4.1-4.3

UNIT 3 - PRODUCTION COSTS, PROFIT, AND PERFECT COMPETITION

  • Focus on the factors that affect producer choice and the supply side of supply and demand. 

  • MODULE 3.1

  • A production function is the relationship between the quantity of inputs a firm uses and the quantity of output it produces

  • A fixed input is an input whose quantity is fixed for a period of time and cannot be vaired

  • A variable input is an input whose quantity the firm can vary at any time

  • The long run is the time period in which all inputs can be varied

  • The short run is the time period in which at least one input is fixed

  • The total product curve shows how the quantity of output depends on the quantity of the variable input for a given quantity of the fixed input

  • The marginal product of an input is the additional quantity of output produced by using one more unit of that input.

  • There are diminishing returns to an input when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input. 

  • INPUTS AND OUTPUT

    • To produce goods or service for sale, a firm must transform inputs into output. 

    • The quantity of output a firm produces depends ont he quantity of inputs; a relationship “production function”

    • PRODUCTION WITH FIXED AND VARIABLE INPUTS

      • Consider a farm. The farmers hire workers to do labor. All knowledgeable and capable workers. The farmers are unable to either increase or decrease the size of their farm. so → The land is a fixed input (input that quantity is fixed). They can still choose how many workers they hire so the labor provided by workers is a →variable input. (quantity the firm can vary). 

      • With enough time of course there are no fixed inputs, bcs firms will eventually be able to adjust the quantity of any input. →long run

      • The short run is the time period where at least 1 input is fixed.  (for now we look only at short run)

      • Total product curve >>

      • The slope is not constant → it flattens out as you move up the curve

      • Look at 3rd column of table → the change  in quantity of output by adding 1 more worker ; ie. shows the marginal product of labor (MPL) the additional quantity of output from using one more unit of labor (1 more worker)

      • Equation to calculate the marginal product of labor

  • Marginal product of labor = 

  • change in quantity of output produced by one additional unit of labor = (change in quantity of output)/(change in quantity of labor)


    • In the image, the fact that the marginal product of the first worker is 19 also means that the slope from 0→1 worker is 19. 

    • In this example the MPL steadily declines as more workers are hired → each adds less to output than the previous worker. As employment increases, TPC flattens


    • PRODUCTION WHEN ALL INPUTS ARE VARIABLE

      • What if the levels of other inputs were allowed to change?

  • If you change the quantities of the other inputs, both the total product curve and the marginal product curve of the remaining inputs will shift. Consider these shifts when making predictions on the basis of diminishing returns. 

  • MODULE 3.2

  • A fixed cost (FC) is a cost that does not depend on the quantity of output produced. It is the cost of the fixed input

  • A variable cost (VC) is a cost that depends on the quantity of output produced. It is the cost of the variable input

  • The total cost (TC) of producing a given quantity of output is the sum of the fixed cost and the variable cost of producing that quantity of output.

  • The total cost curve shows how total cost depends on the quantity of output

  • Marginal cost is the cost of producing one more unit of output, which can be found as the increase in total cost when one more unit is made

  • The marginal cost curve shows how the cost of producing one more unit depends on the quantity that has already been produced

  • The average total cost (ATC) often referred to simply as the average cost, is the toal cost divided by the quantity of output produced

  • The average fixed cost (AFC) is the fixed cost per unit of output

  • The average variable cost (AVC) is the variable cost per unit of output

  • The minimum-cost output is the quantity of output at which the average total cost is lowest – it corresponds to the bottom of the U shaped average total cost curve. 

  • The average product of an input is the total product divided by the quantity of the input. 

  • The average product curve for an input shows the relationship between the average product and the quantity of the input.

  • FROM THE PRODUCTION FUNCTION TO COST CURVES

    • Now that we got firms production function, use it to develop the cost curves.  See how production function is related to cost curves in short run. Look at the farm. If they want to maximize their profits, they need to apply what they know about the relationship between inputs of labor and land and the output of wheat to learn the relationship between output and cost. 

    • So we need to know how much the firm must pay for its inputs. Say they need 400 for the use of the land. So they pay an opportunity cost of 400 by using the land to grow wheat. Since land is a fixed input for them to pay 400, whether they grow one busel of wheat or 100, its cost is a fixed cost. (overhead cost).

