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The Supply Side of the Market A.S 3.3 Introduction Supply is the amount of a good or service that a producers is willing and able to offer the market at a range of prices Key factor affecting supply of a product Cost of production Raw materials Wages Packaging Advertising Costs of production are a key determinant of supply Types of Costs Two main types Variable Costs that change as output changes e.g. wages, electricity, packaging Fixed Costs Costs Costs that remain the same regardless of output e.g. rent, insurance Total Costs = Variable Costs + Fixed Costs Fixed costs are costs that do not vary with output Q FC VC 0 100 1 100 2 100 3 100 TC Fixed costs are costs that do not vary with output Variable costs are costs that increase as output increases Q FC VC TC 0 100 1 100 30 2 100 50 3 100 80 0 Fixed costs are costs that do not vary with output Q FC VC TC Variable costs are costs that increase as output increases 0 100 1 100 30 130 Total costs = Fixed + Variable costs 2 100 50 150 3 100 80 180 0 100 Relationship between Total costs and output TC Costs($) TVC TFC OUTPUT The Shape of Average Cost Curves Costs($) FC are constant so AFC will continually decline as FC are spread over increasing output FC AFC Quantity http://www.youtube.com/wat ch?v=nQ5APwtBig&safe=active Marginal Costs Marginal cost is the extra cost of the last unit produced In the short run only changes in variable costs affect marginal costs The importance of Marginal Cost Marginal cost is important because a firm will only produce an extra unit if the price that it receives is greater than or equal to marginal cost of producing that unit. Marginal cost is important in determining if a firm will supply extra units Example Factory that produces lawn mowers Output Total Cost Marginal Cost 100 $4500 $430 101 $5000 102 $5700 $500 $700 103 $6600 $900 How many units should the firm produce if the price it receives for motor mowers is 101 $500? ___________ 102 $800?___________ Average Costs Average Total costs = Total Cost ÷ Output Average Variable costs = Total Variable costs ÷ Output Average Fixed Costs = Total Fixed Costs ÷ Output Average Total Costs= Average Variable costs + Average Fixed Costs Average Total costs = Total Cost ÷ Output Average Variable costs = Total Variable costs ÷ Output Average Fixed Costs = Total Fixed Costs ÷ Output Average Total Costs= Average Variable costs + Average Fixed Costs Costs Output Total Costs Fixed Costs 0 1 2 3 4 5 100 100 100 135 160 180 192 250 Variable Average Average Costs Costs variable costs 0 N/A N/A 35 60 135 80 35 30 80 60 26.66 100 92 48 23 100 150 50 30 100 100 Average Marginal fixed Cost costs N/A N/A 100 50 33.33 25 20 35 25 20 12 58 The Shape of Average Cost Curves Costs($) The difference between AC and AVC is equal to AFC AC AVC AFC Quantity Workbooks page 123 http://www.youtube.com/watch?v=S3iLM fm6CGY&safe=active http://www.youtube.com/watch?v=UI- LL8-dVAs&safe=active Short-run Time Period In economics we distinguish between various time periods - ie short and long run. The short run, is a period of time in which at least one resource cannot be increased. We usally assume that capital such as machinery is the resource that is fixed in the short run. This means all firms will then be subject to the Law of Diminishing Returns fig Diminishing Returns As more of a variable resource (labour) is added to a fixed resource (capital or land), the extra output (Marginal Product) will eventually decrease. Key Definitions Marginal Product – the extra output from adding one more unit of resource such as labour Increasing returns – occur when a variable resource e.g. labour is added to a fixed resource and marginal product is increasing Constant returns – occur when a variable resource e.g. labour is added to a fixed resource and marginal product increases by a constant amount Decreasing returns – occur when a variable resource e.g. labour is added to a fixed resource and marginal product is decreasing Example Number of workers Number of haircuts Marginal (extra) Increasing or Product of Diminishing extra worker returns? 1 10 10 Increasing 2 30 20 Increasing 3 70 40 Increasing 4 130 60 Increasing 5 160 30 Diminishing Cost Curves and Firms Supply The Shape of the MC curve Costs($) MC decreases initially because of increasing returns MC increases because of diminishing returns MC Note: always plot the MC curve at the mid-point! Quantity The Shape of Average Cost Curves Costs($) AC decreases because of increasing returns and increases because of diminishing returns AC AFC Quantity The Shape of Average Cost Curves Costs($) AC AFC Quantity Marginal Cost & Average Cost Costs($) MC AC If MC<AC then AC will be decreasing Quantity Marginal Cost & Average Cost Costs($) MC AC If MC>AC then AC will be increasing Quantity Marginal Cost & Average Cost MC cuts AC at its minimum point - this is the technical optimum This is when the firm is using the best mix of resources and is producing maximum output at the least possible cost. Costs($) MC AC Quantity Marginal Cost & Average Variable Cost Costs($) MC also cuts AVC at its minimum point MC AC AVC Quantity MC, AVC AND AC Why does MC cut AVC and AC at their lowest points? Marginal cost is the cost of the last unit produced. When marginal cost is below the average cost it is pulling the average down. When it is above the average costs it is pulling them up, therefore it must intersect AC and AVC at their lowest points Break Even & Shut Down A firm must cover AC if it is to break even Costs($) MC AC AVC Break even point is where AR=AC. Where the price is enough to cover all costs and the firms make normal profits. This is the break even point Quantity Break Even & Shut Down Costs($) In the SR a firm can survive if P > AVC MC AC AVC This is the shut down point Quantity A firm’s Supply curve is derived from the MC curve above the shut-down point The Supply Curve Costs($) The supply curve is upwards sloping because of diminishing returns! Producing higher levels of output results in progressively less efficient resource combinations. Because of this the firm will only supply a larger quantity at higher prices. MC =S AC AVC Quantity