AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets Lecture #1 Economic Costs, Profit, and the Production Function

ECONOMIC COST Measures the value of a resource based on its worth in producing the next best alternative Includes Explicit and Implicit Costs (including normal profit)

EXPLICIT VS. IMPLICIT COST Explicit Costs are $ payments to non-owners of the firm for the resources they supply Implicit Costs the opportunity costs of using self-owned resources…What else could you have done with your knowledge skill or expertise?

NORMAL PROFIT The $ value of what you would have been paid for your entrepreneurial talent It is considered an implicit cost

ACCOUNTING vs. ECONOMIC PROFIT Accounting Profits = Total Revenue – Explicit Costs implicit costs are excluded used by business Economic Profits = Total Revenue – Economic Costs includes explicit & implicit costs (with normal profit) used by economists

Figure 1 Economic versus Accountants How an Economist How an Accountant Views a Firm Views a Firm Revenue Economic profit Accounting profit Revenue Implicit costs Total opportunity costs Explicit costs Explicit costs Copyright © 2004 South-Western

SHORT-RUN VS. LONG RUN Short-Run – time period that is too brief for a firm to alter its plant capacity, but long enough to change how the fixed plant is used Long-Run – time period long enough for a firm to adjust the quantities of all the resources it employs, including plant capacity

TOTAL PRODUCT (TP OR Q) The total quantity, or total output, of a particular good produced Independent of inputs

MARGINAL PRODUCT (MP OR MPP)  

AVERAGE PRODUCT (AP OR APP)  

PRODUCTION SCHEDULE UNITS OF LABOR TOTAL PRODUCT MARGINAL PRODUCT AVERAGE PRODUCT X 1 10 2 25 15 12.5 3 45 20 4 60 5 70 14 6 75 7 10.71 8 -5 8.75

GRAPHING TOTAL PRODUCT

AN EXAMPLE # Workers Total Product (TP) Marginal Product (MP) Average Product (AP) 1 12 2 25 3 45 4 55 5 57 6 52

LAW OF DIMINISHING MARGINAL RETURNS As successive increments of a variable resource are added to a fixed resource, the marginal product of the variable resource will eventually decrease Think about how your pizza production when adding additional workers!

AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets Lecture #2 Short-Run Production Costs

FIXED COST (TFC) Those costs which in total do not vary with changes in output Can’t be avoided in the short-run

VARIABLE COST (TVC) Those costs that change with the level of output

TOTAL COST (TC) TC = TFC + TVC The sum of fixed cost and variable cost at each level of output TC = TFC + TVC

TOTAL COST SCHEDULES TP TFC TVC TC $100 $0 1 $90 $190 2 $170 $270 3 $100 $0 1 $90 $190 2 $170 $270 3 $240 $340 4 $300 $400 5 $370 $470 6 $450 $550 7 $540 $640 8 $650 $750 9 $780 $880 10 $930 $1030

TOTAL COST GRAPHS

AVERAGE FIXED COST (AFC)  

AVERAGE VARIABLE COST  

AVERAGE TOTAL COST  

MARGINAL COST  

MARGINAL COST Marginal Cost : the addition either to total cost or to total variable cost resulting from one more unit of output Ex. Another unit of capital, labor, etc. Why might you want to know what adding that extra worker “costs” you? How does this relate to marginal product?

MARGINAL COST vs. MARGINAL PRODUCT MC reaches a minimum at the same output level where MP reaches a maximum MC reaches a maximum at the same output level where MP reaches a minimum They mirror one another

COST CURVE TRUTHS MC intersects AVC and ATC at their lowest points When MC is below ATC, ATC will fall When MC is above ATC, ATC will rise When MC is below AVC, AVC will fall When MC is above AVC, AVC will rise

SHIFTING COST CURVES An increase in fixed costs would shift the AFC and ATC curves upward; however, MC and AVC curves would remain unchanged because variable resource prices have not changed If the price of a variable resource increases, the AVC, ATC, and MC curves would all shift upward, AFC would remain unchanged

COSTS IN THE SHORT RUN AND IN THE LONG RUN Division of total costs between fixed and variable costs depends on the time horizon Short-run - some costs are fixed Long-run - fixed costs become variable costs Why?

