Production and cost objectives

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					Economics 308
    Chapter 5 and 6
Production and Cost
   Market Structure
Administrative Details
   Second Exam.
       Cover Chapters 5 and 6.
       Thursday, Nov. 17th
       The Exam will be based on the following articles:
           How Porsche Revived Itself (1996)
           Putting Porsche in the Pink (1996)
           Porsche's Big Bet: First New Model in Years (1997)
           A Boxster Built Anywhere is Still a Boxster (1997)
           Porsche Doubles Finnish Output of Popular Boxster (1998)
   There will be an in-class quiz on Thursday, Nov. 3rd
    based on the following article. Students are free to
    read the article before the quiz.
       Plan of Action: Production and Supply
Efficient Production:                                                        Economic Analysis
What combination of inputs should the firm use to produce a given
                                                                        Effect of Changes in the World:
level of output efficiently, i.e. at least cost?
                                                                        1.    Changes in Demand
                                                                        2.    Changes in Input Prices
                                                                        3.    Changes in Technology
Unit Cost Curves:
Given that the firm produces efficiently at each level of output what   To Analyze the Effect of a given
will be the unit cost of production at various levels of output.             change in the world:

                                                                        1) figure out what in the graphs is
                                                                               changing.
                                                                               a)     Input Prices
3-Part Output Rule of a Price Taking Firm:                                     b)     Technology
Given that a firm is producing efficiently and knows it’s unit costs           c)     Market Price
of producing at various output levels, what output will maximize a      2)     Shift the Appropriate Curve.
firm’s output given the prevailing market price                         3)     Work your way through all
                                                                               the graphs.
                                                                        4)     Interpret graphs to
                                                                               determine the effects of the
                                                                               Change in the World.
Short and Long Run Industry Supply Curve:
Given a group firms, i.e. an industry, producing an homogeneous
good, what output level will the group of firms choose given
various market prices in the short and long run.
Efficient production in the multiple
input case.
 If a firm is going to produce a certain quantity of a
  good, what is the best, i.e. most efficient method of
  production.
 Consider the two input case, where two inputs, capital
  and labor are used to produce a given quantity of a
  good.
 Will use three theoretical constructs— production
  function, iso-cost curve and iso-output curve.
Production functions
A production function specifies maximum output
from given inputs:
                                     Production Function



         Q  f ( x1 , x2 ,... xn )
                                      Inputs Used in the
                                       Production Fund

              Number of Units of a
               Good Produced.
                    Returns to Scale
Defined: The relation between output and a proportional variation of
all inputs together.
If the firm doubled all inputs would output double, less than double or
more than double.
Consider the following production function and ask the question: what
would happen to output if inputs of K and L doubled?
      Increasing returns to scale (doubling inputs more than doubles
        output):

                                   Q=KL
                                  Q=1*1=1
                                  Q=2*2=4

    Decreasing returns to scale (doubling inputs less than doubles
      output): : Q=K1/3L1/3
    Constant returns to scale (doubling inputs exactly doubles
      output): : Q=K1/2L1/2
                   Returns to a Factor
Returns to a Factor refer to the relation between output and variation in
  only one input while the amount of other inputs is kept constant.
Can measure Returns to a Factor in different ways.
                                                  The bar means keeping
 Total product                                  the amount of K constant
                                      _
                        Q  f ( L; K )
        Given the amount of capital the firm has, how much output will
          the firm produce with different amounts of labor.

 Average product Q/L
 Marginal product Q/L
Iso Cost Curves

An isocost curve shows combinations of
 two inputs (labor and capital) that can be
 purchased for a given amount.
Similar to Budget Line.
Isocost Curve: $10,000 budget, Price of Labor =$50,
Price of Capital=$25

 Capital               Any combination of inputs on the iso-cost curve
                       can be purchased for $10,000.




     400




                           $10,000

       0             200                           Labor
Position of the Isocost curve represents Total Cost: Consider an increase
in expenditures on inputs to $15,000. How will this shift the iso-cost curve?


  Capital
                                 A parallel shift in the isocost curve represents
      600                        and increase in total cost.


     400




                 $10,000                   $15,000

           0                  200    300                      Labor
Slope of the iso-cost curve represents the Relative Price of Inputs:
Consider an increase in the price of labor to $100. How will this shift the
iso-cost curve?
                                     A rotation of the isocost curve represents a
                                     change in the price of one input.
  Capital                            What has happened to the slope of the iso-cost
                                     curve?
   600                               Rise/Run=600/300=2
                                     Rise/Run=600/150=4
                                     An increase in the price of the input on the
                                     horizontal axis makes the iso-cost curve steeper.




                                           $15,000

          0           150            300                      Labor
Iso output Curves

An iso-output curve shows combinations
 of two inputs (labor and capital) that
 produce the same amount of the good.
Similar to an Indifference Curve.
Movement along the iso-output curve represents a change in the way
goods are produced.



  Capital                         At points A and B, the firm is producing 100
                                  units of the good but in different ways.
                                  If these were output curves for an army which
                                  point represents the U.S. Army and which
                      B           represents the insurgents in Iraq?
                                  Which represents a more capital intensive
                                  production process? A or B?
                                  Answer: B

                             A


                                            100 Units

         0                                               Labor
Night Vision: $3500


  Helmet: $140




            Gun: $960




  Body Armour: $1584
Position of the iso output curve represents the amount of the good
produced: the farther out from the origin, the greater the output
produced.

Capital                            Moving from A to C the firm increases
                                   production from 100 to 200 units.



                     B       C
 1000



                             A
    750                                          200 Units


                                           100 Units

        0          250    500                            Labor
Slope of the iso output curve represents the how easily one factor can be
substituted for another factor in the production process.


  Capital                          From point A to B what is the slope of the iso
                                   output curve?
                                   Rise/Run=250/250=1
                                   If you use one less unit of labor, you can keep
                       B      C    output constant if you increase capital by one
   1000                            unit.




                               A
      750                                            200 Units


                                              100 Units

          0         250    500                               Labor
Efficient Production.
  Once the firm has chosen how much to produce, it
   will produce that amount in the most efficient way.
  Efficient production can be described two alternative
   but equivalent ways:
    The firm is producing efficiently if the firm is
       producing at a point where the iso-output and
       iso-cost curve is tangent.
    The firm is producing efficiently if it is on the
       highest iso-output curve that has at least one
       point in common with an iso cost curve.
  Examine the intuition behind each way of describing
   efficient production.
Efficient Production
                    At point A, the firm is producing efficiently because
 Capital            its’ iso-cost and iso-output curve are tangent.




               B
  1000



                     A
    750

                                      100 Units

         0   400   500                              Labor
Efficient Production: Cost Minimization
                         Why is point B an inefficient way of producing
                         100 units?
                         B is an inefficient way of producing 100 units
                         compared to A because at B the same output is
 Capital                 being produced at a higher total cost.
                         If the firm produces at point B it is not
                         minimizing costs. It could produce the same
                         amount of the good at a lower total cost, i.e. the
               B         firm is not cost minimizing.
  1000



                     A
    750

                                  100 Units

         0   400   500                          Labor
Efficient Production: Output Maximization
                          Consider point C.
                          If the firm changes how it produces the good from
                          point B to C, it could produce more output for the
  Capital                 same total cost.
                          Moving from B to C the firm is output maximizing—
                          producing the most output given the amount being
                          spent on inputs.

                B
   1000
                      C

                      A
     750                               150 Units

                                      100 Units
                      $43,750                 $45,000
          0   400   500                              Labor
Efficient Production Revisited.
A firm is producing efficiently if it is:
  Minimizing costs for the amount of the good it is
   producing.
  Maximizing output for the amount it is
   expending on inputs.
Using iso-cost and iso-output curves to analyze
two changes.

Suppose the price of an input changed.
  How would this affect the production decision of
   the firm?
Suppose there was a change in
 technology.
  How would this affect the production decision of
   the firm?
Analyzing a change in the price of inputs.
 Consider a firm which has a total cost of $100,000, and produces 100 units of a good
 using 100 units of capital and 50 units of labor. Depict the situation on the graph
 below.
Capital
                                            Suppose the price of Capital were to fall.
                                            Draw the new iso-cost curve through A.


                                            How will it adjust it’s production process?

                                            Once the price of capital has change, is
                                            the firm producing efficiently at A?


                                   A
     100

                                                  100 Units
                                   $100,000
         0                    50                                Labor
Adjusting to a change in the price of inputs: Cost Minimization


                                    Is the firm cost minimizing at point A, i.e.
Capital                             could the firm produce the same output at a
                                    lower total and average total cost?
                                    Depict the change in production if the firm
                                    cost minimizes.

                                    By moving to point B the firm continues
                       B            to produce the same output (100 units)
                                    but at a lower total cost (iso-cost curve
                                    closer to the origin).

                                A
    100

                                               100 Units
                                $100,000
        0                  50                                Labor
Adjusting to a change in the price of inputs: Output Maximization


                                    Is the firm output maximizing at point A, i.e.
Capital                             could the firm produce more output for the
                                    same total cost?
                                    Depict the change in production if the firm
                                    output maximizes.

                                               By moving to point C the firm keeps
                       C                       total cost constant (stays on the
                                               same iso-cost curve) but increases
                                               output (moves to a higher iso-output
                                               curve).

                                A
    100

                                                100 Units
                                $100,000
        0                  50                                 Labor
Analyzing a change in technology.
 Consider the same firm which has a total cost of $100,000, and produces 100 units
 of the good using 100 units of capital and 50 units of labor.


Capital                                  Suppose an improvement in technology
                                         occurred which allowed the firm to produce
                                         twice as much output with the same labor
                                         and capital.

                                         Depict such a change on the graph.




                                  A
    100

                                                 200
                                                 100 Units
                                  $100,000
         0                   50                                Labor
Analyzing a different change in technology.
 Consider the same firm which has a total cost of $100,000, and produces 100 units
 of the good using 100 units of capital and 50 units of labor.

                                      Suppose someone invented a machine which
Capital
                                      costs the same as the machines in use now
                                      but could produce the same output with half
                                      as much labor.

                                      Draw the iso-output curve for 100 units of
                                      output.




