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Graphing Exercise: Production and Costs In making payments for its resources, the firm incurs costs of production. In the short run, a time frame over which capital is fixed, the total cost of any given level of output can be broken into fixed cost and variable cost. On a per unit basis, these can be expressed as average fixed cost and average variable cost, which together sum to average total cost. Marginal cost refers to the extra cost of producing one additional unit. Obviously, these short-run costs reflect both the costs and the productivity of the inputs.Click here to explore the relationship between input prices, productivity, and costs. The exercise will open in a new browser window. This exercise is from the website for Begg and Ward Economics for Business. Familiarise yourself with the graph and then complete the questions below. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. In making payments for its resources, the firm incurs costs of production. In the short run, a time frame over which capital is fixed, the total cost of any given level of output can be broken into fixed cost and variable cost. On a per unit basis, these can be expressed as average fixed cost and average variable cost, which together sum to average total cost. Marginal cost refers to the extra cost of producing one additional unit. Obviously, these short-run costs reflect both the costs and the productivity of the inputs. The graph contains productivity data - the physical relationship between inputs and output - for a hypothetical firm. Total product, the relationship between labour input and output, is graphed on the upper panel, while marginal and average product are graphed below. Clicking and dragging the Productivity Index slider to the right allows you to increase the productivity of labour by any amount up to 25 per cent. By clicking on the Production/Costs button, the applet toggles to the graphical portrayal of the firm’s cost curves: Variable Cost, Fixed Cost, and Total Cost are in the upper graph, while the lower panel contains the corresponding Marginal and Average-Total-Cost curves. You can change the wage rate and fixed cost by clicking on the corresponding bold values below the tabular productivity data. In either the production or the cost mode, clicking Reset restores all values to their initial levels. 1. How are the positions of the production graphs affected by an increase in labour productivity? AnswerClick and drag the Productivity slider to the right. Labour’s total product increases, as do average and marginal product. 2. Over what range of labour input are there increasing marginal returns to labour? Over what range are there decreasing marginal returns to labour? AnswerIncreasing marginal returns are reflected by increases in labour’s marginal product; decreases in marginal product indicate decreasing marginal returns. From the table and the graph, marginal product increases through the addition of the fourth worker. Decreasing marginal returns begin with the addition of the fifth worker. As is apparent from the lower production panel, average product - output per worker - continues to rise as long as marginal product exceeds average product. If marginal product is below average product, average product is decreasing. 3. Reset productivity to its original level. Over what range of output does marginal cost decrease? Over what range does it increase? How do these ranges correspond to labour productivity? AnswerDrag the Productivity slider all the way to the left then click on the Production/Cost toggle button to display the firm’s cost curves. Marginal cost declines through the production of the 200th unit. This corresponds exactly to the range of increasing marginal returns to labour. Marginal cost is increasing beyond this point, corresponding to the range of decreasing marginal returns to labour. 4. When the wage is £20 and fixed cost is £100, what is the marginal cost of the 420th unit of output? How is this affected by a decrease in fixed cost? How is it affected by an increase in the wage? How is it affected by an increase in labour productivity? AnswerReading either from the table or the graph, the marginal cost associated with an output of 420 is £.50. To check the impact of an increase in fixed cost, click on the Fixed Cost button and enter a new value. Marginal cost is unaffected, although average total cost rises. Next, click on the Wage Rate button and enter a value of £40. Marginal cost doubles, from £.50 to £1.00 with a doubling of the wage rate. Finally, drag the Productivity slider all the way to the right. Marginal cost decreases. 5. Experiment on your own. Considering the three factors investigated in the applet - fixed cost, wage rate, and productivity - which factor(s) will increase marginal cost? How will these same factors affect average total cost? Can average total cost increase without an increase in marginal cost? AnswerMarginal cost will increase with an increase in the wage rate or a decrease in productivity. Both of these will increase average total cost as well. An increase in fixed cost has no impact on marginal cost, but will increase average total cost. Graphing Exercise: Supply and Demand The buying decisions of households and the selling decisions of businesses are brought together in a market. Here, market pressures created by surpluses or shortages serve to determine the price of the product and the amount bought and sold. Exploration: How do changes in supply or demand affect equilibrium price and quantity? Click here to view the exercise. It will open in a new browser window. This exercise is from the website for Begg and Ward Economics for Business. Then answer the questions below. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. 