1. AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets
Lecture #1
Economic Costs, Profit, and the Production Function

2. ECONOMIC COST
Measures the value of a resource based on its worth in producing the next best alternative
Includes Explicit and Implicit Costs (including normal profit)

3. EXPLICIT VS. IMPLICIT COST
Explicit Costs are $ payments to non-owners of the firm for the resources they supply
Implicit Costs the opportunity costs of using self-owned resources…What else could you have done with your knowledge skill or expertise?

4. NORMAL PROFIT
The $ value of what you would have been paid for your entrepreneurial talent
It is considered an implicit cost

5. ACCOUNTING vs. ECONOMIC PROFIT
Accounting Profits = Total Revenue – Explicit Costs
implicit costs are excluded
used by business
Economic Profits = Total Revenue – Economic Costs
includes explicit & implicit costs (with normal profit)
used by economists

6. Figure 1 Economic versus Accountants
How an Economist
How an Accountant
Views a Firm
Views a Firm
Revenue
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Total
opportunity
costs
Explicit
costs
Explicit
costs
Copyright © South-Western

7. SHORT-RUN VS. LONG RUN
Short-Run – time period that is too brief for a firm to alter its plant capacity, but long enough to change how the fixed plant is used
Long-Run – time period long enough for a firm to adjust the quantities of all the resources it employs, including plant capacity

8. TOTAL PRODUCT (TP OR Q)
The total quantity, or total output, of a particular good produced
Independent of inputs

9. MARGINAL PRODUCT (MP OR MPP)

10. AVERAGE PRODUCT (AP OR APP)

11. PRODUCTION SCHEDULE UNITS OF LABOR TOTAL PRODUCT MARGINAL PRODUCT
AVERAGE PRODUCT X 1 10 2 25 15
12.5 3 45 20 4 60 5 70 14 6 75 7
10.71 8 -5
8.75

12. GRAPHING TOTAL PRODUCT

14. AN EXAMPLE # Workers Total Product (TP) Marginal Product (MP)
Average Product
(AP) 1 12 2 25 3 45 4 55 5 57 6 52

15. LAW OF DIMINISHING MARGINAL RETURNS
As successive increments of a variable resource are added to a fixed resource, the marginal product of the variable resource will eventually decrease
Think about how your pizza production when adding additional workers!

16. AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets
Lecture #2
Short-Run Production Costs

17. FIXED COST (TFC)
Those costs which in total do not vary with changes in output
Can’t be avoided in the short-run

18. VARIABLE COST (TVC)
Those costs that change with the level of output

19. TOTAL COST (TC) TC = TFC + TVC
The sum of fixed cost and variable cost at each level of output
TC = TFC + TVC

20. TOTAL COST SCHEDULES TP TFC TVC TC $100 $0 1 $90 $190 2 $170 $270 3
$100 $0 1
$90
$190 2
$170
$270 3
$240
$340 4
$300
$400 5
$370
$470 6
$450
$550 7
$540
$640 8
$650
$750 9
$780
$880 10
$930
$1030

21. TOTAL COST GRAPHS

22. AVERAGE FIXED COST (AFC)

23. AVERAGE VARIABLE COST

24. AVERAGE TOTAL COST

25. MARGINAL COST

26. MARGINAL COST
Marginal Cost : the addition either to total cost or to total variable cost resulting from one more unit of output
Ex. Another unit of capital, labor, etc.
Why might you want to know what adding that extra worker “costs” you?
How does this relate to marginal product?

27. MARGINAL COST vs. MARGINAL PRODUCT
MC reaches a minimum at the same output level where MP reaches a maximum
MC reaches a maximum at the same output level where MP reaches a minimum
They mirror one another

29. COST CURVE TRUTHS MC intersects AVC and ATC at their lowest points
When MC is below ATC, ATC will fall
When MC is above ATC, ATC will rise
When MC is below AVC, AVC will fall
When MC is above AVC, AVC will rise

30. SHIFTING COST CURVES
An increase in fixed costs would shift the AFC and ATC curves upward; however, MC and AVC curves would remain unchanged because variable resource prices have not changed
If the price of a variable resource increases, the AVC, ATC, and MC curves would all shift upward, AFC would remain unchanged

31. COSTS IN THE SHORT RUN AND IN THE LONG RUN
Division of total costs between fixed and variable costs depends on the time horizon
Short-run - some costs are fixed
Long-run - fixed costs become variable costs
Why?

