Wrapping up supply Today: More on profit maximization, determinants of supply, and surplus

Previously… Fixed costs Marginal productivity Variable costs

Today… We make this graph make intuitive sense We will see that: Profits are positive at price P 1 Profits are negative at prices P 2 and P 3 Firms will shut down when price is P 3

Profit maximization Remember that this is our goal For the most part, we will implement MB/MC analysis again Exception: Shutdown condition If a firm can lose less by closing than opening, it will close

Costs Cost to hire an employee is $100/day Assume $1000 in fixed costs for a phone manufacturer per day Note average fixed cost (AFC) decreases as the number of phones increases

Our output example for today # of employees hired per dayNumber of phones produced

Increasing returns? Notice that the marginal productivity for the 1 st worker is 20; 2 nd worker, 25 Why? Specialization Assembly line can help increase marginal productivity up to a certain point Marginal productivity eventually decreases

Cost table # of empl./day Phones per day Fixed cost ($/day) Var. cost ($/day) Total cost ($/day) MC ($/phone)

How to calculate MC Marginal cost (MC) is how much additional cost is necessary to produce an additional phone For example, each additional phone from the 1 st worker is cost to hire worker / # of phones produced ($100/day) / (20 phones/day) = $5/phone

Cost table # of empl./day Phones per day Fixed cost ($/day) Var. cost ($/day) Total cost ($/day) MC ($/phone)

Suppose that phones sell for $18 each How many people should be hired? Hire the next worker if the MB of the next phone produced is at least as much as the MC This is the same as finding the number of workers that maximizes profits

Marginal analysis: Hire 4 employees/day # of empl./dayPhones per day MB ($/phone)MC ($/phone)

How much profit? –$266 # of empl./day Phones per day Total rev. ($/day) Total cost ($/day) Profit ($/day) – – – – – –294

Shutdown condition Finally, we must check to see if the firm is better off shutting down when profits are negative If total revenue is less than total variable cost for all levels of output (Q), then the firm should shut down This is equivalent to the firm making worse profits for all Q > 0 than for Q = 0

Shutdown condition check Profits are better when 4 employees are hired (–$266) than when the firm shuts down (–$1000) This firm stays in business # of empl./day Total cost ($/day) Profit ($/day) 01000– – – – – –294

Back to our graph We have finished a discrete example Now, we will see how we get the marginal cost (MC), average total cost (ATC), and average variable cost (AVC) curves

Marginal cost MC starts by decreasing, then increases sharply # of empl./dayMC ($/phone)

Average total cost ATC falls initially, then eventually increases # of empl./day Phones per day Total cost ($/day) ATC ($/phone) N/A

Average variable cost AVC falls initially, then eventually increases # of empl./day Phones per day VC ($/day)AVC ($/phone) 000N/A

ATC and AVC costs converge Note ATC = AVC + AFC Since AFC is decreasing as Q increases, the difference between ATC and AVC gets smaller as Q increases Thus, ATC and AVC curves get closer as Q increases

MC curve Remember: Marginal means for an additional unit produced If marginal is below average, this brings the average down If marginal is above average, this brings the average up

MC curve Marginal cost curve tells us how average cost curves (ATC and AVC) move MC curve is below average cost curve when average cost curve is decreasing MC curve is above average cost curve when average cost curve is increasing

Back to the graph All curves decrease initially, but eventually increase MC curve tells us which direction ATC and AVC curves are going

Back to the graph At P 1  positive profits, since TR > TC (P  Q > ATC  Q) At P 2  negative profits At P 3  firm shuts down (TR is less than VC for all Q)

Warning! Look at red circle This is a point where P 3 and MC curves intersect Ignore these points on the MC curve that are downward- sloping, since profit is minimized here

Before we wrap up… A few minutes to talk about Determinants of supply Producer surplus

Determinants of supply Changes in the following can shift supply curves Technology Input prices The number of suppliers Expectations of future prices Changes in the price of other relevant products

Some examples If technology improves or input prices decrease, production becomes less costly If the number of suppliers increases, we can horizontally add the additional supply to the market If the price of calculators increases, some phone suppliers may devote more of its capital to producing calculators

Producer surplus Producer surplus is similar conceptually to consumer surplus For a unit or service sold, producer surplus is the difference between the price paid and the minimum payment the seller is willing to accept for it

Example of producer surplus When P = 25 per unit, shaded area is approximate producer surplus Area is a triangle, one-half times length times height: 0.5  10  25 = 125

Why are CS and PS important? Consumer surplus (CS) and producer surplus (PS) are important since these measures give us a crude measure of the total benefits to society Recall the human supply/demand curve activity Next week, we will see situations in which total surplus can be reduced

This concludes supply (End of Unit 1) Important things to remember with supply Individual and market supply Steps to profit maximization Useful to know individual firm supply, production function, FC, VC, TC, MC, AFC, AVC, ATC, shutdown condition Determinants of supply Producer surplus