    • And say they also need to pay workers 200 each. So the cost of labor (number of workers multiplied by 200 ) is the variable cost. 

    • So if you add these numbers, you get the total cost. 400 + (200*workers) = total cost.

    • Total cost curve ^^

  • TWO KEY CONCEPTS; MARGINAL COST AND AVERAGE COST

    • So now we know how to derive a total cost curve from the production function. Now how do we look at total cost by deriving marginal cost and average cost? 

    • MARGINAL COST

      • A firms marginal cost is the cost of producing one more unit of output, which can be found as the increase in total cost when one more unit is made. 

      • Marginal cost is easiest to calculate if data on total cost are available in increments of one unit of output because the increase in total cost for each unit is clear. 

      • Consider selenas gourmet salsas.  → produces and sells to restaurants by the case. Fixed cost of 108$ per day. The third column shows the variable cost. Fourth column shows total cost. And then the total cost curve is plotted. Slopes upward, steeper as quantity increases

      • Marginal cost =

  • Change in total cost generated by 1 additional unit of output = (change in total cost)/(change in quantity of output)

    • So why does the marginal cost curve slope upward? →bcs there are diminishing returns to inputs in this example. 

    • The flattening of the total product curve as output increases and the steepening of the total cost curve as output increases are just flip sides of the same phenomena. As output increases, the marginal cost of output (slope of the total cost curve) increases bcs the marginal product of the variable input (the slope of the total product curve) decreases. 

    • AVERAGE COST

      • Its useful to calculate the average total cost → ATC=(total cost)/(quantity of output) 

        • = TC/Q

      • Tells the producer how much the average or typical unit of output costs to produce. Marginal cost tells the producer how much one more unit of output costs to produce. So how is the atc different from marginal cost?

      • So why is it a U? → average fixed cost and average variable cost

  • Average fixed cost

  • Average variable cost

  • The average total cost (ATC) is the sum of those two. 

  • (fixed cost)/(quantity of output)

  • (variable cost)/(quantity of output)

  • AVC + AFC = ATC

  • Falls as more output is produced bcs the numerator (the fixed cost) is a fixed number but the denominator (quantity of output) increases as more is produced

  • Rises as the output increases. Each additional unit of output adds more to the variable cost than the previous unit bcs increasing amounts of the variable input are required to make another unit

  • So increasing output has 2 opposing effects on average total cost →

  • The spreading effect

  • The diminishing returns effect

  • The larger the output, the greater the quantity of output over which the fixed cost is spread, leading to a lower average fixed cost

  • The larger the output, the lower the marginal product of the variable input, and the greater the additional amount of the variable input required to produce another unit of output, leading to a higher average variable cost. 

  • At low levels of output this is powerful bcs even small increases in output cause large reductions in the average fixed cost; so at low levels of output, the SE dominates the diminish RETURN EF. and causes the average total cost curve to slope downward. 

  • When output is large → AFC is already small so increasing output further has only a very small spreading effect. Diminishing returns, however, usually grow increasingly important as output rises. So when output is large, the diminishing returns effect dominates the SE, causing the average total cost curve to slope upward. 

  • At the point M (bottom of average total the cost curve), the two effects balance each other out. The average total cost is at its minimum level, the minimum average total cost. 

    • MINIMUM AVERAGE TOTAL COST

      • The minimum-cost output is the quantity of output at which the average total cost is lowest – it corresponds to the bottom of the U shaped average total cost curve.

      • At the minimum cost output → the average total cost is equal to the marginal cost

      • At output less than the minimum cost output, the marginal cost is less than the average total cost and teh average total cost is falling

      • And at output greater than the minimum cost output, the marginal cost is greater than the average total cost and the average total cost is rising. 

    • DOES THE MARGINAL COST CURVE ALWAYS SLOPE UPWARD?

      • Economists believe that marginal cost curves often slope downward as a firm increases its production from 0 up to some low level, sloping upward only at higher levels of production; realistic marginal cost curves look like MC →

      • The average product^^

      • The average product curve ^^

  • COST SHIFTERS

    • Firms always wanna lower their costs. How a change in cost shifts cost curves depends on the sie and direction of the change, but also on which type of cost has changed. 

