Download LECTURE SESSION 2

LECTURE SESSION 2
Behind The Supply
The Firm
A Definition
• A general notion of a business:
– A business is a profit-motivated organization that combines
resources for the production and supply of goods and services.
• The term business is often used interchangeably with the
term firm, the namesake of this lesson:
– A firm is an organization that combines resources for the
production and supply of goods and services.
• Two non-profit pursuing firms that stand out are public
(or government) firms and appropriately named nonprofit firms.
Doing Production
• The primary function of any firm is to combine labor,
capital, land, and entrepreneurship inputs into the
production of output:
– Production: Our immediate attention is directed toward the
production activity, the output produced and supplied by the firm.
– Resource Inputs: To produce a valuable output, a firm needs
resources -- labor, capital, land, and entrepreneurship.
• All of these business firms have one thing in common -the transformation of resources into valuable output that
is then supplied to a market.
Entrepreneurship
• The official definition for entrepreneurship:
– Entrepreneurship, is a special sort of human effort that takes on
the risk of bringing labor, capital, and land together to produce
goods. Entrepreneurship is the factor that organizes the other
three.
• Entrepreneurship is the resource that brings resources
together and organizes production.
• A business firm is the entity or organization used by
entrepreneurship to engage in production.
Capital
• The difference between a FACTORY and a FIRM:
– First, let me reiterate that a firm is an organization used by
entrepreneurship to combine the resources used to produce
goods.
– Second, let me examine the term factory.
• A factory is the building and equipment (the physical capital) at a
particular location used for the production of goods and services.
• A factory, also termed plant, is the capital, the physical presence,
used by a firm for actual production.
The Industry
• The relation between a firm and an industry.
• An industry is one or more business firms that produce
similar products.
• In many cases the term industry can be used
interchangeably with the term market.
Staying Alive
• The primary goal of a human consumer is thus to
maximize utility.
– Utility maximization is the process of obtaining the highest
possible level of utility from the consumption or use of goods and
services.
• The primary goal of a business is really no different, in
principle, than that of any consumer. The working
presumption for business firms is that they seek to
maximize profit.
• Profit maximization is the process of obtaining the
highest possible level of profit through the production
and sale of goods and services.
Profit & Maximization
• The guiding principle that prompts business firms to do
what business firms do is profit maximization:
– Profit maximization is the process of obtaining the highest
possible level of profit through the production and sale of goods
and services.
• The notion of profit.
– Profit is the difference between the total revenue a firm receives
from producing and selling output and the total cost of producing
that output.
• Profit is also known in many business circles by the
terms net revenue, net income, and net earnings.
Real World Firms
• Four alternative objectives:
– Sales Maximization
• Some firms might try to maximize their sales, either in terms of quantity or
revenue, rather than to maximize profit.
– Owner Utility
• The owners or entrepreneurs of a firm seek to maximize profit because this
generates income that can be used to acquire wants-and-needs satisfying
goods and services.
– Employee Utility
• A firm's profit might also be sacrificed to enhance the utility of employees.
– Social Responsibility
• A firm might be motivated to forego profit in the pursuit of a "better" society.
Natural Selection
• If real world firms DON'T seek to maximize profit, then
why do pointy-headed economists assume that firms DO
seek to maximize profit when analyzing firm behavior?
• The answer lies with the concept of natural selection.
• Natural selection is the notion that firms best suited to
the economic environment on the ones that tend to
survive.
• It's probably true that individual firms do not consciously
try to maximize profit.
• But it's also true that decisions the surviving firms make
end up with the same results as if the firms DID
consciously try to maximize profit.
Three Types
• Three legal types of business:
– Proprietorship A proprietorship is a firm owned and operated by
a single person. For a proprietorship the owner IS the firm.
– Partnership A partnership is a firm owned and operated, more or
less equally, by a two or more people. The primary difference
between a partnership and a proprietorship is the number of
owners.
– Corporation A corporation is a firm with distinct legal entity, which
exists separately from the owners. A corporation can have any
number of owners, some have millions of owners.
Proprietorship
• A proprietorship:.
– A proprietorship is a firm owned and operated by a single
person. The proprietor/owner often provides a sizeable share of
the resources, especially labor and capital.
