Chapter 1
Introduction to Managerial Economics
CHAPTER SUMMARY
Managerial economics is the science of directing scarce resources to manage cost effectively. It consists of three branches: competitive markets, market power, and imperfect markets. A market consists of buyers and sellers that communicate with each other for voluntary exchange. Whether a market is local or global, the same managerial economics apply.
A seller with market power will have freedom to choose suppliers, set prices, and use advertising to influence demand. A market is imperfect when one party directly conveys a benefit or cost to others, or when one party has better information than others.
An organization must decide its vertical and horizontal boundaries. For effective management, it is important to distinguish marginal from average values and stocks from flows. Managerial economics applies models that are necessarily less than completely realistic. Typically, a model focuses on one issue, holding other things equal.
KEY CONCEPTS
managerial economics average value horizontal boundaries
microeconomics stock market
macroeconomics flow industry
economic model other things equal market power
marginal value vertical boundaries imperfect market
GENERAL CHAPTER OBJECTIVES
1. Define managerial economics and introduce students to the typical issues encountered in the field.
2. Discuss the scope and methodology of managerial economics.
3. Distinguish a marginal concept from its average and a stock concept from a flow. Chapter 1: Introduction to Managerial Economics 2
4. Describe the importance of the "other things equal" assumption in managerial economic analysis.
5. Describe what constitutes a market, distinguish competitive from non-competitive markets, and discuss imperfect markets.
6. Emphasize the globalization of markets.
NOTES
1. Definition. Managerial economics is the science of directing scarce resources to manage cost effectively.
2. Application. Managerial economics applies to:
(a) Businesses (such as decisions in relation to customers including pricing and advertising; suppliers; competitors or the internal workings of the organization), nonprofit organizations, and households.
(b) The “old economy” and “new economy” in essentially the same way except for two distinctive aspects of the “new economy”: the importance of network effects and scale and scope economies.
i. network effects in demand – the benefit provided by a service depends on the total number of other users, e.g., when only one person had email, she had no one to communicate with, but with 100 mm users on line, the demand for Internet services mushroomed.
ii. scale and scope economies – scaleability is the degree to which scale and scope of a business can be increased without a corresponding increase in costs, e.g., the information in Yahoo is eminently scaleable (the same information can serve 100 as well as 100 mm users) and to serve a larger number of users, Yahoo needs only increase the capacity of its computers and links.
iii. Note: the term open technology (of the Internet) refers to the relatively free admission of developers of content and applications.
(c) Both global and local markets.
3. Scope.
(a) Microeconomics – the study of individual economic behavior where resources are costly, e.g., how consumers respond to changes in prices and income, how businesses decide on employment and sales, voters’ behavior and setting of tax policy.
(b) Managerial economies – the application of microeconomics to managerial issues (a scope more limited than microeconomics).
(c) Macroeconomics – the study of aggregate economic variables directly (as opposed to the aggregation of individual consumers and businesses), e.g., issues relating to interest and exchange rates, inflation, unemployment, import and export policies.
Chapter 1: Introduction to Managerial Economics 3
4. Methodology.
(a) Fundamental premise - economic behavior is systematic and therefore can be studied. Systematic economic behavior means individuals share common motivations and behave systematically in making economic choices, i.e, a person who faces the same choices at two different times will behave in the same way both times.
(b) Economic model – a concise description of behavior and outcomes:
i. focuses on particular issues and key variables (e.g., price, salary), omits considerable information, hence unrealistic at times;
ii. constructed by inductive reasoning;
iii. to be tested with empirical data and revised as appropriate.
5. Basic concepts.
(a) Margin vis a vis average variables in managerial economics analyses.
i. marginal value of a variable – the change in the variable associated with a unit increase in a driver, e.g., amount earned by working one more hour;
ii. average value of a variable – the total value of the variable divided by the total quantity of a driver, e.g., total pay divided by total no. of hours worked;
iii. driver – the independent variable, e.g., no. of hours worked;
iv. the marginal value of a variable may be less that, equal to, or greater than the average value, depending on whether the marginal value is decreasing, constant or increasing with respect to the driver;
v. if the marginal value of a variable is greater than its average value, the average value increases, and vice versa.
