Transcript Lecture Week 07

Decision Time Frames
•The actions that a firm can take to influence the relationship
between output and cost depend on the time frame.
Short Run
• Short run: The quantity of at least one input,
(ie: factory size) is fixed and the quantities
of the other inputs, (ie: Labour) can be
varied.
(short run decisions are easily reversed:
there is no time to go in and out of business)
1
Long Run
• Long run: the quantities of all inputs can be
varied, nothing is fixed, (ie: plant size can
vary.)
(long-run decisions are not easily reversed: new firms
can enter and old firms can leave; that is, firms can go in
and out of business)
Decision Time Frames
• Firms make two kinds of decisions:
– Short Run decisions govern the day to day
operations of the firm
– Long Run decisions involve longer term strategic
2
planning
The Costs of Production: Short Run
• S.R. Production Function
–the relationship between quantity of
inputs used to make a good and the
quantity of output when some factors
are fixed and some are variable
3
Total, Marginal, & Average Product
MP=DTP/DQL
Labour
(workers
per day)
a
b
c
d
e
f
0
1
2
3
4
5
AP=TP/QL
Marginal
Total
Product
Product
Average
(sweaters (sweaters per Product
per day)
additional (sweaters
worker)
per worker)
0
4
10
13
15
16
………..4
………..6
………..3
………..2
………..1
4.00
5.00
4.33
3.75
3.20
4
TP
Output (sweaters per day)
15
d
13
c
10
• total
product (TP)
always
increasing
5
4
Marginal product
(sweaters per day per worker)
Total Product & Marginal Product
•as TP , & MP
,
TP
increases at a
decreasing
rate
6
4
3
2
MP
0
1
2
3
4
5
Labour (workers per day)
0
1
2
3
4
5
Labour (workers per day)
5
Marginal Product
Law of diminishing returns
As a firm uses more of a variable input, with a
given quantity of fixed inputs, the marginal
product of the variable input eventually
diminishes.
Similar to diminishing Marginal
Utility for consumers.
6
The Relationship Between a Firm’s
Output and Costs in the Short Run
To produce more output in the short run, the firm
must employ more variable factor, for example,
labour, which increases its costs. There are
three types of costs:
Total Costs
Marginal Cost
Average Cost
Per Unit Costs
7
1.)Total Costs:
TC = TFC + TVC
Total
fixed
cost
Total
variable
cost
Total
cost
(TVC)
(TC)
Labour Output
(workers (sweaters
per day) per day)
a
b
c
d
e
f
0
1
2
3
4
5
0
4
10
13
15
16
(TFC)
(dollars per day)
25
25
25
25
25
25
0
25
50
75
100
125
25
50
75
100
125
1508
Cost (dollars per day)
Total Costs
150
TC = TFC + TVC
TC
TVC
100
50
TFC
0
5
10
15
Output (sweaters per day)
9
the in total cost that results
from a one-unit in output.
2.)Marginal Cost
Total Total
fixed variable
cost
cost
Total
cost
Marginal
cost
MC =
Labour Output
(workers (sweaters (TFC) (TVC)
(TC)
per day) per day)
(dollars per day)
a
b
c
d
e
f
0
1
2
3
4
5
0
4
10
13
15
16
25
25
25
25
25
25
0
25
50
75
100
125
25
50
75
100
125
150
(MC)
DTC
DTO
6.25
4.17
MC =
8.33
DTVC
12.50
DQ
25.00
10
3.)Average Cost
ATC  AFC  AVC
TC
TFC
TVC


Q
Q
Q
Total Total
fixed variable Total
cost
cost
cost
Labour
Output
(workers (sweaters (TFC) (TVC)
(TC)
per day) per day)
(dollars per day)
a
b
c
d
e
f
0
1
2
3
4
5
Marginal
cost
Avg.
Avg.
Avg.
fixed variable total
cost
cost
cost
0
4
10
13
15
16
25
25
25
25
25
25
0
25
50
75
100
125
25
50
75
100
125
150
(MC)
(AFC) (AVC) (ATC)
TFC/Q TVC/Q TC/Q
—
6.25 6.25
4.17 2.50
8.33 1.92
12.50 1.67
25.00 1.56
—
6.25
5.00
5.77
6.77
7.81
—
12.50
7.50
7.69
8.33
9.38
11
Marginal Cost and Average Costs
25
Cost (dollars per sweater)
ATC = AFC + AVC
15
MC
ATC
AVC
10
5
AFC
0
5
10
15
12
Output (sweaters per day)
Marginal Cost and Average Costs
Cost (dollars per sweater)
25
15
10
MC  at low
outputs due to
gains from
specialization,
MC eventually
due to law of
diminishing
returns.
