Economics Questionnaire

Mid?Term Examination
Friday, October 8, 2021
Name:
Instructions: Answer all questions in the space provided. Show your work for each one.
30 pts
1. Consider the production function of the form
= 0013 2 2
0000026 3 3 ,
where , , and denote, respectively, annual output produced, annual capital input
used, and annual labour input used. Suppose, initially, that = 10.
10 pts
(a) What is the equation of the total product of labour curve?
0.5 pts
(b) What is the equation of the average product of labour curve? At what level of labour
input does this average product reach a maximum? How much output is produced at
that point?
2 pts
(c) Plot your part?(b) equation of the average product of labour curve in the following
graph after labelling appropriately the two axes.
2.5 pts
10
8
6
4
2
0
0
10
20
30
1
40
50
(d) What is the equation of the marginal product of labour curve? At what level of
labour input does this marginal product equal zero?
1 pt
(e) Plot your part?(d) equation of the marginal product of labour curve in your part?(c)
graph.
1 pt
(f) Describe what would happen to the intercepts and point of intersection of the curves
in your part?(c) graph if the capital input were to double to = 20.
1.5 pts
(g) What returns?to?scale property is exhibited by the given production function (with
varying and )?
1.5 pts
2. Consider a ?rm that hires hours of labour services at a wage of per hour and rents
hours of machine services at a rental rate of per hour in order to produce units of
output in accordance with the production function
=5 +25 .
10 pts
(a) Determine the ?rm?s long?run total, average, and marginal cost functions.
2
3 pts
(b) Suppose that is ?xed at 20 in the short run. Determine the ?rm?s short?run total,
average, and marginal cost functions.
3.5 pts
(c) Suppose that = 3 and = 1. On appropriate, well?labelled graphs, draw the
short?run total cost curve for
= 20 and the short?run average and marginal cost
curves for = 20.
3.5 pts
3. The industry producing and selling wooden pallets is comprised of 100 identical ?rms
each of which has a short?run total cost function given by
= 0 5 2 + 10 + 5 ,
where is output of (standardized) wooden pallets per day.
10 pts
(a) What is the equation of the short?run supply curve for each ?rm?
1.5 pts
(b) What is the equation of the short?run supply curve for the market as a whole?
0.5 pts
3
Suppose the demand for total wooden?pallet production is given by
= 1 100 50 .
(c) What will be the equilibrium in this market? What will each ?rm?s short?run pro?t
be?
2.5 pts
(d) Draw an appropriate graph showing the determination of the part?(c) market
equilibrium and use it to ?nd the associated total consumer and producer surplus.
4.5 pts
(e) Show that the total producer surplus you calculated in part (d) is equal to total
industry short?run pro?t plus total industry short?run ?xed cost.
1 pt
End of Examination
4
6. Firms and Production
Chapter 6 Outline
Challenge: Labor Productivity During Downturns
6.1 The Ownership and Management of Firms
6.2 Production
6.3 Short Run Production: One Variable and One Fixed Input
6.4 Long Run Production: Two Variable Inputs
6.5 Returns to Scale
6.6 Productivity and Technical Change
Challenge Solution
1
Challenge: Labor Productivity During
Downturns
? Background:
? firms produce less output during recessions as demand for
their products falls
? consequently, firms typically lay off workers during
recessions
? Question:
? Why has a measure of labor productivity ? output produced
per worker ? risen for many firms during recessions?
? If we know about a firm?s production process, can we
predict whether output produced per worker will rise or fall
with each additional layoff?