AVERAGE AND MARGINAL COST SCHEDULES AFC AVC ATC MC $0 X $100 $90 $190 $50 $85 $135 $80 $33.33 $113.33 $70 $25 $75 $60 $20 $74 $94 $16.67 $91.67 $14.29 $77.14 $91.43 $12.50 $81.25 $93.75 $110 $11.11 $86.67 $97.78 $130 $10 $93 $103 $150

AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets Lecture #3 Long-Run Production

COSTS IN THE SHORT-RUN AND IN THE LONG-RUN Remember – Fixed costs in the short-run are VARIABLE COSTS in the LONG-RUN Long-run cost curves will look different than short-run cost curves Goal for a firm is to create the optimal plant size

LONG-RUN COST CURVES Long-run ATC curves are made up of segments of short-run curves The curve is made up of all points of tangency on an unlimited number of short- run ATC curves U-shape is caused by ECONOMIES AND DISECONOMIES OF LARGE-SCALE production

Figure 7 Average Total Cost in the Short and Long Run ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory Cost $12,000 ATC in long run 1,200 Quantity of Cars per Day Copyright © 2004 South-Western

ECONOMIES OF SCALE The downslope of the curve is due to economies of mass production As plant size increases, factors can allow greater production at lower ATC Name an industry or firm that would likely benefit from economies of scale?

FACTORS CREATING ECONOMIES OF SCALE Labor specialization = greater skill & efficiency Managerial specialization allows supervision of more workers and focus on an area of expertise Efficient capital promotes modernization and speed Start-up costs, marketing, advertising are diffused

DISECONOMIES OF SCALE Firms can become TOO BIG and start to increase ATC Upward slope of the curve Bureaucracy leads to inefficiency Top-heavy management increases costs Workers can feel “lost” in a big plant

CONSTANT RETURNS TO SCALE Long-run ATC doesn’t change in some industries, so diseconomies do not result Output stays proportional to increased inputs

Figure 7 Average Total Cost in the Short and Long Run ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory Cost ATC in long run Economies of scale Diseconomies of scale 1,200 $12,000 1,000 10,000 Constant returns to scale Quantity of Cars per Day Copyright © 2004 South-Western

FIRM SIZE There is a lowest level of output where a firm can minimize long-run average costs Called Minimum Efficient Scale (MES) Depending on industry, both large and small firms can operate Natural Monopolies occur in industries where small firms cannot achieve MES because economies of scale are so big

Long-Run ATC Curve Any number of short-run optimum Average Total Costs Output Any number of short-run optimum size cost curves can be constructed 8-43

Long-Run ATC Curve Long-Run ATC The long-run ATC curve just Average Total Costs Output The long-run ATC curve just “envelopes” the short run ATCs 8-44

Long-run ATC curve where economies Long-Run ATC Shapes Economies Of Scale Constant Returns To Scale Diseconomies Of Scale Average Total Costs Long-Run ATC q1 q2 Output Long-run ATC curve where economies of scale exist 8-45

Long-Run ATC Shapes Long-Run ATC Economies Of Scale Diseconomies Of Scale Average Total Costs Long-Run ATC Output Long-run ATC curve where costs are lowest only when large firms are participating 8-46

Long-Run ATC Shapes Long-Run ATC Long-run ATC curve where economies Of Scale Diseconomies Of Scale Long-Run ATC Average Total Costs Output Long-run ATC curve where economies of scale exist, are exhausted quickly, and turn back up substantially 8-47

AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets Lecture #4 Introduction to Market Structures and Perfect Competition