MC
5
0
5
10
15
13
Output (sweaters per day)
Relationship between MC & ATC
Whenever MC < ATC, ATC 
MC > ATC, ATC 
MC crosses ATC at the minimum ATC
(capacity or minimum efficient scale)
 MC crosses AVC at the min. point
14
Shifts in the Cost Curves
The position of a firm’s short-run
cost curves depends on two factors:
• technology
• prices of resources
15
Long Run Costs of Production
•In the long run, all factors of production are
variable,
•nothing is fixed.
•In the long run, firms are looking for
productive efficiency,
•producing a given quantity at as low a
per unit cost as possible.
•assuming a constant state of technology
•and constant resource/input prices.
16
The long run is the firm’s planning
perspective while the short run is
the firm’s operating perspective.
17
The Long-Run Average Cost Curve
• The long-run average cost curve shows the
relationship between the lowest attainable
average total cost and output
• It is therefore derived from the short-run
average total cost curves.
• Each SRATC touches the LRATC at the level of
output for which the quantity of the fixed factor
is optimal and lies above the LRATC for all
other levels of output.
18
Build plant 1 if
expected output
at Q1.
SAC1
SAC2
C2
C4
C1
C3
SAC3
Q1
Q2
Average Cost (dollars per unit of output)
Average Cost (dollars per unit of output)
Preferable Plant Size and the
Long-Run Average Cost Curve
SAC1
SAC2
SAC3
SAC8
SAC7
SAC6
SAC5
SAC4
LAC
envelope
Build plant 2 if
expected output
at Q2.
Output per Time Period
Output per Time Period
19
•Once the plant
size is chosen, the
firm operates on
the short-run cost
curves that apply
to that plant size.
Long-Run Average
Cost Curve
12.00
ATC1
10.00
ATC2
ATC3
8.00
6.00
Least-cost
plant is 1
LRAC curve
Least-cost
plant is 2
0
5
10
15
Least-cost
plant is 3
18
20
Least-cost
plant is 4
2425
20
30
Shape of LRAC & Returns to Scale
• Returns to scale are the increases in output
that result from increasing all inputs by the
same percentage.
• There are 3 Possibilities.
1)Increasing Returns to Scale or
Economies of Scale:
2)Decreasing
Returns to Scale or Diseconomies of
Scale:
3)Constant Returns to Scale
21
Economies/Diseconomies of Scale
%  inputs
is less than
%  output
Decreasing
LAC
Constant
%  inputs
returns to scale is equal to
%  output
Horizontal
LAC
Economies of
scale,
Increasing
Returns
Diseconomies
of scale,
Decreasing
%  inputs
is more than
%  output
Increasing
LAC
22
Long-Run Average Cost Curve
Economies of scale
Diseconomies of scale
12.00
Minimum efficient
scale: the smallest
quantity of output at
which LRATC reaches
its lowest level.
10.00
8.00
MES
LRAC curve
6.00
0
5
10
15
18
20
2425
30
23
What would cause LRATC to shift?
1)
change in the state of
technology
2)
change in input prices
Question
•What is the difference between
diminishing returns (MP) and
diminishing returns to scale?
24
Perfect Competition
• A market structure in which the decisions of
individual buyers and sellers have no effect on
market price
No one person in the market has any
Market Power: the ability to influence the price.
–the minimum efficient scale is small
relative to the demand for a good or
service.
25
Characteristics of a Perfectly
Competitive Market Structure
1.)Large number of buyers and sellers
• no one buyer or seller has power to influence
price
• Both firms and buyers are “price takers”
2) Homogenous products
• goods offered by various producers are largely
the same.
3) No barriers to entry or exit
4) Buyers and sellers have equal information
26
Demand, Price, and Revenue in Perfect
Competition
FIRM
50
S
25
Market
demand
curve
D
0
9
20
Quantity (thousands
of sweaters per day)
Sweater market
Sidney’s
demand
curve
50
Price (dollars per sweater)
Price (dollars per sweater)
INDUSTRY
MR
25
0
9
20
Quantity (sweaters per
day)
Sidney’s demand
and marginal revenue
27
Demand, Price, and Revenue in
Perfect Competition: Firm
(P)
Total
revenue
(TR = PxQ)
Marginal
revenue
(MR =DTR/DQ)
(dollars per
sweater)
(dollars)
(dollars)
Quantity
sold
(Q)
Price
(sweaters per
day)
8
25
200
25
9
25
225
25
10
25
250
28
Economic Profit and Revenue: Firm
Marginal revenue (MR) is the change in
revenue resulting from a one-unit increase in
output sold.
