For something to be created, something must be lost. This tenet is pervasive in every field that seeks to understand how the world operates whether it’s the law of conservation in physics or for producers in economics, inputs or factors of production.
Some inputs include labor, capital, land, and education.
For now, focus on labor (l) and capital (k). You’ll have the opportunity to understand the other inputs later in the context of macroeconomics and how certain countries exceed others in economic output. For example, the United States shot ahead of more labor-intensive countries because of their ability to quickly export capital as well as access to knowledge and a culture that bolsters entrepreneurship.
Okay, bear with me here. Firms do not use these inputs to maximize output. The goal is to maximize profits.
Profit (prɔ́fɪt): like Robin Hood but in reverse.
Firms select a combination of inputs that determines the quantity as well as price they charge and the profits that are yielded. It is as complex as it seems.
A production function may look something like this:
Q = L^(.5)K^(.5) – (Cobb-Douglas Function)
How readily available these inputs depends on the length of time. Economists generally use short-run (< 1 year) and the long-run (> 1 year). In the short-run, most factors are fixed due to liquidity (how fast they can be adjusted), while in the long-run, all factors are variable.
These inputs also have their associated costs. A fixed cost is called such because the cost does not change with output. For example, a factory may cost $2000 a month, regardless of whether you use it to produce 1,000 units or 10,000. Fixed costs are usually associated with capital.
On the other hand, variable costs change with output. For example, labor. If you wish to produce more using workers, you’d need to hire more.
The total cost is the sum of all costs of production. If you have a fixed cost of $2,000 a month for the lease and monthly salary of 2 workers is $1,500, then the total cost is 2000 + (2 * 1500) = 5000.
The most important concept is the marginal cost, the increase in cost to produce an extra unit. If your two workers can produce 1,000 units a month, but it takes 3 workers to produce 1,500, then the marginal cost would be $1,500 additional salary /500 additional units = $3 per additional unit.
You can work with smaller numbers here. If it costs $15 an hour to hire a worker who then puts out two goods each hour, the marginal cost is $7.50. This then means the price of your goods should be $7.50 minimum.
This ties back to the cost-benefit principle of taking a decision only if the benefits to be gained outweighs the costs to be incurred: in this instance, hiring an extra pair of hands who can produce more than they cost.
Producer surplus
So then? How is the producer surplus illustrated on a supply demand curve? Well, if the supply curve indicates the marginal cost up to the price point (marginal benefit), then the surplus is the difference between the price and the cost. Now, you’ve probably fell into the pit trap of conflating producer surplus and profits. Remember the supply curve only resembles the marginal cost and not the total cost. The total cost would be higher so the profits will always be less than the producer surplus (although there is a way to calculate profits, again, we’re interested in the decision-making mechanics here)
Issues in the supply chain, why do they occur?
So we learned how the machine should work (in theory), but then why does the machine often not work? There are various reasons.
Poor decision-making. Probably the number one reason nothing ever works as intended. Humans aren’t robots and even robots are inefficient at times. Not as interesting to economists who prefer to pretend everyone is perfectly logical. Solution: hire consultants.
Shocks in the short-term. The most recent shock that many can recognize is the Coronavirus pandemic, which brought global trade to a standstill. There are other shocks you might recognize including natural disasters or man-made disasters such as wars or reaaaally bad decision-making. (See: 2008 Financial Crisis)
There are even more shocks that are not news-worthy but affect you all the same. For example, two cooks may have just quit your local pizza joint and the only person working is a stoned 17-year old kid who forgot he already placed pizzas in the oven and now you’re wondering what is taking your order so long.
Or perhaps the delivery truck went to the wrong storefront so now your grocery store is out of stock on canned fruits. Sometimes, the solution is apparent and quick to remediate and the shock is short-lived. For example, schedule a truck for a next-day delivery. Other solutions might require time and effort, for example, hiring new cooking may take weeks and training them, even longer. Solution: varies.
Limitations. Other times, decisions are made as best as they can, nothing unexpected occurs, yet there are still problems. Often times, production is slow because of limitations. Inadequate infrastructure, including rail systems and roads, are a burden on not only production but impact transportation costs, travel times, and result in unreliability. Regulations and laws are another form of limitations.
Technology is another limitation, which is why advances are in demand and expensive. You may scorn Apple and Samsung for releasing a phone every year for north of a thousand bucks but overall, better technology allows them and consumers to seize uncontrolled territory, even if only inches. You don’t see too many people using Windows 2000, do you? DO YOU? Solution: talk to your Congressman. Or buy the new Apple Watch. Probably easier.
Ideassey 