1. What is the likely effect on equilibrium price and quantity if corn farmers experience an extended period of bad weather? AnswerAn extended period of bad weather would reduce supply-a shift to the left of the supply curve. The poor weather will reduce corn crop yields, reducing the amount offered for sale to the market at each possible price. To see this, drag the supply curve to the left. Because consumers still wish to purchase the same quantity at the current price, the decrease in supply will create a shortage. Press the New Equilibrium button to see how market equilibrium is restored. The increase in price reduces the quantity consumers wish to purchase. 2. What is the likely effect on the equilibrium price and quantity of corn if the government requires ethanol (a corn byproduct) to be added to all gasoline to reduce emissions? AnswerRequiring the addition of ethanol would increase the demand for corn - a shift to the right of the demand curve. The amount demanded by ethanol producers would be added to the amount demanded by other corn consumers and result in a shortage at the current price. To see this, drag the demand curve to the right. Because corn producers still wish to produce the same amount at the current price, there will be a shortage unless the price changes. Press the New Equilibrium button to see how market equilibrium is restored. The increase in price increases the amount produced and offered for sale. 3. Suppose both of the above incidents occur - bad weather and a government ethanol mandate? How will the corn market be affected? AnswerSupply decreases with bad weather while the government mandate increases demand. Drag the supply curve to the left and the demand curve to the right and click on New Equilibrium to see the impact on price and quantity. You’ll notice that the price increases, but the quantity may rise, fall, or remain the same depending on the magnitude of the shifts in supply and demand. You should verify (by shifting the curves) that whenever both demand and supply change, the impact on either price or quantity will be indeterminate. 4. Experiment on your own: drag either the supply curve or the demand curve followed by pressing the New Equilibrium button. What generalizations can you draw with respect to changes in equilibrium price and quantity? AnswerAn increase in supply (drag the supply curve to the right) will increase quantity and reduce price, while a decrease in supply will decrease quantity and increase price. An increase in demand (drag the demand curve to the right) will increase both quantity and price, while a decrease in demand will decrease both quantity and price. Graphing Exercise: Short-Run Profit Maximization A competitive firm is a price-taker, able to sell as little or as much as it desires at the going market price. In other words, demand for a competitive firm is perfectly elastic at the going price. Its only choice, then, is how much output, if any, to produce. Throughout, firms are assumed to maximize profits. Exploration: With respect to its output choice, what is the rule a competitive firm will follow to obtain maximum profits? Click here to view the exercise. It will open in a new browser window. This exercise is from the website for Begg and Ward Economics for Business. Then answer the questions below.If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. The graph shows the average- and marginal-cost curves of a typical competitive firm. Initially, price is £80 and the firm is producing 80 units per week. Its fixed costs are £2700 per week. To use the graph, click and drag the green triangle on the vertical axis to change the market price, hence the firm’s demand curve. Click and drag the green triangle on the horizontal axis to change the firm’s choice of output. Cost and profit data are shown in the box at right; clicking on the Show Profit/Loss button will provide a graphical illustration of the firm’s profit or loss, profit in green and losses in red. Clicking the Reset button will restore all initial values. 1. At the initial market price of £80 and output level of 80 units per week, how much profit is the firm earning? Is there any other output choice that provides a higher profit? AnswerThe firm’s total revenue and total cost are both £6,400, indicating a profit of zero. Click the Show Profit/Loss button to illustrate changes in the firm’s profit as it moves away from this point. Click and drag on the green triangle on the quantity axis in either direction. The firm loses money at any other output level: The farther one moves away from a quantity of 80 units, the higher the firm’s losses. 2. Holding price constant at £80, compare price and marginal cost at various output levels. How should the firm adjust its output if price exceeds marginal cost? How should the firm adjust its output if price falls short of marginal cost? AnswerClick Reset. Drag the Output slider to the left. Marginal cost is less than price at output levels less than 80 units per week. Profit will increase if output is increased. Drag the slider to the right past 80 units per week. For these output levels, marginal cost exceeds price and profit will increase by reducing output. Maximum profit is achieved at 80 units, the output level at which price (hence marginal revenue) equals marginal cost. 3. Suppose price rises to £100. How should the firm respond? Will its profits increase or decrease? AnswerAdjust the firm’s demand curve up by dragging the green triangle on the vertical axis up to £100. By watching the firm’s profit total in the box, maximum profits are achieved at an output level of 92 units per week, an increase of 12 over the initial level. Profits rise to £1724.80 per week. 4. If price suddenly falls to £60 per week, should the firm shut down? AnswerDrag the price triangle down to £60. Adjust the firm’s output level to find maximum profits (minimum losses in this case) at an output level of 65 per week. At this output level, losses are £1454.69 and price equals marginal cost. If it were to shut down instead, the firm would lose £2700, an amount equal to its fixed costs. 5. Experiment on your own. What is the rule for profit maximization? AnswerDrag the price to any level above £40. Maximum profits (minimum losses) are achieved at the output level at which price equals marginal cost. |