6.1 The Ownership & Management of Firms
(1 of 2)
? A firm is an organization that converts inputs (labor, materials, and capital)
into outputs
? Firm types:
1. Private (for-profit) firms: owned by individuals or other non-
governmental entities trying to make a profit (e.g., Toyota, Walmart);
in almost every country, this sector contributes the most to GDP; in
the U.S., 76% of GDP
2. Public firms: owned by governments or government agencies (e.g.,
Amtrak, public schools); responsible for 11% of U.S. GDP
3. Not-for-profit firms: owned by organizations that are neither
governments nor intended to make a profit, but rather pursue social
or public interest objectives (e.g., Salvation Army, Greenpeace);
responsible for 13% of U.S. GDP
2
6.1 The Ownership & Management of Firms
(2 of 2)
? Legal forms of organization:
1. Sole proprietorship: firms owned by a single individual who is personal
liable for the firm?s debts
? 72% of firms in the U.S., but responsible for 4% of revenue
2. General partnership: businesses jointly owned and controlled by two or
more people who are personally liable for the firm?s debts
? 10% of firms in the U.S., but responsible for 15% of revenue
3. Corporation: firms owned by shareholders in proportion to the number
of shares or amount of stock they hold
? 18% of firms in the U.S., but responsible for 81% of revenue
? corporation owners have limited liability; they are not personally
liable for the firm?s debts even if the firm goes into bankruptcy
6.1 What Owners Want
? We focus on for-profit firms in the private sector in this course
? We assume these firms? owners are driven to maximize profit
? profit is the difference between revenue (R), the money it
makes from selling its product, and cost (C), what it pays for
labor, materials, and other inputs
p = R – C , where R = pq
? To maximize profit, a firm must produce as efficiently as
possible (a necessary condition), where efficient production
means it cannot produce its current level of output with fewer
inputs, given its existing knowledge about technology
3
6.2 Production
? The various ways that a firm can transform inputs into the
maximum amount of output are summarized in the production
function
? assuming labor (L) and capital (K) are the only inputs,
the production function is q ? f (L, K )
? A firm can more easily adjust its inputs in the long run than in
the short run
? the short run is a short enough period of time that at least
one factor of production cannot be varied (the fixed input)
? the long run is a long enough period of time that all inputs
can be varied
6.3 Short Run Production: One Variable and
One Fixed Input
? In the short run (SR), we assume that capital is a fixed input and labor is a
variable input
? SR Production Function:
q ? f (L, K )
? q is output, but also called total product; the short run production
function is also called the total product of labor
? the marginal product of labor is the additional output produced by an
additional (infinitesimal) unit of labor, holding all other factors constant:
MPL ?
?q ?f (L, K )
?
?L
?L
? the average product of labor is the ratio of output to the amount of labor
employed:
APL ?
q
L
4
6.3 SR Production with Variable Labor
6.3 Short Run Production with Variable Input:
Labor
? Interpretations of the graphs:
? total product of labor curve shows output rises with labor
until L = 20
? APL and MPL both first rise and then fall as L increases.
? initial increases due to specialization of activities; more
workers are a good thing
? eventual declines result when workers begin to get in
each other?s way as they struggle with having a fixed
capital stock
? MPL curve first pulls APL curve up and then pulls it down,
thus, MPL intersects APL at its maximum
5
6.3 Law of Diminishing Marginal Returns
? The law holds that, if a firm keeps increasing an input, holding
all other inputs and technology constant, the corresponding
increases in output will eventually becomes smaller
? occurs at L = 10 in previous graph
? Mathematically:
?MPL / ?L ? ?(?q / ?L ) / ?L ?
