Transcript Lecture 5

Econ 1000: Mod 3, Lecture 5
C.L. Mattoli
(C) Red Hill Capital Corp., Delaware, USA
2008
1
Before we move on



If we change price, we move along a supply or
demand curve.
Supply and demand curves are just schedules or
intentions of sellers and buyers of things to sell or
buy certain quantities of a good or service,
depending on price.
Markets, the coming together of supply and
demand, work towards an equilibrium quantity
and price at the intersection of supply and demand
schedules.
(C) Red Hill Capital Corp., Delaware, USA
2008
2
Before we move on



Equilibrium price and quantity will remain until
there is a change in either the whole supply curve
or the whole demand curve, a shift or change to a
whole new curve.
Moreover, if one changes, either the supply or
demand curve, the equilibrium will change by
moving along the unchanged curve towards the
new equilibrium at the intersection of the new one
curve with the old other.
We demonstrate these concepts in the next slide.
(C) Red Hill Capital Corp., Delaware, USA
2008
3
Before we move on


A change in a non-price
factor causes demand to
increase: the demand
curve shifts into a new
curve.
As a result, there is a
movement up along the
old supply curve to a
new equilibrium price
and quantity.
Change in
non-price
Increase
in price
P
D1
(C) Red Hill Capital Corp., Delaware, USA
2008
Increase in
demand
Increase in
quantity supplied
D2
Quantity
4
Elasticity
We use percentage change, sometimes, in
economics because it gives a better basis
for comparison.
 Elasticity is, then, percentage change in
quantity with respect to percentage
change in another variable, such as price,
income, or the price of another related
good or service.

(C) Red Hill Capital Corp., Delaware, USA
2008
5
Elasticity



E = [ΔQ/Q]/[ΔX/X] = [(Q1 – Q0)/Q0]/](X1 –
X0)/X0] = %ΔQ/%ΔX, or the mid-point definition
which uses the mid-points (Q1+Q0)/2 and (X1
+X0)/2 in the denominators of the percentage
change calculations.
If something is elastic, that means that the
quantity will be very sensitive to changes in the
other variable.
If something is inelastic, quantity will not be very
responsive to price.
(C) Red Hill Capital Corp., Delaware, USA
2008
6
Elasticity calculations




Elasticity equals percent change divided by
percent change.
If we have raw numbers for both variables, we
can calculate % changes and then calculate
elasticity.
If we know percentage changes, we can calculate
elasticity directly as the ratio of the % changes.
If we know elasticity and one of the % changes,
we can calculate the other % change.
(C) Red Hill Capital Corp., Delaware, USA
2008
7
Elasticity Logic and Psychology.




Quantity demanded or supplied will depend, at
least, on prices.
It can also depend on income.
Elasticity takes a deeper look at the
responsiveness of quantity change with respect to
changes in some variables.
For example, if there are substitutes for
something, and the price rises, people will just
switch to an alternative. The good will have high
elasticity.
(C) Red Hill Capital Corp., Delaware, USA
2008
8
Elasticity Logic and Psychology.


If something goes with something else, i.e.,
compliments it, like tires for automobile, a
change in price of one will affect quantity
demanded for the other. The good will have
cross-elasticity.
If something is a large part of a person’s total
budget, their spending allowance constraints, the
change in price will have a larger affect on
quantity than on a good that is a small part of a
budget. Salt is more inelastic than automobiles.
(C) Red Hill Capital Corp., Delaware, USA
2008
9
Elasticity Logic and Psychology.


When income rises, people will buy better clothing,
better restaurants, better cars. So, rise in income
will have positive (E>0) elasticity for nicer things
(normal or so-called luxury goods) and negative
elasticity (E<0) for lower quality and less expensive
things (inferior goods).
While price elasticity of demand will always be a
negative number because quantity will decrease as
price increases, elasticity of supply will always be a
positive number because quantity supplied is an
increasing function of price (direct relationship).
(C) Red Hill Capital Corp., Delaware, USA
2008
10
Elasticity Logic and Psychology.
 Income
and cross-elasticities can be
either positive or negative numbers
depending on the type of good.

The elasticity concept is also intimately
connected with change in revenues versus
changes in price, so it is an interesting
piece of information for suppliers to
have.
(C) Red Hill Capital Corp., Delaware, USA
2008
11
Elasticity Logic and Psychology.
When a good or service is elastic, total
revenue will rise with a decrease in price
but fall for a price increase.
 When a good is inelastic, total revenue
will rise and fall with rising and falling
prices.
 If it is unit elastic, changes in price will
have no affect at all on total revenues.

