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"When I give food to the poor, they call me a saint. When I ask why the poor have no food, they call me a communist".
(Dom Helder Camera -former archbishop of Olinda, Recife, Brasil)(1984)
Basic Knowledge on Economics.- by Róbinson Rojas Sandford
Notes: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Session 4

            The Theory of Production [I]. The firm's costs and
            revenues. Price and output determination in conditions of
            perfect competition. Allocation of capital and labour.
            The perfect competition model of price and output
            determination. How real?
                    Fixed costs, variable costs. Total, average and
                    marginal costs. Total, average and marginal
                    revenues. Profit maximization ( normal and
                    abnormal profits ) in the long and short run.

The behaviour of firms will depend on main features of
the market place as related to number of firms, type of product,
relative control over price, conditions of entry in the business, and
relative level of non-price competition (advertising, etc).

By and large, two types of markets are considered in the study of
                       a) markets which allow perfect competition
                       b) markets which work in conditions of
                          imperfect competition.
Perfect markets as defined in a) are a theoretical concept to explain
and justify the capitalist system as a type of organisation of
production which is efficient, fair and dynamic. Perfect markets DO NOT

The following are the hypothetical features of a market with
perfect competition:

         number of firms : a very large number
         type of product : standardized
       control over price: none
      conditions of entry: very easy, no obstacles
     nonprice competition: none
                 examples: none

There are three types of imperfect markets, where competition is
unfair (imperfect competition). The three types from the supply side
are monopolistic, oligopolic and pure monopoly. The three types from
the demand side are monopsonistic, oligopsony and pure monopsony.

             IMPERFECT MARKETS (supply side)
                       Monopolistic     Oligopolic       Pure Monopoly
     number of firms:  Many             Few              One
     type of product:  Differentiated   Standardized or  Unique: no
                                        differentiated   close
  control over price:  Some, but        Circumscribed    Considerable
                       within narrow    by mutual
                       limits           interdependence,
                                        and considerable
 conditions of entry:  Relatively       Significant      Blocked
                       easy             obstacles
nonprice competition:  considerable     Typically a      Mostly
                       emphasis on      great deal,      public relations
                       advertising,     particularly     advertising
                       brand names,     with product
                       trade mark, etc. differentiation
            examples:  Retail trade,    Cars, steel      Some oil
                       dresses,         farm             companies,
                       shoes, etc       implements,      local
                                        households       utilities

                  IMPERFECT MARKETS (demand side)
                         Monopsonistic     Oligopsony   Pure monopsony
   number of firms:          Many             Few           One
control over price:        As above         As above       As above

In the real economy there exist a very large number of selling-buying
(supply-demand) relationships combining monopolistic competition,
oligopoly and pure monopoly with monopsonistic competition, oligopsony
and pure monopsony.
IN 1986
              European Community   23%
              United States        35%
              Japan                24%
Source: OECD

Tobacco industry                      99.1%
Iron and steel                        94.8%
Asbestos goods                        87.4%
Motor vehicles and engineering        87.3%
Aerospace equipment                   77.1%
Ordnance, small arms and ammunition   75.8%
Agricultural machinery and tractors   75.1%
Soap and toilet preparations          56.3%
Brewing and malting                   45.1%
Telecommunications equipment          33.1%
Building products                     31.0%
Woollen and worsted industry          27.7%
Specialized chemicals                 27.6%

Source: Central Statistical Office (1992)

Size by total   Percentage  Employment Percentage of  Percentage of
employment      of firms   (thousands) employment     net output
     1-99         96.28      1,203.7       25.0           19.2
  100-999          3.28      1,156,6       24.0           22.0
 1000-50000+       0.44      2,448.4       51.0           58.8

source: Central Statistical Office (1992)

The classical example of a firm doing business in a perfect competitive
market, is as follows:

COMPETITIVE FIRM (A classical example of "price taker" firm)

  (1)     (2)     (3)      (4)             (5)       (6)
Output   Total   Total   Profit          Marginal   Marginal
(Units   Revenue  Cost   (2)-(3)          Cost      Revenue
  0         0     100     -100                       
  1        70     150     - 80             50         70
  2       140     184     - 44             34         70
  3       210     208        2             24         70
  4       280     227       53             19         70
  5       350     250      100             23         70
  6       420     280      140             30         70
  7       490     318      172             38         70
  8       560     366      194             48         70
  9       630     425      205             59         70
 10       700     500      200             75         70
 11       770     595      175             95         70
 12       840     712      128            117         70
 13       910     852       58            140         70
 14       980    1016     - 36            164         70

Even when this firm cannot dominate the market and fiddle with the
price of its output (70 sterling pounds), it will maximize
profits producing 9 units instead of 13 units.