(b) Stocks and flows.
i. stock – the quantity at a specific point in time, measured in units of the item, e.g., items on a balance sheet (assets and liabilities), the world’s oil reserves in the beginning of a year;
ii. Flow – the change in stock over some period of time, measured in units per time period e.g., items on an income statement (receipts and expenses), the world’s current production of oil per day.
(c) Holding other things equal – the assumption that all other relevant factors do not change, and is made so that changes due to the factor being studied may be examined independently of those other factors. Having analysed the effects of each factor, they can be put together for the complete picture.
6. Organizational boundaries.
(a) Organizations include businesses, non-profits and households.
(b) Vertical boundaries – delineate activities closer to or further from the end user.
(c) Horizontal boundaries - relate to economies of scale (rate of production or delivery of a good or service) and scope (range of different items produced or delivered).
Chapter 1: Introduction to Managerial Economics 4
(d) Organizations which are members of the same industry may choose different vertical and horizontal boundaries.
7. Competitive markets.
(a) Markets.
i. a market consists of buyers and sellers that communicate with one another for voluntary exchange. It is not limited by physical structure.
ii. in markets for consumer products, the buyers are households and sellers are businesses.
iii. in markets for industrial products, both buyers and sellers are businesses.
iv. in markets for human resources, buyers are businesses and sellers are households.
v. Note: an industry is made up of businesses engaged in the production or delivery of the same or similar items.
(b) Competitive markets.
i. markets with many buyers and many sellers, where buyers provide the demand and sellers provide the supply, e.g., the silver market.
ii. the demand-supply model - basic starting point of managerial economics, the model describes the systematic effect of changes in prices and other economic variables on buyers and sellers, and the interaction of these choices.
(c) Non-competitive markets – a market in which market power exists.
8. Market power.
(a) Market power - the ability of a buyer or seller to influence market conditions. A seller with market power will have the freedom to choose suppliers, set prices and influence demand.
(b) Businesses with market power, whether buyers or sellers, still need to understand and manage their costs.
(c) In addition to managing costs, sellers with market power need to manage their demand through price, advertising, and policy toward competitors.
9. Imperfect Market.
(a) Imperfect market - where one party directly conveys a benefit or cost to others, or where one party has better information than others.
(b) The challenge is to resolve the imperfection and be cost-effective.
(c) Imperfections can also arise within an organization, and hence, another issue in managerial economics is how to structure incentives and organizations.
10. Local vis a vis global markets.
(a) Local markets – owing to relatively high costs of communication and trade, some markets are local, e.g., housing, groceries. The price in one local market is independent of prices in other local markets.
Chapter 1: Introduction to Managerial Economics 5
(b) Global markets - owing to relatively low costs of communication and trade, some markets are global, e.g., mining, shipping, financial services. The price of an item with a global market in one place will move together with the pries elsewhere.
(c) Whether a market is local or global, the same managerial economic principles apply.
(d) Note: Falling costs of communication and trade are causing more markets to be more integrated across geographical border – enabling the opportunity to sell in new markets as well as global sourcing. Foreign sources may provide cheaper skilled labor, specialized resources, or superior quality, resulting in lower production costs and/or improved quality.
ANSWERS TO PROGRESS CHECKS
1A. The managerial economics of the “new economy” is much the same as that of the “old economy” with two aspects being more important – network effects in demand and scale and scope economies.
1B. Vertical boundaries delineate activities closer to or further from the end user. Horizontal boundaries define the scale and scope of operations.
ANSWERS TO REVIEW QUESTIONS
1. Marketing over the Internet is a scaleable activity. Delivery through UPS is somewhat scaleable: UPS already incurs the fixed cost of an international collection and distribution network; it may be willing to give Amazon bulk discounts for larger volumes of business.
