Unit 3: Costs of Production and Perfect Competition

Revenue = Price x Quantity Revenue and Profit 3.1 Revenue = Price x Quantity

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

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

No Economic Profit = Normal Profit Practice Assume the following: David left his job as a lawyer earning $8,000 a month to open up an ice cream shop Last month he sold 5,000 sundaes for $2 each and 8,000 cones for $1 each His rent is $1000 per month His other expenses like labor, ice cream, cones, etc. add up to $9,000 per month Last month he took a family vacation that cost $5000 Calculate David’s accounting profit Calculate David’s economic profit Should David go back to being a lawyer? What must be true for accounting profit if economic profit is zero? No Economic Profit = Normal Profit $8,000= Revenue ($18,000) minus explicit costs ($10,000). Don’t include the family vacation since it is not a business expense. $0= Revenue minus explicit costs and implicit costs ($8,000 forgone wage) Not necessarily, he makes just as much money per month with his shop as he did being a lawyer. Accounting profit must be positive when economic profit is zero

Normal Profit In an efficient competitive market, firms that have identical products will make a normal profit. They will break even and make no economic profit Traffic Analogy When there is heavy traffic, why do all lanes go the same slow speed? Cars leave slower lanes and enter faster lanes. Similarly, what happens in perfectly competitive markets if firms earn excessive profit?

Maximizing PROFIT!

Assume every unit can be sold for $10. Which unit maximizes profit? Use marginal analysis to explain why you should never produce 5 units Marginal Cost Price $12 $10 $8 $6 Marginal Revenue Quantity 1 2 3 4 5

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

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

Production = Converting inputs into output

Widget Production Simulation

Production Simulation Overview The class will be divided into two firms. There will be several rounds in which each firm will produce chains out of paper. Each round last exactly 1 minute Each firm is going to hire one more worker at the start of each round. Resources 1 stapler, 1 scissors, 1 table, and plenty of staples and paper Rules Workers cannot stockpile slips of paper. No extras Workers cannot cut more than one paper at a time Workers can only add links to one side of the chain Each link must pass inspection If links don’t meet specifications they won’t count Responsibilities The manager will hire the workers. The inspector will check to make sure each product is made to specifications

Production Simulation Step 1: Cut paper down the middle into two piece Step 2: Fold piece down the middle Step 3: Wrap ends around and staple Step 4: Add more links to one end

Fill out this chart based on your firm’s production # of Workers (Input) # of Links (Output) Marginal Product 1 2 3 4 5 6

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

Fixed vs. Variable Fixed Resources- Resources that don’t change with the quantity produced Ex: Table, scissors, and stapler Variable Resources- Resources that do change with the quantity produced Ex: Workers, paper, and staples Identify three fixed resources and three variable resources for a pizza restaurant

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

Notice that as you hire more workers the additional links each additional worker creates begins to decrease This is because of the fixed resources and the Law of Diminishing Marginal Returns

Graphing Production

Unit 3: Costs of Production and Perfect Competition 3.2

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

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

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

Remember quantity of workers goes on the x-axis. With your partner calculate MP and AP then discuss what the graphs for TP, MP, and AP look like. Remember quantity of workers goes on the x-axis. # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP) 1 10 2 25 3 45 4 60 5 70 6 75 7 8

Remember quantity of workers goes on the x-axis. With your partner calculate MP and AP then discuss what the graphs for TP, MP, and AP look like. Remember quantity of workers goes on the x-axis. # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP) - 1 10 2 25 15 3 45 20 4 60 5 70 6 75 7 8 -5

Remember quantity of workers goes on the x-axis. With your partner calculate MP and AP then discuss what the graphs for TP, MP, and AP look like. Remember quantity of workers goes on the x-axis. # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP) - 1 10 2 25 15 12.5 3 45 20 4 60 5 70 14 6 75 7 10.71 8 -5 8.75

Identify the three stages of returns Total Product(TP) PIZZAS # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP) - 1 10 2 25 15 12.5 3 45 20 4 60 5 70 14 6 75 7 10.71 8 -5 8.75

Identify the three stages of returns Total Product(TP) PIZZAS # of Workers (Input) Total Product(TP) PIZZAS Marginal Product(MP) Average Product(AP) - 1 10 2 25 15 12.5 3 45 20 4 60 5 70 14 6 75 7 10.71 8 -5 8.75

More Examples of the Law of Diminishing Marginal Returns Example #1: Learning curve when studying for an exam Fixed Resources-Amount of class time, textbook, etc. Variable Resources-Study time at home Marginal return- 1st hour-large returns 2nd hour-less returns 3rd hour-small returns 4th hour- negative returns (tired and confused) Example #2: A Farmer has fixed resource of 8 acres planted of corn. If he doesn’t clear weeds he will get 30 bushels. If he clears weeds once he will get 50 bushels. Twice -57, Thrice-60. Additional returns diminishes each time.

