1. Supply and Profit Maximization
President Clinton’s “Level Playing Field” Claim
On April 7, 1994, President Clinton (Hilary’s husband) held a town meeting at the KCTV television studios in Kansas City, Missouri. He fielded a variety of questions concerning his health care proposal. One question was posed by Herman Cain, president and chief executive officer of Godfather Pizza, Inc. Mr. Cain feared that Clinton’s proposal would raise his costs, hurt his business, and force him to lay off workers. President Clinton agreed that costs would rise, but argued that since the costs of all pizza firms would increase, Godfather would not suffer:
“..., so [for] you [the health proposal] would add about one and one-half percent to the total cost of doing business. Would that really cause you to lay a lot of people off if all your competitors had to do it too? Only if people stop eating out. If all your competitors had to do it, and your cost of doing business went up one and one-half percent, wouldn't that leave you in the same position you are in now? Why wouldn't they all be in the same position, and why wouldn't you all be able to raise the price of pizza two percent? I'm a satisfied customer. I'd keep buying from you.”
President Clinton’s “Level Playing Field” Claim: Since the costs of all pizza firms would increase, an individual firm would not be hurt.
Strategy: Two Questions
First Question: Where does the market supply curve come from? We shall show that the market supply curve is the horizontal sum of each firm’s individual supply curve.
Second Question: Where does an individual firm’s supply curve come from? That is, how does a firm decide on the quantity of output to produce?

2. 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?
Claim: The market supply curve is the horizontal sum of each individual firm’s supply curve.
Market Supply Curve: How many cans of beer would firms produce (the quantity supplied), if the price of beer were _______, given that everything else relevant to the supply of beer remains the same
2.00
1.50
.50
1.00
A Firm’s Individual Supply Curve: How many cans of beer would the firm produce (the firm’s quantity supplied), if the price of beer were ______, given that everything else relevant to the supply of beer remains the same.
.50
1.50
2.00
1.00
Firm B
Market
Firm A P P P SA SB S
If P=2.00
If P=1.50
If P=1.00
If P=.50 q q q

3. Second Question: Where does an individual firm’s supply curve come from? That is, how does a firm decide how much output to produce?
Profit = Total Revenue  Total Cost
= TR  TC
Your New Job: Consultant
Mr. Busch, the president of Anheuser-Busch, hires you as a consultant. He wants to know if he is producing the profit maximizing quantity of beer.
Is Anheuser-Busch presently maximizing profits?
If not, should more beer be produced or should less beer be produced?
What information do you need to determine whether or not the profit maximizing quantity is being produced?
In 2013:
Total Revenue = $32.0 billion
Quantity = $50.0 billion cans
Total Cost = $22.5 billion
Price = $.64
Profit = $9.5 billion
Average Total Cost = $.45
Does this help you determine if profits are currently being maximized?

4. Marginal Revenue (MR):
Second Question: Where does an individual firm’s supply curve come from? That is, how does a firm decide how much output to produce?
Profit = Total Revenue  Total Cost
= TR  TC
One fewer unit of output
One additional unit of output
 $1.00
 $.20
 $1.00
 $1.10
 $.80
 $.10
Question: What information do we need to determine if profits are being maximized?
Marginal Revenue (MR):
Marginal Cost (MC):
Change in the firm’s total revenue resulting from a one unit change in the quantity of output produced.
Change in the firm’s total cost resulting in a one unit change in the quantity of output produced.
Scenario 2: MR = $1.00 and MC = $1.10
Scenario 1: MR = $1.00 and MC = $.80
If one additional unit of output were produced, by how much would TR rise?
If one fewer unit of output were produced, by how much would TR fall?
If one additional unit of output were produced, by how much would TC rise?
If one fewer unit of output were produced, by how much would TC fall?
MR > MC
MR < MC
 More production increases profit.
 Less production increases profit.

5. Perfectly competitive industry
Marginal Revenue Curve: In a perfectly competitive industry a firm’s marginal revenue curve is horizontal equal to the price.
Perfectly competitive industry
 Large number of small independent firms
MR=Price
 A single firm’s production decisions do not affect the price significantly q
 Claim:
Each firm takes the price as a given, as a constant: MR = Price
Marginal Revenue (MR): Change in the firm’s total revenue resulting from a one unit change in production.
 Marginal revenue (MR) curve is horizontal equal to the price.
Justifying the claim: What happens to total revenue when one additional unit of output is produced; that is, when the quantity (q) increases by 1.
Initial Total Revenue: TR = Price×q
Increase q by one unit: q  q + 1
New Total Revenue: TR = Price×(q + 1)
= Price×q Price
MR = Price
Change in Total Revenue:

6. Increasing Total Cost and Increasing Marginal Cost
Increasing Total Cost: As a firm produces more output, its total cost increases.
Increasing Marginal Cost: As a firm produces more output, its marginal cost (that is, the change in its total cost resulting from a one unit change in production) increases.
Geometrically, this means that a firm’s marginal cost is upward sloping. MC
Marginal Cost (MC): Change in the firm’s total cost resulting from a one unit change in production. q
Increasing Marginal Cost and Decreasing Marginal Product
Marginal Product of Labor: Change in the quantity of output produced resulting from a one unit change in the amount of labor hired.
Decreasing Marginal Product: As a firm hires more labor, the marginal product of labor (that is, the change in production resulting from a one unit change in labor) decreases.
Claim: Increasing marginal cost and decreasing marginal product are two different ways of viewing the same phenomenon.

