Prices

1. Prices Lesson 10: Production

2. Economic Reasoning Principle # 3: People respond to incentives in predictable ways. Choices are influenced by incentives, the rewards that encourage and the punishments that discourage actions. When incentives change, behavior changes in predictable ways.

3. Production Central to our analysis is production, the process by which inputs are combined, transformed, and turned into outputs.

4. The Role of the Firm • The firm is an economic institution that transforms factors of production into consumer goods – it: • Organizes factors of production. • Produces goods and services. • Sells produced goods and services.

5. The Role of the Firm • A virtualfirm only organizes production. • Virtual firms subcontract out all work. • More and more of the organizational structure of business is being separated from the business. Not in the book but something to think about!

6. The Structure of Production • What is the ERE? • Evenly Rotating Economy • Fictitious construct where the future is certain • All economic activities repeat themselves indefinitely • No price changes whatever – i.e., there is perfect price stability • Equilibrium, all prices are final prices

7. The Structure of Production • Rate of originary interest (the discount of future goods against present goods) is the same for all commodities • All the factors of production are employed in such a way that they provide the highest valued service possible. • Final end state toward which the market would tend if all disturbing influences were held at bay • No uncertainty in the ERE

8. The Structure of Production • The unchanging evenly rotating economy leaves "no room for the entrepreneurial function." • Future prices will be the same as current prices and the entrepreneur has no reason to combine factors of production anew based on the anticipation of future prices • No future price as different from the current price • Therefore, no entrepreneur

9. The Structure of Production • ERE allows the conceptual distinction between profit and interest • Because there is certainty, there can be no profits or losses in the ERE. • However, there is still time preference, and hence interest. • Therefore, no entrepreneur

10. "The same market transactions are repeated again and again. The goods of the higher orders pass in the same quantities through the same stages of processing until ultimately the produced consumers' goods come into the hands of the consumers and are consumed. No changes in the market data occur. Today does not differ from yesterday and tomorrow will not differ from today...Therefore prices--commonly called static or equilibrium prices--remain constant too.“

11. Remember the elements of Production? • L=labor • N=land (natural resources) • K=capital • Yet there are no true K goods, because they can all be traced to N and L • All productive factors earn a (gross) rent or “hire price” per unit time in accordance with their marginal productivity, whether the factor is labor, a piece of land, or a machine.

12. Land and Labor • Born with Labor • Homestead “raw” land • Purchase thereafter • Government’s job is to enforce these property definitions and rights.

13. The Production Process • Production technology refers to the quantitative relationship between inputs and outputs. • A labor-intensive technology relies heavily on human labor instead of capital. • A capital-intensive technology relies heavily on capital instead of human labor.

14. Capitalists • Remember inputs, costs of production, have NO bearing on the price of a good • Capitalists offer to pay workers (and land owners) immediately for services that will not yield finished consumer goods until the future. • Capitalists are exchanging a present good (money) for a future good (the marginal product, in terms of the final consumer good, of the factor in question) • The excess of the capitalists’ income from consumers, over the sum of payments they make to the owners of original factors, is due to interest (i.e., time preference), and not to any bargaining power or other “contribution” of the capitalists

15. Specific vs. Nonspecific Factors • Indispensable inputs to a productive process • A set combination of specific and nonspecific factors • A purely nonspecific factor would be one equally suited to the production of all possible products. It is clear that not all factors could be purely nonspecific, for in that case all factors would be purely interchangeable, i.e., there would be need for only one factor. • L, the scarcest and most nonspecific factor

16. The Production Function • Pricing land, labor, capital • Factors prices are based on costs of production and price of final goods. • Derived Demand • Production Function • Max output with combination of inputs • These tables are determined by engineers, but need to be understood by entrepreneurs. • Law of Variable Proportions • Ceteris paribus all but 1 within limits. In real world, probably in 100s if not 1000s.

