Transcript Powerpoint: Costs and Profit Maximization

Short Run Costs
1
Production Processes
X-Box Production
http://www.youtube.com/watch?v=dzJUSFr5EvQ&feature=related
KTM Factory
http://www.youtube.com/watch?v=jihqmdX0jkM
1939 River Rouge Plant
http://www.youtube.com/watch?v=TcXfk0op6JA
Scorpion Factory
http://www.youtube.com/watch?v=hMCyqyyh5MA
2
What would you need to start a
Panera?
http://www.franchisechatter.com/2014/01/26/franch
ise-costs-detailed-estimates-of-panera-breadfranchise-costs-2013-fdd/
3
Short Run versus Long Run?
short run - a period of time where some
inputs are fixed (capital = building,
equipment, etc.)
 long run - a period of time in which all
inputs can be varied (no inputs are fixed)

4
Short Run Cost Function
Definition:
 A function that defines the minimum
possible cost of producing each output
level when variable factors are employed
in the cost-minimizing fashion. (Based on
the inability to change the fixed factors)
5
In this case, what is your total
product/output (Q)?
Number of Paninis (for simplicity assume
that Panera only produces a single
product).
 In general a firm uses capital, labor and
materials to produce the product/output
where capital is often fixed in the short
run.

6
In Short Run, how does the number
of Paninis produced change as you
change the number of workers?
# of workers
# of paninis
0
0
1
5
2
12
3
20
4
25
5
28
7
How does output change if you
hire one more person?

Depends on how many workers you
currently have. Output increases by 5
paninis when you hire the 1st worker,
increases by 7 paninis when you hire the
2nd worker, …., and increases 3 paninis
when you hire the 5th worker.
8
What happens to “productivity”
as the first few employees are
hired?
 Specialize
and marginal
product increases.
Marginal Product is the change in total output
attributable to the last unit of an input.
9
What would happen to
“productivity” if you continued to
hire more and more workers?
Marginal product would start to fall
because some inputs are fixed in the short
run.
 Law of diminishing marginal returns OR
Law of diminishing marginal product.

10
What costs would you have to pay
even if you didn’t produce a single
panini?
 Fixed
Costs, FC (or Total
Fixed Costs, TFC)
(often involves building and equipment)
Fixed Costs = Costs that do not change with
changes in output
11
What costs would you have to
pay only if you produced
paninis?
Variable
Costs, VC (or Total
Variable Costs, TVC)
(often assumed to be labor and material)
Variable Costs = Costs that change with changes in
output
12
What costs would increase if we
wanted to produce one more
panini?
 Variable
Costs (such as labor
and materials)
13
If you hired more and more
employees

