Download The Demand Curve for Output

Lecture notes - 4
Agricultural Production Economics
THE DEMAND CURVE FOR OUTPUT
Once a firm has produced a product, it must sell it. The demand curve for output
describes the limitations the firm faces in doing this task. The demand curve for
output is a constraint on the firm because it gives the maximum price that a firm
can charge for each level of production. Thus, if the firm in the graph below
wants to sell 24, it can do so by charging $5.00 or any price that is lower. It
cannot charge $10.00 and still sell 24 because buyers will not allow it.
The demand curve facing a firm depends both on the preferences of consumers
and on how well other firms meet those preferences. One can derive a demand
curve for an individual from a set of indifference curves showing the individual's
preferences and a series of budget lines showing changes in price. To get a
demand curve for the entire industry, one must add up all the demand curves of
individuals. To get the demand curve for eggs, for example, one must add up the
number of eggs that Smith and Jones and Nelson and all other consumers in the
market want at each possible price.
When there is only one firm selling in a market, that firm is a monopolist. (The
Greek root mono- means "one.") The demand curve for the monopolist is the
demand curve for the industry. A monopolist is a price searcher or a price
maker. It will search along the demand curve for the price-quantity pair that is
most profitable. When there is more than one seller, the demand curve that a
seller sees is not the same as the demand curve for the industry. The industry
demand is split up among sellers. When there are only a few sellers, the sellers
will still be price searchers or price makers. These sellers, or oligopolists (the
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Greek root oli- means "few"), are price makers because each recognizes that if it
wants to sell more, it must lower its price.
However, the demand curve of each oligopolist will be more elastic than the
demand curve for the industry as a whole. Suppose, for example, that there are
two firms in an industry, each produces 50 units of output, and the elasticity of
the industry demand curve is one. If one firm increases its output by 10% to 55,
the industry output increases to 105, which is a 5% increase. Since the price
elasticity of demand is one, price must decline by 5%. But for the original firm, a
10% increase in production and a 5% decline in price indicate a price elasticity of
two, not one.
As firms get more and more numerous in an industry, the demand curve each
sees gets more and more elastic. When there are a great many sellers in the
market, a change of output by any one of them has an insignificant effect on
price. To each firm the demand curve will look perfectly flat--the firm will seem
able to sell whatever amount it wants at a fixed price. In this case, each firm is a
price taker and sells in a perfectly competitive market. An example of this type of
market is the market for wheat. There are a great many wheat farmers in many
countries, and none has any noticeable control over the price at which it can sell
in the world wheat market.
However, even when there are a great many sellers, each firm may have a
downward-sloping demand curve. If buyers must expend time and effort to
discover prices or the characteristics of the product, they will pick a seller and
stay with it as long as they find the exchange satisfactory. These downwardsloping demand curves of small sellers are a result of the ambiguous definition of
industry. The products most firms produce differ in some way, such as in quality,
service, or location, from the products of other firms in the industry.
From the viewpoint of the firm, it is not the demand curve, but the child of the
demand curve, the marginal revenue curve, which is of vital importance.
Marginal revenue is the extra revenue a seller gets when it produces and sells
another unit. For the price taker, the marginal revenue curve is the demand curve.
For the farmer who can sell corn at $4.00 a bushel, the extra revenue from
selling another bushel is $4.00. The demand curve for this farmer is flat at $4.00,
and so is his marginal revenue curve.
The table below illustrates why marginal revenue will be less than price for a
price searcher. If the firm charges $3.00, it can sell one unit and total revenue will
be $3.00. If it sells one more unit, it will be forced to cut price to $2.00 and total
revenue will rise to $4.00. Selling the extra unit adds only $1.00 to revenue.
Although the second unit sold for $2.00, the firm had to cut the price it was
previously receiving for the first unit by $1.00, so the net increase in revenue was
only $1.00. By similar logic, selling the third unit reduces total revenue by $1.00,
so marginal revenue is -$1.00.
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Demand and Marginal Revenue
Price
Quantity
Marginal Revenue
$3.00
1
.
.
$2.00
$1.00
2
.
$1.00
.
-$1.00
3
.
The previous analysis assumes that the firm can charge only one price. If it can
charge more than one price, charging higher prices to those willing and able to
pay them and lower prices to others, it can move the marginal revenue curve
closer to the demand curve, increasing profits (or reducing losses). This pattern
is called price discrimination.
Economists generally assume that the demand curve is fixed, but many
businesses do not regard it that way. It can vary seasonally, with the general
level of business activity, or with a trend. The demand for turkeys has a
pronounced seasonal movement. The demand for automobiles changes when
there is a recession. The demand for baby food follows the trends in birth rate.
Business also may be able to move its demand curve through advertising.
Advertising may simply give people information, it may change their goals, or it
may change their perception of the product. For the firm it does not matter which
happens. The result is the same--good advertising moves the demand curve to
the right.
