Production and Costs Ch. 19, R.A. Arnold, Economics 9 th Ed

Business / Firms In this chapter we study the economic actor: Business / Firm or Business Firm In Ch. 2 we studied the economic activity of production. You should review those concepts and try to relate it to this chapter. The economic activity of production is undertaken by the business / firm. Production is the transformation of resources / factors of production into goods or services. E.g. Golpea Burger in our cafeteria makes burger (the good!) using: bread, beef patty and cheese (the resources).

Why Firms Exist? Alchian and Demsetz (Dec 1972) provided a theory suggesting that firms exist because of the benefits of working as a team. Sum of team production > Sum of individual production E.g. Person A, B and C can make 10 burgers each per hour (individually). So sum of individual production = 30 burgers per hour. But together (as a team) they may be able to make 40 burgers per hour. Why? Can a theory/concept from Ch. 2 explain this. Remember: Specialization. If A, B, C divide the task of making a burger and each specialize in the task they are good at. E.g. A specializes in beef patty and B makes bread and C makes cheese. Together they may be able to produce more burger. Hence, they get together and open a burger shop

Continued There are benefits of working as a team but there are problems as well. One problem of team production is shirking (when workers put less effort than they are supposed to). Chances of shirking are higher in a team since costs of shirking are lower. How? There’s a nice example in the text-book that explains this. Solution? The Monitor (Manager) in a firm reduces the amount of shirking by firing shirkers and rewarding the productive members of the firm (an incentive for not shirking).

The Firm’s Objective: Maximizing Profit Q: Why do firms undertake the activity of production? A: To maximize profit (it is the incentive for production) Profit = Total Revenue (TR) – Total Cost (TC) Ch. 17, TR = Price (P) x Quantity (Q) E.g. if 40 burgers are sold at 100 BDT each. TR = 100 x 40 = 4,000 BDT Total cost can be divided into two categories: explicit cost and implicit cost. Explicit cost: A cost for which an actual monetary payment was made e.g. cost of labour, capital etc. Implicit cost: A cost for which no monetary payment was made. E.g. the opportunity cost of starting a business.

Continued (Example based on the juice- bar our imaginary friend opened in Quiz 2) If our friend’s juice bar produces 1000 cups of juice per month and sells each at 50 taka. Then, TR = 50 x 1000 = 50, 000 taka Let’s assume, our friend spent 40, 000 taka buying fruits, sugar, blender, paying employees (labour) and renting a van / cart. This is the explicit cost. In accounting we consider the explicit cost only. So, Accounting profit = TR – Explicit Cost = 50, 000 – 40, 000 = 10, 000 In economics we consider the implicit cost as well. Here, instead of opening a juice- shop our friend could have worked at a regular ‘office job’ earning 10, 000 taka per month. This is the opportunity cost of our friend’s decision of starting a business and hence we include it as the the implicit cost. Remember, our friend is the entrepreneur. You could say it is the cost of entrepreneurship. But no actual monetary payment is made for this resource. So it is an implicit cost. Economic Profit = TR – (Explicit + Implicit Cost) = 50, 000 – (40, , 000)

Continued Economic profit = 0. This situation is called ‘zero economic profit’. A business may operate even if it’s earning zero economic profit. Why? As we can see our friend’s opportunity cost (the implicit cost of 10, 000 taka) – the salary he could have earned at the next best line of employment (office job) – is being covered by the total revenue. Hence, he may decide to continue the business instead of working at a office. In other words, he is making an accounting profit of 10, 000 taka Generally, Economic profit < Accounting profit And zero economic profit is acceptable, as we can see above.

Production and Cost Production – transformation of inputs into goods the inputs our friend will need at his juice shop – fruits, sugar, labour and a cart/van. Let’s assume our friend leases (rents) the cart/van for 6 months. Hence, for the 6 months he has to use the (1) cart or van, whether he produces 0 of juice or 1000 cups of juice. So this input (van) does not vary with the output. Hence it is a fixed input. But the other inputs – fruits, sugar and labour will vary as the production/output varies. If we produce more juice we need more fruits, sugar, labour. Hence these are all variable inputs.