Market Structure Continuum Four Market Models Pure competition Pure monopoly Monopolistic competition Oligopoly Oligopoly Pure Competition Monopolistic Competition Pure Monopoly Market Structure Continuum LO1 8-49

Monopolistic Competition Four Market Models Characteristics of the Four Basic Market Models Characteristic Pure Competition Monopolistic Competition Oligopoly Monopoly Number of firms A very large number Many Few One Type of product Standardized Differentiated Standardized or differentiated Unique; no close subs. Control over price None “Price Takers” Some, but within rather narrow limits Limited by mutual inter-dependence; considerable with collusion Considerable Conditions of entry Very easy, no obstacles Relatively easy Significant obstacles Blocked Nonprice Competition Considerable emphasis on advertising, brand names, trademarks Typically a great deal, particularly with product differentiation Mostly public relation advertising Examples Agriculture Retail trade, dresses, shoes Steel, auto, farm implements Local utilities LO1 8-50

Three Measures of Revenue Total Revenue (TR)= P x Q Average Revenue (AR) = TR/Q Marginal Revenue (MR) = ∆TR/∆Q LO2 8-51

Three Measures of Profit Total Profit (Tπ) = TR-TC Average Profit (Aπ) = AR-AC Marginal Profit (Mπ) = MR-MC or (Mπ) = ∆MR/∆Q LO2 8-52

Maximizing Profit The goal of any firm is to maximize profit, but the ability to do so depends on the type of market structure! This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost. LO2 8-53

Rules to Maximize Profit A firm should produce the output at which MR = MC. A firm should charge the price on the demand curve for its optimal output level. A firm should shut down and produce zero output if TR is less than TVC. LO2 8-54

Pure Competition: Characteristics Very large numbers of sellers Standardized product “Price takers” Easy entry and exit Perfectly elastic demand Firm produces as much or little as they want at the price Demand graphs as horizontal line LO2 8-55

Why is demand perfectly elastic? Firms can’t get a higher price by cutting output and don’t need to lower their price to increase sales. With perfectly elastic demand, in pure competition… D = P = MR = AR LO2 8-56

Profit Maximization: TR–TC Approach Three questions: Should the firm produce? If so, what amount? What economic profit (loss) will be realized? LO3 8-57

Average, Total, and Marginal Revenue Firm’s Demand Schedule (Average Revenue) Revenue Data TR P QD TR MR 1 2 3 4 5 6 7 8 9 10 $131 131 $0 131 262 393 524 655 786 917 1048 1179 1310 ] $131 131 D = MR = AR LO3 8-58

Profit Maximization: TR–TC Approach The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price = $131) (1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Costs (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Profit (+) or Loss (-) $100 $0 $-100 1 100 90 190 131 -59 2 170 270 262 -8 3 240 340 393 +53 4 300 400 524 +124 5 370 470 655 +185 6 450 550 786 +236 7 540 640 917 +277 8 650 750 1048 +298 9 780 880 1179 +299 10 930 1030 1310 +280 LO3 8-59

Profit Maximization: TR–TC Approach 1 2 3 4 5 6 7 8 9 10 11 12 13 14 $1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 $500 Total Revenue and Total Cost Total Economic Profit Quantity Demanded (Sold) Break-Even Point (Normal Profit) Total Revenue, (TR) Maximum Economic Profit $299 Total Cost, (TC) P=$131 Break-Even Point (Normal Profit) Total Economic Profit $299 LO3 8-60

Profit Maximization: MR-MC Approach The Profit-Maximizing Output for a Purely Competitive Firm: Marginal Revenue – Marginal Cost Approach (Price = $131) (1) Total Product (Output) (2) Average Fixed Cost (AFC) (3) Average Variable Costs (AVC) (4) Average Total Cost (ATC) (5) Marginal Cost (MC) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) $-100 1 $100.00 $90.00 $190 $90 $131 -59 2 50.00 85.00 135 80 131 -8 3 33.33 80.00 113.33 70 +53 4 25.00 75.00 100.00 60 +124 5 20.00 74.00 94.00 +185 6 16.67 91.67 +236 7 14.29 77.14 91.43 90 +277 8 12.50 81.25 93.75 110 +298 9 11.11 86.67 97.78 130 +299 10 10.00 93.00 103.00 150 +280 LO3 8-61

