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CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and.

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Presentation on theme: "CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and."— Presentation transcript:

1 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 53 8 Short-Run Costs and Output Decisions Costs in the Short RunFixed CostsVariable CostsTotal CostsShort-Run Costs: A ReviewOutput Decisions: Revenues,Costs, and Profit MaximizationTotal Revenue ( TR ) and Marginal Revenue ( MR ) Comparing Costs and Revenues to Maximize Profit The Short-Run Supply CurveLooking Ahead CHAPTER OUTLINE PART II THE MARKET SYSTEM Choices Made by Households and Firms

2 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 2 Terms and Concepts: average fixed cost (AFC): ortalama sabit maliyet average total cost (ATC): ortalama toplam maliyet average variable cost (AVC): ortalama değişken maliyet fixed cost: sabit maliyet homogeneous product: homojen (türdeş) ürün marginal cost (MC): marjinal maliyet marginal revenue (MR): marjinal gelir (hasılat) perfect competition: tam rekabet spreading overhead: sabit masrafları yaymak (dağıtmak) sunk costs: batık-batmış maliyet total cost (TC): toplam maliyet total fixed cost or overhead (TFC): toplam sabit maliyet total revenue (TR): toplam gelir (hasılat) total variable cost (TVC): toplam değişken maliyet total variable cost curve: toplam değişken maliyet eğrisi variable cost: değişken maliyet TC = TFC + TVC AFC = TFC/q Slope of TVC = MC AVC = TVC/q ATC = TC/q = AFC + AVC TR = P x q Profit-maximizing level of output for all firms: MR = MC Profit-maximizing level of output for perfectly competitive firms: P = MC

3 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 3 of 53 Short-Run Costs and Output Decisions You have seen that firms in perfectly competitive industries make three specific decisions that are:  FIGURE 8.1 Decisions Facing Firms Decisions Facing Firms (We will consider here perfectly competitive markets as a teaching device since firms are price-takers in both input and output markets. Many decisions depend on prices over which firms have no control. It means that firm faces less decisions)

4 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 4 of 53 Costs in the Short Run The short run is a period of time for which two conditions hold: 1.The firm is operating under a fixed scale (fixed factor) of production, and 2.Firms can neither enter nor exit an industry. In the short run, all firms (competitive or not competitive) have costs that they must bear regardless of their output. fixed cost Any cost that does not depend on the firms level of output. These costs are incurred even if the firm is producing nothing. There are no fixed costs in the long run. Firms do have certain costs in the short run that depend on output. variable cost A cost that depends on the level of production chosen. total cost (TC) Fixed costs plus variable costs. TC = TFC + TVC Total Cost = Total Fixed Cost + Total Variable Cost

5 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 5 of 53 Costs in the Short Run total fixed costs (TFC) or overhead The total of all costs that do not change with output even if output is zero. For example: insurance premium, the taxes not related to output level, the contract obligations to workers. Another name for fixed costs in the short run is sunk costs is because firms have no choice but to pay for them. Total Fixed Cost (TFC) Fixed Costs TABLE 8.1 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm (1) Q (2) TFC (3) AFC (TFC/Q) 012345012345 $1,000 1,000 1,000 1,000 1,000 1,000 $  1,000 500 333 250 200

6 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 6 of 53 If fixed cost at Q = 100 is $170, then: a.fixed cost at Q = 0 is zero. b.fixed cost at Q = 0 is less than $170. c.fixed cost at Q = 200 is $340. d.fixed cost at Q = 200 is $170. e. There is insufficient information given to calculate any amount of cost.

7 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 53 If fixed cost at Q = 100 is $170, then: a.fixed cost at Q = 0 is zero. b.fixed cost at Q = 0 is less than $170. c.fixed cost at Q = 200 is $340. d.fixed cost at Q = 200 is $170. e. There is insufficient information given to calculate any amount of cost.

