1 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.

2 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

3 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

4 Total, Marginal, & Average Product MP=  TP/  Q L AP=TP/Q L

5 Total Product & Marginal Product Labour (workers per day) Output (sweaters per day) Labour (workers per day) Marginal product (sweaters per day per worker) TP c d MP total product (TP) always increasing as TP , & MP , TP increases at a decreasing rate

6 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.

7 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 Costs Marginal Cost Average Cost Per Unit Costs

8 1.)Total Costs: Total fixed variable Total cost cost cost Labour Output (workers (sweaters (TFC)(TVC) (TC) per day) per day) (dollars per day) a 0 0 b 1 4 c 2 10 d 3 13 e 4 15 f TC = TFC + TVC

9 TC TVC Total Costs Output (sweaters per day) Cost (dollars per day) TFC TC = TFC + TVC

10 a0 0 b1 4 c210 d313 e415 f Total Total Total Total fixed variable Total fixed variable Total cost cost cost cost cost cost Labour Output (workers (sweaters (TFC) (TVC) (TC) per day) per day) (dollars per day) Marginalcost (MC) 2.)Marginal Cost MC =  TC  TO MC =  TVC  Q the  in total cost that results from a one-unit  in output.

11 a0 0 b1 4 c210 d313 e415 f Total Total fixed variable Total cost cost cost Labour Output (workers (sweaters (TFC) (TVC) (TC) per day) 3.)Average Cost Marginal cost (MC) — Avg. fixed cost (AFC) TFC/Q Avg. variable cost (AVC) TVC/Q — Avg. total cost (ATC) TC/Q — (dollars per day)

12 Marginal Cost and Average Costs Output (sweaters per day) Cost (dollars per sweater) AFC AVC ATC ATC = AFC + AVC MC 0 25

13 Marginal Cost and Average Costs Output (sweaters per day) Cost (dollars per sweater) MC 0 25 MC  at low outputs due to gains from specialization, MC eventually  due to law of diminishing returns.

14 Relationship between MC & ATC Whenever MC < ATC, ATC  MC > ATC, ATC   MC crosses ATC at the minimum ATC (capacity or minimum efficient scale)  MC crosses AVC at the min. point

15 Shifts in the Cost Curves The position of a firm’s short-run cost curves depends on two factors: technology prices of resources

16 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.

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

18 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.

19 Preferable Plant Size and the Long-Run Average Cost Curve Output per Time Period Average Cost (dollars per unit of output) Output per Time Period Average Cost (dollars per unit of output) SAC 1 SAC 2 Q1Q1 C2C2 C1C1 C3C3 C4C4 Q2Q2 SAC 3 Build plant 1 if expected output at Q 1. Build plant 2 if expected output at Q 2. SAC 1 SAC 2 SAC 3 SAC 4 SAC 5 SAC 6 SAC 7 SAC 8 LAC envelope

Long-Run Average Cost Curve ATC 1 ATC 2 ATC 3 ATC 4 LRAC curve Least-cost plant is 1 18 Least-cost plant is 2 Least-cost plant is 4 Least-cost plant is 3 24 Once the plant size is chosen, the firm operates on the short-run cost curves that apply to that plant size.

21 Shape of LRAC & Returns to Scale Returns to scale are the increases in output that result from increasing all inputs by the same percentage.Returns to scale are the increases in output that result from increasing all inputs by the same percentage. There are 3 Possibilities.There are 3 Possibilities. 1)Increasing Returns to Scale or Economies of Scale: 2)Decreasing Returns to Scale or Diseconomies of Scale: 3)Constant Returns to Scale 1)Increasing Returns to Scale or Economies of Scale: 2)Decreasing Returns to Scale or Diseconomies of Scale: 3)Constant Returns to Scale

22 Economies/Diseconomies of Scale

Long-Run Average Cost Curve LRAC curve Economies of scaleDiseconomies of scale MES Minimum efficient scale: the smallest quantity of output at which LRATC reaches its lowest level.

24 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?

25 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.

26 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

27 Demand, Price, and Revenue in Perfect Competition D Quantity (thousands of sweaters per day) Price (dollars per sweater) Sweater market S Market demand curve Quantity (sweaters per day) Price (dollars per sweater) Sidney’s demand and marginal revenue MR Sidney’s demand curve FIRM INDUSTRY

28 Demand, Price, and Revenue in Perfect Competition: Firm Quantity sold (Q) (sweaters per day) Price (P) (dollars per sweater) Total revenue (TR = PxQ) (dollars) Marginal revenue (MR =  TR/  Q) (dollars)

29 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.

