David Bryce © Adapted from Baye © 2002 Production and Supply MANEC 387 Economics of Strategy MANEC 387 Economics of Strategy David J. Bryce

David Bryce © Adapted from Baye © 2002 The Structure of Industries Competitive Rivalry Threat of new Entrants Bargaining Power of Customers Threat of Substitutes Bargaining Power of Suppliers From M. Porter, 1979, “How Competitive Forces Shape Strategy”

David Bryce © Adapted from Baye © 2002 Production and Supply Firms acquire inputs from suppliers Economics of production determines demand for inputs Inputs are transformed into outputs through a productivity relationship defined by the “production function” For example, consider the Cobb-Douglas production function: Q = f(L,K) = AL  K  Firms acquire inputs from suppliers Economics of production determines demand for inputs Inputs are transformed into outputs through a productivity relationship defined by the “production function” For example, consider the Cobb-Douglas production function: Q = f(L,K) = AL  K 

David Bryce © Adapted from Baye © 2002 Total Product The Cobb-Douglas Production Function Q = f(K,L) = K 0.5 L 0.5 Assume that in the very short run, capital (K) is fixed at 16 units Short run production function: Q = L 0.5 = 4 L 0.5 What is total product (output) when we use 100 employees? Q = 4 ( ) = 4 (10) = 40 units Q = f(K,L) = K 0.5 L 0.5 Assume that in the very short run, capital (K) is fixed at 16 units Short run production function: Q = L 0.5 = 4 L 0.5 What is total product (output) when we use 100 employees? Q = 4 ( ) = 4 (10) = 40 units

David Bryce © Adapted from Baye © 2002 Product of Labor Marginal product of labor – MP L =  Q/  L –Measures the output produced by the last worker –Slope of the production function Average product of labor – AP L = Q/L –Measures the output of an “average” worker Marginal product of labor – MP L =  Q/  L –Measures the output produced by the last worker –Slope of the production function Average product of labor – AP L = Q/L –Measures the output of an “average” worker

David Bryce © Adapted from Baye © 2002 Productivity in Stages Q Q L L Q=F(K,L) Increasing Marginal Returns Increasing Marginal Returns Diminishing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Negative Marginal Returns MP AP

David Bryce © Adapted from Baye © 2002 Optimal Choice of Input Levels How much of an input do I need? Use enough input such that marginal benefit equals marginal cost Logic – if one more unit provides more value (P Q Q) than it costs (P L L), firm is better off – use another unit Use enough input such that marginal benefit equals marginal cost Logic – if one more unit provides more value (P Q Q) than it costs (P L L), firm is better off – use another unit TVP Input L PLLPLL PLLPLL PQQPQQ PQQPQQ L* Q* Tangency means MVP=MC

David Bryce © Adapted from Baye © 2002 Marginal Rate of Technical Substitution – Cobb-Douglas Isoquants represent the combinations of inputs that produce a particular level of output Slope of isoquant gives the rate at which we can trade one input for another leaving output unchanged – marginal rate of technical substitution (MRTS) Isoquants represent the combinations of inputs that produce a particular level of output Slope of isoquant gives the rate at which we can trade one input for another leaving output unchanged – marginal rate of technical substitution (MRTS) Input K Input L Q3Q3 Q3Q3 Q2Q2 Q2Q2 Q1Q1 Q1Q1 Q 1 < Q 2 < Q 3

David Bryce © Adapted from Baye © 2002 Linear Isoquants Perfect substitutes – Perfect Complements Q3Q3 Q3Q3 Q2Q2 Q2Q2 Q1Q1 Q1Q1 L L K K Q3Q3 Q3Q3 Q2Q2 Q2Q2 Q1Q1 Q1Q1 L L K K Leontief (fixed proportion) technology

David Bryce © Adapted from Baye © 2002 Optimal Choice of Input Combinations Choose optimal inputs such that marginal rate of technical substitution equals the price ratioChoose optimal inputs such that marginal rate of technical substitution equals the price ratio Logic – if MRTS > price ratio, you can get more production/$ from L than from K. Add more L until its marginal contribution equals that of KLogic – if MRTS > price ratio, you can get more production/$ from L than from K. Add more L until its marginal contribution equals that of K Choose optimal inputs such that marginal rate of technical substitution equals the price ratioChoose optimal inputs such that marginal rate of technical substitution equals the price ratio Logic – if MRTS > price ratio, you can get more production/$ from L than from K. Add more L until its marginal contribution equals that of KLogic – if MRTS > price ratio, you can get more production/$ from L than from K. Add more L until its marginal contribution equals that of K Input K Input L Tangency means MRTS = price ratio L* K* P L /P K

