From the Lectern: Weeks 7 and 8

This post is a bit overdue, and that's not even counting the fact that I didn't post last week's lecture. I think it's OK, partly because I doubt anyone reads these (their mostly for storing lecture notes) and partly because last week's lectures make very little sense without this week's lectures. So I'll try to keep it as brief as I can, and get to the key ideas of the last two weeks.

Now that we understand consumer behavior pretty well, we need to try understanding firm behavior. This is a bit more difficult, because very few of us have ever had to think like a producer. The key to understanding the choices and behavior of firms is to keep in mind the goal of any firm: maximizing economic profit. This is not the goal that will be discussed in most business meetings. MBA will gather around a table and start talking about increasing their revenue, or increasing their market share. But let's be clear: the easiest way to get more market share is to drop your prices to essentially zero; the easiest way to increase revenue is to sell bigger, fancier, and more complicated stuff. But firms don't all do these because their are costs involved, and what firms really care about is total revenues minus total costs. They care about profit.

Another thing we need to be clear on is that profit does not mean profit on the accounting ledger. This is due to the fact that economic costs are not the same thing as accounting expenses. Economic costs have to take into account the total opportunity cost of every input used to produce the goods. Even if you own your own building, by using it yourself you are giving up the chance to rent it out and bring in money that way. This doesn't show up on your accounts, but it does affect your decision. Similarly, your entrepreneur has to expect a certain return on his risk in order to be willing to take a risk on it (rather than something else). That's a cost that affects firm decisions, but it definitely doesn't show up in accounting. So when we talk about costs, we always mean opportunity costs; when we talk about profit, we're always going to be talking about profit above and beyond the opportunity cost of the entrepreneur, or economic profit.

So to figure out profit, we need to figure out costs. And to figure out costs, we first need to figure out how we can go about making stuff in the first place. Now, I could go into a long, detailed account of why production in the short run (that is, so short that you can't change every input; you've signed some contracts that are currently binding) looks the way it does. But I won't. There are really two key ideas that determine what production looks like, and therefore what costs look like.

First of all, as we go from hiring 2 workers to hiring 3, or 4, or 5, etc, the first thing that happens is adding more workers makes each of the previous workers more productive. This is because as we hire more workers, we can rearrange the way we do things, giving each worker a specific job that, when combined with the work of everyone else, takes advantage of what we call specialization of labor. The workers can do as a group more than they could if they each tried to work through the entire production process individually. This just means that (because the whole is greater or more productive than the sum of its parts) we get increasing returns to hiring workers initially.

Eventually, though, we'll run out of new ways to specialize, and our workers will be faced with the fact that we only have so much of other inputs. Whether there's only so much space, or there's only so many machines, we eventually crowd our fixed inputs and face diminishing returns. Hiring more workers still increases output, but not as much as the last worker. At some point things could get so crowded that adding workers actually decreases output, because the new worker can't do anything and just gets in the way of everyone else trying to work.

These two assumptions mean that the extra cost for producing one more unit of output (if we're talking processed corn, one more ton/bushel/grain of corn) will be falling for the first few units; our workers are getting more and more productive, but we are probably paying the same for each additional worker. At some point, though, marginal cost has to start rising again as each worker provides less and less extra output (but we pay the same for the work). I could go on about how this connects to other measures of cost, or costs in the long run, but if you're interested you should really read the Krugman and Wells textbook.

The trick here, though, is that this doesn't quite tell us what decisions a firm is going to make. To do that, we need to see what the market they are in looks like, so Wednesday we started looking at a model of perfectly competitive markets.

Several conditions need to be met in order for the market to be well described by perfect competition. First of all, there need to be many firms, so many that no one firm has any influence on the market price, regardless of what they do. This means firms will be price takers, or they'll just take the market price as given. Competitive firms also need to produce a standardized product; they might differ in some sense, but the key is that buyers see the goods as perfect substitutes. No buyer cares whether he gets Farmer Norm's processed corn or Farmer Maynard's processed corn. Corn is corn. This says that the demand curve for any particular firm's product will be equal to the market price for any possible level of output. These two assumptions together imply that the extra revenue for each additional unit of output is always the same as the market price, or P=MR.

This is important, because if the goal of the firm is to maximize profit, the firm has to produce every unit where the additional revenue is greater than the extra costs of production (and produce no units that cost more than the revenue they bring in). The firm will decide to produce its output where MR=MC, which we refer to as the profit maximizing condition. If the firm is perfectly competitive, this condition says that firms keep increasing output until their marginal costs (which remember are rising because of diminishing returns) reach the market price, P=MC.

We also assume that all firms have the same access to resources, information, etc, so that their costs will all look about the same, and that if firms want to enter or exit the market, they are free to do so (at least in the long run). These conditions will be important to see later on.

More perfect competition in two weeks. Have a great spring break!