Review of Economic Concepts AGEC Spring 2010

Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output

Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Average variable = total variable cost ÷ output cost

Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Average variable = total variable cost ÷ output cost Average total = total cost ÷ output cost

Costs associated with levels of output

Profit maximizing level of output, where MR=MC Profit maximizing level of output, where MR=MC P=MR=AR $

Average Profit = $17, or AR – ATC Average Profit = $17, or AR – ATC P=MR=AR $45-$28 $28

Grey area represents total economic profit if the price is $45… Grey area represents total economic profit if the price is $45… P=MR=AR 11.2  ($45 - $28) = $190.40

Zero economic profit if price falls to P BE. Firm would only produce output O BE. AR-ATC=0 Zero economic profit if price falls to P BE. Firm would only produce output O BE. AR-ATC=0 P=MR=AR

Economic losses if price falls to P SD. Firm would shut down below output O SD Economic losses if price falls to P SD. Firm would shut down below output O SD P=MR=AR

Where is the firm’s supply curve? Where is the firm’s supply curve? P=MR=AR

Marginal cost curve above AVC curve? Marginal cost curve above AVC curve?

Key Input Relationships The following input-related derivations also play a key role in decision-making: Marginal value = marginal physical product × price product

Key Input Relationships The following input-related derivations also play a key role in decision-making: Marginal value = marginal physical product × price product Marginal input = wage rate, rental rate, etc. cost

5 B C D E F G H I J Wage rate represents the MIC for labor Wage rate represents the MIC for labor

5 B C D E F G H I J Use a variable input like labor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC Use a variable input like labor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC

5 The area below the green lined MVP curve and above the green lined MIC curve represents cumulative net benefit. The area below the green lined MVP curve and above the green lined MIC curve represents cumulative net benefit. B C D E F G H I J

5 If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC. B C D E F G H I J

5 If you went beyond the point where MVP=MIC, you begin incurring losses. B C D E F G H I J

Multiple Input Cost Relationships

Output is identical along an isoquant Output is identical along an isoquant Isoquant means “equal quantity” Two inputs

Slope of an Isoquant The slope of an isoquant is referred to as the Marginal Rate of Technical Substitution, or MRTS. The value of the MRTS in our example is given by: MRTS =  Capital ÷  labor If output remains unchanged along an isoquant, the loss in output from decreasing labor must be identical to the gain in output from adding capital.

Plotting the Iso-Cost Line Capital Labor Firm can afford 100 units of labor at a wage rate of $10 for a budget of $1,000 Firm can afford 100 units of labor at a wage rate of $10 for a budget of $1, Firm can afford 10 units of capital at a rental rate of $100 for a budget of $1,000 Firm can afford 10 units of capital at a rental rate of $100 for a budget of $1,000

Slope of an Iso-cost Line The slope of an iso-cost in our example is given by: Slope = - (wage rate ÷ rental rate) or the negative of the ratio of the price of the two Inputs. The slope is based upon the budget constraint and can be obtained from the following equation: ($10 × use of labor)+($100 × use of capital)

Least Cost Decision Rule The least cost combination of two inputs (labor and capital in our example) occurs where the slope of the iso-cost line is tangent to isoquant: MPP LABOR ÷ MPP CAPITAL = -(wage rate ÷ rental rate) Slope of an isoquant Slope of an isoquant Slope of iso- cost line Slope of iso- cost line

Least Cost Decision Rule The least cost combination of labor and capital in out example also occurs where: MPP LABOR ÷ wage rate = MPP CAPITAL ÷ rental rate MPP per dollar spent on labor MPP per dollar spent on labor MPP per dollar spent on capital MPP per dollar spent on capital =

Least Cost Decision Rule The least cost combination of labor and capital in out example also occurs where: MPP LABOR ÷ wage rate = MPP CAPITAL ÷ rental rate MPP per dollar spent on labor MPP per dollar spent on labor MPP per dollar spent on capital MPP per dollar spent on capital = This decision rule holds for a larger number of inputs as well…

Least Cost Input Choice for 100 Units At the point of tangency, we know that: slope of isoquant = slope of iso-cost line, or… MPP LABOR ÷ MPP CAPITAL = - (wage rate ÷ rental rate) At the point of tangency, we know that: slope of isoquant = slope of iso-cost line, or… MPP LABOR ÷ MPP CAPITAL = - (wage rate ÷ rental rate)

Firm can afford to produce only 75 units of output using C 3 units of capital and L 3 units of labor Firm can afford to produce only 75 units of output using C 3 units of capital and L 3 units of labor What Inputs to Use for a Specific Budget?

The Planning Curve The long run average cost (LAC) curve reflects points of tangency with a series of short run average total cost (SAC) curves. The point on the LAC where the following holds is the long run equilibrium position (Q LR ) of the firm: SAC = LAC = P LR where MC represents marginal cost and P LR represents the long run price, respectively.

What can we say about the four firm sizes in this graph? What can we say about the four firm sizes in this graph?

Size 1 would lose money at price P Size 1 would lose money at price P

Q3Q3 Firm size 2, 3 and 4 would earn a profit at price P…. Firm size 2, 3 and 4 would earn a profit at price P….

