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1
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)
Decision Time Frames
•The actions that a firm can take to influence the relationship between output and cost depend on the time frame.
2
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 planning
3
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
4
Total, Marginal, & Average Product
Labour
(workers per day)
Total Product
(sweaters per day)
a 0 0
b 1 4
c 2 10
d 3 13
e 4 15
f 5 16
Marginal Product
(sweaters per additional
worker)
………..4
………..6
………..3
………..2
………..1
Average Product
(sweaters per worker)
4.00
5.00
4.33
3.75
3.20
MP=MP=TP/TP/QQLL
AP=TP/QL
5
Total Product & Marginal Product
Labour (workers per day)
10
15
Ou
tpu
t (sw
eate
rs p
er
day
)
0 1 2 3 4 5
Labour (workers per day)
Ma
rgin
al p
rodu
ct(s
we
ate
rs p
er
da
y p
er w
orke
r)
13
2
4
6
3
0 1 2 3 4 5
54
TP
c
d
10
13
2 3
MP
3
2 3
• total product (TP) always increasing
•as TP , & MP , TP increases at a decreasing rate
6
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.
7
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 CostsMarginal Cost Average Cost Per Unit Costs
8
1.)Total Costs:
Total Totalfixed variable Totalcost cost cost
Labour Output(workers (sweaters (TFC) (TVC) (TC)per day) per day) (dollars per day)
a 0 0
b 1 4
c 2 10
d 3 13
e 4 15
f 5 16
25
25
25
25
25
25
0
25
50
75
100
125
25
50
75
100
125
150
TC = TFC + TVC
9
TC
TVC
Total Costs
0 5 10 15Output (sweaters per day)
50
100
150
Cos
t (d
olla
rs p
er d
ay)
TFC
TC = TFC + TVC
10
aa 00 0 0
bb 11 4 4
cc 22 1010
dd 33 1313
ee 44 1515
ff 55 1616
2525
2525
2525
25 25
2525
2525
00
2525
5050
75 75
100100
125125
2525
5050
7575
100 100
125125
150150
Total TotalTotal Total fixed variablefixed variable Total Total cost costcost cost cost cost
Labour OutputLabour Output(workers (sweaters (workers (sweaters ((TFCTFC) () (TVCTVC)) ( (TCTC))per day) per day)per day) per day) (dollars per day) (dollars per day)
6.25
4.17
8.33
12.50
25.00
MarginalMarginalcostcost
((MCMC))
2.)Marginal Cost2.)Marginal Cost
MC =
TC
TO
MC =
TVC
Q
the in total cost that results from a one-unit in output.
11
a 0 0
b 1 4
c 2 10
d 3 13
e 4 15
f 5 16
25
25
25
25
25
25
0
25
50
75
100
125
25
50
75
100
125
150
Total Total fixed variable Total cost cost cost
Labour Output(workers (sweaters (TFC) (TVC) (TC)per day) per day)
3.)Average Cost3.)Average Cost
6.25
4.17
8.33
12.50
25.00
Marginalcost
(MC)
—
6.25
2.50
1.92
1.67
1.56
Avg.fixedcost
(AFC)
TFC/Q
Avg.variable
cost
(AVC) TVC/Q
—
6.25
5.00
5.77
6.77
7.81
Avg.totalcost
(ATC) TC/Q
—
12.50
7.50
7.69
8.33
9.38
(dollars per day)
AVC AFC ATC Q
TVC
Q
TFC
Q
TC
12
Marginal Cost and Average Costs
5 10 15Output (sweaters per day)
5
10
15
Co
st (
dol
lars
per
sw
eat
er)
AFC
AVC
ATC
ATC = AFC + AVC
MC
0
25
13
Marginal Cost and Average Costs
5 10 15Output (sweaters per day)
5
10
15
Co
st (
dol
lars
per
sw
eat
er)
MC
0
25MC at low outputs due to gains from specialization, MC eventually due to law of diminishing returns.
14
Relationship between MC & ATC
Whenever MC < ATC, ATC MC > ATC, ATC
MC crosses ATC at the minimumMC crosses ATC at the minimum ATC ATC
(capacity or minimum efficient scale)(capacity or minimum efficient scale)
MC crosses AVC at the min. pointMC crosses AVC at the min. point
15
Shifts in the Cost Curves
The position of a firm’s short-run
cost curves depends on two factors:• technology• prices of resources
16
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.
17
The long run is the firm’s planning perspective while the short run is the firm’s operating perspective.
