1 Welcome to EC 209: Managerial Economics- Group A By: Dr. Jacqueline Khorassani Week Seven

2 Managerial Economics Week Seven- Class 1 Monday, October 15 11:10-12:00 Fottrell (AM) 11:10-12:00 Fottrell (AM)

3 This week’s Aplia Assignment IS DUE BEFORE 5:00 PM Wednesday You did not send me any questions Should I assume you are ok?

4 Long Run Production Function What is long run? What is long run? –All factor of production are variable –In our example we had K and L –We can hire more of both –This is the planning stage of production –How big the plant should be?

5 Isoquant A curve that shows the combinations of inputs (K, L) that yield the same level of output. A curve that shows the combinations of inputs (K, L) that yield the same level of output. Suppose our goal is to produce 100 widgets per day Suppose our goal is to produce 100 widgets per day –What combinations of K and L yield 100 widgets per day?

6 How does an isoquant look? The shape depends upon: The shape depends upon: 1.the state of technical knowledge, and 2.the degree of substitution between factors. K L

7 The slope of the isoquant is the marginal rate of technical substitution (MRTS) the marginal rate of technical substitution (MRTS) MRTS = -  K/  L MRTS = -  K/  L measures the degree of substitution between the two factors. measures the degree of substitution between the two factors. How many staplers (K) can do the job of 1 worker (L) and still produce 100 widgets? How many staplers (K) can do the job of 1 worker (L) and still produce 100 widgets?

8 How does isoquant relate to marginal product? As we move down on the isoquant and hire more L As we move down on the isoquant and hire more L 1.Q ↑ by  L  MP L 2.Q↓ by  K  MP K – But along an isoquant  Q= 0 – -  K  MP K +  L  MP L = 0 – Or – -  K /  L = MP L / MP K – We know that – -  K /  L = MRTS – So – Slope = MRTS = -  K /  L = MP L / MP K

9 Can isoquant be linear? Yes Yes If capital and labor are perfect substitutes If capital and labor are perfect substitutes Example: Example: –Completely automated dishwasher, or –Worker washing the dishes –Production function: Q = aK + bL –dQ = a dK + b dL –dQ/dK = MP k = a –dQ/dL = MP L = b –MRTS KL = - MP L / MP K = -b/a

10 Linear Isoquant Q3Q3 Q2Q2 Q1Q1 Increasing Output L K Slope = MRTS KL = - MP L / MP K = - b/a Suppose b= 3 and a = 1 Slope is -3/1 3 robots can do the job one labour Her is a question for you What is Q1? Q1= ak + bL Q1 = 5 +3= 8, or Q1 = 2 +6= 8

11 Leontief Isoquants Capital and labor are perfect complements. Capital and labor are perfect complements. Capital and labor are used in fixed-proportions. Capital and labor are used in fixed-proportions. Q = min {bK, cL} Q = min {bK, cL} Example: taxi service Example: taxi service If K = 4 but L = 2  can produce 2 rides If K = 4 but L = 2  can produce 2 rides If K = 6 but L = 2  can produce 2 rides If K = 6 but L = 2  can produce 2 rides Q3Q3 Q2Q2 Q1Q1 K Increasing Output L =2 2 2

12 In most cases inputs are somewhat but not perfectly substitutable Cobb-Douglas Isoquants. Cobb-Douglas Isoquants. Q = K a L b Q = K a L b MP K = dQ/dK = aK a-1 MP K = dQ/dK = aK a-1 MPL= dQ/dL = bL b-1 MPL= dQ/dL = bL b-1 Slope of isoquant = MRTS KL = MP L /MP K Slope of isoquant = MRTS KL = MP L /MP K Slope of isoquant = MRTS KL =bL b-1 / aK a-1 Slope of isoquant = MRTS KL =bL b-1 / aK a-1 Slope is not constant Slope is not constant –As L or K change, slope changes

13 Cobb-Douglas Isoquants As L increases slope decreases As L increases slope decreases Diminishing marginal rate of technical substitution. Diminishing marginal rate of technical substitution. As more of one input is used in the production process, you can give up even less of the other input to produce the same output level. As more of one input is used in the production process, you can give up even less of the other input to produce the same output level. Q1Q1 Q2Q2 Q3Q3 K L Increasing Output

14 So you know your isoquant You decide that you want to produce Q1 amount of output You decide that you want to produce Q1 amount of output What combination of K and L are you going to hire? What combination of K and L are you going to hire? It depends on It depends on What combination of K and L minimizes your cost What combination of K and L minimizes your cost What is the price of labour and capital? What is the price of labour and capital?