Tony’s Hat Store Worksheet

Unit 3: Costs of Production and Perfect Competition 3.3

Short-Run Production Costs

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

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

Definitions Fixed Costs: Variable Costs: Costs for fixed resources that DON’T change with the amount produced Ex: Rent, Insurance, Managers Salaries, etc. Average Fixed Costs = Fixed Costs Quantity Variable Costs: Costs for variable resources that DO change as more or less is produced Ex: Raw Materials, Labor, Electricity, etc. Average Variable Costs = Variable Costs Quantity

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

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

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

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

ATC and AVC get closer and closer but NEVER touch MC Costs ATC $20 $18 $16 $14 $12 $10 $8 $6 $4 $2 AVC ATC and AVC get closer and closer but NEVER touch Average Fixed Cost AFC 1 2 3 4 5 6 Quantity Copyright ACDC Leadership 2015

Calculate TC, VC, and FC of the 5th Unit MC Costs ATC $20 $18 $16 $14 $12 $10 $8 $6 $4 $2 AVC Calculate TC, VC, and FC of the 5th Unit TC= $70 VC= $60 TC = $10 AFC 1 2 3 4 5 6 Quantity

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

Practice

2008 Audit Exam 50. c

1. A C 2.

7.D

Calculating Costs Practice Fill out the chart then calculate: ATC of 6 Units AFC of 2 Units AVC of 3 Units ATC of 5 Units AVC of 2 Units AVC of 4 Units AFC of 4 Units ATC of 4 Units Output Variable Cost Fixed Total Marginal $0 $20 - 1 $12 2 $22 3 $27 4 $40 5 $60 6 $100 $20 $10 $9 $16 $11 $5

How much does the 10th unit costs? MC $30 25 20 15 10 5 ATC AVC Calculate TC, VC, and FC Total Cost=$200 Variable Cost=$150 Fixed Cost=$50 Notice that VC + FC = TC AFC 7 8 9 10 11 Quantity

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

More Practice

Additional Practice TP VC FC TC MC AVC AFC ATC 100 1 10 2 16 3 21 4 26 100 1 10 2 16 3 21 4 26 5 30 6 36 7 46

Calculating TC, VC, FC, ATC, AFC, and MC TP VC FC TC MC AVC AFC ATC 100 1 10 2 16 3 21 4 26 5 30 6 36 7 46

Calculating TC, VC, FC, ATC, AFC, and MC TP VC FC TC MC AVC AFC ATC 100 1 10 110 2 16 116 3 21 121 4 26 126 5 30 130 6 36 136 7 46 146

Per Unit Costs TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 3 21 100 - 1 10 110 2 16 116 3 21 121 4 26 126 5 30 130 6 36 136 7 46 146

Per Unit Costs TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 3 100 - 1 10 110 2 16 116 6 3 21 121 5 4 26 126 30 130 36 136 7 46 146

Per Unit Costs TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 8 100 - 1 10 110 2 16 116 6 8 3 21 121 5 7 4 26 126 6.5 30 130 36 136 46 146 6.6

Per Unit Costs TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 8 100 - 1 10 110 2 16 116 6 8 50 3 21 121 5 7 33.3 4 26 126 6.5 25 30 130 20 36 136 16.67 46 146 6.6 14.3 Asymptote

Per Unit Costs TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 8 100 - 1 10 110 2 16 116 6 8 50 58 3 21 121 5 7 33.3 40.3 4 26 126 6.5 25 31.5 30 130 20 36 136 16.67 22.67 46 146 6.6 14.3 20.9

Per Unit Costs TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 8 100 - 1 10 110 2 16 116 6 8 50 58 3 21 121 5 7 33.3 40.3 4 26 126 6.5 25 31.5 30 130 20 36 136 16.67 22.67 46 146 6.6 14.3 20.9

