ABSE 203 PRODUCER DECISION MAKING
Production and costs
- The firm and its motivation
The firm is at the center of the study of microeconomics. It is the economic agent that directly makes decisions what to produce, how to produce, and for whom to produce. In this course we will concentrate on the decisions that firms make.
The first point of our analysis is the motivation of the firm? Why do firms make one or another decision? What do they want to achieve? Economists can discuss many different goals that firms may set for their operations – to sell as much as possible (maximize sales) and gain a greater market share, to satisfy customers and gain social prestige, to become better than competitors, to increase production steadily and protect environment, etc. All these goals could not be achieved, however, if the firm does not make profits, or if it loses money.
In this course we will take profit maximization as the primary and only firm’s goal.
One does not need going to school to figure out that profit (Π) is the difference between total revenues (TR) and total costs (TC), or
Π = TR – TC
Therefore, in order to study the decisions of the firms, we have to concentrate on the analysis of costs.
- Costs and expenditures
First, we have to make a difference between COSTS and EXPENDITURES.
We studied aggregate expenditures in macroeconomics. They presented the demand side of the economy. Here we will study costs that present the supply side of the economy. While the reduction in aggregate expenditures is a warning factor and at the moment the economy is slowing down due to the sharp fall in expenditures, the decrease in costs is the best news for business. This means that firms can produce more with the same resources, or that they can produce a good or service with fewer resources.
Shortly, costs are the money paid for the factors of production. This is the most general meaning of costs, BUT it is not quite correct from the perspective of business and economics. When we report costs in our accounting records, such an understanding of costs is right, but when we assess the economic profitability of the firm, it does not work out.
- Accounting and economic costs
Accountants keep a record of costs because they have to justify the firm’s operations and the taxes that are paid to the government and to the municipality. Since there is always an opportunity to cheat and report more cost and less profit in order to pay less taxes, the government can check accounting papers of firms. This is why accountants keep documents for every payment that the firm has performed and give these documents as an evidence for the firms’ costs. Therefore, we can conclude that from the point of view of accountants costs are the money paid for the factors of production. In other words, accounting costs are all the costs that have documental evidence and that are recognized by the taxation officers. These are costs that have been explicitly paid and we call the EXPLICIT costs.
If, for example, a firms has paid €1000 for production (raw materials, wages, electricity, etc.)and it has made €1010 total revenues, its profit is €10 and it will even payto the government €1.50 taxes on this profit. From the accounting point of view the firm is profitable and its profit is €10. However, one does not need going to school to figure out that this business does not make any sense, because it is not profitable – the rate of profit is just 1%, while the firm could have had more ( say, 2%) if it would just have had put the money into a bank, instead of running such a business.
This example presents the importance of opportunity costs in economic decisions. Actually, putting money in a business means that the owners lose the interest that could have been earned from a bank. Therefore, from economic point of view, this interest that is lost is a cost of doing business. It is the opportunity cost of capital and should be compensated by the revenues of the business. If it is not, then the business is losing money. It is not profitable. Therefore, the economist will consider this money lost and a cost of business. It is not explicit cost, because it has not been actually paid, but it is a cost. We call it IMPLICIT COST. Thus, from the point of view of economics, we consider not only explicit costs of the firm, but implicit costs, as well.
Economic costs = explicit costs + implicit costs
One example of implicit costs is the interest on the money, invested in the firm, that could have been earned at zero risk elsewhere (from a bank deposit, or from a government bond). Another example of implicit cost is the salary that the owner of the firm could have earned elsewhere, if he were working for someone else instead of working for his own firm. Another example is the rent that the owner of the firm could have get from renting out the shop (if he owns it) instead of making business in it.
Let’s solve the following problem:
One year ago, Tom and Jerry set up a vinegar bottling firm (called TJVB).
Tom and Jerry put €50,000 of their own money into the firm. (They used this money to pay for equipment, labor, etc.)
They rented equipment for € 30,000;
They hired one employee to help them for an annual wage of € 20,000;
Tom gave up his previous job, at which he earned € 30,000, and spent all his time working for TJVB;
Jerry kept his old job, which paid € 30 an hour, but gave up 10 hours of leisure each week (for 50 weeks) to work for TJVB;
The prevailing interest rate was 10%
The cash cost of TJVB (for raw materials and like) were € 10,000 for the year.
What is TJVB’s accounting cost and what is its economic cost?
Explicit costs / 30000+20000+10000 = 60000Implicit costs / 30000+10x50x30+10%x50000 =30000+15000+5000 = 50000
Accounting costs / 60000 = explicit cost
Economic costs / 60000+50000=110000(implicit cost +explicit cost)
The explicit cost includes all the payments that have been really made – for rented equipment, for the worker’s wage and for raw materials and like. These costs will be recognized by the taxation officer and they are accounting costs.
The economic costs will include not only explicit costs but the implicit costs as well – the interest on capital (10% of €50,000), which is lost, Tom’s salary (€ 30,000), which is lost, and Jerry’s time (which is worth € 30 an hour, 10 hours a week, 50 weeks a year), which is lost too.
- Economic profit and accounting profit
If TJVB’s total revenues for the year were €100000, their accounting profit would be TR – accounting costs = €100000 - €60000 = €40000.
However, these €40000 are not enough to compensate Tom andJerry for the money lost in this business. If they had not started this business, they would have had more – interest on capital, Tom’s salary, and Jerry’s leisure time which he could use either to make more money, or to do whatever else he would like.
Economic profit = total revenues – economic costs = €100000 - €110000 = - €10000.
Their economic profit is negative. They have economic loss.
If total revenues were €120000, they would have had €10000 an economic profit.
What if their total revenues just cover the economic costs? If TR = €110000, the accounting profit is €60000, but the economic profit is €0. This means that Tom and Jerry could have made the same money if they would not have started this business. They now make as much as before. Thus, they could have made the same money elsewhere, because it just equals the opportunities lost. Economists say that such a profit is NORMAL PROFIT. It equals the implicit costs.
To Tom and Jerry the business would make sense is they are able to make at least normal profit. In other words, they do not lose anything because they make as much as elsewhere. Their accounting profit equals their implicit costs. Their economic profit is zero. Any accounting profit above €60000 assures a positive economic profit. Any accounting profit below €60000, means that the business is not profitable and they’d better not have started this business.
Let’s conclude. The first question that the firm should raise is whether it makes sense at all to start a business. The positive answer depends on the expected profitability of the business. If we may expect at least a normal profit, then the firm is expected to cover its economic costs and starting business is justified.
- Production function and technological choice
The second problem that the firm has to solve is what technology to use in business. As we know from the very first lecture in economics, technology is a way of putting resources together. It matters for firm’s decisions because profit maximization is a function of output (the more the output, the greater the revenues) and inputs (the cheaper the inputs, the lower the costs).
Therefore the choice of technology depends on the one hand on relationship between the output and inputs and on the other hand on their prices in the market.
Let’s focus on the first factor determining technological choice – the relationship between the output and the inputs. It is presented by the PRODUCTION FUNCTION.
The relationship between the amount of various inputs used in the production process and the level of output is called a production function.
The production function is usuallystated mathematically. Then it isa mathematical representation of the relationship:
Q = f (L,N,K)
Output (Q) is dependent upon the amount of capital (K), Land (N) and Labour (L) used.
The meaning of the production function is to help us to find the maximum output that can be produced with given resources. Therefore, technologists are to find the most effective way of putting resources together in order to have maximum output with minimum inputs.
From this perspective we can distinguish between efficient and inefficient technologies. An efficient technology is the one that minimizes the amount of resources for a given output. Therefore, it is impossible to reduce one of the inputs and not to reduce the amount of output. An inefficient technology is the one that does not minimize the amount of resources for a given output. Therefore, it is possible to reduce one of the inputs and not to reduce the amount of output. For example, if in the post office you fire one of the employees and this does not affect the work of the office, so that they still do the same work, the technology in the post office is not efficient. If however, at Frederick, you cut one of the positions of secretaries, you will find out that the amount of work done by the administration will be reduced and the University will not be able to perform its functions appropriately. This means that it is impossible to reduce one of the inputs and to avoid negative effects on the output. Therefore, the technology at the university is efficient.
Watch out! Technological progress constantly affects the assessment of efficient technology. Technological methods that have been efficient yesterday might be inefficient today. This is why economists and technologists use the production function to improve the organization of production.
Production functions describe only efficient levels of output; that is, the output associated with each combination of inputs is the maximum output possible with that set of inputs, given the existing level of technology. Production functions change as the technology used in the production process changes.
The second factor that affects technological choice are the prices of inputs. A technology with more modern machines and less labor might be more progressive from engineering perspective, but it might be more expensive per unit of output produced. Therefore, firms would prefer a more labor intensive technology that is cheaper per unit of output.
We are familiar with this logic from the theory of consumer choice. In fact, when the firm makes a decision what and how much inputs to buy for the production process, it acts like a regular consumer. Just like Petros makes a choice how many apples and how many books to buy in order to maximize total utility from them in consumption, the firms makes a choice how much labor and how much capital to buy in order to maximize total utility from them in their consumption (the firm consumes labor and capital in production). Therefore, the firm’s technological choice is another version of the consumer choice. We know that the consumer maximized utility from good A and good B if:
MUa/Pa = MUb/Pb
Therefore, the firm will maximize output at minimum cost if it buys labor and capital so that:
MUL/PL = MUK/Pk
What is the marginal utility of labor? It is just the extra utility that firm gets from hiring one more worker. The firm hires one more worker because it expects this worker to contribute to the increase in output. Otherwise it will not waste its money and pay this worker for nothing. Therefore, the utility that the firm gets from the workers is measured by the output. The marginal utility from an extra worker is the increase in output, created because this extra worker is hired.
The increase in output due to the increase in labor by one unit (hiring one more worker) is called MARGINAL PRODUCT OF LABOR (MPL).
The increase in output due to the increase in capital by one unit is called MARGINAL PRODUCT OF CAPITAL (MPK).
Therefore, the firm makes the best technological choice if it finds a technology where:
MPL/PL = MPK/Pk
Such a choice means that the firm can produce maximum output at minimum cost. This is the least cost production decision.
- The Law of Diminishing Marginal Returns
The rule for cost minimization sets a new point of analysis. We shell study the dynamics of marginal productivity. Let’s focus on the marginal product of labor (MPL). As we saw it is the increase in output (increase in the total product of labor – TPL) as a result of hiring one more worker (increase in labor).
MPL = ΔTPL/ΔL
Respectively,
MPK = ΔTPK/ΔK (marginal product of capital is the increase in the total product of capital as a result of the increase in capital by a unit).
a) the short run period
If we want to analyze the dynamics of the marginal product of labor, we should study how it will change with the change in the number of workers in the firm, while all other factors are kept constant. (Otherwise, if the other inputs change too, we cannot know which one contributed more to the change in output). Moreover, this fits the actual situation in the firms. At any given moment, there is at least one factor of production that does not change with the output. For a given period it is fixed and does not depend on output. Such a period in production is called a SHORT RUN period. In the short run there is at least one fixed factor of production. No matter what happens in production, this factor does not change. The firm can increase or reduce production, but this factor will stay fixed. Respectively, the cost of this factor is FIXED COST. A typical example of fixed cost is the rent for a building, office, equipment, etc. The firm signs a contract for renting the building and until this contract expire, it has to be paid, no matter whether the firm produces more, or less, or even zero output. Another example of a fixed cost is the interest paid to the bank on a loan. These fixed costs have to be paid and therefore they set a constraint on firm’s decisions, because they are out of its control. When the contract expire, the short run period is over. Then the firm is free to make any decisions – to renew the contract, to close the business, etc.
We will analyze the dynamics of the marginal product of labor in the short run. The fixed factor is capital. We will change only the number of workers, but everything else will stay fixed. Further, we will assume that all workers are equally good for the job and work equally well. Let’s take an example for better understanding.
Assume that Petros decides to open a bakery in a new neighborhood in Limassol where developers have built a lot of new houses but no shops and bakeries. Petros rents a small place and starts his business with just one worker. The worker produces 15 kilos pitas a day. People in the neighborhood like very much pitas and are ready to buy more. Petros hires a second worker. Workers start specializing in different operations and as a result the bakery produces 32 kilos pitas a day. Output increase by 17 kilos. The marginal product of labor MPL = 17. The demand for pitas is still higher and Petros hires a third worker. Now they produce 57 kilos pitas a day. The MPL = 25. The business is so successful that Petros hires a fourth worker. The output now is 80 kilos. The MPL = 80 – 57 = 23 kilos. The increase in output however is smaller than before. 23<25. Since the demand rises and even people from other parts of Limassol come to buy Petros pitas, he hires a fifth worker. Now he produces 95 kilos pitas. The total product of labor increases, but the marginal product falls further. It is now just 15 kilos.