2. Number of cars in service January 2002 + production + imports – exports – scrappage during 2002 = Number of cars in service January 2003. Number of cars in service is stock; other variables are flows.
3. [omitted].
4. No, models must be less than completely realistic to be useful.
5. (a) Average price per minute = (210 + 120 x 4)/5 = 138 yen per minute. (b) Price of marginal minute = 120 yen.
6. (a) Flow; (b) Stock; (c) Stock.
Chapter 1: Introduction to Managerial Economics 6
7. (a) The electricity market includes buyers and sellers. (b) The electricity industry consists of sellers only.
8. (a) False. (b) False.
9. [omitted].
10. If there are scale economies, the organization could product at a lower cost on a larger scale, which means wider horizontal boundaries; and vice versa.
11. Yes. Horizontal boundaries: how many product categories should it sell? Vertical boundaries: should it operate its own warehouses and delivery service?
12. Intel has relatively more market power.
13. (b).
14. Both (a) and (b).
15. Competitive markets have large numbers of buyers and sellers, none of which can influence market conditions. By contrast, a buyer or seller with market power can influence market conditions. A market is imperfect if one party directly conveys benefits or costs to others, or if one party has better information than another.
WORKED ANSWER TO DISCUSSION QUESTION
Jupiter Car Rental offers two schemes for rental of a compact car. It charges $60 per day for an unlimited mileage plan, and $40 per day for a time-and-mileage plan with 100 free miles plus 20 cents a mile for mileage in excess of the free allowance.
a. For a customer who plans to drive 50 miles, which is the cheaper plan. What are the average and marginal costs per mile of rental? (The marginal cost is the cost of an additional mile of usage.)
b. For a customer who plans to drive 150 miles, which is the cheaper plan. What are the average and marginal costs per mile of rental?
c. If Jupiter raises the basic charge for the time-and-mileage plan to $44 per day, how would that affect the average and marginal costs for a customer who drives 50 miles?
Chapter 1: Introduction to Managerial Economics 7
Answer
(a) It is helpful to sketch the total rental cost as a function of the mileage (see figure below). The breakeven between the two plans is at 200 miles per day. For 50 miles, the time-and-mileage plan is cheaper. Average cost = $40/50 = 80 cents per mile. Marginal cost = 0.
(b) For the 150 mile customer, the time-and-mileage plan is still cheaper. Average cost = $(40 + 0.2 x 50)/150 = 33 cents per mile; marginal cost = 20 cents per mile.
(c) After the increase in the basic charge, the average cost = $(44 + 0.2 x 50)/150 = 36 cents per mile, while marginal cost = 20 cents per mile. The increase in the basic charge doesn’t affect the marginal cost.
Total cost ($)
time-and-mileage plan
$60
unlimitedmileageplan
$40
0
200
100
Quantity (miles per day)
we recall, Malthus did not have firms in mind when he formulated the Law of Diminishing Returns. But this law has applications Malthus did not envision, and we will see how to apply the law to a business firm. In the Reasonable Dialog of economics in the nineteenth century, the development of these ideas was a bit indirect. In about the eighteen-seventies, economists were rethinking the theory of consumer demand. They applied a version of "diminishing returns" and the Equimarginal Principle to determine how a consumer would divide up her spending among different consumer goods. (We'll get into that in another chapter). That worked pretty well, and so some other economists, especially the American economist John Bates Clark, tried using the same approach in the theory of the firm. These innovations were the beginning of Neoclassical Economics.
Following the Neoclassical approach, we will interpret "rational decisions to supply goods and services" to mean decisions that maximize -- something! What does a supplier maximize? The operations of the firm will, of course, depend on its objectives. One objective that all three kinds of firms share is profits, and it seems that profits are the primary objective in most cases. We will follow the neoclassical tradition by assuming that firms aim at maximizing their profits.
