Introduction to Microeconomics

Introduction to Microeconomics
Organizing Production. Output and Costs

Peter Stoyanov

Sofia University “St. Kliment Ohridski”

Faculty of Economics & Business Administration
Lecture slides based on: Parkin, Microeconomics, 9th edition
http://wps.aw.com/aw_parkin_microecon_9/108/27656/7080048.cw/index.html

Fall semester, 2017/2018

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Introduction to Microeconomics
Organizing Production

Organizing Production
1 Organizing Production

The Economic Problem of the Firm

Technology and Economic Efficiency
Information and Organization
Markets and the Competitive Environment
Markets and Firms
2 Output and Costs

Decision Time Frames

Short-Run Technology Constraint
Short-Run Costs
Long-Run Costs

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Introduction to Microeconomics
Organizing Production
The Economic Problem of the Firm

The Firm’s Goal

A firm is an institution that hires the factors of production and
organizes them to produce and sell goods or services.

Definition
We usually assume the firm’s goal is to maximize profit.

(If the firm fails to maximize its profit, the firm is either eliminated or
bought out by other firms seeking to maximize profit.)
Alternative objectives of the Firm:
• Revenue maximization
• Growth maximization
• S ATISFICING: do just enough to be ‘sufficient’, then pursue other
things (i.e. do not work too hard to maximize profit)
• Corporate social responsibility
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Introduction to Microeconomics
Organizing Production
The Economic Problem of the Firm

Accounting vs. Economic Concepts

Definition
Profit = Revenues – Costs

Accounting concept: Follows a prescribed set of rules how to calculate

costs. Used to calculate taxes due, show investors the
state of their investment, etc.
Economic concept: Economics measures the firm’s profit in order to
be able to model and predict the firm’s behavior. Uses
the concept of OPPORTUNITY COST OF PRODUCTION to
measure costs.

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Introduction to Microeconomics
Organizing Production
The Economic Problem of the Firm

A Firm’s Opportunity Cost of Production

Definition
A firm’s OPPORTUNITY COST OF PRODUCTION is the value of the best
alternative use of the resources that a firm uses in production.

There are three types of resources available to the firm:

Bought in the Market: The amount spent by a firm on resources bought in the
market is an opportunity cost of production because the firm
could have bought different resources to produce some other
good or service.
Owned by the Firm: The firm’s opportunity cost of using the capital it owns is
called the IMPLICIT RENTAL RATE of capital. It includes
economic depreciation and interest foregone.
Supplied by the Firm’s Owner: The profit that an entrepreneur can expect to
receive on average is called NORMAL PROFIT. Normal profit is
the cost of entrepreneurship and is a cost of production.

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Introduction to Microeconomics
Organizing Production
The Economic Problem of the Firm

The Firm’s Decision

To maximize profit, a firm must make five basic decisions:

What to produce and in what quantities

How to produce
How to organize and compensate its managers and workers
How to market and price its products
What to produce itself and what to buy from other firms

When answering the five main questions, the firms must take into
account the following constraints:

Technology constraints
Information constraints
Market constraints

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Introduction to Microeconomics
Organizing Production
The Economic Problem of the Firm

The Firm’s Constraints

Technology constraints: Using the available technology, the firm can

produce more only if it hires more resources, which will
increase its costs and limit the profit of additional
output.
Information constraints: A firm never possesses complete information
about either the present or the future. (E.g., limited
information on quality and efforts of the workers,
buying plans of the customers, plans of the
competition...)
Market constraints: The market influences the firm in two ways:
Constrains the selling price of the final product
Influences the price at which the firm buys or hires
factors of production

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Introduction to Microeconomics
Organizing Production
Technology and Economic Efficiency

Technological Efficiency

T ECHNOLOGICAL EFFICIENCY occurs

when a firm produces a given level of
output by using the least amount
inputs.
If it is impossible to produce a given
good by decreasing any one input,
holding all other inputs constant, then
production is technologically efficient.
Method D is technologically inefficient
(Method B is better, uses as much
capital and less labor).

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Introduction to Microeconomics
Organizing Production
Technology and Economic Efficiency

Economic Efficiency

E CONOMIC EFFICIENCY occurs when An economically efficient

the firm produces a given level of production process is always
output at the least cost. The technologically efficient.
economically efficient method depends
A technologically efficient
on the relative costs of capital and
production process is not
labor.
necessarily economically efficient.
The difference between technological
and economic efficiency is that
technological efficiency concerns the
quantity of inputs used in production
for a given level of output, whereas
economic efficiency concerns the cost
of the inputs used.

