The costs of production

The costs of production

The economy is made up of thousands of firms that produce goods and services. Some of them are large and employ thousands of workers and have thousands of shareholders. Others are small and employ only a few workers and may be owned by one person or family.

According to the law of supply, firms are willing to produce and sell a greater quantity of a good when the price of the good is higher, and this response leads to a supply curve that slopes upward.

What are costs?

Total revenue, total cost and profit

To understand what decisions a firm makes we must understand what it’s trying to do. Economists usually assume that the goal of a firm is to maximize profit and they find that this assumption works well in most cases. The amount that the firm receives for the sale of its output is called the total revenue. The amount that the firm pays to by inputs is called its total cost. Profit is a firm’s revenue minus total cost:

Profit = Total revenue – total cost To see how a firm goes about maximizing profit, we must consider fully how measure its total revenue and its total cost. Total revenue equals the quantity of output the firm

produces times the price at which it sells its output.

Costs as opportunity costs

A firm’s opportunity costs of production are sometimes obvious and sometimes less so. Explicit costs are input costs that require an outlay of money by the firm. Implicit costs are input costs that do not require an outlay of money by the firm.

The cost of capital as an opportunity cost

An important implicit cost of almost every business is the opportunity cost of the financial capital that has been invested in the business. The opportunity cost equals the interest on the bank loan plus the forgone interest on savings.

Economic profit versus accounting profit

An economist measures a firm’s economic profit as the firm’s total revenue minus all the opportunity cost (explicit and implicit) of producing the goods and services sold. An accountant measures the firm’s accounting profit as the firm’s total revenue minus the firm’s explicit costs.

For a business to be profitable from an economist’s standpoint, total revenue must cover all the opportunity costs, both explicit and implicit.

Production and costs

Firms incur costs when they buy inputs to produce the goods and services that they plan to sell. In the analysis that follows, we make an important simplifying assumption: we assume that the size of the firm is fixed and that the firm can vary the quantity of the good produced only by changing the number of worker. This assumption is realistic in the short run, but not in the long run.

The production function

The relationship between quantity of inputs used to make a good and the quantity of output of that good is called the production function.

The marginal product of any input in the production is the increase in the quantity of output obtained from one additional unit of that input. When the number of workers increases, the marginal product declines. The diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.

From the production function to the total cost curve

Our next goal is to study firm’s production and pricing decisions. For this purpose, the most important relationship is between quantity produced and total costs. The graph for it is called the total cost curve. If we compare the total cost curve with the production function we see, that these two curves are opposite sides of the same coin. The total cost curve gets steeper as the amount produced rises whereas the production function gets flatter as the production rises. These changes in slope occur for the same reason.

The various measures of cost

From data on a firm’s total cost we can derive several related measures of cost which will turn out to be useful when we analyze production an pricing decisions.

Fixed and variable costs

Some costs, called fixed costs, do not vary with the quantity of output produced. They are incurred even if the firm produces nothing at all. Some of the firm’s costs, called variable costs, change as the firm alters the quantity of output produced.

A firm’s total cost is the sum of fixed and variable costs.

Average and marginal cost

A key part of the decision how much to produce is how the cost will vary as he changes the level of production. To find the cost of the typical unit produced, we would divide the firm’s total costs by the quantity of output it produces. This is called average total cost. Average fixed cost is the fixed cost divided by the quantity of output and average variable cost is the variable cost divided by the quantity of output. Although average total cost tells us the cost of the typical unit, it does not tell us how much total cost will change as the firm alters its level of production. For this we have the marginal cost that shows the increase in total cost that arises from an extra unit of production

   () =  () ()

  () = h    (∆) h   (∆ )

Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced. Marginal costs tell us the increase in total cost that arises from producing an additional unit of output.

Cost curves and their shapes

The efficient scale of the firm is the quantity of output that minimizes average total costs.

Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. This is true for all firms. To see why, consider what happens to average cost as output goes up by one unit. If the cost of the extra unit is above the average cost of units produced up to that point, then it will tend to pull up the new average cost of a unit. If the new unit actually costs less than the average cost of a unit up to that point, it will tend to drag the new average down. But the price of an extra unit is what economists call marginal cost. We can say: the marginal cost curve crosses the average total cost curve at its minimum.