Profit Maximization: MR-MC Approach $200 150 100 50 MR = MC MC P=$131 Economic Profit MR = P ATC Cost and Revenue AVC ATC=$97.78 1 2 3 4 5 6 7 8 9 10 Output LO3 8-62

Three Production Questions Output Determination in Pure Competition in the Short Run Question Answer Should this firm produce? Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost. What quantity should this firm produce? Produce where MR (=P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized. Will production result in economic profit? Yes, if price exceeds average total cost (TR will exceed TC). No, if average total cost exceeds price (TC will exceed TR). LO3 8-63

Loss-Minimizing Case Loss minimization Max. profit or min. loss is where MR=MC Must take into consideration fixed costs If TR > TVC, but less than TC, it should still produce at a loss because it will have leftover revenue to pay toward TFC If TR < TC, it should shut down because it will make a loss on TVC and TFC LO3 8-64

Loss-Minimizing Case Loss minimization Still produce because P > minAVC Losses at a minimum where MR=MC LO3 8-65

Loss-Minimizing Case (TR > TVC) Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output MC Loss ATC=$91.67 ATC AVC P=$81 MR = P AVC = $75 LO3 8-66

Short-Run Shut Down Point Shutdown Case Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output MC ATC AVC = $74 AVC MR = P P=$71 Short-Run Shut Down Point P < Minimum AVC $71 < $74 LO3 8-67

AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets Lecture #5 Short-Run Supply and Equilibrium

The Supply Curve In A Competitive Market The competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above the average variable cost (AVC). Remember, firms won’t produce when MR (0r P) is less than AVC!

Figure 3 The Competitive Firm’s Short Run Supply Curve Costs Firm ’ s short-run supply curve If P > ATC, the firm will continue to produce at a profit. MC ATC If P > AVC, firm will continue to produce in the short run. AVC Firm shuts down if P < AVC Quantity Copyright © 2004 South-Western

The Short Run: Firm and Industry Market Equilibrium For any given price, each firm supplies a quantity of output so that its marginal cost equals price (MR in perfect comp). The market supply curve reflects the summed total individual firms’ MC curves. Although a single firm may have little bearing on price, it takes all of those firms operating to determine price The market supply curve allows you to determine a industry market equilibrium

Firm and Industry: Equilibrium Firm and Market Supply and the Market Demand (1) Quantity Supplied, Single Firm (2) Total 1000 Firms (3) Product Price (4) Demanded 10 10,000 $151 4,000 9 9,000 131 6,000 8 8,000 111 7 7,000 91 6 81 11,000 71 13,000 61 16,000 LO4 8-72

Firm and Industry: Equilibrium S = ∑ MC’s s = MC Economic Profit ATC d $111 $111 AVC D 8 8000 LO4 8-73

Profit Maximization: TR–TC Approach The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price = $131) (1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Costs (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Profit (+) or Loss (-) $100 $0 $-100 1 100 90 190 131 -59 2 170 270 262 -8 3 240 340 393 +53 4 300 400 524 +124 5 370 470 655 +185 6 450 550 786 +236 7 540 640 917 +277 8 650 750 1048 +298 9 780 880 1179 +299 10 930 1030 1310 +280 LO3 8-74

Determining Market Profitability Find TR: multiply product price by output – in our example - (8 x $111) for a single firm or $888 Compare to TC: in our example – TC for 8 units is $750 Economic Profit for Individual Firm: TR – TC = $138 Economic Profit for All Firms: Assuming the fixed number is 1,000 as in our example, economic profit would be $138,000

AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets Lecture #6 The Long-Run in Pure Competition

The Long Run in Pure Competition In the long run… Firms can expand or contract capacity Firms enter and exit the industry LO1 9-77