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Introduction to Microeconomics
Organizing Production
Information and Organization

Information and Organization

A firm organizes production by combining and coordinating
productive resources using a mixture of two systems:
Command systems use managerial hierarchy. Commands pass
downward through the hierarchy and information
(feedback) passes upward.
These systems are relatively rigid and can have many
layers of specialized management.
Incentive systems rely on a market-like mechanism to induce workers
to perform in ways that maximize the firm’s profit.
In reality, almost always a mix of the two systems is used:
Command is used when it is easy to monitor performance, or
when even small deviations from the ideal performance is very
costly.
Incentives are used whenever direct monitoring/control is very
costly.
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Introduction to Microeconomics
Organizing Production
Information and Organization

The Principal–Agent Problem

The PRINCIPAL – AGENT PROBLEM is the problem of devising
compensation rules that induce an agent to act in the best interests of
a principal. For example, the stockholders of a firm are the principals
and the managers of the firm are their agents. It is usually dealt with
through:

Ownership, often offered to managers, gives the managers an

incentive to maximize the firm’s profits, which is the
goal of the owners, the principals.
Incentive pay links managers’ or workers’ pay to the firm’s
performance and helps align the managers’ and workers’
interests with those of the owners, the principals.
Long-term contracts can tie managers’ or workers’ long-term rewards
to the long-term performance of the firm. This
arrangement encourages the agents work in the best
long-term interests of the firm owners, the principals.
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Introduction to Microeconomics
Organizing Production
Information and Organization

Types of Business Organization

A PROPRIETORSHIP is a firm with a single owner who has unlimited

liability, or legal responsibility for all debts incurred by
the firm—up to an amount equal to the entire wealth of
the owner. The proprietor also makes management
decisions and receives the firm’s profit.
A PARTNERSHIP is a firm with two or more owners who have
unlimited liability. Partners must agree on a
management structure and how to divide up the profits.
A CORPORATION is owned by one or more stockholders with limited
liability, which means the owners who have legal
liability only for the initial value of their investment.
The personal wealth of the stockholders is not at risk if
the firm goes bankrupt.

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Introduction to Microeconomics
Organizing Production
Markets and the Competitive Environment

Market Types

Economics identifies four main market types:

Perfect competition
Monopolistic competition
Oligopoly
Monopoly

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Introduction to Microeconomics
Organizing Production
Markets and the Competitive Environment

Perfect Competition

P ERFECT COMPETITION is a market structure with

Many firms, many buyers – no-one is large enough to influence

the market
Each sells an identical product (homogeneous product)
No restrictions on entry of new firms to the industry
Both firms and buyers are all well informed about the prices and
products of all firms in the industry.

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Introduction to Microeconomics
Organizing Production
Markets and the Competitive Environment

Monopolistic Competition

M ONOPOLISTIC COMPETITION is a market structure with

Many buyers
Many firms
Each firm produces similar but slightly different products – called
product differentiation
Each firm possesses an element of market power
No restrictions on entry of new firms to the industry

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Introduction to Microeconomics
Organizing Production
Markets and the Competitive Environment

Oligopoly

O LIGOPOLY is a market structure in which

Many buyers
A small number of firms compete with each other.1
The firms might produce almost identical products or
differentiated products.
Barriers to entry limit entry into the market.

1 If the firms do not compete, we call this a CARTEL , and it behaves as a monopoly.
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Introduction to Microeconomics
Organizing Production
Markets and the Competitive Environment

Monopoly and Monopsony

M ONOPOLY is a market structure in which

One firm produces the entire output of the industry.

There are no close substitutes for the product.
There are barriers to entry that protect the firm from competition
by entering firms.

M ONOPSONY is a market structure in which

Many sellers
One buyer
There are barriers for other buyers to enter the market

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Introduction to Microeconomics
Organizing Production
Markets and the Competitive Environment

Measures of Market Concentration

T HE F OUR -F IRM C ONCENTRATION R ATIO
The four-firm concentration ratio is the percentage of the total
industry sales accounted for by the four largest firms in the industry.
T HE H ERFINDAHL –H IRSCHMAN I NDEX
The Herfindahl–Hirschman index (HHI) is the square of percentage
market share of each firm summed over the firms in the industry:
N
X
HHI = s2i ,
i=1

where si is the market share of firm i, and N is the number of firms.