? 2q / ?L2 ? ? 2f (L, K ) / ?L2 ? 0
? Note that when MPL begins to fall, TPL is still increasing
? Law of diminishing marginal returns is an empirical regularity
more than a law
? application: Malthus and the Green Revolution
6.4 Long Run Production: Two Variable Inputs
? In the long run (LR), we assume that both labor and capital are
variable inputs
? The freedom to vary both inputs provides firms with many
choices of how to produce (labor-intensive versus capital-
intensive methods)
? Consider a Cobb-Douglas production function where A, a, and b
are (positive) constants:
q ? ALaK b
? Hsieh (1995) estimated such a production function (per day) for
a U.S. electronics firm:
q ? L0.5K 0.5
6
6.4 LR Production Isoquants (1 of 4)
? A production isoquant graphically summarizes the
(technologically) efficient combinations of inputs (labor and
capital) that will produce a specific level of output
6.4 Long-Run Production Isoquants
? Properties of isoquants:
1. the farther an isoquant is from the origin, the greater the
level of output
2. isoquants do not cross
3. isoquants slope downward
4. isoquants must be thin
? The shape of isoquants (curvature) indicates how readily a firm
can substitute between inputs in the production process
7
6.4 LR Production Isoquants (2 of 4)
? Types of isoquants:
1. Perfect substitutes?e.g., q = x + y
6.4 LR Production Isoquants (3 of 4)
? Types of isoquants:
2. Fixed-proportions (or Leontief)?e.g., q = min(g, b)
8
6.4 LR Production Isoquants (4 of 4)
? Types of isoquants:
3. (Strictly) Convex?e.g., q ? L0.5K 0.5
6.4 Semiconductor Integrated Circuit Isoquant
? The possible use of different capital-intensive technologies
causes isoquants to curve away from the origin
9
6.4 Substituting Inputs (1 of 2)
? The slope of an isoquant shows the ability of a firm to replace one input
with another (holding output constant)
? Marginal rate of technical substitution (MRTS) is the slope of an isoquant at
a single point
change in capital ?K dK
?
?
MRTS ?
?L dL
change in labor
? MRTS tells us how many units of K the firm can replace with an additional
unit of L (with q held constant)
0?
dq ?f
dK
?f dK
?
?
? MPL ? MPK
dL ?L ?K dL
dL
? MPL = marginal product of labor; MPK = marginal product of
capital
MPL
dK
? Thus, MRTS ?
??
MPK
dL
6.4 Substituting Inputs (2 of 2)
? MRTS diminishes (in absolute value) along a convex isoquant
? the more L the firm has, the harder it is to replace K with L
10
6.4 The Elasticity of Substitution
? Elasticity of substitution
d(K / L )
measures the ease with
%? ( K / L )
MRTS d MRTS
which a firm can
??
? K /L ?
?
substitute capital for
%? MRTS d MRTS
K /L
d(K / L )
labor
MRTS
? Can also be expressed as a logarithmic derivative:
??
dln(K / L )
dln MRTS
d
? Example: CES production function, q ? (aL? ? bK ? ) ?
??
?
1
?
q ? (L ? K ) ? MRTS ? ?
?
?L
L???1 L?? ? K ?
K ??1
??
? K?
?
?
1 ?1
?
1 ?1
?
???
?K ?
? ?? ?
?L?
??
??
1
? ? ? ? KL ? ? ??1 ? ? ?? KL ? ? ? 1??
(constant elasticity)
?
?
6.5 Returns to Scale (1 of 2)
? How much does output change if a firm increases all its inputs
proportionately?
? Production function exhibits constant returns to scale when a
percentage increase in inputs is followed by the same
percentage increase in output
? doubling inputs, doubles output ? f (2L,2K ) ? 2f (L, K )
? More generally, a production function is homogeneous of
degree g if f ( xL, xK ) ? x g f (L, K ) , where x is a positive
constant
11
6.5 Returns to Scale (2 of 2)
? Production function exhibits increasing returns to scale when a
percentage increase in inputs is followed by a larger percentage
increase in output
? f (2L,2K ) ? 2f (L, K )
? occurs with greater specialization of L and K; one large plant more
productive than two small plants
? Production function exhibits decreasing returns to scale when a
percentage increase in inputs is followed by a smaller percentage
increase in output
? f (2L,2K ) ? 2f (L, K )
? occurs because of difficulty organizing and coordinating activities
as firm size increases