17. Factors of Production • Law of Diminishing Marginal Returns • Production Function (optimum combination) • Complementary factors of production • Specific • Nonspecific • Land, Labor, Capital • Consumption • Savings • Roundabout production (more, but longer)

18. Production Tables and Production Functions A production table shows the output resulting from various combinations of factors of production or inputs.

19. Number of workers Marginal product Average product Total output 0 0 — 4 1 4 4 6 2 10 5 7 3 17 5.7 6 4 23 5.8 5 28 5.6 5 3 31 5.2 6 1 32 4.6 7 0 32 4.0 8 -2 30 3.3 9 -5 10 25 2.5 A Production Table

20. Production Tables and Production Functions • Marginal product is the additional output that will be forthcoming from an additional input, say a worker, other inputs remaining constant. • Average product is calculated by dividing total output by the quantity of the input. Not in the text but an important concept to understand Average Cost later!

21. Time and Stages of Production • Immediate • Everything made and ready for sale. • Thus S is vertical in Immediate period • Short-run • Variable inputs and costs can be adjusted. • Long-run • All inputs and costs variable.

22. The Production Function • Law of Diminishing Returns: as more and more inputs are added to fixed quantities of other inputs, output increases, then slow, then declines. • 3 Stages • I: increasing • II: diminishing • III: declining • This due to scarcity, otherwise if only stage I, why not grow all the world’s wheat on 1 acre!! • This law is also called the flower pot law.

23. Number of workers Total output Marginal product Average product 0 0 — 4 Increasing marginal returns 1 4 4 6 2 10 5 7 3 17 5.7 6 4 23 5.8 5 Diminishing marginal returns 28 5.6 5 3 31 5.2 6 1 32 4.6 7 0 32 4.0 8 -2 Diminishing absolute returns 30 3.3 9 -5 10 25 2.5 The Law of Diminishing Marginal Productivity

24. The Law of Diminishing Marginal Productivity Diminishing absolute returns Diminishing marginal returns Diminishing marginal returns Diminishing absolute returns 32 7 30 28 6 26 24 TP 5 22 20 Increasing marginal returns 18 4 Output 16 Output per worker 14 3 12 10 2 8 AP 6 1 4 2 0 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 MP Number of workers Number of workers (a) Total product (b) Marginal and average product

25. Total, Average, and Marginal Product • Marginal product is the slope of the total product function. • At point A, the slope of the total product function is highest; thus, marginal product is highest. • At point C, total product is maximum, the slope of the total product function is zero, and marginal product intersects the horizontal axis.

26. Total, Average, and Marginal Product • When average product is maximum, average product and marginal product are equal. • Then, average product falls to the left and right of point B.

27. Total, Average, and Marginal Product • Remember that: • As long as marginal product rises, average product rises. • When average product is maximum, marginal product equals average product. • When average product falls, marginal product is less than average product.

28. Relationships between TP, AP, MP, MR • As TP goes up, MP is increasing, will reach max with 0 MP. Will decrease as MP is negative. • As long as AP is rising, MP is increasing. When MP=AP MP is at max. • As long as MP is higher than AP, AP rises.

29. Relationships between TP, AP, MP, MR • Never use inputs that are negative MP, never stop hiring in increasing MP (inefficient). A profit is made always in diminishing MP. (Stage II) • If MR>MC (wage, rent) hire that factor.

30. Productivity • Total Product/# of inputs =AP • Marginal Product (MP) • Physical Capital • Human Capital • Technology • Determines "wages"

31. Cost of Production • Accounting Cost • Actual expenses plus depreciation (Explicit) • Economic Cost • Cost to a firm of using resources in production, plus • Opportunity cost, the most valuable forgone alternative (Implicit) • Sunk Cost • Expenditure that has been made and cannot be recovered (Be Careful!)

