Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 47 47 Of course, we recognize that you might just might be able to find someone with a large house in a place like Six Mile who might take the lower offer. We are only using comparative house sizes as a useful guide for narrowing the search or, in other ways, lowering the cost of your search. The person with a mansion in Six Mile is, in short, likely to be a hard sell. What you really want to find is someone who has a small house in a place like Six Mile and who is crazy about the beach and the moderate climate near the coast in Southern California. Indeed, one of the often-overlooked reasons for interview trips is not only to assess the person’s likely ability on the job, but also to assess how much he or she likes the new location relative to his or her established location. People who like your location relatively more can simply be had for less. We need to return to the question we started with, Should relocating workers be compensated for housing cost differences? The answer is a qualified no. That is, if housing makes up the main cost difference, then workers moving to a higher housing cost location would be too well compensated if the full cost of living difference were paid. He or she would take less. How much less is a problem that can only be solved by way of interviews and negotiations. We caution, however, that our analysis flows from an unstated but important assumption, that the housing cost difference in the two locations reflects actual cost differences that are not offset by benefit differences. That is, many times, a questionable assumption. Property near the coast in Southern California is much more expensive than in many (but not all) other parts of the country. It is also much more expensive than similar property fifty or a hundred miles inland, but still in California. We must ask why property is so expensive and why so much of the cost difference is in the land that any house sits on. An acre of land in Six Mile may cost no more than a few thousand dollars. On the other hand, an acre in La Jolla (at this writing) can cost upwards of a cool $1 million (a fact that explains why lots are measured in square feet)! Why the difference? Obviously the demand for property is much higher in La Jolla than in Six Mile, which implies that a lot of people must see some added benefits for being in La Jolla. This implies that for a lot of people, the full difference in housing cost between the two areas need not be covered by added monetary income. A part of the difference in living cost is covered by the “non-money income” associated with the additional amenities in La Jolla that are not compensated for in Six Mile. The first rule of management (and other disciplines) has sometimes been stated as, “Different Strokes for Different Folks.” In our foregoing discussion, we do not mean to suggest that everyone would want to live in La Jolla. If that were the case, the price of land in La Jolla would be far higher than it already is. We mean only to point out that “cost of living” differences cited by business people are not always relevant cost differences because of benefit differences. To make our point in more concrete terms, it may be true that the measured “cost of living” in La Jolla is 30 percent higher than the cost of living in Six Mile and, for that matter, 30 percent higher than the average for the rest of the country. However, no one should conclude that the cost of doing business in La Jolla (or any other “high cost” area) Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 48 48 is 30 percent higher than other parts of the country. The so-called cost of living can be offset in part by amenities and in part by more productive people who are attracted to the high-cost area. Many people with limited productivity will simply not be able to compete with their more productive counterparts in their search for property. 19 In making their employment decisions, firms need to keep these considerations in focus. They need to look carefully at what is implied by “cost of living.” Concluding Comments Demand is not what people would like to have or are willing to buy at a given price. Rather it is the inverse relationship between price and quantity, a relationship described by a downward sloping curve. Although economists do not have complete confidence in all applications of the law of demand, they consider the relationship between price and quantity to be so firmly established, both theoretically and empirically, that they call it a law. In difference curves provide a way of “structuring” consumer preferences and deriving the law of demand. In the real world, when the price of a good goes down, the quantity purchased may fall rather than rise. In such cases, economists normally assume (until strong evidence is presented to the contrary) that some other variable has changed, offsetting the positive effects of the reduction in price. Still, it must be remember that not all downward sloping demand curves are alike. They differ radically in terms of the elasticity of demand, or the responsiveness of consumers to a price change. Managers of public and private entities must be aware that the elasticity of demand can affect their business (pricing) strategies. Review Questions 1. What role does the law of demand play in economic analysis? 