Unit 3: Costs of Production and Perfect Competition

Transcription

1 Unit 3: Costs of Production and Perfect Competition 1

2 Inputs and Outputs To earn profit, firms must make products (output) Inputs are the resources used to make outputs. Input resources are also called FACTORS. Total Physical Product (TP)- total output or quantity produced Marginal Product (MP)- the additional output generated by additional inputs (workers). Change in Total Product Marginal Product = Change in Inputs Average Product (AP)- the output per unit of input Total Product Average Product = Units of Labor 2

3 Production Analysis What happens to the Total Product as you hire more workers? What happens to marginal product as you hire more workers? Why does this happens? The Law of Diminishing Marginal Returns As variable resources (workers) are added to fixed resources (machinery, tool, etc.), the additional output produced from each new worker will eventually fall. Too many cooks in the kitchen! 3

4 Graphing Production 4

5 Three Stages of Returns Stage I: Increasing Marginal Returns MP rising. TP increasing at an increasing rate. Why? Specialization. Total Product Total Product Quantity of Labor Marginal and Average Product Average Product Marginal Product Quantity of Labor 5

6 Three Stages of Returns Stage II: Decreasing Marginal Returns MP Falling. TP increasing at a decreasing rate. Why? Fixed Resources. Each worker adds less and less. Total Product Total Product Quantity of Labor Marginal and Average Product Average Product Marginal Product Quantity of Labor 6

7 Three Stages of Returns Stage III: Negative Marginal Returns MP is negative. TP decreasing. Workers get in each others way Total Product Total Product Quantity of Labor Marginal and Average Product Average Product Marginal Product Quantity of Labor 7

8 With your partner calculate MP and AP then discuss what the graphs for TP, MP, and AP look like. Remember quantity of workers goes on the x-axis. # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP)

9 With your partner calculate MP and AP then discuss what the graphs for TP, MP, and AP look like. Remember quantity of workers goes on the x-axis. # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP)

10 With your partner calculate MP and AP then discuss what the graphs for TP, MP, and AP look like. Remember quantity of workers goes on the x-axis. # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP)

11 Identify the three stages of returns # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP)

12 Identify the three stages of returns # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP)

13 More Examples of the Law of Diminishing Marginal Returns Example #1: Learning curve when studying for an exam Fixed Resources-Amount of class time, textbook, etc. Variable Resources-Study time at home Marginal return- 1 st hour-large returns 2 nd hour-less returns 3 rd hour-small returns 4 th hour- negative returns (tired and confused) Example #2: A Farmer has fixed resource of 8 acres planted of corn. If he doesn t clear weeds he will get 30 bushels. If he clears weeds once he will get 50 bushels. Twice -57, Thrice-60. Additional returns diminishes each time. 13

14 Costs of Production 14

15 Accountants vs. Economists Accountants look at only EXPLICIT COSTS Explicit costs (out of pocket costs) are payments paid by firms for using the resources of others. Example: Rent, Wages, Materials, Electricity Bills Accounting Total Profit Accounting Costs Revenue (Explicit Only) Economists examine both the EXPLICIT COSTS and the IMPLICIT COSTS Implicit costs are the opportunity costs that firms pay for using their own resources Example: Forgone Wage, Forgone Rent, Time Economic Profit Total Revenue Economic Costs (Explicit + Implicit) 15

16 Accountants vs. Economists Accountants look at only EXPLICIT COSTS Explicit costs (out of pocket costs) are payments paid by firms for using the resources of others. Example: Rent, Wages, Materials, Electricity Bills Accounting From now Total on, all Profit Accounting costs Costs Revenue (Explicit Only) Economists examine both the EXPLICIT COSTS and the IMPLICIT ECONOMIC COSTS COSTS Implicit costs are the opportunity costs that firms pay for using their own resources Example: Forgone Wage, Forgone Rent, Time Economic Profit are automatically Total Revenue Economic Costs (Explicit + Implicit) 16

17 Short-Run Production Costs 17

18 Definition of the Short-Run We will look at both short-run and long-run production costs. Short-run is NOT a set specific amount of time. The short-run is a period in which at least one resource is fixed. Plant capacity/size is NOT changeable In the long-run ALL resources are variable NO fixed resources Plant capacity/size is changeable Today we will examine Short-run costs. 18

19 Different Economic Costs Total Costs FC = Total Fixed Costs VC = Total Variable Costs TC = Total Costs Per Unit Costs AFC = Average Fixed Costs AVC = Average Variable Costs ATC = Average Total Costs MC = Marginal Cost 19

20 Definitions Fixed Costs: Costs for fixed resources that DON T change with the amount produced Ex: Rent, Insurance, Managers Salaries, etc. Average Fixed Costs = Fixed Costs Quantity Variable Costs: Costs for variable resources that DO change as more or less is produced Ex: Raw Materials, Labor, Electricity, etc. Average Variable Costs = Variable Costs Quantity 20

21 Total Cost: Sum of Fixed and Variable Costs Average Total Cost = Marginal Cost: Marginal Cost = Total Costs Quantity Additional costs of an additional output. Ex: If the production of two more output increases total cost from $100 to $120, the MC is. $10 Definitions Change in Total Costs Change in Quantity 21

22 Output Variable Cost Calculating Costs Fixed Cost Total Cost Marginal Cost 0 $0 $10 $10-1 $10 2 $17 3 $25 4 $40 5 $60 6 $110 $10 $10 $10 $10 $10 $10 $20 $27 $35 $50 $70 $120 $10 Fill out the chart then calculate: 1. ATC of 6 Units 2. AFC of 2 Units 3. AVC of 4 Units 4. ATC of 1 Unit 5. AVC of 5 Units 6. AFC of 5 Units 7. ATC of 5 Units Notice that the AVC + AFC = ATC For 5 Units: AVC ($12) + AFC ($2) = ATC ($14) $7 $8 $15 $20 $50 Is this is true for 4 Units? 22

23 Calculating Costs Output Variable Cost Fixed Cost Total Cost Marginal Cost 0 $0 $10 $10-1 $10 $10 $20 $10 2 $17 $10 $27 $7 3 $25 $10 $35 $8 4 $40 $10 $50 $15 5 $60 $10 $70 $20 6 $110 $10 $120 $50 AVC AFC ATC $10 $10 $20 $8.50 $5 $13.50 $8.33 $3.33 $11.66 $10 $2.50 $12.50 $12 $2 $14 $18.33 $1.67 $20 Notice that the AVC + AFC = ATC 23

24 Calculating Costs AVC AFC ATC $10 $10 $20 $8.50 $5 $13.50 $8.33 $3.33 $11.66 $10 $2.50 $12.50 $12 $2 $14 $18.33 $1.67 $20 24

25 Costs $20 $18 $16 $14 $12 $10 $8 $6 $4 $2 MC ATC Average Fixed Cost AVC ATC and AVC get closer and closer but NEVER touch AFC Quantity 25

26 Costs $20 $18 $16 $14 $12 $10 $8 $6 $4 $2 MC ATC AVC Calculate TC, VC, and FC of the 5 th Unit AFC Quantity 26

27 Total Cost Curves Costs FC + VC = TC TC VC Fixed Cost $10 FC Quantity 27

28 Practice 28

29 2008 Audit Exam

30 1. 2.

31

32 Output Calculating Costs Practice Variable Cost Fixed Cost Total Cost Marginal Cost 0 $0 $20-1 $12 2 $22 3 $27 4 $40 5 $60 6 $100 Fill out the chart then calculate: 1. ATC of 6 Units 2. AFC of 2 Units 3. AVC of 3 Units 4. ATC of 5 Units 5. AVC of 2 Units 6. AVC of 4 Units 7. AFC of 4 Units 8. ATC of 4 Units 32

