I’ve talked about how variable and fixed costs contribute to the upward slope of the supply line, but I haven’t represented it graphically. I didn’t want to for your sanity’s sake; but if I omit that information, my course would be lacking and illegitimate. Like your mother. So my apologies in advance.
As a reminder, fixed inputs do not vary with quantity of production. Examples of fixed inputs include rent and machines. No matter how much you produce in a month, the price of these inputs that you paid will be the same.
If rent costs you $1000, and you make 1000 watches, then the average cost of rent for each watch is 1 dollar. If you make 2000 watches, then the average cost of rent for each watch is 50 cents. When total fixed cost is the same, and production increases, average fixed cost per unit decreases.
Variable inputs do vary with production. Examples of variable inputs include hourly workers and electricity. The more you have to produce, the more of those variable inputs you will need.
According to the law of diminishing returns, with the same fixed inputs, adding variable inputs one by one will eventually lead to a point where each unit input adds less to production than the unit before it. How does this happen? Because there’s only so much space hourly workers can use, and only so much electricity a machine can convert effectively, as you add more workers and use more electricity, production becomes more inefficient. There are more people bumping into each other and more electricity being wasted as heat. Each additional worker and each additional volt thus cost a lot compared to how little they produce. Because of these increasing inefficiencies, as production increases, the average variable cost per unit increases.
Hey, I warned you this would drive you crazy; there’s no going back now. If it makes you feel better, I’ll leave a summary of points for you to keep in mind a little later.
Anyway, here’s something new that I haven’t even hinted at before: from the beginning of production, right up until the point of diminishing returns, there are increasing returns when you add more variable inputs. Say you own a Chinese Food restaurant where you cook, take orders and handle the cash register, all by yourself. If one worker is not enough to keep up with production, you can add a worker beside yourself. When you do so, will your production potential double? No, actually, it will more than double. As you two specialize in different things (you are in charge of cooking and taking orders, and he’s in charge of cooking and using the cash register), you both become more efficient and skilled with your specialized jobs. So in addition to working twice as hard, your more refined, efficient skills increases overall production by more than twice as much. The cost of each worker relative to the amount of meals produced thus decreases.
Similarly, making more rice on a running stove initially makes your cooking more efficient, because instead of going to waste, the running gas is used to cook more rice. So the variable cost of gas per unit of rice produced thus decreases.
Okay, to revive your sanity, here are six key points for you to remember:
–As you add variable inputs initially, you get increasing returns because of improved efficiency.
–As you add variable inputs later on, you get diminishing returns because of lost efficiency.
–Increasing returns means that average costs (per unit) are going down.
–Diminishing returns means that average costs (per unit) are going up.
-Your mother is illegitimate. I’m calling her a bastard.
-There is nothing wrong with being a bastard. If you took that as an insult, that’s on you. Grow up.
Let’s say you currently make 10 dollars an hour. You decide to go to college so you can make a million dollars an hour. You major in English.
3.5 years into your degree, with one semester left, you learn that of all the jobs available for you, none of them pay close to a million dollars an hour (The nerve of those employers!). In fact, they all only pay 15 dollars an hour. You wasted $175,000 on your education so far, and your last semester will cost you $25,000 more. Should you finish your degree, even though you know your English major was a horrible investment overall?
Yeah you should. Even though you wasted all that money, it’s now in the past, and you have to make an optimum decision based on the costs you will incur now. You should pay the remaining tuition to make that extra five dollars an hour.
The $175,000 is a sunk cost. Sunk costs are the costs you incurred in the past that should not influence the economic decisions you make in the present.
During production, fixed inputs are sunk costs in the short run. Once you buy a machine that can last a year, that money is gone, and you cannot include that cost in your calculations on whether or not you should stay in business for the rest of the year.
What you as an owner ought to be concerned about are your variable costs. If your average variable costs per unit is 1 dollar and 50 cents, and the price you sell each unit for is 2 dollar and 50 cents, then you should probably stay in business because you are making a dollar return per unit sold. Even if your average fixed cost is 20 dollars per unit, because you already paid it, you shouldn’t include it in your calculations for whether or not you should stay in business.
Note: People get stuck with sunk costs because they made poor economic decisions based on misinformation. Whoever told you college would make you a million dollars an hour should be in jail.
To get the total cost per unit, you would have to add up all the variable and fixed costs per unit.
Can we deduce anything from this average total cost curve? Well like always, let’s think of a concrete example.
Say on average, you fart 30 times a day. Today, you fart 50 times. Will that bring the average up or down? Obviously up, because when you add something to a group that’s higher than the average of the group, then the group average goes up.
Now what about if you have a dry spell and don’t fart at all today. That would bring the average down. When you add something to a group that’s lower than the average of the group, the average goes down.
Because of this basic law of averages, we can deduce how the marginal cost curve will look like based on the average total cost curve. Basically, if average total cost is decreasing, then marginal cost (i.e. the additional cost) must be below the average. If average total cost is increasing, marginal cost must be above the average.
This, my farting friend, is the upward sloping supply curve/marginal cost curve. The marginal cost is the price producers are willing to sell their last unit in production for. The higher the marginal revenue curve intersects the marginal cost curve, the more unit output there will be.
I’m gonna need you to pay attention here, since I will not be providing pictures.
The supply line by definition represents the minimum prices producers are willing to sell their last unit of a good, for different quantities of the good. There does come a point where the price is too low (and thus the producer surplus is too low) which causes sellers to leave the market. Likewise, when the price is high enough (and thus producer surplus is high), more sellers will want to enter the market. Thus the market supply line will extend more right ward (meaning higher quantity) in the upper end of the marginal cost curve and more leftward (meaning lower quantity) in the bottom end of the marginal cost curve.