2. If the price of jeans rises and the quantity sold goes up, does the demand curve slope upward? Why or why not? 19 We should, therefore, expect people in high cost areas like La Jolla to have relatively high incomes. One reason is obvious: People need a high-income to cover the high cost of living. Another reason can go unnoticed: People who live in high-cost-of-living areas get much of their income in non-money forms, that is, in the amenities of the area, and these non-money forms of income are not subject to the high marginal tax rates that high-income people pay. For example, people who live on the coast in Southern California have to pay high prices for their housing partly because of the climate, which is very temperate (with high temperatures in the 70s) for much of the year. Accordingly, they have modest heating and cooling bills, which increase the demand and prices of their houses relative to other parts of California and the Southwest where the climate is more extreme and the heating and/or cooling bills are much higher. Of course, pretty scenery can also increase the demand for houses. People in Boulder have been known to say (or lament) that they have to “eat the mountains,” meaning their food and household budgets are constrained by the high prices of their houses, inflated by the views of the Rocky Mountains they have. Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 49 49 3. If the prices of most goods are rising by an average of 15 percent per year, but the price of gasoline rises just 10 percent per year, what is happening to the real, or relative, price of gasoline? How do you expect consumers will react? 4. Suppose that a producer raises the price of a good from $4 to $7, and the quantity sold drops from 250 to 200 units. It is demand for the good elastic or inelastic? 5. If the campus police force is expanded and officers are instructed to increase the number of parking tickets they give out, what will happen to the number of parking violations? What may be necessary to eliminate all parking violations? (Why may that option be rejected?) 6. If the government subsidizes flood insurance, what will happen to the price of that insurance? What will happen to the value of the property that is lost during floods? Why? 7. If the price of ballpoint pens falls, will the demand for ballpoint pens change? What will happen to the demand for pencils? To the demand for paper? 8. If a nation appreciates its currency in relation to other national currencies, what will be the effect on other nations’ exports and imports? On the willingness of that nation’s citizens to invest abroad? 9. Will a tax on imports and a subsidy on exports have the same effect on trade as depreciation of a nation’s currency? PERSPECTIVE: Experimentally Determined Indifference Curves An experiment to determine the characteristics of an individual’s indifference curves was performed by K.R. MacCrimmon and M. Toda with seven students from the University of California at Los Angeles. The seven students were asked to construct indifference curves for money and ballpoint pens and for money and pastries. A separate experiment was conducted for each indifference curve. Each experiment began with an initial reference point, or bundle, containing a given amount of money, measured along the horizontal axis, but none of the other good. The student was then presented with bundles containing varying amounts of money and the other good and asked whether each new bundle was preferred or not preferred to the initial bundle. After repeating this a number of times, a rather concise area remained that contained bundles the student found just as attractive as the initial bundle. The student then constructed his or her indifference curve within this area. This experiment was repeated seven times for the money-pen choices and four times for the money-pastry choices, and each experiment was begun with a different amount of money. So each student constructed seven indifference curves for money and pens and four indifference curves for money and pastries. To motivate students to give thoughtful and honest answers, one of the bundles that had been considered was randomly chosen after each indifference curve was constructed. If it had been preferred to the initial bundle, the student received it; otherwise, the student received the initial bundle containing only money. In the experiments dealing with money and pastries, the student had to eat all the pastries in the bundle received before the money was awarded. The resulting indifference curves were checked to see if they exhibited the characteristics that economists attribute to indifference curves. The indifference curves for each student were overlaid on the same graph to see if any of them intersected. They did not. The money-pen indifference curves and the Chapter 8 Consumer Choice and Demand in Traditional and Network Markets 50 50 money-pastry indifference curves were non-intersecting for all students. (The money-pastry indifference curves for three students did merge together as they moved out over the money axis.) Also, as expected, the money-pen indifference curves were downward sloping. Students would give up money only in return for more pens, and vice versa. In other words, both money and pens were considered goods, not bads. This was not true of the money-pastry indifference curves. When the bundles being considered contained only a few pastries, male students would give up a little money to obtain another pastry so that their indifference curves were downward sloping. But after consuming about three pastries, they would consume another pastry only if they received more money. At this point, pastries became a bad, and the indifference curves became upward sloping. For the two women in the experiment, even the first pastry was a bad, and their money-pastry indifference curves were upward sloping from the beginning. With only one minor exception, the indifference curves were convex everywhere. This is in keeping with the assumption of the normal shapes for indifference curves (which exhibit a diminishing marginal rate of substitution, at least within the vicinity of their tangency with the budget constraint). On the upward-sloping portions of the money-pastry indifference curves, this convexity meant that the more pieces of