32. AVERAGE AND MARGINAL COST SCHEDULES
AFC
AVC
ATC MC $0 X
$100
$90
$190
$50
$85
$135
$80
$33.33
$113.33
$70
$25
$75
$60
$20
$74
$94
$16.67
$91.67
$14.29
$77.14
$91.43
$12.50
$81.25
$93.75
$110
$11.11
$86.67
$97.78
$130
$10
$93
$103
$150

33. AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets
Lecture #3
Long-Run Production

34. COSTS IN THE SHORT-RUN AND IN THE LONG-RUN
Remember – Fixed costs in the short-run are VARIABLE COSTS in the LONG-RUN
Long-run cost curves will look different than short-run cost curves
Goal for a firm is to create the optimal plant size

35. LONG-RUN COST CURVES
Long-run ATC curves are made up of segments of short-run curves
The curve is made up of all points of tangency on an unlimited number of short- run ATC curves
U-shape is caused by ECONOMIES AND DISECONOMIES OF LARGE-SCALE production

36. Figure 7 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
$12,000
ATC
in long run
1,200
Quantity of
Cars per Day
Copyright © South-Western

37. ECONOMIES OF SCALE
The downslope of the curve is due to economies of mass production
As plant size increases, factors can allow greater production at lower ATC
Name an industry or firm that would likely benefit from economies of scale?

38. FACTORS CREATING ECONOMIES OF SCALE
Labor specialization = greater skill & efficiency
Managerial specialization allows supervision of more workers and focus on an area of expertise
Efficient capital promotes modernization and speed
Start-up costs, marketing, advertising are diffused

39. DISECONOMIES OF SCALE
Firms can become TOO BIG and start to increase ATC
Upward slope of the curve
Bureaucracy leads to inefficiency
Top-heavy management increases costs
Workers can feel “lost” in a big plant

40. CONSTANT RETURNS TO SCALE
Long-run ATC doesn’t change in some industries, so diseconomies do not result
Output stays proportional to increased inputs

41. Figure 7 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
ATC
in long run
Economies of
scale
Diseconomies of
scale
1,200
$12,000
1,000
10,000
Constant
returns to
scale
Quantity of
Cars per Day
Copyright © South-Western

42. FIRM SIZE
There is a lowest level of output where a firm can minimize long-run average costs
Called Minimum Efficient Scale (MES)
Depending on industry, both large and small firms can operate
Natural Monopolies occur in industries where small firms cannot achieve MES because economies of scale are so big

43. Long-Run ATC Curve Any number of short-run optimum
Average Total Costs
Output
Any number of short-run optimum
size cost curves can be constructed
8-43

44. Long-Run ATC Curve Long-Run ATC The long-run ATC curve just
Average Total Costs
Output
The long-run ATC curve just
“envelopes” the short run ATCs
8-44

45. Long-run ATC curve where economies
Long-Run ATC Shapes
Economies
Of Scale
Constant Returns
To Scale
Diseconomies
Of Scale
Average Total Costs
Long-Run
ATC q1 q2
Output
Long-run ATC curve where economies
of scale exist
8-45

46. Long-Run ATC Shapes Long-Run ATC
Economies
Of Scale
Diseconomies
Of Scale
Average Total Costs
Long-Run
ATC
Output
Long-run ATC curve where costs are lowest only when large firms are participating
8-46

47. Long-Run ATC Shapes Long-Run ATC Long-run ATC curve where economies
Of Scale
Diseconomies
Of Scale
Long-Run
ATC
Average Total Costs
Output
Long-run ATC curve where economies
of scale exist, are exhausted quickly,
and turn back up substantially
8-47

48. AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets
Lecture #4
Introduction to Market Structures and Perfect Competition

49. Market Structure Continuum
Four Market Models
Pure competition
Pure monopoly
Monopolistic competition
Oligopoly
Oligopoly
Pure
Competition
Monopolistic
Competition
Pure
Monopoly
Market Structure Continuum
LO1
8-49