33 How much does the 10 th unit cost? Costs $ MC ATC AVC Calculate TC, VC, and FC AFC Quantity 33

34 Per-Unit Costs (Average and Marginal) At output Q, what area represents: TC 0CDQ VC 0BEQ FC 0AFQ or BCDE 34

35 More Practice 35

36 Additional Practice TP VC FC TC MC AVC AFC ATC

37 Calculating TC, VC, FC, ATC, AFC, and MC TP VC FC TC MC AVC AFC ATC

38 Calculating TC, VC, FC, ATC, AFC, and MC TP VC FC TC MC AVC AFC ATC

39 Per Unit Costs TP VC FC TC MC AVC AFC ATC

40 Per Unit Costs TP VC FC TC MC AVC AFC ATC

41 Per Unit Costs TP VC FC TC MC AVC AFC ATC

42 Per Unit Costs TP VC FC TC MC AVC AFC ATC Asymptote 42

43 Per Unit Costs TP VC FC TC MC AVC AFC ATC

44 Per Unit Costs TP VC FC TC MC AVC AFC ATC

45 Calculate A-E TP VC FC TC MC AVC AFC ATC A B D E C

46 Calculating TC, VC, FC, ATC, AFC, and MC TP VC FC TC MC AVC AFC ATC

47 Calculating TC, VC, FC, ATC, AFC, and MC TP VC FC TC MC AVC AFC ATC

48 Shapes of Cost Curves

49 Costs Why does marginal cost always go down then up? MC Quantity 49

50 Output Costs Relationship between Production and Cost Quantity of labor Quantity of output MP MC As more workers are hired, their marginal product increases and then eventually decreases because of the law of diminishing marginal returns The additional costs (MC) of the units they produce fall when MP goes up, but eventually increase as additional workers produce less and less output MP and MC are mirror images of each other 50

51 Why is the MC curve U-shaped? The MC curve falls and then rises because of diminishing marginal returns. Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost for each worker (Wage = $10) Workers Total Prod Marg Prod Total Cost Marginal Cost

52 Why is the MC curve U-shaped? The MC curve falls and then rises because of diminishing marginal returns. Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost for each worker (Wage = $10) Workers Total Prod Marg Prod Total Cost Marginal Cost

53 Why is the MC curve U-shaped? The MC curve falls and then rises because of diminishing marginal returns. Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost for each worker (Wage = $10) Workers Total Prod Marg Prod Total Cost Marginal Cost $ $ $ $ $ $ $80 53

54 Why is the MC curve U-shaped? The MC curve falls and then rises because of diminishing marginal returns. Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost for each worker (Wage = $10) Workers Total Prod Marg Prod Total Cost Marginal Cost $ $30 10/5 = $ $40 10/8 = $ $50 10/6 = $ $60 10/4 = $ $70 10/2 = $ $80 10/1 = $10 54

55 Why is the MC curve U-shaped? The additional cost of the first 13 units produced falls because workers have increasing marginal returns. As production continues, each worker adds less and less to production so the marginal cost for each unit increases. Workers Total Prod Marg Prod Total Cost Marginal Cost $ $30 10/5 = $ $40 10/8 = $ $50 10/6 = $ $60 10/4 = $ $70 10/2 = $ $80 10/1 = $10 55

56 Relationship between Production and Cost MC Why does ATC go down ATC then up? When the marginal cost is below the average, it pulls the average down. When the marginal cost is above the average, it pulls Quantity the average up. MC intersects the ATC curve at ATC s lowest point Costs Example: The average income in the room is $50,000. An additional (marginal) person enters the room: Bill Gates. If the marginal is greater than the average it pulls it up. Notice that MC can increase but still pull down the average. 56

57 2008 Audit Question 23

58 2010 Question 18

59 Costs $12 $10 $8 MC When in doubt, graph it out ATC AVC $2 100 AFC Quantity

60 1. 2.

61 Shifting Cost Curves 61

62 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC What if Fixed Costs increase to $

63 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC

64 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC

65 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC Which Per Unit Cost Curves Change? 65

66 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC ONLY AFC and ATC Increase! 66

67 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC ONLY AFC and ATC Increase! 67

68 Shifting Costs Curves If fixed costs change ONLY AFC and ATC Change! TP VC FC TC MC AVC AFC ATC MC and AVC DON T change! 68

69 Costs (dollars) Shift from an increase in a Fixed Cost MC ATC 1 ATC AVC AFC 1 AFC Quantity 69

70 Shift from an increase in a Fixed Cost Costs (dollars) MC ATC 1 AVC AFC 1 Quantity 70

71 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC What if the cost for variable resources increase

72 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC

73 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC

74 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC Which Per Unit Cost Curves Change? 74

75 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC MC, AVC, and ATC Change! 75

76 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC MC, AVC, and ATC Change! 76

77 Shifting Costs Curves If variable costs change MC, AVC, and ATC Change! TP VC FC TC MC AVC AFC ATC

78 Costs (dollars) Shift from an increase in a Variable Costs MC1 MC ATC 1 AVC 1 ATC AVC AFC Quantity 78

79 Costs (dollars) Shift from an increase in a Variable Costs MC1 ATC 1 AVC 1 AFC Quantity 79

80 Long-Run Costs 80

81 2010 Question 19 81

82 Definition of the Short-Run We will look at both short-run and long-run production costs. Short-run is NOT a set specific amount of time. The short-run is a period in which at least one resource is fixed. Plant capacity/size is NOT changeable In the long-run ALL resources are variable NO fixed resources Plant capacity/size is changeable Today we will examine LONG-run costs. 82