pastry that were consumed, the more money that would be required to encourage a subject to consume another pastry. Based on K.R. MacCrimmon and M. Toda, “The Experimental Determination of Indifference Curves,” The Review of Economic Studies (October 1969), pp. 433-51. CHAPTER 9 Production Costs and Business Decisions The economist’s stock in trade—his tools—lies in his ability to and proclivity to think about all questions in terms of alternatives. The truth judgment of the moralist, which says that something is either wholly right or wholly wrong, is foreign to him. The win- list, yes-no discussion of politics is not within his purview. He does not recognize the either-or, the all-or-nothing situation as his own. His is not the world of the mutually exclusive. Instead, his is the world of adjustment, of coordinated conflict, of mutual gain. James M. Buchanan ost is pervasive in human action. Managers (as well as everyone else) are constantly forced to make choices, to do one thing and not another. Cost or more precisely, opportunity cost is the most highly valued opportunity not chosen. Although money is a frequently used measure of cost, it is not cost itself. Although we may not recognize it, cost also pervades our everyday thought and conversation. When we say “that course is difficult” or “the sermon seemed endless,” we are indicating the cost of activities. If the preacher’s extended commentary delayed the church picnic, the sermon was costly. Although complaints about excessive costs sometimes indicate an absolute limitation, more often they merely mean that the benefits of the activity are too small to justify the cost. Many people who “can’t afford” a vacation actually have the money but do not wish to spend it on travel, and most students who find writing research papers “impossible” are simply not willing to put forth the necessary effort. This chapter explores the meaning of cost in human behavior. We will begin by showing how seemingly irrational behavior can often be explained by the hidden costs of a choice. We will then develop the concept of marginal cost, which together with demand and the related concept of supply defines the limits of rational behavior, from personal activities like painting and fishing to business decisions like how much to produce. Inevitably, points made earlier will be reviewed and extended in this chapter. There is a cost in this repetition, but there is also some benefit in a few varied reiterations. We will use the cost analysis to make points that seem to defy common sense in business. For example, we will show that a firm should not necessarily seek to produce at the level at which the average cost of production is minimized. C Chapter 9 Production Costs and Business Decisions 2 Explicit and Implicit Costs Not all costs are obvious. It is not difficult to recognize an out-of-pocket expenditure— the monthly price you pay for a product or service. This is called an explicit cost. Explicit cost is the money expenditure required to obtain a resource, product, or service. For example, the price of your book is an explicit cost of taking a course in economics. Other costs are less immediately apparent. Hidden costs of the course might include the time spent going to class and studying, the risk of receiving a failing grade, and the discomfort of being confronted with material that may challenge some of your beliefs. These are implicit costs; together they add up to the value of what you could have done instead. Implicit cost is the forgone opportunity to do or squire something else or to put one’s resources to another use. Although implicit costs may not be recognized, they are often much larger than the more obvious explicit costs of an action. (Then, there are some “costs” that are recognized on accounting statements that should not be considered in making business decisions. These costs are called “sunk costs.” See the box on the next page.) The Cost of an Education A good illustration of the magnitude of implicit costs is the cost of an education. Suppose an MBA student—Eileen Payne—takes a course and pays $2,000 for tuition and $200 for books. The money cost of the course is $2,200, but that figure does not include the implicit costs to the student. To take a course, Eileen must attend class for about 45 hours and may have to spend twice that much time traveling to and from class, completing class assignments, and studying for examinations. The total number of hours spent on any one course, then, might be 135 (30 hours in class plus 105 hours of traveling, studying, and so forth). The student could have spent that time doing other things, including working for a money wage. If Eileen’s time is valued at $25 per hour (the wage she might have received if working), the time cost of the course is $3,375 (135 hours x $6). Moreover, if she experiences some anxiety because of taking the course, that psychic or risk cost must be added to the total as well. If Eileen would be willing to pay $500 to avoid the anxiety, the total implicit cost of taking the course climbs to $820. Explicit costs Tuition $2,000 Books 200 Total explicit cost $2,200 Implicit costs Time $3,375 Anxiety 500 Total implicit cost $3,875 Total costs of course $6,075 Chapter 9 Production Costs and Business Decisions 3 The opportunity cost of the student’s time represents the largest component of the total cost of the course. The value of one’s time varies from person to person. For students who are unable to find work, the time costs of taking a course may be quite small. That is why many young people go to college. Their time cost is generally lower than that of experienced workers who must give up the opportunity to earn a good wage in order to attend classes full time. The Cost of Bargains Every Wednesday, supermarkets run large newspaper ads listing their weekly