Continued The inputs (fixed and variable) are the source of cost for any business. Hence, Total cost (explicit cost) = total fixed cost + total variable cost Here, we assume – our friend uses only labour (variable input) and capital (the van or cart; the fixed input) - to simplify the following analysis – where we study the production of our friend’s juice-shop in the short run. Short run: A period of time during which at least one input in the production process is fixed. Here the van is leased (fixed) for six months. So here, 6 months is the short run. If the lease was for 3 years. 3 years would be the short run. After 6 months your friend may decide to stop using the van. So this input is no longer fixed after 6 months. Long run: A period of time during which all inputs may be varied.

Production in the short run If your friend wants to increase his production of juice in the short run what should he do? Remember: He cannot change the fixed input (van); so his only option is to hire more labour to make more juice. Our friend may want to know, how many more additional cups of juice can a worker make? This answer is provided by the marginal physical product of labour – the change in output (cups of juice) that results from employing one more labour, holding all other inputs fixed (ceteris paribus). Let’s do this analysis formally in a table (next slide) – where we are studying the production of our friend’s juice shop during 1 month. Rent of van per month = 1000 tk & salary of a worker = 500 taka per month.

Fixed Input, Capital (Van) Variable Input, Labour Quanity of Output, Q (Cups of juice) Marginal physical product of labour Total Fixed Cost Total Variable cost Total CostMarginal Cost In the table above, MPP of the 1 st labour i.e. additional cups of juice produced by the first labour is easy to calculate (1000 – 0 = 1000). Similarly MPP of the 2 nd labour i.e. additional cups of juice produced by the 2 nd labour = 2500 – We are using column 3 (Quantity of output, Q).

Continued Something interesting can be observed when we study the MPP table. The MPP increases initially. Why? Remember team production > individual production. Specialization could explain this as well. But later as we add more labour MPP falls. Why? Ans: The fruit shop becomes overcrowded, workers get in the way of one another, shirking may increase, so the MPP falls. This is the law of diminishing marginal returns – as we combine larger amounts of a variable input with fixed input(s), eventually the marginal physical product of the variable input declines. But the total output still increases (3 rd column; Q) so your friend may hire the 5 th employee.

Continued Total Cost = Total Fixed Cost + Total Variable Cost = Column 5 + Column 6 Marginal Cost (MC) means the additional cost of producing one more cup of juice. The additional cost here is the wage (W) = 500 taka. So to find marginal cost we can use, MC = (W / MPP). For example to find the marginal cost, 0.5 = (500 / 1000). This is how obtain the values in the last column. Here the salary of every additional worker is 500 taka. So we can see as MPP increases, the MC decreases and when MPP decreases, MC increases. You can verify this by studying the table above. Another formula for MC = (∆TC / ∆Q ). Here, ∆TC = W = 500 and ∆Q = MPP. Hence, we get the same result.

Continued Our friend may ask us, should I hire one more worker or labour? Let us answer his question. The 1 st worker he hires adds 1000 cups of juice (MPP of 1 st worker) to the production. Assuming the 1000 cups of juice can be sold at 50 taka each. The business can earn a total revenue of = 50, 000 taka from those 1000 cups. The cost of hiring the worker = 500 taka. Here, the benefit (revenue) of hiring the worker > cost (wage) of hiring the worker. So he should definitely hire the 1 st worker. The same analysis can be extended to any one of the worker. Generally, a firm/business should employ/hire a labour if the additional goods he produces generates a revenue greater than the cost of employing/hiring him.

Maximizing Profit Another question that might arise in our friend’s business (or any business): Should one more cup of juice (output) be produced? This is an example of decision making at the margin (Ch. 1) – where we compare the marginal benefit with marginal cost. The marginal benefit of producing one more good/output is actually the marginal revenue! It is the additional revenue a business can obtain from producing and selling one more unit of good. If the marginal revenue (MR) > marginal cost (MC), then the output/good should be produced. Since profit (revenue – cost) can be obtained from the output/good.

Maximizing Profit Finally, the million dollar question is, how many cups of juice should our friend produce to ‘maximize his profit’ (‘obtain the highest profit out of his business’)? Ans: He should produce the number of cups of juice (Q) at which MR = MC (the profit maximizing condition). At this point his business (any business) will be maximizing profit. Why? Remember a business should produce a an unit of good if MR > MC. But as they produce more units of good using more variable resources MC increases (Why? Ans: Slide 12). And at one point MR = MC. At that point, the business should stop production. The business is now producing the profit maximizing level of output!