[QUIZ 2] COBECON NOTES

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November 7 (m)
PRICE ELASTICITY OF DEMAND
● Measures the responsiveness of demand to price changes
● Businesses will know when it is safe to lower prices
● Helps businessmen or entrepreneurs know the effects of prices on total revenue ●
Total revenue (peso value of sales) = TR = P*Q = selling price x # of units being sold

Compute for the Elasticity of Demand

● e = % change in demand / % change in price
- % change in demand = (Qd2 - Qd1) / Qd1 ; Qd1 = initial demand ; Qd2 = new demand -
% change in price = (P2 - P1) / P1

Example
1. Gasoline
● P1 = P65 per liter ; Qd1 = 1 million liters
● P2 = P68 per liter ; Qd2 = 0.98 million liters
2. Liquor
● P1 = P300 per bottle ; Qd1 = 500,000 bottles
● P2 = P320 per bottle ; Qd2 = 300,000 bottles

- You cannot compare the demand of items with different units of measure
- Compute using the elasticity of demand (% changes) to eliminate units of measure

#1: Gasoline
Compute elasticity of demand
1. Solve the percentage change in demand
● (Qd2 - Qd1) / Qd1 = (0.98-1)/1
2. Solve percentage change in price
● (P2 - P1) / P1 = (68-65)/65
3. e = % change in demand / % change in price
● e = [(0.98-1)/1] / [(68-65)/65]
● e = -0.02 / 0.04615
● e = -0.4334
4. Compare % change in demand and % change in price
● 0.4334 < 1
● A 1% increase in the price of gasoline will reduce demand by 0.4334%
● e = % change in demand / % change in price = -0.4334 = - 0.4334 / 1
● Gasoline demand is LESS RESPONSIVE to a price increase (reduction in demand is
SMALLER than increase in price)
● Gasoline demand is INELASTIC (absolute value of e < 1)
 ● Total revenue at the initial price: TR = P*Q = 65*1M liters = P65 M
● Total revenue at the new price: TR = P*Q = 68*0.98M liters = P66.64 M
- Demand decreased but revenue increased (reduction in demand because of
price increase, but revenue increased because price increase)
- Percent reduction in demand is SMALLER compared to the percentage increase
in price
- Safe to raise prices: revenue will still increase

#2: Liquor
● e = [(300,000-500,000) / 500,000] / [(320-300) / 300]
● e = -0.4 / 0.06667 = -5.9997 = -6.0
● A 1% increase in the price of liquor will reduce demand by 6%
● Liquor demand is RESPONSIVE to a price increase
- It's easier to cut down purchase of liquor when price increases (not a necessity)
● Liquor demand is ELASTIC (absolute value of e > 1)
● Total revenue at the initial price = TR = P*Q = 300*500,000 = P150 M
● Total revenue at the new price = TR = P*Q = 320*300,000 = P96 M
- Price increased, demand decreased, revenue decreased
- Reduction of total revenue: Percent reduction in demand is LARGER compared to the
percentage increase in price

CONSUMER BEHAVIOR
● Studies the basis for the consumers’ willingness to pay
● Utility = refers to the level of satisfaction from consuming a good or service
● Total utility = total satisfaction
● Marginal utility = added satisfaction from consuming an additional unit of the good or service

Consumer Behavior: Cardinal Approach

- Assign a value to the amount of satisfaction obtained from consuming a good or service

Good X Total Utility (TU)

00
1 10 utils of satisfaction
2 15 (satisfaction rises)
3 18
4 18 (saturation point: remains the same, does not contribute to your total satisfaction) 5 17
(satisfaction declines; if you consume too much of something you get fed up)

Good X Total Utility (TU) Marginal Utility (MU)

000
1 10 10 utils
2 15 5
 3 18 3 (decreases, nagsasawa if we consume too much) 4 18 0
5 17 -1 (reducing total satisfaction)

- If we do it much too frequently, our satisfaction declines, we reach a saturation point and get fed up -
Willing to consume until 3 (contribution to satisfaction at 4 is 0)
Good X Total Utility (TU) Marginal Utility (MU) Px = MUx
000
1 10 10
2 15 5
3 18 3
4 18 0
5 17 -1

