Session 4
The Theory of Production [I]. The firm's costs and
revenues. Price and output determination in conditions of
perfect competition. Allocation of capital and labour.
The perfect competition model of price and output
determination. How real?
CONCEPTS FOR REVIEW:
Fixed costs, variable costs. Total, average and
marginal costs. Total, average and marginal
revenues. Profit maximization ( normal and
abnormal profits ) in the long and short run.
The behaviour of firms will depend on main features of
the market place as related to number of firms, type of product,
relative control over price, conditions of entry in the business, and
relative level of non-price competition (advertising, etc).
By and large, two types of markets are considered in the study of
economics:
a) markets which allow perfect competition
b) markets which work in conditions of
imperfect competition.
Perfect markets as defined in a) are a theoretical concept to explain
and justify the capitalist system as a type of organisation of
production which is efficient, fair and dynamic. Perfect markets DO NOT
EXIST.
The following are the hypothetical features of a market with
perfect competition:
number of firms : a very large number
type of product : standardized
control over price: none
conditions of entry: very easy, no obstacles
nonprice competition: none
examples: none
There are three types of imperfect markets, where competition is
unfair (imperfect competition). The three types from the supply side
are monopolistic, oligopolic and pure monopoly. The three types from
the demand side are monopsonistic, oligopsony and pure monopsony.
IMPERFECT MARKETS (supply side)
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Monopolistic Oligopolic Pure Monopoly
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number of firms: Many Few One
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type of product: Differentiated Standardized or Unique: no
differentiated close
substitutes
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control over price: Some, but Circumscribed Considerable
within narrow by mutual
limits interdependence,
and considerable
collusion
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conditions of entry: Relatively Significant Blocked
easy obstacles
present
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nonprice competition: considerable Typically a Mostly
emphasis on great deal, public relations
advertising, particularly advertising
brand names, with product
trade mark, etc. differentiation
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examples: Retail trade, Cars, steel Some oil
dresses, farm companies,
shoes, etc implements, local
households utilities
appliances
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IMPERFECT MARKETS (demand side)
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Monopsonistic Oligopsony Pure monopsony
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number of firms: Many Few One
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control over price: As above As above As above
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In the real economy there exist a very large number of selling-buying
(supply-demand) relationships combining monopolistic competition,
oligopoly and pure monopoly with monopsonistic competition, oligopsony
and pure monopsony.
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SHARE OF THE LARGEST 40 FIRMS IN THE OUTPUT OF MANUFACTURING INDUSTRY
IN 1986
European Community 23%
United States 35%
Japan 24%
Source: OECD
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SHARE OF TOTAL SALES OF THE FIVE LARGEST ENTERPRISES IN THE UK, 1990
Tobacco industry 99.1%
Iron and steel 94.8%
Asbestos goods 87.4%
Motor vehicles and engineering 87.3%
Aerospace equipment 77.1%
Ordnance, small arms and ammunition 75.8%
Agricultural machinery and tractors 75.1%
Soap and toilet preparations 56.3%
Brewing and malting 45.1%
Telecommunications equipment 33.1%
Building products 31.0%
Woollen and worsted industry 27.7%
Specialized chemicals 27.6%
Source: Central Statistical Office (1992)
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UNITED KINGDOM, MANUFACTURING SECTOR, 1990
Size by total Percentage Employment Percentage of Percentage of
employment of firms (thousands) employment net output
1-99 96.28 1,203.7 25.0 19.2
100-999 3.28 1,156,6 24.0 22.0
1000-50000+ 0.44 2,448.4 51.0 58.8
source: Central Statistical Office (1992)
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The classical example of a firm doing business in a perfect competitive
market, is as follows:
SHORT-RUN PROFIT MAXIMIZATION SCHEDULE FOR FIRM 'A' AS A PERFECTLY
COMPETITIVE FIRM (A classical example of "price taker" firm)
(1) (2) (3) (4) (5) (6)
Output Total Total Profit Marginal Marginal
(Units Revenue Cost (2)-(3) Cost Revenue
------------------------------------------------------------
0 0 100 -100
1 70 150 - 80 50 70
2 140 184 - 44 34 70
3 210 208 2 24 70
4 280 227 53 19 70
5 350 250 100 23 70
6 420 280 140 30 70
7 490 318 172 38 70
8 560 366 194 48 70
9 630 425 205 59 70
10 700 500 200 75 70
11 770 595 175 95 70
12 840 712 128 117 70
13 910 852 58 140 70
14 980 1016 - 36 164 70
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Even when this firm cannot dominate the market and fiddle with the
price of its output (70 sterling pounds), it will maximize
profits producing 9 units instead of 13 units.