                     B            A
    100

                                                 100 Units
                                  $100,000
         0         25        50                                Labor
MERCEDES: MADE IN ALABAMA; THE GERMAN CARMAKER IS BUILDING SPORT-UTILITY VEHICLES AT A SPARKLING
NEW PLANT IN THE DEEP SOUTH. IT'S A MODEL OF HOW TO SET UP A TRULY GLOBAL OPERATION.
BYLINE: JUSTIN MARTIN
Tune your car radio to a country music station to set the mood. Then head out of Birmingham, Ala., southwest on I-59. Small
towns go tumbling by: Abernant, Centreville, West Blocton. Presently you're out in the country. Here's a cow, there's a road-
killed armadillo; 18-wheelers whip past; Dot's Farmhouse Restaurant beckons at the next exit. A few more miles, a few more
verses of an old Hank Williams song, and there it is, smack in the heart of deepest Dixie--a Mercedes factory. Through a stand
of tall pines, you catch a glimpse of that famous three-pointed star, rotating above the dazzling new plant.
   Mercedes has touched down in rural, rough-hewn Vance, Ala. (pop. 400). It's about the last place on earth you'd expect to
find the buttoned-down German automaker, but Mercedes has managed to negotiate the various speed bumps and slick
patches that come with setting up a greenfield factory in a foreign land. Production on a new M-class sport-utility vehicle,
priced around $ 35,000, began at the Vance plant earlier this year, and the first models are due to hit showrooms in the autumn.
  The plant has sparked something of a social experiment along a 50-mile stretch from Birmingham to Vance to Tuscaloosa. At
homes, bars, the factory, and everywhere in between, Germans and Alabamians are meeting and melding. "It's the birth of a
melting pot," says Andreas Renschler, CEO of the Alabama factory and a rebel within Mercedes' staid ranks. Renschler was
the perfect choice for this overseas assignment. Just 39 years old, 6-foot-6 and lanky, he has the demeanor of a smart-aleck
schoolboy. His style is to shake things up, push people's buttons. Mercedes had some solid reasons for setting up a plant in the
U.S. Back in Germany labor costs are about 50% higher than in the small-town American South. The plant also gives the
company a leg up on the crucial American market and functions as a kind of laboratory for future foreign manufacturing
ventures. Top Mercedes honchos settled on tiny Vance after considering 150 sites in 30 different states, including Nebraska and
such usual Sunbelt suspects as North and South Carolina. To help its case, Alabama pledged a whopping $ 250 million in tax
abatements and other incentives. As part of the package, the Alabama business community came up with an $ 11 million
offering, presented to Mercedes in the form of a single bank check. But the company wasn't about to make a decision of this
magnitude solely because of incentives. So Alabama went further, submitting a plan for how it would help the families of
German workers adjust to the expat life. "We found in Alabama a surprise," says Renschler. "Every state wants to sell its site.
But you must develop a trust level that lets you say, 'Okay, we can really build a factory here.'"
   Possessing nothing but the proverbial blank sheet of paper, Renschler set out to create a new corporate culture, separate
from headquarters. Starting in 1993, he very deliberately pieced together a team that included U.S. execs with Detroit auto
experience, along with a couple who had worked for Japanese transplants in North America. He drafted a perfectly balanced
ticket: four Germans, four Americans at management's top tier. The plan was to plumb the assembled American automotive
talent for fresh insights about how to run a factory. Those with Japanese transplant experience, it was hoped, could provide
pointers on how a foreign automaker might best go about setting up shop in the U.S.
But the members of the management team hailed from very different manufacturing traditions and possessed vastly different
ideas about how to do things. They all spoke different languages--GM-ese, Nissan-ese, Mercedes-ese, as it were. Quandaries
such as how to configure the <assembly line> set off fierce debates that quickly grew more complicated than a Donald Trump
pre-nup. Duly noted by the Americans was the fact that the Germans' English improved markedly when they got annoyed.
  Progress would probably never have been possible had it not been for one of Stuttgart's infrequent directives--a very rigid
time frame that was in place from day one. Thus, thrown together like roosters in a gunnysack, the team had no choice but to
scratch and peck until it came up with blueprints for a factory and plans for hiring a work force. Here, Mercedes faced a
dilemma. It was drawn to Alabama in part by the promise of cheap labor. But how was the company going to rustle up workers
who could make cars to its uncompromising standards? In the end, the automaker learned that it really didn't matter all that
much that the work force in Alabama was so different from that in Stuttgart. The trick was not to find people who might have
auto skills but those who could be trained.
  Mercedes placed help-wanted ads in ten papers around the state. Acknowledging reality, the ads called simply for high school
graduates, industrial experience preferred. The resulting barrage was akin to lotto frenzy: 45,000 applications poured in for
1,500 positions. Ultimately, Mercedes looks for people who can get along with others and follow directions. Those modest
qualities, the company has determined, are good indicators of whether someone can learn how to do an <assembly-line> job. A
series of job-specific exercises has proved particularly useful at weeding out the untrainable. The exercises are in actuality trick
tests, like those a psychiatrist might give to a patient. Applicants often assume they're being tested for one set of skills when
Mercedes hiring managers are looking for something altogether different.
  Take the tire-changing test. Applicants are given a tire and a series of colored bolts and are told to go to it. Charlene Paige
remembers the test well. She took it hoping to escape the Tuscaloosa mental hospital where she had worked as a nurse's
assistant for 14 years. "A couple of the guys were doing the test really fast," she says. "They were trying to be very impressive,
taking shortcuts."
  She felt intimidated. Lacking technical skill--"I barely knew how to operate a hammer," she jokes--Paige had no choice but to
go slowly. As one of the last to finish, she walked out certain she had blown her chances of being hired by Mercedes. But it was
the guys who suffered a blowout. They'd changed the tires quickly but failed to follow precise directions. And that's what the test
was about. Paige got hired, one of the lucky applicants (one in 30) to land a job with Mercedes. She started at $ 13 an hour,
well above the average wage in the area, and has since been promoted to her current position as a team leader in the
assembly shop.
Mercedes has an exacting way of building cars, an approach that may not be intuitive to people from other cultures. The
company, therefore, makes sure all factory-floor jobs are done in accordance with so-called SMPs (standard methods and
procedures) that spell out the exact, proper, and lone way to do every task. The SMPs are drawn up by German engineers and
posted at workstations for easy reference by American employees. Everything is spelled out, down to the official way to tighten
a lug nut. The American line workers need permission to make even the slightest alteration in their methods. Finished using a
hammer or wrench? Little guides, like chalk body outlines, indicate exactly where it is to be laid down.
   For the average American, this style takes some getting used to. "The Germans are very blunt and don't beat around the
bush," says Paige. "You don't get politeness out of them about work. They might say, 'It looks real bad, and you're going to redo
it.' They're such perfectionists." The Alabamians oftentimes find their bosses to be rigid, formal, even humorless.
  The Germans, in turn, find the Americans lax, loquacious, somewhat superficial. They point out that feedback is an American
concept, yet American workers aren't used to receiving it in strong doses. "They're not used to really open feedback," says
Renschler. "The Americans always want to hear that they're doing a good job." Despite all the cultural differences, the Vance
factory has proved to be a success. The design, a sleek E-shape with interconnected shops, has proved especially efficient.
  Outside the factory walls, the arrival of Mercedes has stirred all sorts of monetary dreams among Vance's residents. "Vance
never used to be concerned about anything, anywhere," says town mayor Mike Sanders. "We got thrust overnight from a local
into a global economy." But many of the folks who sold property to make room for the factory have expressed anger about the
deals they cut, and the rest of the townspeople have been largely bypassed. Just one Vance resident has been hired by
Mercedes, and the only new businesses to open up have been a few modest restaurants.
  A key reason why Vance hasn't profited much is that the 300 or so Germans in the area live up the road in larger cities like
Tuscaloosa. In the interest of fostering local good will, Mercedes has sponsored art exhibits, youth soccer teams, and a
performance by the Stuttgart Orchestra. It hosts an annual German wine festival called Weindorf. Mercedes made a
contribution to Vance's volunteer fire department, and also set up a video link that allowed students at Vance Elementary and a
school in Stuttgart to take a virtual field trip and visit one another.
  Tuscaloosa rolled out a host-family program to help Germans settle into the community. It's run by the local development
authority and seeks to match up Alabamians with visiting Germans according to interests, age, and family size. Shortly after a
new German family arrives, a designated host family shows up on its doorstep often bearing a potted plant. That's the
etiquette. It's based on the notion that Germans love greenery yet can't bring plants through customs into the U.S.
Host families fill the visitors in on such need-to-knows as directions for getting around town, doctor recommendations, and the
fact that most anything can be purchased at Wal-Mart. Some of the relationships blossom into real friendship.
   There's the duo of Billy Minges and Karl Sauer, for example. Minges, 53, is the owner of a local business, Cain Steel. To be
good citizens, he and his wife signed up for the host family program. "But that all went out the window when I met Karl Sauer,"
he says. "It's like we're brothers separated at birth. If you get rid of the accents, we even talk alike." Together, they shoot pistols,
fish, and tinker with a Nascar-style race car. Minges even took his friend to a rattlesnake rodeo. Says Sauer: "Now I have more
feeling for what's going on in America, in a practical way you cannot read in a book."
  American cuisine gets mixed reviews from the Germans. They don't like the local bread, and few have developed a taste for
grits. Barbecue is a different matter. Most of the Germans have set up grills in their backyards, and almost all make regular
pilgrimages to Dreamland, a bona fide barbecue shack. The menu is simple: ribs, bread, beer, and soda. Dreamland, the joke
goes, has come to be known as the most famous restaurant in Alabama--to people in Stuttgart.
  It's not certain how Mercedes' M-class will ultimately fare in the marketplace against such established competition as the Jeep
Grand Cherokee and the Ford Explorer. Yet the company is clearly gaining valuable experience in how to set up and operate a
plant in a distant land, and that experience will be needed soon. It just so happens that Mercedes will start producing its A-class
sedan in a factory in Sao Paulo in 1998. So, in the not so distant future, Mercedes may well transfer an employee born in
deepest Alabama to its operation in sultry Brazil. And the world gets smaller and stranger still.
.
Read the article about Mercedes production in Alabama. Consider the iso-cost and iso-output curves for
Mercedes production in Germany shown below. The author of the article cites a 50% reduction in costs in
Alabama vs. Germany as one of the prime reasons for Mercedes to establish a factory in the U.S.
           1. Depict production in the Alabama plant if Mercedes uses the same combination of K and L used
in Germany despite the fact that labor costs are lower in Alabama. Will the firm be producing efficiently? Depict
and explain.
                                                                       Is this a technological change that will
                                                                       effect the position or slope of the firms
   K                                                                   iso-ouput curves?
                                                                       It still takes the same amount of labor
                                                                       and capital to produce a given output
                                                                       so there has been no technological
                                                                       change and the iso-output curves will
                                                                       remain unchanged.
                                                                       Is this a change in the cost of inputs
                                                                       which will effect the position or slope
                                               A                       of the firms iso-cost curves?
                                                                       Is the iso-cost curve through A going
                                                                       to become steeper or shallower?
                                                                       Shallower. Because the reduced price
                                                                       of labor means that to get enough
                                                                       money to buy another unit of labor,
                                                                       the firm has to give up fewer units of
                                                                       capital because labor is cheaper.