Consumer equilibrium condition

Px = MUx
Price paid by consumers = contribution to total satisfaction of an additional unit consumed - What we’re
willing to pay depends on what we think the contribution will be on our total satisfaction

Example: Movie watching

1 Px < MUx
2 Px = MUx
3 Px > MUx

Example: Mcdo value meal (drink, fries, burger)

- Encourage more spending on consumers
- Cheaper purchased in a bundle rather than ordering the goods separately
- Will continue buying if Px < MUx
- Stop buying when Px > MUx

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November 10 (th)
Consumer Behavior: Ordinal Approach
● Order or ranking preferences based on the satisfaction obtained from consuming the good or the service

Example
Ranking (priority)
1st Laptop (most satisfaction)
2nd Cellphone
3nd Athletic shoes
4th Wristwatch (4th best satisfaction)

Movies
 - Replace spending for the wristwatch with spending for the movie -> delaying the purchase for the
wristwatch (because the wristwatch can wait, it is not a priority)
- Satisfaction gotten from the movie should offset the decision to delay the purchase of the wristwatch -
P300 movie should match the satisfaction from the movie, and temporarily offset the desire for the
wristwatch

Cardinal Approach vs Ordinal Approach

● CA: assign a value to the amount of satisfaction obtained
● OA: comparing several goods and ranking based on what gives you satisfaction; marginal utility goes
smaller as you go through the different products

Why do people buy more when prices fall?

1. Real income effect: when product is cheaper, income can buy more; purchasing power from income
becomes higher
2. Substitution effect: end up buying a cheaper product replacing a more expensive one; substitute the more
expensive good with a cheaper one
3. More goods lead to more satisfaction (even if the marginal utility is declining): we have more satisfaction
when we have more of the good or service

People buy less when prices increase

- Purchasing power of income falls when prices increase -> buy less
- When a product becomes more expensive, they look for a substitute offered at a cheaper price -
When prices increase, buy less of the same good (limited amount)

PRODUCTION THEORY
● Nature of relationship between input and output
● Explains why diminishing returns occurs
● Production Functions = Table, graph or equation which shows the relationship between the minimum
inputs which can be used to produce maximum output

Short Run Productions

● 1 fixed input (remains the same), 1 variable input
● Fixed Input: plant, property, equipment (PPE)
● Variable Input: materials, contractual labor, utilities (electricity, gas, water)

Long Run Productions

● All inputs are variable (because PPE expands when the business performs well)
Example: San Miguel expands in other markets, builds factories, increases PPE, becomes cheaper

Fixed Input
● inputs which remain constant regardless of the level of output in the short run
● expensive, takes time to recover expenses
 e.g. plant property equipment

Variable Input
● inputs which have to increase if production is to be increased
e.g. contractual labor, casual labor, ingredients, raw materials, utilities

Contractual Labor
- Contractual labor: good for a month, 3 months or 6 months; used during peak periods when more labor is
needed
- Used because its expensive to maintain a large group of regular employees
● Total Product = total output of the firm
● Marginal Product = additional output generated given an increase in the input
● Average Product of Labor = total output / total number of workers

PRODUCTION FUNCTION
Example: Firm A Production Function
Factory floor area Labor Production in units
Fixed Input Variable Input Output
100 0 0
100 1 6
100 2 10
100 3 13
100 4 15
100 5 16
100 6 16
100 7 15
100 8 13

- Production is rising up to a maximum of 16 (labor increases; hiring people can help produce more) -
Maximum output level achieved of 16 using 5 workers
- Output level stays at 16 even if you hire a 6th worker (no reason to hire an additional person) - If you hire too
many people but amount of equipment stays fixed, production declines (too many workers to share machinery
and equipment; lesser time for each person to use equipment and contribution of workers becomes smaller)

Example
1 person : 1 computer (for 8 hours) vs 4 persons : 1 computer (2 hours each)
-> too many people sharing the machine, lesser output

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November 15 (m)
Production Function: Table
Land + Equipment Labor Total Production (Q) Contribution of Additional Worker 100 0 0 0
 100 1 10 10
100 2 15 5
100 3 18 3
100 4 20 2
100 5 21 1
100 6 21 0
100 7 18 -3

- Hire only 5 workers to reach maximum productivity

- 6th worker has no contribution to production
- Productivity declines with 7 workers since there are too many people using the same equipment and have
less time to use it
- Diminishing Returns: beyond the optimal level of capacity, every additional unit of production factor will
result in a smaller increase in output

Production Function: Graph

- Nonlinear relationship: realistic, represented by a curve

- Linear relationship: not realistic, no maximum /

Production Theory with Fixed Input

Marginal Product of Labor
● Contribution to output of additional worker
● △Q / △L
● Contribution of additional worker becomes smaller as you hire more workers because they have to share
the use of fixed input (land and equipment) -> congestion (cannot move freely around the place)
Example: bakery with single oven, mixer, refrigerator, utensils

How to offset diminishing returns?

