1. Chapter 4 The supply decision
PowerPoint to accompany:

2. Learning objectives
4.1 Short-run costs; how do a firm’s costs vary with output over the short term?
4.2 Long-run costs; how do a firm’s costs vary with output over the longer term?
4.3 Revenue; how does a firm’s revenue vary with its level of sales?
4.4 Revenue, costs and profits; how much output should a firm produce if it wants to maximise its profit?
4.5 Problems with traditional theory; are firms rational?

3. Short-run and long-run changes in production
Short-run costs
Short-run and long-run changes in production
Fixed factors of production
Variable factors of production
The short run
The long run.
LO 4.1 Short-run costs – How do a firm’s costs vary with output over the short term?

4. Production in the short run
Short-run costs
Production in the short run
The law of diminishing returns
When increasing amounts of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.
LO 4.1 Short-run costs – How do a firm’s costs vary with output over the short term?

5. Short-run costs Costs and output
Costs and the productivity of factors of production
Costs and the price of factors of production
Fixed and variable costs
Total cost (TC)=total fixed cost (TFC) + total variable cost (TVC)
LO 4.1 Short-run costs – How do a firm’s costs vary with output over the short term?

6. Short-run costs
Average (total) cost (AC) AC =TC/Q Average fixed cost AFC=TFC/Q Average variable cost AVC=TVC/Q AC=AFC+AVC Marginal cost (MC) MC =ΔTC/ ΔQ

7. Short-run costs
Table 4.1 Costs for firm X

8. Average fixed cost (AFC)
Short-run costs
Marginal cost (MC)
Initially, MC falls
Beyond a certain level of output, diminishing returns set in and MC rises.
Average fixed cost (AFC)
AFC falls continuously as output rises.
Average (total) cost (AC)
If MC is less than AC, AC must be falling.
If MC is greater than AC, AC must be rising.
The MC curve crosses the AC curve at its minimum point.
LO 4.1 Short-run costs – How do a firm’s costs vary with output over the short term?

9. Average Variable Cost (AVC)
Short-run costs
Average Variable Cost (AVC)
As AVC = AC – AFC, the AVC curve is the vertical difference between the AC and the AFC curves.
As AFC gets less, the gap between AVC and AC narrows.
If MC is less than AVC, AVC must be falling.
If MC is greater than AVC, AVC must be rising.
As with the AC curve, the MC curve crosses the AVC curve at its minimum point.

10. Short-run costs
Figure 4.1 Average and marginal costs

11. Long run production: the scale of production
Long-run costs
Long run production: the scale of production
The ‘long run’ – all input factors variable
The ‘short run’ – at least one factor input fixed
Returns to scale:
constant returns to scale
increasing returns to scale
decreasing returns to scale.
LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

12. Long-run costs
Table 4.2 Short-run and long-run increases in output

13. Economies of scale, achieved through:
Long-run costs
Economies of scale, achieved through:
Specialisation and division of labour
Indivisibilities
The ‘container principle’
Greater efficiency of large machines
By-products
Multi-stage production
Organisational economies
Spreading overheads
Financial economies.
Economies of scope:
Increasing the range of products reduces the cost of producing each one.
LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

14. Diseconomies of scale, incurred through:
Long-run costs
Diseconomies of scale, incurred through:
Management problems
Repetitive work fosters worker alienation
More complex industrial relations
Production-line processes and interdependencies.
The size of the whole industry:
External economies of scale
Industry infrastructure
External diseconomies of scale.
LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

15. Long-run costs Long-run average cost Assumptions behind the curve:
factor prices and quality do not vary
state of technology and factor quality are given
firms choose least-cost combination of factors.
Shape of the LRAC curve
LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

16. Long-run costs
Figure 4.2 A typical long-run average cost curve

17. The envelope curve Long-run costs
Relationship between long-run and short-run average costs
The envelope curve
LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

18. Long-run costs
Figure 4.3 Constructing long-run average cost curves

19. Long-run average cost curves in practice
Long-run costs
Long-run average cost curves in practice
Strong evidence for economies of scale and constant returns to scale
Inconclusive evidence for diseconomies of scale
Possible managerial and industrial relations problems.
LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

20. Long-run costs
Decision making in different time periods
Very short run
Short run
Long run
Very long run.

21. Defining total, average and marginal revenue
Total revenue: TR = P × Q
Average revenue: AR = TR / Q
Marginal revenue: MR = TR / Q
LO 5.1 Revenue - How does a firm’s revenue vary with its level of sales?

