Decision Time Frames

1

Short Run

• Short run: The quantity of at least one input, (ie: factory size) is fixed and the quantities of the other inputs, (ie: Labour) can be

varied.

(short run decisions are easily reversed:

there is no time to go in and out of business)

Decision Time Frames

•The actions that a firm can take to influence the relationship

between output and cost depend on the time frame.

2

Long Run

• Long run: the quantities of all inputs can be varied, nothing is fixed, (ie: plant size can vary.)

( long-run decisions are not easily reversed: new firms can enter and old firms can leave; that is, firms can go in and out of business)

Decision Time Frames

• Firms make two kinds of decisions:

– Short Run decisions govern the day to day operations of the firm

– Long Run decisions involve longer term strategic

planning

3

The Costs of Production: Short Run

• S.R. Production Function

–the relationship between quantity of

inputs used to make a good and the

quantity of output when some factors

are fixed and some are variable

4

Total, Marginal, & Average Product

MP= MP=   TP/ TP/   Q Q

AP=TP/Q

5

Total Product & Marginal Product

Labour (workers per day)

10 15

Output (sweaters per day)

0 1 2 3 4 5

Labour (workers per day)

Marginal product (sweaters per day per worker) 13

2 4 6

3

0 1 2 3 4 5 5

4

TP

c

d

10 13

2 3

MP

3

2 3

• total

product (TP) always

increasing

•as TP , &

MP , TP increases at a

decreasing rate

6

Marginal Product

Law of diminishing returns

As a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal

product of the variable input eventually

diminishes.

Similar to diminishing Marginal

Utility for consumers.

7

The Relationship Between a Firm’s Output and Costs in the Short Run

To produce more output in the short run, the firm must employ more variable factor, for example, labour, which increases its costs. There are

three types of costs:

Total Costs

Marginal Cost

Average Cost Per Unit Costs

8

1.)Total Costs:

Total Total

fixed variable Total

cost cost cost

Labour Output

(workers (sweaters

(TFC) (TVC) (TC)

per day) per day) (dollars per day)

a 0 0

b 1 4 c 2 10

d 3 13 e 4 15 f 5 16

25 25 25 25 25 25

0 25 50 75 100 125

25 50 75 100 125 150

TC = TFC + TVC

9

TC TVC

Total Costs

0 5 10 15

Output (sweaters per day)

50 100 150

C os t (d ol la rs p er d ay )

TFC

TC = TFC + TVC

10

a a 0 0 0 0

b b 1 1 4 4 c c 2 2 10 10

d d 3 3 13 13 e e 4 4 15 15 f f 5 5 16 16

25 25 25 25 25 25 25 25 25 25 25 25

0 0 25 25 50 50 75 75 100 100 125 125

25 25 50 50 75 75 100 100 125 125 150 150

Total Total Total Total

fixed variable fixed variable Total Total

cost cost cost cost cost cost

Labour Output Labour Output

(workers (sweaters

(workers (sweaters

( ( TFC TFC ) ( ) ( TVC TVC ) ) ( ( TC TC ) )

per day) per day)

per day) per day) (dollars per day) (dollars per day)

6.25 4.17 8.33 12.50 25.00

Marginal Marginal

cost cost

( ( MC MC ) )

2.)Marginal Cost 2.)Marginal Cost

MC = TC TO

MC =

TVC Q

the in total cost that results

from a one-unit  in output.

11

a 0 0

b 1 4

c 2 10

d 3 13

e 4 15

f 5 16

25 25 25 25 25 25

0 25 50 75 100 125

25 50 75 100 125 150 Total Total

fixed variable Total cost cost cost

Labour Output

(workers (sweaters (TFC) (TVC) (TC)

per day) per day)

3.)Average Cost 3.)Average Cost

6.25 4.17 8.33 12.50 25.00 Marginal

cost

(MC)

— 6.25 2.50 1.92 1.67 1.56 Avg.

fixed cost

(AFC)

Avg.

variable cost

(AVC) TVC/Q

— 6.25 5.00 5.77 6.77 7.81

Avg.