1. Avoid hiring excess workers
 2. Use more land and buy more equipment (recover previous expenses before expanding)

Cobb Douglas Production Function

Q = A * Lᵅ * Kᵝ
● Q = total output
● A = scale of production (constant value)
● L = labor
● ᵅ = output elasticity of labor
● K = capital
● ᵝ = output elasticity of capital (less than 1, nonlinear)

- ᵅ = %△Q / %△L
- ᵝ = %△Q / %△K
Q = 583.2942 * L0.4 * K0.6
- If you increase L by 1%, Q will increase by 0.4%
- If you increase K by 1%, Q will increase by 0.6%

Example
1. Target output level Q=500,000 units, K=300 machine hours, find L in man hours
500,000 = 583.2942 * L0.4* (300)0.6
500,000 = 583.2942 * L0.4* (30.6389)
500,000 = 17,871.4927 * L0.4
500,000 / 17,871.4927 = L0.4-> transpose on the left equation
(27.9775)1/0.4 = (L0.4)1/0.4-> raise both sides of the equation to the exponent 1/0.4 (27.9775)2.5
=L
4140.2090 = L man hours

2. If Q increases by 10%, find L

Q = 500,000
Q1 = 550,000

550,000 = 17,871.4927 * L0.4

550,000 / 17,871.4927 = L0.4
(30.7753)1/0.4 = (L0.4)1/0.4
(30.7753)2.5 = L
5254.1896 = L man hours

Producer Equilibrium Condition

PL = MPL
Price of labor = value of the marginal product of labor
Wages and salaries = the contribution of workers to production
- Contribution to total output of additional worker
- What you pay to a person depends on how much they contribute -> pay more to higher skilled, trained,
 educated, experienced workers

Examples:
- Professional Sports: Basketball Superstars (team itself is the product: wins, merchandise sales, ticket sales,
hotel, advertising revenue)
- Business: Fresh graduate (limited responsibility, needs to gain more experience, will climb corporate
ladder) vs Owner (huge responsibility, ensure continuous revenue and business growth, has more
experience)

Government: “Inflation is happening because of increasing cost of production”

- Misleading and inaccurate: a result of central bank printing money out of nothing
Example: Clothing vs Textile (very high demand and limited supply increases price and cost)

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November 17 (th)
COBB DOUGLAS PRODUCTION FUNCTION: EXAMPLES
ABC company estimated its production function using the Cobb-Douglas model and came out with the following
results:
Output elasticity with respect to changes in labor = 0.75
Output elasticity with respect to changes in capital = 0.55
Constant = 534.25

Question #1: Labor is expressed in man hours while capital in terms of hours of machine capacity. Assuming
that the production target is 400,000 units and the hours of machine capacity is approximately 5600, determine
the amount of man hours needed in order to meet the production target.

Given: Q = 400,000 units, K = 5600 machine hours

Q = A * Lᵅ * Kᵝ
Q = 534.25 * L0.75* K0.55
400,000 = 534.25 * L0.75* 56000.55
400,000 = 534.25 * L0.75* 115.2135
400,000 / 115.2135 = 534.25 * L0.75
3471.8154 = 534.25 * L0.75
3471.8154 / 534.25 = L0.75
6.4985 = L0.75
(6.4985)(1/0.75) = (L0.75)(1/0.75)
12.1269 = L or 12.1269 man hours (capital intensive)

Question #2: If the production target is to be increased by 20%, keeping machine hours constant, how much
additional man hours will be needed in order to achieve this new target?
400,000 * 1.2 = 480,000
480,000 = 534.25 * L0.75* K0.55
480,000 = 534.25 * L0.75* 56000.55
480,000 = 534.25 * L0.75* 115.2135
480,000 / 115.2135 = 534.25 * L0.75
4166.1784 = 534.25 * L0.75
4166.1784 / 534.25 = L0.75
7.7981 = L0.75
(7.7981)(1/0.75) = (L0.75)(1/0.75)
15.4639 = L or 15.4639 man hours