• Let's consider some of the pros and cons of a
proprietorship:
– Advantages: On the plus side of the ledger account, the owner of
a proprietorship is TOTALLY in charge. The owner decides what
to do, how to do, and more often than not actually does the work.
– Disadvantages: The primary entry on the negative side of the
ledger account is unlimited liability.
Partnership
• A partnership:
– A partnership is a firm owned and operated, more or less equally,
by a two or more people. Each partner shares in the ownership,
operation, rewards, and costs of the firm.
• Let's consider the pluses and minuses of a partnership.
– Advantages: On the pro side, multiple owners increase the
amount of capital that can be accumulated.
– Disadvantages: The primary con of a partnership, like that of
proprietorship, is unlimited liability.
Corporation
• A corporation:
– A corporation is a firm this is a distinct legal entity that exists
separately from its owners. A corporation issues ownership
shares reflecting the extent of ownership interest and of liability.
A corporation is considered a distinct legal entity apart from the
owners.
• Let's consider the good and bad of corporations.
• Advantages:
– The good that makes corporation stand head and shoulders
above proprietorship and partnership is limited liability.
• Disadvantages:
– The bad of a corporation, especially when it has millions of
owners, is the separation of ownership and control.
Other Options
• Attempts have been made to do just that with three
modern variations of the original three:
• Limited Partnership
– A limited partnership is a partnership in which one or more of the
partners have limited liability.
• S Corporation
– An "S" corporation is a corporation that has elected to be taxed
under Chapter S of the Internal Revenue Service tax code.
• Limited Liability Company
– One of the newest types of firms is a limited liability company
which is essentially a partnership in which the owners have
limited liability.
Liability
• Unlimited Liability
– Proprietorships and partnerships are characterized by unlimited
liability.
– Unlimited liability is the condition in which owners are personally
held responsible for any and all debts created by a business.
• Limited Liability
– Limited liability is the condition in which owners are not
personally held responsible for the debts of by a firm.
Legal Types
• Let's see what these numbers can tell
us about firms in the economy.
• The most striking bit of information is
that the overwhelming majority of firms
in the economy are proprietorships.
• These proprietorships, however, tend
to be small operations. Proprietorships
account for only 5% of the total sales.
• While corporations constitute only
20% of the firms in the economy, they
account for a whopping 89% of total
sales.
• When you encounter a firm, the odds
are it's a proprietorship.
• Nothing particular remarkable can be
noted about
A Definition
•
A break down of the legal firm types for
different industries:
– While proprietorships dominant
almost all types of production,
except for finance, they tend to be
most predominant in construction,
transportation, trade, and services.
– Moreover, should you encounter a
proprietorship the chances are
very good that person will be
working in the service industry.
– Partnerships tend to surface in
finance, agriculture, and mining.
– Corporations constitute about 20%
of all firms in the economy.
However, they tend to make up
relatively larger shares of the
manufacturing, trade, and finance
industries.
Market Structures
•
Highlights of four market structures.
– Perfect Competition
• Perfect competition is a market with a large number or relatively small firms that sell
virtually identical products and that have ease of movement into and out of the
market.
– Monopoly
• Monopoly is a market with a single seller of a good with virtually no close
substitutes.
– Monopolistic Competition
• Monopolistic competition is a market with a large number or relatively small firms
that sell similar but not identical products and that have ease of movement into and
out of the market.
– Oligopoly
•
Oligopoly is a market with a small number or relatively large firms.
Business Sector
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The business sector:
The business sector is the basic macroeconomic
sector containing the private, profit-seeking firms in
the economy that combine scarce resources into
the production of goods and services.
The business sector includes all of the productive
business firms in the economy.
This collective of business firms is one of four
aggregate sectors used in the macroeconomic
analysis of the economy.
The key function of the business sector is to
produce the goods and •The
services.
Production
Making Stuff
• The definition of production:
• Production is the general process of combining
resources (inputs) into more valuable goods and
services (outputs).
• The production activities of business firms is a critical
component of market supply.
• How much firms are willing to sell at various prices
depends on the cost of producing the goods.
Two Inputs: Fixed & Variable
• Two different types of inputs -- fixed and variable.
– A fixed input is an input used in the production of goods and
services that does not change in the time period of the analysis.
– A variable input is an input used in the production of goods and
services that does change in the time period of the analysis.
• For short-run production, the quantity of variable inputs
used in production can be changed, but the quantity of
fixed inputs can not.