32. Total Costs of Production • Total Cost • Total Cost =Variable Cost + Fixed Cost • Fixed Cost. A cost that is actually incurred, but independent of the level of output • Variable Cost. A cost that is actually incurred, and dependent of the level of output • Example (Short Run). Capital K is fixed, and Labor L is variable; hence, the cost of K is a fixed cost, and the cost of L is a variable cost • Total TC • Fixed TFC • Variable TVC

33. More Costs+++ • Average Costs • AFC • AVC • ATC • Marginal Costs (MC) • Per unit cost

34. L O M Total Cost Curves TC $400 VC 350 300 TC = VC + FC 250 Total cost 200 150 100 FC 50 0 2 4 6 8 10 20 30 Quantity of earrings

35. ATC Area A Area C MC AVC Area B ATC AVC B A MC Q0 Q1 Relationship Between Marginal and Average Costs $90 80 70 60 50 40 Costs per unit 30 20 10 0 1 2 3 4 5 6 7 8 9 Quantity

36. Profit MR=MC

37. The U Shape of the Average and Marginal Cost Curves • When output is increased in the short-run, it can only be done by increasing the variable input. • The law of diminishing marginal productivity sets in as more and more of a variable input is added to a fixed input. • The average total cost curve is the vertical summation of the average fixed cost curve and the average variable cost curve.

38. Average and Marginal Cost Curves • The average fixed cost curve slopes down continuously. • It tells us that as output increases, the same fixed cost can be spread out over a wider range of output.

39. Average and Marginal Cost Curves • The marginal cost curve goes through the minimum point of the average total cost curve and average variable cost curve. • Each of these curves is U-shaped.

40. Productivity and Average and Marginal Cost Curves • Marginal and average productivities fall and marginal costs rise. • And when average productivity of the variable input falls, average variable cost rise. • If the firm increased output enormously, the average variable cost curve and the average total cost curve would almost meet. • The firm’s eye is focused on average total cost—it wants to keep it low.

41. Relationship Between Marginal and Average Total Costs • The marginal cost and average cost curves are related. • When marginal cost exceeds average cost, average cost must be rising. • When marginal cost is less than average cost, average cost must be falling. • ATC = MC when ATC is at minimum

42. Relationship Between Marginal and Average Variable Costs Marginal and average total cost reflect a general relationship that also holds for marginal cost and average variable cost. • If MC > AVC, then AVC is rising. • If MC = AVC, then AVC is at its low point. • If MC < AVC, then AVC is falling.

43. Relationship Between Marginal and Average Costs As long as average variable cost does not rise by more than average fixed cost falls, average total cost will fall when marginal cost is above average variable cost.

44. The Perfectly Competitive Firm andIndustry in Short-Run Equilibrium

45. To make their long-run decisions: Firms look at costs of various inputs and the technologies available for combining these inputs. Then decide which combination offers the lowest cost. The firm makes long-run decisions on the basis of the expected costs and expected usefulness of inputs. Making Long-Run Production Decisions

46. Technical efficiency – as few inputs as possible are used to produce a given output. Technical efficiency is efficiency that does not consider cost of inputs. Technical Efficiency and Economic Efficiency

47. Technical Efficiency and Economic Efficiency • Economically efficient – the method that produces a given level of output at the lowest possible cost. • It is the least-cost technically efficient process.

48. Determinants of the Shape of the Long-Run Cost Curve • The Law of Diminishing Marginal Productivity does not hold in the long run. • All inputs are variable in the long run. • The shape of the long-run cost curve is due to the existence of economies and diseconomies of scale.

49. Economics of Scale • Scale means size. • Economies of scale: the decrease in per unit costs as the quantity of production increases and all resources are variable • Diseconomies of scale: the increase in per unit costs as the quantity of production increases and all resources are variable • Constant returns to scale: unit costs remain constant as the quantity of production is increased and all resources are variable

50. Economies of Scale (MES) The minimum efficient level of production is the amount of production that spreads setup costs out sufficiently for firms to undertake production profitably.