ECON130 Week 4: Producer Theory

Hi everyone.

My apologies that we can’t meet in person anymore – as the university is now running classes online due to the COVID-19 quarantine. You will have seen that the lectures are already online – feel free to watch them when you can. Lecture 7 slides are here and Lecture 8 slides are here.

This week we are switching from thinking about consumers to thinking about producers. Instead of asking why someone may purchase a product, or select a set of products from an available set, we are asking about the incentive to sell those products.

As is the case with consumer theory we leave prices fixed for now so we can focus on where the scarcity is and what incentives the producer has.

This week we focused solely on costs – lets talk a bit more about those. Specifically I want to summarise some of the ideas we covered in a different way (starting at the end of the 8th lecture rather than the start of the 7th) to hopefully help tie everything together.

Production and costs

Over the two lectures we noted that a firm produces output using inputs.

Given this we know there is some cost associated with buying input. Given this cost, we can think the choice to purchase inputs. Take a fixed quantity of output – the two inputs will act as substitutes for each other. As a result, we will pick a bundle of inputs that is the lowest cost for producing our output.

But things are a bit more complex that that.

Although we called those inputs “labour” and “capital”, by the end it is clear we meant “variable” and “fixed” factor of production – as a result, employment contracts can make our labour input act more like capital, while capital goods like computers may function more like labour than the capital we discussed in class.

So in the short-run we only think about changing these variable inputs. And the cost associated with varying production in the short term only depends on those.

This implies that we can think about our short-run cost curves in terms of charging variable costs and some underling fixed cost associated with the fixed factors of production.

Choices

Then we can come back to choice. What does it cost us if we decide to make “one more unit” – just like with consumer theory we will again think in this, marginalist, way.

The cost here is the cost of purchasing enough of the variable input to make that one unit – which is the amount of the input we have to purchase times the price of that input. The amount of the input depends inversely on the marginal product of that unit (how much output we make if we use one more of the input), and since we have assumed that the marginal product of our input declines as we use more – given all other inputs are fixed – the marginal cost (given an assumption of fixed prices) rises.

As discussed in class, we will assume that these firms are profit maximising – even though this assumption is unrealistic in a number of ways, as firms are made up of a series of individuals with there own interests, it provides us an interesting starting point for thinking about how firms are designed. It will also mirror the utility maximising choice in a situation where we have a sole trading firm – which is often the type of firm we think about in competitive models.

Profit maximisation involves two steps:

• Thinking about the cheapest way to make output, at each output level (this is our cost curve)
• Considering what output level would provide the greatest output – given how changing output changes total costs (marginal costs) and total revenue.

Next week we are going to start thinking about revenue, and we are going to learn how to build this profit maximising model of firm choice.

Practice questions

• If the price of capital equipment falls (something that has happened over time) does this mean that firms will hire fewer workers over time?
• What is an example of a situation where diminishing marginal product of labour does not hold? Can you point out some of the reasons why each additional worker would lead to a larger increase in output in the situation you are thinking about?
• Can you think of a situation where increasing the number of inputs would reduce output? Why would a firm not ever select such a point if it was a profit maximising firm?
• Can we have economies of scale even if there is diminishing marginal product in every input the firm has? Why?