Economics Lecture Six

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The "Firm"

On the CLEP exam that some of you will take to earn college credit, 10–15% of the questions are devoted to decisions by a "Firm". That term refers to the seller, which is alternatively described as a "supplier", a "company", a "producer", a "manufacturer", a "store", or, mostly simply, a "firm". A Firm makes decisions about how much to produce and how to try to earn a profit, such that revenue is in excess of costs.

We are on the "supply side" when we discuss companies or firms. It is on this side (rather than the demand or consumer side) where we have to decide how much you would produce if you were the president of a company. Recall that microeconomics is about supply and demand. When we are on the demand side, then we are discussing what you would buy as a consumer, and how much you would pay. When we are on the supply side, we are considering what you would produce in managing a company. Keep these concepts separate in your mind.

There are three key topics on this side of the "seller" or firm:

• the "short run" as compared with the "long run," and "economies of scale"
• total, average, and marginal costs and revenue
• marginal product and diminishing returns

Let's start with the first point above. “Short run” costs and “long run” costs are associated with the supply of a good or service. Short-run costs include overtime labor to try to increase supply immediately. “Variable inputs” are the focus of short-run costs: they are the inputs (such as materials or labor) that are increased in order to produce more goods or services in the short run. Variable inputs are different from fixed inputs, which cannot be increased in the short run. An example of a fixed input is a manufacturing facility, which cannot be built quickly. A stadium is a fixed input in the sports world.

This leads us to the second point above. Essential to microeconomics are the two concepts of “marginal ____” and “average ____.” For example, we have “marginal cost” and “average cost.” The “marginal cost” is how much it costs to make one more widget (a "widget" in an economics course is an imaginary good). The “average cost” is the overall average per-unit cost for all the widgets you make.

And now the third point above is as follows. The “marginal product” is the increase in supply due to one more unit of input (typically one more unit of labor). If you hire one more laborer (e.g., employee or worker), how much will your output of widgets increase? “Marginal product,” or MP, gives you that answer. Your overall product output (Q) is the sum of all your marginal products (MP). You could then take the average of that, defining “average product” as your total output Q divided by your total labor (L). Expressed as an equation, this is AP = Q/L.

The average _____ always moves towards the marginal _____ as the relevant activity increases. Average cost approaches marginal cost, and average product approaches marginal product. Think about that, providing your own examples to convince yourself.

As president of your firm, you do not want to be paying overtime wages to your employees for a long period of time. By law, overtime wages are 1.5 times regular wages. So when you pay overtime, you are paying 50% more than what you would pay if you could hire another worker. It is inefficient to be paying overtime. You do it only as a quick fix in order to supply more to satisfy an increase in demand.

In the “long run,” you maximize efficiency by making fundamental changes to your business. If you own a professional baseball team, a short-run change to increased demand for tickets by fans would be to build temporary bleachers. But the fans would prefer to pay more for permanent seats, and you would make more money with a larger stadium. So the long-run change is to build an entire new stadium. Many owners have done that.

The Short Run and Long Run

Keep in mind that in this Lecture we are focusing on "supply" rather than "demand". We look at how companies decide how much product to make and put out into the market. How many goods should a company produce, or how many services should it provide?

Before we start, however, we define two terms essential to economics: the “short run” and the “long run.” As its name implies, the “short run” is a relatively short period of time in which a company can make only temporary changes to its operation. In a sporting contest, the “short run” would be during a game, when the coach decides to substitute his players or alter the game plan to try to win that particular contest. During the “short run” only quick and temporary reactions by a company or firm to a fluctuation in demand are possible. For example, changes like using more overtime labor would be a short run adjustment. Or telling workers to take an extended vacation due to lack of demand for the goods would be another short run change.

In the “short run” it is impossible to change the fixed costs, or “sunk costs.” The cost of a factory, and the equipment inside, cannot be altered. Fixed costs can be easily identified by seeing what the total costs are when output is zero. That is because when output is zero, there are no marginal costs, and all the costs are the fixed ones.

The “long run” consists of a time period long enough to make basic and permanent changes, like building new factories, buying new equipment, and hiring and training new employees. In a sporting contest, it would include scouting and drafting new players, or building a new weight room. Everything can be adjusted in the “long run”: workforce, facilities, materials, equipment, investment, etc.