If the firm's output was 13-14 units, it will make NORMAL PROFITS,
but producing only 9 units, the owners of the firm will pocket
NORMAL PROFITS PLUS ABNORMAL PROFITS, maximizing profits.
This action meeting the needs of the capitalist class, will not
meet the needs of the rest of society, because supply will not
be maximum, and employment will be lower than full employment.
The firm, in this so-called perfect competition environment,
will be wasting resources -capital and labour- and will have
an anti-social behaviour producing less than full capacity.
MEMORANDUM: in the region 9-10 units marginal cost is going to
be 70, equals marginal revenue that is.
The above is the golden rule of a maximizing profits
capitalist economy:
firms will produce until
MARGINAL REVENUE EQUALS MARGINAL COST
Logic structure of the above notion:
if marginal revenue is larger than marginal cost, the firm
will produce an extra unit to pocket yet another portion
of abnormal profits;
because marginal costs start increasing after reaching
the lowest point, there will occur a sequence in which
marginal cost will closing the gap with marginal revenue,
until both are going to have the same value;
the next unit of output will have a marginal cost larger
than marginal revenue, therefore the business person will
not produce that extra unit of output...IT DOES MAKE CAPITALIST
SENSE (which is maximising profits)
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TOTAL COSTS WERE DERIVED FROM THE FOLLOWING:
Output Fixed Variable Total Average
(units) Costs Costs Costs Costs
0 100 0 100 100
1 100 50 150 150
2 100 84 184 92
3 100 108 208 69
4 100 127 227 57
5 100 150 250 50
6 100 180 280 47
7 100 218 318 45
8 100 266 366 46
9 100 325 425 47
10 100 400 500 50
11 100 495 595 54
12 100 612 712 59
13 100 752 852 66
14 100 916 1016 73
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Fixed costs and variable costs:
Total, average and marginal costs are often divided into
two components: fixed costs and variable costs.
A fixed cost is the cost of the inputs which
the firm needs to produce any output at all.
The total cost of such inputs does not change
when the firm changes its outputs by an amount
that does not exceed the inputs' production
capacity.
Any other cost of the firm's operation is called
'variable' because the total amount of that cost
will increase when the firm's output rises.
FIXED COSTS are associated with the very existence
of a firm's plant and therefore must be paid even
if the firms's output is zero:
Interest on a firm's indebtedness,
Rental payments,
Depreciation on equipment and buildings,
Insurance premiums,
The salaries of top management and
key personnel,etc.
VARIABLE COSTS (those costs which increase with the level
of output). They include payments for materials, fuel,
power, transportation, services, most labour, etc.
As production begins, variable costs will for a time
increase by decreasing amounts, and then rise by
increasing amounts for each successive unit of output.
The explanation of this behaviour lies in the law of
diminishing marginal returns (see below)
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Total, average and marginal costs:
Total costs show for each possible quantity of output,
the total amount which the firm must spend for its
inputs to produce that amount of output plus any
opportunity cost incurred in the process;
Average costs show for each output the cost per unit,
that is, total cost divided by output;
Marginal cost shows, for each output, the increase in
the firms' total costs required if it increases its
output by an additional unit.
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Total, average and marginal revenues:
Total revenue show for every possible quantity of output,
the total amount of money the firm will accrue. Price
per unit times quantity equals total revenue.
Average revenue is the total revenue divided by the
total output, which will give the revenue per unit of
output.
Marginal revenue is the change in total revenue from the
sale of one additional unit of output.
Example 1:
Output Price Total Marginal
(units) per Revenue Revenue
Unit
1 70 70 --
2 70 140 70
Example 2:
1 70 70 --
2 60 120 50
Example 3:
1 70 70 --
4 70 280 70 (210/3)
Example 4:
1 70 70 --
4 60 240 50.6 (170/3)
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Profit maximization: ( normal and abnormal profits )
Costs in capitalist economics have to do with missed opportunities
or forgone alternatives (i.e., by using a building as a workshop,
the owner sacrifices the monthly rental income which he could
otherwise have earned by renting it to someone else. Similarly,
by using his money capital and labour in his own enterprise, the
owner sacrifices the 'interest' and 'wage' incomes which he
otherwise could have earned by supplying these resources in their
best alternative employments).
