Chap - 6 7 8

Chapter 06, 07,08 Production and Business Organization Analysis of Cost Analysis of Perfectly Competitive Markers
Total Revenue, Total Cost, Profit

We assume that the firms goal is to maximize
profit.
Profit = Total revenue Total cost

the amount a firm receives from the sale of its output the market value of the inputs a firm uses in production
THE COSTS OF PRODUCTION
Costs: Explicit vs. Implicit

Explicit costs require an outlay of money,
e.g., paying wages to workers.
Implicit costs do not require a cash outlay,

e.g., the opportunity cost of the owners time.
The cost of something is the highest value

opportunity foregone.
This is true whether the costs are implicit or

explicit. Both matter for firms decisions.
Economic Profit vs. Accounting Profit

Accounting profit
= total revenue minus total explicit costs
Economic profit
= total revenue minus total costs (including explicit and implicit costs)
Accounting profit ignores implicit costs,

so its higher than economic profit.
The Production Function

A production function shows the relationship
between the quantity of inputs used to produce a good and the quantity of output of that good.
It can be represented by a table, equation, or

graph.
Example 1: Farmer Akira grows wheat. He has 5 acres of land. He can hire as many workers as he wants.
4
Ex 1: Farmer Akiras Production Function

L Q
Quantity of output
3,000 2,500 2,000 1,500 1,000 500 0 0 1 2 3 4 5
(no. of (bushels workers) of wheat)
0 1 2 3 4 5
0 1000 1800 2400 2800 3000
No. of workers
5
Marginal Product
If Akira hires one more worker, his output rises
by the marginal product of labor.
The marginal product of any input is the

increase in output arising from an additional unit of that input, holding all other inputs constant.
Notation:
(delta) = change in Examples: Q = change in output, L = change in labor Q Marginal product of labor (MPL) = L
6
MPL Diminishes
Diminishing marginal product:
the marginal product of an input declines as the quantity of the input increases (other things equal)
Marginal Cost
Marginal Cost (MC)
is the increase in Total Cost from producing one more unit: TC MC = Q
EXAMPLE 1: Total and Marginal Cost

Q (bushels of wheat) 0
Q = 1000
Total Cost $1,000

TC = $2000
Marginal Cost (MC)
$2.00 $2.50 $3.33 $5.00 $10.00

9
1000
Q = 800
$3,000
TC = $2000
1800
Q = 600
$5,000
TC = $2000
2400
Q = 400
$7,000
TC = $2000
2800
Q = 200
$9,000
TC = $2000
3000 $11,000
EXAMPLE 1: The Marginal Cost Curve

Q (bushels of wheat)
0 1000 1800 2400 2800
$12
TC
$1,000
MC
Marginal Cost ($)
$10 $8 $6 $4 $2
MC usually rises as Q rises, as in this example.
$2.00 $3,000 $2.50 $5,000 $3.33 $7,000 $5.00 $9,000 $10.00
$0 0 1,000 2,000 3,000
3000 $11,000
Q
10
Fixed and Variable Costs

Fixed costs (FC) do not vary with the quantity of
output produced. For Farmer Akira, FC = $1000 for his land Other examples: cost of equipment, loan payments, rent
Variable costs (VC) vary with the quantity

produced. For Farmer Akira, VC = wages he pays workers Other example: cost of materials
Total cost (TC) = FC + VC

11
EXAMPLE 2
Our second example is more general,
applies to any type of firm producing any good with any types of inputs.
12
EXAMPLE 2: Costs
Q FC VC TC
$800 $700 $600 $500 Costs $400 $300 $200
FC VC TC
0 $100 1 2 3 4 5 6 7 100
$0 $100 70 170 220 260 310 380
100 120 100 160 100 210 100 280 100 380 100 520
$100
480 620
$0 0 1 2 3 4 Q 5 6 7
13
EXAMPLE 2: Marginal Cost

Q TC MC $70 50 40 3 4 5 6 7 260 310 380 480 620 100 140 50 70
$200 Recall, Marginal Cost (MC) is $175change in total cost from the producing one more unit: $150
0 $100 1 2 170 220
TC MC = Q $100 Usually, MC rises as Q rises, due $75 to diminishing marginal product.

$125 $50
Costs
Sometimes (as here), MC falls $25 before rising.

