CHAPTER 3 DEMAND AND SUPPLY ANALYSIS: THE FIRM Presenter’s name Presenter’s title dd Month yyyy

1. INTRODUCTION Demand for goods by individuals Theory of the Consumer Supply of goods and services by firms Theory of the Firm Copyright © 2014 CFA Institute 2

2. OBJECTIVES OF THE FIRM Copyright © 2014 CFA Institute 3

NORMAL PROFIT AND ECONOMIC PROFIT Normal profit is the accounting profit such that both explicit and implicit costs are covered: Normal profit = Accounting profit – Economic profit -Also known as abnormal profit or supernormal profit. Accounting profit = Economic profit + Normal profit Example: Revenues€1,000 Total explicit costs€500 Opportunity cost€400 Accounting profit€1,000 – 500 = €500 Economic profit€1,000 – 500 – 400 = €100 Normal profit€500 – 100 = €400 Copyright © 2014 CFA Institute 4

ECONOMIC RENT Economic rent is the high profit attributed to a fixed, limited supply. Q1Q1 Demand 2 Demand 1 P2P2 Supply P1P1 Copyright © 2014 CFA Institute 5

3. ANALYSIS OF REVENUE, COSTS, AND PROFITS Copyright © 2014 CFA Institute 6

CALCULATING TR, AR, AND MR QPTRARMR 100 $1.25$125$1.25$ $1.30$260$1.30$ $1.33$399$1.33$ $1.35$540$1.35$ $1.37$685$1.37$1.37* Copyright © 2014 CFA Institute 7 * Assuming $1.37 for quantities beyond 500

THE PRODUCTION FUNCTION The factors of production are inputs to the production of goods or services, including land, labor, capital, and materials. The production function is the relationship between the quantity produced and the factors of production: capital (K) and labor (L) Q = f(K,L) Copyright © 2014 CFA Institute 8

COSTS OF PRODUCTION Total cost (TC) is the sum of all costs of producing goods or services. Total fixed cost (TFC) is the sum of all costs that do not change with the level of production. -A quasi-fixed cost is a cost that is fixed for a specific range of production but that changes at different levels of production. Total variable cost (TVC) is the sum of all costs that change with the level of production. Average fixed cost (AFC) is the total fixed cost divided by the quantity produced. Average variable cost (AVC) is the total variable cost divided by the quantity produced. Average total cost (ATC) is the total cost divided by the quantity produced. Marginal cost (MC) is the change in total cost for one more unit produced. Copyright © 2014 CFA Institute 9

EXAMPLE Suppose that the fixed costs of production are $50 and that the variable cost per unit begins at $24 per unit, declines to $12, and then increases to $15. The average fixed cost declines throughout. The average variable cost declines and then increases. The average total cost declines and then increases. The marginal cost declines and then increases. Copyright © 2014 CFA Institute 10

BREAKEVEN AND SHUTDOWN The breakeven point is the quantity produced at which all costs are covered. -Under perfect competition, the breakeven point is the quantity of production at which the price, average revenue, and marginal revenue are equal to average total cost. -Quantity at which TR = TC. The shutdown point is the quantity produced at which the average revenue is less than the average variable cost. -Quantity at which AR < AVC. -At shutdown, the firm must pay fixed costs but stops production because it cannot cover variable costs. Copyright © 2014 CFA Institute 11

ECONOMIES AND DISECONOMIES OF SCALE The short-run average total cost curve (SRATC) is determined by the firm’s fixed-input constraint. The long-run average total cost curve (LRATC) is composed of the minimums of the possible short-run average total cost curves. Economies of scale (also known as increasing returns to scale) are the lowered cost structures available when a firm grows in size. -They may arise from many sources, including the division of labor, capital intensity, use of by-products, and buying power. -There may be a point where more output increases costs, which would represent diseconomies of scale. Operating at the least cost (the minimum efficient scale, or MES) is important for the long-term survival of a firm. Copyright © 2014 CFA Institute 12

