ECON5503 Week 2 Part 1

Summary

In week two of ECON5503, the focus is on understanding production costs, accounting profit vs. economic profit, and the critical distinction between the short run and the long run in microeconomics. This lecture underscores the importance of incorporating opportunity costs to determine true economic profit, which contrasts the accountant's view of profit. It also elaborates on how production and cost dynamics differ between the short run, where capital is fixed, and the long run, where all inputs can vary. The session uses relatable scenarios to illustrate these concepts.

Highlights

• Engaging explanation of accounting vs. economic profit! 4c1
• Interesting scenario of an accountant-turned-farmer to illustrate opportunity cost! 33e
• Clarifying the misconception about how long the 'short run' is with industry examples! 4c9
• Discussing the impact of demand increase on production in short vs. long run! 4aa
• The significance of opportunity costs and economic profit in evaluating business decisions! 4b0

Key Takeaways

• Understanding economic vs. accounting profit is crucial! 4c8
• Opportunity cost is the foregone alternative, always consider it! 9fe
• Short run vs. long run: It's all about fixed vs. variable inputs! 1f31ec
• In the short run, increase production by adding labor; in the long run, adjust both labor and capital! 528
• Economies of scale can be achieved in the long run, not in the short run! 680

Overview

Welcome to the world of production costs! This week's session dives into the nuanced differences between accounting and economic profits. Paul Crompton introduces the concept with a fascinating story of an accountant who turns to farming, only to realize that the economic profit paints a very different picture due to the opportunity cost of leaving her accounting job. The difference isn't just numbers; it's a shift in perspective that is critical in understanding true profitability and the realities of business ventures.

Our journey next takes us through the intriguing worlds of the short run and the long run in economics. Paul vividly explains how these concepts play out differently in various industries, using relatable examples like hair salons and mining companies. The key takeaway here is that the short run fixes certain inputs (like capital), whereas the long run allows for all inputs to change, offering a broader scope to adjust to market demands and achieve optimal production levels.

Finally, we examine the dynamic interplay between production and cost in both the short and long run. With an increase in demand, businesses may need to expand production, and the strategies differ based on the time horizon. In the short run, adding more workers is the go-to move, but in the long run, expanding both capital and labor makes economic sense and could lead to economies of scale. Understanding these distinctions is vital for making informed production decisions and maximizing efficiency.

Chapters

• 00:00 - 00:30: Introduction to Topic 2: Production Costs This introductory section of Topic 2 focuses on the concept of production costs. It begins by discussing how these costs fluctuate as companies adjust their production levels. A key part of the chapter is the differentiation between accounting profit and economic profit, emphasizing the significance of understanding this distinction. Additionally, the chapter touches on the importance of recognizing the differences between the short run and long run in microeconomics.
• 00:30 - 04:30: Accounting Profit vs Economic Profit The chapter explores the difference between accounting profit and economic profit through a practical scenario. It begins with an accountant who leaves a $120,000/year job to buy a small farm. In her first year, she earns $800,000 in revenue, but must consider three types of operating costs: fixed costs, variable costs, and the cost of capital. The core question revolves around whether the farmer is actually making a profit, setting the stage for a deeper examination of profit types.
• 04:30 - 07:00: Opportunity Costs and Economic Profit This chapter, titled 'Opportunity Costs and Economic Profit,' highlights the difference between accounting profit and economic profit. It uses the example of a farmer to demonstrate how an accountant calculates a profit of $100,000 based on revenue and costs, but an economist might see a loss. The distinction lies in the consideration of opportunity costs by economists, which aren't accounted for in traditional accounting profit calculations. The chapter aims to provide a deeper understanding of how economists evaluate profit beyond the surface-level financial figures.
• 07:00 - 13:30: Short Run vs Long Run in Microeconomics This chapter delves into the distinctions between short run and long run in microeconomics, using examples such as a farmer's earnings to illustrate how accounting and economic profits differ. It highlights the differences in profit calculations, emphasizing that what appears as a $100,000 profit in an accounting sense could translate to a $21,000 loss when assessed from an economic perspective, illustrating the broader scope of economic analysis.
• 13:30 - 17:30: Responding to Increased Demand: Short Run vs Long Run Strategies This chapter discusses the concept of increased demand and differentiates between short-run and long-run strategies. It emphasizes understanding and calculating various types of costs associated with these strategies: fixed costs ($150,000), variable costs ($400,000), and mixed costs ($150,000). Additionally, the chapter introduces the idea of opportunity costs — in this case, the $120,000 that could have been earned working as an accountant instead of farming.