Q3Q3 Firm size #2’s profit would be the area shown below…

Q3Q3 Firm size #3’s profit would be the area shown below…

Q3Q3 Firm size #4’s profit would be the area shown below…

If price were to fall to down size P LR, only size 3 would not lose money; it would break-even. Size 4 would have to down size its operations! If price were to fall to down size P LR, only size 3 would not lose money; it would break-even. Size 4 would have to down size its operations!

Optimal input combination for output=10 Optimal input combination for output=10 How to Expand Firm’s Capacity

Two options: 1. Point B ? Two options: 1. Point B ?

How to Expand Firm’s Capacity Two options: 1. Point B? 2. Point C? Two options: 1. Point B? 2. Point C?

Optimal input combination for output=10 with budget DE Optimal input combination for output=10 with budget DE Optimal input combination for output=20 with budget FG Optimal input combination for output=20 with budget FG Expanding Firm’s Capacity

This combination costs more to produce 20 units of output since budget HI exceeds budget FG This combination costs more to produce 20 units of output since budget HI exceeds budget FG Expanding Firm’s Capacity

Perfect Competition Market Price Discovery #1 Perfect Competition

P=MR=AR Remember the firm’s supply curve? Remember the firm’s supply curve?

Firm’s supply curve starts at shut down level of output Firm’s supply curve starts at shut down level of output P=MR=AR

Profit maximizing firm will desire to produce where MC=MR Profit maximizing firm will desire to produce where MC=MR P=MR=AR

Economic losses will occur beyond output O MAX, where MC > MR Economic losses will occur beyond output O MAX, where MC > MR P=MR=AR

Forecasting Future Commodity Price Trends D S $4 10 $1 $7 D = a – bP + cYD + eX Own price Own price Disposable income Disposable income Other factors Other factors

D S $4 10 $1 $7 S = n + mP – rC + sZ Own price Own price Input costs Input costs Forecasting Future Commodity Price Trends Other factors Other factors

Projecting Commodity Price D = S D S $4 10 $1 $7 D = 10 – 6P +.3YD + 1.2X S = 2 + 4P –.2C Z Substitute the demand and supply equations into the the equilibrium condition and solve for price Substitute the demand and supply equations into the the equilibrium condition and solve for price

Firm is a “Price Taker” Under Perfect Competition Price Quantity D S PEPE QEQE Price O MAX AVCMC The Market The Firm

If Demand Increases…… Price Quantity D S PEPE QEQE Price AVCMC The Market The Firm D1D1

If Demand Decreases…… Price Quantity D S PEPE QEQE Price AVCMC The Market The Firm 9 10 D2D2

Firm is a “Price Taker” in the Input Market Price Quantity D S PEPE QEQE Price L MAX MVP MIC Labor Market The Firm

Price Quantity D S PEPE QEQE Price L MAX MVP MIC Labor Market The Firm If Demand Increases……

Imperfect Competition Market Price Discovery #2 Imperfect Competition

Monopolistic Competitors Many sellers Ability to differentiate product by advertising and sales promotions Profits can exist in the short run, but others bid them away in the long run Equate MC with MR, but price off the downward sloping demand curve

Short run profits. The firm produces Q SR where MR=MC at E above, but prices its products at P SR by reading off the demand curve which reveals consumer willingness to pay Short run profits. The firm produces Q SR where MR=MC at E above, but prices its products at P SR by reading off the demand curve which reveals consumer willingness to pay

Short run loss. The firm suffers a loss in the current period following the same strategy of operating at Q SR given by MC=MR at point E.

At quantity Q SR, average total cost (ATC SR ) is greater than P SR, which creates the loss depicted above…

In the long run, profits are bid away as more firms enter the market. Or losses will no longer exist as firms leave the market. At Q LR, the remaining firms are just breaking even as shown by the lack of gap between the demand curve and ATC curve. In the long run, profits are bid away as more firms enter the market. Or losses will no longer exist as firms leave the market. At Q LR, the remaining firms are just breaking even as shown by the lack of gap between the demand curve and ATC curve.

Monopolies Only seller in the market. Entry of other firms is restricted by patents, etc. They have absolute power over setting market price. They produce a unique product. They can make economic profits in the long run because they can set price without competition.

Total revenue is equal to the area 0P E CQ E, which forms the blue box to the left… Notice the monopoly, like the previous forms of imperfect competition, produces where MC=MR (point A), but then reads up to the demand curve (point C) when setting price P E. Total revenue is equal to the area 0P E CQ E, which forms the blue box to the left… Notice the monopoly, like the previous forms of imperfect competition, produces where MC=MR (point A), but then reads up to the demand curve (point C) when setting price P E.

Total variable costs for the monopolist is equal to area 0NAQ E, or the yellow box to the left. Total variable costs for the monopolist is equal to area 0NAQ E, or the yellow box to the left.

Total fixed costs for the monopolist is equal to area NMBA, or the green box to the left… Total fixed costs for the monopolist is equal to area NMBA, or the green box to the left…

Total cost is therefore equal to area 0MBQ E, or the green box plus the yellow box to the left. Total cost is therefore equal to area 0MBQ E, or the green box plus the yellow box to the left.

Finally, the economic profit earned by the monopolist is equal to area MP E CB, or total revenue (blue box) minus total costs (green box plus yellow box). Finally, the economic profit earned by the monopolist is equal to area MP E CB, or total revenue (blue box) minus total costs (green box plus yellow box).