Microeconomics Lecture 4-5

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Microeconomics Lecture 4-5
Mónika Kis-Orloczki Assistant lecturer orloczki.mo
nika_at_uni-miskolc.hu
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• production The process by which inputs are
  combined, transformed, and turned into outputs.
• firm An organization that comes into being when
  a person or a group of people decides to produce
  a good or service to meet a perceived demand.
  Most firms exist to make a profit.

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The Three Decisions That All Firms Must Make

• 1. How much output to supply
• 2. Which production technology to use
• 3. How much of each input to demand
• The bases of decision making
• 1. The market price of output
• 2. The techniques of production that are
  available
• 3. The prices of inputs
• Output price determines potential revenues. The
  techniques available tell me how much of each
  input I need, and input prices tell me how much
  they will cost. Together, the available
  production techniques and the prices of inputs
  determine costs.

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Determining the Optimal Method of Production
optimal method of production The production
method that minimizes cost.
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Time Horizons for Decision Making

• The short run is a period of time in which some
  of the firms factors of production are fixed.
  Typically capital is fixed in the short run.
• Fixed factor An input whose quantity cannot be
  changed in the short run.
• Variable factor An input whose quantity can be
  changed over the time period under
  consideration.
• The long run is the length of time over which all
  of the firms factors of production can be
  varied, but its technology is fixed.
• The very long run is the length of time over
  which all the firms factors of production and
  its technological possibilities can change.

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1. The Short-run Production Process

• Production function A numerical or mathematical
  expression of a relationship between inputs and
  outputs. It shows units of total product as a
  function of units of inputs.
• Total product of labour total quantity of output
  produced with a given quantity of a variable
  input.
• TP or Q f (L)
• where
• TP or Q total product or quantity of output
• L quantity of labor input
• (quantity of capital input is fixed)

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• Marginal product the additional output produced
  with an additional unit of variable input
• MP ?TP / ?L ?Q / ?L
• Average product amount of output per unit of
  variable input. The productivity of an individual
  worker
• AP TP / L or Q / L

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C
110
90
B
Output, q, Units per day
56
A
11
6
4
L, Workers per day
a
MP
L
20
,
AP
b
15
Average product, APL
Marginal product, MPL
c
11
6
4
L, Workers per day
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Between zero and b, MP curve lies above AP curve,
causing AP curve to increase. Below b, MP curve
is below AP curve, causing AP curve to
decrease. Therefore, MP curve must intersect AP
curve at maximum point of AP curve.
TP increases rapidly up to level of labor input A
then increases at a slower rate as labor input
increases. TP curve becomes flatter and flatter
until it reaches maximum output level at C. Curve
implies that marginal product of labor first
increases rapidly then decreases, eventually
becoming zero or less.
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• Increasing marginal returns region where MP
  curve is positive and increasing
• Law of diminishing returns region where marginal
  product curve is positive but decreasing
• Negative marginal returns region where product
  curve is negative so that TP is decreasing
• Law of Diminishing Returns
• Occurs because capital input and technologies are
  held constant
• Additional output generated by additional units
  of variable input (MP)
• Production becomes less constrained

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• Elasticity of production
• The Relationship between Marginal and Average
  Product

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2. Long-run decisions

• In the long run, all inputs are variable.
• Relationship between a flow of inputs and the
  resulting flow of output where all inputs are
  variable
• Q f (L, K)
• where
• Q quantity of output
• L quantity of labor input (variable)
• K quantity of capital input (variable)
• both inputs are variable

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Technical versus Economic Efficiency

• Technical efficiency Obtaining the greatest
  possible production of goods and services from
  available resources. In other words, resources
  are not wasted in the production process.
• Technical efficiency is not enough for firms to
  maximize profits. The firm must choose among the
  technically efficient options to produce a given
  level of output at the lowest cost Economic
  efficiency

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Profit Maximization and Cost Minimization

• For any level of output, maximizing profits
  requires firms to choose their inputs to minimize
  total costs.
• A firm is not minimizing costs if it is possible
  to substitute one factor for another to keep
  output constant while reducing total cost
• ? The firm should substitute one factor for
  another factor as long as the marginal product of
  one factor per dollar spent on it is greater than
  the marginal product of the other factor per
  dollar spent on it.

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• Labor-intensive method process that uses large
  amounts of labor relative to other inputs
• Capital-intensive method process that uses large
  amounts of capital equipment relative to other
  inputs
• Input substitution degree to which one input can
  be substituted for another
• Can occur in small-scale or large-scale business
• Some processes may not be conducive to
  substitution
• Issue is whether the same quality output is being
  produced with input substitution
• Factors influencing input substitution
• Technology
• Prices of inputs
• Incentives facing a given producer

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• Isoquant A graph that shows all the combinations
  of capital and labor that can be used to produce
  a given amount of output.

K
Input Labour Labour Labour Labour Labour
Capital 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120
5
3
Q75
1
2
L
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• Properties of Isoquants
• The farther an isoquant is from the origin, the
  greater the level of output.
• Isoquants do not cross.
• Isoquants slope downward
• Marginal rate of technical substitution (MRTS)
  The slope of an isoquant, or the rate at which a
  firm is able to substitute one input for another
  while keeping the level of output constant.