18
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.
19
Preferable Plant Size and theLong-Run Average Cost Curve
Output per Time Period
Ave
rag
e C
ost
(dol
lars
per
uni
t of
ou
tpu
t)
Output per Time Period
Ave
rag
e C
ost
(dol
lars
per
uni
t of
ou
tpu
t)
SAC1
SAC2
Q1
C2
C1
C3
C4
Q2
SAC3
Build plant 1 if expected outputat Q1.
Build plant 2 if expected outputat Q2.
SAC1
SAC2
SAC3
SAC4
SAC5
SAC6
SAC7
SAC8
LACenvelope
20
12.00
10.00
8.00
6.00
Long-Run Average Cost Curve
0 5 10 15 20 25 30
ATC1 ATC2 ATC3 ATC4
LRAC curveLeast-costplant is 1
18
Least-costplant is 2
Least-costplant is 4
Least-costplant is 3
24
•Once the plant size is chosen, the firm operates on the short-run cost curves that apply to that plant size.
21
Shape of LRACShape of LRAC & Returns to Scale & Returns to Scale
• Returns to scale are the increases in output Returns to scale are the increases in output that result from that result from increasing all inputs by the increasing all inputs by the same percentage.same percentage.
• There are 3 PossibilitiesThere are 3 Possibilities. .
1)1)Increasing Returns to Scale or Increasing Returns to Scale or Economies of Scale:Economies of Scale: 2) 2)Decreasing Decreasing Returns to Scale or Diseconomies of Returns to Scale or Diseconomies of Scale:Scale: 3) 3)Constant Returns to ScaleConstant Returns to Scale
22
Economies/Diseconomies of Scale
Economies of scale, Increasing Returns
% inputs is less than % output
Decreasing LAC
Constant returns to scale
% inputs is equal to % output
Horizontal LAC
Diseconomies of scale, Decreasing Returns
% inputs is more than % output
Increasing LAC
23
12.00
10.00
8.00
6.00
Long-Run Average Cost Curve
0 5 10 15 20 25 30
LRAC curve
1818 2424
Economies of scale Diseconomies of scale
MES
Minimum efficient scale: the smallest quantity of output at which LRATC reaches its lowest level.
24
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?
25
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.
26
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
27
Demand, Price, and Revenue in Perfect Competition
D
Quantity (thousandsof sweaters per day)
Pric
e (d
olla
rs p
er s
wea
ter)
0 9 20
25
50
Sweater market
S
Marketdemandcurve
Quantity (sweaters per day)
Pric
e (d
olla
rs p
er s
wea
ter)
25
50
Sidney’s demandand marginal revenue
MR
Sidney’sdemandcurve
0 9 20
FIRMINDUSTRY
28
Demand, Price, and Revenue in Perfect Competition: Firm
Quantity sold (Q)
(sweaters per day)
Price
(P) (dollars per
sweater)
Total revenue
(TR = PxQ)
(dollars)
Marginalrevenue
(MR =TR/Q)
(dollars)
8
9
10
25
25
25
200
225
250
25
25
29
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.
30
Demand, Price, and Revenue in Perfect Competition
Quantity (sweaters per day)
Pric
e (d
olla
rs p
er s
wea
ter)
25
50
Sidney’s demandand marginal revenue
MR=P
Sidney’sdemandcurve
0 9 20
D
Quantity (thousandsof sweaters per day)
Pric
e (d
olla
rs p
er s
wea
ter)
0 9 20
25
50
Sweater market
S
Marketdemandcurve
Market Price = $25
INDUSTRY FIRM
31
A firmA 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.
(TC) cost Total - (TR) revenue Total ProfitEconomic
Firm Maximizes Profits: “Supply”
32
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:
output
TR (MR) Revenue Marginal
output
TC (MC) Cost Marginal
MR MR MC MC
33
Total Revenue, Total Cost, & Economic Profit
Quantity(Q)
(sweaters/day)
Total Revenue
(TR) (dollars)
Total Cost(TC)
(dollars)
EconomicProfit
(TR - TC) (dollars)
Average Total Cost (ATC) (dollars)
Average Var. Cost (AVC) (dollars)
Marginal Cost
(MC) (dollars)
0123456789
10111213
0255075
100125150175200225250275300325
22456685
100114126141160183210245300360
-22-20-16-10
011243440424030
0-35
045.0033.0028.3325.0022.8021.0020.1420.0020.3321.0022.27
2527.69
023.0022.0031.5019.5018.4017.3317.0017.2517.8918.8920.2723.1726.00
023.0021.0019.0015.0014.0012.0015.0019.0023.0027.0035.0055.0060.00
025.0025.0025.0025.0025.0025.0025.0025.0025.0025.0025.0025.0025.00
Marginal Revenue
(MR) (dollars)
P=MR
FIRM
34
Profit-Maximizing Output
Quantity (sweaters per day)
8 9 10
10
20
30
$’s.