Typical cost curves

The three properties that are most important to remember:

• Marginal cost eventually rises with the quantity of output
• The average total cost curve is U-Shaped
• The marginal cost curve crosses the average total cost curve at the minimum of average total cost

Cost in the short run and in the long run

The relationship between short-run and long-run average total cost

For many firms, the division of total costs between fixed and variable costs depends on the time horizon. Because many decisions are fixed in the short run but variable in the long run, a firm’s long-run cost curve differ from its short-run cost curves. The long-run average total cost curve is a much flatter U-shape than the short-run average total cost curve.

Economies and diseconomies of scale

The shape of the long-run average total cost curve conveys important information about the technology for producing a good. When long-run average total cost declines as output increases, there are said to be economies of scale (the property whereby long- run average total cost falls as the quantity of output increases). When long-run average total cost rises as output increases, there are said to be diseconomies of scale. When long-run average total cost does not vary with the lever of output, there are said to be constant returns to scale.

Economies of scale often arise because higher production levels allow specialization among workers. Diseconomies of scale can arise because of coordination problems that are inherent in any large organizations.

Oligopoly

In competitive market, each firm is so small compared to the market that it cannot influence the price of its product and, therefore, takes the price as given by market conditions. In a monopolized market, a single firm supplies the entire market for a good, and that firm can choose any price an quantity on the market demand curve. Competition and monopoly are extreme forms of market structure. Yet many industries have competitors but, at the same time, do not face so much competition that they are price takers. Economists call this situation imperfect competition. A particular type of it is called oligopoly. The essence of an oligopolistic market is that there are only few sellers. As a result, the actions of any one seller in the market xan have a large impact on the profits of all the other sellers. That is, oligopolistic firms are interdependent in a way that competitive firms are not.

Between monopoly and perfect competition

The typical firm in our economy is the imperfectly competitive. There are two types of imperfectly competitive markets. An oligopoly is a market with only a few sellers, each offering a product similar or identical to the others. Monopolistic competition describes a market structure in which there are many firms selling products that are similar but not identical. (CD, Books, Games) In a monopolistically competitive market, each firm has a monopoly over the product it makes, but many other firms make similar products that compete for the same customers.

Markets with only a few sellers

Because an oligopolistic market has only a small group of sellers, a key feature of oligopoly is the tension between cooperation and self-interest. The group of oligopolists is best off cooperating and acting like a monopolist – producing a small quantity of output and charging a price above marginal cost. Yet because each oligopolist cares about only its own profit, there are powerful incentives at work that hinder a group of firms from maintaining the monopoly outcome.

A duopoly example

To understand the behavior of oligopolies, let’s consider an oligopoly with only two members, called a duopoly. Duopoly is the simplest type of oligopoly.

Competition, Monopolies and Cartels

An agreement among firms over production and price is called a collusion and the group of firms acting in unison is called a cartel. Once a cartel is formed, the market is in effect served by a monopoly.

The equilibrium for an oligopoly

Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. If the duopolsits individually pursue their own self-interest when deciding how much to produce, they produce a total quantity greater than the monopoly quantity, charge price lower than the monopoly price and earn total profit less than the monopoly profit.

Although the logic of self-interest increases the duopoly’s output above the monopoly level, it does not push the duopolists to reach the competitive allocation.

A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies the others have chosen.

When firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price.

How the size of an oligopoly affects the market outcome

If the oligopolists do not form a cartel they must each decide on their own how much to produce. To see how the increase in the number of sellers affects the outcome, consider the decision facing each seller. At any time, each firm owner has the option to raise production by 1. In making this decision, the well owner weights two effects:

 The output effect:

Because price is above marginal cost, selling one unit more at the going price will raise profit

 The price effect:

Raising production will increase the total amount sold, which will lower the price and lower the profit on all the other units sold.

If the output effect is larger than the price effect, the firm owner will increase production. If the price effect is larger than the output effect, the owner will not raise production. Each oligopolist continues to increase production until these two marginal effects exactly balance, taking the other firms’ production as given.

