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ECN 2020 Chapter 7-1 | Principles of Microeconomics w/Yan Shi | YouTubeToText
YouTube Transcript: ECN 2020 Chapter 7-1
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Summary
Core Theme
This content introduces fundamental concepts in producer theory, focusing on the sequential decision-making process of firms regarding scale, output, and input, and then delves into the short-run analysis of production, including economic profit, normal rate of return, and productivity measures.
Talk about the indirect policy and the direct policy of marketing
price ceiling, price floor, and price tags
Then, we’ll talk about elasticity okay and after that I'll introduce to you the concept of
….
So this chapter here, starting this chapter, we’re going to talk about we’re going
to talk about… theory…
So this theory we’re going to talk about how producers a firm make decisions on
what to produce, how much to produce, and how to produce them
Okay, those kind of decisions
what are the the main decisions in any kind of business has to make…the main decisions before they
even start it
So what are the main decisions, any kind of business have to make
“what are we gonna make it”
What product to make, alright.
Okay what else? “how much it costs”
How much it costs, good. What else?
“resource availability” Resource availability,
Okay. What else?
“demand for that product”
Demand for that product.
Very good, okay.
All those things are very very important.
Okay.
But in this three chapters, we’re going to focus on three kinds of decisions that
we’ll have to make.
And the first one is probably the very first one in very first months, a few of the important
decisions you have to decide is a scale
Okay, once you decide what you want to do, then you want to know how big you want it
For example, if you use a restaurant business as an example.
Do I want it to be a diner or a huge restaurant
Okay, how big Okay?
And also where where I want to locate this restaurant.
Okay, the location of it
“What chapter is this?”
7, 8, 9, So we’re talking about producer theory in general
Okay so the very first decision a firm has to make is a way to scale the business, okay
As they determine, okay, the size of the business, the scale and location of the business, then
the second thing they want to determine is how much sale I want to have…within the
day
So the second main decision is output
What is optimal output level to maximize my profit?
So that’s the second important decision
The third one, so once the output decision is made, okay the next question is how to
produce this much
Okay how many laborers I should hire, how many …I should employ in order to produce
that much input
So the third decision, okay so, that’s what these three chapters talks about.
Basically these three chapters talk about there’s three important decisions to make
Decision on scale, decision on output, and decision on input okay
So you know this is a sequence, there’s a sequence here okay the sequence here is
this has to be determined first, right?
Then this determined afterward then in the end the firm determines the input
So there’s a sequence of this decision making, but if we want to solve a problem for a firm.
Lets say the firm has determined what kind of product what kind of business they want
to get into and they need to determine what is optimal scale and what is optimal output
and what is the optimal input
The firm needs to determine all these three variables.
Okay, how should they tackle this problem.
Which decision they should tackle first?
In a mathematical environment?
Which decision?
“The scale”
The scale is the very first decision they have to make, but if we want to solve it mathematically
“Input”
“The startup cost”
Hmm?
“The start up cost”
Okay, so let me introduce this concept because this is very abstract
So I’m going to talk about this methodology is called the backward induction
What is backward induction?
Backward induction says this.
If there is a sequence of decisions a individual or party has to make, okay, and all those
decisions are decision variables that this business or this party has to solve.
So you have three different variables
A very complicated mathematical equations
So how do we solve this, okay
Backward induction says this.
It’s easiest if you solve the variable at the end first.
Why?
Since there is a sequence, if you’re trying to solve this variable, in the first one these
two are unknows, okay?
And if you’re trying to solve this variable here, when you reach this stage, this is known
but this still unknown
But when you reach the last stage, if they say you know the firm has reach the last stage.
The first has already determined the scale, has already determined the output
Then the last stage the only unknown variable is this input, okay?
So backward induction methodology is a methodology used in mathematics that says okay when you
have a sequence of decisions, where each decision involves variable.
You always target the last stage variable first
Because the reason you tackle the last stage variable is because when you reach this stage,
these two are known already.
The known information.
So you have least amount of unknown information when you solve a problem, okay?