• Fixed and variable inputs are closely connected to the
time period of analysis.
Short Run & Long Run
• The two key time production periods.
• The short run is a production time period in which at
least one input is variable and at least one input is fixed.
– The key is that firms produce and supply output on a day-to-day
basis by adding variable inputs to fixed inputs.
• The long run is a production time period in which all
inputs are variable.
– The long run is a period long enough to alter the quantities of
ALL inputs, especially changing the amount of capital or the size
of a factory.
Two More Runs
• A couple of other time periods can also come into play
for assorted firms:
• Market Period:
– The market period is a time in which at all inputs in the
production process are fixed, meaning the quantity of output
itself is fixed.
• Very Long Run:
– The very long run is a time in which all inputs in the production
process are variable and the technology and assorted social
institutions affecting production can change.
Total Product
• A definition: total product.
• Total product is the total
quantity of output produced by
a firm for a range of different
variable input quantities.
• Total product is simply the total
amount of output produced in a
given period.
• In the short run, total product is
relation between total output
and the quantity of the variable
input.
• The Pretzel Haven's hourly
production of pretzels is
presented in this table.
Average Product
• A definition of average product:
• Average product is the quantity of total
output produced by a firm per unit of a
variable input.
• Average product is simple the average
amount of output produced per worker.
• Here's a formula for calculating
average product from total product:
• average product (AP)= total product
variable input
Marginal Product
• A definition of marginal product:
• Marginal product is the change in the
quantity of total product resulting from a
unit change in a variable input, keeping all
other inputs unchanged.
• Marginal product shows how much total
product changes when one additional
worker is added to the product process.
• It is found by dividing the change in total
product by the change in the variable input
and is calculated using this formula:
marginal product (MP)=
change in total product
change in variable input
The Law
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THE fundamental principle of short-run
production illustrated by these marginal
product numbers is the law of diminishing
marginal returns.
The law of diminishing marginal returns is
a principle stating that as more and more
of a variable input is added to a fixed
input, the marginal product of the variable
input eventually declines.
Two types of marginal returns are actually
illustrated here.
– Increasing Marginal Returns.
– Decreasing Marginal Returns.
Total Product Curve
• The total product curve.
• The total product curve that
graphically represents the
relation between total
production by a firm in the
short run and the quantity of
a variable input added to a
fixed input.
Average Product Curve
• The average product curve:
• The average product curve is a
curve that graphically illustrates
the relation between average
product and the quantity of the
variable input, holding all other
inputs fixed.
Marginal Product Curve
• The marginal product
curve:
• The marginal product
curve graphically
illustrates the relation
between marginal
product and the quantity
of the variable input,
holding all other inputs
fixed.
•
The
Law
Again
How total, average, and marginal
product react to changes in the
variable input is determined by the
law of diminishing marginal returns:
MP curve
– Note the "hump-shape" of the
curve, with increasing marginal
product followed by decreasing
then negative marginal product.
– The negatively-sloped portion of
the curve is due to the law of
diminishing marginal returns.
•
TP curve
– Note that marginal product is the
slope of the TP curve.
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AP curve
– Marginal product and average
product are related by the averagemarginal rule, which applies to the
averages and marginals for any
given variable.
Production Stages
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The pattern of production exhibited by the
total, average, and marginal product curves
gives rise to three distinct production
stages:
Stage I:
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Stage II:
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The total product curve has an increasing
positive slope.
Stage I is characterized by increasing
marginal returns.
The total product curve has a decreasing
positive slope.
Stage II is characterized by decreasing
marginal returns.
Stage III:
–
–
•Theapattern
of production
The total product curve has
negative
slope.
Stage III is also characterized by decreasing
marginal returns.
Making Plans
• An important notion:
• Most firms operate in the short run and long run
simultaneously.
• Firms engage in day-to-day production activities -combining inputs to produce output guided by short-run
production principles, especially the law of diminishing
marginal returns.
• However, at the same time they are making plans to
change any fixed inputs, plans that take time to
implement.
• For this reason, the long run is often termed the planning
period or planning horizon.
Return To Scale
• The key principle guiding long-run production is returns
to scale.
• Returns to scale are the changes in production that
results when all resources are change proportionally in
the long run.
