chapter six the supply curve and the behavior of firms

Chapter Six

The Supply Curve and the

Behavior of Firms

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Definition of a Firm

• A firm: An organization that produces goods and services

Firms in the US can be classified as1) A sole proprietorship 2) A partnership3) A corporation


• Limited Liability Company (LLC) is a new type of business organization that firms started to use only starting the 1990s.

Limited Liability Company (LLC)


Limited Liability Company (LLC) (cont’d) A limited liability company (LLC)

– Is a type of business ownership combining several features of corporation and partnership structures

– Is not a corporation or a partnership

– May be called a limited liability corporation although the correct terminology is limited liability company

– Owners are called members not partners or shareholders

– Number of members are unlimited and may be individuals, corporations, or other LLCs

Source: sbinformation.about.com


A Price Taker in a Competitive Market

• Competitive market – A market in which no firm has power to affect the market price of a good.

• Price-taker – Any firm that takes the market price as given; this firm cannot affect the market price because the market is competitive.


Competitive Markets

Examples of Competitive Markets

1) The market for fresh bread

2) The pumpkin market

• Note: a competitive market requires that there be at least several firms competing with one another. If there are one or two firms, then the market cannot be competitive.


• Because competitive markets are price takers, we can derive the supply curve of each firm by asking how much each firm is willing to supply at a given price.

Competitive Markets (cont’d)


Other Types of Markets

• The exact opposite of a competitive market is a monopoly.

• Monopoly – A market where there is only one firm selling in the market. Unlike a competitive firm, the monopolist has the power to set the price of a good.


• There is no supply curve in a monopoly, because the monopoly does not take prices as given.

• We will discuss monopolies in Chapter 10. For the rest of the chapter, we will focus on price taking competitive firms.

Other Types of Markets (cont’d)


The Firm’s Profits

• We assume that a firm’s objective is to maximize profits.

• Profits – the total revenue received from selling the product minus the total costs of producing the product, or:

• Profits = total revenue – total costs


• Total Revenue (generated from a product) – The price per unit multiplied by the quantity that the firm sells at that price.

• Total Revenue = price of the product X quantity sold at that price= P X Q

• Table 6.1 shows an example of calculating total revenue, using three different prices.

The Firm’s Profits (cont’d)


Total Revenue


• From Table 6.1, we can see that at any given quantity, higher prices will result in higher revenues. Similarly, at any given price, total revenue increases when the quantity sold increases.

• Note that in a competitive market, the increase in revenue brought about by selling one more unit of the good is equal to the price of the good.

Total Revenue (cont’d)


Production and Cost

• Total Cost – The sum of the fixed costs and the variable costs of production. This includes all costs such as salaries, rent, material costs, business permits, etc. In economics, the total costs should also include all opportunity costs.


Short Run vs. Long Run

• Short-Run – A time period where at least one input is fixed, and other inputs are allowed to vary. In our analyses, we usually allow the labor input to vary, and capital input to stay fixed in the short-run.

• Long-Run – A time period long enough for all inputs (both capital and labor) to vary.

• For this chapter, our analysis revolves around short-run decision making.


The Production Function

• Production function – A relationship that shows the quantity of output for any given amount of input.

• Figure 6.3 shows a hypothetical short run production function relating the input used and the corresponding output. Since this is in the short run, capital is an input, but is kept fixed/constant.


The Production Function (cont’d) Figure 6.3


• Marginal Product of Labor: The change in the production due to a one-unit increase in labor input (holding the capital input constant)

• Diminishing (Marginal) returns to labor: A situation in which the increase in output due to a one unit increase in labor declines with increasing labor input (again, holding the capital input constant)

The Production Function (cont’d)


• From Figure 6.3, the marginal product of labor is the slope of the production function. Diminishing returns to labor is illustrated in Figure 6.3 as the flatter slope of the production function as the hours of work increase.



• Diminishing returns to labor occurs in the short run because increases in the labor input (holding the capital or other inputs constant) will result in a smaller share of the capital input per every worker. As a result, the additional worker will contribute less and less as more and more workers are hired.



Costs

• Fixed Costs – Costs of production that do not depend on the quantity of production. These are costs associated with the fixed input.

• Variable Costs - Costs of production that vary with the quantity of production. These are costs associated with the variable input.


Costs (cont’d)

• Table 6.2 shows the relationship between the costs of production and the quantity of pumpkin produced. In order to increase the number of crates produced, the firm must hire more workers, resulting in an increase in the total costs of production.

• Table 6.2 also shows how total costs are calculated, i.e., by adding the fixed costs and the variable costs at every level of production.


Costs (cont’d)


• Marginal cost – the change in the total cost due to a one unit change in the quantity produced.

• Table 6.3 shows how marginal cost is calculated.

Marginal Costs

Note: Since fixed costs do not change with the quantity produced, we can also calculate the marginal cost from the change in the variable cost due to a one unit change in the quantity produced.


Marginal Costs (cont’d)


• Note that in Table 6.3, the rising marginal cost is due to the diminishing marginal product of labor. If the additional output from hiring one worker is declining and the cost of hiring the worker is constant, then the marginal cost of producing one more unit must be rising.

• One thing we will show later is that the firm’s supply curve is derived directly from its marginal cost curve.

Marginal Costs (cont’d)


Graphical Representation of Total Costs and Marginal Costs

• With dollars (costs) on the Y-axis and the quantity of crates produced on the X-axis, we can plot the total cost curve using the first two columns of Table 6.3. Similarly, we can also plot the marginal cost of producing pumpkins using the first and the last column in Table 6.3.

