Micro Econ VEE 1.2 - Supply Analysis

Increasing Marginal Returns

Each additional resource will produce an increasing amount of output.

Firms can experience this as they add more labor to the production process that optimizes efficiency, taking advantage of specialization

Law of Diminishing Marginal Returns

Each additional unit of input will produce a smaller amount of output

Cost of producing anything depends on

the number of inputs and input prices

Inputs are lumped into

labor and capital

Total Cost of Production (TC)

TC = (w L) + (r K)

(w * L) = Labor

(r * K) = Capital

where

- L represents the labor hours

- K represents the capital hours, which could be the number of machine hours per week

- w represents the wage rate per labor hour

- r represents the rental rate per machine hour

Total cost could be reduced with

lower input rates or an increase in productivity of the inputs

Productivity Gains

increase profitability, increase the market value of the company, and increase worker rewards.

Strengthens the position of the company in the long term

Needed for a company to survive

Measuring Operating Efficiency

Beneficial to use only one resource factor as the input variable

Often input is the choice

Total Product (Q)

Aggregate production for a firm during a time period.

Provides a measure of volume but NOT efficiency

Average Product of Labor (AP(L))

Total product Q divided by the total labor input L.

Measure of average efficiency

Marginal Product of Labor (MP(L))

Measures the productivity of each additional unit of labor.

Change in the total product after adding one more unit of labor

Productivity can be measured using

total product, average product, or marginal product.

Total product is NOT a good gauge because it does not measure efficiency

Easiest to measure the average product

Two basic types of profit

1. Account profit

2. Economic profit

Accounting Profit

Referred to as net income

Revenue less accounting costs (explicit costs). Historical costs of fixed capital are spread out over future production. Uses accounting depreciation which looks backwards

Accounting Profit = Total Revenue - Total Accounting Costs

Economic Profit

AKA abnormal or supernormal profit

Total revenue less economic costs (sum of accounting costs and implicit opportunity costs). Focuses on forward-looking depreciation, which is based on the opportunity cost of the fixed capital

Economic Profit = Total Revenue - Total Economic Costs

-OR-

Economic Profit = Accounting Profit - Implicit Opportunity Costs

For-profit firm's goal

Maximize profit = Maximize company value for shareholders. Focus is on economic profit using the concepts of marginal revenue and marginal cost

Total Return

TR = P * Q

where

TR = Total Return

P = Price

Q = Quantity

Marginal Revenue (MR)

Additional revenue from increasing output by one unit

MR = Change TR / Change Q

In perfectly competitive environment,

individual firm would have no influence over the price.

Demand curve is horizontal since price is set by the market

In this case, marginal revenue equals the price, MR = P

In imperfect competition,

firm can influence the price. Happens when firm has a differentiated product and/or has large market share

Demand curve will have negative slope.

Marginal revenue will be less than the price, MR < P. Because the quantity sold will change if the price changes

Alternative formula for marginal revenue

MR = P + Q * (Change P / Change Q)

Remember that Change P / Change Q is the slope of the demand curve which is negative if the law of demand holds true

Revenue will only change because

1. Quantity changes

2. Price changes

3. Quantity and Price change

A firm in perfectly competitive environment would have have a slope of zero, thus

why the marginal revenue is the price

Since the slope of the demand curve is negative with imperfect competition,

the marginal revenue is less than the price

Marginal Cost (MC)

increase in total cost from one additional unit of output

MC = Change TC / Change Q

Short run marginal cost (SMC)

Same as MC but labor is variable and capital is not. Takes a longer period to build or buy new equipment

Additional labor cost needed to increase the level of output by one unit

SMC = W / MP(L)

where

W = wage rate

MP(L) = marginal product of labor

Long run marginal cost (LMC)

Same as MC but all inputs are variable. Flexibility to change all inputs in the long run to increase profitability

Additional cost of all input needed to increase the level of output by one unit

Marginal cost is directly related to input prices and inversely related to productivity

If labor becomes more productive, the marginal costs will fall

If labor wages increase, marginal costs increase

Relationship between cost and productivity is true the average variable cost (AVC)

Variable Costs

Sum of all costs that fluctuate with the level of production.

AVC = TVC / Q

where

TVC = total variable costs

Q = total output

-OR-

AVC = W / AP(L)

where

W = wage rate

AP(L) = average product of labor

Average variable cost rises if labor wages rise or productivity falls - same relationship as with marginal cost

Profit-seeking firm should only increase production if marginal revenue is greater than the marginal cost. MR > MC

Production should be increased until marginal revenue equals marginal cost, and marginal cost is not falling

If marginal revenue is smaller than marginal cost, firm should decrease production.

Every additional unit will incur more cost than revenue

Fixed cost

Cost that does not change with the varying levels of production.

Cannot be easily cut when production declines

Quasi-fixed cost

Cost that is constant over a certain range of output but changes abruptly as the level of production reaches a new range

Ex. utilities and administrative salaries

Normal profit is counted as a

fixed cost because demand an appropriate return regardless of the production.

Represents the opportunity cost in calculation of economic profit

Variable costs have a direct relationship with quantity

Total variable costs are always zero at zero production

Total cost initially increases at a decreasing rate, then

begins to increase at an increasing rate

Average fixed cost curve

decrease with each additional unit produced

Average variable cost curve

downward sloping until the point at which the marginal cost MC of producing a new unit is greater than the AVC

Average total cost curve

Sum of AFC and AVC

Marginal cost Curve

Downward sloping until a certain point Q(MC) then increases.

ATC curve continues to decline as production increases beyond Q(AVC) because

the average fixed cost per unit is decreasing at a faster rate than the increase in AVC

Q(ATC) is the level of production that minimizes the average total cost per unit

Setting production equal to Q(ATC) will maximize profit on a per-unit basis but this will NOT NECESSARILY maximize total profit

Revenue under Perfect Competition

Firms here are price TAKERS. Operate with a perfectly elastic, horizontal demand curve.

Total revenue equal the price times the quantity. The total revenue is linear with the slope equal to the price per unit

Revenue under Imperfect Competition

Here demand curve has a negative slope.

Price is a function of quantity so TR = f(Q) * Q.

Total revenue first rises when marginal revenue is positive and then falls when the marginal revenue is negative

Profit is maximized when

1. Marginal revenue (MR) equals the short-term marginal cost (SMC)

2. SMC is rising

Above is true for firms operating in perfect and imperfect competition.

Under perfect competition, MR = P, so profit is maximized when the P = SMC

Break Even

When total revenue equals total cost

Implies that average revenue will equal the average total cost

True for both perfect and imperfect competition

Firms operating in a perfectly competitive environment may only expect to earn a normal profit.

Means that economic profit is zero because the capital is just earning a rate commensurate with the risk.

Profit above this point would attract competitors which would drive profitability down.

Zero economic profit is still a positive accounting profit

In the long run, firm must have at lest zero economic profit

This will cover all costs of inputs, including the required return on capital.

If TC cannot be covered, the firm should exit the market and look for profits elsewhere

In the short run, may be optimal to operate with negative economic profit

Fixed costs may be unavoidable in the short run since they are a type of sunk costs.

As long as the firm's revenue can cover its variable costs, it should continue to operate to its variable costs and some of its fixed costs

Firms should select an operating size that maximizes profit over a given time frame

In short run, at least one factor of production is fixed, such as tech or plant size

In long run, all factors of production are variable

Time needed for long-run adjustments varies by industry

Short-run Average Total Cost (SATC) curve

defines the per-unit cost in the short run

Dependent on choice of tech, physical capital, and plant size

Long-run Average Total Cost (LRAC) Curve

derived from the SATCs available to the firm

Ex. Each SATC could utilize different type of tech.

LRAC is formed by fitting a curve tangent to the SATCs

Economies of Scale

Firm gains this by growing provided the output increases faster than the inputs

Diseconomies of Scale

Occurs when the increase in output is slower than the increase in input

Economies vs Diseconomies of scale

dictates the shape of the LRAC curve

Minimum per Unit Cost (Minimum Efficient Scale (MES))

dividing line between economies of scale and diseconomies of scale.

Economies of Scale can come from:

- Increasing returns to scale (increases in outputs are proportionately larger than increases in inputs)

- Specialization in functions

- Purchasing more expensive but more efficient equipment

- Reducing waste

- Better use of market information

- Obtaining discounted prices on inputs from bulk purchases

Anything that improves operations and cuts costs can help generate economies of scale

Diseconomies of scale can come from:

- Decreasing returns to scale (increases in outputs are proportionately smaller than increases in inputs)

- Cumbersome management

- Duplication of business functions

- Higher resource prices due to supply constraints

Anything that hampers operations and profitability

Short Run Max Profit (Min Loss)

Where MC = MR

Long Run Max Profit Under Perfect Competition

Operate at minimum efficient scale point.

Economic profit is zero in long run under perfect competition