total cost

(ATC) TC/Q

— 12.50

7.50 7.69 8.33 9.38

(dollars per day)

AVC AFC

ATC  

Q TVC Q

TFC Q

TC  

12

Marginal Cost and Average Costs

5 10 15

Output (sweaters per day)

5 10

15

Cost (dollars per sweater)

AFC AVC ATC

ATC = AFC + AVC

MC

0

25

13

Marginal Cost and Average Costs

5 10 15

Output (sweaters per day)

5 10 15

Cost (dollars per sweater)

MC

0

25 MC  at low outputs due to gains from

specialization, MC eventually

due to law of diminishing

returns.

14

Relationship between MC & ATC Whenever MC < ATC, ATC 

MC > ATC, ATC 

 MC crosses ATC at the minimum MC crosses ATC at the minimum ATC ATC (capacity or minimum efficient scale) (capacity or minimum efficient scale)

  MC crosses AVC at the min. point MC crosses AVC at the min. point

15

Shifts in the Cost Curves

The position of a firm’s short-run

cost curves depends on two factors:

• technology

• prices of resources

16

Long Run Costs of Production

•In the long run, all factors of production are variable,

•nothing is fixed.

•In the long run, firms are looking for productive efficiency,

•producing a given quantity at as low a per unit cost as possible.

•assuming a constant state of technology

•and constant resource/input prices.

17

The long run is the firm’s planning

perspective while the short run is

the firm’s operating perspective.

18

The Long-Run Average Cost Curve

• The long-run average cost curve shows the relationship between the lowest attainable average total cost and output

• It is therefore derived from the short-run average total cost curves.

• Each SRATC touches the LRATC at the level of output for which the quantity of the fixed factor is optimal and lies above the LRATC for all

other levels of output.

19

Preferable Plant Size and the Long-Run Average Cost Curve

Output per Time Period

Average Cost (dollars per unit of output)

Output per Time Period

Average Cost (dollars per unit of output)

SAC₁

SAC₂

Q₁

C₂

C₁ C₃ C₄

Q₂

SAC₃

Build plant 1 if expected output at Q₁.

Build plant 2 if expected output at Q₂.

SAC₁ SAC₂

SAC₃

SAC₄SACSAC_{5 6}

SAC₇

SAC₈

envelopeLAC

20

12.00

10.00

8.00

6.00

Long-Run Average Cost Curve

0 5 10 15 20 25 30 ATC₁ ATC₂ ATC_{3 ATC}

4

LRAC

Least-cost plant is 1

18 Least-cost

plant is 2 Least-cost

plant is 4 Least-cost

plant is 3 24

•Once the plant

size is chosen, the

firm operates on

the short-run cost

curves that apply

to that plant size.

21

Shape of LRAC

Shape of LRAC & Returns to Scale & Returns to Scale

• Returns to scale are the increases in output Returns to scale are the increases in output that result from

that result from increasing all inputs by the increasing all inputs by the same percentage.

same percentage.

• There are 3 Possibilities There are 3 Possibilities . .

1) 1) Increasing Returns to Scale or Increasing Returns to Scale or Economies of Scale:

Economies of Scale: 2) 2) Decreasing Decreasing Returns to Scale or Diseconomies of

Returns to Scale or Diseconomies of Scale:

Scale: 3) 3) Constant Returns to Scale Constant Returns to Scale

22

Economies/Diseconomies of Scale

23

12.00

10.00

8.00

6.00

Long-Run Average Cost Curve

0 5 10 15 20 25 30 LRAC curve

1818 2424

Economies of scale Diseconomies of scale

MES

Minimum efficient scale: the smallest quantity of output at which LRATC reaches its lowest level.

24

What would cause LRATC to shift?

1) change in the state of technology

2) change in input prices

Question

•What is the difference between

diminishing returns (MP) and

diminishing returns to scale?

25

Perfect Competition

• A market structure in which the decisions of

individual buyers and sellers have no effect on market price

No one person in the market has any

Market Power: the ability to influence the price.