                                                                                                                   L
2.          If point A in the diagram shows the optimal combination of K and L used in Germany, what will
happen to the combination of K and L used in the U.S. factory if Mercedes uses a cost minimization strategy to
make production more efficient? Depict on your graph.
3.          How will your answer change if Mercedes uses an output maximization strategy to make production
more efficient? Depict on your graph.
4.          In (2) and (3), what can you say about the unit cost of production? Explain.



   K                                                                         The unit cost is going to
                                                                             decline because the firm is
                                                                             either producing more units
                                                                             with the same total costs or
                                                                             producing the same number
                                                                             of units with a lower total
                                                                             cost.
                                                     Start




                                                                                       Output Maximization:
                                                                                     Same iso-cost, iso-output
                                                                                     farther out from the origin

             Cost minimization: Same
               iso-output, iso-cost
                closer to the origin




                                                                                                                   L
5.   The author describes the testing procedure used to hire new assembly line workers. Draw two sets of
     iso-cost and iso-output curves. One showing the situation if the test works as advertised and one
     showing what will happen if the test is unsuccessful at identifying good employees.
6.   Is this a technological change that will affect the position or slope of the firm’s iso-ouput curves or a
     change in costs which will affect the firms iso-cost curves? Explain.
7.   Is this a change in the cost of inputs which will affect the position or slope of the firm’s iso-output
     curves or a change in costs which will affect the firm’s iso-cost curves? Explain.
8.   Is the iso-output curve through A going to become steeper or shallower? Explain.
K

                                                                  Compliant workers are more productive
                                                                  workers so the iso-output curve at a
                                                                  point is steeper.




                                           A                        The firm will adjust the K/L ratio to the
                                                                    more productive labor.




                                                                                                            L
              Production and Supply-Progress
Efficient Production:                                                        Economic Analysis
What combination of inputs should the firm use to produce a given
                                                                        Effect of Changes in the World:
level of output at least cost?
                                                                        1.    Changes in Demand
                                                                        2.    Changes in Input Prices
                                                                        3.    Changes in Technology
Unit Cost Curves:
Given that the firm produces efficiently at each level of output what   To Analyze the Effect of a given
will be the unit cost of production at various levels of output.             change in the world:

                                                                        1) figure out what in the graphs is
                                                                               changing.
                                                                               a)     Input Prices
3-Part Output Rule of a Price Taking Firm:                                     b)     Technology
Given that a firm is producing efficiently and knows it’s unit costs           c)     Market Price
of producing at various output levels, what output will maximize a      2)     Shift the Appropriate Curve.
firm’s output given the prevailing market price                         3)     Work your way through all
                                                                               the graphs.
                                                                        4)     Interpret graphs to
                                                                               determine the effects of the
                                                                               Change in the World.
Short and Long Run Industry Supply Curve:
Given a group firms, i.e. an industry, producing an homogeneous
good, what output level will the group of firms choose given
various market prices in the short and long run.
Variable and Fixed Costs
 Iso-cost and iso-output curves can be used to analyze the
  difference between fixed and variable costs.
 The short and long run.
   The short run is period so short that the amount of some
      inputs cannot be changed,i.e. some inputs are fixed.
   The long run is a period long enough that all inputs are
      changed i.e. all inputs become variable.
 Consider how a firm adjusts production to vary input in the
  short and long run.
   For the lecture examples, capital is the fixed input and
      labor is the variable input.
Changing output in the short and long run.
Consider the same firm which has a total cost of $100,000, and produces 100 units
of the good using 100 units of capital and 50 units of labor. Capital costs $250 per
unit and labor costs $1500 per unit.
                                          1.   Suppose the firm is considering a short run
Capital                                        change in output, i.e. the amount of capital
                                               is fixed.
                                          2.   Depict the change in output if the firm
                                               increases output to 110 units in the short
                                               run.
                                          3.   In the short run, the firm can increase or
                                               decrease output only by varying the amount
                                               of the variable input (labor) so the firm can
                                               only choose combinations of K and L on the
                                               dotted line in the short run.

                                                    Short Run
                                  Start
    100

                                                                        110 Units

                                                  100 Units
                                                   $100,000

                             50                                   Labor
Changing output in the short and long run.
                                                   1.   Suppose the firm is considering a
                                                        long run change in output, i.e. the
                                                        amount of capital and labor are
                                                        variable.
Capital                                            2.   Depict the change in output if the
                                                        firm increases output to 110 units
                                                        in the long run.
                                                   3.   In the long run, the firm can
                                                        increase output by adjusting both
                                                        fixed (Capital) and variable (Labor)
                                                        inputs. Because of the added
                                                        flexibility, the firm can increase
                                                        output at lower cost in the long run
                                                        vs. the short run.
                                   Long Run



                                               Short Run
                      Start
     100

                                                                   110 Units
                                              100 Units
                      $100,000

           0     50           55              75                        Labor
 Cost Curves and the Output Decision
             of the Firm
 To properly make the decision how much to produce (as
  opposed to the question of how to produce) the firm must
  measure the unit cost of production in four ways.
   Average Short Run Total Cost
   Average Long Run Total Cost
   Average Variable Cost
   Marginal Cost
 Each of these measures of unit cost can be derived using
  iso-cost/iso-output analysis.
 A firm can use these measures of unit cost to decide how
  much to produce in a competitive market.
Capital
                                                   $/unit

                       100*$25=$2500


 100
                                       ($2500-(50*$25))/5=250 units of labor


                   A
  50



                                       500 units


                                  $2500


                 250
                                         Labor
                                                                                        Output
       If capital costs $25 per unit what is the total cost of production at point A?

       If labor costs $5 per unit how many units of labor will be used to produce
       500 units of the good efficiently?
Capital
                                                 $/unit
                                At A, the firm is
                              producing 500 units
                             of the good at a total
                                 cost of $2500.                                   Point A on the
  100                        Therefore, the ATC is                               unit cost graph
                               $2500/500=$5 per                                  is the same as
                                      unit.           $5                          point A on the
                                                                     A           iso-output/iso-
                                                                                    cost graph
  50
                A


                                     500 units


                                  $2500


                    250                                                  500
                                       Labor
                                                                                      Output
        If the firm produces 500 units of the good efficiently, what is the average total
        cost (ATC) of production?
Capital                                          500 units of labor
                                                $/unit of capital cost $2500.
                                                 50 units           costs $1250
                                                  The total cost of producing 800 units is $3750 and the
                                                  average total cost is $3750/800=$4.69



 100

                                                       $5
                                                                                A


  50
             A            B
                                                  800 units
                                                     If the firm had a total cost of $2500 and spent all it’s
                                    500 units        money on labor it would be able to buy 500 units of labor
                                                     (price of labor=$5).
                                $2500                At point B, the firm is also using 500 units of labor.

                              500
                 250                                                                500
                                      Labor
                                                                                                  Output
  Suppose the firm decides to increase output to 800 units in the short run. Depict
  the change on the iso-cost/iso-output graph.
   At point B, what is the total and average total cost of producing 800 units?
   How many units of labor will be used if the firm expands output to 800 units in
   the short run?
Capital
                                                 $/unit
                                         At point A, the firm is using 250 units of labor which cost
                                         250*$5=$1250 to produce 500 units.
                                         Therefore, the AVC is $1250/500=$2.50

                                                    At point B, the firm is using 500 units of labor which cost
                                                    500*$5=$2500 to produce 800 units.
 100
                                                    Therefore, the AVC is $2500/800=$3.13
                                                          $5
                                                                                  A


  50
              A            B                       800 units
                                                                                                           SRATC
                                                          $4.69
                                     500 units                                                  B


                                 $2500


                  250          500                                                                  800
                                                                                      500
                                       Labor
                                                                                                      Output
   Draw the Short Run ATC Curve on the graph on the right.

   If capital is the fixed input and labor is the variable input, what is the average
   variable cost of production at 500 and 800 units
Capital
                                                 $/unit




 100

                                                        $5
                                                                    A


  50
              A            B                      800 units
                                                                                         SRATC
                                                       $4.69
                                     500 units                                 B         AVC
                                                       $3.13

                                 $2500                 $2.50


                  250          500                                                 800
                                                   Labor                500               Output



   Draw the Short Run ATC Curve on the graph on the right.

   If capital is the fixed input and labor is the variable input, what is the average
   variable cost of production at 500 and 800 units
Capital
                                           $/unit                     It costs $2500 to produce 500 units
                                                           and $3750 to produce 800 units. The firm
                                                           increases output 300 units at a cost of $1250.
                                                                      The Marginal Cost is
                                                           $1250/300=$4.17

 100

                                                    $5
                                                                            A
  50
             A           B                     800 units
                                                   $4.69                                           SRATC
                                   500 units                                              B       AVC
                                                   $3.13
                               $2500               $2.50

              250            500                                              500           800
                                    Labor
                                                                                               Output
   What is the marginal cost of increasing output from 500 to 800 units?
 The Firm’s Unit Cost Curves
$/unit

                               MC



                                ATC

                                AVC




     0
                                Output
              Production and Supply-Progress
Efficient Production:                                                        Economic Analysis
What combination of inputs should the firm use to produce a given
                                                                        Effect of Changes in the World:
level of output at least cost?
                                                                        1.    Changes in Demand
                                                                        2.    Changes in Input Prices
                                                                        3.    Changes in Technology
Unit Cost Curves:
Given that the firm produces efficiently at each level of output what   To Analyze the Effect of a given
will be the unit cost of production at various levels of output.             change in the world:

                                                                        1) figure out what in the graphs is
                                                                               changing.
                                                                               a)     Input Prices
3-Part Output Rule of a Price Taking Firm:                                     b)     Technology
Given that a firm is producing efficiently and knows it’s unit costs           c)     Market Price
of producing at various output levels, what output will maximize a      2)     Shift the Appropriate Curve.
firm’s output given the prevailing market price                         3)     Work your way through all
                                                                               the graphs.
                                                                        4)     Interpret graphs to
                                                                               determine the effects of the
                                                                               Change in the World.
Short and Long Run Industry Supply Curve:
Given a group firms, i.e. an industry, producing an homogeneous
good, what output level will the group of firms choose given
various market prices in the short and long run.
Output Level
 The previous discussion has shown how the firm, once it
  has decided how much to produce, determines how (the
  combination of capital and labor) it will produce that
  output— efficient production.
 Turn now to a discussion of how the firm decides how
  much to produce.
   Will assume that the firm is a price taker in a
     competitive market i.e. it assumes that it can sell as
     much or as little as it desires at the prevailing market
     price.
   The firm is in a perfectly competitive market.
     Profit Maximization for the
          Competitive Firm
 The goal of a competitive firm is to maximize profit.
 The firm in a competitive market can maximize profits
  by applying the 3-part output rule of a price taking
  firm.
   Shutdown Decision: Should if produce at all?
   Short Run Output Decision: If the firm is going to
      produce how much should it produce in the short
      run?
   Long Run Entry and Exit Decision: In the long run,
      should the firm stay in business?
 Examine each of these three decision in detail.
         The Firm’s Shut Down Decision
 The firm should shutdown in the short run, i.e. produce nothing if the price is
  below the minimum AVC of production.
    If the price is below the min. AVC, the firm would lose less by shutting
      down.
         If the firm shutdown, it would lose only its’ fixed costs.
         If it produced, it would lose its’ fixed costs and a portion of its’ variable
          costs.
         Therefore, it would lose less in the short run by shutting down.
    If the price is between the min. AVC and the min. ATC, the firm should
      produce even though it loses money by doing so.
         The price it is getting is sufficient to cover its variable costs and a
          portion of its’ fixed costs.
         Therefore the firm will lose less by producing than it would be shutting
          down.
    If the price is above the min. ATC, the the firm can produce at a profit.
         The price it is getting is sufficient to cover all of its’ costs.
           Example of Shutdown Decision
 Gas Station:
     Cost of pumps, building, bullet proof cashiers station, etc--$500,000.
     Labor cost to keep gas station open-$10/hr. and gasoline has a wholesale
       cost of $1/ gallon.
     Gasoline sells for $1.50 per gallon.
 If the gas station is opened for one day (24 hours), they will sell 500 gallons.
  Should the shutdown?
     Compare shutting down vs. opening.
          Shutdown-Lose $500,000
          Open-$750 revenue, $240 labor costs, $500 gasoline costs.
             • Price exceeds the variable cost of producing so the firm loses less
                by producing—only lose $499,990.
             • They are still producing at a loss, but lose less by producing than
                by shutting down.
 Suppose if the gas station opened for one day, they will sell 400 gallons.
  Should the station shut down?
     Shutdown-Lose $500,000
     Open- $600 revenue, $240 labor costs, $400 gasoline costs-lose
       $500,040.
The Economic Ladder of the FOB Immigrant
              Gas Station
                                                 $1 million


    Large Restaurant: Macaroni Grill

                                           $1 million liquid assets
                                            $5 million net worth

            Another Subway



                                           $70,000-$220,000

               Subway
                                         Marry for Money



 Convenience Store in Bad Neighborhood            $12,000-$25,0000
    The Firm’s Decision to Shut Down
                            If P > min ATC, The firm is covering its’
                            fixed and variable costs, is earning a
                            profit and should continue producing..
             $/unit

                                               MC
                          If min AVC<P <min ATC, The firm should
Produce at a profit       keep producing in the short run. It is
                          covering its’ variable costs and a portion of
in the short run
                          its’ fixed costs. Therefore, it loses less by
                                                   ATC
                          producing than shutting down.


                                                  AVC
Produce at a loss                           If P <min AVC, the firm
in the short run              should shutdown.
                                            The price its’ getting is
                              insufficient to cover its’ variable costs.
                              If it produces, the firm will lose not
    Shutdown                  only its’ fixed cost but also a portion of
                              its’ variable cost.
                                            Therefore, the firm would
                      0       lose less if it shutdown and only lost
                              its’ fixed costs.      Output
        Short Run Output Decision
 Once the firm has made the shutdown decision and
  decided not to shutdown, the next decision the firm must
  make is how much to produce.
 The firm can determine the profit maximizing (or loss
  minimizing) level of output by setting P=MC.
 An alternative way of determining the profit maximizing
  level of output is to use the following rule:
    If P>MC increase output.
    If P<MC decrease output.
    If P=MC leave output unchanged.
Profit Maximization for the
Competitive Firm
     Costs
       and
   Revenue
                                MC



                                ATC
        P                        P = AR = MR
                              AVC




         0                             Quantity
Profit Maximization for the
Competitive Firm         The firm maximizes profit by
                         producing the quantity at
                                  which marginal cost equals
      $/unit                      marginal revenue.


                                           MC



                                            ATC
          P                                P = AR = MR
                                        AVC




           0               QMAX                      Output
Profit Maximization for the
Competitive Firm
    $/unit


                                MC



                                ATC
        P                        P = AR = MR
                              AVC




         0          QMAX               Output
Profit Maximization for the
                 If the firm is producing Q1 when the P=MR1, the
Competitive Firm is not maximizing profit.
                 firm
                              What could the firm do to increase profits? Why?
       $/unit                 If it increased output by one unit, the extra cost the
                              firm would incur (its MC) would be less than the
                              extra revenue it would receive from selling that one
                              extra unit produced (the price or marginal revenue).
                                                            MC
                              Therefore, the firm would increase its’ profit or
                              reduce its’ loss by expanding output.

                                                             ATC
      P = MR1                                              P = AR = MR
                                                        AVC

         MC1




            0            Q1          QMAX                               Output
Profit Maximization for the
Competitive Firm
    $/unit


                                        MC



                                        ATC
   P = MR1                              P = AR = MR
                                     AVC

      MC1

                           P > MC,
                           increase Q

         0     Q1   QMAX                      Output
Profit Maximization for the
                                           Q2 when
Competitive Firm If theisfirm is producingprofit. the P=MR1, the
                 firm not maximizing
                             What could the firm do to increase profits? Why?
       Costs
                             If it decreased output by one unit, the extra cost the
         and
                             firm would save (its MC) would be more than the
     Revenue
                             extra revenue it would forego from selling one fewer
                             unit (the price).          MC
                             Therefore, the firm would increase its’ profit or
         MC2                 reduce its’ loss by reducing output.
                                                          ATC
      P = MR2                                            P = AR = MR
                                                      AVC




            0                     QMAX         Q2                    Quantity
Profit Maximization for the
Competitive Firm
     Costs
       and
   Revenue
                                        MC

      MC2
                                        ATC
   P = MR2                               P = AR = MR
                                      AVC



             P < MC,
             decrease Q

         0                QMAX   Q2            Quantity
An Application of the Short Run Output
 Rule and the Importance of Marginal
               Thinking
 Many “business problems” can be solved by using a specific
  type of logic—marginal thinking or thinking at the margin.
 Thinking “at the margin” means asking and answering the
  following question:
    Given what has already happened, what will happen if a firm
       engages in one more unit of an activity.
    This type of logic can be applied to most “business
       problems.”
 Simple cost/benefit analysis is an example of marginal thinking.
    How late should a store stay open?
    Should an amusement park build an additional ride?
    Should carmakers provide additional options on a car-4
       doors/2doors/targa top/hatchback.
      Thinking at the Margin in Action.
 While the idea of Thinking at the Margin principle can be stated simply,
  applying it in real life can be quite complex and involved.
    In some lines of business, hundreds of employees and the MIS of
     the company are designed around the implementation of the
     equimarginal principle.
 Example: The comping system at Las Vegas casinos.
    What is the goal of the casino?
        Maximize profits.
    What is the main source of casino revenue?
        Player losses.
        Profits=Player Losses-Costs
    How does the casino get players to come to their casino and
     gamble, e.g. lose?
        Attractions, entertainment, restaurants, etc
        Giving away free stuff.
           • Rooms, airplane tickets, shows, food, etc.
    Business problem: who gets the free stuff an how much?
  Making the Comping Decision: An Example of Marginal
    Thinking or the Equimarginal Principle in Action.

oCollecting the necessary information.
oLayout of Casino Floor and the Role of
Employees.
         oRunner, Dealer, Pit Boss.
         Casino Host. Shift Manager.
         Casino Manager.
oResponsibilities of Pit Boss
    oPrevent cheating sometimes called
    “maintaining the integrity of the
    game.”
    oCommon forms of cheating.
         oCapping, hold outs, signaling,
         and Card Mechanics.
         oGambling Scams : How They
         Work, How to Detect Them,
         How to Protect Yourself
         by Darwin Ortiz
    oPlayer development. Collection of
    information about players.
The Rating Slip
•What happens when a person
enters the casino?
•Collection of information about
players.
     •Buy in.
     •Time.
     •Average Bet.
     •Estimated Win/Loss
•Information is input into MIS of
the casino—runner.
•Surveying the Rack and
estimating players win/loss.
•Detecting cheating.
•Action=Total amount bet by
player.
    Computing the Player’s Rating
Using the information from the rating slip, the casino’s
management information system uses the following
formula to calculate a players expected loss.
   Expected Loss  average bet * decisions per hour *
              hours played * house edge
 For a player betting $100 per hand at
                                             Lexicon of Gambling
 blackjack.
                                             RFB Comp
  Expected Loss  $100 * 60 * 4 * .02        Run of the House
                 $24,000 * .02              Black player

                  $480                      Green player
                                             Whale
Computing Player Rating (2)
 Casino will give back in comps roughly 50% of the
  expected loss.
   $50 rating-$240 expected loss $120 of comps.
   $100 rating-$480 expected loss$240 of comps.
   $200 rating-$980 expected loss $480 of comps.
 How much must you bet to get a room comp at a various
  casinos.
   A-Hotels--$200+ rating: MGM, Bellagio, Treasure
     Island, Mirage.
   B-Hotels--$100+ rating: Luxor, Venetian, Monte Carlo,
     New York, New York.
   C-Hotels---$50+ rating: Excalibur, Circus Circus,
     Stardust.
     How to get a free weekend in Las
                 Vegas?
 The job of the Casino Host.
 How do you establish yourself   Lexicon of Gambling
  on a casino VIP list?           RFB Comp
 Comp City by Max Rubin          Run of the House
                                  Black player
                                  Green player
                                  Whale
                                  Casino Host
                                  Front Money
                                  CD
    Getting a free weekend in Las Vegas?
•   How do professional gamblers attack the casino?
•   Assumptions the casino is making in its’ rating formula.
    •   Average bet, decisions per hour, hours played, house edge.
    •    Most of the “action” occurs in the assumptions about house edge.
        •    Craps--.1% to 10%, Roulette-5.25%, Caribbean Stud, Let it Ride,
             Etc.—5+%.
        •    Blackjack and Pai Gow-depends upon skill of the player.
             •   Basic Strategy and Counting Systems.