15 Total cost of production Is the cost of capital plus the cost of labour Is the cost of capital plus the cost of labour Total cost = TC = rK + wL Total cost = TC = rK + wLwhere r = payment to a unit of capital w = payment to a unit of labour

16 Isocost curve Shows all combinations of K and L and are going to cost you the same. Shows all combinations of K and L and are going to cost you the same. Example: Example: –w = €2, r = €1 and you want to spend €100 a) You can hire 1L & _____K, or b) You can hire 2L & _____K As move from a to b, dK/dL =? dK/DL= -2/1 = -w/r = slope of isocost curve 98 96

17 Let’s see the isocost curve What if we want to spend €200? What if we want to spend €200? Isocost shifts up Isocost shifts up K L C1C C0C Slope = -w/r

18 Managerial Economics- Group A Week Seven- Class 2 Week Seven- Class 2 –Tuesday, October 16 –Cairnes –15:10-16:00 Aplia assignment is due before 5PM tomorrow Aplia assignment is due before 5PM tomorrow

19 Correction (my booo booo) Cobb-Douglas Isoquants. Cobb-Douglas Isoquants. Q = K a L b Q = K a L b MP K = dQ/dK = aL b K a-1 MP K = dQ/dK = aL b K a-1 MPL= dQ/dL = bK a L b-1 MPL= dQ/dL = bK a L b-1 Slope of isoquant = MRTS KL = MP L /MP K Slope of isoquant = MRTS KL = MP L /MP K Slope = bK a L b-1 /aL b K a-1 = (b/a) * (K/L) Slope = bK a L b-1 /aL b K a-1 = (b/a) * (K/L) –As L ↑  slope ↓

20 Returns to scale Suppose 1L + 2K  10 units of output Suppose 1L + 2K  10 units of output 1. Now double inputs – Out put more than doubles (increasing returns to scale) 2. Now double the inputs again –output less than doubles (decreasing returns to scale) Somewhere between 1&2  constant returns to scale Somewhere between 1&2  constant returns to scale K L

21 Returns to scale Using Q = a K b L c Using Q = a K b L c a study of Canadian manufacturing industries found that a study of Canadian manufacturing industries found that 1.textile industries exhibited decreasing returns to scale 2.shoe factories and jewellery exhibited constant returns to scale 3.while paint and concrete blocks exhibited increasing returns to scale.

22 Remember our iso-cost curve What if w goes down from €2 to €1? K L 100 C0C Slope = -w/r Slope decreases to -1/1 C1

23 Let’s look at our isoquants Suppose we decide that we want to produce Q2 Suppose we decide that we want to produce Q2 What combination of K and L should we use? What combination of K and L should we use? –A or B? Depends on the cost of K and L Depends on the cost of K and L Depends on isocost Depends on isocost Q1Q1 Q2Q2 Q3Q3 K L X X A B

24 To minimize our cost Choose that point on an isoquant which is tangent to the lowest isocost line. Choose that point on an isoquant which is tangent to the lowest isocost line. At B At B The slope of the isocost line = The slope of the isoquant The slope of the isocost line = The slope of the isoquant -w/r = -MP L /MP K, or -w/r = -MP L /MP K, or Q1Q1 Q2Q2 Q3Q3 K L X X A B C1

25 Suppose a firm initially produces 100 widgets by employing 5 L and 20 K. r = 2 and w = 4 (point A ) The firm is spending _______. The firm is spending _______. Suppose w falls to 2. Suppose w falls to 2. Isocost rotates Isocost rotates But you want to produce the same level of output But you want to produce the same level of output Draw a line parallel to the new isocost but tangent to the isoquant Draw a line parallel to the new isocost but tangent to the isoquant Move to point B Move to point B –Hire more L (10) –Hire fewer K (10) –Spend the less (40) –Spend the less (€40) A L K B 30 €

26 Cubic Cost Function C(Q) = f + a Q + b Q 2 + cQ 3 C(Q) = f + a Q + b Q 2 + cQ 3 Marginal Cost is the first derivative of the total cost function Marginal Cost is the first derivative of the total cost function dC/dQ = a + 2bQ + 3cQ 2

27 An Example –Total Cost: C(Q) = 10 + Q + Q 2 –Variable cost function: VC(Q) = Q + Q 2 –Variable cost of producing 2 units: VC(2) = 2 + (2) 2 = 6 –Fixed costs: FC = 10 –Marginal cost function: MC(Q) = 1 + 2Q –Marginal cost of producing 2 units: MC(2) = 1 + 2(2) = 5

28 Average cost in long run LRAC $ Q Economies of Scale Diseconomies of Scale

29 Sources of economies of scale 1. Savings in resources – real economies of scale. 2. Inputs obtained at lower prices - pecuniary economies of scale. 3. Learning by doing

30 Multi-Product Cost Function C(Q 1, Q 2 ): Cost of jointly producing two outputs. C(Q 1, Q 2 ): Cost of jointly producing two outputs. General function form: General function form:

31 Economies of Scope Cost gains made by producing two or more products together rather than separately. Cost gains made by producing two or more products together rather than separately. Example Example –It is cheaper for Time-Warner to produce Internet connections and Instant Messaging services jointly than separately. –Why? Share common inputs. Share common inputs.