ECON5503 Week 2 Part 1 Transcription

• 00:00 - 00:30 welcome to part one of topic two production costs and in this topic we're looking at how production costs actually vary as firms change their level of production so what we're looking at in this particular presentation is accounting profit versus economic profit and the distinction is very important as you'll soon see and also we're drawing a distinction between two periods of two different periods of time in microeconomics and that is the short run versus the long run now in terms of economic profit I've
• 00:30 - 01:00 set up a little scenario here we've got an accountant who was earning $120,000 a year and she leaves her job and purchases a small farm now during the first year of operation I've got revenues there of $800,000 and I've got three categories of uh operating costs um so we've got uh fixed costs variable costs and then the cost of capital and so the question is is the farmer making a profit well well an
• 01:00 - 01:30 accountant would look at that and say revenue is 800,000 those three costs total 700,000 so an accountant would say yep the farmer is making a $100,000 profit an economist however would look at those numbers and say this person is actually making a loss so what is the distinction well to start with on this slide I've got accounting profit here calculated as $100,000 and that definition of of profit is a perfectly valid definition
• 01:30 - 02:00 and that's the one that you'll be learning about in your accounting unit as part of your studies and this farmer would presumably earn the $100,000 pay tax on that and uh whatever is left over the person would split between savings and consumption however an economist wouldn't Define profit that way an economist would actually Define it as I've got uh one line down economic profit equals well it's actually a 20 $1,000 loss because in economics in
• 02:00 - 02:30 addition to those three types of uh costs that I outlined for 150,000 400,000 and 150,000 we also include opportunity costs and that is the $120,000 that this person could have made working as an accountant if they hadn't have switched their labor over to farming so in this sense how do we interpret
• 02:30 - 03:00 this $220,000 this $20,000 loss here this um negative economic profit well that $20,000 loss is really comparing the profit that the farmer made farming with their next best alternative which is working as an accountant and earning $120,000 a year so this economic profit of uus 20,000 is really saying that this person made a loss by by farming
• 03:00 - 03:30 relative to the amount of money they could have earned if they had worked as as an accountant so the concept of economic profit is really comparing the current employment with the next best alternative so in a sense it's comparing what is actually going on with the next best alternative and if we were just looking at this Farmer's options from a monetary sense then it would make most sense for this farmer to actually go back to
• 03:30 - 04:00 accounting unless these numbers change in some way now this idea of opportunity cost that is your next best alternative those opportunity costs are actually built in to the cost curves that we'll be dealing with later on in this topic okay so therefore in microeconomics we consider fixed costs variable costs and opportunity costs as
• 04:00 - 04:30 well so to be doing well in in an economic sense you have to be earning enough Revenue to cover your fixed costs your variable costs and your opportunity costs as well you have to earn enough Revenue to cover those opportunity costs okay so that concept of economic profit uh that'll become very important when we start looking at um the cost curve so we will come back to that concept of economic profit but now there's an equally important concept
• 04:30 - 05:00 that we have to uh understand and that is the distinction between the short run and the long run in economics the short run is a period of time when at least one input cannot be varied and we normally refer to that as capital and the long run is a period of time when all inputs can be varied now over the years I've had a lot of people ask me well how long is the short run is it 6 months is it 12 months is it two years it depends upon the industry the short
• 05:00 - 05:30 run is a period of time where your capital is fixed now if you're running let's just say you're running a hair sellon and you've got some spare room in the back of the shop if you want to actually increase your Capital which would be um items such as the the chair the the mirror and all of the the other sorts of Capital Equipment that go into running a hair cell on then it would probably take you maybe two months to
• 05:30 - 06:00 get the chairs in to get the mirrors installed and actually increase your productive capacity by having more Capital so in the in the uh hair sellon industry the short run may be a period of say two months in the mining industry however to significantly increase the productive capacity of a Mine by introducing more Capital that can take several years so in the mining industry the short run could be three or four years so I can't
• 06:00 - 06:30 give you a nice neat answer in terms of how long the short run actually is it depends upon the industry okay so then the next question is why is this distinction between the short run and the long run very very important sometimes people read about this distinction but they're not fully aware of why it's an important distinction and what I've got there is that it's important because it affects how firms actually increase their production levels so if a firm
• 06:30 - 07:00 experiences an increase in production in the short run the only way of satisfying the increase sorry if a firm uh experiences an increase in demand in the short run the only way to satisfy that extra demand is by employing more workers using the same amount of capital you have because capital is fixed in the short run and producing more that way however if we're dealing with the long run and a firm experiences an increase in demand then the firm has the option won't necessarily do this but it does have the option of increasing both labor
• 07:00 - 07:30 and capital so you can imagine that there would be very different price Dynamics going on when you a can just increase production by increasing labor versus B increasing production by increasing both capital and labor okay the relationship between production and costs are very different under those two scenarios I.E the short run and the long run so that's why it's very very important we have to do
• 07:30 - 08:00 separate uh types of analysis when we are considering production changes in the short run versus production changes in the long run okay because the relationships between production and costs are different in those two uh periods of time okay so let's think through this example and I've I've already sort of spoken about this um in the last couple of minutes assume you're running a
• 08:00 - 08:30 manufacturing plan and experience a 30% increase in demand so let's just imagine that you have a f a factory with say five machines five pieces of Capital Equipment and you want to you experience an increase in demand and you want to match that by increasing your production how are you going to do that in the short run well the only way of doing it in the short run is you've got fixed amount of capital so you'll have to employ more labor and as you employ more and more labor you're going to have to work the capital harder and harder and
• 08:30 - 09:00 harder and what you're actually going to experience in the short run is rising production costs so as you try to produce more and more and more in the short run using a fixed amount of capital your production costs are going to rise so your marginal production costs are going to rise compare that to the long run let's just imagine that we have a 30% increase in demand and we want to match that with a 30% increase in production uction we
• 09:00 - 09:30 also assume that we believe that the increase in demand is permanent so it's not just a temporary thing where where production will need to go back to down to its original level quickly but it's a permanent increase in production and thus demand sorry permanent increase in demand and thus production how are you likely to respond then well if we know it's a permanent increase in demand and therefore production it does doesn't make any sense to keep Capital fixed and just
• 09:30 - 10:00 adding more and more labor because Capital will be worked to intensively the Capital Equipment will get crowded there will be too many people trying to access that Capital Equipment in the short run so if we're dealing with a longer run period of time the long run it would make more sense to respond to this increase in demand by increasing production by increasing both capital and labor
• 10:00 - 10:30 if we can increase both capital and labor then we we aren't restricted in terms of uh the amount of capital we have we can freely increase uh Capital to the optimal level and probably take advantage of some economies of scale okay so hopefully that uh explains why