 For the firm, in perfect competition,
 since the price remains constant when the
quantity sold changes
–Marginal revenue equals price.
 marginal revenue curve is also the demand
curve.
–Demand is perfectly elastic.
29
Demand, Price, and Revenue in Perfect
Competition
Market Price = $25
50
S
25
Market
demand
curve
D
0
9
20
Quantity (thousands
of sweaters per day)
Sweater market
FIRM
Sidney’s
demand
curve
50
Price (dollars per sweater)
Price (dollars per sweater)
INDUSTRY
MR=P
25
0
9
20
Quantity (sweaters per
day)
Sidney’s demand
and marginal revenue
30
Firm Maximizes Profits: “Supply”
A firm will produce the level of output that maximizes
economic profits given the constraints it faces.
market constraints summarized by its revenue
schedules.
technology & cost constraints summarized by its
product & cost curves.
Economic Profit  Total revenue (TR) - Total cost (TC)
31
Profit Maximization Rule
• Produce all those units of output that add
more to revenues than to costs.
• Produce more output until MR comes closest
to being equal to MC without MC exceeding
MR:
MR  MC
DTR
Marginal Revenue (MR) 
Doutput
Marginal Cost (MC) 
DTC
Doutput
32
F
I Total Revenue, Total Cost,
R
MQuantity Total
Total Economic Average
(Q)
(sweaters
/day)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Revenue
(TR)
(dollars)
0
25
50
75
100
125
150
175
200
225
250
275
300
325
& Economic Profit
P=MR
Profit Total Cost
Average
Var. Cost
(TC) (TR - TC) (ATC)
(AVC)
(MC)
(MR)
Cost
Marginal Marginal
Cost
Revenue
(dollars)
(dollars)
(dollars)
(dollars)
(dollars)
(dollars)
22
45
66
85
100
114
126
141
160
183
210
245
300
360
-22
-20
-16
-10
0
11
24
34
40
42
40
30
0
-35
0
45.00
33.00
28.33
25.00
22.80
21.00
20.14
20.00
20.33
21.00
22.27
25
27.69
0
23.00
22.00
31.50
19.50
18.40
17.33
17.00
17.25
17.89
18.89
20.27
23.17
26.00
0
23.00
21.00
19.00
15.00
14.00
12.00
15.00
19.00
23.00
27.00
35.00
55.00
60.00
0
25.00
25.00
25.00
25.00
25.00
25.00
25.00
25.00
25.00
25.00
25.00
25.00
25.00
33
FIRM
Profit-Maximizing Output
$’s.Marginal revenue and marginal cost
Market Price = $25
MC
30
Profitmaximization
Point, MC=MR
MR
25
• Between zero output and
MC = MR output, MR >
MC, TR is increasing
more than TC, and profits
are increasing.
• Beyond MC=MR output,
MC>MR, TC is
increasing more than TR,
and profits are decreasing.