There are two reasons for this assumption. First, despite the growing importance of nonprofit organizations and the frequent calls for corporate social responsibility, profits still seem to be the most important single objective of producers in our market economy. Thus it is the right place to start. Second, a good deal of the controversy in the reasonable dialog of economics has centered on the implications of profit motivation. Is it true, as Adam Smith held, that the "invisible hand" leads profit-seeking businessmen to promote the general good? To assess that question, we need to understand the implications of profit maximization.
Profit
Profit is defined as revenue minus cost, that is, as the price of output times the quantity sold (revenue) minus the cost of producing that quantity of output.
However, we need to be a little careful in interpreting that. Remember, economists understand cost as opportunity cost -- the value of the opportunity given up. Thus, when we say that businesses maximize profit, it is important to include all costs -- whether they are expressed in money terms or not.
For example, a cab-driver -- the self-employed proprietor of an independent cab service -- says: "I'm making a 'profit,' but I can't take home enough to support my family, so I'm going to have to close down and get a job." The proprietor is ignoring the opportunity cost of her own labor. When those opportunity costs are taken into account, we will find that he is not really making a profit after all.
Let's say that the cab-driver makes $500 a week driving his cab, after all expenses (gasoline, maintenance, etc.) have been taken out. Suppose he can get wages (including tips!) of $800 driving for someone else, with hours no longer and about the same conditions otherwise. Then $800 is the opportunity cost of his labor, and after we deduct the opportunity cost from his $500 net as an independent cabbie, he is actually losing $300 per week.
This is one of the most important reasons for using the opportunity cost concept: it helps us to understand the circumstances that will lead people to get into and out of business.
Because accountants traditionally considered only money costs, the net of money revenue minus money cost is called "accounting profit." (Actually, modern accountants are well aware of opportunity cost and use the concept for special purposes). The economist's concept is sometimes called "economic profit." If there will be some doubt as to which concept of profit we mean, we will sometimes use the terms "economic profit" or "accounting profit" to make it clear which is intended.
Short and Long Run
A key distinction here is between the short and long run.
Some inputs can be varied flexibly in a relatively short period of time. We conventionally think of labor and raw materials as "variable inputs" in this sense. Other inputs require a commitment over a longer period of time. Capital goods are thought of as "fixed inputs" in this sense. A capital good represents a relatively large expenditure at a particular time, with the expectation that the investment will be repaid -- and any profit paid -- by producing goods and services for sale over the useful life of the capital good. In this sense, a capital investment is a long-term commitment. So capital is thought of as being variable only in the long run, but fixed in the short run.
Thus, we distinguish between the short run and the long run as follows:
In the perspective of the short run, the number and equipment of firms operating in each industry is fixed.
In the perspective of the long run, all inputs are variable and firms can come into existence or cease to exist, so the number of firms is also variable.
lue of the Marginal Product
The Value of the Marginal Product is the product of the marginal product times the price of output. It is abbreviated VMP.
To review, we have made some progress toward answering the original question. Adding one more unit to the labor input, we have
increase in revenue = value of marginal product
increase in cost = wage
So the answer to "What will one additional labor unit add to profits?" is "the difference of the Value of the Marginal Product Minus the wage." Conversely, the answer to "What will the elimination of one labor unit add to profits?" is "the wage minus the Value of Marginal Product of Labor." And in either case the "addition to profits" may be a negative number: either building up the work force or cutting it down can drag down profits rather than increasing them.
So, again taking the bug's-eye view, we ask "Is the Value of the Marginal Product greater than the wage, or less?" If greater, we increase the labor input, knowing that by doing so we increase profits by the difference, VMP-wage. If less, we cut the labor input, knowing that by doing so we increase profits by the difference, wage-VMP. And we continue doing this until the answer is "Neither." Then we know there is no further scope to increase profits by changing the labor input -- we have arrived at maximum profits.