    • A CHANGE IN FIXED COST

      • Say the owner of the building where selena makes her salsa raises her rent. So theres an increase in the firms fixed cost. 

    • A CHANGE IN VARIABLE COST

      • Say instead of an increase in rent (fixed cost), the cost of bottles increases so that each case costs 40$ more to produce. Since this added costs of change depends on quantity of cases produced, it is an increase in variable cost. Could also increase variable cost if theres a per-unit tax or an increase in shipping costs

  • Unit 3 - module 3.3

  • The long run average total cost curve (lratc) shows the relationship between output and average total cost when fixed cost is chosen to minimize average total cost for each level of output

  • There are economies of scale when long run average total cost declines as output increases

  • There are increasing returns to scale when output increases more than in proportion to an increase in all inputs. for example, with increasing returns to scale, doubling all inputs would cause output to more than double 

  • The minimum efficient scale is the smallest quantity at which a firm's long run average total cost is minimized 

  • There are diseconomies of scale when long run average total cost increases as output increases 

  • There are decreasing returns to scale when output increases less than in proportion to an increase in all inputs 

  • There are constant returns to scale when output increases directly in proportion to an increase in all inputs 

  • Long run production costs
    short run costs

  • If Selena's Gourmet Salsas is considering an acquisition of capital in the form of food preparation equipment then the new capital will affect the firm's total cost in two ways. one) resembles the effect of higher building rent; whether the firm rents or buys the additional equipment the acquisition will mean a higher fixed cost in the short run

  •  second) unlike an increase in rent,  an increase in equipment makes workers more productive as fewer workers will be needed to produce any given output level, so the variable cost for each output level will be reduced 

  • How can I hire fixed cost sometimes raise and sometimes lower average total cost?

    •  when output is low the increase and fixed costs from the additional equipment outweighs the reduction in variable cost from higher worker productivity–There are too many few units output over which to spread the additional fixed cost.  so, if Selena wants to produce four fewer cases per day she's better off choosing the lower level of fixed cost to achieve a lower average total cost of production.  when the plant output is high however the lower variable costs outweighs the higher fixed cost in which case Selena should acquire the additional equipment 

  • In general for each output level there's some amount of fixed inputs such as capital and land,  and a corresponding fixed cost,  that minimizes the firm's average total cost for that output level.  when the firm has a desired output level that it expects to maintain over time, it should choose the optimal fixed cost for that level, that is the level of fixed cost that minimizes its average total cost 

  • Take time into account 

  • At any given time a firm will find itself on the short run average total cost curve corresponding to the fixed cost of its current amount of fixed inputs.  a change in our output will cause the firm to move along its short run curve. if the firms current fixed cost does not minimize the average total cost of its desired level of output, given sufficient time the firm will want to adjust its fixed cost 

  • Long run costs

  • Thought experiment→ (Calculating the lowest possible average total cost for each output level) the long run average total cost curve shows the relationship between output and average total cost when a firm chooses the fixed cost that minimizes average total cost for each level of output. smooth u-shape 

  • Now we can see the distinction between the short run and the long run more clearly

  •  in the long run when a firm has enough time to choose the fixed cost appropriate for its desired level of output that firm will be at some point on the long run average total cost curve. but if the output level is altered the form will no longer be on its long run average to the cost curve and will instead Move Along its current short run average total cost curve little less no week. it'll not be on its long run average total cost curve again until it readjust its fixed cost for a new output level 

  • A company that has to increase output suddenly to meet a surge in demand will typically find that in the short run its average total cost Rises sharply because it's hard to get extra production out of existing  facilities. but given time to build new factories or add Machinery short run average total cost falls

    • Returns to scale 

      • What determines the shape of the long run average total cost curve? → the influence of scale ( the size of a firm's operation) on its long run average  total cost of production

      •  firms that experience scale effects in production find that the long run average total cost changes substantially depending on the quantity of output they produce

      •  economies of scale

      •  how will your family survive another 4 years if you may not be able to economies of scale can result from increasing returns to scale, Which exists when output increases more than in proportion to an increase in all inputs. 