• Figure 6.4 illustrates the total cost curve while Figure 6.5 illustrates the marginal cost curve.


Total Costs Figure 6.4


Marginal Costs Figure 6.5


Profit Maximization and the Individual Firm’s Supply Curve

• Profit Maximization: An assumption that firms try to achieve the highest possible level of profits (total revenues minus total costs) given their production function.

• Table 6.4 shows the profits of the pumpkin firm, calculated from three different prices for a crate of pumpkins.


Profit Maximization and the Individual Firm’s Supply Curve (cont’d)


Note: From Table 6.4 , we can see that 1) At any level of quantity, the profit level is

higher when the price level is higher.2) While total revenue changes when the selling

price changes, total cost does not change across the three panels.

3) If price = $35, profit at all levels of production is less than zero. It may seem fruitless to continue production, but shutting down may not be the best strategy in the short run.



• Why not shut down if price = $35?

• If the firm shuts down, the firm’s profits equal -$50 (a loss of $50). However, the firm can minimize its loss by producing at Q = 2 since the loss is only $30.



• A Profit Graph

• The firm’s profit can be illustrated graphically by putting the firms total revenue curve with the total cost curve in the same graph. This is done in Figure 6.6.



A Profit Graph Figure 6.6


From Figure 6.6, we can see that:

1) The total revenue curve of the competitive firm is a straight line. This is because the firm is a price taker, and additional quantities are sold a the same price.

2) The highest profit generated by the firm (at price =$70) occurs when the quantity is 3. Graphically, this is shown as the largest vertical distance between the Total Revenue line and the Total Cost line .

A Profit Graph (cont’d)


3) At the profit maximizing quantity, the slope of the total cost curve is equal to the slope of the total revenue curve. Since the slope of the total cost curve equals the marginal cost and the slope of the total revenue curve is the price of the good, then profit maximizing implies that:

Marginal Revenue = Price = Marginal Cost



• The bottom panel on Figure 6.6 shows how profits increase and then decrease as production increases. When Q = 3, the price per crate reaches its maximum profit at $70.



The Marginal Approach to Derive the Supply Curve

• Marginal Revenue: The change in the total revenue resulting from a one-unit increase in the quantity sold.

• The marginal revenue (MR) can be expressed as:

Q

TRMR

Note: for a competitive firm, the marginal revenue (the additional revenue that the firm gets from selling one more unit) is equal to the price of the good.


The Marginal Approach to Derive the Supply Curve (cont’d)

• A profit maximizing firm will choose to sell a good as long as the marginal cost is less than the price of the good. The marginal cost of producing the nth unit good represents the minimum price that the firm is willing to accept to sell the nth unit, as a firm will not want to produce a good knowing that the price it gets is lower.


• At any given price, the profit maximizing firm will determine the profit maximizing quantity given that price using the firm’s information on the marginal cost of producing that good. In essence, the firm’s marginal cost is the firm’s supply curve*.


*Note: As we will see in later chapters, this statement is not exactly correct. The firm’s supply curve is the portion of the marginal cost curve above the shut-down point.


• Figures 6.7 and 6.8 show the pumpkin firm’s supply curve (and hence, the firm’s marginal cost of producing pumpkins).

• Figure 6.7 shows the supply curve if the firm can only produce crates of pumpkins in discrete quantities, while Figure 6.8 shows the supply curve if the firm can adjust its production to small amounts (i.e., not require whole numbers).




Figure 6.7



Figure 6.8


The Market Supply Curve

• The market supply curve is obtained by horizontally summing each of the individual firm’s supply curves at every given price. Figure 6.9 shows how the supply curve of two individual firms are horizontally summed together to derive the market supply curve.


Figure 6.9

The Market Supply Curve (cont’d)


• Note that the slope of the market supply curve in Figure 6.9 is flatter at any given price than either of the individual firm’s supply curve. The more firms there are in the market (holding all else constant), the flatter the market supply curve.

The Market Supply Curve (cont’d)


Shifts in the Supply Curve

• Changes in the marginal cost of production will result in a shift in the supply curve to the left or to the right. In Figure 6.10, an increase in the marginal cost shifts the supply curve up and to the left.


Shifts in the Supply Curve (cont’d) Figure 6.10


Producer Surplus

• Producer Surplus - The difference between the price received by a firm for an additional item sold and the marginal cost of the item’s production; for the market as a whole, the producer surplus is the sum of all individual firm’s producer surplus; this can be calculated using the area above the supply curve and below the market price.


• Figure 6.11 and Figure 6.12 graphically illustrate the producer surplus for an individual firm and for the market.

Producer Surplus (cont’d)


Producer Surplus (cont’d) Figure 6.11


Producer Surplus (cont’d) Figure 6.12


Notes:1) An individual firm that is willing to sell the good

higher than the market price (and hence, was unable to sell the good) will have a producer surplus equal to zero.

2) A higher price will result in a larger producer surplus for the market and the individual firm.

3) A lower price will result in a smaller producer surplus for the market and the individual firm.

Producer Surplus (cont’d)


Key Terms

• Firm

• Price taker

• Competitive market

• Profits

• Total revenue and total costs

• Production function

• Marginal product of labor


Key Terms (cont’d)

• Diminishing marginal returns to labor

• Fixed and variable costs

• Marginal costs

• Profit maximization

• Marginal revenue

• Producer surplus

chapter six the supply curve and the behavior of firms

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