32 Managerial Economics- Group A Week Seven- Class 3 Week Seven- Class 3 –Thursday, October 18 –15:10-16:00 –Tyndall Next Aplia Assignment is due before 5 PM Tuesday, October 23 Next Aplia Assignment is due before 5 PM Tuesday, October 23

33 A question The first question in the Graded MCQ for week 8 has two answer choices that are identical but worded differently. The first question in the Graded MCQ for week 8 has two answer choices that are identical but worded differently. –B. the firm should use less L and more K to cost minimize. and –C. the firm should use more K and less L to cost minimize. –C. the firm should use more K and less L to cost minimize. I was wondering if that was a typo or if those are supposed to be two of the possible answer choices. I was wondering if that was a typo or if those are supposed to be two of the possible answer choices.

34 My Answer You are absolutely right. Choices B and C are saying the same thing. You are absolutely right. Choices B and C are saying the same thing. I changed choice B to less K and more L. I changed choice B to less K and more L. Thank you Thank you

35 Another Question What is an expansion path? What is an expansion path?

36 My answer A line that connects the points of tangencies between the isocost lines and the isoquant curves (the optimal choices of L & K) as the quantity of output increases and the price of capital and labor remain constant. (i.e., we move to higher isoquants) A line that connects the points of tangencies between the isocost lines and the isoquant curves (the optimal choices of L & K) as the quantity of output increases and the price of capital and labor remain constant. (i.e., we move to higher isoquants) Q1Q1 Q2Q2 Q3Q3 K L Expansion path C1C1 c2c2 C3C3

37 Cost concepts and strategic advantage 1. Firm seeks to achieve costs lower than rivals. –  Gaining competitive advantage compared to its rivals. 2. Being the least cost operator in an industry means: –can charge lower prices than rival and still make profits. –can charge same price and make higher profits. 3. Sources of lower cost that rivals economies of scope & scale economies of scope & scale

38 Cost Complementarity The marginal cost of producing good 1 declines as more of good 2 is produced: The marginal cost of producing good 1 declines as more of good 2 is produced: Example: Example: –Cow hides and steaks MC Cow hides ↓  MC Cow hides ↓  as Q steaks ↑

39 Chapter 6 of Baye The Organization of the Firm Notes 1. You must also read the article by Michael Jensen on Blackboard. 2. The article by Gibbons (also available on Blackoard) is now recommended but not required.

40 Manager’s Role Produce a the least cost manner, like point B. Produce a the least cost manner, like point B. Provide incentives for workers to put forth effort. Provide incentives for workers to put forth effort. Failure to accomplish this results in a point like A. Failure to accomplish this results in a point like A. Achieving points like B managers must Achieving points like B managers must –Use all inputs efficiently. –Acquire inputs by the least costly method. $ Q Costs A B C(Q)

41 Methods of Procuring Inputs 1. Spot Exchange –When the buyer and seller of an input meet, exchange, and then go their separate ways. –Advantages: Specialization, avoids contracting costs –Disadvantages: Possible “hold-up problem.”

42 Here is what I saw in Brazil (spot exchange)

43 Daily workers specialize in unloading trucks

44 Methods of Procuring Inputs 2. Contracts –A legal document that creates an extended relationship between a buyer and a seller. –Example: I have an employment contract with my university I have an employment contract with my university –Advantages: specialization, high productivity –Disadvantages: costly contracts, fixed cost

45 Methods of Procuring Inputs 3. Vertical Integration –A firm produces its own inputs –Example You have a restaurant You have a restaurant Also produce your own pasta Also produce your own pasta –Advantages: avoids contracting costs. –Disadvantages: lost specialization and may increase organizational costs.

46 Transaction Costs Costs of acquiring an input over and above the amount paid to the input supplier. Costs of acquiring an input over and above the amount paid to the input supplier. Includes: Includes: –Search costs. –Negotiation costs. –Other required investments or expenditures.

47 Transaction costs Coase (1937) contrasted resource allocation in markets and in firms: Coase (1937) contrasted resource allocation in markets and in firms: –In markets, guided by price. –In firms, guided by entrepreneur co-ordinator. Costs of using market – transaction costs. Costs of using market – transaction costs. Costs of organizing firm – governance costs. Costs of organizing firm – governance costs. Firms are more efficient than markets because they avoid transaction costs. Firms are more efficient than markets because they avoid transaction costs. Compare marginal transaction and management costs. Compare marginal transaction and management costs.

48 Specialized Investments Investments made to allow two parties to exchange but has little or no value outside of the exchange relationship. Investments made to allow two parties to exchange but has little or no value outside of the exchange relationship.

49 Types of specialized investments 1.Site specificity. You build your pasta factory near a major restaurant that buys your pasta. You build your pasta factory near a major restaurant that buys your pasta. 2. Physical-asset specificity. Your pasta factory uses a special machine to produce a certain type of pasta that the restaurant needs Your pasta factory uses a special machine to produce a certain type of pasta that the restaurant needs

50 Types of specialized investments 3. Dedicated assets. The restaurant is the main customer of the pasta factory. Without that restaurant your factory will lose money. The restaurant is the main customer of the pasta factory. Without that restaurant your factory will lose money. 4. Human capital. You work for the pasta factory that uses a unique machine. If you lose that job, your skills are not useful at any other pasta factory. You work for the pasta factory that uses a unique machine. If you lose that job, your skills are not useful at any other pasta factory.