Introduction to Managerial Economics
CHAPTER SUMMARY
Managerial economics is the science of directing scarce resources to manage cost effectively. It consists of three branches: competitive markets, market power, and imperfect markets. A market consists of buyers and sellers that communicate with each other for voluntary exchange. Whether a market is local or global, the same managerial economics apply.
A seller with market power will have freedom to choose suppliers, set prices, and use advertising to influence demand. A market is imperfect when one party directly conveys a benefit or cost to others, or when one party has better information than others.
An organization must decide its vertical and horizontal boundaries. For effective management, it is important to distinguish marginal from average values and stocks from flows. Managerial economics applies models that are necessarily less than completely realistic. Typically, a model focuses on one issue, holding other things equal.
KEY CONCEPTS
managerial economics average value horizontal boundaries
microeconomics stock market
macroeconomics flow industry
economic model other things equal market power
marginal value vertical boundaries imperfect market
GENERAL CHAPTER OBJECTIVES
1. Define managerial economics and introduce students to the typical issues encountered in the field.
2. Discuss the scope and methodology of managerial economics.
3. Distinguish a marginal concept from its average and a stock concept from a flow. Chapter 1: Introduction to Managerial Economics 2
4. Describe the importance of the "other things equal" assumption in managerial economic analysis.
5. Describe what constitutes a market, distinguish competitive from non-competitive markets, and discuss imperfect markets.
6. Emphasize the globalization of markets.
NOTES
1. Definition. Managerial economics is the science of directing scarce resources to manage cost effectively.
2. Application. Managerial economics applies to:
(a) Businesses (such as decisions in relation to customers including pricing and advertising; suppliers; competitors or the internal workings of the organization), nonprofit organizations, and households.
(b) The “old economy” and “new economy” in essentially the same way except for two distinctive aspects of the “new economy”: the importance of network effects and scale and scope economies.
i. network effects in demand – the benefit provided by a service depends on the total number of other users, e.g., when only one person had email, she had no one to communicate with, but with 100 mm users on line, the demand for Internet services mushroomed.
ii. scale and scope economies – scaleability is the degree to which scale and scope of a business can be increased without a corresponding increase in costs, e.g., the information in Yahoo is eminently scaleable (the same information can serve 100 as well as 100 mm users) and to serve a larger number of users, Yahoo needs only increase the capacity of its computers and links.
iii. Note: the term open technology (of the Internet) refers to the relatively free admission of developers of content and applications.
(c) Both global and local markets.
3. Scope.
(a) Microeconomics – the study of individual economic behavior where resources are costly, e.g., how consumers respond to changes in prices and income, how businesses decide on employment and sales, voters’ behavior and setting of tax policy.
(b) Managerial economies – the application of microeconomics to managerial issues (a scope more limited than microeconomics).
(c) Macroeconomics – the study of aggregate economic variables directly (as opposed to the aggregation of individual consumers and businesses), e.g., issues relating to interest and exchange rates, inflation, unemployment, import and export policies.
Chapter 1: Introduction to Managerial Economics 3
4. Methodology.
(a) Fundamental premise - economic behavior is systematic and therefore can be studied. Systematic economic behavior means individuals share common motivations and behave systematically in making economic choices, i.e, a person who faces the same choices at two different times will behave in the same way both times.
(b) Economic model – a concise description of behavior and outcomes:
i. focuses on particular issues and key variables (e.g., price, salary), omits considerable information, hence unrealistic at times;
ii. constructed by inductive reasoning;
iii. to be tested with empirical data and revised as appropriate.
5. Basic concepts.
(a) Margin vis a vis average variables in managerial economics analyses.
i. marginal value of a variable – the change in the variable associated with a unit increase in a driver, e.g., amount earned by working one more hour;
ii. average value of a variable – the total value of the variable divided by the total quantity of a driver, e.g., total pay divided by total no. of hours worked;
iii. driver – the independent variable, e.g., no. of hours worked;
iv. the marginal value of a variable may be less that, equal to, or greater than the average value, depending on whether the marginal value is decreasing, constant or increasing with respect to the driver;
v. if the marginal value of a variable is greater than its average value, the average value increases, and vice versa.
