lecture 6 production decisions. goals and economic benefits from production what are the goals of...
TRANSCRIPT
Lecture 6
Production Decisions
Goals and economic benefits from production
• What are the goals of production?– Some productive activities may be motivated by extrinsic
benefits– Some may be motivated by intrinsic benefits– Some, by both
• There are different types of benefits coming from production:– Internal benefits: the benefits of a project based only on the
perspective of the economic decision maker – External benefits: the benefits of a project that accrue to
persons or entities that are not among the economic actors directly responsible for the activity (Ex: environment)
Weighing costs and benefits
• Net benefits: total benefits minus total costs (if it is social benefits-social costs, then it is a measure leading to social efficiency)
• Cost-benefit analysis: a procedure often used by governments for attempting to determine the net benefits of proposed projects– BUT: Some costs and benefits are not easy to measure
in monetary terms!
Marginal thinking
• Marginal thinking: Evaluating incremental (small) changes in production (or input use) levels in order to find an optimum
• If we take the actions of a producer up to a certain point in time as given, the producer’s decision will only depend on marginal cost and marginal benefit– Marginal benefit: the extra benefit that accrues from
producing the last unit of output
• The rule : Net benefits are maximized when producers engage in an activity up to the point where MB equals MC
Marginal thinking in case of profit maximization
Total CostCurve
20
40
60
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120
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Quantity of Hair Dryers
Co
st (
$)
Marginal thinking in case of profit maximization
Total RevenueCurve
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60
80
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Quantity of Hair Dryers
Rev
enu
e (
$)
Slope = 20
Marginal thinking in case of profit maximization
0 1 8632 75 94
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Quantity of Hair Dryers
Co
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nd
Re
ven
ue
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)
Total Revenue Curve
Total Cost Curve
Profit
Loss20
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80
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Marginal thinking in case of profit maximization
101
Line demonstratingthat the two curveshave the sameslope at this point
1 8632 75 94
Quantity of Hair Dryers
Co
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nd
Re
ven
ue
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Total Revenue Curve
Total Cost Curve
Profit
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Pri
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MarginalCost Curve
Price =Marginal
Marginal thinking in case of profit maximization
MCP = 35
P = 20
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Costs and Revenue When the Price of Hair Dryers is $35
(1) Quantity of Hair Dryers
(2) Marginal
Cost ($)
(3) Total Cost ($)
(4) Marginal Revenue (= Price)
($)
(5) Total
Revenue ($)
(6) Total Profit
($)
6 14 81 35 210 129
7 20 101 35 245 144
8 35 136 35 280 144 9 55 191 35 315 124
Marginal thinking in case of profit maximization
… when the price of output changes
Main assumption for marginal thinking: Convexity
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Quantity of Hair Dryers
Pro
fit (
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Convexity: a mathematical term used to describe the special assumptions necessary for marginal thinking
With convexity, net benefits can be maximized by taking incremental steps along a smooth path.
Discrete decision making
• Sometimes marginal thinking may be insufficient for wise economic decision making.
• We may usually have to consider questions like «whether to produce or not to produce», «to build a bridge or not», «to enter a market or not»…
• These are discrete decisions (they involve jumps between different distinct choices)
• There may be non-convexities that require discrete decision making rather than marginal thinking
A discrete decision: whether to produce or not
• Two surprising results:
– In the SR, if the firm can earn enough to cover its variable costs and at least a bit of its fixed costs, it should keep operating, even if it makes losses in the SR
– It doesn’t matter how big the fixed costs are: As long as some of these fixed costs are covered, the firm should continue to operate.Sunk costs shouldn’t matter to present decision making
(sunk cost: a cost that was made in the past and is now irreversible)
WHY?
Cost and Revenue When the Price of Hair Dryers is $9
(1) Quantity of Hair Dryers
(2) Marginal
Cost ($)
(3) Total Cost ($)
(4) Marginal Revenue (= Price)
($)
(5) Total
Revenue ($)
(6) Total
Profit ($)
0 -- 20 -- 0 20
1 12 32 9 9 23
2 8 40 9 18 22
3 8 48 9 27 21
4 9 57 9 36 21
5 10 67 9 45 22
A discrete decision: whether to produce or not
Discrete decision making: Multiple equilibria
Office-worker-oriented hours
Student-orientedhours
Iris's starting point
Pro
fit (
$)
Number of Hours Open After 11 a.m.
Discrete decision making: Lumpiness and increasing returns
• Lumpiness: Some inputs or outputs can be obtained or sold only in «discrete» quantities
• Increasing returns: They may lead to a PPF with a bowed-in shape (and possibly to a corner-solution)
A
C
B
Qu
an
tity
of
Exc
el O
utp
ut
Quantity of Lotus Output
Discrete decision making: Path dependence and switching costs
• Path dependence
Economic developments may depend on particularities of past developments, i.e., «History matters»
• Switching costsTransaction costs associated with a change
Discrete decision making: network externalities
• Network externality (in production)
A particular technology may be advantageous to adopt because other economic actors have adopted it
Examples: PS vs. Macintosh; VHS video vs. BETA video; QWERTY keyboard, etc.
A formal model of producer theory with convexity and perfect competition
• Assumptions: – The firm is only concerned with profit-
maximization, solving only convex problems– The firm is a price-taker (it takes the output
price P as given); i.e. it operates in a perfectly competitive market
– The firm has no market power
A formal model of producer theory with convexity and perfect competition
MC
PATCAVC
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A formal model of producer theory with convexity and perfect competition
Total Revenue
MC
PATCAVC
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A formal model of producer theory with convexity and perfect competition
Total Cost
Economic Profit
MC
PATCAVC
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A formal model of producer theory with convexity and perfect competition
PB
PS
P high
MC
ATC
AVC
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