Chapter 4 The supply decision PowerPoint to accompany:

Learning objectives 4.1 Short-run costs; how do a firm’s costs vary with output over the short term? 4.2 Long-run costs; how do a firm’s costs vary with output over the longer term? 4.3 Revenue; how does a firm’s revenue vary with its level of sales? 4.4 Revenue, costs and profits; how much output should a firm produce if it wants to maximise its profit? 4.5 Problems with traditional theory; are firms rational?

Short-run and long-run changes in production Short-run costs Short-run and long-run changes in production Fixed factors of production Variable factors of production The short run The long run. LO 4.1 Short-run costs – How do a firm’s costs vary with output over the short term?

Production in the short run Short-run costs Production in the short run The law of diminishing returns When increasing amounts of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit. LO 4.1 Short-run costs – How do a firm’s costs vary with output over the short term?

Short-run costs Costs and output Costs and the productivity of factors of production Costs and the price of factors of production Fixed and variable costs Total cost (TC)=total fixed cost (TFC) + total variable cost (TVC) LO 4.1 Short-run costs – How do a firm’s costs vary with output over the short term?

Short-run costs Average (total) cost (AC) AC =TC/Q Average fixed cost AFC=TFC/Q Average variable cost AVC=TVC/Q AC=AFC+AVC Marginal cost (MC) MC =ΔTC/ ΔQ

Short-run costs Table 4.1 Costs for firm X

Average fixed cost (AFC) Short-run costs Marginal cost (MC) Initially, MC falls Beyond a certain level of output, diminishing returns set in and MC rises. Average fixed cost (AFC) AFC falls continuously as output rises. Average (total) cost (AC) If MC is less than AC, AC must be falling. If MC is greater than AC, AC must be rising. The MC curve crosses the AC curve at its minimum point. LO 4.1 Short-run costs – How do a firm’s costs vary with output over the short term?

Average Variable Cost (AVC) Short-run costs Average Variable Cost (AVC) As AVC = AC – AFC, the AVC curve is the vertical difference between the AC and the AFC curves. As AFC gets less, the gap between AVC and AC narrows. If MC is less than AVC, AVC must be falling. If MC is greater than AVC, AVC must be rising. As with the AC curve, the MC curve crosses the AVC curve at its minimum point.

Short-run costs Figure 4.1 Average and marginal costs

Long run production: the scale of production Long-run costs Long run production: the scale of production The ‘long run’ – all input factors variable The ‘short run’ – at least one factor input fixed Returns to scale: constant returns to scale increasing returns to scale decreasing returns to scale. LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

Long-run costs Table 4.2 Short-run and long-run increases in output

Economies of scale, achieved through: Long-run costs Economies of scale, achieved through: Specialisation and division of labour Indivisibilities The ‘container principle’ Greater efficiency of large machines By-products Multi-stage production Organisational economies Spreading overheads Financial economies. Economies of scope: Increasing the range of products reduces the cost of producing each one. LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

Diseconomies of scale, incurred through: Long-run costs Diseconomies of scale, incurred through: Management problems Repetitive work fosters worker alienation More complex industrial relations Production-line processes and interdependencies. The size of the whole industry: External economies of scale Industry infrastructure External diseconomies of scale. LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

Long-run costs Long-run average cost Assumptions behind the curve: factor prices and quality do not vary state of technology and factor quality are given firms choose least-cost combination of factors. Shape of the LRAC curve LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

Long-run costs Figure 4.2 A typical long-run average cost curve

The envelope curve Long-run costs Relationship between long-run and short-run average costs The envelope curve LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

Long-run costs Figure 4.3 Constructing long-run average cost curves

Long-run average cost curves in practice Long-run costs Long-run average cost curves in practice Strong evidence for economies of scale and constant returns to scale Inconclusive evidence for diseconomies of scale Possible managerial and industrial relations problems. LO 4.2 Long-run costs – How do a firm’s costs vary with output over the longer term?

Long-run costs Decision making in different time periods Very short run Short run Long run Very long run.

Defining total, average and marginal revenue Total revenue: TR = P × Q Average revenue: AR = TR / Q Marginal revenue: MR = TR / Q LO 5.1 Revenue - How does a firm’s revenue vary with its level of sales?

Revenue curves when price is not affected by the firm’s output When the demand ‘curve’ is horizontal, output does not affect price and the firm must take the price set by the market. The firm is a ‘price-taker’. Average revenue (AR) is constant and the same as its demand curve. Marginal revenue (MR) is constant and the same as the AR curve. Total revenue (TR) increases at a constant rate. LO 5.1 Revenue - How does a firm’s revenue vary with its level of sales?

Revenue Figure 4.4 Deriving a firm’s AR and MR: price-taking firm

Revenue curves when price varies with output When the demand ‘curve’ slopes downwards to the right, the firm can maximise profit by selling larger quantities at lower prices. The firm becomes a ‘price maker’. Average revenue (AR) lies along the same line as the demand curve. Marginal revenue (MR) is less than average revenue and may even be negative. Total revenue (TR) rises at first and then falls. LO 5.1 Revenue - How does a firm’s revenue vary with its level of sales?

Revenue Table 4.3 Revenues for a firm facing a downward sloping demand curve

Revenue Figure 4.5 AR and MR curves for a firm facing a downward-sloping demand curve

Revenue Figure 4.6 Total revenue for a firm facing a downward-sloping demand curve

Shifts in revenue curves A change in the firm’s output leads to a movement along the revenue curves. A change in any other determinant of demand, such as tastes, income or the price of other goods, will shift the demand curve. By affecting the price at which each level of output can be sold, there will be a shift in all three revenue curves. An increase in revenue is shown by a vertical shift upward; a decrease by a shift downward.

Revenue, costs and profit Short-run profit maximisation Stage one: Using marginal curves to arrive at the profit- maximising output As long as MR>MC, profit can be increased by increasing production. As long as MC>MR, profit can be increased by cutting back on production. Profit maximising rule: MR=MC LO 5.2 Revenue, costs and profit – How much output should a firm produce if it wants to maximise its profit?

Revenue, costs and profit Table 4.4 Revenue, cost and profit

Revenue, costs and profit Figure 4.7 Finding the profit-maximising output using marginal curves

Revenue, costs and profits Short-run profit maximisation Stage two: using average curves to measure the size of profit Total profit is obtained by multiplying average profit by output TΠ = AΠ × Q

Revenue, costs and profit Figure 4.8 Measuring the maximum profit using average curves

Revenue, costs and profit Some qualifications Long-run profit maximisation: MR=long-run MC The meaning of ‘profit’ Normal profit (%) = rate of interest on a riskless loan + a risk premium Supernormal profit. Loss minimising: MR = MC LO 5.2 Revenue, costs and profit – How much output should a firm produce if it wants to maximise its profit?

Revenue, costs and profit Figure 4.9 Loss-minimising output

Revenue, costs and profit Some qualifications Short-run shut-down point: P = AVC Long-run shut-down point: P = LRAC LO 5.2 Revenue, costs and profit – How much output should a firm produce if it wants to maximise its profit?

Revenue, costs and profit Figure 4.10 The short-run shut-down point

Problems with traditional theory Are firms rational? Firms may not have the information to maximise profits: Average cost or marking-up pricing. Firms may not want to maximise profits: Profit satisficing Sales revenue maximisation Principal-agent problem Attitudes to risk.