8 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 8 of 53 Costs in the Short Run Total Fixed Cost (TFC) Fixed Costs  FIGURE 8.2 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm Average fixed cost is simply total fixed cost divided by the quantity of output. As output increases, average fixed cost declines because we are dividing a fixed number ($1,000) by a larger and larger quantity. TABLE 8.1 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm (1) Q(2) TFC(3) AFC (TFC/Q) 012345012345 $1,000 1,000 1,000 1,000 1,000 1,000 $  1,000 500 333 250 200

9 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 9 of 53 Average fixed cost: a.Increases as output increases. b.Decreases as output increases. c.Remains constant as output increases. d.First decreases then, beyond some point, it begins to increase.

10 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 10 of 53 Average fixed cost: a.Increases as output increases. b.Decreases as output increases. c.Remains constant as output increases. d.First decreases then, beyond some point, it begins to increase.

11 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 11 of 53 Costs in the Short Run Average Fixed Cost (AFC) Fixed Costs average fixed cost (AFC) Total fixed cost divided by the number of units of output; a per-unit measure of fixed costs. spreading overhead The process of dividing total fixed costs by more units of output. Average fixed cost declines as quantity rises.

12 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 12 of 53 Costs in the Short Run Total Variable Cost (TVC) Variable Costs total variable cost (TVC) The total of all costs that vary with output in the short run. To produce more output, a firm uses more inputs. The cost of additional output depends directly on the additional inputs that are required and how much they cost. At any given level of output, total variable cost depends on: 1.The techniques of production that are available, and 2.The prices of the inputs required by each technology. The total variable cost is derived from production requirements and input prices.

13 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 13 of 53 (9 x $2) + (6 x $1) = $24 (6 x $2) + (14 x $1) = $26 6 14 9696 ABAB 3 units of output (7 x $2) + (6 x $1) = $20 (4 x $2) + (10 x $1) = $18 6 10 7474 ABAB 2 units of output 4646 (4 x $2) + (4 x $1) = $12 (2 x $2) + (6 x $1) = $10 4242 ABAB 1 unit of output Total Variable Cost Assuming P K = $2, P L = $1 TVC = (K x P K ) + (L x P L ) Using Technique Units of Input Required (Production Function) K LProduce TABLE 8.2 Derivation of Total Variable Cost Schedule from Technology and Factor Prices Costs in the Short Run Total Variable Cost (TVC) Variable Costs

14 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 14 of 53 Which of the following curves embodies information about both input prices and technology? a.The total fixed cost curve. b.The average fixed cost curve. c.The total variable cost curve. d. All of the above.

15 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 15 of 53 Which of the following curves embodies information about both input prices and technology? a.The total fixed cost curve. b.The average fixed cost curve. c.The total variable cost curve. d. All of the above.

16 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 16 of 53 Costs in the Short Run Total Variable Cost (TVC) Variable Costs  FIGURE 8.3 Total Variable Cost Curve In Table 8.2, total variable cost is derived from production requirements and input prices. A total variable cost curve expresses the relationship between TVC and total output. The total variable cost curve shows the cost of production using the best available technique at each output level, given current factor prices. When machinery (capital: K) is expensive and labor (L) is cheap, choose labor-intensive technology, in stead of capital-intensive technology, vice versa (see the examples above). total variable cost curve A graph that shows the relationship between total variable cost and the level of a firm’s output.

17 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 17 of 53 Costs in the Short Run Marginal Cost (MC) Variable Costs marginal cost (MC) The increase in total cost that results from producing 1+ more unit of output. Marginal costs reflect changes in variable costs. Fixed costs do not change when output changes. The table below shows that marginal cost derived from total variable cost by simply subtraction (means that total variable cost is sum of marginal cost, for example the total cost of 2 units of output is: 0 + 10 + 8 = 18). TABLE 8.3 Derivation of Marginal Cost from Total Variable Cost Units of OutputTotal Variable Costs ($)Marginal Costs ($) 01230123 0 10 18 24 10 8 6

18 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 18 The Shape of the Marginal Cost Curve in the Short Run The assumption of a fixed factor of production in the short run means that a firm is stuck its current scale of operation (in our example, the size of the plant). Thus, our definition of the sort run also implies that marginal cost eventually rises with output. The firm can hire more labor and use more materials-that is, it can add variable inputs-but diminishing returns eventually set in. If each additional unit of labor adds less and less to total output, it follows that it requires more labor to produce each additional unit of output. Thus, each additional unit of output costs more to produce. In other words, diminishing returns, or decreasing marginal product, implies increasing marginal cost (see Figure in the next page)