            Expected Loss  average bet * decisions per hour *
                       hours played * house edge
                        Expected Loss  $200 * 60 * 4 * .002
                                       $48,000 * .001
                                         $48
 The Long-Run Decision to Enter or
         Exit an Industry
 The long-run is period of time long enough that a
  firm can control/avoid both its’ variable and fixed
  costs, i.e. they can exit or enter an industry.
 In the long-run, the firm exits if the revenue it
  would get from producing is less than its total
  cost.
   Exit if P<min ATC.
 New firms will enter the industry if such an action
  would be profitable.
   Enter if P >min ATC
The Competitive Firm’s Supply Curve

          The competitive firm’s long-run
          supply curve is the portion of its
  Costs   marginal-cost curve that lies above
          average total cost.
                                                              MC



                                                                 ATC

                                                                 AVC


                                                The firm’s short-run supply curve is
                                                the portion of its marginal cost curve
                                                that lies above average variable cost




      0                                                         Quantity
Profit as the Area Between Price and
Average Total Cost
    Price

                               MC        ATC


       P                            P = AR = MR


                        At this price, how much will the
                        firm produce?




       0                              Quantity
Profit as the Area Between Price and
Average Total Cost
            What will the firm’s profit be if it
    Price   produces Q?
            How much profit is the firm
            making per unit it produces?             MC      ATC


       P                                                  P = AR = MR

     ATC




                                                   Profit-maximizing
                                                   quantity


       0                                   Q                Quantity
     Profit as the Area Between Price and
     Average Total Cost
                  Price

                                               MC      ATC
                          Profit

                     P                              P = AR = MR
Profit per Unit
                  ATC




                                             Profit-maximizing
                                             quantity


                     0                   Q            Quantity
                            Units Sold
Loss as the Area Between Price and
Average Total Cost
            If the price is P, will the firm
    Price   shutdown?
            If it produces, how much should
            it produce?
            Will it be earning a profit?             MC     ATC
            What will its’ loss be?




       P                                         P = AR = MR

                                               AVC



       0                                                  Quantity
Loss as the Area Between Price and
Average Total Cost
    Price



                                MC     ATC



     ATC
                               AVC
       P                       P = AR = MR



                     Loss-minimizing quantity


       0         Q                   Quantity
Loss as the Area Between Price and
Average Total Cost
    Price          How much is the firm
                   losing on each unit it
                   produces?

                                                       MC     ATC



     ATC

       P                                              P = AR = MR

            Loss

                                            Loss-minimizing quantity


       0                        Q                           Quantity
Review: The 3-part output rule of firm in a
competitive market.
 Once the firm knows it’s unit costs (ATC, AVC, and MC) at
  each level of output and the prevailing market price, a
  price taking firm can determine the profit maximizing level
  of output by applying the 3-part output rule.
   Shutdown if the P < min AVC.
       Explain.
   If the firm is going to produce in the short run, produce
     the Q where P=MC even if it means losing money.
       Explain.
   In the long run, exit if P < min ATC.
       Explain.
              Production and Supply-Progress
Efficient Production:                                                        Economic Analysis
What combination of inputs should the firm use to produce a given
                                                                        Effect of Changes in the World:
level of output at least cost?
                                                                        1.    Changes in Demand
                                                                        2.    Changes in Input Prices
                                                                        3.    Changes in Technology
Unit Cost Curves:
Given that the firm produces efficiently at each level of output what   To Analyze the Effect of a given
will be the unit cost of production at various levels of output.             change in the world:

                                                                        1) figure out what in the graphs is
                                                                               changing.
                                                                               a)     Input Prices
3-Part Output Rule of a Price Taking Firm:                                     b)     Technology
Given that a firm is producing efficiently and knows it’s unit costs           c)     Market Price
of producing at various output levels, what output will maximize a      2)     Shift the Appropriate Curve.
firm’s output given the prevailing market price                         3)     Work your way through all
                                                                               the graphs.
                                                                        4)     Interpret graphs to
                                                                               determine the effects of the
                                                                               Change in the World.
Short and Long Run Industry Supply Curve:
Given a group firms, i.e. an industry, producing an homogeneous
good, what output level will the group of firms choose given
various market prices in the short and long run.
Market Supply in a Competitive Market
Market supply equals the sum of the quantities.
  supplied by the individual firms in the market.
 Market Supply with a Fixed Number of Firms
  (Short Run Supply Curve).
    For any given price, each firm supplies a quantity of
     output so that price equals its marginal cost.
    The market supply curve reflects the individual firms’
     marginal cost curves.
 Market Supply with Entry and Exit (Long Run
  Supply Curve).
    Firms will enter or exit the market until profit is driven to
     zero.
    In the long-run, price equals the minimum of average
     total cost.
    The long-run market supply curve is horizontal at this
     price (constant cost industry).
   The left hand graph shows the unit cost curves for a single firm producing the
   good. An industry is composed of many firms with identical cost curves all
        Initial Condition: Long Run Equilibrium
   producing the same good.
   The Short Run Market Supply curve shows the amount produced by the
   existing firms as price varies. The Long Run supply curve shows how the
   amount produces as price varies when the effects of entry and exit to the
   industry are included.
             Representative Firm                                Market
Price                                       Price


                     MC ATC                                          S1
                                                            A
  P1                                           P1                              Long-run
                                                                                supply

                                                                     D1

    0                       Quantity             0          Q1            Quantity
                             (firm)                                       (market)
                   At current output levels (Q1-        . Theincrease in
                           an increase in Demand
   Short-Run Response to q1-firm) the existing
                 industry,                              demand (D1 to D2)
                   firms are producing where P          causes the price in to
                   >MC.                                 increase.
                   Therefore, they can increase
                   profits by increasing output.
                  Firm                                    Market
Price                                    Price


                  MC ATC                                  B S1
                                                    A
  P1                                        P1                        Long-run
                                                                        supply
                                                                     D2
                                                                D1

    0                    Quantity                                    Quantity
             q1    The increase in output by 0
                           (firm)
                                                    Q1
                                                                     (market)
                   existing firms causes a
                   movement along the short run
                   supply curve (S1) from A to B.
    Short-Run Response to an increase in Demand
        Since all existing firms are
        increasing output, industry
        output increases from Q1 to
        Q2.
                  Firm                                  Market
Price                                     Price


                   MC ATC                               B   S1
  P2                                          P2    A
  P1                                                              Long-run
                       Existing firms choose P1
                                                                    supply
                       their output level by                     D2
                       setting price equal to               D1
                       MC.
                       Since the price has
    0                     Quantity              0   Q1 Q2        Quantity
                       risen, the quantity at
                             (firm)                              (market)
                       which P=MC is now
                       higher.
                       Therefore, existing firms
                       increase output.
   Short-Run Response to an increase in Demand


                               In the short run, the existing
                               firms will earn a profit.

                 Firm                                       Market
Price                                Price

        Profit   MC ATC                                    B    S1
  P2                                     P2           A
  P1                                     P1                           Long-run
                                                                        supply
                                                                     D2
                                                                D1

    0                   Quantity          0            Q1 Q2         Quantity
                         (firm)                                      (market)
Increase in Demand in the Long Run
 Over time, the short-run supply curve shifts as
  profits encourage new firms to enter the market.
 Price falls as new firms enter the market
 In the new long-run equilibrium profits return to
  zero and price returns to minimum average total
  cost.
 The market has more firms to satisfy the greater
  demand.
                                         At price P2, existing firms are earning a
                                         profit.
        Long-Run Response                Entrepreneurs see the profit earned by
                                         existing firms and open new firms (enter the
                                         industry).


                     Firm                                       Market

Price                                      Price


            Profit
                     MC     ATC                                 B    S100 firms
    P2                                        P2
                                                           A
    P1                                        P1                                   Long-run
                                                                                    supply
                                                                              D2
                                                                     D1


        0                     Quantity             0       Q1   Q2          Quantity
                               (firm)                                       (market)
    As new firms enter, the amount of the good
    produced at each price by the existing firms
        Long-Run Response
    (new and old) has increased.
    This is depicted as an shift in the short run
    supply curve from S1 to S2.


                      Firm                                      Market

Price                                          Price


            Profit
                       MC    ATC                                B    S100firms
    P2                                              P2                     S150 firms
                                                           A
    P1                                              P1                            Long-run
                                                                                   supply
                                                                             D2
                                                                     D1


        0                       Quantity               0   Q1   Q2          Quantity
                                 (firm)                                     (market)
        Long-Run Response
   As the new firms begin producing, the price
   falls from P2 to P1.
                     Firm                                     Market

Price                                        Price



                      MC    ATC                               B    S100firms
                                                 P2                      S150 firms
                                                         A
    P1                                           P1                             Long-run
                                                                                 supply
                                                                           D2
                                                                   D1


        0                     Quantity               0   Q1   Q2          Quantity
                               (firm)                                     (market)
                                 Demand
        Increase inproduced, shifting thein the Short and
        New firms will continue to enter the industry,
        increasing the quantity
                    Run
        Longprice until potential entrantsdriving
        short run supply curve outward, and
        down the                                no
        longer anticipate earning a profit after
        entering the industry.
                          Firm                                      Market

Price                                              Price



                           MC    ATC                                B    S100firms
                                                                               S150 firms
                                                               A         C
    P1                                                P1                              Long-run
                                                                                       supply
                                                                                 D2
                                                                         D1


        0                           Quantity               0   Q1   Q2   Q3     Quantity
                                     (firm)                                     (market)
Shape of the LR Supply Curve
 The nature of the industry determines the shape of the
  long run supply curve.
   Is the min. ATC of potential entrants higher, lower, or
     the same as existing firms?
 Slope of the long run supply curve.
       Upward sloping-increasing cost industry.
       Downward sloping-decreasing cost industry.
       Flat-constant cost industry.
             Market for Fatburgers.
 What is takes to own a Fatburger.
    Net Worth of $250,000 with $150,000 in liquid assets.
    $30,000 franchise fee.
    $370,000-$730,000 startup costs.
    25% of startup costs funded from personal resources.
    Pay 5% of net sales.
 Example of business in a box.
 Invest $500,000 and earn $200,000 in first year profits.
        Long Run Supply Curve in Fatburger
                    Market.
Price




                                   Long Run Supply
                                   Constant Cost Industry




                                 Quantity
                                 (market)
Basics of Oil Exploration
         World Proven Petroleum Reserves, 2001
                Billions of Barrels and Percent of World


                                     Proven Reserves
       Region

North America                       63.9                   6%
S. & Cent. America                  96                     9%
Europe                              18.7                   2%
Former Soviet Union                 65.4                   6%
Iran                                89.7                   9%
Iraq                                112.5                  11%
Kuwait                              96.5                   9%
Saud iArabia                        261.8                  25%
United Arab Emirates                97.8                   9%
Total Middle East                   685.6                  65%
Africa                              76.7                   7%
Asia Pacific                        43.8                   4%
TOTALWORLD                          1050                   100%
Source: British Petroleum
  $/unit                                    An Increasing Cost Industry
                                                          MCSaudia Arabia
  P1=$30                                                                    In 1930, oil was only produced in the Middle East, the demand
                                                                            for oil was not that great, and the price of oil was low—P1. At
                                                                            P1 it was profitable to produce oil in Saudi Arabia and other
                          Profit                                            parts of the Middle East but not in other parts of the world.