For now, let’s focus on the “short run.” The key concepts for the "short run" are “marginal cost” and “marginal revenue.” How much does it cost to make one more widget, and much revenue does that extra widget generate for the company? That additional cost per unit is called “marginal cost.” The additional revenue per unit is called “marginal revenue.” As we discussed in the last Lecture, as long as marginal revenue is slightly higher than marginal cost, then it makes sense to produce more goods or services (e.g., produce that extra widget). Typically, companies continue making more and more goods until marginal revenue falls below marginal cost, at which time they stop production because they begin to lose money on each additional good they produce. This is similar to when a store owner closes his store at night once the marginal cost of his electricity and employee wages starts to exceed the marginal revenue from new customers coming into the store.

The Short Run: Marginal Product

Imagine yourself as the president of a company making widgets, our imaginary good. If it costs you a total of $200 to make 10 widgets, and a total of $205 to make 11 widgets, then what is your marginal cost (MC) of the 11th unit? It is only $5. What is its average cost? Nearly $19 ($205 total cost divided by 11 total units). Average cost is often greater than the marginal cost. This makes sense, because once you pay for your factory and workers, you do not have much additional cost to produce an extra unit. This is called economies of scale: the bigger your operation, the cheaper you can make one more unit.

Think of a baking some bread. It requires some time and effort to bake one loaf of bread, and the expense of heating the oven. But there is not as much extra effort and expense to stick a second loaf in the oven at the same time. After all, the oven expense is the same for two loaves as it is for one.

Or imagine going to a baseball game. The cost for one person to go is the ticket price plus the cost of gas and parking and wear and tear on the car. The cost for a second person to go with the first person is just the price of the extra ticket. There is no extra gas or parking or wear and tear on the car for a second person to ride along. So the marginal cost for the second person is less than for the first person.

Suppose as president of the widget company, you are deciding how many employees to hire. You have an assembly line that needs workers. Each additional employee whom you hire to work on that assembly line increases the “marginal product of labor,” which is the increase in output for each additional unit of labor. It is often called “MP”.

Let’s explain MP in a different way to make sure you understand it. The more workers you hire, the more goods your company can produce. Suppose you can make 1000 widgets a week with 10 employees. Then you hire one more employee, and your output increases to 1015 widgets. What is the “marginal product of labor,” or MP, for your 11th employee? It is 1015-1000=15. Note that this is less than the average product of labor, which 1015/11 = 92.3 for 11 employees.

When the marginal product of labor (MP) is less than the average product of labor, then you are suffering from the problem of “diminishing marginal returns.” You received much more benefit from the 1-10 employees you hired earlier (their average product of labor is 100) than from the 11th employee (with its MP of only 15).

Again, this makes sense. As you hire more and more employees, your benefit from the additional people will eventually decline. Once the assembly line has enough workers to satisfy demand, for example, you would be wasting money by hiring additional workers. They would end up spending the day talking to each other rather than doing productive work. If you were to keep hiring employees, then eventually the MP for your next employee would fall to zero. He would have nothing productive to do. There is a saying that describes this same problem: "too many cooks spoil the broth!"

The MP for the first employee whom you hire would be greater than zero. Additional employees might have even higher MPs because you are filling your assembly line. If your assembly line needs 10 employees to run it, then the MP for your 10th employee will the highest of all. After that, the MP begins falling.

In general, MP rises as your initial employees are hired, eventually reaches a maximum at some point and then falling back towards zero for each additional employee. It is an upside-down oval, beginning at MP=0 for 0 employees and returning to MP=0 for a large number “n” of employees. The value of “n” depends on the business.

The optimal number of employees for an NBA basketball team, when MP is its maximum, is about only a dozen players. The optimal number of employees for Wal-Mart, when MP is its maximum, is over 1 million employees. So determining the optimal number of employees depends on what the firm is producing.

Can we can find the marginal cost (MC) of making that extra widget based on (i) the wages we have to pay the extra employee and (ii) his marginal productivity (MP)? If it costs us $100 to hire one more employee, and he enables us to make 10 more widgets, then our marginal cost (MC) is simply $100/10 = $10 per unit. In other words, MC = wage/MP (wage divided by marginal product).