Three Assumptions for the Long Run Easy entry and exit The only long-run adjustment we consider Identical costs All firms in the industry have identical costs Constant-cost industry Entry and exit do not affect resource prices LO2 9-78

Long-Run Equilibrium Entry eliminates profits Exit eliminates losses Firms enter when P rises above ATC Ex. Consumer tastes increase demand Supply increases in the short-run Equilibrium price falls Exit eliminates losses Firms exit when P falls below ATC Ex. Consumer tastes decrease demand Supply decreases in the short-run Equilibrium price increases LO3 9-79

Entry Eliminates Economic Profits Single Firm (b) Industry P q Q 100 90,000 80,000 100,000 S1 MC $60 50 40 ATC $60 50 40 S2 MR D2 D1 LO3 9-80

Exit Eliminates Losses Single Firm (b) Industry P q Q 100 90,000 80,000 100,000 S3 MC $60 50 40 $60 50 40 ATC S1 MR D1 D3 LO3 9-81

How do costs impact long-run supply? Constant cost industry Entry/exit does not affect LR ATC Constant resource price Supply curve is perfectly elastic Industry has ability to adjust to demand shifts LO4 9-82

LR Supply: Constant-Cost Industry Q P1 P2 P3 $50 S Z3 Z1 Z2 D3 D1 D2 Q3 Q1 Q2 90,000 100,000 110,000 LO4 9-83

How do costs impact long-run supply? Increasing cost industry More firms = higher costs LR ATC increases with expansion & causes new equilibrium price Supply curve is upward sloping LO4 9-84

LR Supply: Increasing-Cost Industry Q S P2 $55 Y2 P1 $50 Y1 P3 $40 Y3 D2 D1 D3 Q3 Q1 Q2 90,000 100,000 110,000 LO4 9-85

How do costs impact long-run supply? Decreasing-cost industry More firms = lower costs LR ATC increases and changes equilibrium Long-run supply curve is downsloping LO4 9-86

LR Supply: Decreasing-Cost Industry Q X3 P3 $55 X1 P1 $50 X2 P2 $40 S D3 D2 D1 Q3 Q1 Q2 90,000 100,000 110,000 LO4 9-87

Pure Competition and Efficiency In the long run, efficiency is achieved P/MR = min ATC MC intersects ATC at minimum, therefore MR = MC = min. ATC Only normal profits in the long-run LO5 9-88

Pure Competition and Efficiency Productive efficiency Producing where P = min. ATC Benefits consumers/society Only firms who use the best production methods survive LO5 9-89

Pure Competition and Efficiency Allocative efficiency Producing where P = MC Each item produced to the point at which the value of the last unit is equal to the value of the alternative good being sacrificed Best mix of products and use of resources LO5 9-90

Pure Competition Results Consumer and producer surplus maximized P = MC = lowest ATC MC = MB Maximum willingness to pay = minimum acceptable price LO5 9-91

Pure Competition and Efficiency Single Firm Market Price Quantity P=MC=Minimum ATC (Normal Profit) MC Consumer Surplus S ATC P MR P Producer Surplus D Qf Qe LO5 9-92

Purely competitive markets always adjust to Dynamic Adjustments Purely competitive markets always adjust to Changes in consumer tastes Resource supplies Technology Recall the “Invisible Hand” LO6 9-93

Technological Advance: Competition Entrepreneurs seek economic profit (beyond normal profit) Decrease costs by innovating New product development LO6 9-94

Competition and innovation may lead to “creative destruction” Creation of new products and methods destroys the old products and methods LO6 9-95

Efficiency Gains from Entry Patent protected prescription drugs earn substantial economic profits for the pharmaceutical company Generic drugs become available as the patent expires on the existing drug Results in a 30-40% reduction price Greater consumer surplus and efficiency 9-96

Efficiency Gains from Entry P1 b c d f P2 D Q1 Q2 9-97