        • increasing returns to scale therefore imply economies of scale, although economies of scale exist whether long run average total cost is falling, whether or not all inputs are increasing by the same proportion 

      • When economies of scale end, The Firm has reached its minimum efficient scale, 

      • If the minimum efficient scale for a good is quite large it's natural for the markets only have one firm known as a monopoly. when the minimum efficient scale is small the market is likely to be competitive because many small firms can achieve the minimum efficient scale

      • There are diseconomies of scale when long run average total cost increases as output increases.

      •  diseconomies of scale can result from decreasing returns to scale,  which exists when output increases less than in proportion to an increase in all inputs. when output increases directly in proportion to an increase in all inputs the firm is experience constant returns to scale

      •  so what explains these scale effects in production?

        •  firms technology of production→  economies of scale often arrives from The increased specialization that larger output levels allow 

          • in a larger scale of operation individual workers can limit themselves to more specialized tasks becoming more skilled and efficient at doing them

        •  another source of Economies of scale is a very large initial set up cost

        • Diseconomies of scale, the opposite scenario, typically a rise in large firms due to problems of coordination and communication. as a firm grows in size it becomes ever more difficult and therefore more costly to communicate and to organize activities. although economies of scale induced firms to grow larger, dis economies of scale tend to limit their size.

  • - Summing up costs: the short and long of it 

3.4-3.5 

  • An explicit cost is a cost that involves actually paying out money. an implicit cost does not require an outlay of money; it is measured by the value, in dollar terms, of benefits that are forgone 

  • The accounting profit of a business is the business's total revenue minus the explicit cost of deprecation - has explicit costs

  • The economic profit of a business is the business's total revenue minus the opportunity cost of its resources. it is usually less than the accounting point  - has explicit and implicit costs

  • The implicit cost of capital is the opportunity cost of the capital used by a business– the income the owner could have realized from that Capital if it had been used in its next best alternative way 

  • An economic profit equal to zero is also known as a normal profit. it is an economic profit just high enough to keep a firm engaged in its current activity .

  • Understanding profit

  •  the primary goal of most firms is to maximize profit.

  •  a firm's profit is equal to its total revenue ( the price times the quantity sold) Minus it's total cost ( the cost of all the inputs used to produce its output)

  •  but There are different Types of cost that may be used to calculate different types of profit

  • EXPLICIT COST VERSUS IMPLICIT COST

  • Remember the concepts of opportunity cost, because the cost of getting a degree includes the income you for go while in college.

  •  the opportunity cost of additional education, like any cost, can be broken into two parts the explicit cost and the implicit cost.

  •  the explicit cost of a year of college includes tuition.  The implicit cost of a year spent in college includes the additional income that you would have earned if you had taken a full-time job instead

  • ACCOUNTING PROFIT VERSUS ECONOMIC PROFIT

  • The accounting profit of a business is the business's total revenue minus the explicit cost of deprecation 

  • The economic profit of a business is the business's total revenue minus the opportunity cost of its resources. it is usually less than the accounting point 

  • NORMAL PROFIT

  •  when Babette is earning an economic profit, her total revenue is higher than the sum of her implicit and explicit costs. this means that operating her restaurant makes BABETTE better off financially than she would be using the resources in any other activity 

  • A positive economic profit indicates that the current use is the best use of resources.

  •  a negative economic profit indicates that there is a better alternative use for resources.

  • WHAT IF ITS EQUAL TO 0?

    • An economic profit equal to zero is also known as a normal profit. it is an economic profit just high enough to keep a firm engaged in its current activity .

  • According to the principle of marginal analysis, every activity should continue until the marginal benefit equals the marginal cost 

  • Marginal revenue is the change in total revenue generated by an additional unit of output 

  • The Profit maximizing rule says that a profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost 

  • MAXIMIZING PROFIT

  • What quantity of output maximizes th producers profit?
    Find the profit maximizing quantity. Use marginal analysis to determine the profit-maximizing rule. A producer should increase production until marginal benefit equals marginal cost

  • Chart

  • First column is the quantity of output in bushels. Second column shows jennifer and jaydens total revenue from their output. TR=PxQ and TC is the third column. profit=tr-tc.