$0
(In other examples, MC may 6 7 be 0 1 2 3 4 5 constant.) Q

14
EXAMPLE 2: Average Fixed Cost

Q FC AFC n/a $100 50
$200 Average fixed cost (AFC) is fixed cost divided by the $175 quantity of output: $150 Costs
0 $100 1 2 3 4 5 6 7 100 100
AFC $125
$100
= FC/Q
100 33.33 100 100 25 20
100 16.67 100 14.29
Notice that AFC falls as Q rises: $75 The firm is spreading its fixed $50 costs over a larger and larger $25 number of units.
$0 0 1 2 3 4 Q 5 6 7
15
EXAMPLE 2: Average Variable Cost

Q 0 1 2 3 4 5 6 7 VC $0 70 120 160 210 280 380 520 AVC n/a $70 60 53.33 52.50 56.00 63.33 74.29
$200 Average variable cost (AVC) is variable cost divided by the $175 quantity of output: $150
Costs
AVC $125
$100
= VC/Q
As Q rises, AVC may fall initially. $75 In most cases, AVC will $50 eventually rise as output rises.
$25 $0 0 1 2 3 4 Q 5 6 7
16
EXAMPLE 2: Average Total Cost

Q TC ATC
n/a $170 110
AFC
n/a $100 50
AVC
n/a $70 60 53.33 52.50 56.00 63.33 74.29
0 $100 1 2 3 4 5 6 7 170 220
Average total cost (ATC) equals total cost divided by the quantity of output: ATC = TC/Q Also, ATC = AFC + AVC
260 86.67 33.33 310 77.50 380 480 76 25 20
80 16.67
620 88.57 14.29
17
EXAMPLE 2: Average Total Cost

Q TC ATC
n/a $170 110
Costs $200
0 $100 1 2 3 4 5 6 7 170 220
Usually, as in this example, $175 the ATC curve is U-shaped.

$150 $125 $100 $75
260 86.67 310 77.50 380 480 76 80
$50 $25 $0 0 1 2 3 Q 4 5 6 7
620 88.57
18
EXAMPLE 2: The Various Cost Curves Together

$200 $175 $150
ATC AVC AFC MC
Costs
$125 $100 $75 $50 $25 $0 0 1 2 3 Q 4 5 6 7
19
EXAMPLE 2: Why ATC Is Usually U-Shaped

As Q rises: Initially, falling AFC pulls ATC down. Eventually, rising AVC pulls ATC up. Efficient scale: The quantity that minimizes ATC.
$200 $175 $150 Costs $125 $100 $75 $50 $25 $0 0 1 2 3 Q

20
EXAMPLE 2: ATC and MC

When MC < ATC, ATC is falling. When MC > ATC,
Costs $200 $175 $150 $125 $100 $75 $50 $25 $0 0 1 2 3 Q
21
ATC MC
ATC is rising. The MC curve crosses the ATC curve at the ATC curves minimum.
Costs in the Short Run & Long Run

Short run:
Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC.
Long run:
All inputs are variable (e.g., firms can build more factories, or sell existing ones).
In the long run, ATC at any Q is cost per unit

using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC).
22
EXAMPLE 3: LRATC with 3 factory Sizes

Firm can choose from 3 factory sizes: S, M, L. Each size has its own SRATC curve. The firm can change to a different factory size in the long run, but not in the short run. Avg Total Cost
ATCS
ATCM
ATCL
23
EXAMPLE 3: LRATC with 3 factory Sizes

To produce less than QA, firm will choose size S in the long run. To produce between QA and QB, firm will choose size M in the long run. To produce more than QB, firm will choose size L in the long run.
Avg Total Cost
ATCS
ATCM
ATCL
LRATC
Q QA QB
24
A Typical LRATC Curve

In the real world, factories come in many sizes, each with its own SRATC curve. So a typical LRATC curve looks like this: Q ATC LRATC
25
How ATC Changes as the Scale of Production Changes

Economies of scale: ATC falls as Q increases. Constant returns to scale: ATC stays the same as Q increases. Diseconomies of scale: ATC rises as Q increases.
ATC LRATC
26
How ATC Changes as the Scale of Production Changes
Economies of scale occur when increasing

production allows greater specialization: workers more efficient when focusing on a narrow task. More common when Q is low.
Diseconomies of scale are due to coordination

problems in large organizations. E.g., management becomes stretched, cant control costs. More common when Q is high.
27
CHAPTER
2009 South-Western, a part of Cengage Learning, all rights reserved
PERFECT Competition
FIRMS IN COMPETITIVE MARKETS
29
Characteristics of Perfect Competition