(b) Stocks and flows.
i. stock – the quantity at a specific point in time, measured in units of the item, e.g., items on a balance sheet (assets and liabilities), the world’s oil reserves in the beginning of a year;
ii. Flow – the change in stock over some period of time, measured in units per time period e.g., items on an income statement (receipts and expenses), the world’s current production of oil per day.
(c) Holding other things equal – the assumption that all other relevant factors do not change, and is made so that changes due to the factor being studied may be examined independently of those other factors. Having analysed the effects of each factor, they can be put together for the complete picture.
6. Organizational boundaries.
(a) Organizations include businesses, non-profits and households.
(b) Vertical boundaries – delineate activities closer to or further from the end user.
(c) Horizontal boundaries - relate to economies of scale (rate of production or delivery of a good or service) and scope (range of different items produced or delivered).
Chapter 1: Introduction to Managerial Economics 4
(d) Organizations which are members of the same industry may choose different vertical and horizontal boundaries.
7. Competitive markets.
(a) Markets.
i. a market consists of buyers and sellers that communicate with one another for voluntary exchange. It is not limited by physical structure.
ii. in markets for consumer products, the buyers are households and sellers are businesses.
iii. in markets for industrial products, both buyers and sellers are businesses.
iv. in markets for human resources, buyers are businesses and sellers are households.
v. Note: an industry is made up of businesses engaged in the production or delivery of the same or similar items.
(b) Competitive markets.
i. markets with many buyers and many sellers, where buyers provide the demand and sellers provide the supply, e.g., the silver market.
ii. the demand-supply model - basic starting point of managerial economics, the model describes the systematic effect of changes in prices and other economic variables on buyers and sellers, and the interaction of these choices.
(c) Non-competitive markets – a market in which market power exists.
8. Market power.
(a) Market power - the ability of a buyer or seller to influence market conditions. A seller with market power will have the freedom to choose suppliers, set prices and influence demand.
(b) Businesses with market power, whether buyers or sellers, still need to understand and manage their costs.
(c) In addition to managing costs, sellers with market power need to manage their demand through price, advertising, and policy toward competitors.
9. Imperfect Market.
(a) Imperfect market - where one party directly conveys a benefit or cost to others, or where one party has better information than others.
(b) The challenge is to resolve the imperfection and be cost-effective.
(c) Imperfections can also arise within an organization, and hence, another issue in managerial economics is how to structure incentives and organizations.
10. Local vis a vis global markets.
(a) Local markets – owing to relatively high costs of communication and trade, some markets are local, e.g., housing, groceries. The price in one local market is independent of prices in other local markets.
Chapter 1: Introduction to Managerial Economics 5
(b) Global markets - owing to relatively low costs of communication and trade, some markets are global, e.g., mining, shipping, financial services. The price of an item with a global market in one place will move together with the pries elsewhere.
(c) Whether a market is local or global, the same managerial economic principles apply.
(d) Note: Falling costs of communication and trade are causing more markets to be more integrated across geographical border – enabling the opportunity to sell in new markets as well as global sourcing. Foreign sources may provide cheaper skilled labor, specialized resources, or superior quality, resulting in lower production costs and/or improved quality.
ANSWERS TO PROGRESS CHECKS
1A. The managerial economics of the “new economy” is much the same as that of the “old economy” with two aspects being more important – network effects in demand and scale and scope economies.
1B. Vertical boundaries delineate activities closer to or further from the end user. Horizontal boundaries define the scale and scope of operations.
ANSWERS TO REVIEW QUESTIONS
1. Marketing over the Internet is a scaleable activity. Delivery through UPS is somewhat scaleable: UPS already incurs the fixed cost of an international collection and distribution network; it may be willing to give Amazon bulk discounts for larger volumes of business.
