Economics Supply Decisions

8/13/2019 Economics Supply Decisions

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Lecture 4 the supply decisions

Short-run and long-run costs

Revenues and output

Maximisation of profit


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Outputs vs inputs

Outputs depend on the amount of resources(inputs) and how they are used.

An increase in output requires higher

quantities of inputs. But some inputs cannot be increased within a

given time.

Hence a distinction between fixed andvariable factors and a distinction between theshort run and the long run.


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Fixed vs variable factors

the short run vs the long run

A fixed factor, e.g., buildings, is an input thatcannot be increased within a given time period.

A variable factor, e.g., raw material, can be

increased within a given time period.

The short run is a time period during which atleast one factor of production is fixed. In the short run, then, output can be increased only

by using more variable factors.

The long run is a time period long enough for allinputs to be varied.


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Costs of production

Explicit costs:

Cost of factors that are not owned by the firm

Prices the firm has to pay for them = the money the

firm has to sacrifice to get them = direct payment, so

explicit

Implicit costs:

Costs of factors that are already owned by the firm

Implicit costs are what the factors could earn in some

alternative use


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Costs and output

Costs are a function of output.

The more output, the more factors are

needed.

Productivity of factors: The greater productivity,

the less factors are needed for a given level of

output, hence the lower the cost.

The more inputs, the higher costs. Price of factors: The higher the prices, the higher

the costs of production.


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In the short-run

Fixed cost (that of a fixed factor) (TFC)

Does not vary with output.

Variable cost (TVC) The more that is produced, the more raw materials are

used and hence the higher is variable cost.

Total cost (TC) = TFC + TVC


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0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TC

Output

(Q)

0

12

3

4

5

67

TFC

()

12

1212

12

12

12

1212

TVC

()

0

1016

21

28

40

6091

TC

()

12

2228

33

40

52

72103

TVC

TFC

Total costs for firm X


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0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TC

TVC

TFC

Diminishing marginalreturns set in here

Total costs for firm X


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Production in the short run

Output can be increased only by using more

variable factors given productivity.

However, when increasing amounts of a

variable factor are used with a given amount

of a fixed factor, there will come a point when

each extra unit of the variable factor will produce

less extra output than the previous unit

or the extra output from additional units of the

variable factor will diminish.


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The law of diminishing returns

The extra output from additional units of thevariable factor will diminish.

When the law of diminishing returns sets in,

there is a turning point on TC and TVC. The slopes of TC and TVC increase.

Marginal cost will increase.


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Marginal cost

the change in TC that arises when the quantity producedchanges by one unit, i.e., the cost of producing onemore unit of a good.

marginal cost (MC) and the law of diminishing returns

the relationship between the marginal and total costcurves

Average cost

average fixed cost (AFC)

average variable cost (AVC)

average (total) cost (AC)

relationship betweenACand MC


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Output (Q)

Costs()

AFC

AVC

MC

x

AC

z

y

Average and marginal costs


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The long-run costs

All factors are variable in the long run.

The long-run costs will be affected by the scale of

production and the techniques of production used.

The scale of production:

Constant returns to scale: a given percentage increase in

inputs will lead to the same percentage increase in output.

Increasing returns to scale:

Decreasing returns to scale:


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Short run Long run

Input 1 Input 2 Output Input 1 Input 2 Output

3 1 25 1 1 15

3 2 45 2 2 35

3 3 60 3 3 60

3 4 70 4 4 90

3 5 75 5 5 125

Short-run and long-run increases in output


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Economies of scale

Costs per unit of output (AC) fall as the scaleof production increases.

Other things being equal, it will produce at a

lower average cost. Due to

Specialisation & division of labour: production isbroken down into a number of simpler, more

specialised tasks, thus allowing workers to acquire ahigh degree of efficiency.

Indivisibilities

greater efficiency of large machines

economies of scope


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Diseconomies of scale

Costs per unit of output (AC) increase as the scaleof production increases.

Due to

Managerial complexity Alienation

Industrial relations problems

Disruption if part of complex production chains fail

External economies/diseconomies of scale: costsof per unit of output decrease/increase as thesize of the whole industry grows.


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Revenue

Defining total, average and marginal revenue

TR=P*Q

AR=TR/Q=P*Q/Q=P

MR=TR/Q

TR, AR and MR depend on Q.

The relationship between TR, AR and MR and Q willdepend on the market conditions under which a firmoperates.

A price-taker or a price-maker


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O O

Price()

AR,MR()

Pe

S

D

D = AR

= MR

Q(millions) Q(hundreds)

(a) The market (b) The firm

Deriving a firms ARand MR: price-taking firm

Total re en e for a price taking firm


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0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TR

TR()

Quantity

Quantity

(units)

0200

400

600

800

1000

1200

Price =AR

= MR()

55

5

5

5

5

5

TR

()

01000

2000

3000

4000

5000

6000

Total revenue for a price-taking firm

Revenues for a firm facing a


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Q(units)

P = AR()

TR()

MR()

1 8 8

62 7 14

43 6 18

24 5 20

0

5 4 202

6 3 184

7 2 14

Revenues for a firm facing a

downward-sloping demand curve

AR d MR f fi f i d d l i D


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-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

Q

(units)

1

23

4

5

6

7

P =AR

()

8

76

5

4

3

2

TR

()

8

1418

20

20

18

14

MR

()

64

2

0

-2

-4

MR

AR,M

R()

Quantity

AR

ARand MRcurves for a firm facing a downward-sloping Dcurve

TR f fi f i d d l i D


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0

4

8

12

16

20

0 1 2 3 4 5 6 7

TR

Quantity

TR()

Quantity

(units)

1

2

3

4

56

7

P = AR

()

8

7

6

5

43

2

TR

()

8

14

18

20

2018

14

TRcurve for a firm facing a downward-sloping Dcurve


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MR vs. PD

If PD>1, Q>|P|

an increase in revenue. MR>0.

If PD


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-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

Elasticity = -1

Elastic

Inelastic

AR,M

R()

Quantity

MR

AR

ARand MRcurves for a firm facing a downward-sloping Dcurve


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Profit maximisationthe case of a down-ward sloping demand curve

Using MR=MC to locate at which quantity

profit will be maximised.

Profits () maximise where MR=MC

Using AR and AC curves to measure maximum

profit

To find how much profit is at this output

T=Q*(AR-AC)=Q*A

R t d fit f Fi X


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Q

(units)

P = AR

()

TR

()

MR

()

TC

()

AC

()

MC

()

T

()

A

()

0 9 0 6 6

8 4

1 8 8 10 10 2 2

6 2

2 7 14 12 6 2 1

4 2

3 6 18 14 42/3 4 1

1/3

2 4

4 5 20 18 41/2 2

1/2

0 7

5 4 20 25 5 5 1

2 11

6 3 18 36 6 18 3

4 20

7 2 14 56 8 42 6

Revenue, cost and profit for Firm X

Finding maximum profit using marginal curves


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-4

0

4

8

12

16

1 2 3 4 5 6 7

Quantity

Costsandre

venue()

e

MR

MC

Profit-maximisingoutput

Finding maximum profit using marginal curves

At MR>MC: TR>TC, Total profit can be

increased by increasing QAt MRTR, total profit can be

increased by decreasing Q

Measuring maximum profit using average curves


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6.00

4.50

-4

0

4

8

12

16

1 2 3 4 5 6 7

T O T A L P R O F I T

MR

Quantity

Costsandre

venue()

MC

AC

AR

ba

Total profit =

1.50 x 3 = 4.50

Profits maximised at the

output where MC = MR

Measuring maximum profit using average curves


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Some qualifications

Long-run profit maximisation at MR=MC

The meaning of profit:

Normal profit to cover the opportunity cost of staying in thebusiness

= minimum return the owners must make

= interest rate forgone + a risk premium

Supernormal profit, over and above the normal profit

What if a loss is made?

AC>AR, no profit can be made at any output

Still produce where MR=MC to minimise loss

Short-run & long-run shut-down points

SR: variable costs cannot be covered: P=AVC

LR: LRAC cannot be covered: P=LRAC

Loss-minimising output


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LOSS

O

Costsand

revenue()

Quantity

MC

AC

AR

MR

Q

AC

AR

Loss minimising output

The short-run shut-down point


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O

Costsandr

evenue()

Quantity

AR

AVC

ACP =

AVC

Q

IfAVCis higher orAR

lower than that shown,

the firm will shut down.

The firm will shut down in

the short run if it cannot

cover variable costs.

The short run shut down point

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Economics Supply Decisions