Transcript Document

Firm’s decisions
Lecture 26 – academic year 2014/15
Introduction to Economics
Fabio Landini
What do we do today:
• A firm and its costs
• Total, fixed and variable costs
• Average and marginal revenue
• How firm set optimal Q
Firm behaviour
We want to study firm behaviour in in presence of
different market structures (in this case mainly
perfect competition).
Firm’s aim
The main objective of a firm is to
maximize profit
Profit: Total revenue (TR) minus
Total cost (TC)
Profit: revenue - costs
• Revenue: amount that a firm earns
through sales
• Costs: Amount that a firm spends for
factors of production
Opportunity costs
Production costs include both explicit costs
and implicit costs:
• Explicit costs: monetary costs that are
necessary to hire factors of production.
• Implicit costs: costs that do not require any
direct cash outlay.
Taken together we have opportunity costs
Opportunity costs
Economists: look at opportunity costs
Accountants: look at explicit costs, but often
neglect implicit costs
When the revenue is higher than both
explicit costs and implicit costs the firm
makes economic profit
Example: Is University enrolment a good
investment in Italy?
• Average taxes paid by undergraduate students during the first 4 years (data
2003-04): 2.178 euro.
• Other direct expenses to follow classes and write exams: 3.273 .
• Foregone income (comparison with non-Univ. students): 65.838.
• Total expenses: 71.739.
• Income differential for university degree (wit respect to non-Univ. students,
computed during the first 40 years of activity): 134.000.
• Value of university degree neat of its cost: (134.000-71.739) = 62.408
• Average annual return of university degree: 9,9 %.
Source: Moro-Bisin, La laurea: un ottimo investimento, www.LaVoce.info,
24/10/2005.
Production function
Labour
Production
0
0
1
2
3
50
90
120
4
5
140
150
160
140
120
100
80
60
40
20
0
0
1
2
3
4
5
6
Production function
It shows the relationship between the quantity of
production factors “efficiently employed” and the
quantity produced.
Important: it does not describe all possible
combinations between the quantity of production
factors and final product.
But only. those without useless “waste”.
Example: if I can produce 10 units of a good with 5
workers or only 2 workers, the only point in the
production function is (10, 2) (product=10, work=2),
and not (10, 5).
(10, 5) is inefficient with respect to (10, 2).
Production function
• Marginal product (of labour)
Q obtained through L of one unit
• Previous table:
L=0 -> L=1 produces Q = 50
L=1 -> L=2 produces Q = 40
L=2 -> L=3 produces Q=30
And so on….
Marginal product
From the table you can see that the marginal product is
always positive, but decreasing
That is: if L increases:
• The level of production always increases(positive
marginal product),
• However such an increase is smaller at the margin
(decreasing marginal product)
Why?
Presence of fixed factors (e.g. congestion effects in using
a machine)
From production to costs
Labour Production
Variable
cost
(labour)
0
Total
cost
0
0
Fixed
cost(mac
hine)
30
1
50
30
10
40
2
90
30
20
50
3
120
30
30
60
4
140
30
40
70
5
150
30
50
80
30
Curve of total cost
90
80
Costo totale
70
60
50
40
30
20
0
20
40
60
80
Produzione
100
120
140
160
Total and marginal cost
• Marginal cost
Total cost that derive from Q of one unit
Q -> total cost (i.e. marginal cost is positive)
Moreover: the Total cost is greater at the
margin (marginal cost is increasing)
Explanation: it depends on the structure of the
production function (fixed factors)
60
1.20
50
1.00
Costo marginale
Prodotto marginale
Relationship between MP and MC
40
30
20
10
0.80
0.60
0.40
0.20
0
0.00
0
1
2
3
Lavoro
4
5
6
0
20
40
60
80
Produzione
100
120
140
160
Average cost and marginal cost
• Average cost: FC, VC, TC over Q
–
–
–
Average fixed cost (AVFC)
Average variable cost (AVVC)
Average total cost (AVC)
• Marginal cost
–
–
Increase in TC if ΔQ=1
Equal to: ΔCT/ΔQ
• The firm consider both AVC and MC to take
her production decision
The U-shaped AVC
Cost (in euro)
AVC
Q*
Quantity
Costs (pp. 220)
Produz.
FC
VC
TC
AVFC
AVVC
0
1
2
3…
…8
9
3
3
3
3
3
3
0
0,3
0,8
1,5
8,0
9,9
3
3,3
3,8
4,5
11,0
12,9
3
1,5
1
0,38
0,33
0,3
0,4
0,5
1,0
1,1
Costs (pp. 220)
Produz.
FC
VC
TC
AVC
MC
0
1
2
3…
…8
9
3
3
3
3
3
3
0
0,3
0,8
1,5
8,0
9,9
3
3,3
3,8
4,5
11,0
12,9
3,3
1,9
1,5
1,38
1,43
0,3
0,5
0,7
1,7
1,9
Shape of AVC
Why is AVC U-shaped?
• Because it is the sum of AVFC and AVVC
–
AVFC is decreasing with respect to Q
AVVC is increasing with respect to Q
Costo (in euro)
–
AVC
AVVC
AVFC
Quantità
Production in perfect competition
• Given this cost structure, how does a firm
decide the quantity to be produced?
• Let’s study this problem in a perfectly
competitive market
• Characteristics:
 Many sellers and buyers
 Product are perfect substitute
 Free entry
• Consequences:
 firms are price taker
Price and revenue
Q
Price
TR = PxQ
AVR=
TR/Q
1
6
6
6
6
2
6
12
6
6
3
6
18
6
6
4
6
24
6
6
MR =
ΔTR/ΔQ
Firm’s revenue in perfect
competition
In a perfectly competitive market:
MR = price
NB: This is not true in other market structures
Profit maximization
Firm’s objective = max profit
 i.e.: set Q such that the difference between TR
and TC is max
• This happens when the firm set Q such that
MR = MC
If MR > MC, an increase in Q increases profit
If MR < MC, an increase in Q reduces profit
If MR = MC, profit is max
Firm production decision
Price
MC
0
AVC
Quantity
Firm production decision
Price
MC
P
0
AVC
P = AVR = MR
Quantity
Firm production decision
Price
MC
P
AVC
P = AVR = MR
Profit max Q
0
Q
Quantity
Firm production decision
Price
MC
P
AVC
P = AVR = MR
AVC
Profit max Q
0
Q
Quantity
Firm production decision
Price
MC
Profit
P
AVC
P = AVR = MR
AVC
Profit max Q
0
Q
Quantity
What happens in with free entry?
Price
MC
P
0
AVC
P = AVR = MR
Q
Quantity
The existence of a positive profit will lead more
firm to enter -> in supply -> price
Price
MC
P
0
AVC
P = AVR = MR
Q
Quantity
The existence of a positive profit will lead more
firm to enter -> in supply -> price
Price
MC
P
P’
0
AVC
P = AVR = MR
P’ = AVR’ = MR’
Q’ Q
Quantity
The existence of a positive profit will lead more
firm to enter -> in supply -> price
Price
MC
AVC
P
P’
P = AVR = MR
P’ = AVR’ = MR’
P’’
P’’ = AVR’’ = MR’’
0
Q’’ Q’ Q
Quantity
As soon as profit=0 no firm will enter any more…
Price
MC
AVC
P
P’
P = AVR = MR
P’ = AVR’ = MR’
P’’
P’’ = AVR’’ = MR’’
0
Q’’ Q’ Q
Quantity
Conclusion
We studied tools that firms use to take
decision
Firms set profit set Q so that MR=MC, i.e. max
profit
If there is free entry in the market profit tends
to zero in the long period