Archive for the 'Law of diminishing returns' Category

Nov 24 2010

Lesson Plan: Costs of Production Presentation for Y1 IB Economics

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.

Process: Work with a partner in the class to prepare a presentation on the theories behind and the relationships between a firm’s short-run and long-run costs of production. Pairs will create a shared Google Presentation (which should also be shared with Mr. Welker) and collaborate on creating a presentation demonstrating your understanding of the topics outlined below. The presentations that are created will be shared among group members, and edited in class and over the weekend.

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 during our first meeting next week.

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.

Shor-run – Key Concepts

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

Resources on Short-run Costs of Production:

Long-run: 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

Resources on Long-run Costs of Production:

Grading Presentation: Total – 40 marks

Area of assessment

High marks (7-10)

Medium marks (4-6)

Low marks (1-3)

Organization Easy to read. Font size varies appropriately. Text is appropriate length. Presentation falls within the required length limits (10-15 slides) Overall readability is difficult. Too much text. Too many different fonts. Presentation falls within the required length (10-15 slides) Text is difficult to read. Too much text. Inappropriate fonts. Small font size. Presentation is either too short or too long.
Graphs All graphs are related to content. All graphs are appropriate size and good quality. Graphics are explained clearly and illustrate the concepts from the presentation Some of the graphs are unrelated to content. Too many graphics on one page. Some of the graphics distract from the text. Graphs are explained, but explanations are incomplete or unclear Most of the graphs are unrelated to content. Too many graphics on one page. Most of the graphs distract from the text. Explanations are incomplete and unclear
Concepts The economic concepts that were assigned have been completely and accurately incorporated into the presentation. Definitions, explanations, illustrations and examples fully reflect the team’s understanding of the concepts The economic concepts assigned are all addressed in the presentation, but analysis is superficial and lacks original insight from the team members. The economic concepts assigned are not all addressed in the presentation. One or more have been left out completely, and those that were addressed were explained or illustrated incorrectly.

Mark Bands:
27-30: A, 23-26: B, 19-22: C, 15-18: D, 0-15: F

13 responses so far

Nov 22 2010

From short to long: Economies of scale and the long-run average total cost curve

Look closely at the two cost curves below:

srATC

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.

lrATC

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?

78 responses so far

Nov 16 2010

Lesson Plan – Testing the Law of Diminishing Marginal Returns in a Paper Chain Factory

The law of diminishing returns is a basic microeconomic concept that explains how a firm’s costs of production change in the short-run as it varies the amount of labor employed. As workers are added to a fixed amount of capital, the productivity of additional workers decreases beyond a certain point due to the lack of available capital.

To test the law of diminishing returns, it is possible to create a factory floor right in your own classroom. Follow the instructions below to determine whether the law applies to your own imaginary firm.

Introduction: Your classroom is about to turn into a factory that manufactures paper chains (to hold paper anchors for paper boats, of course!). A paper chain is made by taking two long, narrow strips of paper, folding one into a ring and stapling the ends together, then folding the other into a ring and connecting it to the first ring to make a chain. Two loops of paper stapled together make a chain. The longer your chain, the more productive your factory and its workers are. The goal of your paper chain factory, of course, is to make the longest chain possible in a fixed amount of time using a fixed amount of land and capital, with labor as your only variable resource. This is therefore an experiment to test the short-run law of diminishing marginal returns.

Resource:

  • Land resources: You will need one table or a couple of desks pushed together. This is your factory floor. Additionally, you will need a box of paper, preferably recycled or used paper. These are your land resources.
  • Capital resources: Every factory needs tools. The tools you’ll have for this activity are two pairs of scissors and two staplers. Since this is a short-run simulation, the amount of land and capital cannot be varied, therefore you may NOT use more scissors and staplers as more workers join the production process.
  • Labor resources: These will consist of the members of your class. The simulation will start with just one worker, and in each successive round one additonal worker will be added until at least eight members of your class have joined the factory floor.

TIME: The time for each round of production is limited to one minute. Your teacher or a member of your class should be designated as time keeper.

Data Collection: Each student in the class should recored the following down in a data table. If you have access to laptops, the data can be collected in Microsoft Excel or in Google Spreadsheets. This way you can create graphs of the data to assist with your analysis later on. Each student should record the following data during the simulation.

# of Workers (QL) Total Product (TP): Marginal Product (=change in TP): Average Product (TP/QL)

Conducting the simulation: When your land and capital resources are ready and your recorder and time keeper have been designated, you may begin the simulation.

Mr. Welker’s students hard at work in the paper chain factory

[youtube]http://www.youtube.com/watch?v=EiOYTg5kuqQ[/youtube]

  1. In round one, only one student should come to the table. The timekeeper must start the clock and give the worker one minute to cut and staple as many links into one paper chain as he or she can. At the end of the minute the recorder must count the number of links in the chain, record it in the production table, and then take the chain and any links that were cut but not stapled aside in preparation for the next round.
  2. In round two, a second worker should join the first and the two may work together for one minute to make as long a chain as they can. Again, the recorder will count the number of links in the chain at the end of one minute, record this under “total product”, then remove the chain and any unstapled links from the table.
  3. In rounds three through eight, an additional worker is added in each round and the new production team is given exactly one minute to make as long a chain as they can. At the end of each round, the recorder must count the number of links and record this under “total product”.
  4. At the end of the eighth round the factory must close its doors and the simulation is over. Now the class as a whole should look at the total product data and together help the recorder calculate the marginal product and average product for each of the eight rounds.

Data analysis: With your productivity data tables complete, you may now plot your data for total, marginal and average product on a graph similar to those earlier in this chapter, with the quantity of labor on the x-axis and the firm’s output on the y-axis. Using Microsoft Excel or Google Spreadsheets you can create a graph that should look something like the following (created using real data from Mr. Welker’s class recorded in a Google Spreadsheet):

  • As a class, analyze the relationships between total and marginal product.
  • Determine whether your paper chain factory ever experienced increasing returns and whether it ever experienced diminishing returns.
  • Discuss the reasons for the changes in total product during each round of production.

  • The graph above illustrates just marginal and average products. Discuss the meanings of marginal product and average product and determine how they changed as workers were added to your factory floor.
  • What is the relationship between marginal product and average product?
  • Decide whether the law of diminishing marginal returns applied to your factory. If so, why? If not, why not?

4 responses so far

Dec 03 2008

American auto makers insult the intelligence of high school Econ students!

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 Amerhttp://i92.photobucket.com/albums/l10/InsaneMotoGirl86/FordLogo.jpgican 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?

4 responses so far