• 30 (price offers)
• 32
• 34
• 36
• 40
• 45
• 50
• 80
• 120

Buyer prepared to pay 100 AUS
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Interpretation

• 1. The supply at price less than 30 is 0, and
  increases with price.
• 2. If the sellers can coordinate, they would set
  the price to 100. Without coordination, they fear
  the other
• 3. The price bidding stops only when the minimum
  cost seller offers a price just below 32. He
  makes a profit of 2. The buyer makes a surplus
  of 68.
• 4. If one seller other than the minimum cost
  seller captures the market, the price would be
  higher and costs are inefficiently high.

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More buyers .
Buyers prepared to pay

• Sellers (cost) (price offers)
• 30 (100)
• 32 (70)
• 34 (40)
• 36 (35)
• 40 (33)
• 45 (31)
• 50 (29)
• 80
• 120

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Implications

• 1. When price too low (say, 30), more goods are
  demanded than supplied drives up price.
• 2. When price is too high (say, 80), more goods
  are supplied than demanded drives down price
• 3. Here, when the price is just below 35, demand
  equals supply and no other buyer or supplier
  enters the market.
• 4. With many uncoordinating suppliers, it will be
  the lowest cost suppliers who eventually produce
  which is efficient from a social view.