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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 • • • • • 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 • • • 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. • 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 • • The pattern of production exhibited by the total, average, and marginal product curves gives rise to three distinct production stages: Stage I: – – • Stage II: – – • 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 • • • • • • 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 • • • • 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 • • • • • • 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 • • • • • 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 • • 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 • • • • 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 • • • • • 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 • • • • • 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 • • • • • • 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 • • • • • 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 • • • 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 • • • • • • 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 • • • • • • 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 • • • • • 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 • • 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 • • • • • • 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 • • • 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 • • • • • • 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 • • • • 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 • • • • 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 • • • 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 • • • 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 • • • • • 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 • • • • 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 • • 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 • • • • 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.