83 Definition and Purpose of the Long Run In the long run all resources are variable. Plant capacity/size can change. Why is this important? The Long-Run is used for planning. Firms use to identify which plant size results in the lowest per unit cost. Ex: Assume a firm is producing 100 bikes with a fixed number of resources (workers, machines, etc.). If this firm decides to DOUBLE the number of resources, what will happen to the number of bikes it can produce? There are only three possible outcomes: 1. Number of bikes will double (constant returns to scale) 2. Number of bikes will more than double (economies of scale) 3. Number of bikes will less than double (diseconomies of scale) 83

84 Long Run ATC What happens to the average total costs of a product when a firm increases its plant capacity? Example of various plant sizes: I make looms out of my garage with one saw I rent out building, buy 5 saws, hire 3 workers I rent a factory, buy 20 saws and hire 40 workers I build my own plant and use robots to build looms. I create plants in every major city in the U.S. Long Run ATC curve is made up of all the different short run ATC curves of various plant sizes. 84

85 ECONOMIES OF SCALE Why does economies of scale occur? Firms that produce more can better use Mass Production Techniques and Specialization. Example: A car company that makes 50 cars will have a very high average cost per car. A car company that can produce 100,000 cars will have a low average cost per car. Using mass production techniques, like robots, will cause total cost to be higher but the average cost for each car would be significantly lower. 85

86 Long Run AVERAGE Total Cost Costs MC1 ATC 1 $9,900,000 $50,000 $6,000 $3, , ,000 1,000,0000 Quantity Cars 86

87 Long Run AVERAGE Total Cost Costs $9,900,000 MC1 ATC 1 MC2 Economies of Scale- Long Run Average Cost falls because mass production techniques are used. $50,000 ATC 2 $6,000 $3, , ,000 1,000,0000 Quantity Cars 87

88 Long Run AVERAGE Total Cost Costs $9,900,000 MC1 ATC 1 MC2 Economies of Scale- Long Run Average Cost falls because mass production techniques are used. MC3 $50,000 ATC 2 ATC 3 $6,000 $3, , ,000 1,000,0000 Quantity Cars 88

89 Long Run AVERAGE Total Cost Costs MC1 ATC 1 Constant Returns to Scale- The long-run average total cost is as low as it can get. $9,900,000 MC2 MC3 MC4 $50,000 ATC 2 ATC 3 ATC 4 $6,000 $3, , ,000 1,000,0000 Quantity Cars 89

90 Long Run AVERAGE Total Cost Costs $9,900,000 MC1 ATC 1 MC2 Diseconomies of Scale- Long run average costs increase as the firm gets too big and difficult to manage. MC3 MC4 MC5 ATC5 $50,000 ATC 2 ATC 3 ATC 4 $6,000 $3, , ,000 1,000,0000 Quantity Cars 90

91 Long Run AVERAGE Total Cost Costs $9,900,000 MC1 ATC 1 MC2 Diseconomies of Scale- The LRATC is increasing as the firm gets too big and difficult to manage. MC3 MC4 MC5 ATC5 $50,000 ATC 2 ATC 3 ATC 4 $6,000 $3, , ,000 1,000,0000 Quantity Cars 91

92 Long Run AVERAGE Total Cost Costs $9,900,000 MC1 ATC 1 MC2 These are all short run average costs curves. Where is the Long Run Average Cost Curve? MC3 MC4 MC5 ATC5 $50,000 ATC 2 ATC 3 ATC 4 $6,000 $3, , ,000 1,000,0000 Quantity Cars 92

93 Long Run AVERAGE Total Cost Costs Economies of Scale Constant Returns to Scale Diseconomies of Scale Long Run Average Cost Curve , ,000 1,000,0000 Quantity Cars 93

94 LRATC Simplified The law of diminishing marginal returns doesn t apply in the long run because there are no FIXED RESOURCES. Costs Economies of Scale Constant Returns to Scale Diseconomies of Scale Long Run Average Cost Curve Quantity 94

95 4 Market Structures 95

96 FOUR MARKET STRUCTURES Perfect Competition Monopolistic Competition Oligopoly Pure Monopoly Every product is sold in a market that can be considered one of the above market structures. For example: 1. Fast Food Market 2. The Market for Cars 3. Market for Operating Systems (Microsoft) 4. Strawberry Market 5. Cereal Market 96

