lecture 5 studentnotes

8/14/2019 Lecture 5 Studentnotes

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2007 Thomson South-Western, all rights reserved

N . G R E G O R Y M A N K I W

PowerPointSlides

by Ron Cronovich

HE191Principles of Economics

Lecture 5

Chapters 13, 14, 15

Principles of Economics, Fourth Edition

N. Gregory Mankiw


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1

In this lecture, look for the answers

to these questions:

What is a production function? What is marginal

product? What are the various costs, and how are they

related to each other and to output?

What is a perfectly competitive market? How does a competitive firm determine the

quantity that maximizes profits?

When might a competitive firm shut down in theshort run? Exit the market in the long run?

Why do monopolies arise?


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Revenue, 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

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


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Explicit vs. Implicit Costs: An Example

You need $100,000 to start your business.

The interest rate is 5%.

Case 1: borrow $100,000 explicit cost = $5000 interest on loan

Case 2: use $40,000 of your savings,

borrow the other $60,000

explicit cost = $3000 (5%) interest on the loan

implicit cost = $2000 (5%) foregoneinterest youcould have earned on your $40,000.

In both cases, total (exp+ imp) costs are $5000.


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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.


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AACC TT IIVV E LE L EEAARRNN II NN G :G :

Economic profit vs. accounting profitEconomic profit vs. accounting profit

The equilibrium rent on office space has just

increased by $500/month.

Compare the effects on accounting profit and

economic profit if

a. you rent your office spaceb. you own your office space

5


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AACC TT IIVV E LE L EEAARRNN II NN GG ::

AnswersAnswersThe rent on office space increases $500/month.

a.You rent your office space.

Explicit costs ___________________.Accounting profit & economic profit each

____________.

b.You own your office space.

Explicit costs ____________,so accounting profit ____________.Implicit costs __________________ (opp. costof using your space instead of renting it),

so economic profit _________________.6


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7

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 Tan grows durians.

He has 5 acres of land. He can hire as many workers as he wants.


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0

500

1,000

1,500

2,000

2,500

3,000

0 1 2 3 4 5

No. of workers

Quant

ityofoutput

Example 1: Farmer Tans Production Function

30005

28004

24003

18002

10001

00

Q(no. ofdurians)

L(no. of

workers)


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930005

28004

24003

18002

10001

00

QL

EXAMPLE 1: Total & Marginal Product

200

400

600

800

1000

MPL =

Q= 1000L = 1

Q= 800L = 1

Q= 600L = 1

Q= 400L = 1

Q= 200L = 1

Q

L

The marginal product (MP) of any input is the increase in

output arising from an additional unit of that input, holding all

other inputs constant.


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MPL equals the

slope of the

production function.

Notice that

MPL diminishes

as L increases.

This explains why

the productionfunction gets flatter

as L increases.0

500

1,000

1,500

2,000

2,500

3,000

0 1 2 3 4 5

No. of workers

Quantityofoutput

EXAMPLE 1: MPL = Slope of Prod Function

30005200

28004400

24003600

18002800

100011000

00

MPL

Q(no.

of

durians)

L(no. of

workers)


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Why MPL Diminishes

Diminishing marginal product:

the marginal product of an input declines as the

quantity of the input increases (other things equal)

E.g., Farmer Tans output rises by a smaller and

smaller amount for each additional worker. Why?

If Tan increases workers but not land and duriantrees, the average worker has less land and trees

to work with, so will be less productive.

In general, MPL diminishes as L riseswhether the fixed input is land or capital

(equipment, machines, etc.).


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EXAMPLE 1: Farmer Tans Costs

$11,000

$9,000

$7,000

$5,000

$3,000

$1,000

Total

Cost

30005

28004

24003

18002

10001

$10,000

$8,000

$6,000

$4,000

$2,000

$0

$1,000

$1,000

$1,000

$1,000

$1,000

$1,00000

cost of

labor

cost of

land with

trees

Q

(no.of

durians)

L

(no. of

workers)

Fixed cost Variable cost


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EXAMPLE 1: Farmer Tans Total Cost Curve

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

-300 200 700 1200 1700 2200 2700 3200

total cost

fixed cost

cost of labor


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Example 1: Total and Marginal Cost

$10.00

$5.00

$3.33

$2.50

$2.00

$11,000

$9,000

$7,000

$5,000

$3,000

$1,000

Total

Cost

3000

2800

2400

1800

1000

0

Q

Q= 1000 TC = $2000

Q= 800 TC = $2000

Q= 600 TC = $2000

Q= 400 TC = $2000

Q= 200 TC = $2000

TC

QMC=

Marginal Cost (MC) is the increase in Total

Cost from producing one more unit


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MC usually rises

as Qrises,as in this example.

EXAMPLE 1: The Marginal Cost Curve

$11,000

$9,000

$7,000

$5,000

$3,000

$1,000

TC

$10.00

$5.00

$3.33

$2.50

$2.00

MC

3000

2800

2400

1800

1000

0

Q

(bushels

of wheat)

$0

$2

$4

$6

$8

$10

$12

0 1,000 2,000 3,000

Q

MarginalCost($)


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Average costs

Average fixed cost (AFC) is fixed cost divided

by the quantity of output: AFC= FC/Q

Average variable cost (AVC) is variable costdivided by the quantity of output: AVC= VC/Q

Average total cost (ATC) equals total cost

divided by the quantity of output: ATC= TC/Q

Also, ATC= AFC+ AVC


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EXAMPLE 2: Costs

7

6

5

4

3

2

1

620

480

380

310

260

220

170

$100

520

380

280

210

160

120

70

$0

100

100

100

100

100

100

100

$1000

TCVCFCQ

$0

$100

$200

$300

$400

$500

$600

$700

$800

0 1 2 3 4 5 6 7

Q

Costs

FCVC

TC


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Example 2

8

7

6

5

4

3

21

102.50

88.57

80

76

77.50

86.67

_____$170

n.a.

12.50

14.29

16.67

20

25

33.33

_____$100

n.a.

100

100

100

100

100

100

100100

$1000

MCATCAVCAFCTCVCFCQ

90

74.29

63.33

56.00

52.50

53.33

_____$70

n.a.

820

620

480

380

310

260

220170

$100

720

520

380

280

210

160

12070

$0

200

140

100

7050

40

50

$70


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EXAMPLE 2: The Various Cost Curves Together

AFC

AVC

ATC

MC

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Costs


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20

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Costs

EXAMPLE 2: Why ATC Is Usually U-Shaped

As Qrises:

Initially,

falling AFCpulls ATCdown.

Eventually,

rising AVCpulls ATCup.


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EXAMPLE 2: ATC and MC

ATC

MC

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Costs

When MC< ATC,

ATCis falling.

When MC> ATC,ATCis rising.

The MCcurve

crosses theATCcurve at

the ATCcurves

minimum.


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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, ATCat any Qis cost per unit

using the most efficient mix of inputs for that Q

(e.g., the factory size with the lowest ATC).


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EXAMPLE 3: LRATC w ith 3 factory Sizes

ATCS ATCMATCL

Q

AvgTotal

Cost

Firm can choose

from 3 factory

sizes: S, M, L.

Each size has its

own SRATCcurve.

The firm can

change to a

different factory

size in the long

run, but not in theshort run.


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EXAMPLE 3: LRATC w ith 3 factory Sizes

ATCS ATCMATCL

Q

AvgTotal

Cost

QA QB

LRATC

To produce less

than QA, firm will

choose size S

in the long run.To produce

between QA

and QB, firm willchoose size M

in the long run.

To produce more

than QB, firm will

choose size L

in the long run.


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A Typical LRATC Curve

Q

ATCIn the real world,

factories come in

many sizes,

each with its own

SRATCcurve.

So a typical

LRATCcurve

looks like this:

LRATC


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How ATC Changes As

the Scale of Production ChangesEconomies of

scale: ATCfalls

as Qincreases.

Constant returns

to scale: ATC

stays the same

as Qincreases.

Diseconomies ofscale: ATCrises

as Qincreases.

LRATC

Q

ATC


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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 anarrow task.

More common when Qis low.

Diseconomies of scale are due to coordination

problems in large organizations.

E.g., management becomes stretched, cant

control costs.

More common when Qis high.


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Market structure: A Scenario

Three years after graduating, you run your own

business.

You have to decide how much to produce, whatprice to charge, how many workers to hire, etc.