• Firms typically operate in one of three returns to scale
alternatives:
– Increasing returns to scale
– Decreasing returns to scale
– Constant returns to scale
Increasing Return to Scales
• Increasing returns to scale:
• Increasing returns to scale result when a given
proportional increase in all inputs results in a greater
than proportional increase in production.
• Three primary reasons why long-run production
experiences increasing returns to scale:
– Resource Specialization
– Support Activities
– Volume and Area
Decreasing Returns to Scale
• Decreasing returns to scale:
• Decreasing returns to scale result when a given
proportional increase in all inputs results in a less than
proportional increase in production.
• Two notable reasons why long-run production
experiences decreasing returns to scale:
– Management Control
– Fixed External Inputs
Constant Returns To Scale
• Constant returns to scale:
• Constant returns to scale result when a given
proportional increase in all inputs results in a
proportional increase in production.
• The scale of production in which increasing returns to
scale are balanced by decreasing returns to scale is
termed the minimum efficient scale.
• It is the production scale in which a firm is taking
greatest advantage of increasing returns without overly
suffering from decreasing returns.
A Review
• A review:
• Production:
– Each production operation, for example, combines assorted
labor, capital, and land inputs (through the organization of risktaking entrepreneurship) to produce valuable goods and
services.
• Short-run Production:
– Each production operation, regardless of whimsical name, is
guided by the basic short-production principle -- the law of
diminishing marginal returns.
• Long-run Production:
– Each production operation also engages in long-run planning
even while it is engaged in short-run production.
Costs
Opportunity Cost
• The notion of opportunity cost:
• Opportunity cost is the highest valued alternative
foregone in the pursuit of an activity.
• Two key types of opportunity cost encountered in
production are:
– Explicit opportunity cost, which is an opportunity cost that
involves an out-of-pocket payment.
– Implicit opportunity cost, which is an opportunity cost that does
not involve an out-of-pocket payment.
Cost Times Two
• Two types of cost:
– Accounting cost is the actual outlays or expenses incurred in
production that show up in a firm's records or accounting
statements.
– Unfortunately, accounting cost may or may not be compensation
for opportunity cost.
• This gives rise to a second notion of cost, the one that is
most important for the study of economics, economic
cost.
– Economic cost is the highest valued alternative foregone in the
pursuit of an activity.
– Economic cost IS opportunity cost.
Profit Times Three
• The general notion of profit:
• Profit, in general, is the difference between the revenue
received by a firm and the cost incurred in production.
• Accounting Profit
– Accounting profit is the difference between the revenue received
by a firm and the accounting cost incurred in production.
Economic Profit
• Economic profit is the difference between the revenue
received by a firm and the total economic cost incurred
in production.
• Normal Profit
– Normal profit is the opportunity cost of using entrepreneurship in
the production of output.
Fixed & Variable
• The comprehensive measure of the total cost of
production is total cost.
– Total cost is the total opportunity cost incurred by all of the
factors of production used by a firm to produce output.
– Because short-run production involves variable and fixed inputs,
it's useful to separate total cost into total fixed cost and total
variable cost.
• Total fixed cost is the total opportunity cost of production
that DOES NOT change (or vary) with changes in the
quantity of output produced by a firm in the short run.
• Total variable cost is the total opportunity cost of
production that changes (or varies) with changes in the
quantity of output produced by a firm in the short run.
A Table of Totals
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A quick overview of this table.
First, to keep our discussion simple, the quantity
values presented in the table are the number
units of a good produced each minute.
Second, the second column presents total fixed
cost (TFC), which is $3.00 per minute.
Third, the third column presents total variable
cost (TVC), which ranges from a low of $0 to a
high of $43.00.
Fourth, the fourth column is total cost (TC), which
is the sum of TFC and TVC.
These three total cost measures lay an important
foundation for the study of short-run production.
Total Curves
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The graphs of the three total cost
relations important to the study of shortrun production:
Total Fixed Cost Curve: The total fixed
cost (TFC) curve is a horizontal line,
which is horizontal at the value of total
fixed cost.
Total Variable Cost Curve: The total
variable cost (TVC) curve is a positivelysloped line.
Total Cost Curve: The shape of the TC
curve is identical to that of the TVC.
TP & TVC
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Notes about the total variable cost curve and the total product curve:
First, the total product curve is the relation between a variable input and total
product, which is the quantity of output.