97 Perfect Competition 97

98 FOUR MARKET STRUCTURES Perfect Competition Monopolistic Competition Oligopoly Pure Monopoly Imperfect Competition Characteristics of Perfect Competition: Examples of Perfect Competition: Avocado farmers, sunglass huts, and hammocks in Mexico Many small firms Identical products (perfect substitutes) Easy for firms to enter and exit the industry Seller has no need to advertise Firms are Price Takers The seller has NO control over price. 98

99 Perfectly Competitive Firms Example: Say you go to Mexico to buy a hammock. After visiting at few different shops you find that the buyers and sellers always agree on $15. This is the market price (where demand and supply meet) 1. Is it likely that any shop can sell hammocks for $20? 2. Is it likely that any shop will sell hammocks for $10? 3. What happens if a shop prices hammocks too high? 4. Do you think that these firms make a large profit off of hammocks? Why? These firms are price takers because the sell their products at a price set by the market. 99

100 Demand for Perfectly Competitive Firms Why are they Price Takers? If a firm charges above the market price, NO ONE will buy. They will go to other firms There is no reason to price low because consumers will buy just as much at the market price. Since the price is the same at all quantities demanded, the demand curve for each firm is Perfectly Elastic (A Horizontal straight line) 100

101 The Competitive Firm is a Price Taker Price is set by the Industry P S P $15 $15 Demand D 5000 Industry Q Firm (price taker) Q 101

102 The Competitive Firm is a Price Taker Price is set by the Industry What is the additional revenue for selling an additional unit? 1 st unit earns $15 2 nd unit earns $15 Marginal revenue is constant at $15 Notice: Total revenue increases at a constant rate MR equal Average Revenue $15 P Firm (price taker) Demand MR=D=AR=P Q 102

103 The Competitive Firm is a Price Taker Price is set by the Industry What is the additional revenue for selling an additional unit? 1 st unit earns $15 2 nd unit earns $15 Marginal revenue is constant at $15 Notice: Total revenue increases at a constant rate MR equal Average Revenue For Perfect Competition: (Marginal $15 Revenue) P Demand = MR Firm (price taker) Demand MR=D=AR=P Q 103

104 Maximizing PROFIT! 104

105 Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! To maximum profit firms must make the right output Firms should continue to produce until the additional revenue from each new output equals the additional cost. Example (Assume the price is $10) Should you produce if the additional cost of another unit is $5 if the additional cost of another unit is $9 if the additional cost of another unit is $11 105

106 Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! To maximum profit firms must make the right output Firms Profit should Maximizing continue to produce until Rule the additional revenue from each new output equals the additional MR=MC cost. Example (Assume the price is $10) Should you produce if the additional cost of another unit is $5 if the additional cost of another unit is $9 if the additional cost of another unit is $11 106

107 Lets put costs and revenue together to calculate profit. P Industry S P Firm (price taker) MC $7 $7 Demand ATC D 10,000 Q Q 107

108 How much output should be produced? How much is Total Revenue? How much is Total Cost? Is there profit or loss? How much? P $9 MC Profit = $18 Total Cost=$45 Total Revenue =$ MR=D=AR=P Q ATC AVC Don t forget that averages show PER UNIT COSTS 108

109 Suppose the market demand falls. What would happen if the price is lowered from $7 to $5? The MR=MC rule still applies but now the firm will make an economic loss. The profit maximizing rule is also the loss minimizing rule!!! 109

110 How much output should be produced? How much is Total Revenue? How much is Total Cost? Is there profit or loss? How much? Cost and Revenue MC $9 8 7 ATC Loss =$7 AVC MR=D=AR=P Total Cost = $42 Total Revenue=$ Q 110

111 Assume the market demand falls even more. If the price is lowered from $5 to $4 the firm should stop producing. Shut Down Rule: A firm should continue to produce as long as the price is above the AVC When the price falls below AVC then the firm should minimize its losses by shutting down Why? If the price is below AVC the firm is losing more money by producing than they would have to pay to shut down. 111

112 Cost and Revenue SHUT DOWN! Produce Zero $ MC AVC ATC Minimum AVC is shut down point Q 112

113 Cost and Revenue P<AVC. They should shut down Producing nothing is cheaper than staying open. $ Fixed Costs=$10 TC=$35 TR=$ MC ATC AVC MR=D=AR=P Q 113