So that’s what we call a backward induction.
Think about this environment of playing chess.
Have you guys played chess?
Okay, let’s say you know let’s say you only have five moves to make okay
Each, each party has you know five moves to make and you’re trying to figure out what’s
the first move, what’s the second one, what’s third one, Okay?
How are you going to determine that? What’s the best move at first time?
I’m going to leave this question for you to think about
Okay, you were going to say something Jay?
“If you work backwards then it would make more sense because you know where you’re
going to end up”
That’s right.
So, I want to use ….as example.
If you only have five moves to make, you think about okay where do you want to end up at last move. Right?
And then you’re going backwards, you’re …
So this applies you know similarly.
Okay, so mathematically, that’s how we solve.
We always solve the last stage variable first
So that’s why the chapter is arranged this way.
This is in chapter 7, this is in chapter 8 and this is in chapter 9.
Okay, so basically I’m telling you why those chapters are arranged in that order, okay
Okay, alright so that’s what we’re going to do this week and next week
You know these two weeks but at first, before I introduce to you any theory or rationale
to solve those decisions we need some background knowledge, okay
First, we still have to assume we’re in a perfect competitive market.
Anybody remember the characteristics of a perfect market?
“Um perfect knowledge”
Perfect information.
Yes, what else? “perfect competition”
Perfect competition, what else?
[student murmur] “Like maximum efficiency…” That’s true, that is true but that is not one of the, it’s not one of the characteristics but that is true
“The sellers, they aren’t the cost setters
They are price, price what takers.
They are price takers and not price setters
So each supplier, each firm, takes the price determined by marketing and has to sell the product
at that price
They have no control over what price to sell
And how about market power?
Do firms have market power in that market, no, no market power
Marketing power is the power of charging a higher price without losing all the customers
and in a perfect competitive marker, you don’t have that power.
If you have a higher price you’re going to lose everyone, okay?
So this is the perfect competitive market.
So we’re still assuming we’re in that kind of market right?
Okay so first you know background knowledge I want to introduce to you is called economic,
economic profit
So how do we define economic profit?
For economic profit mathematically is equal to the total revenue minus total economic
Total revenue minus total economic cost
Do we know how to compute the total revenue?
Total revenue, what’s total revenue equal to?
“Income minus expenses” Huh?
“Income minus expense” Total revenue. Do we do expense in revenue?
“Oh no”
We don’t right that is in the cost right.
So what is total revenue equal to?
“The price of x times the demand for x”
Price multiplied
“quantity”
Price multiplied quantity.
P multiplied Q
And then we’re going to talk about total economic cost.
Total economic cost includes two parts
“opportunity cost match startup cost
One of them is opportunity cost.
So total opportunity cost include two parts, okay?
What is two parts.
One part is called out of pocket costs.
Out of pockets costs are costs like overhead costs.
Costs that you have to incur in order to run the business.
Okay?
So that’s part of the total economic cost.
And there’s another cost that has to be included in the economic cost that’s called opportunity cost.
So that’s what’s different, okay?
So let's take a look at the example.
Now we’ll use this example to understand why do we want to know about economic profit.
Once we know the number the value of economic profit, what we can conclude about this business?
Okay so suppose we have two people Sue and Ann who decide to start a business selling turquoise
belts in the Denver airport.
Okay they decide to sell belts in the airport.
To get into this business, they have invest in a fancy pushcart and the price of pushcart is
$20,000
And we assume that if some day they decide to get out of this business, they can easily
sell this pushcart to get the $20,000 back.
Okay this is a very important assumption
And this pushcart comes with all the displays and attachment.
Assume that Sue and Ann estimate that they will sell, estimate they will sell 3,000 per
year at
$10 each
and each, each belt cost them $5 to buy
So and additionally, they had to stuff, the pushcart has to be stuffed by a clerk who
works for annual salary, annual wage rate of $14,000 per year
“so the two of them together purchased all of this”
That’s right. “the $20,000 pushcart”. Yep.
So that’s the set up, okay?