                                                                            As the 20th century progressed, the demand for oil increased.
                                                      ATCSaudia Arabia      There was a short term increase in Middle Eastern oil production
                                                                            and in the long run (point B), the high price of oil led to the
  P1=$10                                                                    discovery of higher cost deposits in other parts of the world.
             Profit
                                                                            Will the entry of new firms, i.e. the discovery of new oil
                                                                            deposits outside the Middle East, eliminate the oil profits of
                                                                            Saudi Arabia?

                                                       Quantity
$/unit                                                  (firm)
                                                                                  P

                                        MCrest of world
                                                                                                                            SMiddle East

                                                                                                                B                 SME + rest of world
                                           ATCrest of world
  P2=$30              A                                                                                                          LRS

                                   AVCrest of world
                                                                                                                                  D1970
                                                                                                  A
  P1=$10                                                                          P1

                                                                                                                    D1930
         0                                       Quantity                          0                  Q1                    Quantity
                      q1                          (firm)                                                                    (market)
        Long Run Supply Curve in Fatburger
                    Market.
Price

                                   Increasing Cost Industry




                                   Constant Cost Industry




                                 Quantity
                                 (market)
Shape of the LR Supply Curve
 The shape of the long run supply curve is determined by the min
  ATC of potential entrants.
    If potential entrants have higher costs than existing firms, the
      LR supply curve will be upward sloping (oil industry
      example).
    If potential entrants have the same costs as existing firms,
      the LR supply curve will be flat (business in a box example).
 A constant cost industry is an industry where potential entrants
  face the same unit costs as existing firms.
    Example: Business in a box.
 An increasing cost industry is an industry where potential
  entrants face higher unit costs than existing firms.
    Example: Oil Industry
              Production and Supply-Progress
Efficient Production:                                                        Economic Analysis
What combination of inputs should the firm use to produce a given
                                                                        Effect of Changes in the World:
level of output at least cost?
                                                                        1.    Changes in Demand
                                                                        2.    Changes in Input Prices
                                                                        3.    Changes in Technology
Unit Cost Curves:
Given that the firm produces efficiently at each level of output what   To Analyze the Effect of a given
will be the unit cost of production at various levels of output.             change in the world:

                                                                        1) figure out what in the graphs is
                                                                               changing.
                                                                               a)     Input Prices
3-Part Output Rule of a Price Taking Firm:                                     b)     Technology
Given that a firm is producing efficiently and knows it’s unit costs           c)     Market Price
of producing at various output levels, what output will maximize a      2)     Shift the Appropriate Curve.
firm’s output given the prevailing market price                         3)     Work your way through all
                                                                               the graphs.
                                                                        4)     Interpret graphs to
                                                                               determine the effects of the
                                                                               Change in the World.
Short and Long Run Industry Supply Curve:
Given a group firms, i.e. an industry, producing an homogeneous
good, what output level will the group of firms choose given
various market prices in the short and long run.
K
             The 3-graph setup: showing an increase in output.
                                                                 The firm chooses to
                                                                 produce q1 units of the
                                                                 good efficiently at point A.

                                                                 Producing q1 units efficiently, the firm
                                                                 uses k1 units of capital and l1 units of
                                                                 labor.
     k1
              A                                                  If you know the price of K and L and the
                              q1                                 quantity of K and L used, and the amount of
                                                                 the good produced you can compute total cost,
                                                                 variable cost, average total cost, and average
                                                                 variable cost.
                  l1                                 L
$/unit                                                   Price


                                   MC

                                                                                                 S1

                                    ATC                                             A
                       A
     P1                                                                                                           Long-run
                                                                 P1                                                supply
                            AVC

                                                                                                 D1



         0                                Quantity               0                  Q1                      Quantity
                       q1                  (firm)                                                           (market)
                                                         Suppose the firm increases output from q1 to
K                                                        q2 in the short run. This is depicted as the
                                                         movement from A to B.

                                                                 The increase in the use of labor causes Total Cost, Variable Cost,
                                                                 Average Total Cost, and Average Variable Cost to change.

                                                                 The change in Total Cost divided by the change in quantity yields
                                                                 marginal cost.

     k1                                                                  The change in unit costs is show when output is
             A                 B                                         increased from q1 to q2
                                    q1              q2

                                                                                                                  If all firms in the
                                                                                                                  industry increased
                 l1                 l2                                                                            output, we would slide
                                                             L
$/unit                                                                 Price                                      along the short run
                                                                                                                  supply curve from A to
                                                                                                                  B.9
                                         MC
                           B                                                                                 S1
                                                                                                        B

                                          ATC                                                  A
                      A
     P1                                                                                                                       Long-run
                                                                               P1                                              supply
                                              AVC


                                                                                                             D1



         0                                      Quantity                       0               Q1       Q2            Quantity
                      q1       q2                (firm)                                                               (market)
With Prospect of Chapter 11 Looming, Delta and Pilots Bargain
By MICHELINE MAYNARD


              Delta Air Lines and its pilots union continued bargaining today on the airline's demand for $1 billion in contract
concessions, with the prospect of a Chapter 11 filing as soon as Wednesday hanging over the discussions. Negotiators for
Delta and the Air Line Pilots Association met through the night Monday and into today, a spokeswoman for the union said. She
declined to comment further.
               On Monday, Delta said it had reached a $600 million financing agreement with American Express Travel Related
Services, including a $100 million loan. The airline also said it had reached a deal with various debt holders to defer $135
million in notes that were due next year. But Delta said in a regulatory filing that it had not reached agreement on debtor-in-
possession financing, which it would need in order to run its operations under Chapter 11 protection.
              A court filing could occur as soon as Wednesday if the airline cannot agree with its pilots on $1 billion in wage and
benefit cuts and resolve other financial issues, people with knowledge of Delta's plans have said.
               Delta, the third-largest airline behind American and United, has warned repeatedly that it will have to seek court
protection unless it reaches a deal with its pilots on $1 billion in wage and benefit cuts, and achieves agreements with its debt
holders. Delta's pilots, who are the highest paid in the industry, have proposed cuts worth up to $705 million. A Chapter 11 filing
by Delta would mean half the industry's traditional airlines were under court protection. US Airways filed for its second
bankruptcy in two years on Sept. 12, while United sought Chapter 11 in December 2002. Agreement with the pilots' union is
required for Delta's deal with American Express to take effect. Under it, American Express said it would lend Delta $100 million
as part of a credit facility. Delta said it was still completing deals with other lenders.
                The rest of the agreement, $500 million, is in an arrangement involving Delta's SkyMiles, the points awarded by
its frequent flyer program. The agreement is backed by Delta's assets, and includes lengthy requirements that Delta must meet
in the event that it seeks Chapter 11 protection. Today is an early deadline set by Delta for holders of $20 billion to exchange
their debt under terms that are easier for Delta to meet. The final deadline for the exchange is Nov. 18, but terms are more
attractive to debt holders who exchange early.
              Delta extended the exchange offer in September after it failed to receive enough responses to its first effort.
               The success of the exchange offer is one of the requirements under an agreement reached Monday with various
lenders for Delta to defer $135 million in debt due next year, Delta said. Under that agreement, Delta could exchange that debt
for debt with a higher interest rate that would come due in 2007.
K             Analyzing the effect of a decrease in the price of labor
                                                                         If the firm follows a cost minimizing strategy it can move from
                                                                        A to B on the graph, producing the same output at a lower
                                                                        total cost.


                                                                        The decrease in the price of labor causes a rotation of the
                                                                        iso-cost line. At point A, the firm is no longer producing
                                                                        efficiently because (1) the iso-cost and is-output curves are
     k1                                                                 no longer tangent, (2) the marginal technical rate of
                   A
                                                                        substitution and relative price are not equal.
                                           q1
                                B                                    After the decrease in the price of labor, the unit costs of production
                                                                     are lower at each level of output. At every price each firm will
                                                                     produce more (at P1 the firm will increase output from q1 to q2).
                       l1                                        L
$/unit                                                                    Price
             The increase in output at each price by existing
             firms causes the short run supply curve to shift
                                       MC
             right, lowering price to P2
                                                                                                                S1
                                                                                                                           S2
                                                ATC                                                A
                            A
     P1                                                                                                                         Long-run
                                                                                  P1                                             supply
                                         AVC
     P2

                                                                                                                D1



         0                                            Quantity                    0                Q1                  Quantity
                            q1      q2                 (firm)                                                          (market)
K                Who benefits and loses from a reduction in the cost of labor.
                                                             Consumers are better off because the price of the good
                                                             has fallen.
                                                             In the short run, firms are better off because their costs fall
                                                             and they earn a profit.
                                                             In the long run, if the existing firms are earning a profit
                                                             because of lower costs, new firms will enter shifting the
                                                             short run supply curve to the right, increasing output, and
     k1                                                      further lowering price.
             A
                                  q1                         If this were a constant cost industry, the reduction in the
                                                             cost of labor would cause the long run supply curve to shift
                                                             down.

                 l1                                      L
$/unit                                                        Price


                                       MC

                                                                                                      S1
                                                                                                                 S2
                                        ATC                                                                        S3
                                                                                        A
                      A
     P1                                                                                                                 Long-run
                                                                      P1                                                 supply
                                AVC
     P2

                                                                                                      D1



         0                                    Quantity                0                 Q1                   Quantity
                      q1   q2                  (firm)                                                        (market)
 K
                   Who benefits from an improvement in technology?
                                                                              The improvement in technology allows the firm to
                                                                              produce more output with the same inputs.
                                                                              Different types of technological change may cause the
                                                                              slope of the iso-output curve to change.

                                                                              Because the firm is producing more output with fewer
     The reduced unit costs of production mean that at any given              inputs, and the price of inputs hasn’t changed, the unit
       k1
     price the existing firms will produce more, shifting the short           costs of producing will fall.
     runs supply curveA   outward. Even at the new lower price, the
                                           Q short
     existing firms will earn a profit in the100 unitsrun.

