Level 5 Economics: The Theory of the FirmLearning Outcome Three

Economic Principles Economic Environment

950

960

970

980

990

1000

1010

1020

1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

source: Statistics New Zealand (Infoshare), Labour Cost Index

NZ Labour Costs, Q1-1993 to Q2-2014, inflation-adjusted (Q2-2009 = 1000)

Note: Although the 'economic cake' expanded by 81% from 1993 to 2014, and theaverage slice of the 'cake' per working-age person was 38% bigger in 2014,the average hourly wage has hardly changed.

Supply: Production and Distribution• supply chain of added-value S&R, S fig 5.1

– extraction, manufacturing (ie processing), distribution, consumption

– intermediate goods (material inputs, including raw materials) and final goods

• associated services– producer services

• 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

– 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– floor space, fittings and computers fixed

• Total and Marginal Product S&R, S fig 5.3 – Quick Exercise S&R, S Q2 (end of chapter)

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 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. S&R, S table 5.2

Relationship between Output (Q) and Cost• Average Cost (AC) = 1 / Average Product

– ie, here, AC is inverse of labour productivity

• Marginal Cost (MC) = 1 / Marginal Product– if 1 extra worker allows 2 more items (DQ=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– 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

– 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– 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

– contrast fixed and variable costs S&R, S table 5.1

• total, average & marginal cost curves S&R, S fig 5.4

– 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

Cost Schedules

back AC = TC / Q MC = DTC / DQ = DTVC /

DQ

there is mistake in book p.102 (p.96 4e)

Class exercise on Costs of the Firm

Total Fixed

Total Variable

TotalAverage

FixedAverage Variable

AverageMarginal

Cost(TFC) (TVC) (TC) (AFC) (AVC) (AC) (MC)

$ $ $ $ $ $ $

0 20 n/a n/a

1 50

224

3 90

4 170

Costs

Output (Q)

solutions

Short-run vs. Long-run Costs• short-run cost curve (SAC)

– in the short run, some factor inputs are fixed

• long-run cost curve (LAC)– 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– the decreasing average cost part of the LAC

represents 'economies of scale'– diseconomies of scale occur when the LAC rises

S&R,S fig 5.5

Grocery Shop Example

Exercise (part of day-class tutorial)

do Exercise Sheet 3aa for Homework

Fig 5.6

eg Dairy

eg Superette

50 70 Customers 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: solution

Q TFC TVC TC AFC AVC AC MC

0 20 0 20

1 20 45 65 20.0 45.0 65.045

2 20 80 100 10.0 40.0 50.035

3 20 110 130 6.7 36.7 43.330

4 20 130 150 5.0 32.5 37.520

5 20 160 180 4.0 32.0 36.030

6 20 220 240 3.3 36.7 40.060

7 300 320 2.9 42.9 45.780

0

100 ?

?

20 ?

20

20

20

20

20

20

20

110 ?

20 ?

65 ?

150 ?

160 ? 180 ?

240 ?

320 ?

65 ?

40 ?

4 ? 36 ?

45 ?

35 ?

30 ?

30 ?

60 ?

Labour (L) LandTotal

Output (Q)Average Product

Labou

Marginal Product

0 2 0 0

1 2 30 30.030

2 2 90 45.060

3 2 170 56.780

4 2 320 80.0150

5 2 350 70.030

6 2 350 58.30

Exercise: fill the gaps Fig. back

60

170 56.7150

30

0

ie Total Product

back

0

50

100

150

200

250

300

350

0 1 2 3 4 5 6

Outp

ut

/ Pro

duct

Labour units

Average Product

MarginalProduct

Total Product

Fig 5.5

Meaning of Labour Costs• 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

• 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