Calculate A-E TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 8 A 100 - 1 10 110 2 16 116 6 8 A 58 3 21 121 5 B 33.3 40.3 4 26 126 6.5 25 31.5 30 130 D E 36 136 C 16.67 22.67 7 46 146 6.6 14.3 20.9

Calculating TC, VC, FC, ATC, AFC, and MC TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 8 50 58 3 21 121 5 7 33.3 40.3 4 26 126 6.5 25 31.5 30 130 20 36 136 16.67 22.67 46 146 6.6 14.3 20.9

Calculating TC, VC, FC, ATC, AFC, and MC TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 8 50 58 3 21 121 5 7 33.3 40.3 4 26 126 6.5 25 31.5 30 130 20 36 136 16.67 22.67 46 146 6.6 14.3 20.9

Marshmallow Towers Activity https://youtu.be/Ho8lqhsF1B8 *WATCH THIS VIDEO!*

Shapes of Cost Curves

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

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

Why is the MC curve U-shaped? The MC curve falls and then rises because of diminishing marginal returns. Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost for each worker (Wage = $10) Workers Total Prod Marg Prod Total Cost Marginal Cost 1 5 2 13 3 19 4 23 25 6 26

Why is the MC curve U-shaped? The MC curve falls and then rises because of diminishing marginal returns. Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost for each worker (Wage = $10) Workers Total Prod Marg Prod Total Cost Marginal Cost - 1 5 2 13 8 3 19 6 4 23 25 26

Why is the MC curve U-shaped? The MC curve falls and then rises because of diminishing marginal returns. Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost for each worker (Wage = $10) Workers Total Prod Marg Prod Total Cost Marginal Cost - $20 1 5 $30 2 13 8 $40 3 19 6 $50 4 23 $60 25 $70 26 $80

Why is the MC curve U-shaped? The MC curve falls and then rises because of diminishing marginal returns. Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost for each worker (Wage = $10) Workers Total Prod Marg Prod Total Cost Marginal Cost - $20 1 5 $30 10/5 = $2 2 13 8 $40 10/8 = $1.25 3 19 6 $50 10/6 = $1.6 4 23 $60 10/4 = $2.5 25 $70 10/2 = $5 26 $80 10/1 = $10

Why is the MC curve U-shaped? The additional cost of the first 13 units produced falls because workers have increasing marginal returns. As production continues, each worker adds less and less to production so the marginal cost for each unit increases. Workers Total Prod Marg Prod Total Cost Marginal Cost - $20 1 5 $30 10/5 = $2 2 13 8 $40 10/8 = $1.25 3 19 6 $50 10/6 = $1.6 4 23 $60 10/4 = $2.5 25 $70 10/2 = $5 26 $80 10/1 = $10

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

2008 Audit Question 23 23. C

2010 Question 18 B

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

1. 2. E D

Shifting Cost Curves

What if Fixed Costs increase to $200 Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 8 50 58 3 21 121 5 7 33.3 30.3 4 26 126 6.5 25 31.5 30 130 20 36 136 16.67 22.67 46 146 6.6 14.3 20.9 What if Fixed Costs increase to $200

Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 100 - 1 10 110 2 16 116 6 8 50 58 3 21 121 5 7 33.3 30.3 4 26 126 6.5 25 31.5 30 130 20 36 136 16.67 22.67 46 146 6.6 14.3 20.9

Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 200 100 - 1 10 110 2 200 100 - 1 10 110 2 16 116 6 8 50 58 3 21 121 5 7 33.3 30.3 4 26 126 6.5 25 31.5 30 130 20 36 136 16.67 22.67 46 146 6.6 14.3 20.9

Which Per Unit Cost Curves Change? Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 200 - 1 10 210 100 110 2 16 216 6 8 50 58 3 21 221 5 7 33.3 30.3 4 26 226 6.5 25 31.5 30 230 20 36 236 16.67 22.67 46 246 6.6 14.3 20.9 Which Per Unit Cost Curves Change?

ONLY AFC and ATC Increase! Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 200 - 1 10 210 100 110 2 16 216 6 8 50 58 3 21 221 5 7 33.3 30.3 4 26 226 6.5 25 31.5 30 230 20 36 236 16.67 22.67 46 246 6.6 14.3 20.9 ONLY AFC and ATC Increase!