6.5 Cobb-Douglas Estimates of Returns to
Scale in Various Industries (1 of 2)
Decreasing Returns to Scale
Labor, a
Capital, b
Scale, g = a + b
U.S. tobacco productsa
Blank
0.18
0.33
0.51
Bangladesh glassb
0.27
0.45
0.72
Danish food and beveragesc
0.69
0.18
0.87
Chinese high technologyd
0.28
0.66
0.94
Constant Returns to Scale
Blank
Labor, a
Capital, b
Scale, g = a + b
Japanese synthetic rubbere
0.50
0.50
1.00
Japanese beere
0.60
0.40
1.00
New Zealand wholesale tradef
0.60
0.42
1.02
Danish publishing and printing c
0.89
0.14
1.03
12
6.5 Cobb-Douglas Estimates of Returns to
Scale in Various Industries (2 of 2)
Increasing Returns to Scale
Blank
Labor, a
Capital, b
Scale, g = a + b
New Zealand miningf
0.69
0.45
1.14
Bangladesh leather productsb
0.86
0.27
1.13
Bangladesh fabricated metalb
0.98
0.28
1.26
aHsieh
(1995); bHossain, Basak, and Majumber (2012); cFox and Smeets (2011); dZhang, Delgado, and
Kumbhakar (2012); eFlath (2011); fDevine, Doan, and Stevens (2012)
6.5 Japanese Beer Firm: Constant Returns to
Scale
13
6.5 U.S. Tobacco Firm: Decreasing Returns to
Scale
6.5 Bangladesh Fabricated Metal Firm:
Increasing Returns to Scale
14
6.5 Varying Returns to Scale
6.6 Productivity and Technical Change (1 of 2)
? Even if all firms are producing efficiently (an assumption we make in this
chapter), firms may not be equally productive
? Relative productivity of a firm is the firm?s output as a percentage of the
output that the most productive firm in the industry could have produced
with the same inputs
? relative productivity depends upon:
1. management skill/organization
2. technical innovation
3. union-mandated work rules
4. workplace discrimination
5. government regulations or other industry restrictions
6. degree of competition in the market
15
6.6 Productivity and Technical Change (2 of 2)
? An advance in firm knowledge that allows more output to be
produced with the same level of inputs is called technical
progress
? example: robots used in strawberry picking
? neutral technical change involves more output using the
same ratio of inputs
? non-neutral technical change involves altering the
proportion in which inputs are used to produce more
output
? Organizational change may also alter the production function
and increase output
? example: mass production of Ford automobiles
Challenge Solution
? Why has a measure of labor productivity ? output produced per
worker ? risen for many firms during recessions?
? A plant laying off workers has two effects on the average
productivity of labor, APL :
? when firms hold capital constant, layoffs have the positive effect
of freeing up machines to be used by the remaining workers
? if layoffs mean that the remaining workers might have to
?multitask,? then the layoffs can have a negative effect
? for some production functions, Cobb-Douglas with a < 1, for
example, layoffs always result in increased labor productivity:
?
?
a ?1 b
?APL ? AL K
?
? (a ? 1)ALa ?2K b ? 0
?L
?L
16
7. Costs
Chapter 7 Outline
Challenge: Technology Choice at Home Versus Abroad
7.1 Measuring Costs
7.2 Short-Run Costs
7.3 Long-Run Costs
7.4 Lower Costs in the Long Run
7.5 Cost of Producing Multiple Goods
Challenge Solution
1
Challenge: Technology Choice at Home Versus
Abroad
? Background:
? a manager of a semiconductor manufacturing firm, who can choose
from many different production technologies, must determine whether
the firm should use the same technology in its foreign plant that it uses
in its domestic plant
? the semiconductor manufacturer can produce a chip using sophisticated
equipment and relatively few workers or many workers and less
complex equipment
? in the United States, firms use a relatively capital intensive technology,
because doing so minimizes their cost of producing a given level of
output
? Question:
? Will that same technology be cost minimizing if they move their
production abroad?
Chapter 7: Costs
? How does a firm determine how to produce a certain amount
of output efficiently?
