Short Run Output and the Coase Theorem

I. Introduction

We have talked about the concept of equilibrium, which is when the price and quantity settle down to their appropriate amounts after bouncing around for a while. At equilibrium, supply price and quantity equal demand price and quantity. But it may take time to get to equilibrium, with much trial and error in pricing in the meantime.

Last lecture we focused solely on demand. This time we turn to supply. We look at how companies decide how much product to make and put out into the market. How many goods should a company produce, or how many services should it provide?

Before we start, however, we define two terms essential to economics: the short run and the long run. As its name implies, the short run is a relatively short period of time in which a company can only make temporary changes to its operation. In a sporting contest, the short run would during a game, when the coach decides to substitute his players or alter the game plan to try to win that particular contest. During the short run only quick and temporary reactions by a company or firm to a fluctuation in demand are possible. For example, changes like using more overtime labor would be a short run adjustment. Or telling workers to take an extended vacation due to lack of demand for the goods would be another short run change. This class we will be focusing on the short run.

In the short run it is impossible to change the fixed costs, or sunk costs. The cost of factory, and the equipment inside, cannot be altered. These fixed costs can be easily measured by seeing what the total costs are when output is zero. That is because when output is zero, there are no marginal costs, and all the costs are the fixed ones.

The long run consists of a time period long enough to make basic and permanent changes, like building new factories, buying new equipment, and hiring and training new employees. In a sporting contest, it would include scouting and drafting new players, or building a new weight room. Everything can be adjusted in the long run: workforce, facilities, materials, equipment, investment, etc. We’ll discuss the long run next class.

For now, let’s focus on the short run. The key concepts are marginal cost and marginal revenue. How much does it cost to make one more widget, and much revenue does that extra widget generate for the company? That additional cost per unit is called marginal cost. The additional revenue per unit is called marginal revenue. As long as marginal revenue is slightly higher than marginal cost, then it makes sense to produce that extra widget. Typically, companies continue making more and more goods until marginal revenue falls below marginal cost, at which time they stop production because they begin to lose money on each additional good they produce.

But we are not going to spend the entire class on marginal cost and revenue. We are also going to introduce two other concepts basic to modern economics: efficiency and the Coase Theorem. You’ll find those topics extremely interesting. However, let’s cover the basics first.

II. The Short Run

Imagine yourself as the President of a company making widgets, our imaginary good. If it costs you $200 to make 10 widgets and $205 to make 11 widgets, then what is your marginal cost (MC) of the 11th unit? It is only $5. What is its average cost? Nearly $19 ($205 total cost divided by 11 total units). Average cost is often greater than the marginal cost. This makes sense, because once you pay for your factory and workers, you do not have much additional cost to produce an extra unit. This is called economies of scale: the bigger your operation, the cheaper you can make one more unit.

Think of a baking some bread. It requires some time and effort to bake one loaf of bread. But there is not as much extra effort to stick another loaf in the oven.

Or imagine going to a baseball game. The cost for one person to go is the ticket price plus the cost of gas and parking and wear and tear on the car. The cost for a second person to go with the first person is just the price of the ticket. There is no extra gas or parking or wear and tear on the car for a second person to ride along. So the marginal cost for the second person is much less than for the first person.

But let’s return to your role as President of the widget company. You are deciding how many employees to hire. You have an assembly line that needs workers. Each additional employee that you hire to work on that assembly line increases the marginal product of labor, which is the increase in output for each additional unit of labor. It is often called MP.

Let’s explain MP a different way to make sure you understand it. The more workers you hire, the more goods your company can produce. Suppose you can make 1000 widgets a week with 10 employees. Then you hire one more employee, and your output increases to 1015 widgets. What is the marginal product of labor, or MP, for your 11th employee? It is 1015-1000=15. Note that is less than the average product of labor, which 1015/11 = 92.3 for 11 employees. You are suffering from diminishing marginal returns. You received much more benefit from the 1-10 employees you hired earlier (their average product of labor is 100) than this 11th employee (with its MP of only 15).

Again, this makes sense. As you hire more and more employees, your benefit from will eventually decline. Once the assembly line has enough workers to satisfy demand, for example, you would be wasting money by hiring additional workers. They would end up spending the day talking to each other rather than doing productive work. If you were to keep hiring employees, then eventually the MP for your next employee would fall to zero. He would have nothing productive to do.

On the other side, however, the MP for your first employee would be greater than zero. Additional employees might have even higher MPs because you are filling your assembly line. If your assembly line needs 10 employees to run it, then the MP for your 10th employee will the highest of all. After that, the MP begins falling.

In general, MP rises as your initial employees are hired, eventually reaches a maximum at some point and then falls back towards zero for each additional employee. It is an upside-down oval, beginning at MP=0 for 0 employees and returning to MP=0 for a large number n of employees. The value of n depends on the business.