ONLY AFC and ATC Increase! Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 200 - 1 10 210 110 2 16 216 6 8 100 58 3 21 221 5 7 66.6 30.3 4 26 226 6.5 50 31.5 30 230 40 36 236 33.3 22.67 46 246 6.6 28.6 20.9 ONLY AFC and ATC Increase!

If fixed costs change ONLY AFC and ATC Change! Shifting Costs Curves If fixed costs change ONLY AFC and ATC Change! TP VC FC TC MC AVC AFC ATC 200 - 1 10 210 2 16 216 6 8 100 108 3 21 221 5 7 66.6 73.6 4 26 226 6.5 50 56.5 30 230 40 46 36 236 33.3 39.3 246 6.6 28.6 35.2 MC and AVC DON’T change!

Shift from an increase in a Fixed Cost MC ATC1 ATC AVC Costs (dollars) AFC1 AFC Quantity

Shift from an increase in a Fixed Cost MC ATC1 AVC Costs (dollars) AFC1 Quantity

What if the cost for variable resources increase Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 116 6 8 50 58 3 21 121 5 7 33.3 30.3 4 26 126 6.5 25 31.5 30 130 20 36 136 16.67 22.67 46 146 6.6 14.3 20.9 What if the cost for variable resources increase

Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16 100 - 1 10 110 2 16 116 6 8 50 58 3 21 121 5 7 33.3 30.3 4 26 126 6.5 25 31.5 30 130 20 36 136 16.67 22.67 46 146 6.6 14.3 20.9

Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 11 110 10 2 100 - 1 11 110 10 2 18 116 6 8 50 58 3 24 121 5 7 33.3 30.3 4 30 126 6.5 25 31.5 35 130 20 26 43 136 16.67 22.67 55 146 6.6 14.3 20.9

Which Per Unit Cost Curves Change? Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 11 111 10 110 2 18 118 6 8 50 58 3 24 124 5 7 33.3 30.3 4 30 130 6.5 25 31.5 35 135 20 26 43 143 16.67 22.67 55 155 6.6 14.3 20.9 Which Per Unit Cost Curves Change?

Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 11 111 10 110 100 - 1 11 111 10 110 2 18 118 7 8 50 58 3 24 124 6 33.3 30.3 4 30 130 6.5 25 31.5 5 35 135 20 26 43 143 16.67 22.67 55 155 12 6.6 14.3 20.9 MC, AVC, and ATC Change!

Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 11 111 110 2 100 - 1 11 111 110 2 18 118 7 9 50 58 3 24 124 6 8 33.3 30.3 4 30 130 7.5 25 31.5 5 35 135 20 26 43 143 7.16 16.67 22.67 55 155 12 7.8 14.3 20.9 MC, AVC, and ATC Change!

If variable costs change MC, AVC, and ATC Change! Shifting Costs Curves If variable costs change MC, AVC, and ATC Change! TP VC FC TC MC AVC AFC ATC 100 - 1 11 111 2 18 118 7 9 50 59 3 24 124 6 8 33.3 41.3 4 30 130 7.5 25 32.5 5 35 135 20 27 43 143 7.16 16.67 23.83 55 155 12 7.8 14.3 22.1

Shift from an increase in a Variable Costs MC1 MC ATC1 AVC1 ATC AVC Costs (dollars) AFC Quantity

Shift from an increase in a Variable Costs MC1 ATC1 AVC1 Costs (dollars) AFC Quantity

Long-Run Costs

2010 Question 19

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

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

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

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

Long Run AVERAGE Total Cost Costs MC1 ATC1 $9,900,000 $50,000 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars

Long Run AVERAGE Total Cost Economies of Scale- Long Run Average Cost falls because mass production techniques are used. Costs MC1 ATC1 MC2 $9,900,000 ATC2 $50,000 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars

Long Run AVERAGE Total Cost Economies of Scale- Long Run Average Cost falls because mass production techniques are used. Costs MC1 ATC1 MC2 $9,900,000 MC3 ATC2 $50,000 ATC3 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars

Long Run AVERAGE Total Cost Constant Returns to Scale- The long-run average total cost is as low as it can get. Costs MC1 ATC1 MC2 $9,900,000 MC3 MC4 ATC2 $50,000 ATC3 ATC4 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars

Long Run AVERAGE Total Cost Diseconomies of Scale- Long run average costs increase as the firm gets too big and difficult to manage. Costs MC1 ATC1 MC2 $9,900,000 MC5 MC3 ATC5 MC4 ATC2 $50,000 ATC3 ATC4 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars

Long Run AVERAGE Total Cost These are all short run average costs curves. Where is the Long Run Average Cost Curve? Costs MC1 ATC1 MC2 $9,900,000 MC5 MC3 ATC5 MC4 ATC2 $50,000 ATC3 ATC4 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars

Long Run AVERAGE Total Cost Costs Economies of Scale Constant Returns to Scale Diseconomies of Scale Long Run Average Cost Curve 0 1 100 1,000 100,000 1,000,0000 Quantity Cars

Constant Returns to Scale Long Run Average Cost Curve LRATC Simplified The law of diminishing marginal returns doesn’t apply in the long run because there are no FIXED RESOURCES. Costs Economies of Scale Constant Returns to Scale Diseconomies of Scale Long Run Average Cost Curve Quantity

Unit 3: Costs of Production and Perfect Competition

4 Market Structures Candy Markets Simulation https://youtu.be/KGrmnynjHjI WATCH THIS VIDEO *see folder activities and simulation*

Four Market Structures Perfect Competition Monopolistic Competition Monopoly Oligopoly Every product is sold in a market that can be considered one of the above market structures. For example: Fast Food Market Cars Manufactures Market for Operating Systems (Microsoft) Strawberry Market Cereal Market Monopolistic Competition (differentiated products) Oligopoly Monopoly Perfect Competition Oligopoly (3 main producers)

Four Market Structures Perfect Competition Monopolistic Competition Monopoly Oligopoly Imperfect Competition Characteristics of Perfect Competition: Examples: Corn, Strawberries, Milk, etc. Many small firms Identical products (perfect substitutes) Low Barriers- Easy for firms to enter and exit the industry Seller has no need to advertise Firms are “Price Takers” The seller has NO control over price.

Four Market Structures Perfect Competition Monopolistic Competition Monopoly Oligopoly Characteristics of Monopoly: Examples: The Electric Company, De Beers, One large firm (the firm is the market) Unique product (no close substitutes) High Barriers- Firms cannot enter the industry Monopolies are “Price Makers”

Barriers to Entry Types of Barriers to Entry 1. Economies of Scale A monopoly wouldn’t last long if there were not high barriers to keep other firms from entering. Types of Barriers to Entry 1. Economies of Scale Ex: There is only one electric company because they are the only ones that can make electricity ay the lowest cost. This is a “natural monopoly” 2. Superior Technology 3. Geography or Ownership of Raw Materials 4. Government Created Barriers The government issues patents to protect inventors and forbids others from using their invention

Four Market Structures Characteristics of Oligopolies: Perfect Competition Monopolistic Competition Monopoly Oligopoly Characteristics of Oligopolies: Examples: Cell Phones, Service Providers, Cars A Few Large Producers (Less than 10) Identical or Differentiated Products High Barriers to Entry Control Over Price (Price Maker) Mutual Interdependence Firms must worry about the decisions of their competitors and use strategy

Four Market Structures Perfect Competition Monopolistic Competition Monopoly Oligopoly Characteristics of Mono. Comp: Examples: Fast food, furniture, shoe stores Relatively Large Number of Sellers Differentiated Products Some control over price Low Barriers- easy for firms to enter A lot of non-price competition (Advertising)

Perfect Competition

Imperfect Competition The seller has NO control over price. FOUR MARKET STRUCTURES Perfect Competition Monopolistic Competition Monopoly Oligopoly Imperfect Competition Characteristics of Perfect Competition: Examples: Corn, Strawberries, Milk, etc. Many small firms Identical products (perfect substitutes) Low Barriers- Easy for firms to enter and exit the industry Seller has no need to advertise Firms are “Price Takers” The seller has NO control over price.

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

The Competitive Firm is a Price Taker Price is set by the Industry (all firms) Firm P S P Demand $10 $10 D Q 5000 Q

The Competitive Firm is a Price Taker Price is set by the Industry What is the additional revenue for selling an additional unit? 1st unit earns $10 2nd unit earns $10 Marginal revenue is constant at $10 Notice: Total revenue increases at a constant rate MR equal Average Revenue Firm P Demand $10 MR=D=AR=P Q

For Perfect Competition: Demand = MR (Marginal Revenue) The Competitive Firm is a Price Taker Price is set by the Industry What is the additional revenue for selling an additional unit? 1st unit earns $10 2nd unit earns $10 Marginal revenue is constant at $10 Notice: Total revenue increases at a constant rate MR equal Average Revenue Firm P Demand $10 MR=D=AR=P Q

Maximizing PROFIT!