Question #3: If labor is increased by 15% and capital increased by 30% what is the expected percentage increase in
output?
If L increases by 15%, output will increase by:
Output elasticity = 0.75 = % change in Q / % change in L
0.75 = % change in Q / 15%
0.75 * 15% = % change in Q
11.25% = % change in Q
If K increases by 30%, output will increase by:
Output elasticity = 0.55 = % change in Q / % change in K
0.55 = % change in Q / 30%
0.55 * 30% = % change in Q
16.5% = % change in Q
11.25% + 16.5% = 27.75%
If L increases by 15% and K increases by 30%, output will increase by 27.75%.

COST THEORY
● 1 person’s cost is another person’s selling price

Example: Taxi vs Shell

- Taxi service pays market price of fuel to operate taxi service; shell earns from market price of fuel sold to
taxi service

1. Production Cost = total cost or expenses incurred when producing a good or service

2. Total Cost = fixed cost + variable cost

3. Fixed Cost = cost which remains constant regardless of the level of output
- Rent = continually pay as long as you’re occupying the place even if you aren’t producing anything -
Fire insurance premiums = pay regular fire insurance premiums every year until maturity date to get
the insurance coverage; if factory burns, will receive 10M; if factory doesn’t burn in 20 years, insurance
will pay back everything you’ve paid plus a good return on all of your payments (more than 10M)
- Salaries of permanent employees = regardless of how much the firm is producing, the owner is
required to pay the salaries of employees
 - Debt payments = if you borrow money to buy machinery, whether production increases or falls,
you are obliged to make debt payments
- Depreciation = expense to cover the wear and tear of machinery (recover what you spent for
buying the new equipment over a 10 year period; worth P0 by the 10th year), regardless of the
production, depreciation is deducted every year
Example: Bought new equipment P800,000 with a useful life of 10 years, depreciation expense
of P80,000 per year

4. Variable Cost = cost which depends on the level of output; as production increases variable cost increases
(e.g. cost of raw materials, ingredients, utilities, wages of contractual and casual labor, sales commissions -
Utilities: if you operate for longer hours, pay more for electricity, water, lights
- Contractual and casual workers: less expensive way to produce more, hire during sudden surges in
demand and peak seasons
- Sales commissions: incentive of sales personnel to sell larger volume, if they sell more you have to
pay them more

5. Explicit Cost = accounting cost (cost incurred and recorded)

- Implicit to explicit
Example: When the government forces the firms to shoulder the air pollution they are creating
when residents file a complaint -> pay for the damages created and install an anti-pollution
device
6. Implicit Cost = cost incurred but not recorded / reported (not found in ledgers and accounting books; not
reflected as a cost which you paid money for)

7. Accounting Cost = cost incurred and recorded

8. Opportunity Cost = cost of forgoing an alternative

Example: interest on capital (funded by your own savings), if you used your own money to buy the
equipment, you missed the opportunity to put your money in the bank and earn interest -> interest from
business should offset the interest you would’ve earned from the bank

9. Negative Externality = spill-over effect; someone else suffers from an activity in which you are responsible
for; cost is incurred by the residents and those who suffer will shoulder the costs
Example: factory emits air pollution, residents get sick and pay for their own medical treatment, company
will not take the initiative to pay for the damages unless somebody files a complaint to the local
government (force company to shoulder cost of air pollution they are creating)

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November 21 (m)
Math Problem 4: Given the following information
Output of wheat in Land input in acres Labor input in man
Land rent in $ per acre Labor wage in $ per
 tons hours
hour

0 15 0 12 5

1 15 6 12 5

2 15 11 12 5

3 15 15 12 5

4 15 21 12 5

5 15 31 12 5

6 15 45 12 5

7 15 63 12 5

Question 1: Set up another table showing the fixed cost, variable cost and total cost
Output in tons Input in acres Input in man hours Rent $ per acre Wage $ per hour