Mar
gina
l rev
enue
and
mar
gina
l cos
t
MR25
0
MCProfit-maximizationPoint, MC=MR
MR > MC MC > MR
Market Price = $25
• Beyond MC=MR output, MC>MR, TC is increasing more than TR, and profits are decreasing.
• Between zero output and MC = MR output, MR > MC, TR is increasing more than TC, and profits are increasing.
FIRM
35
Economic profit
0Quantity (sweaters per day)
Pri
ce a
nd
co
st (
dol
lars
pe
r sw
eate
r)
15.00
20.33
25.00
Economic Profit
9 10
30.00
MR
MC ATC
At P = $25, ATC =$ 20.33Output = 9 unitsTR = $25 x 9 = $225TC = $20.33 x 9 =$183Profit = $225-$183=$42Profit = (P-ATC) x output
Market Price = $25
FIRMNote: In Perfect Competition, MR=AR
36
Demand, Price, and Revenue in Perfect Competition
Quantity (sweaters per day)
Pric
e (d
olla
rs p
er s
wea
ter)
25
50
Sidney’s demandand marginal revenue: firm
MR
Sidney’sdemandcurve
0 9 20
D
Quantity (thousandsof sweaters per day)
Pric
e (d
olla
rs p
er s
wea
ter)
0 9 20
25
50
Sweater market: Industry
S
New marketdemandcurve
D
20MR
Sidney’snew demandcurve
20
Market Price = $20FIRMINDUSTRY
37
Total Revenue, Total Cost, and Economic Profit
Quantity(Q)
(sweaters/day)
Total Revenue
(TR) (dollars)
Total Cost(TC)
(dollars)
EconomicProfit
(TR - TC) (dollars)
Average Total Cost (ATC) (dollars)
Average Var. Cost (AVC) (dollars)
Marginal Cost
(MC) (dollars)
0123456789
10111213
020406080
100120140160180200220240260
22456685
100114126141160183210245300360
045.0033.0028.3325.0022.8021.0020.1420.0020.3321.0022.27
2527.69
023.0022.0031.5019.5018.4017.3317.0017.2517.8918.8920.2723.1726.00
023.0021.0019.0015.0014.0012.0015.0019.0023.0027.0035.0055.0060.00
020.0020.0020.0020.0020.0020.0020.0020.0020.0020.0020.0020.0020.00
Marginal Revenue
(MR) (dollars)
New Price
-22-25-26-25-20-14
-6-10
-3-10-25-60
-100
FIRM
38Quantity (sweaters per day)
Pri
ce a
nd
co
st (
dol
lars
pe
r sw
eate
r)
1515..0000
25.0025.00
88 10 10
30.0030.00
MRMR
MCMC ATCATC
20.0020.00
Break-even Point, MR=MC=ATC
00
Short-Run Break-Even Price
Break-Even PriceP=$20; ATC=$20
TR = $20X8 units/day
= $160
TC = $20X8units/day
= $160
TR = TC
= 0 Economic Profits
Market Price = $20
FIRM
39
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?
FIRM
40
Demand, Price & Revenue: Perfect Competition
Quantity (sweaters per day)
Pric
e (d
olla
rs p
er s
wea
ter)
25
50
Sidney’s demandand marginal revenue:Firm
MR1
0 9 20
D1
Quantity (thousandsof sweaters per day)
Pric
e (d
olla
rs p
er s
wea
ter)
0 9 20
25
50
Sweater market:Industry
S
New marketdemandcurve
D2
20 MR2
Sidney’snew demandcurve
20
D3
19 MR319
Market Price = $19
FIRM INDUSTRY
41
Total Revenue, Total Cost, and Economic Profit
Quantity(Q)
(sweaters/day)
Total Revenue
(TR) (dollars)
Total Cost(TC)
(dollars)
EconomicProfit
(TR - TC) (dollars)
Average Total Cost (ATC) (dollars)
Average Var. Cost (AVC) (dollars)
Marginal Cost
(MC) (dollars)
0123456789
10111213
01938577695
114133152171190209228247
22456685
100114126141160183210245300360
045.0033.0028.3325.0022.8021.0020.1420.0020.3321.0022.27
2527.69
023.0022.0031.5019.5018.4017.3317.0017.2517.8918.8920.2723.1726.00
023.0021.0019.0015.0014.0012.0015.0019.0023.0027.0035.0055.0060.00
019.0019.0019.0019.0019.0019.0019.0019.0019.0019.0019.0019.0019.00
Marginal Revenue
(MR) (dollars)
New Price
-22-51-28-28-24-19-12
-8-8
-12-20-36-72
-113
FIRM
42
SR Economic Loss Minimization
MRMR
Quantity (sweaters per day)
Pri
ce a
nd
co
st (d
olla
rs p
er s
wea
ter)
1919..000020.0020.00
25.0025.00
30.0030.00 MCMC
ATCATC
88 10 10 00
AVCAVC
lossloss
Loss Min,P=$19.00• MC = MR @ 8 units
ATC ($20) > P ($19); Losses = $8
• TFC = $22.00• Shut down,
lose $22.00• Produce, lose $8
• Minimize losses by producing when
• P >AVC < ATC
Market Price = $19
FIRM
43
Total Revenue, Total Cost, and Economic Profit
Quantity(Q)
(sweaters/day)
Total Revenue
(TR) (dollars)
Total Cost(TC)
(dollars)
EconomicProfit
(TR - TC) (dollars)
Average Total Cost (ATC) (dollars)
Average Var. Cost (AVC) (dollars)
Marginal Cost
(MC) (dollars)
0123456789
10111213
0163248648096
112128144160176192208
22456685
100114126141160183210245300360
045.0033.0028.3325.0022.8021.0020.1420.0020.3321.0022.27
2527.69
023.0022.0031.5019.5018.4017.3317.0017.2517.8918.8920.2723.1726.00
023.0021.0019.0015.0014.0012.0015.0019.0023.0027.0035.0055.0060.00
016.0016.0016.0016.0016.0016.0016.0016.0016.0016.0016.0016.0016.00
Marginal Revenue
(MR) (dollars)
New Price
-22-29-34-37-36-34-30-29-32-39-50-69
-108-152
FIRM
44
Short Run Shut Down
MRMR
Quantity (sweaters per day)
Pri
ce
an
d c
os
t (d
oll
ars
per
sw
eate
r)
1616..0000
20.1420.14
25.0025.00
30.0030.00 MCMC
ATCATC
7 107 1000
AVCAVC
lossloss
Shutdown:P=$16.00• 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 Minimize losses by
shutting down whenshutting down when PP AVC at MC = MR AVC at MC = MR
Market Price = $16
FIRM
45
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 &…….
FIRM
46
MR2
Profitpoint
A Firm’s SR Supply Schedule
Quantity (sweaters per day)7 8 9 10
17
25
31
Pric
e an
d co
st (
dolla
rs p
er s
wea
ter)
MC
MR3
MR0
Shutdown point
0
20
Break-evenpoint
MR1Minimizelosses
MC=Supply
47
“Supply”
The Short Run “supply” schedule of the firm is found to be the “MC” schedule
• but with 2 qualifications.
FIRM
48
•1.) Only the upward slopingpart of MCqualifiesas the SR “supply”• 2.) Only thatpart of the MC that lies above the AVC qualifies as the SR “supply”
Quantity (sweaters per day)
Pri
ce a
nd
co
st (
dol
lars
pe
r sw
eate
r)
15.00
25.00
8 10
30.00
MR
MC
AVC
0
QualificationsFIRM
49
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.
50
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.
51
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?
52
Total Revenue, Total Cost, & Economic Profit
Quantity(Q)
(sweaters/day)
Total Revenue
(TR) (dollars)
Total Cost(TC)
(dollars)
EconomicProfit
(TR - TC) (dollars)
Average Total Cost (ATC) (dollars)
Average Var. Cost (AVC) (dollars)
Marginal Cost
(MC) (dollars)
0123456789
1011121314
918273845546372819099
108117126
15222730323334363944516076
104144
-15-13
-9-36
122027333739393213
-18
022.0013.5010.00
8.006.605.675.144.884.895.105.456.338.009.21
7.006.005.004.253.603.173.003.003.223.604.095.086.859.21
75321123579
162840
Marginal Revenue
(MR) (dollars)
P=$9.00=MR
9.009.009.009.009.009.009.009.009.009.009.009.009.009.00