and the store became more and more
crowded until the marginal product of a
worker started to fall, what would happen
to the cost of producing one more panini
(marginal cost)?
Marginal cost = cost of producing an
additional unit of output
14
CostsQ
FC
VC
TC
AFC
AVC
0
100
0
100
-
-
Fixed costs do not
vary with output
1
ATC
MC
(150-100)/1= 50
100
50
150
100
50
Variable costs increase by 50 from 0 to 1 unit
of output and increases by 30 from 1 to 2
2
100
80
180
50
40
units.
150
30
90
20
Average Fixed Costs (AFC) = Average Variable Costs (AVC)
3
33.3
33.33
66.7 so at an
Costs/Q
Fixed Costs/Q
so100at an100
output200 = Variable
output of 2, AVC=80/2=40.
of 2, AFC=100/2=50.
10
4
5
100
110
210
25
27.5
52.5
Average Total Costs (ATC) = Total
Costs/Q so at an output of 2,
ATC=180/2=90
100
130
230 or AFC+ATC.
20
26
46
20
15
Costs Q
FC
VC
TC
AFC
AVC
ATC
5
100
130
230
20
26
46
MC
30
6
100
160
260
16.7
26.67
43.3
40
7
100
200
300
14.3
28.57
42.9
50
8
100
250
350
12.5
31.25
43.8
60
9
100
310
410
11.1
34.44
45.6
70
10
100
380
480
10
38
48
16
TC= ATC*Q
What is happening to TC as Q increases?
MC
3
33.33
33.33
66.67
60
4
25.00
27.50
$/Q
10
52.50
20
5
20.00
26.00
46.00
30
6
7
8
16.67
14.29
12.50
26.67
28.57
31.25
11.11
34.44
MC
70
ATC
50
40
AVC
30
20
43.33
40
10
50
0
42.86
43.75
60
9
80
AFC
Q
45.56
70
10
10.00
38.00
48.00
480
17
10
40.00
8
50.00
90
7
2
15030
90.00 180
20
150.00
6
50.00
5
100.00
4
1
100
9
50
3
ATC
-
2
AVC
-
1
AFC
-
0
Q
0
Increases!
What are total fixed costs in this example? AFC*Q
30
80
20
70
90.00
66.67
60
5
20.00
26.00
46.00
30
6
16.67
26.67
43.33
40
7
14.29
28.57
42.86
50
8
12.50
31.25
43.75
60
9
11.11
34.44
40
AVC
30
20
AFC
10
0
Q
45.56
70
10
10.00
38.00
48.00
18
10
20
9
52.50
8
27.50
7
25.00
ATC
50
6
10
4
MC
5
33.33
90
4
40.00
100
50
3
33.33
50.00 150.00
100*1=100
MC
2
3
50.00
ATC
-
1
2
100.00
AVC
-
0
1
AFC
-
$/Q
Q
0
Why are AFC diminishing? Spreading a fixed number out
over a larger and larger Q
MC
100
50
80
20
70
90.00
66.67
60
52.50
20
5
20.00
26.00
46.00
30
6
16.67
26.67
43.33
40
7
14.29
28.57
42.86
50
8
12.50
31.25
43.75
60
9
11.11
34.44
40
AVC
30
20
AFC
10
0
Q
45.56
70
10
10.00
38.00
48.00
19
10
27.50
9
25.00
ATC
50
8
10
4
MC
7
33.33
30
6
33.33
40.00
90
150.00
5
3
50.00
50.00
4
2
100.00
$/Q
1
3
ATC
-
2
AVC
-
1
AFC
-
0
Q
0
Why is AVC getting closer to ATC?
MC
100
50
80
20
70
90.00
66.67
60
52.50
20
5
20.00
26.00
46.00
30
6
16.67
26.67
43.33
40
7
14.29
28.57
42.86
50
8
12.50
31.25
43.75
60
9
11.11
34.44
40
AVC
30
20
AFC
10
0
Q
45.56
70
10
10.00
38.00
48.00
20
10
27.50
9
25.00
ATC
50
8
10
4
MC
7
33.33
30
6
33.33
40.00
90
150.00
5
3
50.00
50.00
4
2
100.00
$/Q
1
3
ATC
-
2
AVC
-
1
AFC
-
0
Q
0
Because ATC = AVC+AFC
and AFC is getting close to 0
Where does the law of diminishing marginal product
set in and how do you know? Where MC starts increasing!
MC
100
50
80
20
70
90.00
66.67
60
52.50
20
5
20.00
26.00
46.00
30
6
16.67
26.67
43.33
40
7
14.29
28.57
42.86
50
8
12.50
31.25
43.75
60
9
11.11
34.44
45.56
70
10
10.00
38.00
48.00
40
AVC
30
20
AFC
10
0
Q
Why does this happen?
An input is fixed in the short run!
21
10
27.50
9
25.00
ATC
50
8
10
4
MC
7
33.33
30
6
33.33
40.00
90
150.00
5
3
50.00
50.00
4
2
100.00
$/Q
1
3
ATC
-
2
AVC
-
1
AFC
-
0
Q
0
Where does MC cross ATC?
Where does MC cross AVC?
100
At their minimums
90
80
MC
70
$/Q
60
ATC
50
40
AVC
30
20
AFC
10
9
8
7
6
If MC<ATC, ATC is decreasing
If MC>ATC,
ATC is increasing
Q
22
Same for AVC
5
3
2
1
0
0 relationship
What is the
between MC and ATC?
MC and AVC?
4
10
How do you know this is the short run?
100
50
80
20
70
90.00
66.67
60
52.50
20
5
20.00
26.00
46.00
30
6
16.67
26.67
43.33
40
7
14.29
28.57
42.86
50
8
12.50
31.25
43.75
60
9
11.11
34.44
40
AVC
30
20
AFC
10
0
Q
45.56
70
10
10.00
38.00
48.00
23
10
27.50
9
25.00
ATC
50
8
10
4
MC
7
33.33
30
6
33.33
40.00
90
150.00
5
3
50.00
50.00
4
2
100.00
$/Q
1
There are fixed costs
MC
3
ATC
-
2
AVC
-
1
AFC
-
0
Q
0
Fixed Cost versus Sunk Cost
Fixed Cost = costs that do not change with changes in
output
Sunk Cost= a cost that is forever lost after it has been paid