50. Monopolistic Competition
Four Market Models
Characteristics of the Four Basic Market Models
Characteristic
Pure Competition
Monopolistic Competition
Oligopoly
Monopoly
Number of firms
A very large number
Many
Few
One
Type of product
Standardized
Differentiated
Standardized or differentiated
Unique; no close subs.
Control over price
None
“Price Takers”
Some, but within rather narrow limits
Limited by mutual inter-dependence; considerable with collusion
Considerable
Conditions of entry
Very easy, no obstacles
Relatively easy
Significant obstacles
Blocked
Nonprice Competition
Considerable emphasis on advertising, brand names, trademarks
Typically a great deal, particularly with product differentiation
Mostly public relation advertising
Examples
Agriculture
Retail trade, dresses, shoes
Steel, auto, farm implements
Local utilities
LO1
8-50

51. Three Measures of Revenue
Total Revenue (TR)= P x Q
Average Revenue (AR) = TR/Q
Marginal Revenue (MR) = ∆TR/∆Q
LO2
8-51

52. Three Measures of Profit
Total Profit (Tπ) = TR-TC
Average Profit (Aπ) = AR-AC
Marginal Profit (Mπ) = MR-MC or
(Mπ) = ∆MR/∆Q
LO2
8-52

53. Maximizing Profit
The goal of any firm is to maximize profit, but the ability to do so depends on the type of market structure!
This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.
LO2
8-53

54. Rules to Maximize Profit
A firm should produce the output at which MR = MC.
A firm should charge the price on the demand curve for its optimal output level.
A firm should shut down and produce zero output if TR is less than TVC.
LO2
8-54

55. Pure Competition: Characteristics
Very large numbers of sellers
Standardized product
“Price takers”
Easy entry and exit
Perfectly elastic demand
Firm produces as much or little as they want at the price
Demand graphs as horizontal line
LO2
8-55

56. Why is demand perfectly elastic?
Firms can’t get a higher price by cutting output and don’t need to lower their price to increase sales.
With perfectly elastic demand, in pure competition…
D = P = MR = AR
LO2
8-56

57. Profit Maximization: TR–TC Approach
Three questions:
Should the firm produce?
If so, what amount?
What economic profit (loss) will be realized?
LO3
8-57

58. Average, Total, and Marginal Revenue
Firm’s
Demand
Schedule
(Average
Revenue)
Revenue
Data TR P QD TR MR 1 2 3 4 5 6 7 8 9 10
$131
131 $0
131
262
393
524
655
786
917
1048
1179
1310 ]
$131
131
D = MR = AR
LO3
8-58

59. Profit Maximization: TR–TC Approach
The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price = $131)
(1)
Total Product
(Output) (Q)
(2)
Total Fixed Cost (TFC)
(3)
Total Variable Costs (TVC)
(4)
Total Cost
(TC)
(5)
Total Revenue (TR)
(6)
Profit (+)
or Loss (-)
$100 $0
$-100 1
100 90
190
131
-59 2
170
270
262 -8 3
240
340
393
+53 4
300
400
524
+124 5
370
470
655
+185 6
450
550
786
+236 7
540
640
917
+277 8
650
750
1048
+298 9
780
880
1179
+299 10
930
1030
1310
+280
LO3
8-59

60. Profit Maximization: TR–TC Approach1 2 3 4 5 6 7 8 9 10 11 12 13 14
$1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
$500
Total Revenue and Total Cost
Total Economic
Profit
Quantity Demanded (Sold)
Break-Even Point
(Normal Profit)
Total Revenue, (TR)
Maximum
Economic
Profit
$299
Total Cost,
(TC)
P=$131
Break-Even Point
(Normal Profit)
Total Economic
Profit
$299
LO3
8-60

61. Profit Maximization: MR-MC Approach
The Profit-Maximizing Output for a Purely Competitive Firm: Marginal Revenue – Marginal Cost Approach (Price = $131)
(1)
Total
Product
(Output)
(2)
Average Fixed Cost (AFC)
(3)
Average Variable Costs (AVC)
(4)
Average Total Cost
(ATC)
(5)
Marginal Cost
(MC)
Price = Marginal Revenue
(MR)
(6)
Total Economic Profit (+)
or Loss (-)
$-100 1
$100.00
$90.00
$190
$90
$131
-59 2
50.00
85.00
135 80
131 -8 3
33.33
80.00
113.33 70
+53 4
25.00
75.00
100.00 60
+124 5
20.00
74.00
94.00
+185 6
16.67
91.67
+236 7
14.29
77.14
91.43 90
+277 8
12.50
81.25
93.75
110
+298 9
11.11
86.67
97.78
130
+299 10
10.00
93.00
103.00
150
+280
LO3
8-61