–the minimum efficient scale is small

relative to the demand for a good or

service.

26

Characteristics of a Perfectly Competitive Market Structure

1.)Large number of buyers and sellers

• no one buyer or seller has power to influence price

• Both firms and buyers are “price takers”

2) Homogenous products

• goods offered by various producers are largely the same.

3) No barriers to entry or exit

4) Buyers and sellers have equal information

27

Demand, Price, and Revenue in Perfect Competition

D

Quantity (thousands of sweaters per day)

Price (dollars per sweater)

0 9 20

25 50

Sweater market

S

Market demand curve

Quantity (sweaters per day)

Price (dollars per sweater)

25 50

Sidney’s demand

and marginal revenue MR Sidney’s

demand curve

0 9 20

INDUSTRY FIRM

28

Demand, Price, and Revenue in Perfect Competition: Firm

Quantity sold

(Q)

(sweaters per day)

Price (P)

(dollars per sweater)

Total revenue (TR = PxQ)

(dollars)

Marginal revenue

(MR =TR/Q)

(dollars)

8 9 10

25 25 25

200 225 250

25

25

29

Economic Profit and Revenue: Firm

Marginal revenue (MR) is the change in

revenue resulting from a one-unit increase in output sold.

 For the firm , in perfect competition,

 since the price remains constant when the quantity sold changes

–Marginal revenue equals price.

 marginal revenue curve is also the demand curve.

–Demand is perfectly elastic.

30

Demand, Price, and Revenue in Perfect Competition

Quantity (sweaters per day)

Price (dollars per sweater)

25 50

Sidney’s demand

and marginal revenue

MR=P

Sidney’s demand curve

0 9 20

D

Quantity (thousands of sweaters per day)

Price (dollars per sweater)

0 9 20

25 50

Sweater market

S

Market demand curve

Market Price = $25

INDUSTRY FIRM

31

A firm

A firm will produce the level of output that maximizes economic profits given the constraints it faces.

market constraints summarized by its revenue schedules.

technology & cost constraints summarized by its product & cost curves .

(TC) cost

Total -

(TR) revenue

Total Profit

Economic 

Firm Maximizes Profits: “Supply”

32

Profit Maximization Rule

• Produce all those units of output that add more to revenues than to costs.

• Produce more output until MR comes closest to being equal to MC without MC exceeding MR:

output (MR) TR

Revenue Marginal



  output

(MC) TC Cost

Marginal



 

MR MR   MC _MC

33

Total Revenue, Total Cost, & Economic Profit

Quantity

(Q)

(sweaters /day)

Total Revenue

(TR)

(dollars)

Total Cost

(TC)

(dollars)

Economic Profit

(TR - TC)

(dollars)

Average Total Cost

(ATC)

(dollars)

Average Var. Cost

(AVC)

(dollars)

Marginal Cost

(MC)

(dollars)

0 12 34 5 67 89 10 1112 13

0 2550 10075 125 150175 200225 250 275300 325

22 4566 10085 114 126141 160183 210 245300 360

-22 -20-16 -100 11 2434 4042 40 300 -35

0 45.00 33.00 28.33 25.00 22.80 21.00 20.14 20.00 20.33 21.00 22.27 25 27.69

0 23.00 22.00 31.50 19.50 18.40 17.33 17.00 17.25 17.89 18.89 20.27 23.17 26.00

0 23.00 21.00 19.00 15.00 14.00 12.00 15.00 19.00 23.00 27.00 35.00 55.00 60.00

0 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00

Marginal Revenue

(MR)

(dollars)

P=MR

F

I

R

M

34

Profit-Maximizing Output

Quantity (sweaters per day)

8 9 10 10

20 30

$’s.Marginal revenue and marginal cost

25 MR

0

MC

Profit-

maximization Point, MC=MR

MR > MC MC > MR

Market Price = $25

• Beyond MC=MR output, MC>MR, TC is increasing more than TR, and profits are decreasing.

