MR=P MC Market Equilibrium The equilibrium price and quantity are determined by the market demand and market supply curves. First Question: Where does the market supply curve come from? The market supply curve is the horizontal sum of each individual firm’s supply curve. Second Question:Where does an individual firm’s supply curve come from? Profit Maximization Marginal Revenue (MR):Change in the firm’s total revenue resulting from a one unit change in the quantity of output produced. Marginal Cost (MC):Change in the firm’s total cost resulting from a one unit change in the quantity of output produced. MR > MC  More production increases profit MR < MC  Less production increases profit MR = MC  Profit is maximized Marginal Revenue and Perfect Competition: MR = P Marginal Cost Curve: Upward Sloping q q*

q MR =.50 MC Second Question: Where does an individual firm’s supply curve come from? That is, how does a firm decide how much output to produce? Firm A’s supply curve: How many cans of beer would firm A produce, if the price of beer were _____, given that everything else relevant to the supply of beer remains the same? If P =.50 MR = 1.00If P = 1.00 MR = 1.50If P = 1.50 Profit Maximization: Produce the quantity of output at which MR = MC It looks like an individual firm’s supply curve is the firm’s marginal cost curve. P In fact, we must add one caveat. Individual Firm’s Supply Curve: The individual firm’s supply curve is its marginal cost curve until the price is very low and falls below average variable cost. When the price is less than average variable cost, the firm will shut down and produce nothing. S

Short Run versus Long Run Short Run  Firms must meet their short run commitments  Terminology: When a firm goes out of business in the short run, we say that the firm shuts down. Long Run  Firms can escape their short run commitments  Terminology: When a firm goes out of business in the long run we say that the firm exits the industry. Short Run Shutdown “Rule” Price and Average Variable Cost (AVC)  P < AVC  Firm goes out of business in the short run  The firm shuts down. Long Run Exit “Rule” Price and Average Total Cost (ATC)  P < ATC  Firm goes out of business in the long run  The firm exits the industry.

Jeff Lord and His Consulting Firm For many years, Jeff Lord, a business consultant, worked for Arthur Anderson earning a salary of $25,000 a month. On January 1, 2014, he resigned from Arthur Anderson to start his own consulting firm. He signed a one-year lease for office space. The one-year lease legally requires Jeff to pay his landlord $20,000 per month in rent until January 1, hired several employees whose wages summed to $35,000 a month. All other out-of-pocket costs that Jeff incurs are negligible. Jeff departed from Anderson on very good terms; the management at Anderson told him that he could return to their firm anytime at his old $25,000 per month salary. Anderson Salary: $25,000 per month Shortly after Jeff started his business he acquired several loyal clients. Jeff charges his clients $650 per hour and records 100 billable hours per month. Rent: $20,000 per month Employee Wages: $35,000 per month Price: $650 per hour Quantity: $100 hours Total Revenue = P  q = 650  100 = $65,000 per month

Jeff’s Monthly Income When Operating His Firm Price: $650/hourQuantity: 100 hours per monthRent: $20,000 per month Employee Wages: $35,000 per month Total Revenue: P  q = $65,000 per month Jeff’s monthly income when operating his firm =$65,000  ($20,000 + $35,000) $65,000  $55,000= $10,000  Accounting Costs: Payments the owner of the firm makes to others, the owner’s out-of-pocket costs. Jeff’s monthly income when operating his firm = Total Revenues  Accounting Costs = $650  100 Generalizing: Accounting Costs $55,000 Rent $20,000 Employee Wages $35,000 Total Revenue  Rent  Wages 

Short Run versus Long Run Short Run  Firms must meet their short run commitments  Terminology: When a firm goes out of business in the short run, we say that the firm shuts down. Long Run  Firms can escape their short run commitments  Terminology: When a firm goes out of business in the long run we say that the firm exits the industry. Question: Will Jeff operate his firm in the long run, after lease expires on January 1, Jeff’s monthly income when operating his firm =$10,000  Total Revenues  Accounting Costs Jeff’s monthly income in the long run if he goes out of business on January 1, 2015 $25,000  Anderson Salary =  What Jeff foregoes when he operates his firm  Opportunity Costs Answer: After January 1, 2015, Jeff will go out of business and return to Anderson. Anderson Salary $25,000 Accounting Costs $55,000 Total Costs (TC) $80,000 Rent $20,000 Employee Wages $35,000 Opportunity Costs $25,000

Long Run:The long run refers to the period of time after the commitments expire. In Jeff’s case, the long run begins when his lease expires on January 1, Jeff’s monthly income if he continues to operate his firm =Total Revenue Jeff’s monthly income in the long run if he goes out of business = Opportunity Costs Generalizing: What happens in the long run?  Accounting Costs Opportunity Costs $25,000 Accounting Costs $55,000 Total Costs (TC) $80,000 Rent $20,000 Employee Wages $35,000 Anderson Salary $25,000 Profit of Jeff’s FirmTotal Revenue  Total Costs= Total Revenue  (Accounting Costs + Opportunity Costs)= Total Revenue  Accounting Costs  Opportunity Costs = (Total Revenue  Accounting Costs)  Opportunity Costs =  Jeff’s monthly income if he continues to operate his firm  Jeff’s monthly income in the long run if he goes out of business  Profit compares Jeff’s income when he operates his firm with his income in the long run if he goes out of business. =Profit of Jeff’s Firm