Second, the total variable cost curve is the relation between the variable cost of
production and the quantity of output, which is total product.
Third, variable cost are the cost that change with the quantity of output, and the
quantity of output changes by changing variable inputs.
Fourth, the total product curve is the relation between output quantity and the
QUANTITY of variable inputs, whereas the total variable cost curve is the relation
between the quantity of output and the COST of variable inputs.
Note that the shape of the TVC curve, is the same as the TP curve.
Three Averages
• The average total cost:
– Average total cost is per unit total cost found by dividing total
cost by the quantity of output produced.
• The second average cost item is average fixed cost:
– Average fixed cost is per unit total fixed cost found by dividing
total fixed cost by the quantity of output produced.
• The third average cost item is average variable cost:
– Average variable cost is per unit total variable cost found by
dividing total variable cost by the quantity of output produced.
A Definition
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This table presents the three total
cost measures used to calculated
the three corresponding averages.
First, note that the quantity values
presented in the table are the
number of units produced each
minute.
Second, the second column
presents total fixed cost (TFC),
which is constant at $3.00.
This
Third, the third column
presents
total variable cost (TVC), which
rises from a low of $0 to a high of
$43.00.
Fourth, the fourth column is total
cost (TC), which rises from $3.00
to $46.00.
Average Costs
• The "U-shaped Cost Curves."
• Three distinctive lines:
• Average Fixed Cost: The first line is
the average fixed cost curve (AFC)
• Average Variable Cost: The lower
of the two U-shaped curves is the
average variable cost curve (AVC)
• Average Total Cost: The upper of
the two U-shaped curves is the
average total cost curve (ATC).
One Marginal
• Marginal cost:
– Marginal cost is the change in total cost resulting from a change
in the quantity of output produced by a firm in the short run.
– Marginal cost is also defined based on total variable cost.
– Marginal cost is the change in total variable cost resulting from a
change in the quantity of output produced by a firm in the short
run.
A Marginal Table
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The table presents total cost (TC) and total
variable cost (TVC) data to examine the
calculation of marginal cost.
Note that:
– MC begins with a high value of $5 for the
first unit produced, declines to a low of
$1.50 for the fourth and fifth units, then
rises again until reaching $12 for the
tenth unit.
– The decrease-increase, U-shaped
•The table presents total cost (
pattern of MC is an extremely important
aspect of both marginal cost and shortrun production.
– MC values increase after the fifth unit for
one simple reason -- the law of
diminishing marginal returns.
Marginal Curve
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Highlights of the marginal cost curve (MC).
First, the MC curve is U-shaped, much like
the ATC and AVC curves.
Second, the negatively-sloped segment of
the MC curve is due to increasing marginal
returns. The positively-sloped segment is
due to decreasing marginal returns.
Third, note the relation between the MC
curve and the two U-shaped average curves
(AVC and ATC). The connection between
MC and each average curve is governed by
the average-marginal relation.
Long Run
• The notion of the long run.
• The long run is a period in which all inputs are variable.
• Long-run production is guided by a different set of
principles -- returns to scale. To review:
• Returns to scale are the changes in production that
results when all resources are change proportionally in
the long run.Returns to scale can be:
– Increasing returns to scale
– Decreasing returns to scale
– Constant returns to scale
A Choice of Plants
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Deciding on the correct factory size.
We simply need to select the factory
size with the lowest average total
cost.
However, which factory size I select
depends on the quantity of output I
plan to produce.
The segments of each short-run ATC
curve that would be relevant for the
alternative production levels is a line
that goes by the official name longrun average cost curve (LRAC).
The long-run average cost curve is
the minimum short-run average total
cost incurred at a given output
quantity in the long run when all
inputs are variable.
Long Run Average Cost Curve
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By adding more factory sizes, two
things happen:
The range of production in which a
given factory has the lowest short-run
average total cost declines.
The long-run average cost curve
becomes smoother and less jagged.
Our suppositions are correct.
The long-run average cost curve is
the minimum short-run average total
cost incurred at a given output
quantity in the long run when all
inputs are variable. It is the envelope
of short-run average total cost
curves.
Scale of Economies
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Economies of Scale:
Economies of scale are declining longrun average cost that occur as a firm
increases all inputs and expands its'
scale of production.