1. Many buyers and many sellers. 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market.
Because of 1 & 2, each buyer and seller is a

price taker takes the price as given.
30
The Revenue of a Competitive Firm

Total revenue (TR) Average revenue (AR) Marginal revenue (MR):
The change in TR from selling one more unit. TR = P x Q TR =P AR = Q TR MR = Q
31
ACTIVE LEARNING 1
Calculating TR, AR, MR TR, AR,

Fill in the empty spaces of the table.
Q 0 1 2 3 4 5 P $10 $10 $10 $10 $10 $10 $40 $10 $50
32
TR
AR n/a $10
MR
ACTIVE LEARNING 1
Answers
Fill in the empty spaces of the table.
Q 0 1 2 3 4 5 P $10 $10 $10 $10 $10 $10 TR = P x Q $0 $10 AR = TR Q TR MR = Q
n/a $10
$10 $10 $10 $10
Notice that $20 $10 MR = P

$30 $40 $50 $10 $10
$10 $10
33
MR = P for a Competitive Firm

A competitive firm can keep increasing its output
without affecting the market price.
So, each one-unit increase in Q causes revenue

to rise by P, i.e., MR = P. MR = P is only true for firms in competitive markets.
34
Profit Maximization
What Q maximizes the firms profit? To find the answer, think at the margin.
If increase Q by one unit, revenue rises by MR, cost rises by MC.
If MR > MC, then increase Q to raise profit. If MR < MC, then reduce Q to raise profit.
35
Profit Maximization
(continued from earlier exercise) At any Q with MR > MC, increasing Q raises profit. At any Q with MR < MC, reducing Q raises profit.
Q 0 1 2 3 4 5 TR $0 10 20 30 40 50 TC $5 9 15 23 33 45 Profit MR MC $5 1 5 7 7 5
36
(Profit =
MR MC $6 4 2 0 2
$10 $4 10 10 10 10 6 8 10 12
MC and the Firms Supply Decision

Rule: MR = MC at the profit-maximizing Q. At Qa, MC < MR. So, increase Q to raise profit. At Qb, MC > MR. So, reduce Q to raise profit. At Q1, MC = MR. Changing Q would lower profit.
Costs MC
P1
MR
Qa Q1 Qb
Q
37
MC and the Firms Supply Decision

If price rises to P2, then the profitmaximizing quantity rises to Q2. The MC curve determines the firms Q at any price. Hence, the MC curve is the firms supply curve. Q1
Costs MC P2 P1 MR2 MR
Q2
Q
38
Shutdown vs. Exit

Shutdown:
A short-run decision not to produce anything because of market conditions.
Exit:
A long-run decision to leave the market.
A key difference: If shut down in SR, must still pay FC. If exit in LR, zero costs.
39
A Firms Short-run Decision to Shut Down

Cost of shutting down: revenue loss = TR Benefit of shutting down: cost savings = VC
(firm must still pay FC)
So, shut down if TR < VC Divide both sides by Q: So, firms decision rule is:
Shut down if P < AVC TR/Q < VC/Q
40
A Competitive Firms SR Supply Curve

The firms SR Costs supply curve is the portion of its MC curve If P > AVC, then above AVC. firm produces Q where P = MC.
If P < AVC, then firm shuts down (produces Q = 0).
MC ATC AVC
Q
41
The Irrelevance of Sunk Costs

Sunk cost: a cost that has already been
committed and cannot be recovered
Sunk costs should be irrelevant to decisions;

you must pay them regardless of your choice.
FC is a sunk cost: The firm must pay its fixed

costs whether it produces or shuts down.
So, FC should not matter in the decision to shut

down.
42
A Firms Long-Run Decision to Exit

Cost of exiting the market: revenue loss = TR Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
So, firm exits if TR < TC Divide both sides by Q to write the firms
decision rule as: Exit if P < ATC
43
The Competitive Firms Supply Curve

The firms LR supply curve is the portion of its MC curve above LRATC.
Costs MC LRATC
Q
44
ACTIVE LEARNING 2
Identifying a firms profit