This notion of cost is called the 'opportunity cost' doctrine.
Therefore, for an individual firm 'economic costs' are those
payments a firm must make, or incomes it must provide, to
resource suppliers in order to attract these resources away from
alternative lines of production.
These payments or incomes may be either 'explicit' or 'implicit'.
EXPLICIT COSTS: are cash outlays which a firm makes to those
"outsiders" who supply LABOUR services, MATERIALS,
fuels, transportation services, power, etc.
IMPLICIT COSTS: are the opportunity costs of certain resources
which the firm itself owns, such as buildings,
machinery, money capital and own labour. An
important part of implicit costs is NORMAL PROFITS.
Thus, implicit costs will include:
rent on own buildings,
depreciation on machinery,
interest on own capital,
payment for services by owner of capital,
and
normal profits.
NORMAL PROFITS: The minimum payment required to keep the owner's
entrepreneurial skills engaged in the firm is
called a NORMAL PROFITS. This amount, of course,
is included in COSTS.
Therefore, when a capitalist (business person) says that a firm is
JUST COVERING ITS COSTS, s/he means that all explicit and implicit
costs are being met and that the business person is therefore receiving
a RETURN large enough to retain her/his interest in her/his present
line of production.
ABNORMAL PROFITS: If a firm's total revenue exceeds all its economic
costs, any residual will belong to the owner of the capital (firm).
This residual receives different names in accordance with the level of
accuracy of the definition:
ABNORMAL PROFITS,
SUPER PROFITS,
ECONOMIC PROFITS,
PURE PROFITS.
It is not a cost, because by definition it is a return in excess of the
normal profit required to retain the business person in this particular
line of production.
Capitalist economic theory associates abnormal profits with monopoly
power, but abnormal profits can be made in any type of capitalist
market (see table above)
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SHORT RUN and LONG RUN (in economics):
The quantities employed of many resources (labour, raw materials, fuel,
power, etc.) can be varied relatively quick and easy. But other
resources demand more time for adjustment. For example, the capacity
of a manufacturing plant, that is, the size of the factory building and
the amount of machinery and equipment therein, can only be varied over
a considerable period of time.
Therefore:
The SHORT RUN refers to a period of time too brief to permit an
enterprise to alter its plant capacity, yet long enough to permit
a change in the level at which the fixed plant is utilized. The
firm's plant capacity is 'fixed' in the short run, but output can
be varied by applying larger or smaller amounts of manpower,
materials, etc. Existing plant capacity can be used more or less
intensively in the short run.
The LONG RUN refers to a period of time enough to allow the firms
to change the quantities of all resources employed, including plant
capacity. Also encompasses enough time for existing firms to
dissolve and leave the industry and for new firms to be created
and to enter the industry. The long run is a 'variable-plant'
period.
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Marginal physical product:
the marginal physical product of an input is the increase in
total output that results from a one-unit increase in the
input, holding the amounts of all other inputs constant.
Numerical Example:
Number of Total Physical Marginal Physical
Workers Product (pins) Product (pins)
1 1000 ---
2 1250 250
3 1550 300
4 1900 350
5 2200 300
6 2450 250
7 2600 150
8 2650 50
9 2650 0
10 2600 -50
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The "law" of Diminishing Marginal Returns:
This "law", which has played a key role in economics for more than
two centuries **, asserts that when we increase the amount of any
one input, holding the amounts of all others constant, the marginal
returns to the expanding input ultimately begin to diminish. The
so-called law is no more than an empirical regularity based on some
observation of the facts; it is not a theorem deduced analytically.
The reason why returns to a single input are usually
diminishing is straightforward. As we increase the quantity of
one input while holding all others constant, the input whose
quantity we are increasing gradually becomes more and more
abundant compared with the others.
A classical example: as the farmer uses more and more
fertilizer with his fixed plot of land, the soil gradually
becomes so well fertilized that adding yet more fertilizer
does little good. Eventually the plants are absorbing so
much fertilizer that any further increase in fertilizer will
actually harm them. At this point the marginal physical
product of fertilizer becomes negative.
** The "law" is generally credited to Anne Robert Jacques Turgot
(1727-1781), one of the most famous Comptrollers-General of France
before the revolution, whose liberal policies, it is said,
represented the old regime's last chance to save itself. But, with
characteristic foresight, the king fired him.
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