   In the long run, new firms will Q100 units entering shifting the
                                    continue
   SR supply curve farther to the right, increasing supply, and
   reducing price until lthe existing firms are just breaking even
                         1                                    L
   with
$/unit their lower costs.                                             Price

     In the SR, firms and consumers benefit from the
                                        MC
     improvement in technology. In the LR just consumers
     benefit.                                                                                                S1       S2
                                                                                                                           S2
                                            ATC                                                 A
                          A
       P1                                                                                                                       Long-run
                                                                              P1                                                 supply
                                    AVC

                                                                                                             D1



         0                                          Quantity                  0                 Q1                  Quantity
                            q1                       (firm)                                                         (market)
       If this were a constant cost industry, the technological
       change would shift the long run supply curve down.
                                          COLUMN ONE
                                     Telecom's Fiber Pipe Dream
      Upstart firms saw riches in circling the globe with high-capacity optic cable. Instead, they
                          were laying the foundation for their own downfall.
                             By JON HEALEY, TIMES STAFF WRITER


The world's phone calls, faxes and e-mails zip through strands of glass no thicker than a human
   hair, riding across countries and continents on pulses of multicolored light.
   The strands are bundled in cables that run beneath city streets, through mountain passes
   and under the seas.
   The cables were laid by a band of upstart companies that spent $50 billion or more in the
   last few years to wire the planet. These massive networks will serve the public for years to
   come, delivering the electronic goods of the Digital Age. But the companies that built them
   are not celebrating. Many are in financial ruin. The recent collapses of Global Crossing Ltd.
   and other communications firms have roiled financial markets and cost investors and
   employees tens of billions of dollars.
   How did such a triumph of engineering leave so much corporate wreckage?
   News reports of Global Crossing's meltdown have dwelt on accounting sleight of hand and
   extravagant executive pay. But what actually drove the company and others like it into the
   ground was an epic miscalculation.
   These upstarts bet that if they built communications networks with far more capacity, or
   bandwidth, than had ever been available before, customers would rush to use them.
   The network builders employed new technology that crammed much more data onto each
   strand of glass. This enabled them to slash prices for long-distance data transmission well
   below the rates charged by established networks, such as those of AT&T Corp. and British
   Telecom, that used older equipment.
The newcomers believed that the combination of low prices and abundant bandwidth would
   unleash a frenzy of activity on the Internet. Consumers and businesses would pay for all
   kinds of services that previously had been too expensive. People would watch Web movie
   channels on their TV sets. Doctors would diagnose illnesses via the Internet. Corporations
   would hold video conferences with employees around the world.
   The problem was that too many companies had the same dream, and they built too many
   digital toll roads to the same destinations. The prices commanded by long-distance
   networks did drop--but much more steeply than the newcomers expected. And the
   demand for their services did rise--but not nearly as much as they had banked on.
   As a result, many of the upstarts couldn't bring in enough cash to pay interest on the
   money they borrowed to lay all that cable.
   Their plight is a textbook example of the boom-and-bust cycle of high-tech capitalism. It
   illustrates how technological innovation, plowing relentlessly forward, can make companies
   and then break them.
   The financial outlook is not universally bleak--many network operators remain healthy, and
   some regions are not overloaded with fiber. But on many of the routes that drew the
   heaviest investment, such as those between the United States and Europe, the bandwidth
   glut is likely to remain for five years or more.
   "People have laid huge amounts of fiber in the ground," said Internet analyst Tony Marson
   of Probe Research Inc., "and there is a distinct possibility that quite a lot of that will never
   actually see any traffic."
   Explosion of Internet Traffic Fueled Demand
   If any one person inspired the burst of network building, it would be an English computer
   scientist named Tim Berners-Lee.
The expert in storing and retrieving data invented the World Wide Web in 1989 while
working at a European nuclear research laboratory.
Before then, Internet users had to type arcane computer commands to search for and
view files on the network. Berners-Lee devised a way to present documents, pictures
and graphics on electronic pages that could be retrieved with the click of a mouse.
The new technique transformed the Internet from a hard-to-use research tool into a
communications medium for the masses.
Two developments in the early 1990s aided that transformation. First, in 1992
Congress lifted the ban on commercial uses of the Net. Then, in 1993 and late 1994,
the first easy-to-use browser programs were released, simplifying the task of viewing
or building a Web site.
Up to that point, Internet use had doubled every year or so. Afterward, traffic
exploded, increasing tenfold in 1995 and again in 1996, according to researchers at
AT&T Labs.
"People thought it could double every quarter forever," said analyst Paras Bhargava
of BMO Nesbitt Burns, a Canadian investment bank.
As people and businesses began buying, selling and chatting online by the millions, it
seemed that no amount of Internet bandwidth would be enough.
"All these [dot-com] companies were cropping up, it seemed weekly, and there was
no end to that in sight," said Glenn Jasper of Ciena Corp., a telecom equipment
manufacturer in Maryland. "So the conventional wisdom was we've got to grow the
capacity of our networks not for the traffic that's out there now or even next week but
for a year from now."
For years, those networks had been operated in the U.S. by a handful of giant phone
companies and abroad by government monopolies. These companies relied on a small
number of equipment suppliers, such as AT&T's Western Electric subsidiary.
They lost their chokehold on the industry, however, just as Web traffic was exploding.
Governments around the world started prying open their telecommunications markets to
competition. At the same time, advancing technology gave birth to a litter of new equipment
suppliers that specialized in fiber-optic gear.
Long frozen out of the telecommunications business, investors suddenly had a chance in
the mid-to-late 1990s to crash the party. Venture capitalists opened their checkbooks to
bankroll new networks and equipment companies. Investors jumped on board as soon as
shares were offered to the public.
"There was a lot of money available," said Todd Brooks, a general partner at Mayfield
Funds, a venture capital firm in Menlo Park. "You had billion-dollar IPOs, and the gold rush
mentality set it."
Before long, engineers were stringing glass around the globe--a "new economy" version of
the race to build railroads across America in the 19th century.
Global Crossing and other companies tunneled under streets, carved trenches and sent
ships across the oceans, laying hundreds of thousands of miles of fiber-optic cable. Many of
the network builders were so sure of the growth to come that they packed the cables with
extra fibers that were left inactive--"dark," in industry vernacular--for future use.
But all the while, technology was advancing in a way that would delay the need for those
extra fibers--and, paradoxically, lure more competitors into the fray.
Fiber-optic networks use lasers to transmit light in split-second flashes. Think of them as
tiny, high-speed versions of the blinking semaphore signals that ships use to communicate
at sea.
Equipment makers improved that technology in two ways: by speeding up the flashes of
light and by using different colors to send multiple signals at the same time over a single
fiber. These innovations greatly expanded the capacity of fiber-optic networks.
Statistics illustrate the magnitude of the change.
In 1994, the entire global communications network could transmit about 1 trillion pieces of
data a second, said economist, author and technology pundit George Gilder.
Today, a single fiber strand has more than 1 1/2 times that capacity if it uses the best
optical equipment on the market.
In the U.S., 10 of the largest networks had a total of about 40 such fiber strands in service
in 2000, according to a study by Probe Research, based in Cedar Knolls, N.J. The
networks also had 570 dark fibers waiting in reserve. And since then, two emerging
national data networks, Touch America Inc. and Velocita Corp., have added more than
100 fibers to the total.
The increase in bandwidth is even more dramatic between the U.S. and the rest of the
world. For example, the capacity of networks linking the United States and Europe has
multiplied nearly 80 times since 1997, said Richard Elliott, co-founder of the Band-X
technology research group in London.
By the end of 2002, capacity is expected to nearly double again--and that's just counting
the fibers that are in service, not those left dark to accommodate hoped-for growth.
Marketing to Businesses
A catalyst in this explosion of capacity was Global Crossing. Unlike AT&T and other
established long-distance companies, Global Crossing showed little interest in
consumers' phone calls. Instead, company executives wanted to sell bandwidth
wholesale to other long-distance companies and corporations, which would use it for their
own communications needs.
Global Crossing's founder was financier Gary Winnick, a onetime furniture salesman and
investment banker who worked alongside junk-bond king Michael Milken in Beverly Hills.
Trumpeting the opportunities presented by telecommunications deregulation and fiber
optics, Winnick raised $750 million in 70 days in 1997 for the first leg of his network: an
8,700-mile cable from the United States to Britain, Germany and the Netherlands.
No single company had ever built an undersea cable with private investors' money before.
But when Global Crossing quickly found buyers for all that new capacity, "any doubts
about the need were quieted," said Elliott of Band-X.
Winnick soon had plenty of company on the fund-raising circuit. A host of other
entrepreneurs dazzled investors with charts showing the skyrocketing growth of the
Internet and the plummeting cost of doing business.
For example, James Q. Crowe, chief executive of Colorado-based Level 3, boasted that
his company's state-of-the-art fiber network would undercut its older rivals' prices by 15%
to 20%. Crowe raised a reported $6.5 billion before Level 3 had activated its first strand of
fiber.
"There were a lot of companies sort of going at this in parallel," said Dave Passmore,
research director at Burton Group, a network analysis firm. "They all got in when they
viewed this as an unexploited market."
Ron Kline, an analyst for the telecommunications research firm RHK Inc. in South San
Francisco, said it wasn't necessarily wrong for a new carrier to think it could win the battle
for customers. "The problem was there were too many people thinking about it."
The greatest advantage went to the carrier with the newest technology and highest
capacity. It spent less to push data through its network than its competitors did, which
meant it could charge lower prices.
So companies kept building networks even as the supply of bandwidth grew well beyond
demand. And as technology kept improving, the upstarts soon had to compete with
newer, more advanced players. No network could hold on to its advantage for long.
"In some bizarre movie about the telecom industry, you would have guys from the carriers going
out and killing guys in the labs to prevent them from coming up with new technologies," said
Ron Banaszek of TFS Telecom, a Swiss consulting and investment firm for communications
and energy companies.
Today, about 16 advanced transcontinental fiber networks are competing in the U.S. long-
distance business, said Larry Roberts of Caspian Networks in San Jose, which supplies
communications equipment. That's three times as many as there were two years ago.
The increase in capacity and competition drove prices to the floor.
Wholesalers such as Global Crossing typically sell companies a certain amount of capacity from
one city to the next--for example, enough to transmit 155 million pieces of data a second from
New York to London. A bank with offices in those two cities might use that capacity to connect
its computers.
In 1997, that capacity cost about $14 million upfront, plus annual fees of $250,000 to $380,000,
said Elliott of Band-X. Today, the same bandwidth could be bought for $350,000 upfront and
$15,000 a year.
Industry Forecasts Were Too High
So what happened to the burgeoning demand that was supposed to be the industry's lifeblood?
The extreme growth rates in Internet traffic seen in 1995 and 1996 were just a blip, reflecting
the advent of Web browsers, said Andrew Odlyzko, director of the Digital Technology Center at
the University of Minnesota. Since then, he said, the amount of data flowing over the Net has
reverted to its previous rate of increase, roughly doubling every year.
That's a lot of bits to move--but not nearly enough to fill the networks built during the boom.
One reason demand failed to mushroom as expected was the shortage of bandwidth in
local fiber-optic networks. Before consumers start downloading symphonies or watching
pay-per-view events online, they need a high-speed connection to the Internet. But in the
U.S., fewer than 10% of all homes have one.
There may be a data fire hose running from coast to coast, but the typical consumer is
still connecting through a straw.
Many consumers are unwilling to pay the extra cost of a high-speed line because, in their
view, the Internet is not compelling or important enough to justify it. The entertainment
companies that could make the Net more appealing to consumers, including most movie
studios and TV networks, are staying on the sidelines until more homes have high-speed
connections.
Some analysts and equipment makers argue that demand is growing faster than the
prevailing estimates indicate, increasing 2 1/2 to three times a year on the main U.S.
Internet pipelines. They argue that networks are getting so jammed in some areas that
long-distance companies will be ordering more within a few months to a year.
But even those growth estimates fall well short of the giddy projections of a few years
ago. And the situation may get worse before it gets better, if Bankruptcy Court allows
Global Crossing and other insolvent carriers to write off their debt and stay in service.
"That will launch a whole 'nother round of price wars that will cause pain for everybody in
the industry," said Russ McGuire, chief strategy officer for telecommunications consultant
TeleChoice Inc. "It will get worse for everyone, and in the end, Global Crossing will still go
away."
                      Sample Exam Problem
 Part One.
     1.Using short and long run supply curves and market demand curves depict the effect
      of the anticipated change in demand.
     2.If they act passively, i.e. do not try to anticipate the future, graphically show the short
      run adjustments firms will make on the iso-cost/iso-output graph if demand changed as
      anticipated.
     3.Using unit cost curves, show the situation of fiber cable companies, if demand
      changed as anticipated.
 Part Two. Suppose, as described in the article, firms anticipated a change in
  future demand, planned ahead, and demand changed as expected.
     1.On the iso-cost/iso-output graph show the firm increasing output in response to the
      anticipated increase in demand if the firm planned ahead.
     2.What effect would correctly anticipating the future have on the unit costs of
      production and the profitability of the firms if demand had changed as anticipated?
      Show on the firm’s unit cost graph.
 Part Three.
     1.Depict using short and long run demand curves and iso-cost and iso-output curves
      what actually happened.
     2.Show the effect of incorrectly anticipating the future on unit costs and profits.
             The Fiber Optic Transmission Market
   Firms anticipated an increase in demand for fiber optic transmission to Danticipated.
   If firms were surprised by the increase in demand, after the demand increased, prices would rise from P1
   to P2, existing firms would increase supply in the short run, and existing firms would earn a profit in the
   short run.