19 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 19 of 53 Costs in the Short Run The Shape of the Marginal Cost Curve in the Short Run Variable Costs  FIGURE 8.4 Declining Marginal Product Implies That Marginal Cost Will Eventually Rise with Output In the short run, every firm is constrained by some fixed factor of production. A fixed factor implies diminishing returns (declining marginal product) and a limited capacity to produce. As that limit is approached, marginal costs rise.

20 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 20 of 53 Costs in the Short Run The Shape of the Marginal Cost Curve in the Short Run Variable Costs In the short run, every firm is constrained by some fixed input that (1)leads to diminishing returns to variable inputs and (2)limits its capacity to produce. As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output. Marginal costs ultimately increase with output in the short run.

21 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 21 of 53 Costs in the Short Run Graphing Total Variable Costs and Marginal Costs Variable Costs  FIGURE 8.5 Total Variable Cost and Marginal Cost for a Typical Firm See the Figure on the right and notice that the shape of marginal cost curve is consistent with short run diminishing returns. At first MC declines, but eventually the fixed factor of production begins to constrain the firm, and marginal cost rises. More output costs more than less output. Total variable cost, therefore always increase when output increase. Even though the cost of each additional unit changes, total variable cost rises when output rises. Thus the total variable cost curve always has a positive slope.

22 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 22 of 53 Costs in the Short Run Graphing Total Variable Costs and Marginal Costs Variable Costs  FIGURE 8.5 Total Variable Cost and Marginal Cost for a Typical Firm Total variable costs always increase with output. Marginal cost is the cost of producing each additional unit. Thus, the marginal cost curve shows how total variable cost changes with single- unit increases in total output. The slope of TVC is the change in TVC divided by the change in output. Because MC is by definition the change in TVC resulting from an increase in output of one unit (Δq =1), MC actually is the slope of the TVC curve.

23 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 23 Graphing Total Variable Costs and Marginal Costs Notice that up to 100 units, MC decreases and TVC curve becomes flatter. The slope of TVC curve is declining –that is, TVC increases, but at a decreasing rate. Beyond 100 units of output, MC increases and TVC curve gets steeper –TVCs continue to increase, but at an increasing rate. See a more complete picture of the costs of a hypothetical firm in the Table in Table 8.4

24 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 24 of 53 Which of the following is marginal cost? a.The slope of the total variable cost curve. b.Total variable cost divided by the number of units of output. c.The wage rate times the units of labor employed. d. All of the above.

25 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 25 of 53 Which of the following is marginal cost? a.The slope of the total variable cost curve. b.Total variable cost divided by the number of units of output. c.The wage rate times the units of labor employed. d. All of the above.

26 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 26 of 53 Costs in the Short Run Average Variable Cost (AVC) Variable Costs average variable cost (AVC) Total variable cost divided by the number of units of output (q). See the costs of a hypothetical firm in Table 8.4. We calculate AVC in column 4 by dividing the numbers in column 2 (TVC) by the numbers in column 1 (q). For example, if TVC of producing five units of output is $42, then AVC is $42/5 = $8.4. Marginal cost is the cost of one additional unit, while average variable cost is the variable cost per unit of all the units being produced.

27 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 27 of 53 Costs in the Short Run Average Variable Cost (AVC) Variable Costs TABLE 8.4 Short-Run Costs of a Hypothetical Firm (1) q (2) TVC (3) MC (  TVC) (4) AVC (TVC/q) (5) TFC (6) TC (TVC + TFC) (7) AFC (TFC/q) (8) ATC (TC/q or AFC + AVC) 0$0$  $  $1,000$ $  $  110 1,0001,0101,0001,010 218891,0001,018500509 324681,0001,024333341 432881,0001,032250258 54210 8.41,0001,042200 208.4      5008,00020 161,0009,0002 18

28 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 28 of 53 Costs in the Short Run Graphing Average Variable Costs and Marginal Costs Variable Costs  FIGURE 8.6 More Short-Run Costs When marginal cost is below average cost, average cost is declining. When marginal cost is above average cost, average cost is increasing. Rising marginal cost intersects average variable cost at the minimum point of AVC. After 100 units of output, we begin to see diminishing returns. Marginal cost begins to increase as higher and higher levels of output are produced. However, notice that average cost is falling until 200 units since marginal cost remains below it.