  • USING MARGINAL ANALYSIS TO CHOOSE THE PROFIT MAXIMIZING QUANTITY OF OUTPUT 

  • Principle of marginal analysis

  • The marginal revenue = change in total revenue generated by one additional unit of output = (change in total rev/change in quantity of output)

  • mr=change in TR/Change in q

  • Profit maximizing rule

  • Marginal revenue curve shows how marginal revenue varies as output varies

  • WHEN IS PRODUCTION PROFITABLE

  • The answer is the market price of tomatoes. Specifically whether selling the firms optimal quantity of output at the market price results in at least a normal profit.

  • 3.6-3.7

  • 3.5 Main idea

  • 3.5 

    • The marginal revenue curve shows the marginal revenue for each unit. A producer chooses output according to the profit maximizing rule (produce the quantity at which marginal revenue equals marginal cost). More generally, the principle of marginal analysis suggests that every activity should continue until marginal benefit equals marginal cost. A sunk cost is a cost that has been incurred and cannot be recovered. A sunk cost should be ignored in decisions about future actions.

  • 3.6 

    • A producer chooses output according to the profit maximization rule (produce the quantity at which the price equals the marginal cost). However a firm that produces the profit maximizing quantity may not earn a positive economic profit

    • A firm is profitable if its total revenue exceeds its total cost or equivalently, if the average revenue exceeds the average total cost. A firm's average revenue is the average amount it takes in per unit of output, which equals the market price in a perfectly competitive market. The break even price is the minimum average total cost. If the market price exceeds the break even price, the firm is profitable. If the market price is less than the minimum average total cost, the firm is unprofitable. If the market price is equal to the minimum average total cost, the firm breaks even. When profitable, the firms per unit profit is P-ATC; when profitable, its per unit loss is ATC-P.

    • A firm's fixed cost is irrelevant to its optimal short run production decision. That decision depends on the firm's shut down price – its minimum average variable cost –along with its marginal cost and the market price. When the market price is equal to or exceeds the shutdown price, the firm produces the quantity at which the marginal cost equals the market price. When the market price falls below the shutdown price, the firm ceases production in the short run. These decisions determine the shape of the short run firm supply curve.

    • Fixed cost matters over time. If the market price is below the minimum average total cost for an extended period of time, firms will exit the industry in the long run. If the market price is above the minimum average total cost, existing firms are profitable and new firms will enter the industry in the long run. 

  • The average revenue is the average amount of revenue received per unit of output . This can be found as the total revenue divided by the quantity of output. The average revenue equals the price if every unit sells for the same price

  • The break even price of a price taking firm is the market price at which it earns zero economic profit, also known as normal profit. 

  • A firm will cease production in the short run if the market price falls below the shutdown price, which is equal to the minimum average variable cost. 

  • A sunk cost is a cost that has already been incurred and is nonrecoverable. A sunk cost should be ignored in a decision about future actions

  • The short run firm supply curve shows how an individual firm's profit maximizing level of output depends on the market price taking the fixed cost as given. 

  • A price taking firm is a firm whose actions have no effect on the market price of the good or service it sells

  • A price taking consumer is a consumer whose actions have no effect on the market price of the good or service purchased. 

  • A perfectly competitive market is a market in which all consumers and producers are price takers. 

  • A perfectly competitive industry is an industry in which all firms are price takers. 

  • A firms market share is the fraction of the total industry output accounted for by that firms output

  • A good is a standardized product, also known as a commodity, when consumers regard the products of different firms as the same good. 

  • An industry has free entry and exit when new firms can easily enter into the industry and existing firms can easily leave the industry. 

  • The industry supply curve (or market supply curve) shows the relationship between the price of a good and the total output of the industry as a whole. 

  • The short run industry supply curve shows how the quantity supplied by an industry depends on the market price, given a fixed number of firms

  • A market is in long run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for producers to enter or exit the industry

  • The long run industry supply curve shows how the quantity supplied responds to the price once firms have had time to enter or exit the industry. 

  • In a constant -cost industry, the firms’ cost curves are unaffected by changes in the size of the industry and the long run industry supply curve is horizontal (perfectly elastic)

  • In an increasing-cost industry, the firm's production costs increase with the size of the industry and the long run industry supply curve is upward sloping

  • In a decreasing cost industry the firm production costs decrease as the industry grows and the long run supply curve is downward sloping. 

  • Allocative efficiency is achieved when the goods and services produced are those most valued by society

  • Productive efficiency is achieved when firms minimize the average cost of producing their goods