? First, determine which production processes are technologically
efficient
? produce the desired level of output with the least inputs
? Second, select the technologically efficient production process
that is also cost efficient
? minimize the cost of producing a specified amount of
output
? Because any profit-maximizing firm minimizes its cost of
production, we will spend this chapter examining firms? costs
2
7.1 Measuring Costs (1 of 3)
? Explicit costs are direct, out-of-pocket payments for inputs such
as labor, capital, energy, and materials
? Implicit costs reflect a forgone opportunity
? The opportunity cost of a resource is the value of the best
alternative use of that resource; across all resources utilized, it
is the sum of implicit and explicit costs
? ?there?s no such thing as a free lunch? refers to the
opportunity cost of your time, an often overlooked
resource
? Although many businesspeople consider only explicit costs,
economists also take into account implicit costs
? a fallacy is to ignore the opportunity cost of time
7.1 Measuring Costs (2 of 3)
? Capital is a durable good, which means it is a product that is
usable for many years
? Difficult to measure the cost of a durable good
? initial purchase cost must be allocated over some time
period (for accounting purposes)
? value of capital may change over time; capital depreciation
implies opportunity costs fall over time
? avoid cost measurement problems if capital is rented
? Opportunity costs are not always easily observed, but should
always be taken into account in production decisions
3
7.1 Measuring Costs (3 of 3)
? Sunk costs, past expenditures that cannot be recovered, are
easily observed, but are never relevant in production decisions
? sunk costs are not included in opportunity costs
? example: grocery store checkout line
? time already spent waiting in a slow line should not
influence your decision to switch to a different checkout
line or stay put
? nonetheless, sunk cost should be deducted from income
before paying taxes
7.2 Short-Run Costs (1 of 2)
? Recall that the short run is a period of time in which some
inputs can be varied, while other inputs are fixed
? Short run cost measures all assume labor is variable and capital
is fixed
? fixed cost (F): a cost that doesn?t vary with the level of
output (e.g. expenditures on land or production facilities)
? variable cost (VC): production expense that changes with
the level of output produced (e.g. labor cost, materials cost)
? total cost (C): the sum of variable and fixed costs
C ? VC ? F
4
7.2 Short-Run Cost Curves (1 of 2)
7.2 Short-Run Costs (2 of 2)
? To decide how much to produce, a firm uses measures of marginal
and average costs:
? marginal cost (MC): the amount by which a firm?s cost changes if
it produces one more unit of output
MC ?
dC ( q )
dq
? average fixed cost (AFC): fixed cost divided by output produced
AFC ? F / q
? average variable cost (AVC): variable cost divided by output
AVC ? VC / q
produced
? average cost (AC): total cost divided by output produced
AC ?
C VC F
?
? ? AVC ? AFC
q
q
q
5
7.2 Short-Run Cost Curves (2 of 2)
7.2 Production Functions and the Shape of
Cost Curves (1 of 3)
? The SR production function, q ? f (L, K ), determines the
shape of a firm?s cost curves
? we can write q ? g ? L ? because capital is fixed in the SR
? amount of L needed to produce q is L ? g ?1 ? q ?
? If the wage paid to labor is w and labor is the only variable
input, then variable cost is VC = wL
? VC is a function of output: VC ? q ? ? wL ? wg ?1 ? q ?
? Total cost is also a function of output:
C ? q ? ? VC ? q ? ? F ? wg ?1 ? q ? ? F
6
7.2 Production Functions and the Shape of
Cost Curves (2 of 3)
? Shape of the MC curve:
MC ?
dVC (q )
dL
?w
dq
dq
? MC moves in the
opposite direction of
MPL :
w
MC ?
MPL
7.2 Production Functions and the Shape of
Cost Curves (3 of 3)
Shape of the AC curve
? Two components:
? spreading fixed cost over
output,
AFC ? F / q
? diminishing marginal returns to
labor in the AVC curve,
AVC ?
w
APL
? AC moves in the opposite
direction of APL since
AVC ?