(C) Red Hill Capital Corp., Delaware, USA
2008
12
Elasticity and Taxation


Governments add excise
taxes on things, like
gasoline and cigarettes.
Adding a tax to a product
shifts the supply curve
up since a cost is added
for every quantity, so
every quantity comes at
a higher price in the new
supply schedule as
shown:
(C) Red Hill Capital Corp., Delaware, USA
2008
Tax cost
13
Elasticity and Taxation


In the case of perfect
inelastic demand, the
extra cost is born totally
by the buyer because
the equilibrium quantity
is the same before and
after the tax is added but
the price paid is higher
by exactly the extra cost
tax.
See the figure:
(C) Red Hill Capital Corp., Delaware, USA
2008
D
S1
Tax
S0
14
Elasticity and Taxation



When demand is other than
perfectly elastic (vertical) it will
have a downward slope.
Because of the downward
slope, the burden will shift from
totally on the buyer to a split
between buyer and seller.
Thus, of T = Tax, the added
cost, the part that is shifted to
the buyer is the difference
between what he paid before
and what he is paying now,
which change in price is less
than the added cost = T
(C) Red Hill Capital Corp., Delaware, USA
2008
Change in
market price
= ΔP
T – ΔP
Buyer
Seller
Total
Tax = T
15
Elasticity and Taxation

In the diagram, we also
show what happens when
supply is more inelastic
(blue lines). Then, the part
of the tax shifted to the
buyer is less, the more
inelastic the supply for the
same tax.
Change in
market price
= ΔP
T – ΔP
Buyer
Seller
Total
Tax = T
(C) Red Hill Capital Corp., Delaware, USA
2008
16
Elasticity and Taxation
Limiting cases are, thus:
1. Inelastic demand: all tax to consumer.
2. Perfect elastic demand: all cost to
seller.
3. Perfect inelastic supply: all cost to
seller.
4. Perfect elastic supply: all cost to buyer

(C) Red Hill Capital Corp., Delaware, USA
2008
17
This week


Chapter 6:
Production costs
(C) Red Hill Capital Corp., Delaware, USA
2008
18
Learning objectives
On successful completion of this module,
you should be able to:
 Explain the concepts of ‘explicit’ and
implicit’ costs
 Define the terms ‘economic profit’,
‘accounting profit’ and ‘normal’ profit
 Use the law of diminishing returns to
explain and illustrate the short-run
production function
(C) Red Hill Capital Corp., Delaware, USA
2008
19
Learning objectives



Explain the relationship between short
run costs and output in terms of total,
average, and marginal cost curves
Explain the relationship between marginal
and average cost and between marginal
product and marginal cost
Explain the construction and shape of the
firm’s long run average cost curve.
(C) Red Hill Capital Corp., Delaware, USA
2008
20
Where we are coming from



We have looked at concepts of supply and
demand, and we have examined the underlying
psychological factors involved on both sides.
A fundamental driver of economic people is
self-interest.
We usually assume that self-interest is
enlightened, but the fact that people would
pollute the environment to produce goods
and services proves otherwise.
(C) Red Hill Capital Corp., Delaware, USA
2008
21
Where we are coming from



Demand is driven by wants, tempered by
people’s 1) limited financial resources, 2) a
desire to pay less rather than more, and 3) a
tendency to be slow to accept change.
Thus, people have unlimited wants but
limited personal resources with which to
get what they want.
They can trade their time, and make their
own clothing, or they get a job and trade their
time to earn money to buy things from others.
(C) Red Hill Capital Corp., Delaware, USA
2008
22
Where we are coming from



They give up one opportunity, their time and
their money, to make a choice and take
another opportunity.
Indeed, most people try to find a
comparative advantage for their time, and
they get a job. They trade their time for the
intermediary of transactions: money.
Some might give up a paying job to start a
business. Then, their opportunity cost will
be money from another job.
(C) Red Hill Capital Corp., Delaware, USA
2008
23
Where we are coming from



Once in business, their might be several
business opportunities that they have to
weigh against one another: to make more
forks or to grow more corn.
Suppliers and producers have taken
initiative to take on risk to fulfill the needs
and wants of others. They are motivated by
profits.
People are competitive, at least because of
self-interest, whether it is to win a basketball
game or an on-line auction for a computer.
(C) Red Hill Capital Corp., Delaware, USA
2008
24
Where we are coming from


That natural competitive tendency
helps make competitive markets in the
economy.
However, just as self-interested profit
seeking can lead to undesirable
results, such as pollution, it can lead to
other undesirable economic behavior,
like anti-competitive or collusive
behavior, in the marketplace.
(C) Red Hill Capital Corp., Delaware, USA
2008
25
Where we are coming from


The demand side is also complicated.
People will take substitutes. People
can be stubborn. People are concerned
about their incomes and the prices of
the things that they buy, along with other
personal welfare issues.
We have seen, in our study of elasticity,
that the interaction of price and quantity,
on the demand side of the equation, can
have an affect on total revenues.
(C) Red Hill Capital Corp., Delaware, USA
2008
26
Where we are coming from



Total revenues can be sensitive to
changes in price, perhaps decreasing
when prices are raised beyond a certain
level.
A rise in price will help unit profit
margins, but a decrease in revenues will
also affect overall margins.
That is a limitation on the situation for
suppliers, originating on the demand
side.
(C) Red Hill Capital Corp., Delaware, USA
2008
27
Where we are coming from


We looked at production on a larger
scale in the PPF. There we found a
maximum capacity output line for
simultaneous production of a number of
goods.
Then, we can figure out, for example, that
the opportunity to produce 10,000 more
tons of corn will mean giving up the
opportunity to make 50,000 forks, so the
cost is 5 forks per ton of corn.
(C) Red Hill Capital Corp., Delaware, USA
2008
28
Where we are coming from



In looking at the PPF, we discovered that
substitutes are also available to
suppliers: they can be attracted to one
business or another.
Their decision is based on opportunity
costs.
Next, we shall look more closely at the
cost side of the production function, in
order to examine limitations on profits.
(C) Red Hill Capital Corp., Delaware, USA
2008
29
Where we are coming from