Diseconomies of Scale:
Diseconomies of scale are increasing
long-run average cost that occur as a
firm increases all inputs and expands its'
scale of production.
Minimum Efficient Scale:
Minimum efficient scale is the quantity of
production that places a firm at the
lowest point on its long-run average cost
curve.
Production Stages
•
The connection between short-run
production and short-run cost
creates an important role for the
three stages of production. Recall
that:
– Stage I: Total product and
marginal product both
increase, and marginal product
is positive.
– Stage II: Total product
increases, but marginal
product decreases, and
marginal product is positive.
– Stage III: Total product and
marginal product both
decrease, and marginal
product is negative.
– Most important of all, the law
of diminishing marginal returns
sets in with the start of Stage II
Marginal Cost
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Review the law of supply:
The law of supply states that a direct
relation exists between supply price
and the quantity supplied, ceteris
paribus.
Important considerations are
competition and market structure.
The selling side of markets tend to
come in one of four varieties:
– Perfect Competition
– Monopoly
– Monopolistic Competition
– Oligopoly
The more control a firm has over the
price, the less likely it is to be guided by
the marginal cost curve when deciding
on the quantity to supply.
Perfect Competition
A Perfect Market
• Perfect competition:
– Perfect competition is a market structure characterized by a
large number of relatively small firms, each producing the same
product, with freedom of entry and exit, and complete knowledge
of prices and technology.
• The definition of market structure:
– A market structure is the configuration of a market or industry,
especially in terms of the number of firms in the market and the
competitiveness of each firm.
• Perfect competition is THE idealized "benchmark" which
is used as a measuring stick to evaluate the efficiency of
these other three market structures.
Characteristics
• The four characteristics of perfect
competition are:
– A large number of relatively small
firms.
– Identical products supplied by each
firm.
– Perfect resource mobility.
•The fourof prices and
– Perfect knowledge
technology.
Revenue
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Each firm in a perfectly competitive
market has no market control and is a
price taker.
A price taker is a firm that takes, or
accepts, the going market price and has
no ability to control it or to charge a
different price.
Because a perfectly competitive firm is
such a small part of the overall market, it
has no choice but to sell output at the
going market price:
– There is no WAY to sell output
ABOVE the going market
price.
•Each firm in a
– There's no REASON to sell output
BELOW the going market price.
Profit Maximization
• Whether firms are big or little, a large part of their market
or a small part, they are generally motivated by the
pursuit of profit maximization.
• Profit maximization is the process of obtaining the
highest possible level of profit through the production
and sale of goods and services.
• Like any firm, a perfectly competitive firm makes
decisions that generate the greatest difference between
total revenue and total cost.
Revenue Side
• Understanding the revenue side of perfect competition
involves three related revenue measures:
• total revenue.
– Total revenue is the revenue received by a firm from the sale of
output, calculated as the price times quantity.
• Consider the definition of average revenue.
– Average revenue is the revenue received by a firm per unit of
output sold, which can be calculated as total revenue divided by
quantity.
• The third revenue concept is marginal revenue.
– Marginal revenue is the addition to total revenue resulting from
the sale of additional output, which is calculated as the change in
total revenue divided by the change in output.
Revenue Numbers
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The revenue side of a typical perfectly
competitive firm is presented in this table.
Quantity (Q): The quantity of output
produced by the firm, presented in the
first column, ranges from 0 to 10 units.
Price (P): The second column presents
the price received by the firm. This is the
market price.
Total Revenue (TR): The firm's total
revenue is presented in the third column.
Average Revenue (AR): The fourth
column presents average revenue, which
is total revenue per unit of output, or total
revenue divided by the quantity.
Marginal Revenue (MR): The fifth column
presents marginal revenue, the change in
total revenue divided by the change in
quantity.
The Cost Side
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Numbers illustrating the cost side of a perfectly
competitive firm is presented in this table.
Typical Numbers: First, note that the cost of producing
output by a perfectly competitive firm is comparable to
that for any firm.
Quantity (Q): The quantity produced by the firm is
presented in the first column.
Total Cost (TC): The total cost of production is
presented in the second column.
Marginal Cost (MC): The change in total cost for a
given change in quantity, marginal cost, is presented in
the third column.
Any Averages? This table does not display any of the
average cost values (average total cost, average
variable cost, or average fixed cost).
