1 short run short run: the quantity of at least one input, (ie: factory size) is fixed and the...

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.

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

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

Total, Marginal, & Average Product

Labour

(workers per day)

Total Product

(sweaters per day)

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)

MP=MP=TP/TP/QQLL

AP=TP/QL

Total Product & Marginal Product

Labour (workers per day)

0 1 2 3 4 5

Labour (workers per day)

0 1 2 3 4 5

• total product (TP) always increasing

•as TP , & MP , TP increases at a decreasing rate

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.

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

1.)Total Costs:

Total Totalfixed variable Totalcost cost cost

Labour Output(workers (sweaters (TFC) (TVC) (TC)per day) per day) (dollars per day)

c 2 10

d 3 13

e 4 15

f 5 16

TC = TFC + TVC

Total Costs

0 5 10 15Output (sweaters per day)

TC = TFC + TVC

aa 00 0 0

bb 11 4 4

cc 22 1010

dd 33 1313

ee 44 1515

ff 55 1616

100100

125125

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)

MarginalMarginalcostcost

((MCMC))

2.)Marginal Cost2.)Marginal Cost

the in total cost that results from a one-unit in output.

c 2 10

d 3 13

e 4 15

f 5 16

Total Total fixed variable Total cost cost cost

Labour Output(workers (sweaters (TFC) (TVC) (TC)per day) per day)

3.)Average Cost3.)Average Cost

Marginalcost

Avg.fixedcost

Avg.variable

(AVC) TVC/Q

Avg.totalcost

(ATC) TC/Q

(dollars per day)

AVC AFC ATC Q

Marginal Cost and Average Costs

5 10 15Output (sweaters per day)

ATC = AFC + AVC

Marginal Cost and Average Costs

5 10 15Output (sweaters per day)

25MC at low outputs due to gains from specialization, MC eventually due to law of diminishing returns.

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

Shifts in the Cost Curves

The position of a firm’s short-run

cost curves depends on two factors:• technology• prices of resources

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.

The long run is the firm’s planning perspective while the short run is the firm’s operating perspective.

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.

Preferable Plant Size and theLong-Run Average Cost Curve

Output per Time Period

Build plant 1 if expected outputat Q1.

Build plant 2 if expected outputat Q2.

LACenvelope

Long-Run Average Cost Curve

0 5 10 15 20 25 30

ATC1 ATC2 ATC3 ATC4

LRAC curveLeast-costplant is 1

Least-costplant is 2

•Once the plant size is chosen, the firm operates on the short-run cost curves that apply to that plant size.

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

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

Long-Run Average Cost Curve

0 5 10 15 20 25 30

LRAC curve

1818 2424

Economies of scale Diseconomies of scale

Minimum efficient scale: the smallest quantity of output at which LRATC reaches its lowest level.

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?

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.

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

Demand, Price, and Revenue in Perfect Competition

Quantity (thousandsof sweaters per day)

0 9 20

Sweater market

Marketdemandcurve

Quantity (sweaters per day)

Sidney’s demandand marginal revenue

Sidney’sdemandcurve

0 9 20

FIRMINDUSTRY

Demand, Price, and Revenue in Perfect Competition: Firm

Quantity sold (Q)

(sweaters per day)

(P) (dollars per

sweater)

Total revenue

(TR = PxQ)

(dollars)

Marginalrevenue

(MR =TR/Q)

(dollars)

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.

Sidney’s demandand marginal revenue

0 9 20

Sweater market

Marketdemandcurve

Market Price = $25

INDUSTRY FIRM

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”

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

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

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)

Profit-Maximizing Output

8 9 10

$’s.

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.

Economic profit

0Quantity (sweaters per day)

Economic Profit

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

Sidney’s demandand marginal revenue: firm

0 9 20

Sweater market: Industry

New marketdemandcurve

Sidney’snew demandcurve

Market Price = $20FIRMINDUSTRY

Total Revenue, Total Cost, and Economic Profit

Quantity(Q)

(sweaters/day)

Total Revenue

(TR) (dollars)

Total Cost(TC)

(dollars)

EconomicProfit

(TR - TC) (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

-3-10-25-60

38Quantity (sweaters per day)

1515..0000

25.0025.00

88 10 10

30.0030.00

MCMC ATCATC

20.0020.00

Break-even Point, MR=MC=ATC

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

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?

Demand, Price & Revenue: Perfect Competition

Sidney’s demandand marginal revenue:Firm

0 9 20

Sweater market:Industry

New marketdemandcurve

20 MR2

Sidney’snew demandcurve

19 MR319

Market Price = $19

FIRM INDUSTRY

Quantity(Q)

(sweaters/day)

Total Revenue

(TR) (dollars)

Total Cost(TC)

(dollars)

EconomicProfit

(TR - TC) (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

-12-20-36-72

SR Economic Loss Minimization

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

Quantity(Q)

(sweaters/day)

Total Revenue

(TR) (dollars)

Total Cost(TC)

(dollars)

EconomicProfit

(TR - TC) (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

Short Run Shut Down

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

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 &…….

Profitpoint

A Firm’s SR Supply Schedule

Quantity (sweaters per day)7 8 9 10

Shutdown point

Break-evenpoint

MR1Minimizelosses

MC=Supply

“Supply”

The Short Run “supply” schedule of the firm is found to be the “MC” schedule

• but with 2 qualifications.

•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”

QualificationsFIRM

Market Supply

• Total amount provided to the market at each possible price…

• The marginal cost of providing additional output to the market, given current production conditions.

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.

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?

Total Revenue, Total Cost, & Economic Profit

Quantity(Q)

(sweaters/day)

Total Revenue

(TR) (dollars)

Total Cost(TC)

(dollars)

EconomicProfit

(TR - TC) (dollars)

Marginal Cost

(MC) (dollars)

0123456789

1011121314

918273845546372819099

108117126

15222730323334363944516076

104144

-15-13

122027333739393213

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

1 short run short run: the quantity of at least one input, (ie: factory size) is fixed and the...

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