114 Profit Maximizing Rule MR = MC Three Characteristics of MR=MC Rule: 1. Rule applies to ALL markets structures (PC, Monopolies, etc.) 2. The rule applies only if price is above AVC 3. Rule can be restated P = MC for perfectly competitive firms (because MR = P) 114

115 Practice 115

116 #1 1. Should the firm produce? Yes 2. What output should the firm produce? What is the TR and TC at that output? TR=$ How much profit or loss? TC=$100 Price Profit=$40 $ MC MR=D=AR= P ATC Quantity 116

117 #2 What output should the firm produce? 6 What is TR at that output? $90 What is TC? $120 How much profit or loss? Loss= $30 Price MC ATC AVC MR=D=AR=P Quantity 117

118 #3 1. What output should the firm produce? Zero Shutdown 2. What is TR at MR=MC point? $45 (Price below AVC) 3. What is TC at MR=MC point? $55 4. How much profit or loss? Loss=Only Fixed Cost $5 Price $ MC ATC AVC MR=D=AR=P Quantity 118

119 #4 1. Should the firm produce? Yes 2. What output should the firm produce? What is the TR and TC at that output? TR=$ How much profit or loss? TC=$60 Price Profit=$40 $ MC MR=D=AR= P ATC Quantity 119

120

121 2007 Form B FRQ

122 2007 Form B FRQ

123 Output Variable Cost Maximizing Profit Fixed Cost Total Cost Marginal Cost 0 $0 $20-1 $12 2 $22 3 $27 4 $40 5 $60 6 $100 Assume the firm can sell each unit at a price of $30 1. How many units should the firm produce to maximize profit? 2. What is the total revenue at that quantity? 3. How much is the profit? Notice that at 6 units the firm is still making profit. It s just not maximizing profit 123

124 Maximizing Profit Output Variable Cost Fixed Cost Total Cost Marginal Cost 0 $0 $20-1 $12 2 $22 3 $27 4 $40 5 $60 6 $100 TR MR Profit $30 $30 -$2 $60 $30 $18 $90 $30 $43 $120 $30 $60 $150 $30 $70 $180 $30 $60 Notice that at 6 units the firm is still making profit. It s just not maximizing profit 124

125 2006 FRQ 125

126 2006 FRQ 126

127 Short-run Supply Curve 127

128 Cost and Revenue Marginal Cost and Supply $ As price increases, the quantity increases MC AVC ATC MR 5 MR 4 MR 3 MR 2 MR 1 Q 128

129 Cost and Revenue Marginal Cost and Supply When price increases, quantity increases When price decrease, quantity decreases $ MC = Supply ATC AVC Q 129

130 Cost and Revenue Marginal Cost and Supply When price increases, quantity increases When price decrease, quantity decreases $ MC = Supply ATC Short-run Supply Curve: AVC MC above AVC Q 130

131 Cost and Revenue Marginal Cost and Supply If variable costs increase (ex: per unit tax) $ MC 2 =Supply 2 MC 1 =Supply 1 AVC AVC When MC increases, SUPPLY decrease Q 131

132 Cost and Revenue Marginal Cost and Supply What if variable costs decrease (ex: subsidy)? $ MC 1 =Supply 1 MC 2 =Supply 2 AVC AVC When MC decreases, SUPPLY increases Q 132

133 Marginal Cost and Supply What happens to quantity if fixed costs Price increase? MC P F MR=D=AR= P ATC 1 ATC Quantity stays the same because MC/Supply doesn t change Q F Quantity 133

134 Per Unit vs. Lump Sum A PER UNIT tax or subsidy is effects the VARIABLE COSTS so MC, AVC, and ATC will shift. This WILL effect the quantity produced A LUMP SUM tax or subsidy only effects FIXED COSTS so only AFC and ATC will shift. MC stays the same. This WILL NOT effect the quantity produced 134

135 2008 Audit Exam

136 Perfect Competition 136

137 Review 1. Identify the 4 Market Structures 2. Identify the characteristics of perfect competition 3. Why is a perfectly competitive firm a price taker? 4. Explain why perfectly competitive firms make little profit 5. How do ALL firms determine what output to produce? 6. Draw a perfectly competitive firm producing 10 units at a price of $10 making a profit of $30 7. Draw and label a perfectly competitive firm making a loss. 8. On your graph, identify the shut down point 9. List 10 words that rhyme with the word great 137