In the case of the consumer and demand,
we found the concept of marginal utility.
We will find the law of diminishing returns
on the supply side of the market.
These are concepts that involve marginal
thinking.
We will use further marginal concepts, like
marginal costs, which will lead to another:
marginal product.
Our study of the limitations on producers
will give us an idea of how much suppliers
can supply.
(C) Red Hill Capital Corp., Delaware, USA
2008
30
Mathematically: total revenue & elasticity



Total revenue equals price times quantity
demanded: RT = QxP
The variation of total revenues with
respect to price is given by: Δ RT /ΔP = P
x[ΔQ/ΔP] + QxΔP/ΔP = P x[ΔQ/ΔP] + Q
If we want to find the condition for
increasing total revenue that means that
the change in revenue should always be a
positive number. In algebra, we require:
ΔRT /ΔP > 0.
(C) Red Hill Capital Corp., Delaware, USA
2008
31
Mathematically: total revenue
So, Δ RT /ΔP = P x[ΔQ/ΔP] + Q >0
 Rearranging the symbols in the
equation, we get ΔQ/(ΔP/P) > – Q
 Or, (ΔQ/Q)/(ΔP/P) = %ΔQ/%ΔP =
ED> – 1
 So, if P is increasing, and E is
inelastic (absolute value less than 1)
 We shall also take a closer look at
revenues, in this module.

(C) Red Hill Capital Corp., Delaware, USA
2008
32
Costs and the supply curve




We have discussed shifts in the supply curve.
A shift up or to the left is called a decrease in
supply because in the new supply less
quantity will be supplied at each price versus
the old curve.
Such a shift can, for example, come from
some type of cost increase. In that case,
any quantity will come at a higher price than
before the change in cost, which is the same
as less quantity will be supplied at any price.
We show the two ways of looking at up and
left shifts in the next slide.
(C) Red Hill Capital Corp., Delaware, USA
2008
33
Costs and the supply curve




A decrease in supply is a
shift up or left of the
supply curve.
A higher price is charged
for each quantity
supplied,
or
Less quantity is supplied
at each price.
P
S2
S1
P
(C) Red Hill Capital Corp., Delaware, USA
2008
Q
34
Costs and the supply curve: prior examples
We have discussed various reasons, so
far, that supply curves can shift.
 New technology introduced into an
industry can substantially reduce costs
and shift the supply curve down or right.
 Increases in labor costs can shift it up or
left.

(C) Red Hill Capital Corp., Delaware, USA
2008
35
Costs and the supply curve: prior examples
Another type of cost that can shift it
up or left are taxes, like excise taxes
on “sin” products or taxes on
pollution.
 In this module we shall examine,
more closely, the issue of costs
versus revenues and profits in
shaping the supply curve.

(C) Red Hill Capital Corp., Delaware, USA
2008
36
Costs and Profits
(C) Red Hill Capital Corp., Delaware, USA
2008
37
Profit motive




It is a basic tenet of economics that the
motivation for business is profit
maximization.
Revenues will depend on demand:
quantity demanded times price.
To get to profits we must understand costs.
Before we do that, we must understand
how economists define costs and profits
versus how those concepts are defined in
accounting and finance.
(C) Red Hill Capital Corp., Delaware, USA
2008
38
Explicit and implicit costs



Explicit costs are costs paid to nonowners of the firm for resources. That
includes things, like labor costs, electricity,
raw materials, rentals of PP&E.
Implicit cost are the opportunity costs
associated with using firm resources one
way versus another.
Thus, we find opportunity costs entering
our economic analysis, again.
(C) Red Hill Capital Corp., Delaware, USA
2008
39
Explicit and implicit costs



We first found that opportunity costs
enter consumers’ decisions to purchase:
If I buy an expensive lunch, I might not
have enough money to go to the movies.
A company decides whether to buy a
machine to produce candles or a jet to
ferry its executives around the world.
Then, we encountered opportunity costs
when we looked at production
possibilities.
(C) Red Hill Capital Corp., Delaware, USA
2008
40
Explicit and implicit costs
We considered that to produce more
of good A, we had to give up a
certain amount of production of good
B, and we called the trade-off:
opportunity costs.
 Now, we extend that thinking to
directly apply to our accounting for
costs and profits.

(C) Red Hill Capital Corp., Delaware, USA
2008
41
Explicit and implicit costs



We can pay money for more laborers or
we can buy an expensive machine to
lessen our dependence on labor but might
also increase our dependence on energy,
like electricity or oil.
Trade labor for machinery and electricity
A building, for example, might be used for
warehousing of one product or
manufacture of another. There is an
opportunity trade-off for its use.
(C) Red Hill Capital Corp., Delaware, USA
2008
42
Explicit and implicit costs
Moreover, even the owner of the
business might better use his or her
time and money in another business.
 We, therefore, must think about the
other opportunities for his time and
his money.
 Then, economics defines the total
opportunity cost as the sum of all
explicit and implicit costs.

