Unit 3: Costs of Production and Perfect Competition Copyright ACDC Leadership 2015

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 Copyright ACDC Leadership 2015

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 Copyright ACDC Leadership 2015

Short-run Supply Curve 4 Copyright ACDC Leadership 2015

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 5

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 6 Copyright ACDC Leadership 2015

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 8 Copyright ACDC Leadership 2015

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 Copyright ACDC Leadership 2015

Per Unit vs. Lump Sum A PER UNIT tax or subsidy 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 10 Copyright ACDC Leadership 2015

2008 Audit Exam 18.B

Perfect Competition Copyright ACDC Leadership 2015

2006 FRQ 13 Copyright ACDC Leadership 2015

2006 FRQ 14 Copyright ACDC Leadership 2015

#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 Profit=$40 $16 15 10 9 5 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 16

#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 TR=$100 10 TC=$60 Profit=$40 $12 11 6 5 3 Price MC MR=D=AR= P 10 ATC Quantity 3 7 10 12

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” Copyright ACDC Leadership 2015

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 20 Copyright ACDC Leadership 2015

Which of the following is a correctly labeled graph for firm making economic profit? 21 Copyright ACDC Leadership 2015

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

#1 #3 #2 #4 ATC MC MC ATC PF MR=D MR=D Q Q QF QF MC ATC ATC MC MR=D Copyright ACDC Leadership 2015

#1 #3 #2 #4 ATC MC MC ATC PF MR=D MR=D Q Q QF QF MC ATC ATC MC MR=D Economic Loss Profit too big 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 more profit in making corn. What do you do in the long run? Copyright ACDC Leadership 2015

(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. Copyright ACDC Leadership 2015

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 28 Copyright ACDC Leadership 2015

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 29 Copyright ACDC Leadership 2015

Going from Short-Run to Long-Run 30 Copyright ACDC Leadership 2015

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 32 Copyright ACDC Leadership 2015

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 33 Copyright ACDC Leadership 2015

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 34

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 36 Copyright ACDC Leadership 2015

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 37 Copyright ACDC Leadership 2015

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 38 Copyright ACDC Leadership 2015

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. 39 Copyright ACDC Leadership 2015

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 41 Copyright ACDC Leadership 2015

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 42 Copyright ACDC Leadership 2015

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 43 Copyright ACDC Leadership 2015

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 45 Copyright ACDC Leadership 2015

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 46 Copyright ACDC Leadership 2015

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 47 Copyright ACDC Leadership 2015

Practice 48

2012 Multiple Choice #23 Answer: D 49

2008 Audit Exam 26. C

2012 Multiple Choice #38 Answer: C 51

C

2010 FRQ #1 53

54

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) 55 Copyright ACDC Leadership 2015

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 56 Copyright ACDC Leadership 2015

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 57 Copyright ACDC Leadership 2015

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 58 Copyright ACDC Leadership 2015

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 59 Copyright ACDC Leadership 2015