VC wL
?
q
q
7
7.2 Short-Run Cost Curves: Japanese Beer
Manufacturer
? Production function with K ? 100 : q ? 1.52L0.6 1000.4
? r = $8 and w = $24
? Total fixed cost:
$800
? Total variable cost:
VC ? 0.55q1.67
? Average fixed cost:
AFC ? 800 / q
? Average var. cost:
AVC ? 0.55q 0.67
? Marginal cost:
MC ? 0.92q 0.67
7.2 Effects of Taxes on Costs
? A $10 per unit tax increases firm costs, shifting up both AC and
MC curves
8
7.2 Short-Run Cost Summary
? Costs of inputs that can?t be adjusted are fixed and costs of
inputs that can be adjusted are variable
? Shapes of SR cost curves (VC , MC , and AC) are determined by
the shape (or functional form) of the production function
? When a variable input has diminishing marginal returns, VC
and C become steeper as output increases
? thus, the AC, AVC, and MC curves rise with output
? When MC lies below AVC and AC, it pulls both down; when MC
lies above AVC and AC, it pulls both up
? MC intersects AVC and AC at their minimum points
7.3 Long-Run Costs
? Recall that the long run is a period of time in which all inputs
can be varied
? in the LR, firms can change plant size, build new equipment,
and adjust inputs that were fixed in the SR
? we assume that LR fixed costs are zero (F = 0)
? In the LR, the firm concentrates on C , AC , and MC when it
plans how much labor (L) and capital (K) to employ in its
production process
9
7.3 Long-Run Costs and Input Choice
? Isocost line summarizes all combinations of inputs that require
the same total expenditure
? if the firm hires L hours of labor at a wage of w per hour,
total labor cost is wL
? if the firm rents K hours of machine services at a rental rate
of r per hour, total capital cost is rK
? cost is fixed at a particular level along a given isocost line:
C ? wL ? rK
? Rewrite the isocost equation for easier graphing:
K?
C w
? L
r r
7.3 Isocost Lines
? Three properties of isocost lines:
1. the firm?s costs, C , and input prices determine where the
isocost line hits the axes
2. isocost lines farther from the origin have higher costs than
those closer to the origin
3. the slope of each isocost is the same and is given by the
relative prices of the inputs
dK
w
??
dL
r
10
7.3 Cost Minimization
? This firm is seeking the least cost way of producing 100 units of
output
7.3 Minimizing Cost
? Three equivalent approaches to minimizing cost:
1. Lowest-isocost rule: Pick the bundle of inputs where the lowest
isocost line touches the isoquant associated with the desired
level of output
2. Tangency rule: Pick the bundle of inputs where the desired
isoquant is tangent to the budget line
MRTS ? ?
w
r
3. Last-dollar rule: Pick the bundle of inputs where the last dollar
spent on one input yields as much additional output as the last
dollar spent on any other input
MPL w
MPL MPK
?
?
is equivalent to
MPK
r
w
r
11
7.3 Using Calculus to Minimize Cost
? Minimizing cost subject to a production constraint yields the
Lagrangian and its first-order conditions:
=
? Dividing the 1st FOC by the 2nd reveals the tangency rule:
7.3 Output Maximization with Calculus
? The ?dual? problem to cost minimization is output maximization
? Maximizing output subject to a cost constraint yields the Lagrangian
and its first-order conditions:
? Dividing the 1st FOC by the 2nd reveals the tangency rule:
12
7.3 Output Maximization
? This firm is seeking the maximum-output way of spending
$2 000
7.3 Factor Price Changes
? Originally, w = $24 and
r = $8 ; when w falls to $8,
the isocost becomes
flatter and the firm
substitutes toward labor,
which is now relatively
cheaper
? firm can now produce
same q = 100 more
cheaply
13
7.3 How LR Cost Varies with Output (1 of 2)
? As a firm increases output,
the expansion path traces
out the cost-minimizing
combinations of inputs
employed
7.3 How LR Cost Varies with Output (2 of 2)
? The expansion path enables
construction of a LR cost
curve that relates output to
the least cost way of
producing each level of
output
14
7.3 The Shape of LR Cost Curves
? The LR AC curve may be U-shaped
? not due to downward-sloping AFC or diminishing marginal returns,
both of which are SR phenomena, as it is for SR AC
? shape is due to returns to scale (of the production function)
? A cost function exhibits economies of scale if the average cost of
production falls as output expands (due to IRS)
? doubling inputs more than doubles output, so AC falls with higher
output
? A cost function exhibits diseconomies of scale if the average cost of
production rises as output expands (due to DRS)
? doubling inputs less than doubles output, so AC rises with higher
output
7.4 Lower Costs in the Long Run
? Because a firm cannot vary K in the SR but it can in the LR,
SR cost is as least as high as LR cost
? ? and even higher if the ?wrong? level of K is used in
the SR
15
7.4 SR and LR Cost Curves with Constant
Returns to Scale in Long Run
7.4 Average Cost of Printed Pages
? Average cost function with the option to use inkjet printer (for
low outputs) or laser printer (for high outputs)
16
7.4 SR and LR Expansion Paths
? Firms have more flexibility in the LR
? expanding output is cheaper in LR than in SR because of
ability to move away from fixed capital choice
7.4 Learning by Doing
17
7.5 Cost of Producing Multiple Goods (1 of 2)
? If a firm produces multiple goods, the cost of one good may depend
on the output level of the other
? outputs are linked if a single input is used to produce both
? There are economies of scope if it is cheaper to produce goods
jointly than separately
? measure:
SC ?