Let’s make sure we understand this by looking at another example. Suppose that hiring one more sales agent at $80 per day in our clothing store enables us to sell 8 more dresses. What is our marginal cost for dresses at that point? It is simply the additional cost of $80 (the wage) divided by that employee’s marginal productivity of 8 new sales, yielding a marginal cost of $10 per dress.

The above section covered much ground. You may benefit from re-reading it.

The Long Run: Economies of Scale

The "long run" is the period of time long enough to build new factories. Depending on the issue, the long run is usually more than a year. In the Bible, Jesus looked for disciples who would stick with him for the long run:

From that time many of his disciples went back, and walked no more with him. Then said Jesus unto the twelve, Will ye also go away? Then Simon Peter answered him, Lord, to whom shall we go? thou hast the words of eternal life. And we believe and are sure that thou art that Christ, the Son of the living God.

Peter was obviously dedicated for the long run. Over thirty years after Jesus’ crucifixion, Peter remained true to what he said and allowed himself to be crucified (upside down). Jesus picked the Apostles for the long run.

There is a "long run" in most businesses also. When you are doing business with a supplier you want to be confident it will still be there a year or five years later. You want to set up your firm so that it is efficient for the long run. Quick fixes are typically short-lived and inefficient, and long run planning is crucial to long run success. People who become doctors or lawyers go through more education at short-term expense, in order to succeed in the long run afterward.

Efficiency is maximized by focusing on the long run. As president of your widget company, you want to maximize the efficiency of your company. You want the lowest total cost per unit. You do not want idle workers or equipment. You do not want wasted inventory.

The changes you make to your company in the long run will be designed to maximize efficiency. You want to reduce overtime, and you want loyal workers at a relatively low wages. You want manufacturing facilities that are utilizing close to 100% of their capacity for production. If demand is increasing, then that means building new facilities. If demand is decreasing, then that means selling facilities that you already have.

Scale

There is a concept for the long run known as “scale”. "Scale" refers to the total amount of inputs (workers, facilities, equipment, etc.) that a company has. The “large scale” means large facilities and number of workers. The “small scale” means small facilities and number of workers.

We expect the output of a firm to increase in proportion to an increase in scale. As president of your company, you may think that doubling everything (facilities, workers, etc.) will double your output. Often that is true. When output increases on a one-to-one basis with input, this is called “constant returns to scale.” When scale increases by a factor of ‘x’, then output also increases by the same factor of ‘x’.

An assembly line is perhaps the best example of this. Suppose one assembly line produces 1000 widgets a month. How much would two assembly lines, with double the workers, produce? We would expect about twice the output, or 2000 widgets a month.

But equally important are situations where there are “increasing returns to scale” (output goes up by a greater percentage than the increase in input) and “decreasing returns to scale” (output goes up by a smaller percentage than the increase in input). The popular term “economies of scale” refers to “increasing returns to scale,” which are what one often sees in a well-managed company.

Our example of the assembly line may yield slightly increasing returns to scale. When we double the assembly line, we may not have to double the number of administrative workers like managers, clerks, phone operators, etc. We can double our output without doubling our workforce. Perhaps we can even squeeze the second assembly line into our existing manufacturing plant. We would still need twice the materials for the goods produced, but not twice the labor and facilities. In this case we have increasing returns to scale: output doubles when inputs increased by less than 100%.

When would a firm have decreasing returns to scale? How could it be that we can double our workers and facilities and not produce at least twice the output? The reason is that inefficiencies creep in. Workers may spend more time talking with each other than doing productive work. Managers and other workers may fight each other for power rather than doing what is best for the company. People may call in sick more often, knowing that others are there to fill in for them. Waste could spiral out of control as more purchases are made. Each employee will feel less needed, and may become less motivated.

As president of your company, think before you make long-run changes to increase output: do you have increasing, constant, or decreasing returns to scale?