(C) Red Hill Capital Corp., Delaware, USA
2008
43
Profits





Given an economic definition of costs, we
also have to revise our concept of profits.
Our standard notion of profits is what
economists refer to as accounting profits.
Accounting profits = Total revenues –
Total explicit costs
In contrast, economists define economic
profits as total revenues less all costs; thus
Economic profits = Total revenues –
Total opportunity costs
(C) Red Hill Capital Corp., Delaware, USA
2008
44
Profit example




Assume that Craig decides to quit his job at
Starbucks to start his own coffee business.
He already has store space on a busy street
in Guangzhou that he could use to house the
business and he has some savings that he
can use for business startup costs.
He borrows funds to cover initial investment
requirements, and he opens the business.
In the next slide, we show a comparison of
accounting and economic profits for his first
year of business.
(C) Red Hill Capital Corp., Delaware, USA
2008
45
Profits example
Craig’s Coffee Clutch
Accounting Profit
Revenue
Less explicit
Wages
Materials
Interest paid
Other
Less implicit
Salary forgone
Rent forgone
Interest forgone
Profits
Economic Profit
$500,000
$500,000
40,000
50,000
10,000
10,000
40,000
50,000
10,000
10,000
Not included
Not included
Not included
$30,000
70,000
10,000
5,000
– $55,000
(C) Red Hill Capital Corp., Delaware, USA
2008
46
Profits example


The table shows economic and accounting
profits.
While accounting profit is positive,
economic profit is negative after
accounting for lost opportunities: $70,000
Craig could have earned at his old job,
rental income that he could have gotten
from renting his space, and the interest
he could have earned on his savings.
(C) Red Hill Capital Corp., Delaware, USA
2008
47
Zero Profit: the proper economic goal


In the above example, Craig is failing to
cover his opportunity costs, so his
resources would be put to better use and
could earn a higher return if used
elsewhere.
In other words, by comparing all of his
opportunities to make money, he can
choose among them based on total
opportunity costs and, thereby, maximize
his intrinsic worth.
(C) Red Hill Capital Corp., Delaware, USA
2008
48
Zero Profit: the proper economic goal




In that manner, he will be able to choose
the right career path.
In economic terms, zero economic
profits are called normal profits.
Normal profits are the minimum profit
necessary to justify keeping a firm in
business.
When normal profits are equal to zero it is
the state in which there is just enough
revenue to cover all costs, including
opportunity costs.
(C) Red Hill Capital Corp., Delaware, USA
2008
49
Zero Profit: the proper economic goal




In other words, at that minimum, there is no
benefit from reallocating resources to
another use.
We can now better appreciate the discussion
of opportunity costs in looking at the PPF.
There, we quantified costs in terms of how
much of one good we gave up to produce
another. That is output or revenue.
Now, we find that opportunity costs must be
taken into account for calculating profits.
(C) Red Hill Capital Corp., Delaware, USA
2008
50
Zero Profit: the proper economic goal




Thus, they will affect decisions of where
actual production might occur on the PPF.
For example, if a company can produce
napkins or parachutes, it will decide how to
divide its labor and machinery to producing
each.
That decision will be based on how much it
gives up in producing one to produce more of
the other.
It can reallocate production from one to the
other until its incremental economic profits
are zero.
(C) Red Hill Capital Corp., Delaware, USA
2008
51
Choice and Opportunity Costs





Economics is a socio-psychologically, logical
theory of business transactions.
Thus, money is not what most often enters
analysis.
Money is just an intermediate thing that
allows us to buy many different things.
However, costs are better measured in terms
of opportunities: what they are worth, in terms
of other available options.
We give up a hotdog to have a hamburger at
lunch: opportunity costs are that simple.
(C) Red Hill Capital Corp., Delaware, USA
2008
52
Choice and Opportunity Costs




We go to college and spend 4 years of
earning no money and giving up time.
We become a financial analyst instead of a
brain surgeon.
Then, we decide how production should be
allocated to a number of different
possibilities, depending on our perceived
opportunities created by choices in demand
made in the markets.
In the end, the whole economy lands
somewhere in its production possibilities set.
(C) Red Hill Capital Corp., Delaware, USA
2008
53
Short-run Production
(C) Red Hill Capital Corp., Delaware, USA
2008
54
Short-run versus long-run?



Economists do not distinguish between the
short and long terms on an arbitrary basis
of time. Time only has meaning in terms of
what you can do with it.
In economics, the line between short and
long run is drawn in terms of the ability to
vary the quantity of inputs of resources,
factors of production, in the production
process.
To analyze the question, we must
distinguish between fixed and variable
inputs.
(C) Red Hill Capital Corp., Delaware, USA
2008
55
Short-run versus long-run?




Fixed inputs are resources for which the
quantity cannot be changed during the period
of time under consideration.
Fixed inputs include things, like the size of
a firm’s physical plant or the capacity of a
machine to produce output.
Such things cannot be changed in a short
period of time.
They must remain fixed while managers
decide upon other ways to vary output…the
variable inputs.
(C) Red Hill Capital Corp., Delaware, USA
2008
56
Short-run versus long-run?



Then, there are variable inputs, over
which managers do have some
control, given the fixed inputs.
A simple example of variable input is
the number of employees and
employee hours in a given period of
time.
Of course, at some point even
employee and machine hours will max
out.
(C) Red Hill Capital Corp., Delaware, USA
2008
57
Short-run versus long-run?



Given those concepts, we can finally make
a proper distinction between short-run and
long-run.
The short-run is the period during which
there is at least one fixed input.
The short-run is, for example, the period
in which a firm can hire more employees,
variable input, while it cannot change the
size of its physical plant, fixed input.
(C) Red Hill Capital Corp., Delaware, USA
2008
58
Short-run versus long-run?
The long-run is the period of time
that is sufficient to allow for changes
in fixed inputs.
 In the long-run a firm can build new
plant and buy more equipment.
 In the long-run, new firms can enter
the business and old firms might
exit, changing the supply curve.

(C) Red Hill Capital Corp., Delaware, USA
2008
59
Short-run versus long-run?



Thus, the difference between SR & LR can
vary for different businesses or even for the
same business at different times.
An airplane manufacturer will have certain
fixed plant capacity, and to increase it might
take a year or more to build new buildings
and to order and install new equipment.
It might only take a few months to build a
repair shop for old airplanes.
(C) Red Hill Capital Corp., Delaware, USA
2008
60
Short-run versus long-run?



A clothing sales chain might take several
months to find space for a new store and to
build it out.
If it want to begin sales in another country, it
might take a year or more to do all of the
paper work and find international shippers for
its international aspirations.
Thus, SR & LR will depend on the particular
business and situation.
(C) Red Hill Capital Corp., Delaware, USA
2008
61
Break time

Please, take a 10 minute break
(C) Red Hill Capital Corp., Delaware, USA
2008
62
The Production Function Model



The next step is to look at the transformation of
inputs into output.
This is done using the production function, the
relationship giving the maximum output that can
be produced using varying quantities of the
various inputs to production.
In production function theory, as presented
herein, ceteris paribus is that technology
remains unchanged since changes in technology
would change the output that can be achieved
with given inputs and would, therefore, change
the production function.
(C) Red Hill Capital Corp., Delaware, USA
2008
63
Production function example: Chateau
Mattoli Vineyards.




Consider a business that grows grapes to
produce wine.
The input for the business is labor, and we
assume all potential laborers have equal job
skills.
The land, number of vines, the machinery, and
all other inputs are categorized as fixed.
Thus, our production model description is in
the short run.
(C) Red Hill Capital Corp., Delaware, USA
2008
64
Production function example: Chateau
Mattoli Vineyards.
Output will vary with employment: the
more employees, the more man hours, the
higher the maximum output.
 Output begins at zero when zero
employees are employed.
 With only one employees, maximum
daily output is 1 ton.
 However, there is a lot of wasted time
with only one employee.

(C) Red Hill Capital Corp., Delaware, USA
2008
65
Production function example: Chateau
Mattoli Vineyards.

1.
2.
3.
4.

She has to:
pick the grapes and put them in a cart,
she has to transport the cart to the shed,
then, press the grapes,
make the wine and store it in casks, and
follow up with the aging process and final
bottling, labeling, and boxing of the wine.
It is very inefficient.
(C) Red Hill Capital Corp., Delaware, USA
2008
66
Production function example: Chateau
Mattoli Vineyards.



The addition of a second employee adds
efficiency.
The 2 can save time by dividing tasks that
might overlap.
After a cart is filled with grapes, the second
employee could have brought a second cart
to start on, and she can take the first cart
back to the press to begin the next step,
while the first continues to fill up the next cart.
(C) Red Hill Capital Corp., Delaware, USA
2008
67
Production function example: Chateau
Mattoli Vineyards.





They can process 2.2 tons per day, together.
Thus, they produce more than 2 times the
amount that can be produced with only one
employee.
Adding a third employee increases production
to 3.3 tons per day.
However, by the time we have increased the
employees to 6, production is only to up 5 tons.
See the next slide for graphical details.
(C) Red Hill Capital Corp., Delaware, USA
2008
68
Production function example: Chateau
Mattoli Vineyards.
Total Output versus Employees
Employees
Total Output
Employees
Production
0
0
1
1
2
2.2
3
3.3
4
4.2
5
4.8
6
5
6
5
4
3
2
1
0
0
2
4
6
8
Tons
(C) Red Hill Capital Corp., Delaware, USA
2008
69
Marginal Product
The example points out an interesting
phenomena: adding labor increases
output, first, at a magnified rate and,
later, as more employees are added, at a
shrunken rate.
 We define marginal product as the
change in total output (TO) per unit
change in labor (L): ΔTO/ΔL

(C) Red Hill Capital Corp., Delaware, USA
2008
70
Marginal Product
It is the slope of the total output
curve, at any point along the curve.
 For Chateau Mattoli, marginal product
is equal to 1 when the first employee
is added, 1.2 for the second, 1.1 for
the third, and is down to 0.2 by the
time that the 6th employee is hired.
 We show the figures in the next slide.

(C) Red Hill Capital Corp., Delaware, USA
2008
71
Marginal Product: Chateau Mattoli
Marginal product decreases because the slope of the output curve is
decreasing
Marginal Product
Marginal
Product
Marginal Product
Employees
Marginal Product
0
0.0
1
1.0
2
1.2
0.5
3
1.1
0.0
4
0.9
5
0.6
6
0.2
1.5
1.0
0
2
4
6
8
Employees
(C) Red Hill Capital Corp., Delaware, USA
2008
72
Law of diminishing returns



What is at work in the preceding analysis
is another law of economics: the law of
diminishing returns.
The law of diminishing returns states that,
beyond a certain point, the addition of a
unit of variable factor to a fixed factor will
result in decreasing marginal product.
Since the law assumes that there is a fixed
factor, it is necessarily a short-run law.
(C) Red Hill Capital Corp., Delaware, USA
2008
73
Law of diminishing returns



At first, additional employees use the fixed
resources more efficiently by working
together’
But as more employees are added to the
fixed inputs, their sharing begins to
decrease the initial efficiency of dividing
tasks.
In chapter 11, a detailed analysis of the
labor market tells how to decide on the right
number of employees.
(C) Red Hill Capital Corp., Delaware, USA
2008
74
Law of diminishing returns
We shall not cover those details, in
this course.
 For now, we only say that a firm would
never hire an employee who has
marginal product of zero or less.
 The law is a simple statement of the
reality of business organization.
 Eventually, too many cooks spoil the
soup.

