Level 5 Economics: The Theory of the Firm Learning Outcome Three Economic Principles Economic Principles Economic Environment Economic Environment

Supply: Production and Distribution supply chain of added-value supply chain of added-value S & R, S fig 5.1fig 5.1 – extraction, manufacturing (ie processing), distribution, consumption goods – intermediate goods (material inputs, including raw materials) and final goods associated services associated services services – producer services factor inputs factor inputs – labour (variable), land/capital (fixed) – entrepreneurial input S & R, S fig 5.2 decision-making; factor-hiring and risk-taking Non-Factor Inputs Payments: Wages, Rents, Interest, Profits

Law of Diminishing (decreasing) Returns adding labour to capital adding labour to capital variable input fixed inputs – as increasing quantities of a variable input (esp labour) are added to fixed amounts of other inputs (eg capital, land), the additions to output gained will at some point start to decrease – additional output (marginal product) initially increases, eventually decreases consider workers hired in an open-plan office consider workers hired in an open-plan office – floor space, fittings and computers fixed Total and Marginal Product Total and Marginal Product S & R, S fig 5.3fig 5.3 – Quick Exercise S & R, S Q2 (end of chapter) Quick Exercise

Short Period and Long Period In the short run, as we have seen, factors typically demonstrate increasing returns before decreasing returns take effect In the short run, as we have seen, factors typically demonstrate increasing returns before decreasing returns take effect In the long run, all inputs are variable: In the long run, all inputs are variable: – increasing returns is usual, although decreasing returns still occur when a firm gets too big A special long run case is returns to scale where all inputs are increased proportionately. A special long run case is returns to scale where all inputs are increased proportionately. S & R, S table 5.2table 5.2

Relationship between Output (Q) and Cost Average Cost (AC) = 1 / Average Product Average Cost (AC) = 1 / Average Product – ie, here, AC is inverse of labour productivity Marginal Cost (MC) = 1 / Marginal Product Marginal Cost (MC) = 1 / Marginal Product  Q=MP=2 marginal cost one item is half (½) a worker – if 1 extra worker allows 2 more items (  Q=MP=2) to be produced per hour, then the marginal cost of one item is half (½) a worker per hour. – from employers' point of view MC equals $10 if workers earn $20 per hour MC equals $7 if workers earn $14 per hour Total Product vs. Total Cost Total Product vs. Total Cost – example example from Mankiw, Principles of Economics (4e), p.272

Workers Paid $10 per hour. Fixed cost (eg rent) of $30 per hour. variable input from Mankiw, Principles of Economics (4e), p.272 decreasing returns = increasing costs

Accounting Cost vs Economic Cost Accounting costs are money costs Accounting costs are money costs – explicit payments for the: materials and services purchased by a firm, and factors of production (eg labour) hired by that firm Economic costs include additional opportunity costs Economic costs include additional opportunity costs – examples of small business implicit factor costs: salary of owner-manager rent on owner-occupied land interest on a firm's capital – example of an owner-occupied farm as a firm When should freehold farmers let someone else farm their land?

When should freehold accountant-farmers let someone else farm their land? The market salary of a sheep farm manager is part of a farm's cost, whether the owner or someone else is the manager. If the freehold accountant-farmer can earn more as an accountant, s/he should do that instead, and employ a manager at the market rate. – the farmer owns and sells the sheep for profit; in addition s/he earns say $100,000 as an accountant, paying $80,000 to manager Further, a land-owner could lease (rent-out) the land and gain a return on the land as pure rent – the tenant (a firm) owns and sells the produce for profit if the land-holding was large enough, the landowner would not have to work "gentlemen" were landowners who lived on their tenants' rents

Economic Profit vs. Accounting Profit from Mankiw, Principles of Economics (4e), p.270 we will see later that a competitive firm in long-run equilibrium has zero economic profit case of zero economic profit

Cost Schedules and Cost Curves cost schedules show economic costs cost schedules show economic costs – contrast fixed and variable costs S & R, S table 5.1table 5.1 total, average & marginal cost curves total, average & marginal cost curves S & R, S fig 5.4 totalcost curves totalcost curves – short-run economies (falling average cost) and diseconomies (rising average cost) – technical optimum ("efficient quantity"): quantity at which average cost is at its lowest (minimum) exercise exercise exercise

Cost Schedules back AC = TC / Q MC =  TC /  Q =  TVC /  Q there is mistake in book p.102 (p.96 4e)

solutions

Short-run vs. Long-run Costs short-run cost curve (SAC) short-run cost curve (SAC) short runinputs – in the short run, some factor inputs are fixed long-run cost curve (LAC) long-run cost curve (LAC) long runinputs – in the long run, all factor inputs are variable – the 'scale' (ie size) of firms change over time firms' SACs shift to the right as firms get bigger the possible SAC shifts trace out a firm's LAC Economies of Scale Economies of Scale – the decreasing average cost part of the LAC represents 'economies of scale' – diseconomies of scale occur when the LAC rises S & R,S fig 5.5fig 5.5 Grocery Shop Example

Exercise (part of day-class tutorial) do Exercise Sheet 3aa for HomeworkExercise Sheet 3aa

Fig 5.6 eg Dairy eg Superette 5070Customers per hour $ Grocery Retail Industry

eg small Supermarket $

economies of scale diseconomies of scale eg large Supermarket eg Dairy eg Superette eg small Supermarket $ back

from (Tutorial) Exercise Sheet 3ab: solutionExercise Sheet 3ab solution QTFCTVCTCAFCAVCACMC ? ? 2020 ? ? 20 ? 65 ? 150 ? 160 ? 180 ? 240 ? 320 ? 65 ? 40 ? 4 ? 36 ? 45 ? 35 ? 30 ? ? 60 ?

Exercise Exercise: fill the gaps Fig. back ie Total Product

back

Fig 5.5

Meaning of Labour Costs In this section, average labour cost for a firm is properly understood as: In this section, average labour cost for a firm is properly understood as: 1 / labour productivity (ie inputs / outputs) thus 'high productivity' by definition means low cost and high reward thus 'high productivity' by definition means low cost and high reward the actual hourly wage-rate (ie reward) paid may not reflect workers' actual productivity the actual hourly wage-rate (ie reward) paid may not reflect workers' actual productivity in the previous chart, the falling labour price means falling reward rather than falling cost in the previous chart, the falling labour price means falling reward rather than falling cost