David Bryce © Adapted from Baye © 2002 Input Factor Demands How much do we need from suppliers? Input K Input L L0L0 L0L0 K0K0 K0K0 P L /P K L1L1 L1L1 K1K1 K1K1 When the price of labor rises, firm demand for labor falls and demand for capital rises

David Bryce © Adapted from Baye © 2002 Input Factor Demand L L K K $ $ L L DLDL DLDL P1P1 P1P1 L0L0 L0L0 L1L1 L1L1 The firm’s demand for an input (from a supplier) is derived from each new equilibrium point found on the isoquant as the price of the input is varied. P0P0 P0P0

David Bryce © Adapted from Baye © 2002 Elements of Cost Firms Incur Costs Using Inputs Total cost is an (always) increasing function of output and assumes that firms produce efficiently. Variable cost is the cost of variable inputs (e.g., direct labor, raw materials, sales commissions) and varies directly with output. Fixed costs remain constant as output increases Total cost is an (always) increasing function of output and assumes that firms produce efficiently. Variable cost is the cost of variable inputs (e.g., direct labor, raw materials, sales commissions) and varies directly with output. Fixed costs remain constant as output increases Q Q TC(Q) = VC(Q) + FC VC(Q) FC $ $

David Bryce © Adapted from Baye © 2002 Properties of Cost The properties of cost are determined by the shape of total cost function Average cost (AC(Q)) is the average cost per unit (TC(Q)/Q) Marginal cost (MC(Q)) is the cost of the last unit and defines the rate at which cost changes as quantity changes The properties of cost are determined by the shape of total cost function Average cost (AC(Q)) is the average cost per unit (TC(Q)/Q) Marginal cost (MC(Q)) is the cost of the last unit and defines the rate at which cost changes as quantity changes $ $ Q Q ATC AVC AFC MC

David Bryce © Adapted from Baye © 2002 Fixed Cost $ $ Q Q ATC AVC MC ATC AVC Q0Q0 Q0Q0 AFC Fixed Cost Q 0  (ATC-AVC) = Q 0  AFC = Q 0  (FC/ Q 0 ) = FC Q 0  (ATC-AVC) = Q 0  AFC = Q 0  (FC/ Q 0 ) = FC

David Bryce © Adapted from Baye © 2002 Variable Cost $ $ Q Q ATC AVC MC AVC Q0Q0 Q0Q0 Variable Cost Q 0  AVC = Q 0  [VC(Q 0 )/Q 0 ] = Q 0  (FC/ Q 0 ) = VC(Q 0 ) Q 0  AVC = Q 0  [VC(Q 0 )/Q 0 ] = Q 0  (FC/ Q 0 ) = VC(Q 0 ) ATC

David Bryce © Adapted from Baye © 2002 Total Cost $ $ Q Q ATC AVC MC AVC Q0Q0 Q0Q0 TotalCostTotalCost Q 0  ATC = Q 0  [TC(Q 0 )/Q 0 ] = TC(Q 0 ) Q 0  ATC = Q 0  [TC(Q 0 )/Q 0 ] = TC(Q 0 ) ATC

David Bryce © Adapted from Baye © 2002 Time and Cost Once a firm commits to a technology, it cannot immediately change scale – costs are more fixed in the short-run In the long-run, firms can change technology and scale – costs are more variable The long-run average cost is the minimum of all short-run cost curves over time. Once a firm commits to a technology, it cannot immediately change scale – costs are more fixed in the short-run In the long-run, firms can change technology and scale – costs are more variable The long-run average cost is the minimum of all short-run cost curves over time. SRAC 1 SRAC 5 SRAC 3 LRAC Quantity Cost

David Bryce © Adapted from Baye © 2002 Decision-Making and Cost Accounting costs inform external constituents. Economic costs inform internal decision makers and include opportunity costs. Sunk costs have already been incurred and cannot be avoided. –Economic decisions depend on avoidable costs. –When fixed costs can be redeployed or sold, they are not entirely sunk. –Sunk costs are the basis for strategic commitment. Accounting costs inform external constituents. Economic costs inform internal decision makers and include opportunity costs. Sunk costs have already been incurred and cannot be avoided. –Economic decisions depend on avoidable costs. –When fixed costs can be redeployed or sold, they are not entirely sunk. –Sunk costs are the basis for strategic commitment.