Okay also we assume the interest rate is is current interest rate
is 10% annually.
So two people selling belts in an airport. They have to buy a $20,000 pushcart, they have to hire
a clerk which costs them $14,000 per year.
They assume they are going to sell 3,000 belts, each one they are going to sell at
$10.
And when they bought they belts it costs them $5 each.
Pretty simple right?
Okay so, I want you to use a concept we learned here to answer this question.
Is this business making positive economic profit?
Is this building making positive economic profit or not.
“no”
Okay tell me why and give me some calculations here.
“Well the belts only come up to $30,000 in total revenue.
And the pushcart and the clerk are…”
Okay, what is total revenue? “30,000”
Everybody agrees? $30,000, okay good.
Okay then total economic cost?
What’s total economic cost?
“20,000 for the pushcart”
$20,000 for the push cart
“and 14,000 for the clerk”
“plus the cost of making the belt”
What else?
“Plus the cost of making the belt which is 15 grand, 15,000”
What else?
“3,000”
“Yeah 10% of 3,000”
“3,000”
“$3,000”
Okay, 3,000.
I’m going to put two questions marks here.
So that’s why we want to do example, to analyze what other costs you will need to
include here and what not, okay?
First, what is an out-of-pocket cost?
“pushcart”
“20 grand”
Did I mention assumption?
“yes”
What assumption is
“you can get that money back if you sell it”
So, is that an expense for you
“no”
No.
You have that push cart, that is your asset.
You can liquify that at any time.
That is not an expense because of the assumption.
So, that’s why $20,000 should not be included in the total economic cost, okay
How about $14,000 clerk fee, wage.
Can we get that money back that we paid somebody?
So, that is out of pocket cost.
How about that $15,000 that you buy belts.
Can you get it back?
“no”
When you buy from seller you cannot sell those belts back, right?
So those are out of pocket costs.
Okay.
And the last is its very good that you’re thinking about adding opportunity cost.
So now let’s go back to the concept of opportunity cost.
So what is opportunity cost?
“the cost of the next best alternative”
The cost that you forgo by not making the best alternative choice, right?
So, you have $20,000.
Sue and Ann have this $20,000 to invest.
Now they decide to do this business with that money.
But if they don’t do this business with that money, what can they do with this money?
“they can invest it in a different business”
They can invest in a different business or put it in the bank.
Earning an interest which is how much?
“10 percent”
10 percent of $20,000.
That is?
“$2,000”
$2,000.
So, if they do not do this business with this $20,000 and just simply put this money in
the bank, they can make $2,000 interest every year.
And that’s their, so far, best alternative price.
Because we do not know other business opportunity or the profit they could make.
Assuming there is another option, very easy to see that option that is put money in the
bank, earn interest.
And that will give them $2,000.
So, they give up that $2,000 interest in order to do this business.
So what is opportunity cost of doing this business.
It’s $2,000.
“so if we see a question like this on a test or a quiz,
we should assume that unless otherwise told, putting money into the bank is the opportunity”
Yeah, if I gave you the interest rate, that’s the indication
“Okay” Yeah.
So now you know what should be included in the total economic cost.
Can you calculate what is total economic cost is right now?
“$31,000”
$31,000.
Now can you tell me what is total economic cost?
Oh no no no.
The total economic profit?
“They only make the …”
So following the formula here, what is the total economic profit?
Negative?
How much?
“16,000”
This minus this is equal to what?
“oh I’m sorry, I was using the”
“it’s 1,000”
“1,000, negative 1,000”
This business making negative economic profit.
What does this tell you?
“They should invest in something else”
Very good.
So all this tells you is, they should not invest in this turquoise belt business.
But does it tell you whether this business is making money or not.
No.
This is business actually is making some money.
How much money are they making annually?
“$30,000”
How much profit they make.
“nothing”
Each year.
Look at the number there.
Number tells you that.
The total revenue is $30,000.
This is money, if we don’t include this opportunity cost, this is really what you
have to pay, right?
Out of pocket, right, that’s $29,000 right?