29 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 29 of 53 Costs in the Short Run Total Costs  FIGURE 8.7 Total Cost = Total Fixed Cost + Total Variable Cost Total cost ls graphed in Figure above where the same vertical distance (equal to TFC, which is constant) is simply added to TVC at every level of output. Column 6 in the Table 8,4 adds the total fixed cost of $1000 to total variable cost to arrive at total cost. Adding TFC to TVC means adding the same amount of total fixed cost to every level of total variable cost. Thus, the total cost curve has the same shape as the total variable cost curve; it is simply higher by an amount equal to TFC.

30 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 30 of 53 Costs in the Short Run Total Costs Average Total Cost (ATC) average total cost (ATC) Total cost divided by the number of units of output. Column 8 in the Table 8,4 shows the result of dividing the costs in column 6 by the quantities in column 1. Average total cost is to add average fixed cost and average variable cost together. Because AFC falls with output, an ever-declining amount is added to AVC.

31 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 31 of 53 Costs in the Short Run Total Costs Average Total Cost (ATC)  FIGURE 8.8 Average Total Cost = Average Variable Cost + Average Fixed Cost The relationship between average total cost and marginal cost is exactly the same as the relationship between average variable cost and marginal cost. The average total cost curve fallows the marginal cost curve, but lags behind because it is an average over all units of output. The average total cost curve lags behind the marginal cost curve even more than the average variable cost curve does, because the cost of each added unit of production is now averaged not only with the variable cost of all previous units produced, but also with fixed costs as well.

32 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 32 of 53 Costs in the Short Run Total Costs Average Total Cost (ATC)  FIGURE 8.8 Average Total Cost = Average Variable Cost + Average Fixed Cost To get average total cost, we add average fixed and average variable costs at all levels of output. Because average fixed cost falls with output, an ever-declining amount is added to AVC. Thus, AVC and ATC get closer together as output increases, but the two lines never meet. If marginal cost is below average total cost, average total cost will decline toward marginal cost. If marginal cost is above average total cost, average total cost will increase. As a result, marginal cost intersects average total cost at ATC’s minimum point, for the same reason that it intersects the average variable cost curve at its minimum point.

33 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 33 of 53 Refer to the figure below. Which distance from point D is equal to total fixed cost? a.The distance from D to B. b.The distance from D to C. c.The distance from D to A. d. None of the above. Fixed cost cannot be measured from point D.

34 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 34 of 53 Refer to the figure below. Which distance from point D is equal to total fixed cost? a.The distance from D to B. b.The distance from D to C. c.The distance from D to A. d. None of the above. Fixed cost cannot be measured from point D.

35 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 35 of 53 Costs in the Short Run Short-Run Costs: A Review TABLE 8.5 A Summary of Cost Concepts TermDefinitionEquation Accounting costsOut-of-pocket costs or costs as an accountant would define them. Sometimes referred to as explicit costs.  Economic costsCosts that include the full opportunity costs of all inputs. These include what are often called implicit costs.  Total fixed costsCosts that do not depend on the quantity of output produced. These must be paid even if output is zero. TFC Total variable costsCosts that vary with the level of output.TVC Total costThe total economic cost of all the inputs used by a firm in production. TC = TFC + TVC Average fixed costsFixed costs per unit of output.AFC = TFC/q Average variable costsVariable costs per unit of output.AVC = TVC/q Average total costsTotal costs per unit of output.ATC = TC/q ATC = AFC + AVC Marginal costsThe increase in total cost that results from producing 1 additional unit of output. MC =  TC/  q