Total Revenue  Total Cost= PqPq   ATC  q = Total Revenue = P  q ATC = Total Cost Total Cost = ATC  q q = (P  ATC)  q Profit of Jeff’s Firm= Jeff’s monthly income if he continues to operate his firm Jeff’s monthly income in the long run if he goes out of business  P<ATC  Jeff’sJeff’s incomeincome when < in the long run operatingif he goes his firmout of business  Jeff earns less income by operating his firm than by working for someone else.  Exit occurs in the long run P>ATC  Jeff’sJeff’s incomeincome when > in the long run operatingif he goes his firmout of business  Jeff earns more income by operating his firm than by working for someone else.  Entry occurs in the long run P=ATC  Jeff’sJeff’s incomeincome when = in the long run operatingif he goes his firmout of business  Jeff earns the same income by operating his firm or by working for someone else.  Long run equilibrium  Profit<0  Profit=0  Profit>0

Short Run:The short run refers to the period of time before the commitments expire. In Jeff’s case, the short run is until his lease expires on January 1, Answer: Jeff will not go out of business, he will continue to operate his firm. Jeff’s monthly income if he continues to operate his firm =TR  $65,000   $55,000 = $10,000  Acc’t Costs = Question: What will Jeff do on October 1, 2014? Fixed Costs (FC) $20,000 Opportunity Costs $25,000 Variable Costs (VC) $60,000 Accounting Costs $55,000 Total Costs (TC) $80,000 Rent $20,000 Employee Wages $35,000 Anderson Salary $25,000 VC = TC  FC Jeff’s monthly income in the short run if he goes out of business on October 1, 2014 =Anderson Salary  $25,000  Opp Costs  Rent  $20,000  Fixed Costs = $5,000 =  Generalizing: Fixed Costs: Costs that arise as a consequence of short run fixed commitments, the costs Jeff would incur even if he went out of business in the short run.  Rent  $20,000  Fixed Costs =  Variable Costs: All costs that are not fixed.

Jeff’s monthly income if he continues to operate his firm = TR  Acc’t Costs Jeff’s monthly income in the short run if he goes out of business = Opp Costs  FC Question: In fact, Jeff would not go out of business in the short run, but under what circumstances would the owner of a firm do so? TR  Acc’t Costs Opp Costs < TROpp Costs < Acc’t Costs+ TR < TC PqPq < VC P < q P < AVC Total Costs = Acc’t Costs + Opp Costs VC q AVC = TR = P  q FC    TR < VC VC = TC  FC Fixed Costs (FC) Opportunity Costs Variable Costs (VC) Accounting Costs Total Costs (TC) $80,000 RentEmployee WagesAnderson Salary VC = TC  FC

q MR =.50 MC Second Question: Where does an individual firm’s supply curve come from? That is, how does a firm decide how much output to produce? Firm A’s supply curve: How many cans of beer would firm A produce, if the price of beer were _____, given that everything else relevant to the supply of beer remains the same? If P =.50 MR = 1.00If P = 1.00 MR = 1.50If P = 1.50 Profit Maximization: Produce the quantity of output at which MR = MC It looks like an individual firm’s supply curve is the firm’s marginal cost curve. P In fact, we must add one caveat. Individual Firm’s Supply Curve: The individual firm’s supply curve is its marginal cost curve until the price is very low and falls below average variable cost. When the price is less than average variable cost, the firm will shut down and produce nothing. S Shutdown: P < AVC

Short Run Shutdown “Rule” Price and Average Variable Cost (AVC)  P < AVC  Firm goes out of business in the short run  The firm shuts down. Long Run Exit “Rule” Price and Average Total Cost (ATC)  P < ATC  Firm goes out of business in the long run  The firm exits the industry. Fixed Costs (FC) $20,000 Opportunity Costs $25,000 Variable Costs (VC) $60,000 Accounting Costs $55,000 Total Costs (TC) $80,000 Rent $20,000 Employee Wages $35,000 Anderson Salary $25,000 P = $650 q = 100 AVC = VC q 60, == $600ATC = TC q 80, = $800 P > AVC Jeff operates in the short run. P < ATC Jeff exits in the long run.

Tying Up a Loose End: Producer Surplus and Profit – Revisit Mr. Atkins’ Apple Orchard Labor Hired (hours) Total Apples Picked (bushels) Marginal Cost Total Labor Costs Wage Rate: $10 per hour Marginal Cost: The change in its total cost resulting from a one unit change in production MR=25 Price=25 S (MC) Suppose that the price were $25. Mr. Atkins would produce 4 bushels. What does producer surplus equal? 15 How much profit would Mr. Atkins earn from the 1 st bushel? 2 nd bushel? 3 rd bushel? 4 th bushel? Profit = Producer Surplus $15 $ = = 50 Producer Surplus: The area above the supply curve lying below the price. – Fixed Costs