7. Total Apples Picked (bushels) Total Apples Picked (bushels)
Mr. Atkins Apple Orchard
Labor Hired (hours)
Total Apples Picked (bushels)
Marginal Product
Marginal Product of Labor: Change in the quantity of output produced resulting from a one unit change in the amount of labor hired.
0.0
1.0 1
1.0
1.0 2
2.0
1.0
Decreasing Marginal Product: As a firm hires more labor, the marginal product of labor (that is, the change in production resulting from a one unit change in labor) decreases. 3
3.0
0.6 4
3.6
0.4 5
4.0
Wage Rate: $10 per hour
Total Apples Picked (bushels)
Labor Hired (hours)
Total Labor Costs
Marginal Cost
Marginal Cost: The change in its total cost resulting from a one unit change in production.
0.0 10
1.0 1 10 10
Increasing Marginal Cost: As a firm produces more output, its marginal cost increases.
2.0 2 20 10
3.0 3 30 20
4.0 5 50
Increasing marginal cost and decreasing marginal product are two different ways of viewing the same phenomenon.

8. First Question: Where does the market supply curve come from?
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?
Marginal Revenue (MR): Change in the firm’s total revenue resulting from a one unit change in the quantity of output produced.
Profit Maximization
Marginal Cost (MC): Change in the firm’s total cost resulting from a one unit change in the quantity of output produced.
MR > MC
MR = MC
MR < MC
 Less production increases profit
 More production increases profit
 Profit is maximized MC
Marginal Cost Curve: Upward Sloping
Marginal Revenue and Perfect Competition: MR = P
MR=P q q*

9. Profit Maximization: Produce the quantity of output at which MR = 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?
1.00
.50
1.50
Profit Maximization: Produce the quantity of output at which MR = MC. P MC S
If P = 1.50
MR = 1.50
If P = 1.00
MR = 1.00
If P = .50
MR = .50 q
It looks like an individual firm’s supply curve is the firm’s marginal cost curve.
In fact, we must add one caveat.
Individual Firm’s Supply Curve: The individual firm’s supply curve is its marginal cost curve.
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.

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

11. 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.
Anderson Salary: $25,000 per month
On January 1, 2015, 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, 2016.
Rent: $20,000 per month
hired several employees whose wages summed to $35,000 a month.
Employee Wages: $35,000 per 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.
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.
Price: $650 per hour
Quantity: $100 hours
Total Revenue = Pq = 650 100 = $65,000 per month

12. Jeff’s Monthly Income When Operating His Firm Price: $650/hour
Quantity: 100 hours per month
Rent: $20,000 per month
Total Revenue: Pq
= $650100
Employee Wages: $35,000 per month
= $65,000 per month
Total Revenue 
Rent 
Wages
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.
Generalizing:
Jeff’s monthly income when operating his firm
Total Revenues
Accounting Costs = 
Accounting Costs $55,000
Rent $20,000
Employee Wages $35,000

13. Accounting Costs, Opportunity Costs, and (the Economist’s) Total Costs
Question: What does the term opportunity costs represent?
Answer: What is foregone when an activity is pursued.
Question: What opportunity costs does Jeff incur by operating his firm?
$25,000
Answer: To operate his firm Jeff must resign from Anderson. Therefore, he is forgoing the $25,000 monthly income he has been earning at his job with Anderson.
Total Costs (TC) $80,000
Accounting Costs $55,000
Opportunity Costs $25,000
Rent $20,000
Employee Wages $35,000
Anderson Salary $25,000
The Short Run versus the Long Run
Short Run
Long Run 
Firms must meet their
short run commitments 
Firms can escape their
short run commitments
Question: What date separates the short run from the long run in Jeff’s case?
Answer: January 1, 2016
Jeff’s lease requires him to pay his landlord $20,000 a month until the lease expires on Janyary 1, 2016.

14. Jeff’s monthly income if he continues to operate his firm
Question: Will Jeff go out of business in the short run, before January 1, 2016? More precisely will he goes out of business on October 1, 2015?
Answer: No.
Jeff will not go out of business in the short run, he will continue to operate his firm.
Jeff’s monthly income if he continues to operate his firm = TR 
Acc’t Costs
 $65,000 
$55,000 = 
= $10,000
Jeff’s monthly income in the short run if he goes out of business on October 1, 2015 =
Anderson Salary 
Rent
 $25,000
 $20,000 = 
= $5,000
 Opp Costs 
Fixed Costs
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.
Total Costs (TC) $80,000
VC = TC  FC
Accounting Costs $55,000
Opportunity Costs $25,000
Rent $20,000
Employee Wages $35,000
Anderson Salary $25,000
Fixed Costs (FC) $20,000
Variable Costs (VC) $60,000

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

16. Profit Maximization: Produce the quantity of output at which MR = 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?
1.00
1.50
.50
Profit Maximization: Produce the quantity of output at which MR = MC. P MC S
If P = 1.50
MR = 1.50
Shutdown Rule: A firm will go out of business in the short run, shutdown, whenever the price is less than its average variable cost.
If P = 1.00
MR = 1.00
Terminology: We use the term shut down to refer to a firm going out of business in the short run.
If P = .50
MR = .50
Shutdown: P < AVC q
It looks like an individual firm’s supply curve is the firm’s marginal cost curve.
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.