Now consider how the number of firms in the industry affects the marginal analysis of each oligopolist. The larger the number of sellers, the less concerned each seller is about its own impact on the market price. That is, as the oligopoly grows in size the magnitude of the price effect falls. When the oligopoly grows very large, the price effect disappears altogether, leaving only the output effect. In this extreme case, each firm in the oligopoly increases production as long as price is above marginal cost.

We can now see that a large oligopoly is essentially a group of competitive firms. Thus, as the number of seller in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

Game theory and the economics of cooperation

As we have seen, oligopolies would like to reach the monopoly outcome, but doing so requires cooperation, which at times is difficult to maintain. In this section we look more closely at the problems people face when cooperation is desirable but difficult. To analyze the economics of cooperation, we need to learn a little about game theory. Game theory is the study of how people behave in strategic situations. By “strategic” we mean a situation in which each person, when deciding what actions to take, must consider how others might respond to that action. A particularly important “game” is called the prisoners’ dilemma. This game provides insight into the difficulty of maintaining cooperation.

The prisoners’ dilemma

Two suspects, A and B, are arrested for a crime. The local prosecutor has little evidence in the case and is anxious to extract a confession. She separates the suspects and tells each if they confess and his partner doesn’t she can reduce the sentence (one year) and on the basis of his confess

his partner will get ten years. If both confess, both get three years. Each suspect knows, that if neither of them confesses, the lack of evidence will cause them to be tried for a lesser crime for which they will receive two-year sentences.

B A

Confess

Silent

Confess

-3 -3

-1 -10

Silent

-10 -1

-2 -2

In the language of game theory a strategy is called a

dominant strategy if it is the best strategy for a player to follow regardless of the strategy pursued by other players. In the case of prisoners it would be to confess.

Oligopolies as a prisoners’ Dilemma

It turns out that the game oligopolists play in trying to reach the monopoly outcome is similar to the game that the two prisoners play in the prisoners’ dilemma.

The monopoly outcome is jointly rational for the oligopoly, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma to confess, self-interest makes it difficult for the oligopoly to maintain the cooperative outcome with low production, high prices and monopoly profits.

The prisoners’ dilemma and the welfare of society

The prisoners’ dilemma describes many of lifes’s situations, and it shows that cooperation can be difficult to maintain, even when cooperation would make both players better off. Clearly, this lack of cooperation is a problem for those involved in these situations. But is lack of cooperation a problem from the standpoint of society as a whole? The answer depends on the circumstances. In some cases, the non- cooperative equilibrium is bad for society as well as the players. In the case of oligopolists trying to maintain monopoly profits, lack of cooperation is desirable from the standpoint of society as a whole. The monopoly outcome is good for the oligopolist, but is bad for the consumers of the product. When oligopolists fail to cooperate, the quantity they produce is closer to the maximum total surplus.

Why people sometimes cooperate

Cartels sometimes do manage to maintain collusive arrangements, despite the incentive members to defect. Very often, the reason that players can solve the prisoners’ dilemma is that they play the game not once but many times.

Public policy toward oligopolies

As we have seen, cooperation among oligopolists is undesirable from the standpoint of society as a whole, because it leads to production that is too low and prices that are too high. To move the allocation of resources closer to the social optimum, policy makers should try to induce firms in an oligopoly to compete rather than to cooperate.

Restraint of trade and competition law

One way that policy discourages cooperation is through the common law. Normally, freedom of contract is an essential part of a market economy. Yet, for many centuries, courts in Europe and North America have deemed agreements among competitors to reduce quantities and raise prices to be contrary to the public interest. They have therefore, refused to enforce such agreements.

Controversies over competition policy

Over time, much controversy has centred on the question of what kinds of behavior competition law should prohibit. Most commentators agree that price-fixing agreements among competing firms should be illegal. Yet competition law has been used to condemn some business practices whose effects are not obvious.

monopolisitc competition

Monopolistic competition is a market structure in which many firms sell products that are similar but not identical. Monopolistic competition describes a market with the following attributes:

 Many sellers:

there are many firms competing for the same group of customers

 Product differentiation:

Each firm produces a product that is at least slightly different from those of other

firms.

 Free entry:

Firms can enter or exit the market without restriction.

Monopolistic competition, like oligopoly, is a market structure that lies between the extreme cases of competition and monopoly.