Price                                                       Price
                      Firm                                                                 Market


                             MC     ATC                                                       S1
   P2                                                                                                       Santicipated

    P1                                                           P1                                           Long-run
                                                                                                               supply
                                                                                                    Danticipated

                                                                                              D1


        0                                Quantity                   0             Q1                  Quantity
                                          (firm)                                                      (market)
              Unit Costs With/Without Planning
                         The firm starts at point B.
                         If the firm does not plan ahead and the demand for fiber optic
                         transmission capacity increased, the firms will be forced to increase
                         output in the short run with insufficient capital. (B to A).
Capital                  At point A, they are not producing efficiently.
                         If firms planned ahead, they would increase capital in anticipation of
                         the increase in demand and be able to produce the higher level of
                         output using a more efficient combination of inputs (point C).
                         They could then increase output more efficiently, i.e. at a lower ATC.


                     C
                            A

                B                           After increase in demand




                                                        Before increase in demand

          0                                                  Labor
             The Fiber Optic Transmission Market
   Firms anticipated an increase in demand for fiber optic transmission to Danticipated.
   If a firm anticipated an increase in demand that actually happened, the firms costs would be lower and
   their profits would be higher when demand actually increased.
   If the firms anticipated an increase in demand that didn’t occur, they would have too much capacity and
   produce at a loss.


Price                                                       Price
                      Firm                                                                 Market


                             MC     ATC                                                       S1
   P2                                                                                                       Santicipated

    P1                                                           P1                                           Long-run
                                                                                                               supply
                                                                                                    Danticipated
             Loss
    P3                                                                                        D1


        0                                Quantity                   0             Q1                  Quantity
                                          (firm)                                                      (market)
              Unit Costs With/Without Planning
                         If the firm plans for an increase in demand that does not occur, they
                         will end up with too much capital for the level of output they actually
                         produce.
                         Point D on the graph.
Capital




                 D   C
                            A

                B                           After increase in demand




                                                        Before increase in demand

          0                                                 Labor
Second Exam.
Second Exam.
 Cover Chapters 5 and 6.
 Thursday, Nov. 17th
 The exam will be based on the following
  articles:
   How Porsche Revived Itself (1996)
   Putting Porsche in the Pink (1996)
   Porsche's Big Bet: First New Model in Years (1997)
   A Boxster Built Anywhere is Still a Boxster (1997)
   Porsche Doubles Finnish Output of Popular Boxster
    (1998)
                     Articles                                                                          Economic Analysis
 How Porsche Revived Itself (1996)
            Putting Porsche in the Pink (1996)                                      Effect of Changes in the World:
            Porsche's Big Bet: First New Model in
                   Years (1997)                                                     1.       Changes in Demand
            A Boxster Built Anywhere is Still a                                     2.       Changes in Input Prices
                   Boxster (1997)                                                   3.       Changes in Technology
            Porsche Doubles Finnish Output of
                   Popular Boxster (1998)                                           To Analyze the Effect of a given change in the
  K                           Input prices: new price of K or L                           world:
                                 causes rotation of iso-cost
                                                                                    1) figure out what in the graphs is changing.
                                                                                            a)      Input Prices
                                      Technological change causes a
                                                                                            b)      Technology
                                      shift and/or rotation is iso-output
    k1                                                                                      c)      Market Demand
               A
                           q1                                                       2)      Shift the Appropriate Curve.
                                                                                    3)      Work your way through all the graphs.
                 l1                     L                                           4)      Interpret graphs to determine the effects
                                                                                            of the Change in the World.
         Unit Cost up or           SR or LR?
             Down?                                            Change in Demand causes a change in the market
                                                                price triggering a change in firms production.

$/unit                                                                      Price
                            MC                                                                                               Entry or exit
                                                                                                                              of firms in
                                                    Change in Price                               S1                           the LR?
                                ATC
                   A                                                                     A
   P1
                                                      Increase or              P1                          Long-run
                        AVC                                                                                 supply
                                                      decrease in
                                                        supply                                    D1
    0              q1            Quantity
                                  (firm)                                        0        Q1             Quantity
                                                                                                        (market)
                                     ArticleCopyright 1997 Investor's Business Daily, Inc.

                                                   Investor's Business Daily

                              HEADLINE: Porsche's Big Boxster Bet: 1st New Model In 20 Years

                                        BYLINE: By Paul A. Eisenstein, Investor's Daily

                BODY: It may be only a two-seater, but Porsche has a lot riding on its new Boxster sports car.

The German manufacturer's first all-new model since 1978, the eagerly-awaited Boxster, is designed to not only expand the
company's lineup, but help it regain some of the volume lost during a precipitous plunge in the late 1980s and early 1990s.
Porsche will have a tough challenge, though, for the Boxster is going up against other new sports cars, including the
Mercedes SLK and Chevrolet's completely new Corvette.

Times have certainly been tough for Porsche. Worldwide volume peaked at nearly 50,000 in 1986, with 60% in the U.S. But
three years later, the market collapsed. And by the time the company hit bottom U.S. sales had fallen below 3,000.

With the auto maker bleeding cash, there were serious questions about Porsche's viability.

After a string of management changes, its new chairman, Dr. Wendelin Wiedeking, launched an aggressive cost-cutting
program. Wiedeking called in a cadre of Japanese consultants, including former executives from Toyota, the world's most
efficient automaker.

By the time the dust settled, Porsche had cut nearly in half - to an average 70 hours - the time it takes to build the redesigned
911. That bought the company some time. ''The Boxster is a very important step for our company,'' proclaimed Wiedeking. ''A
company can't survive just by cost-savings. You also need good products.''

At around $ 45,000 out the dealer's door, the new roadster is extremely affordable, at least by Porsche standards. Yet it lives
up to the company's high-performance image. Completely new from the ground up, the sleekly styled Boxster is powered by
an aluminum, 24-valve 2.5 liter flat-six engine (the design is the source of the car's odd name) pumping out 201 horsepower.
Stomp on the gas and the roadster will race from 0 to 60 in a neck-snapping 6.7 seconds. Top speed is 149 mph.

Initial reviews have been extremely positive, with Car & Driver magazine crowing, ''The Boxster is pure, taut and sparkling
with desirability.''
Customers apparently agree, even before they've have a chance to drive the car. The Boxster's first year of production is
already sold out, according to Wiedeking. And he insists the company will have no problem maintaining volume of 15,000
units a year. The U.S. is expected to be Boxster's biggest export market, accounting for a third of sales, roughly equal to the
volume projected for Germany. While some skeptics worry the new car might cannibalize sales of the more expensive 911,
Porsche officials expect to draw up to 90% of the new car's volume from competitors - or owners of older Porsches who
were priced out of the market.
''There are those who bought 911s in the mid 1980s at around $ 32,000, who can't afford one today at $ 63,000,''
acknowledges Schwab, President of Porsche Cars North America.
While the 911 is typically used as a weekend plaything by its affluent owners, the Boxster is expected to serve as the only
car for many owners. And it also is expected to attract about 20% female buyers, double the rate for the 911.
Porsche's forecasts might seem a bit optimistic in light of current market realities.
Demand for sports cars, particularly in the vital U.S. market, has all but dried up in recent years. And as sales have slipped,
a procession of long-lived Japanese nameplates have pulled up stakes. Gone are the Nissan 300zx and the Mazda RX-7.
Yet at the same time, the Germans have re-entered this market niche with a vengeance. BMW has barely been able to keep
up with demand for the Z3 roadster it introduced last year following a splashy tie-in to the latest James Bond film,
''Goldeneye.'' An updated model of the Z3, with a larger, faster engine, is just going on sale.
Then there's Mercedes, which took the wraps off its SLK roadster last fall. The car has been a smash in Europe and it's
expected to meet strong demand in the U.S. as well following its North American introduction in Detroit. The price starts at $
40,000.
General Motors is back, too. It came close to killing off the once-coveted Chevy Corvette three years ago. But after some
soul-searching -and cost-cutting - it has completely reengineered the Vette. According to initial reviews, the new car is a
clear rival to the new European sports cars.
Despite all the new competition, auto analyst Joe Phillippi, of Lehman Brothers, is bullish about the Boxster - and the other
new European two-seaters.
''There's heritage to companies like BMW, Mercedes-Benz and Porsche,'' Phillippi said. ''You don't get that from Nissan,
Toyota or Honda.''

				
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