Lecture 6 Production Decisions

Goals and economic benefits from production What are the goals of production? –Some productive activities may be motivated by extrinsic benefits –Some may be motivated by intrinsic benefits –Some, by both There are different types of benefits coming from production: –Internal benefits: the benefits of a project based only on the perspective of the economic decision maker –External benefits: the benefits of a project that accrue to persons or entities that are not among the economic actors directly responsible for the activity (Ex: environment)

Weighing costs and benefits Net benefits: total benefits minus total costs (if it is social benefits-social costs, then it is a measure leading to social efficiency) Cost-benefit analysis: a procedure often used by governments for attempting to determine the net benefits of proposed projects –BUT: Some costs and benefits are not easy to measure in monetary terms!

Marginal thinking Marginal thinking: Evaluating incremental (small) changes in production (or input use) levels in order to find an optimum If we take the actions of a producer up to a certain point in time as given, the producer’s decision will only depend on marginal cost and marginal benefit –Marginal benefit: the extra benefit that accrues from producing the last unit of output The rule : Net benefits are maximized when producers engage in an activity up to the point where MB equals MC

Marginal thinking in case of profit maximization

Marginal thinking in case of profit maximization

Marginal thinking in case of profit maximization

Marginal thinking in case of profit maximization … when the price of output changes

Main assumption for marginal thinking: Convexity Convexity: a mathematical term used to describe the special assumptions necessary for marginal thinking With convexity, net benefits can be maximized by taking incremental steps along a smooth path.

Discrete decision making Sometimes marginal thinking may be insufficient for wise economic decision making. We may usually have to consider questions like «whether to produce or not to produce», «to build a bridge or not», «to enter a market or not»… These are discrete decisions (they involve jumps between different distinct choices) There may be non-convexities that require discrete decision making rather than marginal thinking

A discrete decision: whether to produce or not Two surprising results: –In the SR, if the firm can earn enough to cover its variable costs and at least a bit of its fixed costs, it should keep operating, even if it makes losses in the SR –It doesn’t matter how big the fixed costs are: As long as some of these fixed costs are covered, the firm should continue to operate. Sunk costs shouldn’t matter to present decision making (sunk cost: a cost that was made in the past and is now irreversible) WHY?

A discrete decision: whether to produce or not

Discrete decision making: Multiple equilibria

Discrete decision making: Lumpiness and increasing returns Lumpiness: Some inputs or outputs can be obtained or sold only in «discrete» quantities Increasing returns: They may lead to a PPF with a bowed- in shape (and possibly to a corner-solution)

Discrete decision making: Path dependence and switching costs Path dependence Economic developments may depend on particularities of past developments, i.e., «History matters» Switching costs Transaction costs associated with a change

Discrete decision making: network externalities Network externality (in production) A particular technology may be advantageous to adopt because other economic actors have adopted it Examples: PS vs. Macintosh; VHS video vs. BETA video; QWERTY keyboard, etc.

A formal model of producer theory with convexity and perfect competition Assumptions: –The firm is only concerned with profit- maximization, solving only convex problems –The firm is a price-taker (it takes the output price P as given); i.e. it operates in a perfectly competitive market –The firm has no market power

A formal model of producer theory with convexity and perfect competition