22. Revenue curves when price is not affected by the firm’s output
When the demand ‘curve’ is horizontal, output does not affect price and the firm must take the price set by the market. The firm is a ‘price-taker’.
Average revenue (AR) is constant and the same as its demand curve.
Marginal revenue (MR) is constant and the same as the AR curve.
Total revenue (TR) increases at a constant rate.
LO 5.1 Revenue - How does a firm’s revenue vary with its level of sales?

23. Revenue
Figure 4.4 Deriving a firm’s AR and MR: price-taking firm

24. Revenue curves when price varies with output
When the demand ‘curve’ slopes downwards to the right, the firm can maximise profit by selling larger quantities at lower prices. The firm becomes a ‘price maker’.
Average revenue (AR) lies along the same line as the demand curve.
Marginal revenue (MR) is less than average revenue and may even be negative.
Total revenue (TR) rises at first and then falls.
LO 5.1 Revenue - How does a firm’s revenue vary with its level of sales?

25. Revenue
Table 4.3 Revenues for a firm facing a downward sloping demand curve

26. Revenue
Figure 4.5 AR and MR curves for a firm facing a downward-sloping demand curve

27. Revenue
Figure 4.6 Total revenue for a firm facing a downward-sloping demand curve

28. Shifts in revenue curves
A change in the firm’s output leads to a movement along the revenue curves.
A change in any other determinant of demand, such as tastes, income or the price of other goods, will shift the demand curve. By affecting the price at which each level of output can be sold, there will be a shift in all three revenue curves.
An increase in revenue is shown by a vertical shift upward; a decrease by a shift downward.

29. Revenue, costs and profit
Short-run profit maximisation
Stage one: Using marginal curves to arrive at the profit- maximising output
As long as MR>MC, profit can be increased by increasing production.
As long as MC>MR, profit can be increased by cutting back on production.
Profit maximising rule: MR=MC
LO 5.2 Revenue, costs and profit – How much output should a firm produce if it wants to maximise its profit?

30. Revenue, costs and profit
Table 4.4 Revenue, cost and profit

31. Revenue, costs and profit
Figure 4.7 Finding the profit-maximising output using marginal curves

32. Revenue, costs and profits
Short-run profit maximisation
Stage two: using average curves to measure the size of profit
Total profit is obtained by multiplying average profit by output
TΠ = AΠ × Q

33. Revenue, costs and profit
Figure 4.8 Measuring the maximum profit using average curves

34. Revenue, costs and profit
Some qualifications
Long-run profit maximisation: MR=long-run MC
The meaning of ‘profit’
Normal profit (%) = rate of interest on a riskless loan + a risk premium
Supernormal profit.
Loss minimising: MR = MC
LO 5.2 Revenue, costs and profit – How much output should a firm produce if it wants to maximise its profit?

35. Revenue, costs and profit
Figure 4.9 Loss-minimising output

36. Revenue, costs and profit
Some qualifications
Short-run shut-down point: P = AVC
Long-run shut-down point: P = LRAC
LO 5.2 Revenue, costs and profit – How much output should a firm produce if it wants to maximise its profit?

37. Revenue, costs and profit
Figure 4.10 The short-run shut-down point

38. Problems with traditional theory
Are firms rational?
Firms may not have the information to maximise profits:
Average cost or marking-up pricing.
Firms may not want to maximise profits:
Profit satisficing
Sales revenue maximisation
Principal-agent problem
Attitudes to risk.