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

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

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

How much output should be produced? How much is Total Revenue? How much is Total Cost? Is there profit or loss? How much? P $9 8 7 6 5 4 3 2 1 MC MR=D=AR=P Profit = $18 ATC Total Cost=$45 Total Revenue =$63 Q 1 2 3 4 5 6 7 8 9 10

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

How much output should be produced? How much is Total Revenue? How much is Total Cost? Is there profit or loss? How much? MC $9 8 7 6 5 4 3 2 1 ATC Cost and Revenue Loss =$7 MR=D=AR=P Total Cost = $42 Total Revenue=$35 Q 1 2 3 4 5 6 7 8 9 10

The Shut Down Rule

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

Minimum AVC is shut down point SHUT DOWN! Produce Zero Price MC $9 8 7 6 5 4 3 2 1 ATC AVC Minimum AVC is shut down point Q 1 2 3 4 5 6 7 8 9 10

P<AVC. They should shut down Producing nothing is cheaper than staying open. Price MC $9 8 7 6 5 4 3 2 1 ATC Fixed Costs=$10 AVC TC=$35 MR=D=AR=P TR=$20 Q 1 2 3 4 5 6 7 8 9 10

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

Practice

#1 MC MR=D=AR= P ATC Quantity $16 15 10 9 14 5 1. Should the firm produce? 2. What output should the firm produce? 3. What is the TR and TC at that output? 4. How much profit or loss? Yes 10 TR=$140 TC=$100 $16 15 10 9 5 Profit=$40 Price MC MR=D=AR= P 14 ATC Quantity 3 7 10 12

#2 MC ATC AVC MR=D=AR=P Quantity 24 20 12 18 15 What output should the firm produce? What is TR at that output? What is TC? How much profit or loss? 6 $90 $120 Loss= $30 24 20 12 Price MC ATC 18 AVC 15 MR=D=AR=P Quantity 3 6 8 10

#3 MC ATC AVC MR=D=AR=P Quantity $12 10 11 9 1. What output should the firm produce? 2. What is TR at MR=MC point? 3. What is TC at MR=MC point? 4. How much profit or loss? Zero Shutdown (Price below AVC) $45 $55 Loss=Only Fixed Cost $5 $12 10 Price MC ATC AVC 11 9 MR=D=AR=P Quantity 5 6 7 8

#4 MC MR=D=AR= P ATC Quantity $12 11 6 5 10 3 1. Should the firm produce? 2. What output should the firm produce? 3. What is the TR and TC at that output? 4. How much profit or loss? Yes 10 TR=$100 TC=$60 $12 11 6 5 3 Profit=$40 Price MC MR=D=AR= P 10 ATC Quantity 3 7 10 12

B D

2007 Form B FRQ

2007 Form B FRQ

Assume the firm can sell each unit at a price of $30 Maximizing Profit Assume the firm can sell each unit at a price of $30 How many units should the firm produce to maximize profit? What is the total revenue at that quantity? How much is the profit? Output Variable Cost Fixed Total Marginal $0 $20 - 1 $12 2 $22 3 $27 4 $40 5 $60 6 $100 5 Units $150 Total Revenue ($30 x 5) $70 Profit ($150 - $80) Notice that at 6 units the firm is still making profit. It’s just not maximizing profit

Maximizing Profit Output Variable Cost Fixed Total Marginal $0 $20 - 1 $12 2 $22 3 $27 4 $40 5 $60 6 $100 TR MR Profit - $30 -$2 $60 $18 $90 $43 $120 $150 $70 $180 5 Units $150 Total Revenue ($30 x 5) $70 Profit ($150 - $80) Notice that at 6 units the firm is still making profit. It’s just not maximizing profit

2006 FRQ

2006 FRQ 149

Short-run Supply Curve

Marginal Cost and Supply As price increases, the quantity increases $50 45 40 35 30 25 20 15 10 5 MC ATC MR5 Cost and Revenue AVC MR4 MR3 MR2 MR1 Q 1 2 3 4 5 6 7 9