Determine this firms total profit. Identify the area on the graph that represents the firms profit.
A competitive firm Costs, P MC P = $10 $6 MR ATC
50
Q
45
ACTIVE LEARNING 2
Answers
A competitive firm Costs, P Profit per unit = P ATC = $10 6 = $4 MC P = $10 MR ATC
profit
$6
Total profit = (P ATC) x Q = $4 x 50 = $200
50
Q
46
ACTIVE LEARNING 3
Identifying a firms loss

Determine this firms total loss, assuming AVC < $3. Identify the area on the graph that represents the firms loss.
A competitive firm Costs, P MC ATC
$5 P = $3 30 MR Q
47
ACTIVE LEARNING 3
Answers
A competitive firm Costs, P Total loss = (ATC P) x Q = $2 x 30 = $60 MC ATC
$5 P = $3
loss
loss per unit = $2 MR
30
Q
48
Market Supply: Assumptions

1) All existing firms and potential entrants have
identical costs.
2) Each firms costs do not change as other firms
enter or exit the market.

3) The number of firms in the market is
fixed in the short run

(due to fixed costs) variable in the long run (due to free entry and exit)
49

identical costs.


50
The SR Market Supply Curve

As long as P AVC, each firm will produce its
profit-maximizing quantity, where MR = MC.
Recall from Chapter 4:

At each price, the market quantity supplied is the sum of quantities supplied by all firms.
51

Example: 1000 identical firms At each P, market Qs = 1000 x (one firms Qs) P
P3 P2 P1 10 20 30 AVC One firm MC P3 P2 P1
Market S
Q (firm)
10,000
Q (market)
20,000 30,000
52

identical costs.


53

As long as P AVC, each firm will produce its
profit-maximizing quantity, where MR = MC.
Recall from Chapter 4:

At each price, the market quantity supplied is the sum of quantities supplied by all firms.
54

Example: 1000 identical firms At each P, market Qs = 1000 x (one firms Qs) P
P3 P2 P1 10 20 30 AVC One firm MC P3 P2 P1
Market S
Q (firm)
10,000
Q (market)
20,000 30,000
55
Entry & Exit in the Long Run

In the LR, the number of firms can change due to
entry & exit.
If existing firms earn positive economic profit, new firms enter, SR market supply shifts right. P falls, reducing profits and slowing entry. If existing firms incur losses, some firms exit, SR market supply shifts left. P rises, reducing remaining firms losses.
56
The Zero-Profit Condition

Long-run equilibrium:
The process of entry or exit is complete remaining firms earn zero economic profit.
Zero economic profit occurs when P = ATC. Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
Recall that MC intersects ATC at minimum ATC. Hence, in the long run, P = minimum ATC.
57
Why Do Firms Stay in Business if Profit = 0?
Recall, economic profit is revenue minus all costs

including implicit costs, like the opportunity cost of the owners time and money.
In the zero-profit equilibrium, firms earn enough revenue to cover these costs accounting profit is positive
58
The LR Market Supply Curve

In the long run, the typical firm earns zero profit. P
P= min. ATC One firm MC LRATC long-run supply
The LR market supply curve is horizontal at P = minimum ATC. P

Market
Q (firm)
Q (market)
59
SR & LR Effects of an Increase in Demand

but then an increase A firm begins in driving profits to zerodemand raises P, leading to SR Over time, in profits induce entry, long-run eqm and restoring long-run eqm. profits for the firm. shifting S to the right, reducing P P
One firm MC Profit P2 P1 ATC P2 P1 A
Market S1 S2 B C long-run supply D1 Q1 Q2 Q3 D2
Q (firm)
Q (market)
60
Why the LR Supply Curve Might Slope Upward
The LR market supply curve is horizontal if

1) all firms have identical costs, and 2) costs do not change as other firms enter or
exit the market.
If either of these assumptions is not true,

then LR supply curve slopes upward.
61
1) Firms Have Different Costs

As P rises, firms with lower costs enter the market
before those with higher costs.
Further increases in P make it worthwhile

for higher-cost firms to enter the market, which increases market quantity supplied.
Hence, LR market supply curve slopes upward. At any P, For the marginal firm,
P = minimum ATC and profit = 0.
For lower-cost firms, profit > 0.