(C) Red Hill Capital Corp., Delaware, USA
2008
75
Short-run cost formulas
(C) Red Hill Capital Corp., Delaware, USA
2008
76
Total cost curves



For a business to make a decision to
produce a product, in the long or short
runs, it must first determine the costs
associated with producing various
quantities.
For example, in Mattoli Vineyards, we saw
that output was varied by adding
employees.
In the short run, costs are divided
between total fixed costs and total variable
costs.
(C) Red Hill Capital Corp., Delaware, USA
2008
77
Total cost curves
Fixed costs (TFC), like mortgage or
rent, interest on loans, and insurance,
must be paid even if there is nothing
produced.
 Variable costs (TVC) will vary with
the output.
 Variable costs will include labor,
materials for production, and the like.

(C) Red Hill Capital Corp., Delaware, USA
2008
78
Total cost curves





You rent or buy a space for a dress store.
You have to pay rent, no matter if you have
business or not.
You have to pay interest on borrowings
whether you have sold any dresses or not.
You have to have the lights and climate
control on whether or not you make sales.
You can vary the amount of inventory that
you purchase and the hours that you have
people work at the store.
(C) Red Hill Capital Corp., Delaware, USA
2008
79
Total cost curves



In the simple example of Mattoli’s
Vineyards, we assumed that the only
variable cost was labor. We also assume
that each employee is equally skilled and
that they are all paid the same wage rate.
Then, total cost (TC) will be the sum of
fixed and variable costs, TC = TFC + TVC.
In the next slide we show cost data for
another mythical business: MAT ATM
machines (Mattoli’s automatic teller bank
machines).
(C) Red Hill Capital Corp., Delaware, USA
2008
80
MAT ATM Data
MAT ATM's
Q

The quantity versus cost
data for MAT ATM
Cost ($)
Cost vs. Quantity
800
700
600
500
400
300
200
100
0
0
5
10
Quantity
15
TFC
+ TVC
= TC
0
100
0
100
1
100
50
150
2
100
84
184
3
100
108
208
4
100
127
227
5
100
150
250
6
100
180
280
7
100
218
318
8
100
266
366
9
100
325
425
10
100
400
500
11
100
495
595
12
100
612
712
(C) Red Hill Capital Corp., Delaware, USA
2008
81
Average cost curves
Costs are nice to look at but more interesting to a
manager are costs per unit of product produced,
or average costs.
 Like prices, average costs are stated on a per
unit basis.
 Thus, we have the following definitional formulae:
AFC = FC/Q
AVC = VC/Q
ATC = AFC + AVC = FC/Q + VC/Q = (FC+VC)/Q =
TC/Q
Note: there is a mistake in the book on page 153
for ATC; book says ATC = TVC/Q

(C) Red Hill Capital Corp., Delaware, USA
2008
82
Connection with marginal cost



Marginal cost is, basically, the change in
cost when one additional unit is produced.
In terms of our new equation definitions, we
can say marginal cost is the change in
total cost per change in unit output.
Moreover, since fixed cost never changes,
we can write an equation for MC as:
MC = ΔTC/ΔQ = ΔTVC/ΔQ
In the next slide, we show average and
marginal costs in table and graph forms.
(C) Red Hill Capital Corp., Delaware, USA
2008
83
AC & MC Data

Average and marginal
costs are shown for MAT
ATM’s.
MAT ATM's
Q
MC
AFC
AVC
AC
1
50
100.00
50.00
150.00
2
34
50.00
42.00
92.00
3
24
33.33
36.00
69.33
4
19
25.00
31.75
56.75
5
23
20.00
30.00
50.00
6
30
16.67
30.00
46.67
7
38
14.29
31.14
45.43
8
48
12.50
33.25
45.75
9
59
11.11
36.11
47.22
10
75
10.00
40.00
50.00
AFC
11
95
9.09
45.00
54.09
14
12
117
8.33
51.00
59.33
Average and Marginal Costs vs.
Output
160.00
Unit Cost($)
140.00
MC
120.00
100.00
80.00
ATC
60.00
AVC
40.00
20.00
0.00
0
2
4
6
8
Quantity
10
12
(C) Red Hill Capital Corp., Delaware, USA
2008
84
Details

Q
TC = TFC+TVC; MC(n+1) = TC(n+1) –
TC(n); ATC = TC/n for Q = n units
TFC + TVC = TC MC =ΔTC/ΔQ AFC = FC/Q AVC = VC/Q AC = TC/Q
0 100
0 100
0
1 100
50 150
50
100.00
50.00
150.00
2 100
84 184
34
50.00
42.00
92.00
3 100
108 208
24
33.33
36.00
69.33
4 100
127 227
19
25.00
31.75
56.75
5 100
150 250
23
20.00
30.00
50.00
6 100
180 280
30
16.67
30.00
46.67
7 100
218 318
38
14.29
31.14
45.43
8 100
266 366
48
12.50
33.25
45.75
9 100
325 425
59
11.11
36.11
47.22
10 100
400 500
75
10.00
40.00
50.00
11 100
495 595
95
9.09
45.00
54.09
12 100
612 712
117
8.33
51.00
59.33
(C) Red Hill Capital Corp., Delaware, USA
2008
85
Cost curve analyses