These two measures are not enough, we must also consider:
The geographical scope of the market
Barriers to entry and firm turnover
The correspondence between a ‘market’ and an ‘industry’
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Introduction to Microeconomics
Organizing Production
Markets and Firms

Market Coordination and Firm Coordination

Markets and firms both coordinate production:
M ARKET C OORDINATION : The Demand/Supply framework explains
how markets coordinate the buying and selling plans. Outsourcing –
buying parts or products from other firms – is an example of market
coordination of production.
F IRM COORDINATION: Firms coordinate more production than
markets do. They do so when they can produce more efficiently than
the market:

Lower transactions costs than the market

Economies of scale (producing more units is cheaper)
Economies of scope (producing linked products)
Economies of team production (members of a team can specialize
in mutually supporting tasks)

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Introduction to Microeconomics
Output and Costs

Output and Costs

1 Organizing Production

The Economic Problem of the Firm

Technology and Economic Efficiency
Information and Organization
Markets and the Competitive Environment
Markets and Firms
2 Output and Costs

Decision Time Frames

Short-Run Technology Constraint
Short-Run Costs
Long-Run Costs

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Introduction to Microeconomics
Output and Costs
Decision Time Frames

Decision Time Frames

Some decisions are critical to the survival of the firm.
Some decisions are irreversible (or very costly to reverse).
Other decisions are easily reversed and are less critical to the survival of the
firm, but still influence profit.
All decisions can be placed in two time frames:
T HE SHORT RUN is a time frame in which the quantity of one or more
resources used in production is fixed. Short-run decisions are
easily reversed.
T HE LONG RUN is a time frame in which the quantities of all resources,
including the plant size, can be varied. Long-run decisions
are not easily reversed.
Firms do all production in the short run.
Firms do all planning in the long run.
A SUNK COST is a cost incurred by the firm and cannot be changed. If a firm’s
plant has no resale value, the amount paid for it is a sunk cost. Sunk costs are
irrelevant to a firm’s current decisions.
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Introduction to Microeconomics
Output and Costs
Short-Run Technology Constraint

Product Schedules

T OTAL PRODUCT is the total output produced in a given period.

T HE MARGINAL PRODUCT of labor is the change in total product that
results from a one-unit increase in the quantity of labor
employed, with all other inputs remaining the same.
T HE AVERAGE PRODUCT of labor is equal to total product divided by
the quantity of labor employed.

When the quantity of a variable resource (e.g. labor) is increased:

Total product increases

Marginal product initially increases but then eventually decreases
Average product initially increases but then eventually decreases

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Introduction to Microeconomics
Output and Costs
Short-Run Technology Constraint

Total Product Curve

Similarly to the PPF, the TP curve

shows the maximum output level
given a quantity of resource(s).

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Introduction to Microeconomics
Output and Costs
Short-Run Technology Constraint

Marginal Product Curve

Using the TP curve, we can separate For almost all production processes,
the contribution of each additional we have this shape of the Marginal
worker to Total Product. Product Curve:
Increasing returns initially,
Diminishing returns eventually.

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Introduction to Microeconomics
Output and Costs
Short-Run Technology Constraint

The Law of Diminishing Returns

Increasing marginal returns arise from increased specialization and

division of labor.
Diminishing marginal returns arises from the fact that employing
additional units of labor means each worker has less access to capital
and less space in which to work.
The law of diminishing returns states that:

Definition
As a firm uses more of a variable input with a given quantity of fixed
inputs, the marginal product of the variable input eventually
diminishes.

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Introduction to Microeconomics
Output and Costs
Short-Run Technology Constraint

Average Product Curve

When marginal product exceeds

average product, average product
increases.
When marginal product is below
average product, average product
decreases.
When marginal product equals average
product, average product is at its
maximum.

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Introduction to Microeconomics
Output and Costs
Short-Run Costs

Total Cost

A firm’s TOTAL COST (TC) is the cost of

all resources used.
T OTAL FIXED COST (TFC) is the cost of
the firm’s fixed inputs. Fixed costs do
not change with output.
T OTAL VARIABLE COST (TVC) is the
cost of the firm’s variable inputs.
Variable costs do change with output.
Total cost equals total fixed cost plus
total variable cost. That is:

TC = TFC + TV C

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Introduction to Microeconomics
Output and Costs
Short-Run Costs

Deriving the Total & Variable Cost Curves

Start with the Total Product Curve. Now invert the axes – put cost on the
vertical axis instead of the horizontal.
Add a second axis, showing total
Now we have the TVC curve.
variable cost. (In our case: 1 worker
costs $25/day.)

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Introduction to Microeconomics
Output and Costs
Short-Run Costs

Marginal Cost and Average Cost

M ARGINAL COST (MC) is the increase in total cost that results from a
one-unit increase in total product.