36 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 36 of 53 Refer to the figure below. What is the value of total variable cost when 300 units of output are produced? a.$1,800 b.$10,200 c.$20,000 d.$7,200 e.$17,400

37 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 37 of 53 Refer to the figure below. What is the value of total variable cost when 300 units of output are produced? a.$1,800 b.$10,200 c.$20,000 d.$7,200 e.$17,400

38 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 38 of 53 Costs in the Short Run Short-Run Costs: A Review Average and Marginal Costs at a College Costs in Dollars StudentsTotal Fixed CostTotal Variable CostTotal CostAverage Total Cost 500$60 million$ 20 million$ 80 million$160,000 1,00060 million40 million100 million100,000 1,50060 million 120 million80.000 2,00060 million80 million140 million70,000 2,50060 million100 million60 million60,000

39 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 39 of 53 Output Decisions: Revenues, Costs, and Profit Maximization perfect competition An industry structure in which there are many firms, each small relative to the industry in which no firm is large enough to have any control over prices (price taker), producing virtually, identical (homogeneous) products, and, in perfectly competitive industries, new competitors can freely enter and exit the market (free entrance). homogeneous products Undifferentiated products; products that are identical to, or indistinguishable from, one another In such as environment, product price is determined by the interaction of many suppliers and many demanders. The figure in the next page shows a typical firm in a perfectly competitive industry/market. Price is determined in the market at P*=$2,45. The individual firm can charge any price that it wants for its product, but if it charges above $5, the quantity demanded falls zero, and the firm will not sell anything. The firm could also sell its product for less than $2,45, but there is no reason to do so. Perfect Competition

40 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 40 Output Decisions: Revenues, Costs, and Profit Maximization Perfect Competition  FIGURE 8.9 Demand Facing a Single Firm In a Perfectly Competitive Market If a representative firm in a perfectly competitive market raises the price of its output above $2.45, the quantity demanded of that firm’s output will drop to zero. Each firm faces a perfectly elastic demand curve, d.

41 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 41 Output Decisions: Revenues, Costs, and Profit Maximization The perfectly competitive firm faces a perfectly elastic demand curve for its product. In the short run, a competitive firm faces a demand curve that is simply a horizontal line at the market/industry equilibrium price. In other words, competitive firms face perfectly elastic demand in the short run. In the Figure in the previous page, market equilibrium price is P*=$2,45 and the firm’s perfectly elastic demand curve is labeled d. Because perfectly competitive firms are very small relative to the market, they have no control over price. A firm can sell all it wants at the market price but would sell nothing if it charged a higher price. Thus, the demand curve facing a perfectly competitive firm is simply a horizontal line at the market.

42 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 42 of 53 Output Decisions: Revenues, Costs, and Profit Maximization Total Revenue (TR) and Marginal Revenue (MR) total revenue (TR) The total amount that a firm takes in from the sale of its product: the price per unit times the quantity of output the firm decides to produce (P x q). marginal revenue (MR) The additional revenue that a firm takes in when it increases output by one additional unit. In perfect competition, P = MR In the Figure 8.9,, for example, the market price is $2,45. Thus, if the representative firm raises its output one unit its revenue will increase by $2,45. A firm’s MR curve shows how much revenue the firm will gain by raising output by one unit at every level of output. The MR curve and demand curve facing a competitive firm is identical. The horizontal line in the Figure 8.9 can be thought of as both the demand curve facing the firm and its MR curve: P* = d = MR

43 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 43 of 4743 of 53 Marginal revenue equals the change in total revenue associated with: a.Marginal cost. b.Hiring an additional worker. c.Increasing the price per unit of output sold. d.Selling an additional unit of output. e.Decreasing sales revenue from laying off an additional worker.

44 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 44 of 53 Marginal revenue equals the change in total revenue associated with: a.Marginal cost. b.Hiring an additional worker. c.Increasing the price per unit of output sold. d.Selling an additional unit of output. e.Decreasing sales revenue from laying off an additional worker.