62. Profit Maximization: MR-MC Approach
$200
150
100 50
MR = MC MC
P=$131
Economic Profit
MR = P
ATC
Cost and Revenue
AVC
ATC=$97.78 1 2 3 4 5 6 7 8 9 10
Output
LO3
8-62

63. Three Production Questions
Output Determination in Pure Competition in the Short Run
Question
Answer
Should this firm produce?
Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost.
What quantity should this firm produce?
Produce where MR (=P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized.
Will production result in economic profit?
Yes, if price exceeds average total cost (TR will exceed TC). No, if average total cost exceeds price (TC will exceed TR).
LO3
8-63

64. Loss-Minimizing Case Loss minimization
Max. profit or min. loss is where MR=MC
Must take into consideration fixed costs
If TR > TVC, but less than TC, it should still produce at a loss because it will have leftover revenue to pay toward TFC
If TR < TC, it should shut down because it will make a loss on TVC and TFC
LO3
8-64

65. Loss-Minimizing Case Loss minimization
Still produce because P > minAVC
Losses at a minimum where MR=MC
LO3
8-65

66. Loss-Minimizing Case (TR > TVC)
Cost and Revenue
$200
150
100 50 1 2 3 4 5 6 7 8 9 10
Output MC
Loss
ATC=$91.67
ATC
AVC
P=$81
MR = P
AVC = $75
LO3
8-66

67. Short-Run Shut Down Point
Shutdown Case
Cost and Revenue
$200
150
100 50 1 2 3 4 5 6 7 8 9 10
Output MC
ATC
AVC = $74
AVC
MR = P
P=$71
Short-Run Shut Down Point
P < Minimum AVC
$71 < $74
LO3
8-67

68. AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets
Lecture #5
Short-Run Supply and Equilibrium

69. The Supply Curve In A Competitive Market
The competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above the average variable cost (AVC).
Remember, firms won’t produce when MR (0r P) is less than AVC!

70. Figure 3 The Competitive Firm’s Short Run Supply Curve
Costs
Firm ’
s short-run
supply curve
If P > ATC, the firm will continue to produce at a profit. MC
ATC
If P > AVC, firm will continue to produce in the short run.
AVC
Firm
shuts
down if P
<
AVC
Quantity
Copyright © South-Western

71. The Short Run: Firm and Industry Market Equilibrium
For any given price, each firm supplies a quantity of output so that its marginal cost equals price (MR in perfect comp).
The market supply curve reflects the summed total individual firms’ MC curves.
Although a single firm may have little bearing on price, it takes all of those firms operating to determine price
The market supply curve allows you to determine a industry market equilibrium

72. Firm and Industry: Equilibrium
Firm and Market Supply and the Market Demand
(1)
Quantity
Supplied,
Single
Firm
(2)
Total
1000 Firms
(3)
Product
Price
(4)
Demanded 10
10,000
$151
4,000 9
9,000
131
6,000 8
8,000
111 7
7,000 91 6 81
11,000 71
13,000 61
16,000
LO4
8-72

73. Firm and Industry: Equilibrium
S = ∑ MC’s
s = MC
Economic
Profit
ATC d
$111
$111
AVC D 8
8000
LO4
8-73

74. Profit Maximization: TR–TC Approach
The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price = $131)
(1)
Total Product
(Output) (Q)
(2)
Total Fixed Cost (TFC)
(3)
Total Variable Costs (TVC)
(4)
Total Cost
(TC)
(5)
Total Revenue (TR)
(6)
Profit (+)
or Loss (-)
$100 $0
$-100 1
100 90
190
131
-59 2
170
270
262 -8 3
240
340
393
+53 4
300
400
524
+124 5
370
470
655
+185 6
450
550
786
+236 7
540
640
917
+277 8
650
750
1048
+298 9
780
880
1179
+299 10
930
1030
1310
+280
LO3
8-74

75. Determining Market Profitability
Find TR: multiply product price by output – in our example - (8 x $111) for a single firm or $888
Compare to TC: in our example – TC for 8 units is $750
Economic Profit for Individual Firm: TR – TC = $138
Economic Profit for All Firms: Assuming the fixed number is 1,000 as in our example, economic profit would be $138,000