Over the output range with increasing marginal returns, marginal

cost falls as output increases.
Over the output range with diminishing marginal returns,
marginal cost rises as output increases.

AVERAGE COST measures can be derived from each of the total cost
measures:

AVERAGE FIXED COST (AFC) is total fixed cost per unit of output.
AVERAGE VARIABLE COST (AVC) is total variable cost per unit of
output.
AVERAGE TOTAL COST (ATC) is total cost per unit of output.
AT C = AF C + AV C.
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Introduction to Microeconomics
Output and Costs
Short-Run Costs

The AVC and AFC Curves

AFC falls as output increases (a fixed The Marginal Cost (MC) curve
amount is spread over more and more crosses the AVC and the ATC curves
units). at their lowest point.
The AVC curve is U-shaped. As output
increases, average variable cost falls to
a minimum and then increases.

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Introduction to Microeconomics
Output and Costs
Short-Run Costs

Product Curves and Cost Curves

A Firm’s product curves are

shaped by the technology it uses.
A Firm’s cost curves are shaped by
its product curves and the cost of
the resources used.

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Introduction to Microeconomics
Output and Costs
Short-Run Costs

Shifts in the Cost Curves

Technology
Technological change influences both the productivity curves and
the cost curves.
An increase in productivity shifts the average and marginal product
curves upward and the average and marginal cost curves
downward.
If a technological advance brings more capital and less labor into
use, fixed costs increase and variable costs decrease.
In this case, average total cost increases at low output levels and
decreases at high output levels.
Prices of Factors of Production
An increase in the price of a factor of production increases costs and
shifts the cost curves.
An increase in a fixed cost shifts the total cost (TC) and average
total cost (ATC) curves upward but does not shift the marginal cost
(MC) curve.
An increase in a variable cost shifts the total cost (TC), average total
cost (ATC), and marginal cost (MC) curves upward.
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Introduction to Microeconomics
Output and Costs
Long-Run Costs

Long-Run Costs
In the long run, all inputs are variable and all costs are variable.
The behavior of long-run cost depends upon the firm’s production
function.
Definition
The firm’s PRODUCTION FUNCTION is the relationship between the
maximum output attainable and the quantities of both capital and
labor.

Diminishing Marginal Product of (Variable) Factors: The Marginal

Product of each factor eventually decreases, given that the quantity of
the other factors does not change.
For each level of any resource, we have a complete set of short-run
product and cost curves. (E.g. for each plant, we have a complete
set of curves.)

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Introduction to Microeconomics
Output and Costs
Long-Run Costs

From Short-Run Cost to Long-Run Cost

The average cost of producing a given output varies and depends on
the firm’s plant size. The larger the plant, the greater is the output at
which ATC is at a minimum.
Example: The firm has 4 different plants: 1, 2, 3, or 4 knitting
machines.

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Introduction to Microeconomics
Output and Costs
Long-Run Costs

From Short-Run Cost to Long-Run Cost

The Firm decides how much output it wants to produce.
Because in the Long Run it may vary plant size freely (i.e. choose a
specific sets of SR cost curves), the Firm chooses the set of SR curves
which has the lowest production cost for the given quantity.
Example: Produce 13 sweaters:

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Introduction to Microeconomics
Output and Costs
Long-Run Costs

The Long-Run Average Cost Curve

Definition
The LONG - RUN AVERAGE COST CURVE is the relationship between the
lowest attainable average total cost and output when all factors of
production are variable.

The long-run average cost curve is a planning curve that tells the firm
the plant that minimizes the cost of producing a given output range.
Once the firm has chosen its plant, the firm incurs the costs that
correspond to the (Short-Run) ATC curve for that plant. Production
takes place in the short run.

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Introduction to Microeconomics
Output and Costs
Long-Run Costs

The Long-Run Average Cost Curve

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Introduction to Microeconomics
Output and Costs
Long-Run Costs

Economies and Diseconomies of Scale

Definitions
E CONOMIES OF SCALE are features of a firm’s technology that lead to
falling long-run average cost as output increases.
D ISECONOMIES OF SCALE are features of a firm’s technology that lead
to rising long-run average cost as output increases.
C ONSTANT RETURNS TO SCALE are features of a firm’s technology that
lead to constant long-run average cost as output increases.
M INIMUM EFFICIENT SCALE is the smallest quantity of output at which
the long-run average cost reaches its lowest level.

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Introduction to Microeconomics
Output and Costs
Long-Run Costs

Economies and Diseconomies of Scale

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