So every year, how much money you take home?
“$1,000”
$1,000 for those two people.
So they’re making money, they’re not losing money.
So this total economic profit does not tell you whether this business is making money or not.
But, it tells you that compared to the best alternative choice, it is a worse one
“they’re losing $1,000”
That’s right.
Yeah.
If they’re making the best alternative choice, they can make $2,000.
Instead of $1,000.
So that’s why it come out as negative number.
So that’s what total economic profit tells you.
It tells you whether it’s worthwhile doing this business.
It does not tell you whether you’re making profit or not.
Alright?
So. Now I'm going to ask this question here.
What would be the interest rate that will make the economic profit equal to zero?
And when economic profit equal to zero, what does it mean?
Hmm?
“It’s in the good”
It’s good.
And actually you’re indifferent, right?
You’re indifferent between doing this business and putting money in the bank, right?
That’s when economic profit equal to zero.
So what does the interest rate have to be in order for the economic profit to be zero?
The interest has to be $1,000 right?
If the interest has to be $1,000 per year, what would be the interest rate?
“Five percent”
Five percent, right?
If the interest rate is five percent, then the economic profit in the situation would be equal
to zero.
Okay.
So, when the interest rate equal to five percent, what you have is this.
Then we give a name to this five percent.
We can this normal rate of return.
What is normal rate of return?
Normal rate of return is rate of return that make you just satisfied with what you’re doing.
So basically normal rate of return will give you zero economic profit.
So if, and I’m going to ask you a question in another way.
So if a business is making a normal rate of return is this business making money?
“Yes”
Yes, that’s right.
“But they’re not making any economic profit.”
That’s right.
But they’re making money.
So that’s the first background I want to introduce to you is economic profit and normal
rate of return.
And we’re going to come back to the concept.
So, that’s number one and two the next concept.
There are some practice questions in my econ lab for this.
Normal rate of return and economic profit.
“when are you gonna open up that homework?
Or is it already open? Yes.
If I don’t do it, then remind me.
Okay so the concept I want to introduce is about a different time period that we use
in order to analyze a firm’s decision.
Short run and the long run.
Okay.
We analyze a firm’s decision in this two different kind of time periods.
One is short run, one is long run.
Why do we want to do that?
Think about it.
If you start a business that’s you know let’s continue using the restaurant as an example.
And you put a lot of money into this restaurant business by you know buying all the equipment,
tables, utensils and you store everything it’s a big investment in the beginning.
Do you expect to get all that money back in the first couple years?
“No”
No.
So the first couple of years, which we would call short run, those costs which actually
we would call the fixed costs are not your primary concern.
What’s your primary concern in this restaurant in the beginning?
“staying afloat”
As long as your revenue, your daily revenue, or monthly revenue covers your expense overhead.
Let’s say you utility and the wage you know for the staff and the cost of material
As long as your revenue covers those kind of costs, then you’re happy, right?
You can continue to run this business.
So in the short run, your concern, your primary concern is different from long run.
But if, let’s say you are five years into your business of course you start thinking
about have I got all my initial investment back, right?
So within the long run, long period of time, your concern has changed.
Has switched from those daily expenses covering daily expenses to covering …daily expenses
and fixed cost.
So that’s why we want to analyze firm decisions in both these two different time period.
Because their primary concerns are different.
So that’s the reason, okay
But then you may ask me, how do we differentiate the short run and the long run.
Is two year, three years, short run or four year long run.
How do we determine that?
Again, this is really this is a subjective question actually.
It is subjective. There is no absolute answer for any kind of business, okay.
But concept here is, you know, and as a business owner you will know at certain time you’re
going to start thinking about covering fixed costs
Okay, and then your concern will start switching and your decision will change following that.
So that’s why we differentiate short run and long run.
Okay, so in order to talk about firms decision in short run long run, we going to let’s
say assume a couple of things, okay.
In the long run, okay.
You’re trying to cover all the costs, you can lots of things in the long run and you
can even get out of this business after five years or six years if you’re still not covering
bit of your fixed costs you know, you’re not having the gross rate that you expected.