0 15 0 12 5

1 15 6 12 5

2 15 11 12 5

3 15 15 12 5

4 15 21 12 5

5 15 31 12 5

6 15 45 12 5

7 15 63 12 5

(Q) Output of (FC = Land*Rent) (VC = Labor*Wages)

wheat in tons Fixed Cost = rent (TC = FC+VC) Total
(MC = change in TC /
Variable Cost = labor
Cost
change in Q) Marginal
Cost

0 15 * 12 = 180 0 * 5 = 0 180 + 0 = 180 0

1 180 6 * 5 = 30 180 + 30 = 210 210-180 / 1-0 =30

 2 180 55 235 235-210 / 2-1 = 25

3 180 75 255 20

4 180 105 285 30 (gotten larger)

5 180 155 335 50

6 180 225 405 70

7 180 315 495 90

- Variable Cost = upward sloping curve

- Marginal Cost: additional to total cost of additional output produced
- MC = change in TC / change in Q = (210-180 / 1-0) = 30

Question 2: Set up another table showing the average fixed cost, average variable cost, average total cost and
the marginal cost

Output of wheat in Average Fixed Average Variable Cost

tons Cost (AFC = Average Total Cost
FC/Q) Marginal Cost (change
(AVC = VC/Q)
(ATC = TC/Q)
in TC / change in Q)
(ATC = AFC+AVC)

0 180 / 0 = ∞ 0/0=0
180 / 0 = ∞ 0

1 180 / 1 = 180 30 / 1 = 30 210 / 1 = 210 210-180 / 1-0 =30 27.5 117.5 235-

2 90 210 / 2-1 = 25

3 60 25 85 20

4 45 26.25 71.25 30

5 36 31 67 50

6 30 37.5 67.5 70

7 25.714 45 70.717 90

Question 3: At what output level is the lowest average total cost achieved?
Output level 5, ATC = 67, Q = 5

Question 4: If the price of wheat was $72 per ton, at what output level would profits be maximized?
 Output of wheat in Total Revenue Total Cost (TC =
tons (TR = P*Q)
Profit (π = TR-TC) Marginal Revenue
FC+VC)
(change in TR /
change in Q)

0 72 * 0 = 0 180 0 - 180 = -180 0

1 72 * 1 = 72 210 72 - 210 = -138 72

2 144 235 -91 72

3 216 255 -39 (negative) 72

4 288 285 3 (positive) 72

5 360 335 25 72

6 432 405 27 72

7 504 495 9 72

Profits are maximized at output level 6, profits = 27

- Output level 3 = loss

- Output level 4 = profit
- Between output levels 3 and 4 = breakeven point

- Loss (negative profits): TC > TR

- Profits: TC < TR
- Breakeven Point: TC = TR (intersection)

- P (constant) = 72
- TR is at constant increments of 72
- Profit Maximizing Output Level: MR = MC (largest gap between TR and TC)

Profits
 ● Firms must earn profit to continue the business: means consumers are willing to pay because of they
benefit from it -> earning a profit indicates that the firm is doing something right
● If you incur a loss (not generate enough sales), it means consumers are not willing to pay because they do
not benefit from it -> forces firms to produce something else, leads to efficiency

Profits tell you that you are doing something right

- Price is reasonable
- Customers benefit from the good or service
- Product quality is good
- Goods are offered at market price or lower compared to competitors
- P > ATC

Profit per Unit = P - ATC

● More practical to use than Profit Maximizing Output Level
● P > ATC to make a profit
● To compute for profit, compare selling price and average selling cost
● Even if you sell at P69 (lower than P72 and competitors’ but higher than lowest ATC P67), you will still
earn a profit when you increase the volume of production (sell in bulk)

Lowest ATC = 67, Q = 5, P = 72

P > ATC = 72 > 67 (earning a profit)

Profits (π)
● π = TR - TC
● TR = P * Q
ATC = TC / Q -> TC = ATC * Q
π / Q = (P*Q) - (ATC*Q) / Q = P - ATC
π = P - ATC
P > lowest ATC
P > 67

- If you sell at P68 but in bulk (100,000 units), you still earn P100,000 profit -> lower price than competitors -
Compete on the basis of ATC