• Between zero output and MC = MR output, MR >

MC, TR is increasing

more than TC, and profits are increasing.

FIRM

35

Economic profit

0

Quantity (sweaters per day)

Price and cost (dollars per sweater)

15

.

20.33 25.00

Economic Profit

9 10

30.00

MR MC ATC

At P = $25, ATC =$ 20.33 Output = 9 units

TR = $25 x 9 = $225 TC = $20.33 x 9 =$183 Profit = $225-$183=$42 Profit = (P-ATC) x output Market Price = $25

FIRM

Note: In Perfect

Competition,

MR=AR

36

Demand, Price, and Revenue in Perfect Competition

Quantity (sweaters per day)

Price (dollars per sweater)

25 50

Sidney’s demand

and marginal revenue:

firm

MR Sidney’s

demand curve

0 9 20

D

Quantity (thousands of sweaters per day)

Price (dollars per sweater)

0 9 20

25 50

Sweater market: Industry

S

New market demand

curve

D

20 MR

Sidney’s new demand curve

20

Market Price = $20

INDUSTRY FIRM

37

Total Revenue, Total Cost, and Economic Profit

Quantity

(Q)

(sweaters /day)

Total Revenue

(TR)

(dollars)

Total Cost

(TC)

(dollars)

Economic Profit

(TR - TC)

(dollars)

Average Total Cost

(ATC)

(dollars)

Average Var. Cost

(AVC)

(dollars)

Marginal Cost

(MC)

(dollars)

01 2 34 56 7 89 1011 12 13

0 2040 6080 100 120140 160180 200 220240 260

2245 66 10085 114126 141 160183 210245 300 360

0 45.00 33.00 28.33 25.00 22.80 21.00 20.14 20.00 20.33 21.00 22.27 25 27.69

0 23.00 22.00 31.50 19.50 18.40 17.33 17.00 17.25 17.89 18.89 20.27 23.17 26.00

0 23.00 21.00 19.00 15.00 14.00 12.00 15.00 19.00 23.00 27.00 35.00 55.00 60.00

0 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00 20.00

Marginal Revenue

(MR)

(dollars) New Price

-22 -25-26 -25-20 -14 -6-1 -30 -10 -25-60 -100

FIRM

Quantity (sweaters per day) 38

Price and cost (dollars per sweater)

1515

. .

8 8 10 10

30.00 30.00

MR MR MC MC ATC ATC

20.00 20.00

Break-even Point, MR=MC=ATC

0 0

Short-Run Break-Even Price

Break-Even Price

P=$20; ATC=$20

TR = $20X8 units/day = $160

TC = $20X8units/day = $160

TR = TC

= 0 Economic Profits Market Price = $20

FIRM

39

Short-Run Losses, & Shutdown Price

• What do you think?

– Would you continue to produce if you were incurring a loss?

– What if price fell to $19.00?

– What if price fell to $16.00 or lower?

FIRM

40

Demand, Price & Revenue: Perfect Competition

Quantity (sweaters per day)

Price (dollars per sweater)

25 50

Sidney’s demand

and marginal revenue:

Firm

MR1

0 9 20

D

Quantity (thousands of sweaters per day)

Price (dollars per sweater)

0 9 20

25 50

Sweater market:

Industry

S

New market demand

curve

D

20 MR2

Sidney’s new demand curve

20

D

19 19 MR3

Market Price = $19

FIRM INDUSTRY

41

Total Revenue, Total Cost, and Economic Profit

Quantity

(Q)

(sweaters /day)

Total Revenue

(TR)

(dollars)

Total Cost

(TC)

(dollars)

Economic Profit

(TR - TC)

(dollars)

Average Total Cost

(ATC)

(dollars)

Average Var. Cost

(AVC)

(dollars)

Marginal Cost

(MC)

(dollars)

