1. Theory of The Firm Lecture 16
Dr. Jennifer P. Wissink
©2018 John M. Abowd and Jennifer P. Wissink, all rights reserved.
March 21, 2018

2. Announcements: micro Spring 2018
Please make sure you see the Bb message all about prelim 1.
Reminder: last day to change grade option or to drop is March 21.
Any requests for grading re-considerations must be given to me NO LATER than this Friday March 23, please use the form:  
Wissink added office hour for rest of semester: Wednesday 12-1pm
MEL Quiz#07 due Friday night! Don’t forget about it!
CES EVENT. GO!!

3. IC/BL Application #5: Reacting to a Wage Change: The Odd Case of Labor/Leisure! BEWARE!
Consider a day in the life of John.
John is endowed with 24 hours of time.
He can consume his time as Leisure (Z) or…
He can sell his time at $w/hour as Labor (L).
His time constraint is: Z + L = 24
Suppose John gets utility from Z and $aog.
Suppose John’s only source of income is his labor income = $wL, which he spends on all other goods.

4. Z is relatively more expensive
IC/BL Application #5: Reacting to a Wage Change: The Odd Case of Labor/Leisure! BEWARE!
Suppose John’s wage ($w) increases
INCOME EFFECT
SUBSTITUTION EFFECT
John feels RICHER–his endowment of time is more valuable
Z is relatively more expensive
Z normal
Z inferior
Quantity of Z demanded decreases
Quantity of Z demanded increases  Labor supplied decreases
Quantity of Z demanded decreases Labor supplied increases
NOTE: This case is DIFFERENT, since when the price of leisure increased, John felt RICHER (not poorer). Beware!
This situation can lead to a “backward bending demand for leisure” which generates a “backward bending supply of labor”!

5. The Odd Case of Labor/Leisure! BEWARE!
$aog or $mlo
BL2
BL1
BLO
Hours of Leisure Demanded (Z)
Hours of Labor Supplied (L)

6. Backward Bending Leisure Demand and Labor Supply Curves
Z=Leisure
L=Labor
John gets utility from Leisure(Z) and $aog.
Leisure(Z) + Labor(L) = 24 hour and $w = hourly wage rate

7. Shifting Gears to the Theory of the Firm

8. What Is A Firm? Recall...
Broadly: A firm is an organization producing goods or services, also called a business.
Examples of common businesses: Grisamore Farms, Microsoft, FedEx, the campus store (a business within Cornell University).
Examples of organizations that are not common businesses in the same sense: Cornell University as a whole, U.S. 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.

9. What Is A Market? Recall...
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.

10. 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.

11. What We Assume (For Now)
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.
Note: We will eventually relax the assumption that we are in a perfectly competitive market environment.

12. Recall: 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 buyers and sellers 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 single seller can cause the price to move up or down.
In this case, we say that all buyers and sellers are “price takers.”

13. i>clicker question
So… which organization is a “firm” for which the model of perfect competition would be “right” for predicting behavior? B A D E C

14. 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

15. Profit Maximization
We assume the objective of the firm is to maximize economic profit.
For economic profit we must subtract from revenue ALL the relevant economic costs.
Two types of costs to differentiate and subtract from revenue:
Explicit costs: costs incurred for transactions that took place through a market interface.
Implicit costs: costs incurred for entrepreneurial supplied factors of production, where no market transaction outside the firm actually took place, but for where there was an opportunity cost borne by the entrepreneur.
Accounting profit versus Economic profit
For accounting profit we only subtract out the explicit costs.
For economic profit we subtract out the explicit costs AND the implicit costs.
So, accounting profit will be larger than economic profit.

16. i>clicker question
You own an economics tutoring center in Ithaca. On January 1st you purchased a $500,000 portrait of Adam Smith from BritishArt, Inc. to hang in the lobby of your center. To buy this picture you took $500,000 out of your savings account at Bank of America where it was earning 2% interest per year. When preparing your cost data for the year you should
A. enter only the $500,000 you paid as a cost.
B. enter the $500,000 you paid plus the $10,000 you gave up in interest as the costs.
C. enter only the $10,000 you gave up in interest as a cost.
D. enter what the current market value of the portrait is as a cost.
So remember.... Total Revenue explicit costs = Accounting profit - implicit costs = Economic profit

17. Profit Maximization Requires Cost Minimization
Profit (π) = Total Revenue - Total Cost
There are lots of ways to describe production and cost concepts.
You will need to understand them all.
For example:
explicit and implicit concepts
total, fixed and variable concepts
long run and short run concepts
total, average and marginal concepts
all related to each other

18. Consider Jonathan’s New York State Apple Farm
Jonathan’s farm is a business organized to grow and sell apples.
Jonathan realizes he is operating in a perfectly competitive apple market.
Jonathan is the owner operator/proprietor and Jonathan tries to maximize his profits from the business.
Assume he uses his own orchard and land, his own time, and hired labor to run his apple business.

19. Jonathan’s Apple Farm Short Run Production Function

20. Jonathan’s Total, Marginal & Average Products of Labor

21. 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.
Each of the entries in this table represents a price that Jonathan must pay for an input.
He hires labor at $8/hour.
Notice that he “pays” for his managerial time because his next best alternative is to earn $12/hour.
He also “pays” for the land since he could rent it out if he wasn’t farming it himself.

22. Jonathan’s Apple Farm Cost Structure
PA=$124/acre PL=$8/hr PO=$12/hr
Fixed cost Variable cost
Total cost
Average fixed cost
Average variable cost
Average total cost
Marginal cost

23. Jonathan’s Apple Farm Cost Structure