Average fixed cost is an ever decreasing
value versus output since the total cost is
spread over more and more units.
All other curves fall, initially, hit a minimum,
and, then, begin to rise.
Notice, also, that the MC curve intersects
with both the AVC and ATC curves at their
minimums. It is no accident, and we shall
take a closer look and find that it is a general
result.
(C) Red Hill Capital Corp., Delaware, USA
2008
86
Marginal Relationships



The marginal-average rule is a relationship
that applies to any marginal versus
average variables.
The marginal-average rule states that as
long as the marginal variable is below the
average, the average curve will be falling.
When marginal is above the average, the
average will be rising. Thus, the average will
be equal to the marginal at the minimum of
the average.
Thus, both AVC and ATC will obey the rule
(C) Red Hill Capital Corp., Delaware, USA
2008
87
Marginal average example
To understand the average marginal
rule in more familiar territory, let us
consider average class grades.
 If the average grade of 20 students is
80% and another person’s grade is
added to the average, if the grade is
above 80%, it will increase the
average. If it is below average, it will
pull the average down.

(C) Red Hill Capital Corp., Delaware, USA
2008
88
Marginal average example



Take 20x80%, then, add the new grade,
and divide by 21.
As you can easily understand, the new
average will be below 80%, if you add a
grade below 80%, and conversely, if you
add a grade above 80%.
Thus, the marginal-average rule holds for
average grades or any other averagemarginal relationship.
(C) Red Hill Capital Corp., Delaware, USA
2008
89
Marginal Costs versus Marginal Product




The marginal cost declines if the
marginal product is increasing when the
price of a variable input is constant.
Marginal cost begins to increase when
marginal product is on the decline.
It is only logical.
As long as marginal product is increasing,
we will get more and more efficient use of
variable inputs and lower our average costs.
(C) Red Hill Capital Corp., Delaware, USA
2008
90
Marginal Costs versus Marginal Product



When marginal product hits it peak, we
begin to lose benefits, and average costs
begin to increase.
The result also shows that marginal cost
begins to rise at the point of diminishing
returns, so it is a result of the law.
We return to Mattoli Vineyards for an
example look at the relationship of MC and
MP, in the next slide.
(C) Red Hill Capital Corp., Delaware, USA
2008
91
Chateau Mattoli Marginals


Assume that Chateau Mattoli
pays its employees $100/day.
Each worker is equally skilled
and equally paid.
MP vs. MC
600
1.4
1.2
500
Labor
MP
Output
TVC
MC/unit
1.0
0.0
0
0
1
1.0
1
100
100.00
2
1.2
2.2
200
83.33
3
1.1
3.3
300
90.91
4
0.9
4.2
400
111.11
5
0.6
4.8
500
166.67
6
0.2
5
600
500.00
0.8
MP
0
Cost ($)
400
300
0.6
200
0.4
100
0.2
0
0.0
0
(C) Red Hill Capital Corp., Delaware, USA
2008
2
4
6
Output
92
Chateau Mattoli Marginals
In the example, marginal cost begins
at $100 for the first employee, and
hits a low at $83 with the second.
 After that there are diminishing
returns from hiring more employees.
 As you can see in the graphs, the
minimum MC is at the maximum MP.
 MC and MP are inversely related.

(C) Red Hill Capital Corp., Delaware, USA
2008
93
Long run production costs
(C) Red Hill Capital Corp., Delaware, USA
2008
94
Long run average cost curves




The long run, as previously stated, is a period
of time long enough to change the quantities
of all fixed input that was fixed in the short
run.
In the long run, a business can change the
size of its physical plant, larger or smaller. It
can change the machinery capacity.
Whenever a business makes a change in
fixed inputs it puts itself back in the short run
again.
In the next slides, we look at the decision for
MAT ATM’s on the proper size of a plant,
given only 3 choices of size.
(C) Red Hill Capital Corp., Delaware, USA
2008
95
MAT’s Choices

MATATM has 3 choices of factory sizes.
Each has its own cost curve.
Cost curves for 3 factories
60
50
Unit costs

40
30
20
10
0
0
2
4
6
8
10
12
14
16
Quantity of output
(C) Red Hill Capital Corp., Delaware, USA
2008
96
Size matters to MAT



The previous slide shows graphs of short run
average total cost curves (SRATC) for three
factory sizes.
If MAT thought that it will produces 6
machines a week for the foreseeable future.
Then, it would be better off with the smaller
size plant represented by the curve on the
right.
If MAT thought that it will be producing 9
machines a week, it will choose the mid-size
plant.
(C) Red Hill Capital Corp., Delaware, USA
2008
97
Size matters to MAT
If it believes that it will produce 12
machines a week it will choose the
large plant.
 In all 3 factory sizes, it can produce at
a number of levels.
 Although the graph does not show it,
production possibilities for all size
plants will range from 0 up to some
maximum output.