Question 5: Graph the results

Output of wheat in tons Fixed Cost Variable Cost Total Cost

0 180 0 180

1 180 30 210

2 180 55 235

3 180 75 255
4 180 105 285

5 180 155 335

6 180 225 405

 7 180 315 495 COST THEORY

- Accelerating total cost reflects diminishing returns

- Variable Cost: increasing, starts to flatten then accelerate ~
- Total Cost: exact same shape as VC ~ (not linear)

Diminishing Returns: ↓MPL(marginal product of labor)

● As you hire more workers, productivity declines because more people have to share the fixed space and
 equipment (have less time to use the equipment thus output per worker declines)
● Fixed input can only accommodate a certain amount of variable input
● When a firm has low productivity or contribution per worker but needs a larger output target, they will
make workers work longer -> costs accelerate (pay them more to work longer)

Output of wheat in Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost
tons

0 ∞ 0
∞0

1 180 30 210 30

2 90 27.5 117.5 25

3 60 25 85 20

4 45 26.25 71.25 30

5 36 31 67 50

6 30 37.5 67.5 70

7 25.714 45 70.717 90

Short Run Costs

a. Average Fixed Cost
● Continually declining because you are able to spread FC over a larger volume of output ●
FC is constant and spread out to decline while Q increases
● The more output you produce, the better you can spread out your fixed costs
● Downward sloping curve
b. Average Variable Cost
● As production increases, AVC initially declines then starts rising
● U shaped curve

c. Average Total Cost

 ● Declines, reaches a minimum, then starts rising
● U shaped curve located above AVC

d. Marginal Cost
● Initially declines, reaches a minimum, starts rising
● AVC is initially bigger, then MC gets bigger
● U shaped but intersects AVC and ATC at their minimum points

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November 24 (th)
ECONOMIES OF SCALE
- When you increase scale of production, you are mass producing the good
- ATC1 = first plant size when you started out the business; initial u shaped curve
- When is it time to expand? when you have recovered what you spent to build the factory, and buy the
equipment and land
- When you recover what you initially invested, open a new factory ATC2: ATC shifting downward when you
increase plant size (mass produce the good and lower average total cost)
- Importance of finding the lowest ATC: basis for being competitive (as long as the price is higher than ATC,
you will still make money)
- minimum efficient scale = lowest ATC at the given output level
- If you continue to build a third factory ATC3, you reach minimum efficient scale -> you are efficient when
the ATC (cost per unit of goods) is low
- you will still earn a profit when you sell at a lower price as long as the lowest ATC is lower than P -
ATC declines as your ATC shifts downward: increase plant size
- Ideally you should maintain plant size 3 when you have the lowest ATC to sell at a low price and make
money

Economies of Scale
● When output is mass produced, the ATC declines

Example:
TC = P120 M
Q = 100,000 units
ATC = TC/Q = P1,200 per unit

TC = P160 M (33% increase in TC)

Q = 200,000 units (100% increase in Q)
ATC = P800 per unit

ATC ↓ = TC ↑ / Q ↑

- Output grew faster compared to your total cost

 - We don't compete on the basis of TC, but ATC which will decline
- When you produce more, your total cost will be higher (variable cost increases when you raise production)

Reasons behind Economies of Scale

1. Fixed cost is spread out when goods are mass produced
● AFC = FC/Q, if FC is constant and Q is increased, AFC will decrease
● ATC ↓ = TC ↓ / Q ↑ , ATC = AFC (declining) + AVC (u shaped, declining)
2. Division of labor
● each worker is assigned a task, and does it repeatedly -> leads to efficiency in production ● as long
as you keep doing a task repeatedly, you will be good at it -> make less mistakes, produce more,
produce faster, lesser products to throw away, lesser cost
3. Specialization of labor
● workers specialize in one area and become experts in it
● big firms need different people to perform highly specialized tasks
Example: accountant (keep all transactions), engineer (make sure that the factory operates efficiently with
minimal waste), lawyer (take care of all legal documentations of the firm), finance specialist (take care of
investing cash and generating a return), economist, marketing specialist
4. Mechanization
● equipment and machinery increase the volume of production and lower ATC
● to mass produce a product, you need machines and equipment to speed up production (lowers ATC
as you can spread out the depreciation of the equipment) as compared to producing manually 5. Discounts on
the purchases of raw materials in bulk
● if you buy materials in bulk, supplier of mass produced textile (also lowers their cost) will offer
significant discounts which will lower cost