Economics for CED Noémi Giszpenc Spring 2004 Lecture

Economics for CED Noémi Giszpenc Spring 2004 Lecture 3: Micro: Supply February 24, 2004 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc

First, a little expansion of Demand From Lecture 2: The proximate causes of demand Tastes: A Prices: B 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc Effective Demand 2

From Lecture 2: longer causal chains Tastes: A 1 A 2 A 3 Prices: B 1 B 2 B 3 Other: C 1 C 2 C 3 Effective Demand (e. g. laws) 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 3

A bigger picture Commercial persuaders Wants and desires Effective demands Prices Marketers’ perspective 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 4

An even bigger picture Nature, Law, Culture, Home & School, other persuaders Commercial persuaders Wants and desires Effective demands Prices Provident or improvident uses of the environment Environmentalists’ perspective 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 5

An even bigger picture Nature, Law, Culture, Home & School, other persuaders Commercial persuaders Unsatisfied desires Wants and desires Prices Effective demands= satisfied Fit or misfit desires between Sociologists’, social psychologists’ perspective 2/24/04 Deprivation, anxiety, unhappiness, bad behavior Economics for CED: Lecture 3, Noémi Giszpenc wants generated and wants satisfied 6

An even bigger picture Few households own capital Unsatisfied desires Commercial persuaders Bargaining strengths Many households contribute labor 2/24/04 Wants and desires Incomes HH rewards =firms’ costs of production Deprivation, anxiety, unhappiness, bad behavior Effective demands Prices Left economists’ perspective Economics for CED: Lecture 3, Noémi Giszpenc 7

Nature, Law, Culture, Home & School, other persuaders Few households own capital Commercial persuaders Bargaining strengths Many households contribute labor 2/24/04 Wants and desires Incomes HH rewards =firms’ costs of production Unsatisfied desires Effective demands Deprivation, anxiety, unhappiness, bad behavior Fit or misfit between wants generated and wants satisfied Prices Broad economists’ perspective Economics for CED: Lecture 3, Noémi Giszpenc Provident or improvident uses of the environment 8

Can even that picture be broadened? “Sixto Roxas, a Filipino economist, argues that the main problem with conventional economics is that it focuses its analysis on the interests of the individual and the firm rather than those of the family and the community. ‘Neo-classical economics is not just a mathematical framework or analytical guideline to facilitate the understanding of reality: it is a full-fledged ideology and design for remaking the world, ’ he says… People are reduced to flesh-and-blood machines that earn wages and salaries and generate profits but whose noneconomic existence is not recognized. ” [emphasis added] 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 9

Now, on to supply • Who produces for the market? Firms. – Households and Government are also producers, but not for the market • Relations between producers: – Organized relations (within-firm) – Market relations (beyond firm) • Ex: Restaurant owner organizes menu, shoppers, cooks, and waiters • But goes to market for meat, vegetables supplied by farmers, truckers, and shopkeepers 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 10

Firms’ purposes (1) • • Maximize profit, silly Remember, profits = revenue - costs Or π = Px. Q - C(Q) Assume firm’s Q has no effect on P (for now) • So main focus is effect of Q on C 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 11

Another way to see profit Rev=3 Q Cost=5+Q 2/4 And π=Rev-Cost At what point is profit maximized? What is the slope of the cost curve? 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 12

Firms’ costs • (Do not include all costs--i. e. , external) • In the “short run” means during the time that you cannot replace existing fixed K – What is the most economical way to use existing fixed K (capital): or, how to produce goods at least cost? • A dual problem: productivity (subject to diminishing marginal returns) and costs 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 13

First, costs: a few simple definitions • Total costs – All the accrued costs of producing • Average cost – Total cost divided by number of units produced • Marginal cost – Additional cost of producing the last unit 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 14

Let’s produce some widgets! • Typical good produced in economics classes. • Nobody knows what they are, really. • At left, a drawing of a widget by Leonardo da Vinci. 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 15

A numerical example Quantity produced Total cost Average cost 0 1 2 3 4 5 5 8 10 12 16 $25 8 5 4 4 $5 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc Marginal cost of last unit 3 2 2 4 $9 16

The example graphed 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 17

Marginal cost drives TC and AC • Marginal cost is always positive: total cost is always rising • If marginal cost < average cost, then marginal cost is pulling average cost down • If marginal cost > average cost, then marginal cost is pulling average cost up 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 18

What happens to profits? • Assume the price for output sold is $6 units Total cost Sell for Total π Avg. cost Sell for 3 12 18 6 4 6 2 4 16 24 8 4 6 5 25 30 5 5 6 2/24/04 Avg Add’l π/unit cost Add’l rev. Add’l π 2 6 4 2 4 6 2 1 9 6 -3 Economics for CED: Lecture 3, Noémi Giszpenc 19

Information from Costs • All three cost measures show that biggest total profit comes from producing 4 units. • Only marginal cost shows when firm is actually losing, and how much. • Rule: Produce until MC = price – This will give us the supply curve 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 20

Types of costs • Fixed: can’t be altered at short notice – Factory, equipment, salaried staff – Also called sunk costs, overheads – Predictable economies of scale • average fixed cost per unit output declines w/ Q • Variable: can vary w/ Q of output – Raw materials, fuel, temp workers – May not vary evenly 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 21

Costs = Fixed + Variable • Total Costs: C(Q) = F + V(Q) • Average Costs: AC = (F + V(Q) ) ÷ Q – Average Fixed costs = F ÷ Q – Average Variable costs = V(Q) ÷ Q • Marginal Costs: MC = d(F+V(Q))/d. Q – Fixed costs have no effect on MC 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 22

Some cost curves TC TC VC AC MC=AVC AFC MC=AC=1 F = 0, V(Q) = Q 2/24/04 F = 1, V(Q) = Q Economics for CED: Lecture 3, Noémi Giszpenc 23

Another cost curve: “U-shaped” V(Q)=(Q/3 -2)2 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 24

Yet another cost curve: very high fixed costs, low MC TC F=100 V(Q)=Q/100 MC 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 25

A counter-intuitive result • If a firm has fixed costs, and if it can keep meeting its variable costs, it should keep producing regardless of whether it is making a loss. – Making a little toward meeting fixed costs is better than making nothing at all – Explains success of early railroads despite lack of profitability--they just kept chugging! 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 26

Now, productivity: diminishing returns • Holding other factor(s) of production fixed, increasing a factor eventually adds less and less output – Not all producers encounter rising costs and diminishing returns as output increases • Some producers don’t get demand for that level of volume • Some factors of production have fixed capacity – Beyond limit, no production at all • Some factors of production are variable (can vary in proportion to each other) 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 27

Production Function • In general, Production is the transformation of inputs into outputs. – Inputs are the factors of production -- land, labor, and capital -- plus raw materials and business services. • A production function -- f(L, K, etc. )=q -describes how combinations of inputs produce output (given a certain technology) – We saw a production function in first class 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 28

Average and marginal productivity • Productivity is ratio of output to input • Average productivity is total output divided by total input • Marginal productivity is increase in output with addition of last unit of input – With all other inputs held steady (cet. par. ) 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 29

A numerical example: farmer Ted Hours of Labor Output: bushels of wheat Average Productivity Marginal Productivity 0 0 0 9. 45 100 945 9. 45 8. 35 200 1780 8. 9 7. 25 300 2505 8. 35 6. 15 400 3120 7. 8 5. 05 500 3625 7. 25 3. 95 600 4020 6. 7 2. 85 700 4305 6. 15 1. 75 800 4480 5. 6 0. 65 900 4545 5. 05 -0. 45 1000 4500 4. 5 0 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 30

Output Diagram • As the variable input increases, output increases at a decreasing rate. • This is the Law of Diminishing Marginal Productivity 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 31

Average and marginal productivity • Marginal productivity is decreasing and pulling average productivity down. 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 32

What happens to profits? • Assume: – cost of variable input fixed (wage rate of farmer=opportunity cost of working elsewhere), and – price of good produced fixed (price of wheat determined by world markets) • Profits ≈ revenue - costs = Px. Q - C(Q) = Pxf(L, K) - C(L, K) for given L, K 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 33

The relationship will look like this • As labor input increases, output does not increase as fast. • Cost of labor input goes up steadily but return, or value of marginal product slows down 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 34

How to maximize Profit • What does one additional labor unit add to cost? w = wage • What does one additional labor unit add to revenue? p*MP = value of marginal product • Profit is max’ed when p*MP = w 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 35

Costs and types of firms • Natural monopolies – Ex: power & gas, water & sewerage, canals & RR • Continually increasing returns to scale – Big firms out-compete small firms – Ex: steel, machine-making, petro-chemicals • U-shaped costs – Medium-sized firms – Ex: house-building, furniture-making, textiles 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 36

Costs and types of firms • Constant unit costs – Can be big or small – Ex: book publishing, brewing, wineries • Diseconomies of scale – Small firms have lower unit costs than big – Ex: tailoring, repair, individual arts, some farming • Each type of industry has different temptations and remedies 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 37

Firms’ purposes (2) • Working and managing for owners – When firms were mostly sole propietorships – Maximizing profit or return on equity • Directors’ purposes – In 20 th C. , more separation of ownership and control – Adolf A. Berle and Gardner C. Means, The modern corporation and private property (1932) – What are the directors going to do? 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 38

Berle and Means: 3 alternatives 1. Directors maximize owners’ π • but own π motive weakened 2. Manage for their own benefit • • Just enough π paid out to comply with law, attract K Keeps π motive but leads to corp. plunder 3. Manage for good of all society • 2/24/04 Purely neutral technocracy Economics for CED: Lecture 3, Noémi Giszpenc 39

“The state seeks in some aspects to regulate the corporation, while the corporation, steadily becoming more powerful, makes every effort to avoid such regulation. ” Berle and Means (1932) 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 40

Firms are responsible to… – (Can’t survive without any of the below) • • • Owners Creditors Employees Customers Community Local & National government 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 41

Firms’ policy choices • Profit: maximize, moderate, or (for tax purposes) minimize? • Short, medium, or long-term profit? • How to divide profit between dividends and reinvestment in growth? • Aim for big revenue, market share, profit/sales, profit/equity? • Stability or growth? Safety or risk? • Working conditions? Neighborliness? • Sketchiness: offshore taxes, unsavory partners, bribery? 2/24/04 Economics for CED: Lecture 3, Noémi Giszpenc 42