76. AP MICROECONOMICS UNIT #3 Production, Costs, and Competitive Markets
Lecture #6
The Long-Run in Pure Competition

77. The Long Run in Pure Competition
In the long run…
Firms can expand or contract capacity
Firms enter and exit the industry
LO1
9-77

78. Three Assumptions for the Long Run
Easy entry and exit
The only long-run adjustment we consider
Identical costs
All firms in the industry have identical costs
Constant-cost industry
Entry and exit do not affect resource prices
LO2
9-78

79. Long-Run Equilibrium Entry eliminates profits Exit eliminates losses
Firms enter when P rises above ATC
Ex. Consumer tastes increase demand
Supply increases in the short-run
Equilibrium price falls
Exit eliminates losses
Firms exit when P falls below ATC
Ex. Consumer tastes decrease demand
Supply decreases in the short-run
Equilibrium price increases
LO3
9-79

80. Entry Eliminates Economic Profits
Single Firm
(b)
Industry P q Q
100
90,000
80,000
100,000 S1 MC
$60 50 40
ATC
$60 50 40 S2 MR D2 D1
LO3
9-80

81. Exit Eliminates Losses
Single Firm
(b)
Industry P q Q
100
90,000
80,000
100,000 S3 MC
$60 50 40
$60 50 40
ATC S1 MR D1 D3
LO3
9-81

82. How do costs impact long-run supply?
Constant cost industry
Entry/exit does not affect LR ATC
Constant resource price
Supply curve is perfectly elastic
Industry has ability to adjust to demand shifts
LO4
9-82

83. LR Supply: Constant-Cost IndustryQ P1 P2 P3
$50 S Z3 Z1 Z2 D3 D1 D2 Q3 Q1 Q2
90,000
100,000
110,000
LO4
9-83

84. How do costs impact long-run supply?
Increasing cost industry
More firms = higher costs
LR ATC increases with expansion & causes new equilibrium price
Supply curve is upward sloping
LO4
9-84

85. LR Supply: Increasing-Cost IndustryQ S P2
$55 Y2 P1
$50 Y1 P3
$40 Y3 D2 D1 D3 Q3 Q1 Q2
90,000
100,000
110,000
LO4
9-85

86. How do costs impact long-run supply?
Decreasing-cost industry
More firms = lower costs
LR ATC increases and changes equilibrium
Long-run supply curve is downsloping
LO4
9-86

87. LR Supply: Decreasing-Cost IndustryQ X3 P3
$55 X1 P1
$50 X2 P2
$40 S D3 D2 D1 Q3 Q1 Q2
90,000
100,000
110,000
LO4
9-87

88. Pure Competition and Efficiency
In the long run, efficiency is achieved
P/MR = min ATC
MC intersects ATC at minimum,
therefore MR = MC = min. ATC
Only normal profits in the long-run
LO5
9-88

89. Pure Competition and Efficiency
Productive efficiency
Producing where P = min. ATC
Benefits consumers/society
Only firms who use the best production methods survive
LO5
9-89

90. Pure Competition and Efficiency
Allocative efficiency
Producing where P = MC
Each item produced to the point at which the value of the last unit is equal to the value of the alternative good being sacrificed
Best mix of products and use of resources
LO5
9-90

91. Pure Competition Results
Consumer and producer surplus maximized
P = MC = lowest ATC
MC = MB
Maximum willingness to pay = minimum acceptable price
LO5
9-91

92. Pure Competition and Efficiency
Single Firm
Market
Price
Quantity
P=MC=Minimum
ATC (Normal Profit) MC
Consumer Surplus S
ATC P MR P
Producer Surplus D Qf Qe
LO5
9-92

93. Purely competitive markets always adjust to
Dynamic Adjustments
Purely competitive markets always adjust to
Changes in consumer tastes
Resource supplies
Technology
Recall the “Invisible Hand”
LO6
9-93

94. Technological Advance: Competition
Entrepreneurs seek economic profit (beyond normal profit)
Decrease costs by innovating
New product development
LO6
9-94

95. Competition and innovation may lead to “creative destruction”
Creation of new products and methods destroys the old products and methods
LO6
9-95

96. Efficiency Gains from Entry
Patent protected prescription drugs earn substantial economic profits for the pharmaceutical company
Generic drugs become available as the patent expires on the existing drug
Results in a 30-40% reduction price
Greater consumer surplus and efficiency
9-96

97. Efficiency Gains from EntryP1 b c d f P2 D Q1 Q2
9-97