If the firm's output was 13-14 units, it will make NORMAL PROFITS,
but producing only 9 units, the owners of the firm will pocket

This action meeting the needs of the capitalist class, will not
meet the needs of the rest of society, because supply will not
be maximum, and employment will be lower than full employment.

The firm, in this so-called perfect competition environment,
will be wasting resources -capital and labour- and will have
an anti-social behaviour producing less than full capacity.

MEMORANDUM: in the region 9-10 units marginal cost is going to
            be 70, equals marginal revenue that is.
            The above is the golden rule of a maximizing profits
            capitalist economy:
            firms will produce until

Logic structure of the above notion:

       if marginal revenue is larger than marginal cost, the firm
       will produce an extra unit to pocket yet another portion
       of abnormal profits;

       because marginal costs start increasing after reaching
       the lowest point, there will occur a sequence in which
       marginal cost will closing the gap with marginal revenue,
       until both are going to have the same value;

       the next unit of output will have a marginal cost larger
       than marginal revenue, therefore the business person will
       not produce that extra unit of output...IT DOES MAKE CAPITALIST
       SENSE (which is maximising profits)


Output    Fixed    Variable   Total  Average
(units)   Costs    Costs      Costs  Costs
   0       100       0        100     100
   1       100      50        150     150
   2       100      84        184      92
   3       100     108        208      69
   4       100     127        227      57
   5       100     150        250      50
   6       100     180        280      47
   7       100     218        318      45
   8       100     266        366      46
   9       100     325        425      47
  10       100     400        500      50
  11       100     495        595      54
  12       100     612        712      59
  13       100     752        852      66
  14       100     916       1016      73


Fixed costs and variable costs:
            Total, average and marginal costs are often divided into
            two components: fixed costs and variable costs.
            A fixed cost is the cost of the inputs which
            the firm needs to produce any output at all.
            The total cost of such inputs does not change
            when the firm changes its outputs by an amount
            that does not exceed the inputs' production
            Any other cost of the firm's operation is called
            'variable' because the total amount of that cost
            will increase when the firm's output rises.
            FIXED COSTS are associated with the very existence
            of a firm's plant and therefore must be paid even
            if the firms's output is zero:
                     Interest on a firm's indebtedness,
                     Rental payments,
                     Depreciation on equipment and buildings,
                     Insurance premiums,
                     The salaries of top management and
                       key personnel,etc.
            VARIABLE COSTS (those costs which increase with the level
            of output). They include payments for materials, fuel,
            power, transportation, services, most labour, etc.
            As production begins, variable costs will for a time
            increase by decreasing amounts, and then rise by
            increasing amounts for each successive unit of output.
            The explanation of this behaviour lies in the law of
            diminishing marginal returns (see below)
Total, average and marginal costs:
          Total costs show for each possible quantity of output,
          the total amount which the firm must spend for its
          inputs to produce that amount of output plus any
          opportunity cost incurred in the process;
          Average costs show for each output the cost per unit,
          that is, total cost divided by output;
          Marginal cost shows, for each output, the increase in
          the firms' total costs required if it increases its 
          output by an additional unit.
Total, average and marginal revenues:
          Total revenue show for every possible quantity of output,
          the total amount of money the firm will accrue. Price
          per unit times quantity equals total revenue.
          Average revenue is the total revenue divided by the
          total output, which will give the revenue per unit of
          Marginal revenue is the change in total revenue from the
          sale of one additional unit of output.
          Example 1:
                         Output    Price   Total   Marginal
                         (units)   per     Revenue Revenue
                           1        70       70      --
                           2        70      140      70
          Example 2:
                           1        70       70      --
                           2        60      120      50
          Example 3:
                           1        70       70      --
                           4        70      280      70 (210/3)
          Example 4:
                           1        70       70      --
                           4        60      240      50.6 (170/3)

Profit maximization: ( normal and abnormal profits )
      Costs in capitalist economics have to do with missed opportunities
      or forgone alternatives (i.e., by using a building as a workshop,
      the owner sacrifices the monthly rental income which he could
      otherwise have earned by renting it to someone else. Similarly,
      by using his money capital and labour in his own enterprise, the
      owner sacrifices the 'interest' and 'wage' incomes which he
      otherwise could have earned by supplying these resources in their
      best alternative employments).
      This notion of cost is called the 'opportunity cost' doctrine.
      Therefore, for an individual firm 'economic costs' are those
      payments a firm must make, or incomes it must provide, to
      resource suppliers in order to attract these resources away from
      alternative lines of production.
      These payments or incomes may be either 'explicit' or 'implicit'.
      EXPLICIT COSTS: are cash outlays which a firm makes to those
                      "outsiders" who supply LABOUR services, MATERIALS,
                      fuels, transportation services, power, etc.
      IMPLICIT COSTS: are the opportunity costs of certain resources
                      which the firm itself owns, such as buildings,
                      machinery, money capital and own labour. An
                      important part of implicit costs is NORMAL PROFITS.
                      Thus, implicit costs will include:
                              rent on own buildings,
                              depreciation on machinery,
                              interest on own capital,
                              payment for services by owner of capital,
                              normal profits.
      NORMAL PROFITS: The minimum payment required to keep the owner's
                      entrepreneurial skills engaged in the firm is
                      called a NORMAL PROFITS. This amount, of course,
                      is included in COSTS.

Therefore, when a capitalist (business person) says that a firm is
JUST COVERING ITS COSTS, s/he means that all explicit and implicit
costs are being met and that the business person is therefore receiving
a RETURN large enough to retain her/his interest in her/his present
line of production.

    ABNORMAL PROFITS: If a firm's total revenue exceeds all its economic
costs, any residual will belong to the owner of the capital (firm).
This residual receives different names in accordance with the level of
accuracy of the definition:
                         ABNORMAL PROFITS,
                         SUPER PROFITS,
                         ECONOMIC PROFITS,
                         PURE PROFITS.

It is not a cost, because by definition it is a return in excess of the
normal profit required to retain the business person in this particular
line of production.
Capitalist economic theory associates abnormal profits with monopoly
power, but abnormal profits can be made in any type of capitalist
market (see table above)
SHORT RUN and LONG RUN (in economics):
The quantities employed of many resources (labour, raw materials, fuel,
power, etc.) can be varied relatively quick and easy. But other
resources demand more time for adjustment. For example, the capacity
of a manufacturing plant, that is, the size of the factory building and
the amount of machinery and equipment therein, can only be varied over
a considerable period of time.
     The SHORT RUN refers to a period of time too brief to permit an
     enterprise to alter its plant capacity, yet long enough to permit
     a change in the level at which the fixed plant is utilized. The
     firm's plant capacity is 'fixed' in the short run, but output can
     be varied by applying larger or smaller amounts of manpower,
     materials, etc. Existing plant capacity can be used more or less
     intensively in the short run.

     The LONG RUN refers to a period of time enough to allow the firms
     to change the quantities of all resources employed, including plant
     capacity. Also encompasses enough time for existing firms to
     dissolve and leave the industry and for new firms to be created
     and to enter the industry. The long run is a 'variable-plant'
Marginal physical product: 
      the marginal physical product of an input is the increase in
      total output that results from a one-unit increase in the
      input, holding the amounts of all other inputs constant.
              Numerical Example:
       Number of       Total Physical    Marginal Physical
       Workers         Product (pins)    Product (pins)
          1                1000                ---
          2                1250                250
          3                1550                300
          4                1900                350
          5                2200                300
          6                2450                250
          7                2600                150
          8                2650                 50
          9                2650                  0
         10                2600                -50      
The "law" of Diminishing Marginal Returns:
     This "law", which has played a key role in economics for more than
     two centuries **, asserts that when we increase the amount of any
     one input, holding the amounts of all others constant, the marginal
     returns to the expanding input ultimately begin to diminish. The
     so-called law is no more than an empirical regularity based on some
     observation of the facts; it is not a theorem deduced analytically.
         The reason why returns to a single input are usually
         diminishing is straightforward. As we increase the quantity of
         one input while holding all others constant, the input whose
         quantity we are increasing gradually becomes more and more
         abundant compared with the others.
         A classical example: as the farmer uses more and more
         fertilizer with his fixed plot of land, the soil gradually
         becomes so well fertilized that adding yet more fertilizer
         does little good. Eventually the plants are absorbing so
         much fertilizer that any further increase in fertilizer will
         actually harm them. At this point the marginal physical
         product of fertilizer becomes negative.

** The "law" is generally credited to Anne Robert Jacques Turgot
   (1727-1781), one of the most famous Comptrollers-General of France
   before the revolution, whose liberal policies, it is said,
   represented the old regime's last chance to save itself. But, with
   characteristic foresight, the king fired him.