Competition with differentiated products

To understand monopolistically competitive markets, we first consider the decisions facing an individual firm.

The monopolistically competitive firm in the short run

Each firm in a monopolistically competitive market is like a monopoly. Because its product is different from those offered by other firms, it faces a downward sloping

demand curve. Thus, the monopolistically competitive firm follows a monopolit’s rule for profit maximation: it chooses the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price consistent with that quantity. In the short run, the monopolistically competitive market structure and the monopolist market structure are similar.

The long run equilibrium

When firms are making profits new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market. In other words, profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms’ products falls, these firms experience declining profit. Conversely, when firms are making losses firms in the market have an incentive to exit.

This process of entry and exit continues until the firms in the market are making exactly zero economic profit. The demand curve and the average total cost curve must be tangent once entry and exit have driven profit to zero. Because the profit per unit sold is the difference between price and average total cost, the maximum profit is zero only if these two curves touch each other without crossing.

To sum up, two characteristics describe the long-run equilibrium in a monopolistically competitive market:

• As in a monopoly market, price exceeds marginal cost. This conclusion arises because a profit maximization requires marginal revenue to equal marginal cost and because the downward sloping demand curve makes marginal revenue less than price.
• As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic profit to zero.

Monopolistic versus perfect competition

There are two noteworthy differences between monopolistic and perfect competition: excess capacity and the mark-up.

Excess capacity: The quantity of output in a competitive market is smaller than the quantity that minimizes average total cost. Thus, under monopolistic competition, firms produce on the downward sloping portion of their average total cost curves. The quantity that minimizes average total cost is called the efficient scale of the firm. Whereby firms are said to have excess capacity under monopolistic competition.

Mark-up over marginal cost

For a competitive price equals marginal cost. For a monopolistically competitive firm, price exceeds marginal cost, because the firm always has some market power.

Monopolistic competition and the welfare of society

A monopolistically competitive market has the normal deadweight loss of monopoly pricing. There is no easy way for policy makers to fix this problem, because the policymakers would need to regulate all firms that produce differentiated products. Because such products are so common, the administrative burden of such regulation would be overwhelming. Also monopolistic competitors are making zero profits. A regulation would make them have losses.

Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the ideal one. Whenever a new firm considers entering the market with a new product, it considers only the profit it would make. Yet its entry would also have two external effects:

• The product-variety-effect
• The business-stealing-effect

Both of these externalities are closely related to the conditions for monopolistic competition.

Advertising

When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product. The amount of advertising varies substantially across products. Firms that sell highly differentiated consumer goods typically spend between 10 and 20 per cent of revenue for advertising. Firms that sell industrial products typically spend very little on advertising and firms that sell homogenous products spend nothing at all.

The debate over advertising

Critics of advertising argue that firms advertise in order to manipulate people’s tastes. Much advertising is psychological rather than informational. They also argue that advertising impedes competition. Advertising often tries to convince consumers that products are more different than they truly are.

Defenders of advertising argue that firms use advertising to provide information to customers. Defenders also argue that advertising fosters competition. Because it allows customers to be more fully informed about all the firms in the market, customers can more easily take advantage of price difference.

Advertising as a Signal of quality

Many types of advertising contain little apparent information about the product being advertised. Defenders of advertising argue that even advertising that appears to contain little hard information may in fact tell consumers something about product quality. The willingness of the firm to spend a large amount of money on advertising can itself be a signal to consumers about the quality of the product being offered. What is most surprisingly about this theory of advertising is, that the content of the advertisement is irrelevant. A firm signals the quality of its product by its willingness to spend money on advertising.

Brand names

Advertising is closely related to the existence of brand names. In many markets, there are two types of firms. Some firms sell products with widely recognized brand names, while other firms sell generic substitutes. Most often, a firm with a famous brand name spends more on advertising and charges a higher price for its product.

Critics of brand names argue that brand names cause consumers to perceive differences that do not really exist. Economists have defended brand names as a useful way for consumers to ensure that the goods they buy are of high quality. First, brand names provide consumers with information about quality. Second, brand names give firms an incentive to maintain high quality.

The debate over brand names thus centres on the question of whether consumers are rational in preferring brand names over generic subsitiutes.