C(q1,0) ? C (0, q2 ) ? C (q1, q2 )
C (q1, q2 )
? C (q1,0) = cost of producing q1 units of good 1 by itself
? C (0, q2 ) = cost of producing q2 units of good 2 by itself
? C(q1, q2 ) = cost of producing both goods together
? SC > 0 implies it is cheaper to produce the goods jointly
7.5 Cost of Producing Multiple Goods (2 of 2)
? Production possibilities frontier (PPF) bows away from the
origin if there are economies of scope
18
Challenge Solution
? A semiconductor manufacturer can use one of three manufacturing
technologies: water-handling stepper, stepper, or aligner
? The U.S. isocost line, with relatively higher labor costs, is C 1;
use water-handling stepper
technology in the U.S.
? If the foreign isocost line is C 2 ,
then same manufacturing technology
as in the U.S.; if the isocost line is C 3 ,
then the stepper technology; if even
flatter isocost lines, then the aligner
technology
19
8. Competitive Firms
and Markets
Chapter 8 Outline
Challenge: The Rising Cost of Keeping on Truckin?
8.1 Perfect Competition
8.2 Profit Maximization
8.3 Competition in the Short Run
8.4 Competition in the Long Run
Challenge Solution
1
Challenge: The Rising Cost of Keeping on
Truckin?
? Background:
? in recent years, federal and state fees have increased substantially
and truckers have had to adhere to many new regulations
? the many additional fees and costly regulations that a trucker or
firm must pay to operate are largely lump-sum costs, which are
not related to the number of miles driven
? Questions:
? What effect do these new fixed costs have on the trucking
industry?s market price and quantity?
? Are individual firms providing more or fewer trucking services?
? Does the number of firms in the market rise or fall?
8.1 Perfect Competition (1 of 2)
? Market structure provides information about how firms operating in
the market will behave; it is a function of:
? the number of firms in the market
? the ease with which firms can enter and leave the market
? the ability of firms to differentiate their products from those of
their rivals
? Perfect competition is one type of market structure in which
buyers and sellers choose to be price takers
? a firm is unable to sell its output at a price greater than market
price; a consumer is unable to purchase at a price less than the
market price
? this is what most people mean when they talk about ?competitive
firms?
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8.1 Perfect Competition (2 of 2)
? Perfect competition is a market structure in which:
? there is a large number of firms
? firms sell identical products
? buyers and sellers have full information about prices charged by all
firms
? transaction costs, the expenses of finding a trading partner and
completing the trade above and beyond the relevant price, are low
? firms can freely enter and exit the market
? Examples:
? agricultural/commodities markets like wheat and soybeans
? building and construction
8.1 Perfect Competition: Assumptions
1. Large number of firms
? no single firm?s actions can raise or lower the market price
? individual firm?s demand curve is a horizontal line at the market price
2. Identical (homogeneous) products
? if all firms are selling identical products, it is difficult for any firm to raise
its price above the going market price charged by all firms
3. Full information
? consumer knowledge of all firms? prices makes it easy for consumers to
buy elsewhere if any one firm were to raise its price above market price
4. Negligible transaction costs
? buyers and sellers waste little time and/or money finding each other
5. Free entry and exit
? leads to large number of firms and promotes price taking
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8.1 Competitive Firm?s Demand (1 of 2)
? Are perfectly competitive firms? demand curves really flat?