Short-run Supply Curve: MC above AVC Marginal Cost and Supply When price increases, quantity increases When price decrease, quantity decreases $50 45 40 35 30 25 20 15 10 5 MC = Supply Short-run Supply Curve: MC above AVC ATC Cost and Revenue AVC Q 1 2 3 4 5 6 7 9

Marginal Cost and Supply If variable costs increase (ex: per unit tax) MC2=Supply2 $50 45 40 35 30 25 20 15 10 5 MC1=Supply1 AVC Cost and Revenue AVC When MC increases, SUPPLY decrease Q 1 2 3 4 5 6 7 9

Marginal Cost and Supply What if variable costs decrease (ex: subsidy)? MC1=Supply1 $50 45 40 35 30 25 20 15 10 5 MC2=Supply2 AVC Cost and Revenue AVC When MC decreases, SUPPLY increases Q 1 2 3 4 5 6 7 9

Marginal Cost and Supply What happens to quantity if fixed costs increase? Price MC MR=D=AR= P PF ATC1 ATC Quantity stays the same because MC/Supply doesn’t change Quantity QF

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

2008 Audit Exam 18.B

Unit 3: Costs of Production and Perfect Competition

Perfect Competition

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

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

Which of the following is a correctly labeled graph for firm making economic profit? 162

#1 #3 #2 #4 ATC MC MC ATC PF MR=D MR=D Q Q QF QF MC ATC ATC MC MR=D

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

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

Where is the profit maximization point? How do you know? What output should be produced? What is TR? What is TC? How much is the profit or loss? Where is the Shutdown Point? $25 20 15 10 MC MR=P Profit ATC Cost and Revenue AVC Total Revenue Total Cost 1 2 3 4 5 6 7 8 9 10

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

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

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

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

Going from Short-Run to Long-Run

Is this the short or the long run? Why? What will firms do in the long run? What happens to P and Q in the industry? What happens to P and Q in the firm? P S P MC ATC $15 $15 MR=D D Q 5000 6000 8 Q Industry Firm

Firms enter to earn profit so supply increases in the industry Price decreases and quantity increases P S P MC S1 ATC $15 $15 MR=D $10 D Q 5000 6000 8 Q Industry Firm

Price falls for the firm because they are price takers. Price decreases and quantity decreases P S P MC S1 ATC $15 $15 MR=D $10 $10 MR1=D1 D Q 5000 6000 5 8 Q Industry Firm

New Long Run Equilibrium at $10 Price Zero Economic Profit P P MC S1 ATC $10 $10 MR1=D1 D Q 5000 6000 5 Q Industry Firm

Is this the short or the long run? Why? What will firms do in the long run? What happens to P and Q in the industry? What happens to P and Q in the firm? P S P MC ATC $15 $15 MR=D D Q 4000 5000 8 Q Industry Firm

Firms leave to avoid losses so supply decreases in the industry Price increases and quantity decreases S1 P S P MC ATC $20 $15 $15 MR=D D Q 4000 5000 8 Q Industry Firm

Price increase for the firm because they are price takers. Price increases and quantity increases S1 P S P MC ATC $20 $20 MR1=D1 $15 $15 MR=D D Q 4000 5000 8 9 Q Industry Firm

New Long Run Equilibrium at $20 Price Zero Economic Profit S1 P P MC ATC $20 $20 MR1=D1 D Q 9 4000 Q Industry Firm

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

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

Demand Increases The price increases and quantity increases Profit is made in the short-run P S P MC ATC $20 $20 MR1=D1 $15 $15 MR=D D1 D Q 5000 8 9 Q Industry Firm

Firms enter to earn profit so supply increases in the industry Price Returns to $15 P S S1 P MC ATC $20 $20 MR1=D1 $15 $15 MR=D D1 D Q 5000 8 9 7000 Q Industry Firm

Back to Long-Run Equilibrium The only thing that changed from long-run to long-run is quantity in the industry P S1 P MC ATC $15 $15 MR=D D1 D Q 7000 8 Q Industry Firm

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

Demand Decreases The price increases and quantity increases Profit is made in the short-run P S P MC ATC $15 $15 MR=D $10 $10 MR1=D1 D D1 Q 5000 7 8 Q Industry Firm

