Production Costs and Entry & Exit - Exam Notes

Accounting vs Economic Profits

Accounting Profit: Total revenue minus explicit financial costs.
Economic Profit: Total revenue minus explicit financial costs and implicit opportunity costs.

Forgone Wages: Potential earnings from the next best career option.
Forgone Interest: Potential interest earned from investing capital elsewhere.
Cost of Capital: Minimum payment to secure capital, including interest on debt and expected return on equity.

Variable Costs: Costs that vary with production level and are paid only when used.
Fixed Costs: Costs that do not vary with production level and must be paid regardless of production.
Total Cost: Sum of fixed and variable costs.

Average Total Cost (ATC): Cost per unit of output. ATC = \frac{Total Cost}{Quantity}
Average Variable Cost (AVC): Variable costs per unit of output. AVC = \frac{Total Variable Cost}{Quantity}
Average Fixed Cost (AFC): Fixed costs per unit of output. AFC = \frac{Total Fixed Cost}{Quantity}

Marginal cost and average variable cost start at the same point because marginal costs are variable, so for the first unit, MC = AVC.
AFC is downward sloping due to fixed costs being spread over larger quantities.
Total fixed costs are represented by the area under the AFC curve (AFC * Q).
The distance between ATC and AVC is equal to AFC.
ATC is U-shaped because initially decreasing AFC has a strong effect, but eventually increasing AVC dominates.
Marginal cost (MC) intersects ATC at the minimum of ATC.

MES is the level of production that minimizes average costs, occurring where MC = ATC.
Steps to calculate MES and minimum ATC:
1. Calculate ATC by dividing total cost (TC) by quantity (Q).
2. Set ATC equal to MC and solve for Q* (the MES).
3. Plug Q* back into ATC to find the minimum ATC.
- Example:
- Total Cost = 32 + 2Q^2
- Marginal Cost = 4Q
- ATC = \frac{32}{Q} + 2Q
- \frac{32}{Q^} + 2Q^ = 4Q^*
- \frac{32}{Q^} = 2Q^
- 32 = 2Q^{*2}
- 16 = Q^{*2}
- Q^* = 4
- MES = 4
- ATC_{min} = \frac{32}{4} + 2 * 4 = 16

Economies of Scale: ATC decreases as quantity increases.
Diseconomies of Scale: ATC increases as quantity increases.
Constant Returns to Scale: ATC remains constant as quantity changes.
Economies of scale are often due to declining average fixed costs.
Diseconomies of scale are often due to rising variable costs, such as overtime payments or diminishing marginal productivity.

Profits are represented by (P - AC) * Q, where P is price, AC is average cost, and Q is quantity.

In the long run, firms will exit an industry if they are earning a loss.
Shutdown Condition: Shutdown (Q=0) if P < AC{minimum}, and produce at P=MC when P >= AC{minimum}.
Following P=MC may lead to losses if fixed costs are not covered.

Short-Run: Production capacity cannot change, firms are locked into fixed costs, and firms cannot enter or exit.
Long-Run: Production capacity can change, firms are not locked into fixed costs, and new firms may enter or existing firms may exit.

In the short-run firms produce at P=MC so long as P>AVC, which is the short-run shutdown condition.

In the long-run, new firms can enter if existing firms are earning an economic profit (P > AC_min).
Entry of new firms shifts the market supply function, decreasing market price.
In the long-run, price must equal the minimum average cost (P = AC_{min}).
Long-run market supply function is approximately a flat horizontal line at the minimum average total cost.
Economic profits are zero in the long-run (Economic Profits = (P - ATC) * Q = 0).
Zero economic profits mean firms are doing as well as their next best alternative.

If economic profits persist in the long-run, there must be barriers to entry.
Barriers to entry can include:
- Regulatory or legal barriers
- Demand-side factors (customer lock-in)
- Supply-side factors (unique cost advantages)
- Deterrence (aggressive practices to discourage entry)