45 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 45 Comparing Costs and Revenues to Maximize Profit We assume that: (1) the industry we are examining is perfectly competitive and (2) firms choose the level of output that yields the maximum total profit. The Figure in the next page representing a perfectly competitive market shows MC curve and ATC curves together with demand curve. The profit-maximizing level of output for all firms (not just those in perfectly competitive industries/markets) is the output level where: MR = MC. The Figure in the next page shows that at 300 units of output MC curve and MR curve (that is also demand curve) intersect. Thus at 300 units of output level (q*): MR = MC In perfect competition, MR = P, therefore, the firm will produce up to the point where the price of its output is just equal to short- run marginal cost. Thus, at 300 units of output level (q*): P* = MR = MC = $5

46 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 46 of 53 Output Decisions: Revenues, Costs, and Profit Maximization Comparing Costs and Revenues to Maximize Profit  FIGURE 8.10 The Profit-Maximizing Level of Output for a Perfectly Competitive Firm If price is above marginal cost, as it is at 100 and 250 units of output, profits can be increased by raising output; each additional unit increases revenues by more than it costs to produce the additional output. Beyond q* = 300, however, added output will reduce profits. At 340 units of output, an additional unit of output costs more to produce than it will bring in revenue when sold on the market. Profit-maximizing output is thus q*, the point at which P* = MC. The Profit-Maximizing Level of Output

47 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 47 of 53 Output Decisions: Revenues, Costs, and Profit Maximization Comparing Costs and Revenues to Maximize Profit The Profit-Maximizing Level of Output As long as marginal revenue is greater than marginal cost, even though the difference between the two is getting smaller, added output means added profit. Whenever marginal revenue exceeds marginal cost, the revenue gained by increasing output by 1 unit per period exceeds the cost incurred by doing so. The profit-maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to short-run marginal cost—the level of output at which P* = MC. The profit-maximizing output level for all firms is the output level where MR = MC.

48 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 48 of 53 Refer to the figure below. Which level of output maximizes profit? a.100 units. b.200 units. c.300 units. d.340 units. e. None of the above.

49 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 49 of 53 Refer to the figure below. Which level of output maximizes profit? a.100 units. b.200 units. c.300 units. d.340 units. e. None of the above.

50 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 50 of 53 Output Decisions: Revenues, Costs, and Profit Maximization Comparing Costs and Revenues to Maximize Profit A Numerical Example The key idea here is that firms will produce as long as marginal revenue exceeds marginal cost. Thus, the profit – maximizing level of output is four unit that offers more profit *($20): P = MR = 15 ≥ MC = 10 TABLE 8.6 Profit Analysis for a Simple Firm (1) q (2) TFC (3) TVC (4) MC (5) P = MR (6) TR (P x q) (7) TC (TFC + TVC) (8) PROFIT (TR  TC) 0$10$0$  $15$0$10$-10 110 15 20-5 210155 30255 31020515453015 410301015604020 510502015756015 61080301590 0

51 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 51 Output Decisions: Revenues, Costs, and Profit Maximization Comparing Costs and Revenues to Maximize Profit A Numerical Example Case Study in MarginalAnalysis: An Ice CreamParlor An analysis of fixed costs, variable costs, revenues, profits, and opening longer hours were used by this ice cream parlor to determine whether to stay in business.

52 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 52 Output Decisions: Revenues, Costs, and Profit Maximization The Short-Run Supply Curve  FIGURE 8.11 Marginal Cost Is the Supply Curve of a Perfectly Competitive Firm A rightward shift of demand curve in an industry leads to an increase in price and in units of output at both the industry and a representative firm. The points on the MC curve represent not only MC but also the firm’s short-run supply that shows a relationship between price and quantity supplied.

53 CHAPTER 8 Short-Run Costs and Output Decisions © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 53 of 53 Output Decisions: Revenues, Costs, and Profit Maximization The Short-Run Supply Curve  FIGURE 8.11 Marginal Cost Is the Supply Curve of a Perfectly Competitive Firm At any market price, the marginal cost curve shows the output level that maximizes profit. Thus, the marginal cost curve of a perfectly competitive profit- maximizing firm is the firm’s short-run supply curve. This is true except when price is so low that it pays a firm to shut down—a point that will be discussed in Chapter 9.


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