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Substitution Among Inputs

K
a
16
b
10
3
c
1
7
d
2
1
5
e
1
4
1
0
1
2
3
4
5
6
7
8
9
10
L
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Substitutability of Inputs
Isoquants When Inputs Are Perfect Substitutes
Fixed-Proportions Production Function
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Holding the amount of capital fixed at a
particular level (say 3), we can see that each
additional unit of labor generates less and less
additional output.
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• Isocost line A graph that shows all the
  combinations of capital and labor available for a
  given total cost.
• Slope of isocost line
• Movements of the isocost line
• Change in the budget constraint
• The price ratio of the two inputs changes

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Finding The Least-cost Technology with Isoquants
and Isocosts
The firm will choose the combination of inputs
that is least costly. The least costly way to
produce any given level of output is indicated by
the point of tangency between an isocost line
(TC) and the isoquant (Q) corresponding to that
level of output.
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Finding The Least-cost Technology with Isoquants
and Isocosts

• At the point where a line is just tangent to a
  curve, the two have the same slope. At each point
  of tangency, the following must be true

Thus,
Dividing both sides by PL and multiplying both
sides by MPK, we get
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Example

• Suppose the marginal product of capital is 40
  units of output and the price of one unit of
  capital is 10. The marginal product of labor is
  20 units of output and the price of one unit of
  labor is 2.
• In this case, the firm can reduce the cost of
  producing its current level of output by using
  more labor and less capital.

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How does output respond to increases in all
inputs together?

• Increasing returns to scale output increases
  more than in proportion to inputs as the scale of
  a firms production increases.
• Constant returns to scale output increases in
  proportion to inputs as the scale of a firms
  production increases.
• Decreasing returns to scale output increases
  less than in proportion to inputs as the scale of
  a firms production increases.

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3. The Very Long Run Changes In Technology

• In the very long run, there are changes in the
  available techniques and resources for firms.
  Such changes shifts the long-run cost curves.
• Technological change refers to all changes in
  the available techniques of production.
• Economists use the notion of productivity to
  measure the extent of technological change.
• Faced with increases in the price of an input,
  firms may either substitute away (LR) or innovate
  away (VLR) from the input.
• These two options can involve different actions
  and can have different implications for
  productivity.

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Microeconomics Lecture 6
Mónika Kis-Orloczki Assistant lecturer orloczki.mo
nika_at_uni-miskolc.hu
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• Explicit costs payment to an individual that is
  recorded in an accounting system.
• Implicit costs value of using a resource that is
  not explicitly paid out, is often difficult to
  measure, and partly not recorded in an accounting
  system.
• Economic depreciation measured as the change in
  the market value of capital over a given period.
• Normal profit is the return to entrepreneurship.
  A rate of return on capital that is just
  sufficient to keep owners and investors
  satisfied. For relatively risk-free firms, it
  should be nearly the same as the interest rate on
  risk-free government bonds. It is part of a
  firms economic cost because it is the cost of
  the entrepreneur not running another firm. It is
  the minimum level of profit required to keep the
  factors of production in their current use in the
  long run.

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• Total revenue The amount received from the sale
  of the product (Q x P).
• Total cost (total economic cost) The total of
  explicit (out-of-pocket) and implicit costs.
• Accounting profit difference between total
  revenue and accountable costs (explicit costs
  accountable implicit costs (for example
  depreciation).
• Economic profit difference between total revenue
  and total cost, both implicit and explicit.
• ? TR - TC

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Implicit Costs versus Explicit Costs, an example
Pizza dough, tomato sauce, and other ingredients 20,000
Wages 48,000
Interest payments on loan to buy pizza ovens 10,000
Electricity 6,000
Lease payment for store 24,000
Foregone salary 30,000
Foregone interest 3,000
Economic depreciation 10,000
Total 151,000
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Costs and revenues of the firm
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Short-Run Costs and Output Decisions

• Fixed cost (FC) Any cost that does not depend on
  the firms level of output. These costs are
  incurred even if the firm is producing nothing.
  There are no fixed costs in the long run.
• Variable cost (VC) A cost that depends on the
  level of production chosen.
• Total cost (TC) Fixed costs plus variable costs.

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• Average fixed cost (AFC) Total fixed cost divided
  by the number of units of output a per-unit
  measure of fixed costs.

Average variable cost (AVC) Total variable cost
divided by the number of units of output.
Average total cost (AC) Total cost divided by the
number of units of output.
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• Marginal cost (MC) The increase in total cost
  that results from producing one more unit of
  output. Marginal costs reflect changes in
  variable costs.

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Because fixed costs do not vary with output, the
only part of TC that changes is the variable
cost.
The marginal cost (MC), average total cost (AC),
and average variable cost (AVC) curves are all U
shaped, and the marginal cost curve intersects
the average variable cost and average total cost
curves at their minimum points.
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Relation of MP - MC and AP - AVC
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Summary
Total fixed costs Costs that do not depend on the quantity of output produced. These must be paid even if output is zero. TFC
Total variable costs Costs that vary with the level of output. TVC
Total cost The total economic cost of all the inputs used by a firm in production. TC TFC TVC
Average fixed costs Fixed costs per unit of output. AFC TFC/Q
Average variable costs Variable costs per unit of output. AVC TVC/Q
Average total costs Total costs per unit of output. ATC TC/Q ATC AFC AVC
Marginal costs The increase in total cost that results from producing one additional unit of output. MC DTC/DQ
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Long-run costs

• Since all inputs are variable, all costs are
  variable in the long run.
• Long-run average cost (LRAC) measures the
  long-run cost of producing one unit of output

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The Relationship between Short-Run Average Cost
and Long-Run Average Cost
LRAC shows minimum average cost of producing any
level of output when all inputs are variable
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Return to scale
what happens to LRAC as a firm increases its
plant size