PROFIT-MAXIMIZING OUTPUT Profit is maximized when the difference between total revenue and total cost is maximized, which is also the point at which marginal revenue is equal to marginal cost. Determining profit-maximizing output requires 1.forecasting the revenues and costs in order to estimate the production level at which the difference is maximized. 2.computing the change in total revenue per unit and the change in total cost per unit and produce to the point at which they are equal. 3.comparing the estimated cost per unit of input with the contribution margin per unit. Copyright © 2014 CFA Institute 13

PROFIT MAXIMIZATION: SHORT AND LONG RUN In the short run, without economies of scale, the firm earns a normal profit. In the long run, although the firm is able to exploit economies of scale, the firm earns an economic profit. -If the market is imperfectly competitive, the firm is able to earn an economic profit as long as competitors do not enter the market. -If the market is perfectly competitive, competitors will enter and the economic profit is driven to zero. Copyright © 2014 CFA Institute 14

LONG-RUN INDUSTRY SUPPLY The long-run supply curve for an industry is the relationship between quantities supplied and prices under perfect competition. An increasing-cost industry is one in which the prices and costs increase for increased output. -Long-run supply curve is upward sloping. A decreasing-cost industry is one in which the prices and costs decrease for increased output. -Long-run supply curve is downward sloping A constant-cost industry is one in which the prices and costs remain the same for increased levels of output. -Long-run supply curve is flat. Copyright © 2014 CFA Institute 15

PRODUCTIVITY Copyright © 2014 CFA Institute 16

EXAMPLE: PRODUCTIVITY OF LABOR LaborTotal ProductMarginal ProductAverage Product – 0 =1010/1 = – 10 =919/2 = – 19 =827/3 = – 27 =734/4 = – 34 =640/5 =8.0 Copyright © 2014 CFA Institute 17

DIMINISHING MARGINAL RETURNS The marginal product (MP) is the change in the total product from a one-unit change in the input. Increasing marginal returns exist when the marginal product of an input increases when using more of the input. Diminishing marginal returns exist when the marginal product of an input decreases when using more of the input. -The law of diminishing returns is the law that adding another unit of input will result in less marginal product than the previous unit of input. The marginal revenue product (MRP) is the change in total revenue from a one-unit change in the input. Copyright © 2014 CFA Institute 18

PROFIT-MAXIMIZING LEVELS OF OUTPUT Copyright © 2014 CFA Institute 19

EXAMPLE: OPTIMAL LEVEL OF INPUTS Input 1Input 2 Units Total Product Marginal Product Marginal Revenue Product MRP/ Price of Input Units of Total Product Marginal Product Marginal Revenue Product MRP/ Price of Input € € € € € € € € € € Copyright © 2014 CFA Institute 20 Suppose that the cost per unit of Input 1 is €16 and the cost per unit of Input 2 is €10. If the cost of the product is €2.50 and the total products are as below, what are the optimal levels of Input 1 and Input 2? The optimal levels are four units of Input 1 and three units of Input 2. Profit = €2.5 ( ) – (4 × €16) – (3 × €10) = €185 – 64 – 30 = €91

SUMMARY The profit of concern in the theory of the firm is economic profit, which considers not only explicit costs but also implicit costs. If a firm is able to maintain a comparative advantage (such as economies of scale), it can earn economic profit. In a market with perfect competition, however, economic profits are zero; firms can earn a normal profit, which is a profit in which revenues just cover both implicit and explicit costs. Profit maximization occurs at the level of production at which the difference between total revenue and total costs is the greatest or, equivalently, where marginal revenue equals marginal cost. In the long run, all inputs to the firm are variable, which expands profit potential and the number of cost structures available to the firm. Under perfect competition, long-run profit maximization occurs at the minimum point of the firm’s long-run average total cost curve. Copyright © 2014 CFA Institute 21

SUMMARY A firm shuts down in the short run if total revenue does not cover variable cost in full. A firm’s production function defines the relationship between total product and inputs, whereas average product and marginal product are key measures of a firm’s productivity. Increases in productivity reduce business costs and enhance profitability. An industry supply curve that is positively sloped will increase production costs to the firm in the long run. An industry supply curve that is negatively sloped will decrease production costs to the firm in the long run. In the short run, assuming constant resource prices, increasing marginal returns reduce the marginal costs of production and decreasing marginal returns increase the marginal costs of production. Copyright © 2014 CFA Institute 22