Does profit maximizing output depend on
whether cost if fixed or sunk given that you
produce paninis?
No

Does the decision whether to produce any
paninis depend on whether cost is fixed or
sunk?
Yes
24
Short Run versus Long Run?
short run - a period of time where some
inputs are fixed (capital = building,
equipment, etc.)
 long run - a period of time in which all
inputs can be varied (no inputs are fixed)

UQM Technologies
http://www.youtube.com/watch?v=UvnHQz6lDQ8&feature=related
25
Profit Maximization
26
Profit Maximization assuming:
1.
2.
Firm must charge every consumer the
same price (i.e., no price discrimination)
No Strategic Interaction among Firms
We will consider three industry structures:
 Price taking Firms
 Monopoly
 Monopolistic Competition
27
Price Taking Firm’s Short Run Costs
Q
FC
VC
TC
AFC
AVC
0
100
0
100
-
-
ATC
MC
50
1
100
50
150
100
50
150
30
2
100
80
180
50
40
90
20
3
100
100
200
33.3
33.33
66.7
10
4
100
110
210
25
27.5
52.5
20
5
100
130
230
20
26
46
28
Price Taking Firm’s Short Run Costs
Q
FC
VC
TC
AFC
AVC
ATC
5
100
130
230
20
26
46
MC
30
6
100
160
260
16.7
26.67
43.3
40
7
100
200
300
14.3
28.57
42.9
50
8
100
250
350
12.5
31.25
43.8
60
9
100
310
410
11.1
34.44
45.6
70
29
What output maximizes profits if the marginal revenue (MR)
for each unit the firm sells is $55? What are these profits?
8
MC
55*8-43.75*8=90
50
150.00
100
30
90.00
20
33.33
33.33
66.67
10
5
6
25.00
20.00
16.67
27.50
26.00
26.67
46.00
20
50
30
40
43.33
40
7
8
9
14.29
12.50
11.11
28.57
31.25
34.44
10.00
38.00
ATC
AVC
30
20
42.86
50
10
60
0
43.75
AFC
45.56
70
10
MC
70
60
52.50
$/Q
4
80
48.00
10
3
90
9
40.00
8
50.00
7
2
2
50.00
1
100.00
0
1
6
ATC
-
5
AVC
-
4
AFC
-
3
Q
0
Q
30
What output maximizes profits if the marginal revenue for
each unit the firm sells is $35? What are these profits?
50
80
20
70
90.00
66.67
60
52.50
20
5
20.00
26.00
46.00
30
6
7
8
16.67
14.29
12.50
26.67
28.57
31.25
11.11
34.44
10.00
38.00
10
50
0
42.86
43.75
45.56
48.00
30
40
70
10
AVC
20
43.33
60
9
40
AFC
10
27.50
ATC
50
9
25.00
$/Q
10
4
MC
8
33.33
30
7
33.33
40.00
90
150.00
6
3
50.00
50.00
35*6-43.33*6=-50
5
2
100.00
100
4
1
6
MC
3
ATC
-
2
AVC
-
1
AFC
-
0
Q
0
Q
Produce an output of 6 in shortrun if fixed costs are sunk.
31
What output maximizes profits if the marginal revenue for
each unit the firm sells is $25? What are these profits?
MC
50
80
20
70
90.00
66.67
60
52.50
20
5
20.00
26.00
46.00
30
6
7
8
16.67
14.29
12.50
26.67
28.57
31.25
11.11
34.44
10.00
38.00
10
50
0
42.86
43.75
45.56
48.00
30
40
70
10
AVC
20
43.33
60
9
40
AFC
10
27.50
ATC
50
9
25.00
$/Q
10
4
MC
8
33.33
30
7
33.33
40.00
90
150.00
6
3
50.00
50.00
25*5-46*5=-105
5
2
100.00
5?
4
1
100
3
ATC
-
2
AVC
-
1
AFC
-
0
Q
0
Q
Better off producing 0 so
profits=-FC=-100
32
Short-Run Profit Maximizing Rule
 Produce
at an Output where
Marginal Revenue = Marginal Cost
(MR)
(MC)
if Total Revenue > Variable Cost
[When the firm cannot price discriminate, this is
the same thing as saying as long as
Price > AVC (from P*Q > AVC*Q) ]
33
Monopoly Characteristics
1.
2.
3.
There is a single seller
There are no close substitutes
for the good
There are extremely high
barriers to entry
34
Monopolist Marginal Revenue
TR
(with no price discrimination) MR 
Q
P
Q TR MR
10
0
+9
1 9
+7
2 16
+5
3 21
+3
4
3
D
2
1
11
10
9
8
7
MR
Note that Marginal Revenue for a given
unit is plotted at the midpoint of that unit.
35
12
Q
0
6
+1
-1
-3
-5
-7
-9
5
0
5
4
10
6
3
0
7
2
24
25
24
21
16
9
8
1
2
1
4
5
6
7
8
9
5
4
3
9
0
0
9
8
7
6
10
Use Calculus to Obtain MR curve for Linear
Demand Curve

Demand Curve:
Slope of D
 P=a-bQ
 TR

= (a-bQ)Q

=aQ-bQ2
 MR

=ΔTR/ ΔQ =∂TR/ ∂Q
Slope of MR

=a-2bQ
[In prior graph, a=10 and b=1]
36
Monopoly


If the firm’s goal were to
maximize total revenue,
where would it produce?
P=$5; TR=$25
10
9
8
7
6
5
4
3
D
12
11
10
9
8
7
6
5
4
3
2
Q
1

Will a monopolist ever charge a2
price less than $5?
1
What price will the monopolist 0
charge?
0

MR
37
Monopoly Maximizing Profits


If the monopolist
maximizes profits, where
would it produce?
At an output where
MR=MC as long as
P>AVC.
10
9
MC
8
7
ATC
6
5
AVC
4
3
2
D
1
12
11
10
9
8
7
6
5
4
3
2
0
1
This is at an output of
Q=4 so a price of P=6.
0

Q
MR
38
MATH BEHIND: Maximizing Profits
being where MR=MC
MaxQ Profits = MaxQ TR(Q)-TC(Q)
so profits are maximized where
TR TC

 MR  MC  0
Q
Q
Or where,
MR  MC
Applies when Q>0
39
Monopoly Maximizing Profits
TR
10
9
Profits
MC
8
7
ATC
6
5
AVC
4
3
2
D
1
12
11
10
9
8
7
6
5
3
2
1
0
0
4
At Q=4 and P=6, what
is Total Revenue?
TR=P*Q=6*4=24
 At Q=4, what are Total
Costs?
TC=ATC*Q=4.5*4=18
 At Q=4 and P=6, what
are Profits?
Profits=TR-TC=24-18=6
Or
Profits=P*Q-ATC*Q
=(P-ATC)*Q
=(6-4.5)*4=6

Q
TC
MR
40
Monopolist in Long Run
What should this
monopolist do in the
Long Run assuming
that the monopolist
thinks his costs will not
change and neither will
demand?
Keep producing Q=4 or
change plant size
depending if there is a
plant size that would
result in greater profits.

10
9
Profits
MC
8
7
ATC
6
5
AVC
4
3
2
D
1
12
11
10
9
8
7
6
5
4
3
2
1
0
0
Q
MR
41
Monopolist in Long Run
Profits

What should this
monopolist do in the
Long Run assuming
that the monopolist
thinks his costs will not
change and neither will
demand?
10
MC
9
8
ATC
7
6
AVC
5
4
3
1
12
11
10
9
8
7
6
5
4
3
2
1
0
0
Exit the industry or change
plant size depending if
there is a plant size that
would result in positive
profits given demand
curve.
D
2
MR
42
Monopolistic Competition
Characteristics
1.
2.
3.
There are many buyers and
seller
Each firm in the industry
produces a differentiated product
There is free entry into and exit
from the industry
[Think bakery or coffee shop in big city.]
43
Bakery in a Monopolistically Competitive Industry
Maximizing Profits in the Short Run
13
12
 If bakery maximizes
11
profits, where would it
10
produce?
9
Where MR=MC which is at 8
an output of Q=3.5 so a 7
6
price of P=8.
5
 What are the bakery’s
4
profits?
3
TR-TC=P*Q-ATC*Q
2
=8*3.5 - 6.25*3.5 = 6.12 1
0
MC
ATC
AVC
10
9
8
7
6
5
4
3
2
1
0
D
Q
MR
44
Bakery in a Monopolistically Competitive Industry
Maximizing Profits in the Long Run
In long-run if the bakery 12
is making positive
11
economic profits, we
10
9
would expect other
8
bakeries to enter
7
causing a reduction in
6
demand.
5
 What are maximum
4
profits when demand is
3
D’?
2
Q=3 so a price of P=6.67.
1
Profits=P*Q-ATC*Q
0
=6.67*3-6.67*3=0

MC
ATC
AVC
10
9
8
7
6
5
4
3
2
1
0
D’
Q
MR
45
Review of Profit Maximization (when setting a single price)
46
Marginal Revenue from 5th Unit is just the shaded area
below. This area is $11.
20
18
MC
When the MR curve
is linear, the area
under the MR curve
can be obtained by
just taking the MR at
Dthe midpoint of the
quantities – in this
case at 4.5.
16
14
ATC
12
$/unit
AVC
10
8
6
4
2
0
0
1
2
3
4
5
6
The orange area is the
same as the purple
area.
7
8
9
10
Q
11
12
13
MR
14
15
16
17
18
19
20
47
Marginal Cost of 5th Unit is just the shaded area below.
This area is $9.
20
18
MC
When the MC curve
is linear, the area
under the MC curve
can be obtained by
taking the MC at
D the midpoint of the
quantities – in this
case at 4.5.
16
14
ATC
12
$/unit
AVC
10
8
6
4
2
0
0
1
2
3
4
5
6
7
The purple area is the
same as the red area
8
9
10
Q
11
12
13
MR
14
15
16
17
18
19
20
48
Change in Profits associated with producing
5 Units rather than 4 units.
20
18
MC
Yellow area is
change in profits
associated with
producing 5 units
rather than 4 units.
DThis area is $2.
16
14
ATC
12
$/unit
AVC
10
8
6
4
2
0
0
1
2
3
4
5
6
7
Subtract MC of 5th unit
from MR of 5th unit–
brown area from purple.
8
9
10
Q
11
12
13
MR
14
15
16
17
18
19
20
49
Review of Profit Maximization (when setting a single price)
50
PROFIT MAXIMIZATION
Profits are
maximized at an
output where
MR=MC which is
Q=5. Price is 15
and ATC is 11.2 at
Q=5.
20
18
MC
16
15
14
ATC
12
11.2
$/unit
AVC
10
D
8
Profits are then
15*5-11.2*5=19
6
4
2
0
0
1
2
3
4
5
6
7
8
9
10
Q
11
12
13
MR
14
15
16
17
18
19
20
51