Anyway, that trivia is not important. What’s more important is to know that producers leave or enter the market depending on their opportunity costs. An opportunity cost is the value of an alternative choice; it’s the value of the choice you give up when making the choice you do. As an example, when you attend school, your opportunity cost is the value of the full time job you could’ve had instead. When you have a full time job for a year, your opportunity cost is the value of the education you could be getting.
Generally, economists limit their definition of opportunity cost to the value of your “next best choice”. Say you have the skills to be a clown that gets paid $70,000 a year. But you currently own a restaurant and make $100,000 a year. The salary from being a clown is your opportunity cost. If demand for your restaurant decreases significantly, to the point where you only make $50,000 a year, the lost $70,000 opportunity cost will cause you to quit your restaurant and put on some clown make up.
The marginal cost curve in the previous point assumed no opportunity costs. But opportunity costs do affect the shape of the Supply Curve; they tell us about the price points that would cause people to stop producing in a market.
Say I squeeze apples to make apple juice by hand, and you squeeze apples to make apple juice by machine. If we each attempted to produce 100 gallons of apple juice in a week, who is more likely to be at diminishing returns?
Unfortunately, me. In this example I’m making up, I become more inefficient when I make more than 20 gallons in a week; you only become more inefficient when you make more than 2000 gallons in a week. When a production process has more effective technology, the point of diminishing returns starts at much higher quantities.
For a visualization of this, just imagine after a company implements new technology, that the average cost curve is more rightward (because of the higher quantity produced) and downward (because of the lower cost from technological efficiency).
Because of the implementation of technology across almost all industries in today’s world, more and more companies are operating at increasing or constant returns, rather than diminishing ones. (That is: their average costs are going down, not up, when they produce more). This means that companies today do not lose overall efficiency as they expand production. They thus have an incentive to get larger.
The consequences of this aren’t always clear. On one hand, the more rightward and downward a marginal cost curve is, the more likely the existing demand will intersect the curve at a lower price and quantity.
On the other hand however, as companies become larger, they gain more monopolistic power. With the amount of growth-promoting technology in today’s world, the potential monopolistic power individual companies can have (if not regulated by government) is unprecedented. As we learned from the first page of this course, monopolistic power means that these companies will try to produce lower quantities at higher prices, just because they can.
When a company becomes a monopoly due to the benefits of increasing returns, it is known as a natural monopoly. The overall effect on quantities and prices from having a natural monopoly will vary; every industry is different. In some industries, the efficiency effect will be stronger, and prices will be lower; in other industries, the monopoly effect will be stronger, and prices will be higher. Both effects would generally be present.
To make this course less like your mother, it’s imperative that I don’t miss anything important so you don’t spend the rest of your life uninformed and deluded. What I should’ve mentioned somewhere in the last point are two concepts: economies of scale and diseconomies of scale.
Economies of scale are things that make a company more efficient as it gets larger. When a company is larger, it is able to buy its inputs in bulk, and thus get discounted prices. It is also able to follow best business practices (for their given market) based on the particular experience they attained from years of growth. These advantages are examples of economies of scale; they help large companies reduce average costs and ensure better returns.
Diseconomies of scale are things that make a company less efficient as it gets larger. When a company is larger, bureaucracies, patterns of miscommunication and office politics are more likely to develop. They will all bring down the average productivity of the firm.
The reason I should’ve mentioned this is because I may have given the impression in the last point that lack of machines is the only source of inefficiency. Efficiencies and inefficiencies can come from anywhere; the world is complex.
There, now you can’t accuse me of over-simplifying everything like your mother. . . . even though your mother only over-simplified everything because she knew it was the only way your baby ass could learn anything new. I apologize for being as considerate as your mother!
I have some bad news; the concepts of Supply and Demand as I have been explaining them was not given to us by God. It’s not in the Quran, or the Bible, or the Vedas, hell it’s not even written on our money (I’m trying to be inclusive of everybody’s God, okay?). Supply and Demand is a model conceived by man (Alfred Marshal to be precise); and as such, it does not have an answer to every question in life.
One issue with Supply and Demand (also known as the Marshallian Cross) is that it’s difficult to construct the curves in the real world. Nobody goes around drawing supply and demand for every single market; it would require too much research. How much does production change with every combination of inputs? How much do customers buy for any given price point? Collecting information like this is costly and it may not even be useful because these responses can change quickly year to year, month to month, day to day and hour to hour without a clear reason why. So it’s impossible to empirically prove the Marshallian Cross for every situation, and a lot of what we know about it comes from pure intuition.
On the other hand though, the reason economists have so much faith in the model is because basic reasoning and general trends give the model a lot of credence. We all know that when demand shifts to the right, i.e. when people want to buy more of a good, prices go up. We know that when demand shifts to the left, i.e. when people want to buy less of a good, prices go down. We know that when supply shifts to the right, i.e. when the costs of input lower, prices go down. And we know that when supply shifts to the left, i.e. when costs of input rises, prices go up.
We also know that given a certain price change, the elasticity of demand, that is whether the good is considered a necessity or a luxury, and the elasticity of supply, that is whether the good is easy or difficult to produce, determine the degree of change of quantity that will then be produced in the market.
With all that said, there are cases where supply and demand aren’t enough to predict changes in price and quantity. The effects of supply and demand could be miniscule, or overridden by other forces. For these, we need to explore new economic models.
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