138 Side-by-side graph for perfectly completive industry and firm. Is the firm making a profit or a loss? Why? P S P MC $15 $15 ATC MR=D AVC D 5000 Industry Q 8 Firm (price taker) Q 138

139 Which of the following is a correctly labeled graph for firm making economic profit? 139

140 P #1 MC ATC P #3 MC ATC P F MR=D MR=D P #2 Q F MC Q P #4 Q F ATC Q ATC MC MR=D MR=D Q Q Q F Q F

141 P #1 MC ATC P #3 MC ATC P F MR=D MR=D P #2 Q F MC Q They are all wrong ATC P #4 Q F for different reasons ATC MC Q MR=D MR=D Q Q Q F Q F

142 P #1 MC ATC P #3 MC ATC P F P #2 MR=D ATC>P Q Q F MC P #4 Q F ATC MR=D Profit too big Q ATC MC Q F MR=D MR > MC Q Q F MR=D MC&ATC Wrong Q

143 Cost and Revenue Where is the profit maximization point? How do you know? What output should be produced? What is TR? What is TC? How much is the profit or loss? Where is the Shutdown Point? $ Profit MC MR=P ATC AVC 10 Total Revenue Total Cost

144 Perfect Competition in the Long-Run You are a wheat farmer. You learn that there is a more profit in making corn. What do you do in the long run? 144

145 In the Long-run Firms will enter if there is profit Firms will leave if there is loss So, ALL firms break even, they make NO economic profit (No Economic Profit=Normal Profit) In long run equilibrium a perfectly competitive firm is EXTREMELY efficient. 145

146 Side-by-side graph for perfectly competitive industry and firm in the LONG RUN Is the firm making a profit or a loss? Why? P S P MC ATC $15 $15 MR=D D 5000 Industry Q 8 Firm (price taker) Q 146

147 Firm in Long-Run Equilibrium P Price = MC = Minimum ATC Firm making a normal profit MC ATC $15 TC = TR MR=D There is no incentive to enter or leave the industry 8 Q

148 Going from Long-Run to Short-Run 148

149 1. Is this the short or the long run? Why? 2. What will firms do in the long run? 3. What happens to P and Q in the industry? 4. What happens to P and Q in the firm? P S P MC $15 $15 ATC MR=D D Industry Q 8 Firm Q 149

150 Firms enter to earn profit so supply increases in the industry Price decreases and quantity increases P S S 1 P MC $15 $15 $10 D Industry Q 8 Firm ATC MR=D Q 150

151 Price falls for the firm because they are price takers. Price decreases and quantity decreases P S S 1 P MC $15 $15 ATC MR=D $10 $10 MR 1 =D 1 D Industry Q 5 8 Firm Q 151

152 New Long Run Equilibrium at $10 Price Zero Economic Profit P S 1 P MC ATC $10 $10 MR 1 =D 1 D Q Industry Firm Q

153 1. Is this the short or the long run? Why? 2. What will firms do in the long run? 3. What happens to P and Q in the industry? 4. What happens to P and Q in the firm? P S P MC ATC $15 $15 MR=D D Industry Q 8 Firm Q 153

154 Firms leave to avoid losses so supply decreases in the industry Price increases and quantity decreases P S 1 S P MC ATC $20 $15 $15 MR=D D Industry Q 8 Firm Q 154

155 Price increase for the firm because they are price takers. Price increases and quantity increases P S 1 S P MC ATC $20 $20 $15 $15 MR 1 =D 1 MR=D D Industry Q 8 9 Firm Q 155

156 New Long Run Equilibrium at $20 Price Zero Economic Profit P S 1 P MC ATC $20 $20 MR 1 =D D Q Industry Firm Q

157 Going from Long-Run to Long-Run Constant Cost Industry- New firms entering the market does not increase the costs for the firms already in the market. 157

158 Currently in Long-Run Equilibrium If demand increases, what happens in the short-run and how does it return to the long run? P S P MC ATC $15 $15 MR 1 =D 1 MR=D D 5000 Industry Q 8 Firm Q 158

159 Demand Increases The price increases and quantity increases Profit is made in the short-run P S P MC $20 $20 $15 $15 ATC MR 1 =D 1 MR=D D 1 D 5000 Industry Q 8 Firm 9 Q 159