Diminishing Returns v. Returns to Scale

Do not confuse decreasing returns to scale with diminishing returns. Diminishing returns are something that occurs in the short run: the decline in marginal productivity as you keep increasing a variable input while all other inputs remain constant. For example, asking one employee to work more and more overtime is going to have diminishing returns. He is going to become so tired that he will not work as efficiently as when he is rested. And even if he did not tire, the added benefit of the worker to your company by himself is going to decline without adding other workers or facilities to support him. The different concept of decreasing returns to scale refers to long term economic changes due to big modifications to your company. Diminishing returns are always expected; decreasing returns to scale are not.

A typical firm can initially expect average unit costs to decline as it increases inputs (workers, facilities, etc.) from zero. This is an increasing return to scale. But at some point, call it when input = X, those increasing returns disappear and the company can obtain only constant returns to scale. It has attained its “minimum efficient scale” at that point. It can continue to increase its inputs, but its output increases by only the same amount as its input. Ultimately, the company will find that increasing inputs further does not even increase output much. It has too many workers or facilities at that point, and it begins to have decreasing returns to scale.

Division of Labor

The key to increasing returns to scale, which is what every firm owner wants, is division of labor. Train your employees to become specialists at certain functions so that they can be performed more efficiently. Henry Ford was a master at this, training his workforce in a way that each employee was an expert at a particularized aspect of the assembly line. The more specialized employees can become, the faster they can accomplish their task. After a while, they can almost do their job in their sleep. And that is a good thing, because doing the same task over and over puts one to sleep!

Charlie Chaplin mocked this division of labor in the mostly silent movie, “Modern Times,” made in 1936. In it he portrays a factory working toiling in a dehumanizing position under the pressure of a mean boss. Charlie is just trying to earn a decent living and buy a house for his wife Paulette and himself, but bad luck keeps getting the way. The theme of class struggle occurs repeatedly in politics to this day.

Costs: Long Run Is Cheaper than Short Run

Well-planned long-run changes are more efficient than short-run adjustments. For example, it is cheaper to hire a new employee at the basic wage than to pay time-and-a-half for existing employees to work overtime. It should always be more efficient to build a facility the way you need it than to pay someone else to rent a facility that is not exactly what you need. There may be reasons why you do not want to take a risk on a new facility, but efficiency is always on the side of long-run expenses.

That is true in life also. When you make decisions, you are better off thinking about the long-run consequences. Many mistakes are caused by short-term thinking. If drug addicts considered the long-run impact of their decision to take drugs, then they would never try drugs in the first place. By avoiding drugs they would save themselves from dying in a gutter some day or ending up homeless.

Exercise is not always the most pleasant activity in the short run. But its benefit is substantial for the long run.

Jesus focused on the long run in many ways. Christianity talks in terms of eternity, while anti-Christians talk in terms of the short run, or even the past.

Economically, long-run unit costs are always less than or equal to short-run unit costs at all levels of output Q. If you graph unit cost on the y-axis and output Q on the x-axis, then the curve for the long run is the shape of a big bowl (or “U” with a flattened bottom): downward sloping for small Q, flat for medium Q, and then upward sloping for large Q. That reflects the increasing returns to scale as production begins, constant returns to scale when production is medium, and then decreasing returns to scale as production becomes very large.

If plotted on the same graph, the short-run unit costs would be little bowls (or “U”s) are sitting on top of the bigger curve of long run costs. SHORT-RUN UNIT COSTS NEVER DIP BELOW LONG-RUN UNIT COSTS. That is because short-run unit costs are always equal or greater than long-run unit costs.

Accounting

"Accountants" keep track of all the revenue, expenses and profits of a firm. They take courses in this in college, and pass exams to become a certified public accountant (CPA). The math is never more complicated than ordinary arithmetic. A personality that likes to keep track of financial matters and likes the stability of steady work, with little conflict, may be well-suited to becoming an accountant.

It is the job of accountants to calculate the profits of a business. A special term, "accounting profits," is defined as follows: Accounting profits equal total revenue minus explicit costs. The explicit costs are the expenses of the inputs, such as workers’ wages, cost of materials, and the cost of maintenance and depreciation on facilities like plants and equipment. ("Depreciation" is the predictable wear and tear on something that makes it gradually less valuable and useful, such as depreciation of your car's tires every time you drive somewhere, because the tire tread wears down with every ride.)