Comparing Totals
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This table presents the necessary
total revenue and total cost values.
Quantity (Q): The first column, once
again, presents the quantity of output
produced.
Total Revenue (TR): The second
column presents total revenue.
Total Cost (TC): The third column
presents the total cost incurred by the
firm in the production of this output.
Profit is calculated as the difference
between total revenue and total cost.
Comparing Marginals
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•
A look at the numbers: Our focus at
this point, however is on marginal
revenue and marginal cost:
– Marginal Revenue (MR): The
third column displays marginal
revenue, which is a constant at
the $4 per unit at every
quantity of output. The price is
fixed and so too is marginal
revenue.
– Marginal Cost (MC): The fifth
look at the
column presents the•A marginal
cost the firm incurs in the short
run for the production of units.
The analysis of total revenue
indicates that the profit-maximizing
production is 7 units, which
generates a profit of $7.
Total Curves
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Total Revenue: The first curve to note is the
total revenue curve, labeled TR. The
reason is that it is a straight line.
Total Cost: The second curve is the total
cost curve, labeled TC.
The shape of the total cost curve reflects
the principles of short-run production.
Profit is the difference between total
revenue and total cost, which is visually
seen as the vertical distance between the
two curves.
The breakeven output.
Breakeven output is the quantity of output
in which the total revenue is equal to total
cost such that a firm earns exactly a normal
profit, but receives no economic profit nor
incurs an economic loss.
Profit Curve
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The profit curve.
A profit curve is the graphical
representation of the relation between a
firm's profit and the quantity of output
produced.
Notes:
– Breakeven output occurs at the
quantities where economic profit is
zero.
– Profit maximization occurs at the
quantity of output where the profit
curve reaches it's peak. This quantity
is 8 units.
Margianl Curve
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The logic behind using marginals to
identify profit maximization.
Marginal revenue indicates how much
total revenue changes by producing one
more or one less unit of output.
Marginal cost indicates how much total
cost changes by producing one more or
one less unit of output.
Profit increases if marginal revenue is
greater than marginal cost and profit
decreases if marginal revenue is less than
marginal cost.
Profit neither increases nor decreases if
marginal revenue is equal to marginal
cost.
As such, the production level that equates
marginal revenue and marginal cost is
profit maximization.
Dividing Revenue
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A diagram can help us identify the firm's
division of revenue.
Total Revenue: First, the MR curve is also
average revenue and the product price, $4
per unit. This total revenue can be graphically
highlighted as the rectangle bounded by the
vertical and horizontal axes on the left and
bottom, the MR curve on the top, and the
vertical line connecting the MR-MC
intersection point with the quantity axis on the
right.
Total Cost: Total cost can be graphically
highlighted as the rectangle bounded by the
vertical and horizontal axes on the left and
bottom, the horizontal line indicating $3.00
average total cost on the top, and the vertical
line connecting the MR-MC intersection point
with the quantity axis on the right.
Profit: The difference between the total
revenue area and the total cost area is
economic profit. This is the smaller rectangle
near the top of the total revenue are.
Short Run Alternatives
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The three alternatives for short-run production facing a
perfectly competitive firm are:
P > ATC: Total revenue exceeds total cost and the firm
receives a positive economic profit. In this case, a firm
maximizes profit by producing the quantity of output
that equates marginal revenue and marginal cost.
ATC < P > AVC: Total revenue falls short of total cost,
meaning the firm incurs an economic loss (or negative
economic profit). In spite of the loss, because the
price exceeds average variable cost, the firm can
maximize profit (minimize loss) by producing the
quantity of output that equates marginal revenue and
marginal cost.
P < AVC: Total revenue also falls short of total cost,
and the firm incurs an economic loss (or negative
economic profit). In this case the firm maximizes profit
(that is, minimizes loss) by reducing the quantity of
output to zero.
Short Run Supply
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The short-run supply curve:
A perfectly competitive firm's short run
supply curve is that segment of it's
marginal cost curve that above lies above
the average variable cost curve.
Three key points:
– A profit-maximizing firm produces
the quantity of output that equates
marginal revenue and marginal cost
(MR = MC).
– A perfectly competitive firm is
characterized by the equality
between price and marginal revenue
(P = MR).
– The law of diminishing marginal
returns means that the marginal cost
curve has a positive slope.