160 Firms enter to earn profit so supply increases in the industry Price Returns to $15 P S S 1 P MC $20 $20 $15 $15 ATC MR 1 =D 1 MR=D D 1 D Industry Q 8 Firm 9 Q 160

161 Back to Long-Run Equilibrium The only thing that changed from long-run to long-run is quantity in the industry P S 1 P MC ATC $15 $15 MR=D D 1 D 7000 Industry Q 8 Firm Q 161

162 What if demand falls? If demand decreases, what happens in the shortrun and how does it return to the long run? P S P MC ATC $15 $15 MR=D D 5000 Industry Q 8 Firm Q 162

163 Demand Decreases The price increases and quantity increases Profit is made in the short-run P S P MC ATC $15 $15 $10 $10 MR=D MR 1 =D D 1 Industry D Q 7 8 Firm Q 163

164 Demand Decreases The price increases and quantity increases Profit is made in the short-run P S 1 S P MC ATC $15 $15 $10 $10 MR=D MR 1 =D D 1 Industry D Q 7 8 Firm Q 164

165 Demand Decreases The price increases and quantity increases Profit is made in the short-run P S 1 P MC ATC $15 $15 MR=D 3000 D 1 Industry Q 8 Firm Q 165

166 Practice 166

167 2012 Multiple Choice #23 167

168 2012 Multiple Choice #38 168

169

170 2010 FRQ #1 170

171 171

172 Going from Long-Run to Long-Run Increasing Cost Industry- New firms entering the market increase the costs for the firms already in the market. (Only asked once on a FRQ Form B) 172

173 Currently in Long-Run Equilibrium If demand increases, what happens in the short-run and how does it return to the long run? P S P MC ATC $15 $15 MR=D D Industry Q Firm Q 173

174 INCREASING COST Industry The price increases and quantity increases Profit is made in the short-run P S P MC $25 $25 ATC $15 $15 MR=D D D 1 Industry Q Firm Q 174

175 Firms enter to earn profit but fight for resources causing costs to increase Price Falls to $20 P S S 1 $25 $25 $20 $15 $15 P MC1 MC ATC1 ATC MR=D D 1 D Industry Q Firm Q 175

176 Firms enter to earn profit but fight for resources causing costs to increase Price Falls to $20 P S 1 P MC1 ATC1 $20 MR1 D 1 Q Industry Firm 176 Q

177 2008 Audit Exam

178 Efficiency 178

179 PURE COMPETITION AND EFFICIENCY In general, efficiency is the optimal use of societies scarce resources Perfect Competition forces producers to use limited resources to their fullest. Inefficient firms have higher costs and are the first to leave the industry. Perfectly competitive industries are extremely efficient There are two kinds of efficiency: 1. Productive Efficiency 2. Allocative Efficiency 179

180 Bikes Efficiency Revisited Which points are productively efficient? Which are allocatively efficient? A B E G C D F Productive Efficient combinations are A through D (they are produced at the lowest cost) Computers Allocative Efficient combinations depend on the wants of society 180

181 Productive Efficiency The production of a good in a least costly way. (Minimum amount of resources are being used) Graphically it is where Price = Minimum ATC 181

182 Price Profit Short-Run MC ATC D=MR P Notice that the product is NOT being made at the lowest possible cost (ATC not at lowest point). Q Quantity 182

183 Price Short-Run MC ATC P Loss D=MR Notice that the product is NOT being made at the lowest possible cost (ATC not at lowest point). Q Quantity 183

184 Price Long-Run Equilibrium MC ATC P D=MR Notice that the product is being made at the lowest possible cost (Minimum ATC) Q Quantity 184

185 Allocative Efficiency Producers are allocating resources to make the products most wanted by society. Graphically it is where Price = MC Why? Price represents the benefit people get from a product. 185

186 Price Long-Run Equilibrium MC P Q Quantity MR Optimal amount being produced The marginal benefit to society (as measured by the price) equals the marginal cost. 186

187 Price What if the firm makes 15 units? MC $5 MR The marginal benefit to $3 society is greater the marginal cost. Not enough produced. Society wants more Underallocation Quantity of resources 187

188 Price What if the firm makes 22 units? $7 MC $5 MR The marginal benefit to society is less than the marginal cost. Too much Produced. Society wants less Overallocation of Quantity resources 188

189 Price Long-Run Equilibrium MC ATC P D=MR P = Minimum ATC = MC EXTREMELY EFFICIENT!!!! Q Quantity 189