You’re probably thinking, maybe, maybe I should get out of this business.
So in the long run, you can exit the business, exit market.
So exit is a decision you can make in the long run.
However, in the short run, nobody wants to shut down their business within the first
couple of years.
You want to give it time for the business to grow.
You want to give it time for the customers to get to know this business.
So usually, exit decision is not decision is not even a choice variable for the firm in
the short run.
Okay, so no exit.
Okay, so that’s one difference. And another difference is this.
After you start everything build your business and you’re going to keep that kind of business
in the first couple of years.
Nobody wants to let’s say they open a showgun in Lumberton and then in one year they say
Im going to change the location and change it to Pinecrest.
No one is going to do that, right?
Or in a year they say Im going to expand it you know even bigger.
Unless this business is going really crazy, you know, nobody wants to do that right?
So in the short run, you not really changing your scale or location of the business.
You’re not changing those kind of fixed input factors, okay.
But in the long run, anything can happen.
You may change the location, you may shrink the business, you may expand the business
and you can change all this kind of things.
So in the short run, we assume no exit and also in short run we assume the capitol gross,
capital input are fixed.
So basically this indicates that you know we’re not changing the scale of the business
so that’s what we, how do we differentiate the short run and long run.
So in the short run, really you’re just going to concern about okay how much sale will take
place each month and will that sale cover my overhead costs.
Okay, so.
Alright so now we’re going to start with the short run decision, okay?
So we’re going to start with short run.
Short run analysis.
And I’m going to introduce to you a few more concepts here and one is called the total
total product.
And then I'm going to talk about
average product and I will talk about marginal product.
Total product adjust total output.
And here we assume that there are two kinds of inputs that will be employed or used in
order to make this production.
Two kinds of input.
One is what we call the capitol input and the other one is called labor input.
So basically we simplify the inputs all the input into these two categories.
The first one is capitol input and the second one is labor input.
Labor input basically is how many workers you hire, okay.
So there’s kind of inputs okay.
Where in a short run capitol input affects and only changing variable
is the labor input is changing, okay
You guys with me? So total product we’ll just say this is the total output.
You can use q to represent it.
Or you can use tp to represent it.
They are the same thing.
Average product has to in relationship with one of the input.
So in short run analysis capitol input is fixed and average product here we can just
say average product of labor.
So average product of labor is computed this way.
Is equal to total product divided by the labor units.
Labor input we us L to represent it.
Capitol input, we use K to represent it.
So this is the formula here.
Last one, marginal product.
Again, it has to be in a relationship with one of the input we use labor.
Marginal product of labor is equal to this.
Change of total product divided by the change of labor.
So what this means here is when you change your labor by one more unit, what is the change
of your total product.
So if I increase, I employ one more waiter or waitress, how many more sells that will
happen.
That’s what marginal product labor and labor means what is total product each worker will
produce on average.
So this is average marginal and total.
Next I am going to show you the graph, show you the relationship among those with respect
to.
But why do we want to do that.
Let’s think about those, total product, average product of labor, marginal product labor.
They all are measurements of productivity, they all are measurements of productivity.
We use those things to tell us how productive your business is right now, okay?
So each one tells you something about productivity.
That’s why we’re interested in all of them.
I’m going to show you the picture of the first one that I want you to think about what
is the relationship.
Second one and
So the first one total product was labor.
Look at that graph there and I want you to tell me why you think this total product increase
with labor has that kind of pattern has that kind of shape.
In the beginning we call convex shape this is called concave shape.
Why it has these two different shape at the beginning and after.
After we talk about that I will stop you.
Why?
This part here at the beginning is increasing with increasing rate or is it increasing with
decreasing rate?
“increasing rate”
Increasing rate.
So this part here is increasing with increasing rate and this part here is increasing with
a decreasing rate.
So if we just look at shape it tells us the output increase very fast at the beginning
when you hire more and more workers.
But after a certain point, its still increase but the speed of increase slows down every
time you increase another worker.
Why is that?
[student murmur]
That’s right.
So the idea here within the short.
If we’re in a short run, we have a fixed capitol input which means the scale of the
business is fixed, right?
The size or scale of the business is fixed.
When those things are fixed, you have fixed capacity of production.
You have the fixed capacity to accommodate certain number of workers.
For diner, it can only accommodate at most three workers.
That’s the most they can accommodate.
And at the beginning when you don’t have enough workers every time you hire an additional
one then you’re really going to see a dramatic increase of your revenue or your production.
But after you reach that limit, after you exhausted all your production potential within
that scale then if you want to keep increasing, then the increase of your produce is going
to decrease.
And at a certain point it may go down, okay.
So the reason of this shape here is due to this assumption because we have fixed capitol
input Because the scale the size of business is fixed.
Because production capacity is fixed.
If that can be relaxed if the business can spend if the scale can increase of course
you can increase, you can have more and more workers work for you and still enjoy the benefit of
the increasing rate.
But since we’re in short run, we’re not changing the scale.
And for each scale it can only accommodate certain level of input comfortably.
So that’s why that has this increasing shape and decreasing, Okay?
And in fact, product labor and marginal product labor there’s two other productivity measurements
also based on this same idea.
Okay?
Based on this same idea here.
And I’m going to tell you the shape and we’re to talk more next time.
So, for these two is that.
So at the beginning, average product labor increases marginal product labor increases.
So that tells you okay productivity increases okay.
But after certain point, the productivity goes down again for the same reason.
Okay due to the same reason, you know you have a fixed scale you have fixed production
potential.
You can only accommodate certain level of input comfortably.
Okay?
Alright so.
Now I’m going to
put APL and so this is abbreviation of this is APL abbreviation of
this is MPL.
So if we put them together here, APL is this and MPL is this.
So that’s the relationship between the APL and the MPL.
Now I’m going to ask you to look at this graph and answer the following questions for me.
If APL is greater than MPL is MPL increasing or decreasing?
If business is employing a level of input at level that satisfies that MPL is increasing
or decreasing?
“increasing”
Increasing, decreasing?
“increasing”
Somebody said decreasing, somebody said increasing.
How do you see that?
When is the stage or period that APL is going to.
I’m going to divide these two apart.
Lets say this is L zero.
Before L zero, APL graph is above MPL.
What happens when MPL increases.
And after this level MPL is APL and MPL is decreasing.
So this is the relationship between the two productivity measurements.
The very last thing just very small thing here.
I’m just going to draw MPL okay.
And we use MPL value to divide whole production into three stages.
Stage one stage two and stage three.
Most of the businesses will follow this stage.
But with the internet booming or the internet and social media new technology coming into
the market place, this may not follow.
Traditional business change here.
What is stage one.
At stage one, when you increase your labor or employment, your marginal product of labor
increases, okay?
So as you hire more and more workers, your marginal productivity increases.
At stage two, after you hire certain number of workers which is in stage two.
At stage two, MPL marginal productive labor is decreasing but is still positive.
So which means every time you higher an additional worker, your total product, your total output
still increases but it isn’t increasing speed, it’s becoming smaller and smaller.
So you’re still enjoying the more product due to additional hire.
But that marginal you know increase it gets smaller and smaller.
So that’s the second stage.
So stage three.
If you keep employing more workers, you’ll reach stage three.
At stage three, your MPL marginal productive labor is decreasing not only that actually
become negative.
So what is tells you that now you’ve hired another worker, there’s too many people
working at small place.
You’re getting too confident, your output goes down, your sale goes down.
And your cost goes up.
Your management cost your conflict resolving cost goes up and then that cost you sale goes
down, your revenue goes down.
So you as a business you really should should not get into stage three but no business knows
exactly where it stops.
So sometimes what we see is back and forth switch but eventually they will figure out
where to stop.
So this is a general trend for kind of traditional business.
Any questions here?
Okay so that’s what I want to cover in majority of chapter 7 okay?
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