specials. Generally only a few items are offered at especially low prices, for store managers know that most bargain seekers can be attracted to the store with just a few carefully selected specials. Once the customer has gone to the store offering a special on steak, he would have to incur a travel cost in order to buy other items in a different store. Even though peanut butter may be on sale elsewhere, the sum of the sale price and the travel cost exceed the regular price in the first store. Through attractive displays and packaging, customers can be persuaded to buy many other goods not on sale, particularly toiletries, which tend to bear high markups. Supermarket chains do not necessarily make huge profits. The grocery industry is reasonably competitive, and supermarket chains as a group are not highly profitable compared to other corporations. The stores manage to recoup some of the revenues lost on sale items by charging higher prices on other goods. In other words, the cost of a bargain on sirloin steak may be a high price for toothpaste. PERSPECTIVE: Why “Sunk Costs” Don’t Matter A sunk cost is a past cost. Economists define past costs as historical costs that cannot be altered by current decisions. Such costs are beyond the realm of choice. Will a rational, profit-maximizing business firm base its current decisions on its historical costs? An example can help to answer this question. Suppose an oil exploration firm purchases the mineral rights to a particular piece of property for $1 million. After several month of drilling, the firm concludes that the land contains no oil (or other valuable mineral resources). Will the firm reason that, having spent $1 million for the mineral rights, it should continue to look for oil on the land? If the chances of finding oil are nonexistent, the rational firm will cease drilling on the land and try somewhere else. The $1 million is a sunk cost that will not influence the decision to continue or cease exploration. Indeed, the firm may begin drilling on land for which it paid far less for mineral rights, if management believes that the chances of finding oil are higher there than on the $1 million property. The underlying reason that sunk costs do not matter to current production decisions is that in the economist’s use of the term, sunk costs are not really costs. The opportunity cost of an activity is the value of the best alternative not chosen. In the case of an historical cost, however, there are no longer any alternatives. Although the oil exploration firm at one time could have chosen an alternative way to spend the $1 million, once the choice was made the alternative ceased to be available. Nor can the firm resell the mineral rights for $1 million; those rights are now worth far less because of accumulated evidence that the land contains little or no valuable minerals. Sunk costs, however painful the memory of them might be, are gone and best forgotten by the firm. Profits are made by looking forward, not backward. Chapter 9 Production Costs and Business Decisions 4 Some shoppers make the rounds of the grocery stores when sales are announced. For such people, time and transportation are cheap. A person who values his or her time at $10 an hour is not going to spend an hour trying to save a dollar or two. The cost of gas alone can make it prohibitively expensive to visit several stores. Because of the costs of acquiring information, many shoppers do not even bother to look for sales. The expected benefits are simply not great enough to justify the information cost. These shoppers enter the market “rationally ignorant.” Marginal Cost So far we have been considering cost as the determining factor in the decision to undertake a particular course of action. The rational person weight the cost of an action against it benefits and comes to a decision: whether to invest in an education, to shop around for a bargain, or to operate an airplane. The question is, how much of a given good or service will an individual choose to produce or consume? How does cost limit a behavior once a person has decided to engage in it? The answer lies in the concept of marginal cost. Rational Behavior and Marginal Cost Marginal cost is the additional cost incurred by producing one additional unit of a good, activity, or service. Marginal cost is the cost incurred by reading one additional page, making one additional friend, giving one additional gift, or going one additional mile. Depending on the good, activity, or service in question, marginal cost may stay the same or vary as additional units are produced. For example, imagine that Jan smith wants to give Halloween candy to ten of her friends. In a sense, Jan is producing gifts by procuring bags of candy. If she can buy as many bags as she wants at a unit price of fifty cents, the marginal cost of each additional unit she buys is the same, fifty cents. The marginal cost is constant over the range of production. Marginal cost can vary with the level of output, however, for two reasons. The first has to do with the opportunity cost of time. Suppose Jan wants to give each friend a miniature watercolor, which she will paint herself over the course of the day. To make time for painting, Jan can forgo any of the various activities that usually make up her day. She may choose to give up recreational activities, housekeeping chores, or time spent on work or study. If she behaves rationally, she will give up the activities she values least. To do the first painting, she may forgo straightening up her room—an activity that is low on most people’s lists of preferences. The marginal cost of her first watercolor is therefore a messy room. To paint the second watercolor, Jan will give up the more next-to-last item on her list of favorite activities. As she produces more and more paintings, Jan will forgo