2. Number of cars in service January 2002 + production + imports – exports – scrappage during 2002 = Number of cars in service January 2003. Number of cars in service is stock; other variables are flows.
3. [omitted].
4. No, models must be less than completely realistic to be useful.
5. (a) Average price per minute = (210 + 120 x 4)/5 = 138 yen per minute. (b) Price of marginal minute = 120 yen.
6. (a) Flow; (b) Stock; (c) Stock.
Chapter 1: Introduction to Managerial Economics 6
7. (a) The electricity market includes buyers and sellers. (b) The electricity industry consists of sellers only.
8. (a) False. (b) False.
9. [omitted].
10. If there are scale economies, the organization could product at a lower cost on a larger scale, which means wider horizontal boundaries; and vice versa.
11. Yes. Horizontal boundaries: how many product categories should it sell? Vertical boundaries: should it operate its own warehouses and delivery service?
12. Intel has relatively more market power.
13. (b).
14. Both (a) and (b).
15. Competitive markets have large numbers of buyers and sellers, none of which can influence market conditions. By contrast, a buyer or seller with market power can influence market conditions. A market is imperfect if one party directly conveys benefits or costs to others, or if one party has better information than another.
WORKED ANSWER TO DISCUSSION QUESTION
Jupiter Car Rental offers two schemes for rental of a compact car. It charges $60 per day for an unlimited mileage plan, and $40 per day for a time-and-mileage plan with 100 free miles plus 20 cents a mile for mileage in excess of the free allowance.
a. For a customer who plans to drive 50 miles, which is the cheaper plan. What are the average and marginal costs per mile of rental? (The marginal cost is the cost of an additional mile of usage.)
b. For a customer who plans to drive 150 miles, which is the cheaper plan. What are the average and marginal costs per mile of rental?
c. If Jupiter raises the basic charge for the time-and-mileage plan to $44 per day, how would that affect the average and marginal costs for a customer who drives 50 miles?
Chapter 1: Introduction to Managerial Economics 7
Answer
(a) It is helpful to sketch the total rental cost as a function of the mileage (see figure below). The breakeven between the two plans is at 200 miles per day. For 50 miles, the time-and-mileage plan is cheaper. Average cost = $40/50 = 80 cents per mile. Marginal cost = 0.
(b) For the 150 mile customer, the time-and-mileage plan is still cheaper. Average cost = $(40 + 0.2 x 50)/150 = 33 cents per mile; marginal cost = 20 cents per mile.
(c) After the increase in the basic charge, the average cost = $(44 + 0.2 x 50)/150 = 36 cents per mile, while marginal cost = 20 cents per mile. The increase in the basic charge doesn’t affect the marginal cost.
Total cost ($)
time-and-mileage plan
$60
unlimitedmileageplan
$40
0
200
100
Quantity (miles per day)
we recall, Malthus did not have firms in mind when he formulated the Law of Diminishing Returns. But this law has applications Malthus did not envision, and we will see how to apply the law to a business firm. In the Reasonable Dialog of economics in the nineteenth century, the development of these ideas was a bit indirect. In about the eighteen-seventies, economists were rethinking the theory of consumer demand. They applied a version of "diminishing returns" and the Equimarginal Principle to determine how a consumer would divide up her spending among different consumer goods. (We'll get into that in another chapter). That worked pretty well, and so some other economists, especially the American economist John Bates Clark, tried using the same approach in the theory of the firm. These innovations were the beginning of Neoclassical Economics.
Following the Neoclassical approach, we will interpret "rational decisions to supply goods and services" to mean decisions that maximize -- something! What does a supplier maximize? The operations of the firm will, of course, depend on its objectives. One objective that all three kinds of firms share is profits, and it seems that profits are the primary objective in most cases. We will follow the neoclassical tradition by assuming that firms aim at maximizing their profits.
