Producer decision Making

City University

2007

Producer Decision MakingTC

05

10

152025303540

45

1 2 3 4 5

TR

The firmprofit

0

1400

1 2 3 4 5 6

Production FunctionQ = F(L,K, N)

Economic and Accounting Costs Costs vs. expenditures Opportunity cost Explicit and implicit cost Accounting cost vs. economic cost Sunk cost Depreciation Accounting profit =

TR – accounting cost Economic profit =

TR – economic cost

Analysis of the Production Function in the Short Run technological choice

Technology – a way of putting resources together

Efficient technology

Technological choice and consumer choice

Consumer choice

MUa/Pa = MUb/Pb

The firm as a consumer:

MUL/PL = MUK/Pk

Technological choice

MPL/PL = MPK/Pk

Analysis of the production functionshort run

short run There is at least one fixed factor Firm’s decisions are constrained by

the fixed factor Is the demand changes, the firm

can respond only by changing the quantity of output, not the scale of production

short run The Law of Diminishing Returnstotal, average and marginal product

L TPL0 01 152 323 574 805 956 1087 1198 128

short run The Law of Diminishing Returns

total, average and marginal product

L TPL MPL APL0 01 15 15 152 32 17 163 57 25 194 80 23 205 95 15 196 108 13 187 119 11 17

Analysis of the Production Functionlong run

Long run All factors are variable The firm can change its production

capacity – the scale of production

Short-Run vs.Long-Run Costs

Short run – Diminishing marginal returns results from adding successive quantities of variable factors to a fixed factor

Long run – Increases in capacity can lead to increasing, decreasing or constant returns to scale

Returns to Scale

Rs = % change in the output : % change in production factors

Economies of Scale Rs > 1 Constant Returns to Scale Rs = 1 Diseconomies of Scale Rs < 1

Short-Run CostsShort-Run Costs

Q FC VC TC = FC+ VC0 10 0 101 10 6 162 10 11 213 10 14 244 10 16 265 10 21 316 10 27 377 10 35 458 10 46 56

Short run – there is at least one fixed factor

Fixed cost – does not vary with the output

Variable cost – directly related to variations in output

The Law of diminishing marginal returns

Short-Run Costs Total Cost - the sum of all costs incurred

in production TC = FC + VC

Average Cost – the cost per unit of output

AC = TC/Output Marginal Cost – the cost of one more or

one fewer units of production MC = TCn – TCn-1 units

Short Run CostsMarginal Costs

Q FC VC TC = FC+ VC MC = ΔTC/Δ Q0 10 0 101 10 6 16 62 10 11 21 53 10 14 24 34 10 16 26 25 10 21 31 56 10 27 37 67 10 35 45 88 10 46 56 11

Marginal costs

МС –Extra cost involved in the

production of an extra unit of

output

Short-Run Costs

Q FC VC TC = FC+ VC AFC = FC/Q AVC= VC/Q AC = TC/Q0 10 0 101 10 6 16 10 6 162 10 11 21 5 5,5 10,53 10 14 24 3,3 4,7 84 10 16 26 2,5 4 6,55 10 21 31 2 4,2 6,26 10 27 37 1,7 4,5 6,127 10 35 45 1,4 5 6,48 10 46 56 1,25 5,75 7

Q FC VC TC = FC+ VC AFC = FC/Q AVC= VC/Q AC = TC/Q MC = TC/ΔQ0 10 0 101 10 6 16 10 6 16 62 10 11 21 5 5,5 10,5 53 10 14 24 3,3 4,7 8 34 10 16 26 2,5 4 6,5 25 10 21 31 2 4,2 6,2 56 10 27 37 1,7 4,5 6,12 67 10 35 45 1,4 5 6,4 88 10 46 56 1,25 5,75 7 11

Short-Run Costs

The Revenues of the Firm

Total Revenue TR = P x Q

Average RevenueAR = P

Marginal RevenueMR = Δ TR/Δ Q

The Profit of the Firm

Short RunMaximum Profit

MC = MR P > ACMinimum Loss

MC = MR P > AVC

Long RunMaximum Profit

MC = MR P > AC

The Theory of the Firm

City University

2007

Theories of the Firm

Neoclassical theory – profit maximization

Assumptions: Single-minded purpose Rationality Operational rules: MC = MR

Transaction Costs

Transaction costs – “the costs of providing for some good or service through the market rather than having it provided from within the firm” – Ronald Coase

Search and information costs Bargaining and decision costs Policing and enforcement costs

Transaction costs

Three dimensions along which transactions may vary:

asset specificity uncertainty frequency

The three main characteristics of the firm

Collectivity of people in an organization

Action by superior-subordinate direction

Continuity over time

Firms vs. Markets

The firm’s benefits

specialization in teams

transaction-cost savings

corporate capital formation

morale

The firm’s costs

shirking

agent misdirection

rent seeking

The Problem of X-inefficiency

X-inefficiency - the difference between efficient behaviour of firms assumed or implied by economic theory and their observed behaviour in practice.

- the cost that is higher than it needs to be because the firm is operating inefficiently

Factors causing X-inefficiency

Internal Factors Poor contracts

between principals and agents

Large firms may be difficult to control

External Factors Diffuse share

ownership Limited threat of

takeover Degree of

competition Barriers to entry

The Principal – Agent Problem the principal-agent problem - the difficulties

that arise under conditions of incomplete and asymmetric information when a principal hires an agent

the agent’s actions affect the principal's payoff, but they are not directly observable by the principal, or they are not verifiable to outsiders.

The central dilemma - how to get the employee or contractor (agent) to act in the best interests of the principal (the employer) when the employee or contractor has an informational advantage over the principal and has different interests from the principal.

Theories of the Firm

Theory of Managerial Utility – Oliver Williamson

Sales Revenue Maximization Model – William Baumol

Maximizing Present Value of the Firm’s Future Stream of Sales Revenues – William Baumol

Theories of the Firm

Maximizing Growth – Robin Marris - the managerial utility depends on

the firm’s rate of growth Supply led growth vs. Demand led

growth, or profitability vs. diversification The principal-agent problem

The Theory of the Firm

The Integrative Model – Oliver Williamson

Integrates the growth maximization model and the profit/sales maximization models and the maximization of the present value of future sales

Max growth = max sales

Theories of the Firm

Behavioral theories - Herbert Simon, Richard Cyert and James March

Firms – multi-goal, multi-decision, organizational coalitions

Imperfect knowledge and bounded rationality

Managers cannot meet the aspiration levels of all stakeholders

Managers cannot maximize, instead they have to satisfice

Stakeholders in the Firm Owners/investors Employees Customers Suppliers Distributors Creditors/banks The government Public at large