? A firm?s residual demand curve, D r ( p ) , is the portion of the
market demand that is not met by other sellers at any given
price:
D r ( p ) ? D( p ) ? S o ( p )
? D( p ) ? market demand
o
? S ( p ) ? amount supplied by other firms
? If not perfectly horizontal, the residual demand curve of an
individual firm is much flatter than market demand
8.1 Competitive Firm?s Demand (2 of 2)
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8.2 Profit Maximization
? Profit maximization in this course always refers to economic profit,
which is revenue minus opportunity cost, p = R – C
? differs from business (or accounting) profit, which only subtracts
off explicit costs from revenues
? common fallacy: it pays to run your own firm if you are making a
business profit
? Maximizing profit involves two important questions:
1. Output decision: If the firm produces, what output level (q*)
maximizes its profit or minimizes its loss?
2. Shutdown decision: Is it more profitable to produce q* or to
shut down and produce no output?
8.2 Profit Maximization: Output Rules (1 of 3)
? A firm can use one of three equivalent output rules to choose
how much output to produce:
1. a firm sets its output where its profit is maximized
2. a firm sets its output where its marginal profit is zero
3. a firm sets its output where its marginal revenue equals its
marginal cost
? Output rules 1 and 2 are easily depicted in a single graph
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8.2 Profit Maximization: Output Rules (2 of 3)
? Output rules 1 (maximum profit) and 2 (zero marginal profit)
both point to q*
8.2 Profit Maximization: Output Rules (3 of 3)
? Output rule 3 (marginal revenue = marginal cost) is less obvious
on the previous graph
? Mathematically, if we take the derivative of ? (q ) ? R(q ) ? C(q )
with respect to output and set it equal to zero (output rule #2),
we find:
d?(q *) dR (q *) dC (q *)
?
?
? MR (q *) ? MC(q *) ? 0
dq
dq
dq
? MR(q *) ? MC(q *)
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8.2 Profit Maximization: Shutdown Rule
? A firm shuts down only if it can reduce its loss by doing so
? shutting down means that the firm stops producing (and
thus stops receiving revenue) and stops paying avoidable
costs
? only fixed costs are unavoidable because they are (typically)
sunk costs
? firms compare revenue to variable cost when deciding
whether to stop operating
? shutting down may be temporary
? The shutdown decision is a short run decision because in the
long run all costs are avoidable
8.3 Competition in the Short Run (1 of 5)
? Given the foregoing general description of firms? profit
maximization decisions, how do perfectly competitive firms
maximize profits in the SR?
? Because it faces a horizontal demand curve, a competitive
firm can sell as many units of output as it wants at the market
price, p
? Revenue is R (q ) ? pq, thus, q * satisfies
d?(q *) d ? pq * ? dC(q *)
?
?
? p ? MC(q *) ? 0
dq
dq
dq
? marginal cost equals the market price
? MC = p is equivalent to MC = MR because MR = p in perfect
competition
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8.3 Competition in the Short Run (2 of 5)
? Profit is the rectangle q * ? p ? AC ? q * ? ?
8.3 Competition in the Short Run (3 of 5)
? Maximum profit can also be expressed on the profit function
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8.3 Competition in the Short Run (4 of 5)
? The introduction of
specific tax t
? increases marginal
cost by t
? increases average
cost by t
? firm reduces output
from q1 to q2
? reduces firm?s
profits from A+B
to A
8.3 Competition in the Short Run (5 of 5)
? The graph on the preceding slide does not allow us to address
the firm?s shutdown decision
? Recall that firms compare revenues to variable costs to
determine shutdown:
VC