Lecture 7:The Firm Sources: http://www.arts.cornell.edu/econ/wissink/econ1110jpw/ http://www.investopedia.com/university/economics  http://ingrimayne.com/econ/ Case, Fair, Oster, Introduction to Microeconomics Case, Fair, Principles of Microeconomics

What Is A Firm? Broadly: A firm is an organization producing goods or services, also called a business. Examples of common businesses: Ülker, Microsoft, FedEx, the campus store (a business within University). Examples of organizations that are not common businesses in the same sense: World Health Organization, Turkish 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. "industry" cannot be used interchangeably with "firm." An industry is defined as all firms producing similar products.

The circular flow diagram divides the economy into 2 sectors: This division of economic life is illustrated below in the circular flow.   The circular flow diagram divides the economy into 2 sectors: one concerned with producing goods and services, and the other with consuming them.

3 fundamental tasks of all firms 1) a firm must obtain inputs. Inputs include raw materials, energy, machinery, office space, workers, and anything else needed to produce output. 2) the firm must combine or use inputs to produce output. Output may either be a tangible good such as a pair of shoes or an automobile, or a service such as a haircut or a medical checkup. 3)Third, the firm must sell its output to someone else.

What Is A Market? 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. Overview

What We Assume 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. We will eventually relax the assumption that we are in a perfectly competitive market environment.

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.” So… which of the below are best described by the model of perfect competition?

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 analysis of the firm is being done today. We know, however, that the life of a firm plays out over time with benefits and costs in each period of the firm’s lifetime.

Production & Cost Structures There are lots of ways to describe production and cost concepts. You will need to understand them all. For example: total, fixed and variable concepts average and marginal concepts long run and short run concepts all related to each other

Ahmet’s Amasya Apple Farm The farm is a business organized to grow and sell apples. The owner/proprietor, Ahmet, tries to maximize his profits from the business.

Production Functions The production function shows the input requirements for each level of production. For some businesses the production function is relatively simple--a few processes with little substitution. For some businesses the production function involves thousands of different processes and millions of substitution possibilities. The production function is the economist’s summary of the input requirements for each level of production.

Fixed Factors A fixed factor is one that does not vary as the quantity produced increases or decreases. Some factors are fixed in the short run (managerial time). Some factors are fixed in the medium run (cultivated acreage (arazi alanı). No factors are fixed in the long run.

Variable Factors A variable factor is one that must be increased in order to increase output. The classic variable factor is labor. Variable factors usually exhibit diminishing marginal productivity--the amount of extra product generated by each additional unit of the input, holding other inputs constant, declines.

Ahmet’s Apple Farm Short Run Production Function The table describes Ahmet’s inputs for the annual production of apples shown in the first column.

Ahmet’s Apple Farm Short Run Production Function 2 Labor Total Product Marginal Product Average Product Of Units Tons Of Of Labor (Employees) Apples - 1 10 10,0 2 25 15 12,5 3 37,5 4 40 2,5 5 41,5 1,5 8,3 6 42 0,5 7,0 7 6,0 Marginal Product: The additional output that can be produced by adding one more unit of a specific input, ceteris paribus. Law of diminishing returns: When additional units of a variable input are added to fixed inputs after a certain point, the marginal product of the input decreases.

Ahmet’s Total Product of Labor TPL = # of apples produced as a function of labor used holding other fixed inputs constant. TPL = f(L) Always in short run every firm will face diminishing returns . Thus, every firm finds it progressively more difficult to increase its outputs as it approaches CAPACITY OF PRODUCTION Labor Total Product Units Tons Of (Employees) Apples (TPL ) 1 10 2 25 3 37,5 4 40 5 41,5 6 42 7 Apples in tons

Ahmet’s Marginal & Average Products of Labor Total Product Marginal Product Average Product Of Units Tons Of Of Labor Apples - 1 10 10,0 2 25 15 12,5 3 37,5 4 40 2,5 5 41,5 1,5 8,3 6 42 0,5 7,0 7 6,0 Number of employees

Getting the Short Run Cost Curves

Ahmet’s Apple Farm Short Run Production Function The table describes Ahmet’s inputs for the annual production of apples shown in the first column.

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. Ahmet Each of the entries in this table represents a price that Ahmet must pay for an input. Notice that he “pays” for his managerial time because his next best alternative is to earn $12/hour. He must pay rent for his land.

The Seven Short Run Cost Concepts Total values fc = fixed costs = vc = variable costs = 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 cost srmc = short run marginal cost = srtc/q = vc/q

Ahmet's Apple Farm Cost Structure Apples (tons/year) $fc $vc $srtc $afc $avc $sratc $srmc 50 100 150 200 250 300 350 Ahmet

Diminishing returns, or decreasing marginal product, implies increasing marginal cost. MP(q) SRMC(q) Marginal product Marginal cost Units of Labor, L Units of output, q

Graphs of Short Run “Totals” Cost Curves Quantity of apples 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 start increasing at an increasing rate. Short Run Total Costs are simple the vertical sum of fixed and variable costs.

Marginal & Average Cost Curves Average Fixed Cost Short Run Average Total Cost Average Variable Cost Short Run Marginal Cost

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 someone’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. vc = Ps•Ls*(q) + Pu•Lu*(q) 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: MPs/Ps = MPu/Pu

Suppose q=100 tons of output. Example: The Bang/Buck Rule The phrase is obviously American in its origin (as a 'buck" is a dollar) John Foster Dulles laid the policy of "massive retaliation" ... in 1954 and told the Council on Foreign Relations ... "it is now possible to get, and share, more basic security and less cost." Defense Secretary Charles E. Wilson promptly dubbed the policy the "New Look"... and said it would provide a "bigger bank for a buck." Suppose q=100 tons of output. Suppose Ls=10 hours and the MPs at 10 hours is 48 tons. Suppose Lu=25 hours and the MPu at 25 hours is 36 tons. Suppose Ps=$12/hour and Pu=$6/hour Variable cost = $12•10 + $6•25 = $270 Bang/buck in skilled = 48/12 = 4 Bang/buck in unskilled = 36/6 = 6 So… take $1 out of skilled and move it to unskilled labor Ok, let’s make the point easier… hire 1 less skilled worker, and with the money saved, hired as many unskilled workers as you can. Variable cost will stay the same. You’ll hire 1 less skilled worker and 2 more unskilled workers (based on the two wages). You will produce 48 fewer tons using 1 less skilled worker, but… You will produce 72 more tons using 2 more unskilled workers, so…. Spending the same amount in costs, you now have produced 24 more tons!

So What? The 7 short run cost curves will still look and feel and hang together the same way. We just now know that if there is more than one variable input behind the scenes, the plant manager has successfully carried out the cost minimization exercise correctly and has equated the bang/buck across all variable inputs. In this way we derive “best” or “minimum” cost functions.