more and more valuable alternatives. In other words, the marginal cost of her paintings will rise with her output. If the marginal cost of each new painting is plotted against the quantity of paintings produced, a curve like the one in Figure 9.1 will result. Because the marginal Chapter 9 Production Costs and Business Decisions 5 cost of each additional painting is higher than the marginal cost of the last one, the curve slopes upward to the right. Although the marginal cost curve is generally assumed to slope upward, as the one in Figure 9.1 does, that need not be the case. If Jan placed equal value on all the forgone activities, her marginal cost would be constant and the marginal cost curve would be horizontal. FIGURE 9.1 Rising Marginal Cost To produce each new watercolor, Jan must give up an opportunity more valuable than the last. Thus the marginal cost of her paintings rises with each new work. __________________________________ The Law of Diminishing Returns The second reason marginal cost may vary with output involves a technological relationship known as the law of diminishing marginal returns. According to the law of diminishing marginal returns, as more and more units of one resource labor, fertilizer, or any other resource are applied to a fixed quantity of another resource land, for instance the increase in total added output gained from each additional unit of the variable resource will eventually begin to diminish. In other words, beyond some point less output is received for each added unit of a resource. That is, more of the resource will be required to produce the same amount of output as before. Beyond some point, the marginal cost of additional units of output rises. Although the law of diminishing returns applies to any production process, its meaning is most easily grasped in the context of agricultural production. Assume you are producing tomatoes. You have a fixed amount of land (an acre) but can vary the quantity of labor you apply to it. If you try to do planting all by yourself dig the holes, pour the water, insert the plants, and core them up you will waste time changing tools. If a friend helps you, you can divide the tasks and specialize. Less time will be wasted in changing tools. Chapter 9 Production Costs and Business Decisions 6 The time you would have spent changing tools can be spent planting more tomatoes, thus increasing the harvest. At first, output may expand faster than the labor force. That is, one laborer may be able to plant 100 tomatoes an hour; two working together may be able to plant 250 an hour. Thus the marginal cost of planting the additional 150 plants is lower than the cost of the first 100. Up to a point, the more workers, the greater their efficiency, and the lower the marginal cost—all because of the economies of specialization. At some point, however, the addition of still more laborers will not contribute as much to production as in the past, if only because a large number of workers on a single acre of ground will start bumping into one another. Then the marginal cost of putting plants into the ground will begin to rise. Diminishing returns are an inescapable fact of life. If returns did not diminish at some point, output would expand indefinitely and the world’s food supply could be grown on just one acre of land (For that matter, it could be grown in a flower box.) The point at which output begins to diminish varies from one production process to the next, but eventually all marginal cost curves will slope upward to the right, as in Figure 9.1. Table 9.1 shows the marginal cost of producing tomatoes with various numbers of workers, assuming that each worker is paid $5 and that production is limited to one acre. Working alone, one worker can produce a quarter of a bushel; two can produce a full bushel (columns 1 and 2). The third column shows the amount each additional worker adds to total production, called the marginal product. Marginal product is the increase in total output that results when one additional unit of a resource—for example, labor, fertilizer, and land is added to the production process, everything else held constant. The first worker contributed 0.25 (one quarter) of a bushel; the second worker, an additional 0.75 of a bushel, and so on. These are the marginal products of successive units of labor. The important information is shown in the last two columns of the table. Although two workers are needed to produce the first bushel (column 4), because of the efficiencies of specialization, only one additional worker is needed to produce the second. Beyond that point, however, returns diminish. Each additional worker contributes less, so that two more workers are needed to produce the third bushel and give more to produce the fourth. If the table were extended, each bushel beyond the fourth would require a progressively larger number of workers. Column 5 shows that if all workers are paid the same wage, $5, the marginal cost of a bushel of tomatoes will decline from $10 for the first bushel to $5 for the second before rising to $10 again for the third bushel. That is, increasing marginal costs (or diminishing returns) emerge after the addition of the third worker. If the marginal cost of each bushel (column 5) is plotted against the number of bushels harvested, a curve like the one in Figure 9.2 will result. Although the curve slopes downward at first, for most purposes the relevant segment of the curve is the upward-sloping portion above point a, will be explained in detail later). . bushel of tomatoes will decline from $10 for the first bushel to $5 for the second before rising to $10 again for the third bushel. That is, increasing. ballpoint pens falls, will the demand for ballpoint pens change? What will happen to the demand for pencils? To the demand for paper? 8. If a nation appreciates