20
10
0
MR > MC
8
9
10
MC > MR
Quantity (sweaters per day)
34
FIRM
Economic Profit
Note: In
Perfect
Competition,
MR=AR
Price and cost (dollars per sweater)
Market Price = $25
30.00
MC
25.00
MR
Economic
profit
At P = $25, ATC =$ 20.33
Output = 9 units
TR = $25 x 9 = $225
TC = $20.33 x 9 =$183
Profit = $225-$183=$42
Profit = (P-ATC) x output
20.33
15.00
0
ATC
9 10
Quantity (sweaters per day)
35
Demand, Price, and Revenue in Perfect
Competition
Market Price = $20
FIRM
S
50
New market
demand
curve
25
20
D
0
9
D
20
Quantity (thousands
of sweaters per day)
Sweater market: Industry
Price (dollars per sweater)
Price (dollars per sweater)
INDUSTRY
Sidney’s
demand
curve
50
Sidney’s
new
demand
curve
MR
MR
25
20
0
9
20
Quantity (sweaters per
day)
Sidney’s demand
and marginal revenue:
36
firm
FIRM
Total Revenue, Total Cost, and Economic Profit
New Price
Quantity
(Q)
(sweaters
/day)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Total
Revenue
(TR)
(dollars)
0
20
40
60
80
100
120
140
160
180
200
220
240
260
Total
Cost
Economic Average
Profit Total Cost
Average
Var. Cost
(TC) (TR - TC) (ATC)
(AVC)
(MC)
(MR)
(dollars)
(dollars)
(dollars)
(dollars)
0
45.00
33.00
28.33
25.00
22.80
21.00
20.14
20.00
20.33
21.00
22.27
25
27.69
0
23.00
22.00
31.50
19.50
18.40
17.33
17.00
17.25
17.89
18.89
20.27
23.17
26.00
0
23.00
21.00
19.00
15.00
14.00
12.00
15.00
19.00
23.00
27.00
35.00
55.00
60.00
0
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
(dollars)
22
45
66
85
100
114
126
141
160
183
210
245
300
360
(dollars)
-22
-25
-26
-25
-20
-14
-6
-1
0
-3
-10
-25
-60
-100
Marginal Marginal
Cost
Revenue
37
FIRM
Short-Run Break-Even Price
Price and cost (dollars per sweater)
Market Price = $20
30.00
25.00
MC
Break-Even Price
ATC
Break-even Point,
MR=MC=ATC
20.00
MR
P=$20; ATC=$20
TR = $20X8 units/day
= $160
TC = $20X8units/day
= $160
TR = TC
= 0 Economic Profits
15.00
0
8
10 Quantity (sweaters per day)
38
FIRM
Short-Run Losses, & Shutdown Price
• What do you think?
– Would you continue to produce if you
were incurring a loss?
– What if price fell to $19.00?
– What if price fell to $16.00 or lower?
39
Demand, Price & Revenue: Perfect Competition
Market Price = $19
INDUSTRY
S
50
New market
demand
curve
25
20
19
D3 D2
0
9
D1
20
Quantity (thousands
of sweaters per day)
Sweater market:
Industry
Price (dollars per sweater)
Price (dollars per sweater)
FIRM
Sidney’s
new
demand
curve
MR1
MR2
MR3
50
25
20
19
0
9
20
Quantity (sweaters per
day)
Sidney’s demand
and marginal revenue:
Firm
40
FIRM
Total Revenue, Total Cost, and Economic Profit
New Price
Quantity
(Q)
(sweaters
/day)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Total
Revenue
(TR)
(dollars)
0
19
38
57
76
95
114
133
152
171
190
209
228
247
Total
Cost
Economic Average
Profit Total Cost
Average
Var. Cost
(TC) (TR - TC) (ATC)
(AVC)
(MC)
(MR)
Marginal Marginal
Cost
Revenue
(dollars)
(dollars)
(dollars)
(dollars)
(dollars)
(dollars)
22
45
66
85
100
114
126
141
160
183
210
245
300
360
-22
-51
-28
-28
-24
-19
-12
-8
-8
-12
-20
-36
-72
-113
0
45.00
33.00
28.33
25.00
22.80
21.00
20.14
20.00
20.33
21.00
22.27
25
27.69
0
23.00
22.00
31.50
19.50
18.40
17.33
17.00
17.25
17.89
18.89
20.27
23.17
26.00
0
23.00
21.00
19.00
15.00
14.00
12.00
15.00
19.00
23.00
27.00
35.00
55.00
60.00
0
19.00
19.00
19.00
19.00
19.00
19.00
19.00
19.00
19.00
19.00
19.00
19.00
19.00
41
FIRM
SR Economic Loss Minimization
Market Price = $19
Price and cost (dollars per sweater)
Loss Min,P=$19.00
30.00
• MC = MR @ 8 units
ATC ($20) > P ($19);
ATC
Losses = $8
• TFC = $22.00
AVC
• Shut down,
lose $22.00
• Produce, lose $8
MR
MC
25.00
20.00
19.00
0
loss
8
10
Quantity (sweaters per day)
• Minimize losses by
producing when
• P >AVC < ATC
42
FIRM
Total Revenue, Total Cost, and Economic Profit
