Lecture 6 Production Decisions. Goals and economic benefits from production What are the goals of production? –Some productive activities may be motivated

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

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Quantity of Hair Dryers

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Total RevenueCurve

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Slope = 20


0 1 8632 75 94

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Total Revenue Curve

Total Cost Curve

Profit

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101

Line demonstratingthat the two curveshave the sameslope at this point

1 8632 75 94


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Total Revenue Curve

Total Cost Curve

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MarginalCost Curve

Price =Marginal


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


… when the price of output changes

Main assumption for marginal thinking: Convexity

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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

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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

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Qu

an

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of

Exc

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utp

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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


MC

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Total Revenue

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Economic Profit

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Documents

Lecture 6 Production Decisions. Goals and economic benefits from production What are the goals of production? –Some productive activities may be motivated