Demand Decreases The price increases and quantity increases Profit is made in the short-run S1 P S P MC ATC $15 $15 MR=D $10 $10 MR1=D1 D D1 Q 3000 5000 7 8 Q Industry Firm

Demand Decreases The price increases and quantity increases Profit is made in the short-run S1 P P MC ATC $15 $15 MR=D D1 Q 3000 8 Q Industry Firm

Practice

2012 Multiple Choice #23 Answer: D

2012 Multiple Choice #38 Answer: C

C

2010 FRQ #1

Going from Long-Run to Long-Run Increasing Cost Industry- New firms entering the market increase the costs for the firms already in the market. (Only asked once on a FRQ- 2011 Form B)

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

INCREASING COST Industry The price increases and quantity increases Profit is made in the short-run P S P MC $25 ATC $25 $15 $15 MR=D D1 D Q Q Industry Firm

Firms enter to earn profit but fight for resources causing costs to increase Price Falls to $20 P S P MC1 S1 MC ATC1 $25 ATC $25 $20 $15 $15 MR=D D1 D Q Q Industry Firm

Firms enter to earn profit but fight for resources causing costs to increase Price Falls to $20 P P MC1 S1 ATC1 $20 MR1 D1 Q Q Industry Firm

2008 Audit Exam 26. C

Unit 3: Costs of Production and Perfect Competition

Law of Demin. Marginal Returns Fixed Cost Low Barriers Price Taker NAME THAT CONCEPT Law of Demin. Marginal Returns Fixed Cost Low Barriers Price Taker MR = MC

Variable Costs Shut Down Rule MR=D=AR=P (Mr. Darp) Normal Profit NAME THAT CONCEPT Variable Costs Shut Down Rule MR=D=AR=P (Mr. Darp) Normal Profit Economies of Scale

Review Draw and label a perfectly competitive firm making a profit Draw and label a perfectly competitive firm making a loss Why is that firm considered a “price taker”? How do firms determine what output to produce? On your graph, identify the shut down point On your graph, identify the firms supply curve What happens in the industry if there is a profit? What happens in the industry if there is a loss? List 10 rides at Disneyland

Four Market Structures Perfect Competition Monopolistic Competition Monopoly Oligopoly Imperfect Competition Characteristics of Perfect Competition: Examples: Corn, Strawberries, Milk, etc. Many small firms Identical products (perfect substitutes) Low Barriers- Easy for firms to enter and exit the industry Seller has no need to advertise Firms are “Price Takers” The seller has NO control over price.

Shifting Cost Curves A change in fixed costs change ATC and AFC (but not MC) A change in variable costs change ATC, AVC, and MC

Changes in fixed costs don’t change output

Changes in variable costs change output 50. D Changes in variable costs change output

Efficiency

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

Graphically it is where price equals the minimum ATC Productive Efficiency- Producing at the lowest possible cost (minimum amount of resources are being used) Graphically it is where price equals the minimum ATC Allocative Efficiency- Producing at the amount most desired by society (allocating resources towards the products society wants) Graphically it is where price equals marginal cost

Short-Run Profit Not Productively Efficient MC MR=D=AR=P $10 ATC Notice that Q1 is NOT being made at the lowest possible cost (ATC not at lowest point). Q Q1

Short-Run Loss Not Productively Efficient MC ATC MR=D=AR=P $5 Notice that Q2 is NOT being made at the lowest possible cost (ATC not at lowest point). Q2 Q

Long-Run Equilibrium Productively Efficient in the Long-Run MC ATC $8 MR=D=AR=P In the long-run, Q2 IS being made at the lowest possible cost (ATC at lowest point) Q3 Q

Allocatively Efficient Short-Run Profit Allocatively Efficient P MC MR=D=AR=P $10 ATC Notice that the price people are willing to pay equals the additional cost to produce Q1 (Price = MC) Q Q1

NOT Allocatively Efficient Short-Run Profit NOT Allocatively Efficient P MC MR=D=AR=P $10 $5 ATC At Q2, the price is greater than the MC so society wants more output produced Q Q2

competitive profit maximizing firm is always allocatively efficient Long-Run Equilibrium P MC ATC $8 MR=D=AR=P A perfectly competitive profit maximizing firm is always allocatively efficient Q3 Q

Summary Perfectly competitive firms are allocatively and productively efficient in the long-run In the short-run, they are always allocatively efficient, but they are not productively efficient.