Long Run Marginal Cost
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The firm's long-run marginal cost:
Long-run marginal cost is the change in
total cost resulting from a change in the
quantity of output produced by a firm in the
long run.
The primary difference between the long
run and short run is what constitutes cost.
– In the short run, cost changes due to
changes in variable inputs such as
labor and materials. In the long run,
cost changes due to changes in ALL
inputs, because ALL inputs are now
variable.
– Moreover, short-run
•The changes in cost
are guided by the law of diminishing
marginal returns. Long-run changes
in cost, in contrast, are guided by
returns to scale.
Adjustment
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•
Conditions to maximize profit by
adjustment plant size in the long run:
Long-Run Profit Maximization: First, the
firm maximizes its profit in the long run by
equating marginal revenue (MR) and longrun marginal cost (LRMC).
Short-Run Profit Maximization: Second,
the firm maximizes its profit in the short run
by equating marginal revenue (MR) and
short-run marginal cost (SRMC).
Marginal Cost Equality: Third, combining
the first two conditions, means that the firm
has equality between short-run marginal
cost (SRMC) and long-run marginal cost
(LRMC).
Efficient Plant Size: Fourth, the firm has
also selected the most efficient plant size
for short-run production given its long-run
scale of operations. In other words, his
short-run average total cost (SRATC) and
long-run average cost (LRAC) are also
equal.
Entry & Exit
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One of the key characteristics of
perfect competition is perfect resource
mobility.
The phrase that captures the mobility
of resources in a perfectly competitive
industry is entry and exit. It works like
this:
– New firms will enter the industry if
economic profit is positive.
– Existing firms in the industry exit if
economic profit is negative.
– Firms will neither
enter nor exit an
•One
industry if economic profit is zero
and all firms earn a normal profit.
The movement of firms into and out of
the industry guarantees one outcome - zero economic profit.
Zero economic profit is achieved when
the market price is equal to average
cost -- both short run (SRATC) and
long run (LRAC).
A Definition
• The conditions for perfect
competition:
– Profit maximization: MR =
SRMC = LRMC.
– Normal profit: P = SRATC =
LRAC.
• Let me also include the
condition that exists
•The conditions
because a firm
is perfectly
competitive:
– Perfect competition: P = MR =
AR.
Long Run Supply Curve
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•
What is the industry's long-run supply
curve?
Three types of industries and long-run
supply curves:
– Increasing-cost industry: Should
input prices rise with greater
industry-wide production, then the
average cost of production rises.
– Decreasing-cost industry: Should
input prices fall with greater
industry-wide production, then the
average cost of production falls.
– Constant-cost industry: Should
input prices remain unchanged
with greater industry-wide
production, then the average cost
of production are also constant.
Evaluation
• Economists are very fond of perfect competition. The
reason is efficiency
• Here's how perfect competition achieves efficiency.
– First, perfectly competitive firms maximize profit by producing the
quantity of output that equates marginal revenue and marginal
cost.
– Second, perfectly competitive firms produce at the minimum
point of the short-run and long-run average cost.
– Third, perfectly competitive firms earn only a normal profit,
equating price and average cost.
• Perfect competition is the ONLY market structure that
achieves efficiency.
• This is why economists use perfect competition as THE
benchmark for efficiency.
The Bad
• Unfortunately all is NOT perfect with perfect competition,
it has three key failures.
– First, perfect competition provides no incentive to innovate, grow,
and expand.
– Second, perfect competition provides no incentive nor way to
achieve differences.
– Third, perfect competition is an idealized market structure
designed to highlight the extreme possibility of perfect efficiency.
• In spite of these imperfections perfect competition
provides an invaluable tool in the study of markets,
market structures, and efficiency.
Market Control
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Market control.
Market control is the ability of a firm to control the price and/or quantity of
the good sold.
Most real world firms are not price takers. They have some degree of
market control.
What does this mean?
– First, because many firms in the real world have some degree of market
control, they have the ability to charge a price that is a little more (or a
lot more) or a little less (or a lot less) than the going market price.
– Second, real world firms with market control do not have equality
between price and marginal revenue.
– Third, the inequality between price and marginal revenue means that
profit-maximizing firms that equate marginal revenue and marginal cost
do NOT equate price and marginal cost.
– Fourth, perfect competition is most important in evaluating the degree of
inefficiency of real world firms.