(C) Red Hill Capital Corp., Delaware, USA
2008
98
Size matters to MAT




However, all three sizes will have maximum
outputs that are different: the larger the
factory, the larger the maximum output.
There are also overlaps. For example, 9
machines per week could be produced with
all factory sizes.
However, the mid-sized factory can produce
9 machines per week with the lowest cost for
not only that size but for all sizes.
Thus, we construct a LR curve, using the
better parts of the three SR curves, as in the
next slide.
(C) Red Hill Capital Corp., Delaware, USA
2008
99
Long run average cost curves
Referring back to the last set of graphs, the long run cost
curve for MAT ATM is the combination of the lower
connected parts of the three graphs.
Cost curves for 3 factories
60
50
Unit costs

40
30
20
10
0
0
2
4
6
8
10
12
14
16
Quantity of output
(C) Red Hill Capital Corp., Delaware, USA
2008
100
Long run average cost curves

We might imagine a more comprehensive case of more
possibilities in the long run, as shown in the graph below.
(C) Red Hill Capital Corp., Delaware, USA
2008
101
Long run average cost curves



In constructing the LR curve, we no longer
just connect the better parts of a few SR
curves.
In this case, we imagine an infinite number of
possible factory sizes.
Then, we construct the LR continuous curve
as the set of points of tangents of the SR
curves to that line, as shown in the figure,
above.
(C) Red Hill Capital Corp., Delaware, USA
2008
102
Scales of production



Again, even the long run cost curve
decreases, hits a minimum, then, rises,
just like the short run cost curves.
The law of diminishing returns is not
responsible in this case because
diminishing returns is a short run, fixedinput phenomenon.
Firms starting out small face decreasing
long run average cost curves because of
economies of scale.
(C) Red Hill Capital Corp., Delaware, USA
2008
103
Reasons for economies of scale



First, when the size of the firm increases,
there is more chance for division of labor
and specialization.
In that case, each person can specialize and
become proficient in one small tack instead of
being jack-of-all-trades.
The classic example is Henry Ford’s
assembly line for automobile manufacturing,
which substantially reduced the cost of
automobiles and ushered in a new era or
mass production.
(C) Red Hill Capital Corp., Delaware, USA
2008
104
Reasons for economies of scale




A second factor is greater efficiency of capital.
A machine with a capacity of 1000 units/day
might cost $100,000 while a $400,000 machine
might have capacity of 8000 units/day, 8 times
the output for 4 times the price.
A smaller company might find the second
machine too large for its needs and cannot take
advantage of the lower machine cost per unit of
output.
In that regard newer companies are sometimes
competing with older larger companies that have
been able to take advantage of economies of
scales.
(C) Red Hill Capital Corp., Delaware, USA
2008
105
Reasons for economies of scale
Economies of scale might last up to a
certain level of output in the long-term
average cost curve.
 After that, there might be a region of
output for which there are constant
returns to scale. In that region the
long-term average cost curve remains
flat and increasing size of plant
neither helps or hurts the business.

(C) Red Hill Capital Corp., Delaware, USA
2008
106
Reasons for economies of scale


A final region of the average cost long term
curve might begin to rise, again, and we
say that there are diseconomies of scale.
After a certain size, a firm can become
bulky to manage. The chain of command
and communication becomes stretched out.
The firm becomes laden with bureaucracy
and red tape, and the result is increasing
average cost with increasing output.
(C) Red Hill Capital Corp., Delaware, USA
2008
107
Long run Possibilities

In the long run there can be economies of scale, constant returns to
scale, and even diseconomies of scale as size becomes too bulky and
unmanageable.
35
Cost
30
Economies of scale
Diseconomies of scale
25
20
Constant returns
to scale
15
10
5
0
0
20
40
60
80
(C) Red Hill Capital Corp., Delaware, USA
2008
100
120
Output
108
Epilogue






We have talked about costs in this lecture.
The other half of the equation is revenues.
You can’t be in business, just taking on costs
without making sales.
The variable costs come from production and
increase with units produced.
We make sales, incur costs, and, in the end,
we hope that Revenue – costs = Profits > 0.
In the next lecture we will discuss these next
steps in the process of being in business.
(C) Red Hill Capital Corp., Delaware, USA
2008
109
Exam-caliber Questions
Question 22
 The table below shows total output and total cost of
a CD manufacturing firm. Assume that the lease
payment for the company’s machine is $40 per day,
which must be paid whether the company makes
any CDs or not. This payment is a fixed cost since it
does not depend on the number of CDs per day the
firm makes. Also assume that the only variable
factor is labor.

If CDs sell for 35 cents each, calculate how many
CDs should the firm produce each day to maximize
profit? Show your working
(C) Red Hill Capital Corp., Delaware, USA
2008
110
Exam-caliber Questions
Employees
per day
Output
(CDs/day)
Total cost
($/day)
0
1
2
0
80
200
40
52
64
3
4
5
260
300
330
76
88
100
6
7
350
362
112
124
(C) Red Hill Capital Corp., Delaware, USA
2008
111
Homework



Chapter 6
Questions 1-11
MC questions 1-19
(C) Red Hill Capital Corp., Delaware, USA
2008
112
Next week


We continue analyzing cost, revenue and supply
curves in the case of perfect competition.
Textbook chapter 7.
(C) Red Hill Capital Corp., Delaware, USA
2008
113
END
END
(C) Red Hill Capital Corp., Delaware, USA
2008
114