30 Demand, Price, and Revenue in Perfect Competition Quantity (sweaters per day) Price (dollars per sweater) Sidney’s demand and marginal revenue MR=P Sidney’s demand curve D Quantity (thousands of sweaters per day) Price (dollars per sweater) Sweater market S Market demand curve Market Price = $25 INDUSTRY FIRM

31 A firm A 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. Firm Maximizes Profits: “Supply”

32 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: MR  MC

33 Total Revenue, Total Cost, & Economic Profit Quantity (Q) ( sweaters /day) Total Revenue (TR) (dollars) Total Cost (TC) (dollars) Economic Profit (TR - TC) (dollars) Average Total Cost (ATC) (dollars) Average Var. Cost (AVC) (dollars) Marginal Cost (MC) (dollars) Marginal Revenue (MR) (dollars) P=MR FIRMFIRM

34 Profit-Maximizing Output Quantity (sweaters per day) $’s.Marginal revenue and marginal cost MR 25 0 MC Profit- maximization Point, 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. FIRM

35 Economic profit 0 Quantity (sweaters per day) Price and cost (dollars per sweater) Economic Profit MR MC ATC At P = $25, ATC =$ Output = 9 units TR = $25 x 9 = $225 TC = $20.33 x 9 =$183 Profit = $225-$183=$42 Profit = (P-ATC) x output Market Price = $25 FIRM Note: In Perfect Competition, MR=AR

36 Demand, Price, and Revenue in Perfect Competition Quantity (sweaters per day) Price (dollars per sweater) Sidney’s demand and marginal revenue: firm MR Sidney’s demand curve D Quantity (thousands of sweaters per day) Price (dollars per sweater) Sweater market: Industry S New market demand curve D 20 MR Sidney’s new demand curve 20 Market Price = $20 FIRM INDUSTRY

37 Total Revenue, Total Cost, and Economic Profit Quantity (Q) ( sweaters /day) Total Revenue (TR) (dollars) Total Cost (TC) (dollars) Economic Profit (TR - TC) (dollars) Average Total Cost (ATC) (dollars) Average Var. Cost (AVC) (dollars) Marginal Cost (MC) (dollars) Marginal Revenue (MR) (dollars) New Price FIRM

38 Quantity (sweaters per day) Price and cost (dollars per sweater) MR MCATC Break-even Point, MR=MC=ATC 0 Short-Run Break-Even Price Break-Even Price P=$20; ATC=$20 TR = $20X8 units/day = $160 TC = $20X8units/day = $160 TR = TC = 0 Economic Profits Market Price = $20 FIRM

39 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? FIRM

40 Demand, Price & Revenue: Perfect Competition Quantity (sweaters per day) Price (dollars per sweater) Sidney’s demand and marginal revenue: Firm MR D1D1 Quantity (thousands of sweaters per day) Price (dollars per sweater) Sweater market: Industry S New market demand curve D2D2 20 MR 2 Sidney’s new demand curve 20 D3D3 19 MR 3 19 Market Price = $19 FIRM INDUSTRY

41 Total Revenue, Total Cost, and Economic Profit Quantity (Q) ( sweaters /day) Total Revenue (TR) (dollars) Total Cost (TC) (dollars) Economic Profit (TR - TC) (dollars) Average Total Cost (ATC) (dollars) Average Var. Cost (AVC) (dollars) Marginal Cost (MC) (dollars) Marginal Revenue (MR) (dollars) New Price FIRM

42 SR Economic Loss MinimizationMR Quantity (sweaters per day) Price and cost (dollars per sweater) MCATC AVC loss Loss Min,P=$19.00 MC = 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 FIRM

43 Total Revenue, Total Cost, and Economic Profit Quantity (Q) ( sweaters /day) Total Revenue (TR) (dollars) Total Cost (TC) (dollars) Economic Profit (TR - TC) (dollars) Average Total Cost (ATC) (dollars) Average Var. Cost (AVC) (dollars) Marginal Cost (MC) (dollars) Marginal Revenue (MR) (dollars) New Price FIRM

44 Short Run Shut DownMR Quantity (sweaters per day) Price and cost (dollars per sweater) MC ATC AVC loss Shutdown:P=$16.00 MC = 7 units ATC (20.14) > P ($16): Losses = $29.00 TFC = $22.00 Shut down, lose $22 Produce, lose $29 Minimize losses byMinimize losses by shutting down when shutting down when  P  AVC at MC = MR Market Price = $16 FIRM

45 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 &……. FIRM

46 MR 2 Profit point A Firm’s SR Supply Schedule Quantity (sweaters per day) Price and cost (dollars per sweater) MC MR 3 MR 0 Shutdown point 0 20 Break-even point MR 1 Minimize losses MC=Supply

47 “Supply”  The Short Run “ supply ” schedule of the firm is found to be the “ MC ” schedule but with 2 qualifications. FIRM

48 1.) Only the upward sloping part of MC qualifies as the SR “supply” 2.) Only that part of the MC that lies above the AVC qualifies as the SR “supply” Quantity (sweaters per day) Price and cost (dollars per sweater) MR MC AVC 0 Qualifications FIRM

49 Market Supply Total amount provided to the market at each possible price… »Or The marginal cost of providing additional output to the market, given current production conditions.

50 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.

51 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?

52 Total Revenue, Total Cost, & Economic Profit Quantity (Q) ( sweaters /day) Total Revenue (TR) (dollars) Total Cost (TC) (dollars) Economic Profit (TR - TC) (dollars) Average Total Cost (ATC) (dollars) Average Var. Cost (AVC) (dollars) Marginal Cost (MC) (dollars) Marginal Revenue (MR) (dollars) P=$9.00=MR 9.00