The demand curve can move for other reasons. If a firm lowers its price and later
raises it back to its previous level, it may find that sales at the old price have
changed. The lower price may attract new customers who have not tried the
product before, and who find they like the product enough to stick with it when
the old price is restored. Alternatively, some customers may expect prices to be
cut again sometime in the future, and may decide to postpone purchases until it
happens again. The opposite can happen if the firm temporarily raises price. It
may encourage some customers to try substitutes, which they may find suit them
better than the original product. Or it may encourage customers to buy more
when the price comes down to prepare for any future increase.
The firm may also be able to change its demand curve by changing the
characteristics of its product.
Finally, many firms sell several products that may be interrelated, and any pricing
decision on one product will have effects not only on that product but also on
others. For example, the prices that General Motors charges for Chevrolets will
affect the demand curve for Pontiacs.
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COST CURVES FROM PRODUCTION FUNCTION
Costs are the expenses incurred in organizing and carrying out the production
process. In the short run, total costs include fixed and variable costs. In the long
run, all costs are considered variable costs because all inputs are variable.
Fixed and Variable Costs
A resource or input is called fixed resources if its quantity is not varied during the
production period. Costs of fixed inputs are called fixed costs, while costs of
variable inputs are called variable costs.
Fixed costs are independent of output. In farming, cash fixed costs include land
taxes, principal and interest on land payments, insurance premiums, and similar
costs. Non cash fixed costs includes building depreciation, machinery and
equipment depreciation caused by the passing of time, interest on capital
investment, charges of family labor and charges of management.
Total Variable Cost (TVC), is computed by multiplying the amount of variable
input used by the price per unit of input.
Total Costs, TC, are the sum of total variable costs and total fixed costs.
TC = TFC + TVC = TFC + Px X
Input
X
Output
Y
0
2
4
6
8
10
12
14
16
18
20
0.0
3.7
13.9
28.8
46.9
66.7
86.4
104.5
119.5
129.6
133.3
Total Fixed
Costs
TFC
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
Total Variable
Costs
TVC
0
200
400
600
800
1000
1200
1400
1600
1800
2000
Average Fixed, Average Variable and Average Total Costs
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Total Costs
TC
1000
1200
1400
1600
1800
2000
2200
2400
2600
2800
3000
Average Fixed Costs (AFC) is computed by dividing total costs by the amount of
output. AFC varies for each level of output; as output increases, AFC decreases.
AFC = TFC / Y
Average Variable Costs (AVC) is computed by dividing total variable costs by the
amount of output. AVC varies depends on the amount of production. AVC is
inversely related to average physical product. When APP is increasing, AVC is
decreasing; when APP is at the maximum, AVC attains a minimum, when APP is
decreasing, AVC is increasing.
AVC = TVC / Y = Px X / Y
Average Total Cost (ATC), can be computed in two ways. Total costs can be
divided by output or AFC and AVC can be added. The shape of the ATC curve
depends on the shape of the production function. ATC decreases as output
increases from zero, attains a minimum and increases there after.
ATC = AFC + AVC
Marginal Cost, MC, is defined as the changes in total cost per unit increase in out
put. It is the cost of producing an additional unit of output. MC is computed by
dividing the changes in total costs by the corresponding change in output. The
shape of the MC curve is in an inverse relationship to that of MPP.
MC = TC / Y = TVC / Y = Px ( X) /  Y = Px (( X / ( Y) = Px ? MPP
Average Fixed
Cost
AFC
270.3
71.9
34.7
21.3
15.0
11.6
9.6
8.4
7.7
7.5
Average
Variable Cost
AVC
54.1
28.8
20.8
17.1
15.0
13.9
13.4
13.3
13.9
15.0
Average Total
Cost
ATC
324.4
100.7
55.5
38.4
30.0
25.5
23.0
21.7
21.6
22.5
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Marginal Cost
MC
Average
Exact
54.1
27.8
19.6
15.6
13.4
11.9
11.0
10.4
10.0
10.0
10.1
10.4
11.0
11.9
13.3
15.6
19.8
27.8
54.1
-
Graphically:
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Cost curves usually are expressed as that output Y, is the so called independent
variable. The cost themselves represent the costs on inputs, either fixed or
variable. Thus, cost curves express the cost of fixed and variable inputs as
function of the amount of output.
Production function, on the other hand, express output as function of input. But
input costs are input quantities multiplied by input prices. Therefore, cost
functions and production functions are by nature are inversely related to each
other.
Deriving cost function from Production Function.
TC = 100 + 6Y – 0.4Y2 + 0.02Y3
In this cost function
TFC = 100 and TVC = 6Y – 0.4Y2 + 0.02Y3
AVC = TVC/Y = (6Y – 0.4Y2 + 0.02Y3 ) / Y
= 6 – 0.4 Y + 0.02Y2
AFC = 100 / Y
MC =  TVC /  Y = 6 – 0.8Y + 0.06Y2
 AVC /  Y = - 0.4 + 0.04Y = 0 or Y = 10
 MC /  Y = -0.8 + 0.12Y = 0 or Y = 6.67
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