62
2) Costs Rise as Firms Enter the Market In some industries, the supply of a key input is
limited (e.g., amount of land suitable for farming is fixed).
The entry of new firms increases demand for this

input, causing its price to rise.
This increases all firms costs. Hence, an increase in P is required to increase

the market quantity supplied, so the supply curve is upward-sloping.
63
CONCLUSION: The Efficiency of a Competitive Market

Profit-maximization: Perfect competition: So, in the competitive eqm:
MC = MR P = MR P = MC
Recall, MC is cost of producing the marginal unit. P is value to buyers of the marginal unit. total surplus.
So, the competitive eqm is efficient, maximizes In the next chapter, monopoly: pricing &
production decisions, deadweight loss, regulation.
64

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Chapter 06, 07,08 Production and Business Organization Analysis of Cost Analysis of Perfectly Competitive Markers

Total Revenue, Total Cost, Profit

Profit = Total revenue Total cost

THE COSTS OF PRODUCTION

Costs: Explicit vs. Implicit

 Implicit costs do not require a cash outlay,

 The cost of something is the highest value

 This is true whether the costs are implicit or

THE COSTS OF PRODUCTION

Economic Profit vs. Accounting Profit

 Accounting profit ignores implicit costs,

THE COSTS OF PRODUCTION

The Production Function

 It can be represented by a table, equation, or

Ex 1: Farmer Akiras Production Function

(no. of (bushels workers) of wheat)

0 1000 1800 2400 2800 3000

THE COSTS OF PRODUCTION

 The marginal product of any input is the

THE COSTS OF PRODUCTION

THE COSTS OF PRODUCTION

EXAMPLE 1: Total and Marginal Cost

Total Cost $1,000

Marginal Cost (MC)

$2.00 $2.50 $3.33 $5.00 $10.00

THE COSTS OF PRODUCTION

EXAMPLE 1: The Marginal Cost Curve

MC usually rises as Q rises, as in this example.

$2.00 $3,000 $2.50 $5,000 $3.33 $7,000 $5.00 $9,000 $10.00

$0 0 1,000 2,000 3,000

Fixed and Variable Costs

 Variable costs (VC) vary with the quantity

 Total cost (TC) = FC + VC

THE COSTS OF PRODUCTION

$800 $700 $600 $500 Costs $400 $300 $200

$0 $100 70 170 220 260 310 380

THE COSTS OF PRODUCTION

EXAMPLE 2: Marginal Cost

0 $100 1 2 170 220

TC MC = Q $100 Usually, MC rises as Q rises, due $75 to diminishing marginal product.

Sometimes (as here), MC falls $25 before rising.

(In other examples, MC may 6 7 be 0 1 2 3 4 5 constant.) Q

THE COSTS OF PRODUCTION

EXAMPLE 2: Average Fixed Cost

0 $100 1 2 3 4 5 6 7 100 100

100 33.33 100 100 25 20

100 16.67 100 14.29

THE COSTS OF PRODUCTION

EXAMPLE 2: Average Variable Cost

THE COSTS OF PRODUCTION

EXAMPLE 2: Average Total Cost

0 $100 1 2 3 4 5 6 7 170 220

260 86.67 33.33 310 77.50 380 480 76 25 20

620 88.57 14.29

THE COSTS OF PRODUCTION

EXAMPLE 2: Average Total Cost

0 $100 1 2 3 4 5 6 7 170 220

Usually, as in this example, $175 the ATC curve is U-shaped.

260 86.67 310 77.50 380 480 76 80

THE COSTS OF PRODUCTION

EXAMPLE 2: The Various Cost Curves Together

ATC AVC AFC MC

Implicit costs do not require a cash outlay,

The cost of something is the highest value

This is true whether the costs are implicit or

Accounting profit ignores implicit costs,

It can be represented by a table, equation, or

The marginal product of any input is the

Variable costs (VC) vary with the quantity

Total cost (TC) = FC + VC

In the long run, ATC at any Q is cost per unit

Economies of scale occur when increasing

Diseconomies of scale are due to coordination

Because of 1 & 2, each buyer and seller is a

So, each one-unit increase in Q causes revenue

Sunk costs should be irrelevant to decisions;

FC is a sunk cost: The firm must pay its fixed

So, FC should not matter in the decision to shut

fixed in the short run

fixed in the short run

Recall from Chapter 4:

fixed in the short run

Recall from Chapter 4: