Wrapping up supply

Today: More on profit maximization, determinants

of supply, and surplus

Today… We make this

graph make intuitive sense

We will see that: Profits are positive

at price P1

Profits are negative at prices P2 and P3

Firms will shut down when price is P3

Profit maximization

Remember that this is our goal For the most part, we will

implement MB/MC analysis again Exception: Shutdown condition

If a firm can lose less by closing than opening, it will close

Costs

Cost to hire an employee is $100/day

Assume $1000 in fixed costs for a phone manufacturer per day Note average fixed cost (AFC)

decreases as the number of phones increases

Our output example for today

# of employees hired per day

Number of phones produced

0 0

1 20

2 45

3 55

4 63

5 67

Increasing returns? Notice that the marginal productivity

for the 1st worker is 20; 2nd worker, 25 Why?

Specialization Assembly line can help increase

marginal productivity up to a certain point

Marginal productivity eventually decreases

Cost table# of

empl./day

Phones per day

Fixed cost

($/day)

Var. cost ($/day)

Total cost

($/day)

MC ($/phone

)

0 0 1000 0 1000

1 20 1000 100 1100

2 45 1000 200 1200

3 55 1000 300 1300

4 63 1000 400 1400

5 67 1000 500 1500

How to calculate MC

Marginal cost (MC) is how much additional cost is necessary to produce an additional phone

For example, each additional phone from the 1st worker is cost to hire worker / # of phones

produced ($100/day) / (20 phones/day) =

$5/phone

Cost table# of

empl./day

Phones per day

Fixed cost

($/day)

Var. cost ($/day)

Total cost

($/day)

MC ($/phone

)

0 0 1000 0 1000

5.00

1 20 1000 100 1100

4.00

2 45 1000 200 1200

10.00

3 55 1000 300 1300

12.50

4 63 1000 400 1400

25.00

5 67 1000 500 1500

Suppose that phones sell for $18 each

How many people should be hired? Hire the next worker if the MB of

the next phone produced is at least as much as the MC

This is the same as finding the number of workers that maximizes profits

Marginal analysis: Hire 4 employees/day

# of empl./day

Phones per day

MB ($/phone) MC ($/phone)

0 0

18.00 5.00

1 20

18.00 4.00

2 45

18.00 10.00

3 55

18.00 12.50

4 63

18.00 25.00

5 67

How much profit? –$266# of

empl./dayPhones per day

Total rev. ($/day)

Total cost ($/day)

Profit ($/day)

0 0 0 1000 –1000

1 20 360 1100 –740

2 45 810 1200 –390

3 55 990 1300 –310

4 63 1134 1400 –266

5 67 1206 1500 –294

Shutdown condition Finally, we must check to see if the firm

is better off shutting down when profits are negative

If total revenue is less than total variable cost for all levels of output (Q), then the firm should shut down

This is equivalent to the firm making worse profits for all Q > 0 than for Q = 0

Shutdown condition check Profits are better

when 4 employees are hired (–$266) than when the firm shuts down (–$1000)

This firm stays in business

# of empl./da

y

Total cost

($/day)

Profit ($/day)

0 1000 –1000

1 1100 –740

2 1200 –390

3 1300 –310

4 1400 –266

5 1500 –294

Back to our graph We have finished a

discrete example Now, we will see

how we get the marginal cost (MC), average total cost (ATC), and average variable cost (AVC) curves

Marginal cost MC starts by

decreasing, then increases sharply

# of empl./day

MC ($/phone)

0

5.00

1

4.00

2

10.00

3

12.50

4

25.00

5

Average total cost ATC falls

initially, then eventually increases

# of empl./da

y

Phones per day

Total cost ($/day)

ATC ($/phone)

0 0 1000 N/A

1 20 1100 55

2 45 1200 26.67

3 55 1300 23.64

4 63 1400 22.22

5 67 1500 22.39

Average variable cost AVC falls

initially, then eventually increases

# of empl./da

y

Phones per day

VC ($/day)

AVC ($/phone)

0 0 0 N/A

1 20 100 5.00

2 45 200 4.44

3 55 300 5.45

4 63 400 6.35

5 67 500 7.46

ATC and AVC costs converge Note ATC = AVC + AFC Since AFC is decreasing

as Q increases, the difference between ATC and AVC gets smaller as Q increases

Thus, ATC and AVC curves get closer as Q increases

MC curve Remember: Marginal

means for an additional unit produced

If marginal is below average, this brings the average down

If marginal is above average, this brings the average up

MC curve

Marginal cost curve tells us how average cost curves (ATC and AVC) move

MC curve is below average cost curve when average cost curve is decreasing

MC curve is above average cost curve when average cost curve is increasing

Back to the graph All curves

decrease initially, but eventually increase

MC curve tells us which direction ATC and AVC curves are going

Back to the graph

At P1 positive profits, since TR > TC (P Q > ATC Q)

At P2 negative profits

At P3 firm shuts down (TR is less than VC for all Q)

Warning! Look at red circle This is a point

where P3 and MC curves intersect

Ignore these points on the MC curve that are downward-sloping, since profit is minimized here

Determinants of supply

Technology Input prices The number of suppliers Expectations of future prices Changes in the price of other

relevant products

Some examples If technology improves or input prices

decrease, production becomes less costly

If the number of suppliers increases, we can horizontally add the additional supply to the market

If the price of calculators increases, some phone suppliers may devote more of its capital to producing calculators

Producer surplus

Producer surplus is similar conceptually to consumer surplus

For a unit or service sold, producer surplus is the difference between the price paid and the minimum payment the seller is willing to accept for it

Example of producer surplus When P = 25 per

unit, shaded area is approximate producer surplus

Area is a triangle, one-half times length times height: 0.5 10 25 = 125

Why are CS and PS important?

Consumer surplus (CS) and producer surplus (PS) are important since these measures give us a crude measure of the total benefits to society

Next week, we will see situations in which total surplus can be reduced

This concludes supply Important things to remember with

supply Individual and market supply Steps to profit maximization

Useful to know individual firm supply, production function, FC, VC, TC, MC, AFC, AVC, ATC, shutdown condition

Determinants of supply Producer surplus