The optimal number of employees for an NBA basketball team, when MP is its maximum, is only about a dozen players. The optimal number of employees for Wal-Mart, when MP is its maximum, is over 1 million employees. So it all depends on what the company is producing.

Can we can find the marginal cost (MC) of making that extra widget based on (i) the wages we have to pay the extra employee and (ii) his marginal productivity (MP)? If it costs us $100 to hire one more employee, and he enables us to make 10 more widgets, then our marginal cost (MC) is simply $100/10 = $10 per unit. In other words, MC = wage/MP.

Let’s make sure we understand this by looking at another example. Suppose that hiring one more sales agent at $80 per day in our clothing store enables us to sell 8 more dresses. What is our marginal cost for dresses at that point? It is simply the additional cost of $80 (the wage) divided by that employee’s marginal productivity of 8 new sales, yielding a marginal cost of $10 per dress.

III.       Efficiency

Imagine what your day is like as President of the widget factory. You arrive to work earlier than everyone else, because you care the most about the success of your company. During the workday you walk through your factory to see how things are going. You see employees chatting at the water cooler, talking to their friends on the phone, or not showing up for work at all. This irritates you because you are paying for their time. You tell them to get back to work.

You also see equipment sitting idle for various reasons. That annoys you too. You paid for the equipment, or you are renting it, but it is not helping your business by sitting idle. You want to return or sell it, or find a way to make it useful.

Less easy to see are the wasted opportunity costs. Perhaps your assembly line could be making a different kind of widget that would be more profitable than the one you are making.

All your concerns can be summed in one economic term: efficiency. Efficiency is the maximum possible productivity at any given time. It consists of the least amount of wasted time, effort or money. There is no wasted opportunity cost in an efficient operation.

For once, this is an economic term (efficiency) that has the same meaning as its common everyday usage. It was an inefficient use of my time to sit here all morning waiting for you! Try to do your chores more efficiently so that you can finish sooner. She finishes her homework faster than you because she works more efficiently.

Generally, maximum efficiency is desired and people want to avoid wasted time, materials, effort, and expense. However, there is a significant obstacle to true efficiency: transaction costs. Recall that transaction costs are all the incidental expenses that a consumer must spend to acquire a good. One textbook defines transaction costs as the time, effort, and expense that go into the purchase of a good. (Spencer, Contemporary Economics, at p. D-53). Nobel laureate Ronald Coase, discussed below, describes transaction costs as simply the costs of using the market.

If you love the homemade ice cream at your favorite restaurant, then you have to spend the time and money driving there, waiting for a table, tipping the waitress, paying the sales tax, etc. All you wanted was the homemade ice cream, but many transaction costs stand in the way of a perfectly efficient transaction.

One day you may want to buy a house. Ideally, you would like to drive up to the house you want and pay the owner directly, and then move in. But in reality, there are enormous transaction costs in buying a house. These include finding what you want, bargaining over the price, paying the real estate broker and attorney, and so on. Those transaction costs drive up the price of the house, and create inefficiencies.

Some transaction costs are imposed by governmental regulations. In many areas, homeowners must receive permission to chop down trees on their yards or build an addition. The time and expense in obtaining that approval by the local zoning board are transaction costs.

IV. A Brief Look at Law and Economics

We live in what is known as the regulatory state. The government regulates almost every aspect of business. It is even worse in most other countries. In many industries, the government tells business how much they can charge, how much they can pollute, how much they have to pay their employees, and so on. Government has even more regulations for itself, regulating nearly every aspect of hiring and firing government employees and doling out benefits to the public.

The vision of many liberals has been to gain control of the economy and limit free enterprise by imposing rules about who owns what property and how it can be used. The law defines who holds what rights and liabilities, and business often consists of exchanging money for those rights. For example, the law says that Disney continues to own a copyright in Mickey Mouse, even though it was created about 75 years ago. People who want to use the image of Mickey Mouse must pay Disney money because of the legal rule.

To take another example, states tried to eliminate people from welfare when they felt it was no longer needed or desirable. People eliminated from welfare sued, demanding a formal hearing on their rights to welfare before being eliminated. The Supreme Court agreed with the welfare recipients and created a constitutional right to a hearing prior to be removed from a welfare program. Can you think of a purely economic argument against that requirement?

V. The Coase Theorem

There is a remarkable economist named Ronald Coase, who is now in his nineties. He is responsible for perhaps the single greatest economic insight of the past fifty years, for which he won an entire Nobel prize in 1991 (most Nobel prize awards are shared among multiple recipients, but not Coase’s).

It is worth reading an interview of him, published in full at this location:

It is especially worthwhile to read from the beginning through his discussion of the Coase theorem.

Coase had a physical handicap and did not attend regular school. A high percentage of great thinkers and businessmen, in fact, did not go through the formal schooling system. They learned to think for themselves rather than conform to the government’s way of thinking.

Coase started out thinking that government control (socialism) was good, but he thought some more for himself and became a supporter of the free market. He ended up at the University of Chicago, one of the few universities that is friendly to free market economists.

Coase’s work in economics almost never mentioned a single mathematical equation or formula. His insight is simply restated, but takes a long time to understand. Most esteemed economists, such as Milton Friedman, were initially adamant that Ronald Coase was wrong in his statement. But Coase was right and everyone else was wrong. Friedman, to his credit, admitted his own mistake and began teaching and lecturing about the Coase Theorem.

Coase’s brilliant observation was as follows. He said that, in the absence of transaction costs, there is the same amount of a certain economic activity regardless of who owns the legal rights or property or money. There will be the same number of images of Mickey Mouse regardless of whether Disney still owns the copyright or not. The same number of fans will attend New York Yankees baseball games regardless of whether George Steinbrenner owns the seats at Yankee stadium or 57,478 random members of the public do. The same amount of Microsoft products will sell regardless of whether Bill Gates is the richest or poorest person in the world.

Ralph Waldo Emerson once said, Build a better mousetrap and the world will beat a path to your door. In the absence of transaction costs, it does not matter if you are rich or poor in determining how many will buy the mousetrap and what they will pay for it. The economic activity of selling mousetraps is determined how desirable the mousetrap itself is, not who owns rights to it or how wealthy the inventor is. The person who owns the mousetrap will profit from it if it is better than the competition, but the same number of mousetraps will sell regardless of who owns it.

This observation of Coase (and Emerson) is true only when there are no transaction costs. That means there is no time or expense lost in bargaining, or finding the mousetrap in the first place. No advertising expenses, for example. No incidental expenses can exist in connection with buying a good or service. Using these assumptions, people get what they want with additional expense, and trade however they like without further cost. Although it may seem unrealistic to assume there are no transaction costs, it is very useful to start with this premise. Some activities, like trading stocks over the internet, do have very little transaction costs.

The Coase Theorem is easy to state. With some reflection, everyone can understand it. But you have to think about it a great deal to grasp it. It will help you understand what the free market really is. The implications of the Coase Theorem are indeed extraordinary. Its effects are still being felt.

Homework questions will explore some of the consequences. But here is one example to start you in the right direction. Suppose the government of the State of Massachusetts heard that Ralph Waldo Emerson built a better mousetrap and many people were beating a path to his door to buy it. The government then seized the rights to the mousetrap and auctioned those rights off to the highest bidder, pocketing the cash. Afterwards, will more or less mousetraps be sold? The exact same number will be sold. It doesn’t matter who owns the mousetrap (assuming transaction costs are zero).

VI. Assignment

Read and, if necessary, reread the above lecture. Then read the handout, which is also at: (Only the first half is necessary to read.)

Homework questions:

  1. Your boss asked you to work overtime. Is that a short-run or long-run solution for him?
  2. You just hired a new employee at $1000 per month, and he boosted your production from 100 widgets a month to 118 widgets a month. Widgets are selling for $50 apiece. Compare your marginal cost (MC) and marginal revenue (MR) of that hiring decision. What should you do?
  1. Say you open a new store next to Wal-Mart, and are profitable with ten employees. You decide to double your size and number of employees. Will you double your profit? Discuss.
  1. Your widget company has the following costs: Producing 10 widgets, your costs are $2000. Producing 8 widgets, your costs are $1800. Producing 6 widgets, your costs are $1500. Producing 4 widgets, your costs are $1200. Producing 2 widgets, your costs are $800. Producing 0 widgets, your costs are $400. What is your fixed cost? MC for widgets 7 & 8? Average costs for producing 4 widgets?
  1. A regulator had to choose new regulation A or B: (A) imposed substantial new transaction costs on consumers, while (B) did not. Which does the Coase Theorem tend to prefer?
  1. Define economic efficiency. Give an example of something that is efficient, and something else that is not.
  1. Ronald Coase says that transaction costs are the costs of using the market. Explain your view of that phrase, with examples.
  1. Suppose a New York Times editorial complained about the gap between the rich and poor, declaring that the gap is impeding economic recovery. Suppose it claimed the economy would grow quicker if the gap were smaller. In the absence of transaction costs, is that correct?
  1. Each year Forbes magazine lists the wealthiest persons. Assume for the moment a world without transaction costs. What is the significance of that list? Will the ideas of people on that list be more influential?

Extra credit (4 points each for questions 10 and 11; 6 points for question 12):

  1. John Kerry needs votes from environmentalists and donations by internet users. So suppose he announced a program to transfer all ownership rights in trees from logging companies to people who easily sell goods over the internet (say on Ebay). Should this thrill the tree-huggers?
  1. The Fifth Amendment says nor shall private property be taken for public use, without just compensation. How does that benefit the economy?
  1. The pen is mightier than the sword. Assuming that the sword is used mainly to seize property, explain economic justifications for that statement.