1. 1 Econ 201 Spring 09 Lecture 4.2 Microeconomics - A Firm’s Perspective: Costs of Production & Supply

2. 2 Firm’s Objectives Maximize Profits –Total Revenues – Total Costs of Production Assume (for the time being) –Firm is a price-taker (no market power) »Price is constant and independent of the level of the firm’s output »TR = P x Qs –Firm can choose (variable): Types and quantities of inputs Level of output

3. 3 Long-run vs. Short-run In the long-run all inputs and costs are variable –Before entering the market, no costs are incurred –Decisions are: (1) to enter the market; (2) and how much to produce In the short-run at least one input is fixed (Sunk costs) –Typically capital –Decision is how much to produce Zero is an option

4. 4 Types of Costs In the short-run –Fixed (sunk) costs Costs that are incurred, regardless of the level of output –E.g., Capital equipment – machinery, computers, buildings –Variable costs Costs that vary with the level of output –E.g., labor, fuel and materials –Total Costs(Q) = Fixed Costs + Variable Costs(Q) In the long-run –All costs are variable (dependent on entry decision)

5. 5 How Do These Costs Vary with Output? Fixed Costs –Independent of level of output (Q) –AFC = FC/Q Variable Costs –Vary with level of output –AVC = VC(Q)/Q

6. 6 Putting It All Together Short-run Cost Curve –ATC = AFC + AVC

7. 7 Why Is the ATC U-shaped? Economies of Scale and Scope Increase in output from Q to Q2 causes a decrease in the average cost of each unit from C to C1. –Indivisibility of resources, specialization, bargaining power (CostCo)

8. 8 Why is the ATC U-shaped? Beyond Q (ideal firm size), additional production will increase per- unit costsideal firm sizeper- unit costs –Exceed max efficient scale, communications issues, duplication of effort, entrepreneurial ability

9. 9 Why is the ATC U-Shaped? Economies and diseconomies of scale

10. 10 Constant-returns-to-scale

11. 11 Long-run vs. Short-run Decisions Firm’s decision to enter the market: –Are Total Revenues > Total Costs? At point of entry -> all costs are variable Costs also include opportunity costs –Opp. Costs for resources are signaled by market prices for inputs –Opp. Costs of money invested -> “normal rate of return” –Opp. Costs for your (owner’s) labor -> what you could have earned elsewhere In the short-run decision on how much to produce: –Are Revenues > Variable Costs? –Fixed Costs are “sunk” and irrelevant to production decision

12. 12 Will the Firm Enter the Market? Assume –Firm is a price-taker/has no market power So no matter how much the firm is willing to supply, its decision has no impact on the market demand price –Firm’s revenues then are: TR = P x Qs Assume market price is $4 per zuke

13. 13 What is this Firm’s Supply Curve? Will the firm to enter the market at p = $4?

14. 14 What is this Firm’s Supply Curve? What are the firm’s fixed costs? What is the minimum Qs at $4 per zuke? What is the maximum Qs at $4 per zuke?

15. 15 A Graphical Version Firm’s entry decision is based on: TR > TC? –Between Qs = 4->9: TR > TC How much to produce?

16. 16 What is the Profit Maximizing Output for the Firm? http://www.amosweb.com/cgi- bin/awb_nav.pl?s=wpd&c=dsp&k=perfect %20competition,%20short- run%20production%20analysishttp://www.amosweb.com/cgi- bin/awb_nav.pl?s=wpd&c=dsp&k=perfect %20competition,%20short- run%20production%20analysis When the firm is a price-taker: profits are max’ed when TR-TC are greatest –Largest vertical difference between the TR and TC curve

17. 17 Firm Chooses How Much to Supply By Maximizing Its Profits When the firm is a price-taker: profits are max’ed when TR-TC are greatest –Largest vertical difference between the TR and TC curve http://www.amosweb.com/cgibin/awb_nav.pl?s=wpd&c=dsp&k=perfect%20competitio n,%20short-run%20production%20analysishttp://www.amosweb.com/cgibin/awb_nav.pl?s=wpd&c=dsp&k=perfect%20competitio n,%20short-run%20production%20analysis

18. 18 What is this Firm’s Supply Curve? Firm’s profit maximizing output is at Q =7 –Rule is profit maximizing output is MR = MC –Since firm is a price-taker: MR = P => P = MC

19. 19 Firm’s Supply Curve Firm’s supply curve –Marginal Cost curve In the long-run: –P >= MC –TR >= TC (=TFC + TVC) In the short-run –P >= MC –TR >= Total Variable Costs (TVC) –There is a price below which a firm can not afford to supply any of the good

20. 20 Short-run Supply Curve

21. 21 Short-run Supply Curve Firm will supply if P > AVC

22. 22 Factors that Shift Supply Curves Individual Firms and Market Supply –Prices of Inputs Qs goes down if price of inputs goes up –Supply curve shifts to the left SC shifts right if price of inputs goes down –Technology Technological improvement -> inputs are more productive –Same as input prices going down -> shift to the right of SC Market Supply Only –Number of firms

23. 23 Firm and Market Supply Curves Similar to Individual and Market Demand Curves –Market supply curve = sum of all of the individual firm supply curves Graphically –Horizontal sum of the quantities supplied by each firm at a given price

24. 24 Useful Websites –Understanding differences between factors that cause shifts in demand or supply –http://hspm.sph.sc.edu/COURSES/ECON/SD/ SD.html –http://www.investopedia.com/university/econo mics/economics3.asp

25. 25 Supply Curves First law of supply Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue. A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.

26. 26 The Production Function

27. 27 Firm’s Objective Once the firm has decided to enter the market –Objective will to be minimize the costs of producing a given level of output –That is, minimize

28. 28 The Production Function the production function, summarizes the process of conversion of factors into a particular commodity. –first proposed by Philip Wicksteed (1894):Wicksteed Q = F(K,L,E,M;T) relates a output y to a series of factors of production K, L, E, M – given current technology T. http://cepa.newschool.edu/het/essays/product/pr odfunc.htm