What factors should affect these decisions?

Your costs (studied in preceding chapter) How much competition you face

We begin by studying the behavior of firms inperfectly competitive markets.


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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.

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.


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The Revenue of a Competitive Firm

Total revenue (TR)

Average revenue (AR)

Marginal Revenue (MR):

The change in TRfromselling one more unit.

TRQMR=

TR= Px Q

TRQAR= = P


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3131

$50$105

$40$104

$103

$10

$10

$10

$10$102

$10$101

n.a.

$30

$20

$10

$0$100

TR= Px QPQTR

Q

MR=TR

Q

AR=

$10

$10

$10

$10

$10

Example 4: Total Revenue, Average

Revenue and Marginal Revenue


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Example 4: Profit Maxim ization:

505

404

303

202

101

45

33

23

15

9

$5$00

Profit =MRMC

MCMRProfitTCTRQ

At any QwithMR> MC,

increasing Q

raises profit.

5

7

7

5

1

$5

1010

10

10

20

2

4

$6

1210

8

6

$4$10

At any Qwith

MR< MC,

reducing Q

raises profit.


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profit

33

Q

Costs, P

MC

ATC

P= $10 MR

4

$8.25

A competitive firm

profit per unit= PATC

= $10 8.25

= $1.75

Total profit

= (PATC) x Q= $1.75 x 4

= $7

Example 4: Profit Maxim ization:

C d h S l


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P1 MR

P2 MR2

MC and the Firms Supply Decision

If price rises to P2,then

the profit-maximizing

quantity rises to Q2.

Q

Costs

MC

Q1 Q2the MCcurve is the

firms supply curve.

P3 MR3

Q3

If price rises to P3,

then the profit-

maximizing quantity

rises to Q3.

The MCcurve

determines the

firms Qat any price.

Hence,


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Shutdown vs. Ex it

Shutdown:

A short-run decision not to produce anything

because of market conditions.

Exit:

A long-run decision to leave the market.

A firm that shuts down temporarily must still pay

its fixed costs. A firm that exits the market does

not have to pay any costs at all, fixed or variable.


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A Firms Short-run Decision to Shut Down

If firm shuts down temporarily,

revenue falls by TR

costs fall by VC So, the firm should shut down if TR< VC.

Divide both sides by Q: TR/Q < VC/Q

So we can write the firms decision as:

Shut down if P< AVC


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The firms SRsupply curve is theportion of its MC

curve above AVC.

Q

Costs

A Competitive Firms SR Supply Curve

MC

ATC

AVC

If P> AVC, then

firm produces Q

where P= MC.

If P< AVC, then

firm shuts down

(produces Q= 0).


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A Firms Long-Run Decision to Exit

If firm exits the market,

revenue falls by TR

costs fall by TC So, the firm should exit if TR< TC.

Divide both sides by Q to rewrite the firmsdecision as:

Exit if P< ATC


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A New Firms Decision to Enter Market

In the long run, a new firm will enter the market if

it is profitable to do so: if TR> TC.

Divide both sides by Q to express the firmsentry decision as:

Enter if P> ATC


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The firms

LR supply curve

is the portion of

its MCcurve

above LRATC.

Q

Costs

The Competitive Firms Supply Curve

MC

LRATC


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1) All existing firms and potential entrants have

identical costs.

2) Each firms costs do not change as other firmsenter 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)

Market Supply: Assumptions

Th SR M k t S l C


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The SR Market Supply Curve

MC

P2

Market

Q

P

(market)

One firm

Q

P

(firm)

S

P3

Example: 1000 identical firms.

At each P, market Qs = 1000 x (one firms Qs)

AVCP2

P3

30

P1

2010

P1

30,00010,000 20,000


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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 curve shifts right.

P falls, reducing firms profits. Entry stops when firms economic profits have

been driven to zero.


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Entry & Exit in the Long Run

In the LR, the number of firms can change due

to entry & exit.

If existing firms incur losses, Some will exit the market. SR market supply curve shifts left.

P rises, reducing remaining firms losses. Exit stops when firms economic losses have

been driven to zero.


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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 MCintersects ATCat minimum ATC. Hence, in the long run, P= minimum ATC.

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 theowners time and money.

In the zero-profit equilibrium, firms earn enough revenue

to cover these costs.

The LR Market Supply Curve


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The LR Market Supply Curve

MC

Market

Q

P

(market)

One firm

Q

P

(firm)

In the long run,

the typical firm

earns zero profit.

LRATC

long-runsupply

P=min.ATC

The LR market supply

curve is horizontal at

P= minimum ATC.

SR & LR Effects of an Increase in Demand


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S1

Profit

D1

P1long-runsupply

D2

SR & LR Effects of an Increase in Demand

MC

ATC

P1

Market

Q

P

(market)

One firm

Q

P

(firm)

P2P2

Q1 Q2

S2

Q3

AB

C

Wh th LR S l C Mi ht Sl U d


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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 orexit the market.

If either of these assumptions is not true,

then LR supply curve slopes upward.

1) Fi H Diff t C t


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1) Firms Have Different Costs

As Prises, firms with lower costs enter the market

before those with higher costs.

Further increases in Pmake it worthwhilefor 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.

2) C t Ri Fi E t th M k t


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2) Costs Rise as Firms Enter the Market

In some industries, the supply of a key input islimited (e.g., theres a fixed amount of land

suitable for farming).

The entry of new firms increases demand for this

input, causing its price to rise.

This increases all firms costs.

Hence, an increase in Pis required to increase

the market quantity supplied, so the supply curve

is upward-sloping.

Monopoly


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Monopoly

A monopoly is a firm that is the sole sellerof a

product without close substitutes.

Monopoly firm vs competitive firm: A monopoly firmhas market power, the ability

to influence the market price of the product it

sells. A competitive firmhas no market power; A monopoly firmis the only seller, so it faces

the downward-sloping market demand curve. A

competitive firmis a price taker and has ahorizontal demand curve.

Why Monopolies Arise


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The main cause of monopolies is barriers

to entry other firms cannot enter the market.

Three sources of barriers to entry:1. A single firm owns a key resource.

E.g., DeBeers owns most of the worlds

diamond mines

2. The govt gives a single firm the exclusive right

to produce the good.E.g., patents, copyright laws



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3. Natural monopoly: a single firm can producethe entire market Qat lower ATCthan could

several firms.

Q

Cost

ATC

1000

$50

Example: 1000 homes

need electricity. Electricity

Economies of

scale due tohuge FC

ATCis lower ifone firm servicesall 1000 homes

than if two firmseach service500 homes. 500

$80

AACC TT IIVV E LE L EEAARRNN II NN GG 11 :: TRMR


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A monopolyA monopoly s revenues revenue

Moonbucks is

the only seller of

cappuccinos in town.The table shows the

market demand for

cappuccinos.Fill in the missing

spaces of the table.

What is the relationbetween Pand AR?

Between Pand MR?

54

1.506

2.005

2.504

3.003

3.502

4.001$4.500

MR =

TR/ Q

AR =

TR/Q

TR=

PxQPQ

n.a.

Q

MR=

Moonbucks D and MR Curves


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Moonbuck s D and MR Curves

-3-2

-1

01

2

34

5

0 1 2 3 4 5 6 7 Q

P, MR

Demand curve (P)

MR

$

Profit-Maximization


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Profit-Maximization

Like a competitive firm, a monopolist maximizes

profit by producing the quantity where MR= MC.

Once the monopolist identifies this quantity,it sets the highest price consumers are willing to

pay for that quantity.

It finds this price from the Dcurve.

Profit-Maximization


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Profit Maximization

1. The profit-

maximizing Qis where

MR= MC.

2. Find P fromthe demand

curve at this Q.

Quantity

Costs andRevenue

MR

D

MC

Profit-maximizing output

P

Q

The Monopolists Profit


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The Monopolist s Profit

As with a

competitive firm,

the monopolistsprofit equals

(PATC) x Q

Quantity

Costs andRevenue

ATC

D

MR

MC

Q

P

ATC

A Monopoly Does Not Have an S Curve


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A Monopoly Does Not Have an S Curve

A competitive firm

takes Pas given

has a supply curve that shows how its Qdepends

on P

A monopoly firm

is a price-maker, not a price-taker

Qdoes not depend on P;

rather, Qand Pare jointly determined by

MC, MR, and the demand curve.

So there is no supply curve for monopoly.

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