New Price
Quantity
(Q)
(sweaters
/day)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Total
Revenue
Total
Cost
(TR)
(TC)
(dollars)
(dollars)
0
16
32
48
64
80
96
112
128
144
160
176
192
208
22
45
66
85
100
114
126
141
160
183
210
245
300
360
Economic Average Average
Profit Total Cost Var. Cost
(TR - TC) (ATC)
(dollars)
-22
-29
-34
-37
-36
-34
-30
-29
-32
-39
-50
-69
-108
-152
(dollars)
0
45.00
33.00
28.33
25.00
22.80
21.00
20.14
20.00
20.33
21.00
22.27
25
27.69
Marginal Marginal
Cost
Revenue
(AVC)
(MC)
(MR)
(dollars)
(dollars)
(dollars)
0
23.00
22.00
31.50
19.50
18.40
17.33
17.00
17.25
17.89
18.89
20.27
23.17
26.00
0
23.00
21.00
19.00
15.00
14.00
12.00
15.00
19.00
23.00
27.00
35.00
55.00
60.00
0
16.00
16.00
16.00
16.00
16.00
16.00
16.00
16.00
16.00
16.00
16.00
16.00
16.00
43
Price and cost (dollars per sweater)
FIRM
Short Run Shut Down
Market Price = $16
30.00
Shutdown:P=$16.00
MC
ATC
25.00
AVC
20.14
loss
16.00
0
MR
7
•
•
•
•
•
•
MC = MR @ 7 units
ATC (20.14) > P ($16):
Losses = $29.00
TFC = $22.00
Shut down, lose $22
Produce, lose $29
• Minimize losses by
shutting down when
 P AVC at MC = MR
10
Quantity (sweaters per day)
44
FIRM
Short Run Supply
• Def’n: Quantity that producers will produce at
various possible prices in a set of prices, for a given
time period: ceteris paribus.
• At each price a firm will produce the output
for which MC comes closest to being equal
to MR without MC exceeding MR &…….
45
Price and cost
(dollars per sweater)
A Firm’s SR Supply Schedule
Minimize
losses
MC=Supply
Profit
point
MC
31
MR3
Break-even
point
25
Shutdown
point
MR2
MR1
20
MR0
17
0
7 8 9 10
Quantity (sweaters per day)
46
FIRM
“Supply”
•  The Short Run “supply”
schedule of the firm is found to be
the “MC” schedule
• but with 2
qualifications.
47
FIRM
Price and cost (dollars per sweater)
Qualifications
30.00
MC
AVC
25.00
MR
15.00
0
8
•1.) Only the
upward sloping
part of MC
qualifies
as the SR “supply”
• 2.) Only that
part of the MC
that lies above
the AVC
qualifies as the
SR “supply”
10
Quantity (sweaters per day)
48
Market Supply
• Total amount provided to the market at each
possible price…
»Or
• The marginal cost of providing additional
output to the market, given current
production conditions.
49
Market Supply
• Note: In the SR, quantity supplied is positively
related to price for 2 reasons:
– As the market price increases,
• 1.) each firm uses its capital more intensively
thereby increasing output, but also increasing
marginal cost.
• 2.) firms that were previously providing output
but had ceased production, to minimize losses,
will find it profitable to begin production again,
using capital that had been idle.
50
Problem: Perfect Competition.
1. The following tables give the costs and
revenue for a firm in perfect competition.
2. What will the firm supply in order to
maximize profits given the various prices in
the market?
3. What is the industry supply if there are 100
firms in the industry?
4. What is the Market Price and Output?
51
Total Revenue, Total Cost, & Economic Profit
P=$9.00=MR
Quantity
(Q)
(sweaters
/day)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Total
Revenue
(TR)
(dollars)
9
18
27
38
45
54
63
72
81
90
99
108
117
126
Total
Cost
Economic Average
Profit Total Cost
Average
Var. Cost
(TC) (TR - TC) (ATC)
(AVC)
(MC)
(MR)
(dollars)
Marginal Marginal
Cost
Revenue
(dollars)
(dollars)
(dollars)
(dollars)
(dollars)
15
22
27
30
32
33
34
36
39
44
51
60
76
104
144
-15
-13
-9
-3
6
12
20
27
33
37
39
39
32
13
-18
0
22.00
13.50
10.00
8.00
6.60
5.67
5.14
4.88
4.89
5.10
5.45
6.33
8.00
9.21
7.00
6.00
5.00
4.25
3.60
3.17
3.00
3.00
3.22
3.60
4.09
5.08
6.85
9.21
7
5
3
2
1
1
2
3
5
7
9
16
28
40
9.00
9.00
9.00
9.00
9.00
9.00
9.00
9.00
9.00
9.00
9.00
9.00
9.00
52
9.00