There are two reasons for this assumption. First, despite the growing importance of nonprofit organizations and the frequent calls for corporate social responsibility, profits still seem to be the most important single objective of producers in our market economy. Thus it is the right place to start. Second, a good deal of the controversy in the reasonable dialog of economics has centered on the implications of profit motivation. Is it true, as Adam Smith held, that the "invisible hand" leads profit-seeking businessmen to promote the general good? To assess that question, we need to understand the implications of profit maximization.
Profit
Profit is defined as revenue minus cost, that is, as the price of output times the quantity sold (revenue) minus the cost of producing that quantity of output.
However, we need to be a little careful in interpreting that. Remember, economists understand cost as opportunity cost -- the value of the opportunity given up. Thus, when we say that businesses maximize profit, it is important to include all costs -- whether they are expressed in money terms or not.
For example, a cab-driver -- the self-employed proprietor of an independent cab service -- says: "I'm making a 'profit,' but I can't take home enough to support my family, so I'm going to have to close down and get a job." The proprietor is ignoring the opportunity cost of her own labor. When those opportunity costs are taken into account, we will find that he is not really making a profit after all.
Let's say that the cab-driver makes $500 a week driving his cab, after all expenses (gasoline, maintenance, etc.) have been taken out. Suppose he can get wages (including tips!) of $800 driving for someone else, with hours no longer and about the same conditions otherwise. Then $800 is the opportunity cost of his labor, and after we deduct the opportunity cost from his $500 net as an independent cabbie, he is actually losing $300 per week.
This is one of the most important reasons for using the opportunity cost concept: it helps us to understand the circumstances that will lead people to get into and out of business.
Because accountants traditionally considered only money costs, the net of money revenue minus money cost is called "accounting profit." (Actually, modern accountants are well aware of opportunity cost and use the concept for special purposes). The economist's concept is sometimes called "economic profit." If there will be some doubt as to which concept of profit we mean, we will sometimes use the terms "economic profit" or "accounting profit" to make it clear which is intended.
Short and Long Run
A key distinction here is between the short and long run.
Some inputs can be varied flexibly in a relatively short period of time. We conventionally think of labor and raw materials as "variable inputs" in this sense. Other inputs require a commitment over a longer period of time. Capital goods are thought of as "fixed inputs" in this sense. A capital good represents a relatively large expenditure at a particular time, with the expectation that the investment will be repaid -- and any profit paid -- by producing goods and services for sale over the useful life of the capital good. In this sense, a capital investment is a long-term commitment. So capital is thought of as being variable only in the long run, but fixed in the short run.
Thus, we distinguish between the short run and the long run as follows:
In the perspective of the short run, the number and equipment of firms operating in each industry is fixed.
In the perspective of the long run, all inputs are variable and firms can come into existence or cease to exist, so the number of firms is also variable.
lue of the Marginal Product
The Value of the Marginal Product is the product of the marginal product times the price of output. It is abbreviated VMP.
To review, we have made some progress toward answering the original question. Adding one more unit to the labor input, we have
increase in revenue = value of marginal product
increase in cost = wage
So the answer to "What will one additional labor unit add to profits?" is "the difference of the Value of the Marginal Product Minus the wage." Conversely, the answer to "What will the elimination of one labor unit add to profits?" is "the wage minus the Value of Marginal Product of Labor." And in either case the "addition to profits" may be a negative number: either building up the work force or cutting it down can drag down profits rather than increasing them.
So, again taking the bug's-eye view, we ask "Is the Value of the Marginal Product greater than the wage, or less?" If greater, we increase the labor input, knowing that by doing so we increase profits by the difference, VMP-wage. If less, we cut the labor input, knowing that by doing so we increase profits by the difference, wage-VMP. And we continue doing this until the answer is "Neither." Then we know there is no further scope to increase profits by changing the labor input -- we have arrived at maximum profits.
