1. CH5: SUPPLY Essential Question
How do firms/suppliers decide what goods and services to offer?

2. Objectives Analyze the production costs of a firm.
Explain how a firm chooses its profit-maximizing output
Explain how firms decide how much labor to hire in order to produce a certain level of output.
Identify the factors that a firm must consider before shutting down a profitable business.

3. Introduction
How can a firm/producer maximize profits if it can’t change the price?
producers think about the revenue and the cost involved in producing/selling one more unit of a good.
Firms must incur costs for inputs to production (land, labor, capital)
There are two major production costs:
Fixed cost
Variable cost
Marginal cost is part of variable cost
Fixed + Variable = Total cost

4. Fixed Costs
Fixed costs mainly involve the production facility and include:
Rent
Machinery repair
Property taxes
Worker’s salaries
Startup costs
Physical Capital
They are costs you pay no matter how much you sell

5. Variable Costs Variable costs include:
Price of raw materials
Some labor
Electricity and heating bills
Variable costs are based on marginal costs, which is the cost of producing one more unit of a good

6. Fixed vs. Variable Costs
Let’s brainstorm Fixed and Variable costs for some businesses
FIXED VARIABLE 1. 2. 3. 6

7. Labor, Cost and Output Why should you hire more workers?
How many workers should you hire?
More workers will increase production
More workers will increase costs
Marginal Product of Labor is the change in output from hiring one additional worker

8. Specialization: Increasing Marginal Returns to Labor
The addition of more workers to a firm allow for a greater amount of specialization.
Specialization increases the output and the firm enjoys increasing marginal returns.

9. Diminishing Marginal Returns to Labor
Eventually, though, the benefits of specialization end and the addition of more workers increases total output but at a diminishing rate.
A firm with diminishing marginal returns will produce less and less output from each additional unit of labor.
Answer: 5 beanbags per hour

10. Profit-Maximizing Output: Marginal Revenue = Marginal Cost
the marginal cost of production at each level is the additional cost of producing one more unit.
Marginal cost initially decreases from specialization. Eventually, the diminishing marginal returns to inputs means marginal cost increases with quantity supplied
Law of supply and marginal cost are similar: quantity supplied increases when price increases and when marginal cost increases
Think of the pen and paper demo
The profit-maximizing output is where marginal cost is equal to marginal revenue, or the additional income from selling one more unit of a good.
If marginal revenue (price) is greater than marginal cost, we will keep producing
If marginal revenue (price) is less than marginal cost, we will stop producing

11. Profit-Maximizing Output: Marginal Revenue = Marginal Cost
Let’s assume our producer/firm is a price-taker: they don’t set prices on things, they compete and have to use the market price
MR < MC
Stop producing
Marginal revenue = price
Price/
MR > MC
Keep producing
Profit-Maximizing Output: Q*
MR = MC 11

12. Cost, Profit, Profit-Maximizing Output How to Calculate It All
Answer: Because that is the market price for each beanbag and does not change regardless of how many beanbags are produced.
Where is profit maximized? What do you notice at the profit-maximizing output?

13. Cost, Profit, Profit-Maximizing Output How to Calculate It All
Marginal Cost = Additional cost of producing one more good; = Difference of Variable Cost
Variable Cost = Sum of Marginal Cost
Total Cost = Fixed Costs + Variable Cost
Marginal Revenue = Price
Total Revenue = Sum of Marginal Revenue
Profit = Total Revenue – Total Cost
Profit-Maxiziming Output where MR = MC
TC = FC + VC
MR = P
TR = Price * Quantity = PQ
Answers: 1. Output would decrease. 2. Because the firm stands to make a larger profit when a beanbag costs $37.
Profit = TR – TC
π = PQ – (FC+VC)
π = PQ – FC - VC
Q* where MR = MC

14. Shut Down the Factory: Fixed Costs are Sunk Costs
Sometimes, even though a factory is producing at the profit-maximizing output, the market price is so low that the factory’s total revenue is still less than its total cost.
This is true if fixed costs are high and price/variable costs are low
If a firm shuts the factory down it still has to pay all of its fixed costs so it would have money going out but nothing coming in.
The firm would lose an amount equal to its fixed costs.
For this reason, Fixed Costs are often called Sunk Costs

15. Key Terms
marginal product of labor: the change in output from hiring one additional unit of labor
increasing marginal returns: a level of production in which the marginal product of labor increases as the number of workers increases
diminishing marginal returns: a level of production in which the marginal product of labor decreases as the number of workers increases
fixed cost: a cost that does not change, no matter how much of a good is produced.
sunk cost: a cost that you cannot recover. Fixed costs are sometimes called sunk costs because you have to pay them, even if you sell nothing or go out of business.

16. Key Terms, cont.
variable cost: a cost that rises and falls depending on the quantity produced
total cost: the sum of fixed costs plus variable costs
marginal cost: the cost of producing one more unit of a good
marginal revenue: the additional income from selling one more unit of a good
average cost: the total cost divided by the quantity produced