Microeconomics Third Edition

Chapter 11 Behind the Supply Curve: Inputs and Costs

Copyright © 2013 by Worth Publishers

Paul Krugman and Robin Wells

1. Economics of the firm: An overview

A. Profit = Revenue – Costs We assume that the firm wants to maximize profit; to describe profit maximization, we must consider both revenue and costs B. Discussing revenue can be complicated, because behavior of revenue depends on market structure: is the market… perfectly competitive? (many firms)? see Chapter 12 dominated by a single firm (monopoly)? see Chapter 13 dominated by a few firms (oligopoly)? see Chapter 14 one with many firms producing slightly different (“differentiated”) products? see Chapter 15 C. Discussing costs is a bit simpler (mainly because we assume that markets for inputs – labor, machines, etc. – are competitive). This is the subject of Chapter 11.

2. Marginalism and profit maximization Regardless of market structure, some simple “marginal” rules will always result in higher profits:

• If an action raises revenue by more than it raises costs, do it! • If an action reduces costs more than it reduces revenue, do it!

or, in symbols: If MR > MC > 0, do it! if MC < MR < 0, do it! An example: should Continental Airlines run this Denver-LA flight? revenue (ticket sales, freight fees, etc.) $25k costs * direct costs of flight (fuel, ground crew, landing fees, etc.) $20k * overhead allocated to flight $10k (total spent on executives’ salaries, lease on HQ building, long-term contracts, etc., divided by total number of flights)

Yes! Put on the flight!

Overheads are “sunk costs.” We have to pay them whether or not we put on the flight, so they shouldn’t figure in our calculations.

We only need to ask: how much will the flight add to revenue,

and how much will it add to costs? amount if we… don’t fly do fly 1. revenue (ticket sales, freight, etc.) $0 $25 2. costs * direct costs (fuel, etc.) $0 $20 * overheads allocated to flight $10 $10 PROFIT (= revenue – costs) -$10 -$5 We lose less (improve profits) if we put on the flight. The flight adds $25 to revenues, but adds only $20 to costs. (Remember that we pay the overheads no matter what.)

3. Some preliminaries: MARGINAL

marginal = extra, additional, added (e.g., marginal cost, marginal revenue: “do it so long as marginal revenue is greater than marginal cost”) note that “marginal” is forward-looking

When Y depends on X, then… * “marginal (extra) Y per unit of marginal (extra) X” is simply ΔY/ΔX * if we graph Y and X, then marginal Y per unit of marginal X at a given value of X is equal to the gradient of the graph of Y vs. X at that value of X

Economists usually measure marginal Y per unit of marginal X “in the limit,” as the change in X (= ΔX) gets very small. This is the slope of the line tangent to the graph of Y vs. X. It’s usually called the “slope of the tangent line.”

So “marginal Y per unit of marginal X” (or “marginal Y,” for short) at any given level of X would be measured as the slope of the line tangent to the curve at that value of X, or, for short, “the slope of the tangent line.”

4. Some preliminaries: AVERAGE

average = amount per unit if Y depends on X, then… “average Y per unit of X” is equal to the value of Y divided by the value of X, = Y/X “average Y per unit of X” at any given value of X is equal to the slope of the line from the origin (sometimes called the “slope of the origin line,” for short) to the value of Y corresponding to that value of X Note that “average” is “backward-looking,” i.e., “average” considers where X and Y have been, but does NOT consider where they’re going (Compare with “marginal”!)

5. Some preliminaries: inputs, outputs, costs, and profits

A. Implicit vs. explicit costs; opportunity costs

explicit costs involve actual outlay of $ (e.g., wages paid to workers)

implicit costs do not involve actual outlay of $, but do involve foregone opportunity (e.g., you own a building and use it in your business instead of renting it to someone else – if you could have rented it to someone else for $500, then that is the opportunity cost of using it for your own business; this is an implicit cost, because you don’t pay anyone to use it)

opportunity costs consist of the total of explicit and implicit costs B. accounting vs. economic profits

accounting profits measure only revenues minus explicit costs (do not include implicit costs) economic profits measure revenues minus all opportunity costs (including implicit as well as explicit costs)

Example of accounting profit vs. economic profit:

• You operate a business. Your revenues are $500/month. • Your explicit costs are $100/month for labor. • Your business also uses a building which you own, and which you could have rented to someone else for $500/month).

So your profits under the two methods would be calculated as follows: category economic profit accounting profit Revenue 500 500 Costs Explicit costs 100 100 Implicit costs 500 <none> Profit (revenue – costs) -100 400 So an accountant would report a profit of $400, But an economist would report a loss of $100! Who’s right? Actually, there’s no real difference. A smart accountant would say, “You made an accounting profit of $400, but if you had rented out your building, you could have made $500. You’re losing $100!”

C. Inputs, costs, and output; short run vs. long run “costs” = ALL costs (implicit as well as explicit) of producing output Production uses inputs (labor, machines, etc.), so the cost of production is the cost of getting the inputs to produce the output. In the long run, all inputs can be varied. (e.g., rental housing) In the short run, some inputs (machinery, buildings, “capital”) can’t be changed – they’re fixed in the short run. So, in the short run, the costs of fixed inputs are “fixed costs” (FC). Other inputs (e.g., labor) can be changed in the short run. They’re variable. So the costs of these variable inputs are “variable costs” (VC). So in the short run, total costs = fixed costs + variable costs i.e., TC = FC + VC

Table 11.3 Concepts and Measures of Cost Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers