Unit 2.3.1 Costs of Production: Team Presentation Activity

Learning Objectives:

• Distinguish between fixed and variable costs of production
• Understand how the law of diminishing returns affects the shape of a firm’s short-run total costs and short-run average costs.
• Understand the relationships between marginal cost and the average costs faced by a firm
• Distinguish between the short-run and the long-run and understand how economies of scale determines the shape of a firm’s long-run ATC curve.
• Evaluate the importance to a business firm of understanding its short-run and long-run costs of production.
  

Success Indicators: Each team will create one Google Doc Presentation on costs of production. The two presentations that are created will be shared among group members, and edited as a team in class and over the weekend. Next week both teams will share their presentation with the class, and share them so that everyone can use the presentations to study for next week’s test on Costs of Production.

Process:

1. Place students into four teams.
   • Teams 1 and 2 will research and prepare a presentation on Short-run Costs of Production
   • Teams 3 and 4 will research and prepare a presentation on Long-run Costs of Production
   • Teams will work independently. On presentation day, a team presenting on short-run costs will partner with a team that did long-run costs and combine their presentations into one. Ultimately, two presentations will be submitted to Mr. Welker for review.
2. One person from the table will go to the website: http://docs.google.com/
3. That person should log in to Google Docs using his/her Google account
4. Once logged into Google Docs, select “Presentation” from the “Create New” drop-down menu. Title the presentation either “Short-run Costs of Production” or “Long-run Costs of Production”. Include teammates names on the first slide.
5. Next, the person who created the Presentation must invite his/her teammates to the presentation so everyone can contribute to it. Go to the upper right hand corner of the screen and click “Share” and “Invite people”. Enter the email addresses of your teammates and make sure the bubble “to edit” is selected. Click “Send”.
6. All teammates must check their email and make sure they received an invitation to edit the presentation. If you do not have a Google account, you may need to create one to get access to the document.

The assignment: Each team is to make one Google Presentation on an assigned topic based on what they learn using the web-resources provided by Mr. Welker below. Presentations will be shared with Mr. Welker and presented to the class on Tuesday, December 1.

Guidelines for presentation:

1. Presentations must be at least 10 slides long, but no more than 15.
   
2. Presentations must include definition, explanations, illustrations and examples (when possible) for the key concepts identified below
3. Presentations must include graphs from the resources provided to illustrate concepts where necessary
4. Presentation must use each group’s own words. Copying and pasting text from the resources provided is not permitted.

Teams 1 and 2 – Key Concepts

• Short-run
• Total, average and marginal product
• Law of diminishing returns
• Short-run total costs
• Short-run marginal and average costs

Teams 3 and 4 – Key Concepts

• Long-run
• Long-run Average Total Cost
• Economies of scale/Increasing returns to scale
• Minimum efficient scale
• Constant returns to scale
• Diseconomies of scale/Decreasing returns to scale

Teams 1 and 2 – Resources on Short-run Costs of Production:

• Course Companion pages 73-79
  
• Unit 2.3.1 Study Guide
• Wiki page – Economic Costs
  
• Calculating total costs – BizEd
  
• Wiki page – Short-run Production Relationships
  
• Wiki page – Short-run Production Costs
  
• WW Blog – Diminishing Returns and graphing short-run costs (Read and respond to the discussion questions as a table group)
• Biz-Ed PowerPoint on short-run costs (slides 1-28)
  

Teams 3 and 4 – Resources on Long-run Costs of Production:

• Course Companion pages 79-83
• Unit 2.3.1 Study Guide
• Wiki page – Economic Costs
• Wiki page – Long-run Production Costs
• Biz-Ed PowerPoint on long-run costs (slides 29-57):
• WW Blog – Economies of scale and the long-run ATC (Read and respond to the discussion questions as a table group)
• Biz-Ed – Economies of scale in farming
• Biz-Ed – Economies of scale in fishing

Grading Presentation: Total – 40 marks

Look closely at the two cost curves below:

The curve on the left is a firm’s short-run average total cost curve. The one on the right represents a firm’s long-run average total cost curve. See the difference?

I didn’t think so. The shape of a typical firm’s short-run and long-run ATC curves may in fact be identical. But there are some very important differences to understand about the short-run costs and long-run costs faced by firms.

The Short-Run: In microeconomics, we define the short-run as the period of time over which a firm’s plant size is fixed. The only variable resource is labor and raw materials, meaning that when demand increases for a firm’s product, the firm is able to increase employee work hours, hire more workers and use existing capital more intensively, but it does not have the time to acquire new capital or expand factory size. Likewise, when demand falls for a firm’s products, it can cut back on work hours, fire workers, but cannot downsize its plants or factories.

The Long-Run: The long-run is defined as the variable-plant period. A firm can adjust the number of all its inputs: land, labor and capital. One way of thinking about the difference between the short-run and the long-run is imagining the long-run as several different short-runs spread out over a larger range of output. The graph below will illustrate this concept for you.

When we examine the long-run ATC more closely, it becomes apparent that there are in fact lots of little short-run ATC curves along the length of the long-run curve. Each of the gray lines in the graph above represent a short-run period in which this firm opened a new factories. There are three distinct phases of this firm’s long-run ATC:

• Economies of scale: As this firm first begins to grow and open new factories, it becomes better and better at what it is producing, is able to get more output per unit of input, and thus experiences lower and lower average total costs as it grows larger. “Scale” is a synonym for size. The bigger the firm’s size, the lower its costs of production: this is called “economies of scale”. My favorite illustration of the concept of economies of scale is to think about two shoe companies: Nike and Luigi’s Fine Italian Shoes. Nike makes shoes in giant factories in Indonesia, ships them in giant containers to all corners of the world in shipments containing 100,000 shoes each. Luigi makes shoes in his basement in Milan, has two employees, and ships shoes one at a time to customers around Europe. Who will have a lower average total cost of producing shoes? Luigi or Nike? Clearly, Nike has economies of scale, Luigi does not. If Luigi were to grow his business, chances are his average total costs would decline.
• Constant Returns to Scale: For the firm above, economies of scale assure that the larger it becomes, the lower its average total costs get. Efficiency in production improves whether through the lower price of inputs achieved through bulk-ordering, its ability to attract and hire skilled managers, the lower per unit cost of shipping larger quantities of products, or other such benefits of being big. At a certain point, however, the benefits of getting larger begin to diminish. This firm’s tenth factory is its minimum efficient scale: The level of total output this firm must achieve to minimize its long-run average total cost. Beyond this level of production, as this firm continues to grow, it will see no further cost benefits; in other words, it will achieve constant returns to scale (size).
• Diseconomies of scale: Why did the Mongol, the British and the Soviet empires collapse? Some historians argue it was because they became too big for their own good. When an organization (whether it’s a country or a firm) becomes TOO big, it begins to experience inefficiencies. When a firm grows so large that it has factories in all corners of the world, a dozen levels of management, and countless opportunities for corruption and miscommunication, its efficiency decreases and its average total costs begin to increase. In the 1980’s General Motor Company began to lose lots of business to smaller Japanese rivals. The outcome was the gigantic corporation broke up into smaller divisions, which then began to operate as different firms. For a while, GM remained competitive, partially because as a smaller firm, it was more efficient and able to compete on cost with its foreign rivals.

Diminishing Returns versus Economies of Scale: A common area of confusion for economics students is the difference between these two seemingly similar concepts. The difference lies in the two curves above, the short-run ATC and the long-run ATC.

• The shape of short run costs (MC, ATC and AVC) are determined by the law of diminishing returns. Since short-run costs are determined by the productivity of the variable resource in the short-run (labor), diminishing returns assures that at first, since a firm can expect to get MORE output for additional units of labor (as fixed capital is used more efficiently) ATC declines as output increases. But beyond a certain point, diminishing returns sets in and the additional output attributable to more units of the variable resource declines. Inevitably, a firm will experience higher and higher average costs as its output continues to grow, since it’s only able to vary the amount of labor used, not capital.
• The shape of long run ATC is determined by economies of scale (and diseconomies of scale). All resources are variable in the long-run, but lower costs cannot be guaranteed the larger a firm gets. At first, efficiency is improved as the firm grows, but at some point it becomes “too big for its own good” and costs start to rise as productivity of resources (land, labor and capital) is inhibited due to the firm’s massive size.

Discussion Questions:

1. What does it mean that a firm can become “too big for its own good”? Can you think of any other organizations (economic or otherwise) that have gotten so big that they’ve failed?
2. Why does your hometown have only one electricity company? Why aren’t utility industries such as water, natural gas, and garbage collection more competitive? How does the concept of economies of scale lead to certain industries being “natural monopolies”?
3. Why don’t more companies make jumbo jets?

YouTube – Econ Concepts in 60 Seconds: The Law of Diminishing Marginal Returns

Mr. Clifford, an AP Economics teacher from San Diego, demonstrates the law of diminishing returns by deriving a total product and marginal product curve using production data from a student’s lawn mowing business.

Econ Concepts in 60 Seconds: The Law of Diminishing Marginal Returns The video above is most useful to Econ students because it enforces the Law of Diminishing Returns. The more important application of this basic economic concept, however, is the short-run per-unit cost curve, Marginal Cost, Average Variable Cost and Average Total Cost. Mr. Clifford offers his quick explanation of the relationships between a firm’s short-run costs in the following video.

Econ Concepts in 60 Seconds: Per Unit Costs Curves

Discussion Questions:

1. Mr. Clifford derives a Marginal Product Curve in the first video and a Marginal Cost Curve in the second video. What is the relationship between the marginal product of a firm’s variable resource and the firm’s marginal cost of production? How are the shapes of both these curves determined by the law of diminishing marginal returns?
2. Why does a firm care about its costs of production? Which of the four per-unit cost curves in the second video would a firm be most concerned with when determining whether or not it is earning profits or losses?
3. What can cause a firm’s cost curves to shift up or down? How would a shift of the cost curves affect a firm’s profits?
4. What is the primary economic goal of firms, and how can understanding their short-run costs of production help them achieve this goal?

Why Are Large Companies Losing More Jobs Than Small Ones? – TIME

This is a fascinating, short article from TIME. Before reading it, see if you can answer the multiple choice question below:

Q: Why do small companies lay off proportionately fewer workers during a recession than large companies?

A) Because small firms are less likely to be in the industries hardest hit by a recession (such as manufacturing)?
B) Because small firms are less focused on maintaining profits to satisfy greedy shareholders?
C) Because small companies are able to hang on to employees and even hire new ones during a recession because of all the talent being laid off by big firms.

Still thinking? Well, it’s likely that all three are true to some extent. But it’s the third one that seems most intriguing as a student of economics. Here’s what the article says:

…small companies hire disproportionately more early on in an economic recovery because it’s easy for these firms to find good workers while unemployment is still high—and easy for workers to come across small companies since there are so many of them. Once the economy is chugging along at full-steam and the labor market is tight, larger companies regain the advantage, since they’re likely able to offer more money—and poach from smaller outfits.

Seems pretty straight forward, right? Sure, but the fact that small firms are likely to hire when unemployment is high supports one side in a long-running economic debate over the economy’s ability to “self-correct” in times of recession.

As any student of Macroeconomics learns early on, there are two dominant theories of macroeconomics, both which are represented in the aggregate demand/aggregate supply diagram that we learn and use in AP and IB Economics.

The two models below represent the two opposing views of macroeconomics. First we see the Keynesian model, which shows that when overall demand in an economy falls, unemployment increases drastically and output tanks, plunging the economy into a deep recession. This is primarily because of the “inflexible” nature of wages, meaning that even when unemployment rises, workers are unwilling to accept lower wages and firms therefore are unwilling to hire more workers.

According to Keynesians, the only way to get the economy out of the recession is by increasing overall demand through heavy doses of government spending (case in point, the $775 billion stimulus in the US).

Next is the Classical AD/AS model with a vertical long-run aggregate supply curve. The implication of the vertical AS curve is that regardless of the level of overall demand in the economy, output will always return to the full-employment level, and thus unemployment will always return to its natural level. The major assumption underlying the Classical model is that wages are in fact flexible in times of recession. As unemployment rises, workers will accept lower wages since they’d rather be making less than making nothing at all. As wages fall firms will begin hiring more workers, increasing overall output and decreasing unemployment until full-employment output is restored.

The implication of the model on the right is that government is NOT needed to get the economy out of a recession, because it will self-correct due to the new hiring and production by firms in response to falling wages in the labor market.

The reason this article stood out to me was that it seems to offer some evidence in support of the flexible-wage, Classical model of macroeconomic self-correction. There has been surprisingly little talk among news anchors, pundits and politicians about the likelihood of the US or ANY economy suffering in the global slowdown “self-correcting” as the Classical model would suggest it should. But the fact that small businesses are less likely to lay off workers in a recession and more likely to begin hiring them due to the large number of workers being laid of by big companies offers at least an inkling of evidence in support of the Classical model of flexible wages and macroeconomic self-correction.

Discussion Questions:

1. Why is laying off workers the first thing big companies do when faced with falling demand for their products? Why don’t they shut down factories instead?
2. What pressures does a publicly traded company (one that sells stocks to investors) face in times of recession that a small, privately owned business does not?
3. When the global recession is finally over, do you think more people or fewer people will be working for small companies (less than 50 people) than before the recession? What would you rather work for, a small firm or a large one? Why?

Does the Economy Self-Correct? – Welker’s Wikinomics Page

The debate in Washington over Obama’s fiscal stimulus package, which has now been re-written by both the House and the Senate, is ultimately one of the validity of orthodox economic theories. By voting for a nearly $1 trillion government spending bill, the Obama administration and Congress are clearly taking the position that an economy in recession will either not be able to correct itself, or will take too long to self-correct, thus the government is needed to accellerate the recovery process.

Washington’s stimulus package presents students and teachers of economics with an all too rare opportunity to put to the test the two competing hypotheses of macroeconomics: the Demand-side Theory versus the Supply-side Theory.

At the core of the long-running macroeconomic debate is the simple question, “Does the economy self-correct in times of recession?” The supply-side theory, attributed to the “classical” economists dating back to Adam Smith and David Ricardo, argues that the answer to this question is YES. The rationale between this laissez faire approach to macroeconomics is the following:

1. Falling demand in an economy means less output by firms, forcing them to lay off workers.
2. As inventories build up due to their inability to sell their output, firms will be forced to lower their prices, putting downward pressure on the price level in the economy (deflation).
3. High unemployment and falling prices eventually lead to workers in the economy being willing to accept lower wages.
4. Weak demand for commodities such as oil and minerals put downward pressure on raw material and energy prices faced by firms.
5. Falling wages and raw material prices mean more potential for profits for firms in various enterprises, even as overall demand in the economy is weak. Firms begin hiring workers at lower wages, and increase production to take advantage of lower input costs. Overall supply of goods and services in the economy begins to increase due to lower costs faced by firms in all sectors.
6. The downward spiral caused by weak aggregate demand, rising unemployment, falling prices for output, falling wages and commodity prices, is eventually reversed and turns into an upward spiral as firms hire more workers, employ more resources, creating more income and spending, moving the economy towards recovery and economic growth.

The supply-side theory of self-correction (so called because recovery results due to an outward shift of aggregate supply) outlined above depends on the downward flexibility of wages. If wages do NOT fall, as some demand-siders propose, then the idea that firms will eventually begin to hire more workers is busted, and unemployment will only continue to increase as overall demand remains weak.

Today, there is some evidence that wages in the United States may in fact be downwardly flexible.

GM Slashing 10,000 White-Collar Jobs, Cutting Pay – washingtonpost.com

…the base pay of higher-level U.S. executives will be lowered by 10 percent, while other salaried employees will face cuts of between 3 and 7 percent.

General Motors employees are beginning to accept lower wages. Rising unemployment, especially in the white collar sector, mean that the number of highly educated and skilled American workers unable to find work will grow as corporate layoffs continue.

A “shovel-ready” stimulus package from Washington may indeed help to “create or save” 3 million jobs, as Obama claims, but it is the self-correcting nature of markets due to flexible commodity prices and wages that will ultimately contribute to a recovery of the US economy. As prices of commodities fall, combined with lower wages for white collar workers and deflation in the overall economy, firms will find it profitable to begin employing resources at their lower costs, putting people back to work, stimulating spending through market forces.

Fiscal stimulus may accellerate the recovery process, but the threat it poses is the same threat posed by all forms of government intervention in the free market: that the nearly trillion dollars will go towards satisfying the priorities of politicians rather than the wants and needs of society as a whole, resulting in a misallocation of the nation’s resources towards goods, services, and infrastructure projects that are chosen by legislators, not the market itself. Stimulus is needed, but only the right kind. The recognition by politicians and the media that markets may also self-correct is also needed. News like GM’s wage cuts may sound dire, but the underlying implication of falling wages may be a sign that the US economy is already on the path to recovery, even before Washington has spent a single dollar on stimlus.

Professor Preston McAfee on Price Discrimination

(you must have RealPlayer to view this video. Mac users can download it here)

CalTech Economics professor Preston McAfee is an expert on prices. His research spans three decades and examines the pricing behavior of firms in various market structures. In the lecture linked above the professor shares several examples of firms practicing price discrimination. I was surprised to see that many of the examples he discusses are ones that I have been using in my own lectures on price discrimination for the last few years.

McAfee presents a mathematical formula for monopoly pricing, which no AP or IB text that I’ve seen has included:

Monopoly Price = [PED/(1-PED)] x MC where PED is the price elasticity of demand of the customer and MC is the firm’s marginal cost of production.

The basic idea is that the more inelastic the customer’s demand, the higher price the monopolist should charge over its marginal cost. The implication, therefore, is that a monopolist prefers to charge higher prices to customer’s whose demand is inelastic and lower prices to customers who are “price sensitive” or whose demand is elastic. The charging of different prices to different consumers for the exact same product is what economists call price discrimination.

McAfee begins talking about price discrimination at minute 8:44 in the video. His examples include:

• Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
• Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
• Grocery stores: Offer coupons to price sensitive consumers (people whose demand is inelastic won’t bother to cut coupons, thus will pay more for the same products as price sensitive consumers who take the time to collect coupons).
• Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
• Dell Computers: Dell price discriminates based on customer answers to questions during the online shopping process. Dell charges higher prices to large business and government agencies than to households and small businesses for the exact same product!
• Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don’t even bother to ask.
• Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don’t bother to ask.
• Damaged goods discounts: When a company creates  and sells two products that are essentially identical except one has fewer features and costs significantly less to capture more price-sensitive consumers.
• Book publishers: Some paperbacks cost more to manufacture but sell to consumers for significantly less than hard covers. Price sensitive consumers will buy the paperback while those with inelastic demand will pay more for the hard cover.
• Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a roundtrip ticket that departs and returns during the week.

McAfee also goes into a fascinating discussion of price dispersion which is essentially a theory of oligopoly pricing. All Econ teachers should watch this video and find examples of price discrimination and oligopoly pricing that they can incorporate into their own class.

If you’re up for a challenge, try deciphering some of the mathematics in McAfee’s free, downloadable intro to economics text, available here.

Automakers turnaround plans sent to Congress – Dec. 2, 2008

…and hopefully every other American with a functioning cerebral cortex. Ford Motor Company announced today its ambitious plan to cut costs and restore its profitability as it appeals once again to Washington for a $25 billion “low-interest bridge loan” (aka bailout).

The company announced that the salary of Ford CEO Alan Mulally would be cut to $1 a year if Ford actually borrowed money from the government. When Mulally appeared before the House Financial Services Committee last month, he did not agree to the suggestion of such a paycut…

Ford and GM also announced plans to get rid of corporate jets. Mulally, Wagoner and Nardelli were all roundly criticized at a House hearing last month when they admitted they had each flown their corporate jets to Washington to ask for help…

Mulally and Wagoner will be driving to Washington in hybrid vehicles made by their companies when they return to Capitol Hill later this week to make their case for loans. Nardelli is also not planning to fly to Washington but Chrysler has not disclosed any more specifics of his travel plans.

So the CEOs of the three largest auto companies are agreeing to be exploited for one year by accepting a salary of one dollar. The combined savings from the salary cuts of the three companies’ CEOs  equal roughly $6 million, or about 0.024% of the sum the companies are asking for from the government. Selling corporate jets during a recession when demand for such frivolous luxuries is at a record low will also do little to cut the costs of the incredibly inefficient US automakers.

As for any serious cost cutting plans, Ford had little to report:

…the Ford plan is perhaps most notable for what it did not include. The company did not mention that it would be dropping any brand or unprofitable models…

There was also no announcement of additional plants being closed or capacity being eliminated. Ford said it continues to work with its unions and dealers to achieve additional savings, but it did not set any cost savings targets for those discussions.

Ford highlighted many of the cuts it has already made, including closing 14 plants and reducing salaried personnel by 36% over the past three years. The company also touted labor cost savings that would bring the cost of factory workers’ pay and benefits close to those of the nonunion U.S. plants operated by Asian automakers

Real cost savings will only be achieved by the further closing of plants. With the economy in a deep recession and auto sales at their lowest in decades, the demand for new cars is just not there. Until Ford and its American competitors begin adjusting their plant capacities to the realities of market demand, the chances of achieving profitibility seem slim.

Allow me to make a connection between the situation faced by American auto makers and a basic economic concept we are currently studying in Microeconomics class. Firms, as any first year econ student knows, are profit maximizers. In fact, all companies are trying to make the same thing as all other companies, profits. When a firm experiences negative profits, or losses, as American auto makers are today, it can do one of two things to restore profitability: 1) Increase its revenues or 2) Lower its costs. Since demand for new cars is so low, the revenue increasing option is just not there, so American auto makers must reduce costs to restore profits.

There are two main types of costs we study in microeconomics. Short-run and long-run costs. In the short-run, which in the case of the auto industry we can consider the last few months since the financial crisis began, firms can do one thing to lower their costs: reduce the use of labor. Workers can be asked to take unpaid vacations, jobs can be eliminated, work hours can be cut back. In the short-run, plant size is fixed, meaning firms cannot add nor eliminate capital and land resources. The only variable resource is labor. By “reducing salaried personnel by 36% over the past three years” Ford has taken steps to lower its short-run costs of production.

Long-run costs must also be considered when firms are faced with negative profits. The long-run in the automobile industry is considered the period of time over which auto makers can either add new plant facilities or shut down existing facilities, lowering the costs of capital and land to firms. Long-run cost reductions have also been undertaken by Ford, including “closing 14 plants… over the past three years”.

Clearly, Ford has made an effort to reduce short-run labor costs and long-run capital costs by eliminating some of its work force and closing some of its factories in recent years. But today, as the US officially enters what is likely to be a deep, long recession, the announcement by Ford and its competitors that its new strategy for further cutting costs hinges on paying its CEOs one dollar and making them travel across the country in hybrid cars represents a laughable insult to the intelligence of high school Econ students.

Discussion Questions:

1. What is the “variable resource” that firms can use less of in the short-run if cost reductions are needed?
2. In Microeconomics, we sometimes refer to the long-run as the “variable plant period”. Explain the meaning of this concept.
3. The law of diminishing marginal returns would indicate that if Ford were to close additional factories, it would almost certainly have to simultaneously lay off thousands of additional workers. What is the law of diminishing marginal returns and why does it require firms to lay off workers as plants are closed?