“Economic profit” is a broader concept than “accounting profit.” “Economic profit” includes all of the implicit costs, such as the opportunity cost of the time and effort spent by an owner (which can be enormous) and also the opportunity cost of investment in the firm. If a company has only a $1 “accounting profit” in a certain year, then its economic loss is much bigger once you factor in all the opportunity costs.

There are tricks of accounting to overstate the profitability of a company, and that has led to huge scandals and bankruptcies for firms like Enron. If you ever consider investing in a firm, you should be aware of the distortions that are possible in accounting. The rule “caveat emptor” (buyer beware) applies to investors just as much as consumers.

It is easy to overstate sales projections. It is easy to overstate the value of a firm’s inventory (goods in its warehouse and store). Firms also have a tendency to understate depreciation (wear and tear) and future liabilities.

Occasionally a major firm will suddenly declare itself to be broke and will ask the government for a “bailout” to save its jobs, as General Motors has done. The car maker Chrysler also did this about 30 years ago. The federal government, despite substantial criticism, provided cheap loans to Chrysler to keep it out of bankruptcy. So many jobs were at stake that there was political benefit to some officials for doing this. But don’t expect the government ever to save your firm from going bankrupt.

Assignment

Read and, if necessary, reread the above lecture. Complete any six of the first seven questions below:

1. Fixed costs can be easily identified by seeing what the total costs are when output is _______. Separately, give an example of a variable cost.

2. Apple Computer probably has ______________ returns of scale for its production of iPhones. Explain briefly.

3. Give an example of a "short run" cost for a firm, and give an example of a "long run" cost. This can refer to any type of firm, from a grocery store to a baseball team to homeschooling.

4. Suppose you own a mechanics' shop that fixes cars, and you have 4 employees whom you pay $12 per hour. On average your 4th employee can fix 3 cars an hour. What is your marginal product (MP) and marginal cost (MC), and what is the minimum on average that you need to charge customers (your marginal revenue) for fixing cars? (Assume your only cost is labor, and the customer pays the cost of any parts.)

5. Earlier in this course we learned that someone who obtains a college degree earns, over the course of his life, about $500,000 more than someone who does not. How can you explain this fact in terms of the advantages of "long run" costs over "short run" costs?

6. Suppose you spent one million dollars to build your factory, and another million dollars for materials and labor and electricity to make 50 cars. What is your fixed cost, average variable cost, and average total cost? Now suppose it costs you $18,000 to make a 51st car. What is your marginal cost?

7. Suppose you could earn $8 an hour. Instead, you watch television for an hour. What is your accounting profit or loss, and what is your economic profit or loss, for that hour?

Honors

Provide brief answers to any four of the following questions:

8. Suppose there is a sudden increase in the market price for a firm's widget. The firm will hire more employees to produce more output until the point where the value of its marginal product of labor equals its _____________. [Hint: the answer is NOT simply "marginal cost"].

9. Explain the following from the lecture: if inflation is 10% per year for three years, but one particular good keeps the same price during those three years, then its opportunity cost and real price actually decreased.

10. Are "long run" average costs lower than "short run" average costs and, if so, why?

11. (Difficult, but try): Your firm seeks to produce a certain level of output in the most efficient way (the lowest cost). It should use its resources in which of the following ways:

(a) use materials that generate the highest marginal product
(b) use materials that have increasing returns to scale
(c) use as much material as possible until there are diminishing returns
(d) use resources such that their marginal products per unit cost are equal

12. The greater the number of substitutes for a good, is it more or less price elastic? Explain briefly.

13. The smaller the proportion of income consumed by the purchase of a good, is it more or less income elastic? Explain briefly.

14. Would government prefer taxing a good that is price elastic or price inelastic? Explain briefly.

15. Suppose french fries cost $1 and ketchup 10 cents. When the price of ketchup goes up to 20 cents, the quantity demanded for french fries falls by 10%. What is the cross elasticity of demand for french fries with respect to ketchup? Show your work and state whether these goods are complements or substitutes.

Extra Credit for Anyone

16. Discuss this statement: the most efficient "division of labor" in the world is ... traditional marriage between a man and woman.