Theory of The Firm Lecture 16 Dr. Jennifer P. Wissink ©2017 John M. Abowd and Jennifer P. Wissink, all rights reserved. March 27, 2017

Shifting Gears to the Theory of the Firm

What Is A Firm? Recall... Broadly: A firm is an organization producing goods or services, also called a business. Examples of common businesses: Grisamore Farms, Microsoft, FedEx, the campus store (a business within Cornell University). Examples of organizations that are not common businesses in the same sense: Cornell University as a whole, U.S. Department of Defense, The Educational Testing Service. What they all have in common: engaging in economic activity via markets and the need to allocate scarce resources.

What Is A Market? Recall... A collection of buyers and sellers organized for the purpose of exchanging goods and services for money. Markets can be global, national, regional, or local depending upon the item being bought and sold.

Theory of The Firm WHY? Note: To bake the supply function from scratch. To better understand firm behavior. To analyze market structures that are NOT characterized by simple demand and supply. Note: There are lots of different types of firms. There are lots of ways to organize entrepreneurial activity. There are lots of firm objectives.

What We Assume (For Now) For our analysis we assume that... we have an owner manager, who runs a firm or business, with the primary objective to maximize economic profit, operating in perfectly competitive input and output markets. Note: We will eventually relax the assumption that we are in a perfectly competitive market environment.

Recall: A Market Is Perfectly Competitive ... When there are many buyers and sellers. When each item traded in the market is identical to all the others. When firms can freely enter and exit the market. When all buyers and sellers have full and symmetric information. So... The law of one price prevails. No single buyer or seller can cause the price to move up or down. In this case, we say that the firms are “price takers.”

i>clicker question So… which organization is a “firm” for which the model of perfect competition would be “right” for predicting behavior? B A D E C

Profit Maximization We assume the objective of the firm is to maximize economic profit. Profit (π) = Total Revenue - Total Cost Total Revenue: determined by the level and nature of competition in your market Total Cost: determined by factor market prices and the firm’s technology or production function

Profit Maximization We assume the objective of the firm is to maximize economic profit. For economic profit we must subtract from revenue ALL the relevant economic costs. Two types of costs to differentiate and subtract from revenue: Explicit costs: costs incurred for transactions that took place through a market interface. Implicit costs: costs incurred for entrepreneurial supplied factors of production, where no market transaction outside the firm actually took place, but for where there was an opportunity cost borne by the entrepreneur. Accounting profit versus Economic profit For accounting profit we only subtract out the explicit costs. For economic profit we subtract out the explicit costs AND the implicit costs. So, accounting profit will be larger than economic profit.

i>clicker question You own an economics tutoring center in Ithaca. On January 1st you purchased a $500,000 portrait of Adam Smith from BritishArt, Inc. to hang in the lobby of your center. To buy this picture you took $500,000 out of your savings account at Bank of America where it was earning 2% interest per year. When preparing your cost data for the year you should A. enter only the $500,000 you paid as a cost. B. enter the $500,000 you paid plus the $10,000 you gave up in interest as the costs. C. enter only the $10,000 you gave up in interest as a cost. D. enter what the current market value of the portrait is as a cost. So remember.... Total Revenue - explicit costs ------------------------ = Accounting profit - implicit costs ------------------------ = Economic profit

Profit Maximization Requires Cost Minimization Profit (π) = Total Revenue - Total Cost There are lots of ways to describe production and cost concepts. You will need to understand them all. For example: explicit and implicit concepts total, fixed and variable concepts long run and short run concepts total, average and marginal concepts all related to each other

Consider Jonathan’s New York State Apple Farm Jonathan’s farm is a business organized to grow and sell apples. Jonathan realizes he is operating in a perfectly competitive apple market. Jonathan is the owner operator/proprietor and Jonathan tries to maximize his profits from the business. Assume he uses his own orchard and land, his own time, and hired labor to run his apple business.

Jonathan’s Apple Farm Short Run Production Function

Jonathan’s Total, Marginal & Average Products of Labor

From Production Functions to Seven Short Run Cost Curves By combining the production function and the factor prices, we produce the firm’s 7 short run cost curves. Each of the entries in this table represents a price that Jonathan must pay for an input. He hires labor at $8/hour. Notice that he “pays” for his managerial time because his next best alternative is to earn $12/hour. He also “pays” for the land since he could rent it out if he wasn’t farming it himself.

The Seven Short Run Cost Concepts Total values fc = fixed costs = $PA•Acres + $PM•Manager vc = variable costs = $PL•Labor*(q) srtc = short run total costs = fc + vc Average values afc = average fixed cost = fc/q sravc = short run average variable cost = vc/q sratc = short run average total cost = srtc/q = (afc + sravc) Marginal values srmc = short run marginal cost = srtc/q = vc/q

Jonathan’s Apple Farm Cost Structure

Jonathan’s Apple Farm Cost Structure

Graphs of Jonathan’s Short Run “Totals” Cost Curves Quantity of apples (q) on the horizontal. Costs ($) on the vertical. Fixed Costs are “flat”. Variable Costs increase with apple production. They increase at a decreasing rate at first. They eventually increase at an increasing rate. WHY? Short Run Total Costs are simply the vertical sum of fixed and variable costs.

Graphs of Jonathan’s Short Run Marginal & Average Cost Curves Average Fixed Cost Average Variable Cost Short Run Average Total Cost Short Run Marginal Cost THE COST GRAPH

THE COST GRAPH 1360 485.33 400

Short Run Cost Curves: Locations, Shifts and Movements Movements Along

Short Run Cost Curves With Multiple Variable Factors: Bang/Buck Suppose there are two types of hired labor: skilled and unskilled, Ls and Lu, with wages per hour Ps and Pu, respectively. How would this change Jonathan’s cost structure? Would need to know the short run production function for how skilled and unskilled labor can be substituted for each other. Suppose we knew this information and that it led to us knowing the marginal product curves for skilled and unskilled labor. Suppose we are operating where marginal product curves are declining. How would our derivation of the 7 short run cost curves change? The only real change occurs in the variable cost function. NOW... vc = $Ps•Ls*(q) + $Pu•Lu*(q) So: How do you determine Ls*(q) and Lu*(q)? Employ the “equal bang per buck” rule. So… given the input prices and marginal productivity information, find the combination of skilled and unskilled labor where the following is met: at LS*(q) and LU*(q) you need to have [MPs/$Ps] = [MPu/$Pu]

Example: The Bang/Buck Rule Suppose q=100 tons of apples. Suppose: Ls=10 hours & the MPs at 10th hour is 48 tons. Suppose: Lu=25 hours & the MPu at 25th hour is 36 tons. Suppose Ps=$12/hour Suppose Pu=$6/hour Jonathan’s Variable Cost = $12•10 + $6•25 = $270 Bang/buck in skilled = MPs/Ps = 48/12 = 4 tons Bang/buck in unskilled = MPu/Pu = 36/6 = 6 tons i>clicker Question Given this information, to make q=100 tons of apples more cost efficiently, Jonathan should A. do nothing – he’s doing great! B. use more Skilled and the same Unskilled. C. use only Skilled. D. use more Skilled and less Unskilled. E. use more Unskilled and less Skilled. tons 48 mpskilled 10 Hours Skilled Labor tons 36 mpunskilled 25 Hours Unskilled Labor