01 2 34 56 7 89 1011 12 13

0 1938 5776 95 114133 152171 190 209228 247

2245 66 10085 114126 141 160183 210245 300 360

0 45.00 33.00 28.33 25.00 22.80 21.00 20.14 20.00 20.33 21.00 22.27 25 27.69

0 23.00 22.00 31.50 19.50 18.40 17.33 17.00 17.25 17.89 18.89 20.27 23.17 26.00

0 23.00 21.00 19.00 15.00 14.00 12.00 15.00 19.00 23.00 27.00 35.00 55.00 60.00

0 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00 19.00

Marginal Revenue

(MR)

(dollars) New Price

-22 -51-28 -28-24 -19 -12-8 -12-8 -20 -36-72 -113

FIRM

42

SR Economic Loss Minimization

MR MR

Quantity (sweaters per day)

Price and cost(dollars per sweater)

1919

. .

30.00

MC MC

ATC ATC

8 8 10 10 0 0

AVC AVC

lossloss

Loss Min,P=$19.00

• MC = MR @ 8 units ATC ($20) > P ($19);

Losses = $8

• TFC = $22.00

• Shut down, lose $22.00

• Produce, lose $8

• Minimize losses by producing when

• P >AVC < ATC

Market Price = $19

FIRM

43

Total Revenue, Total Cost, and Economic Profit

Quantity

(Q)

(sweaters /day)

Total Revenue

(TR)

(dollars)

Total Cost

(TC)

(dollars)

Economic Profit

(TR - TC)

(dollars)

Average Total Cost

(ATC)

(dollars)

Average Var. Cost

(AVC)

(dollars)

Marginal Cost

(MC)

(dollars)

0 12 34 5 67 89 10 1112 13

0 1632 4864 80 11296 128144 160 176192 208

22 4566 10085 114 126141 160183 210 245300 360

0 45.00 33.00 28.33 25.00 22.80 21.00 20.14 20.00 20.33 21.00 22.27 25 27.69

0 23.00 22.00 31.50 19.50 18.40 17.33 17.00 17.25 17.89 18.89 20.27 23.17 26.00

0 23.00 21.00 19.00 15.00 14.00 12.00 15.00 19.00 23.00 27.00 35.00 55.00 60.00

0 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00 16.00

Marginal Revenue

(MR)

(dollars) New Price

-22 -29-34 -37-36 -34 -30-29 -32-39 -50 -108-69 -152

FIRM

44

Short Run Shut Down

MR MR

Quantity (sweaters per day)

Price and cost(dollars per sweater)

1616

. .

30.00

MC MC

ATC ATC

7 10 7 10 0 0

AVC AVC

lossloss

Shutdown:P=$16.00

• MC = MR @ 7 units

• ATC (20.14) > P ($16):

• Losses = $29.00

• TFC = $22.00

• Shut down, lose $22

• Produce, lose $29

• Minimize losses by Minimize losses by shutting down when shutting down when

 P P   AVC at MC = MR AVC at MC = MR

Market Price = $16

FIRM

45

Short Run Supply

• Def’n: Quantity that producers will produce at various possible prices in a set of prices, for a given time period: ceteris paribus.

• At each price a firm will produce the output for which MC comes closest to being equal to MR without MC exceeding MR &…….

FIRM

46

MR

Profit point

A Firm’s SR Supply Schedule

Quantity (sweaters per day)

7 8 9 10 17

25 31

Price and cost (dollars per sweater)

MC

MR

MR

Shutdown point

0 20

Break-even point

MR

Minimize losses

MC=Supply

47

“Supply”

 The Short Run “ supply ^”

schedule of the firm is found to be the “ MC ” schedule

• but with 2 qualifications.

FIRM

48

•1.) Only the upward sloping part of MC

qualifies

as the SR “supply”

• 2.) Only that part of the MC that lies above the AVC

qualifies as the SR “supply”

Quantity (sweaters per day)

Price and cost (dollars per sweater)

15

.

8 10

30.00

MR MC

AVC

0

Qualifications

FIRM

49

Market Supply

• Total amount provided to the market at each possible price…

»Or

• The marginal cost of providing additional output to the market, given current

production conditions.

50

Market Supply

• Note: In the SR, quantity supplied is positively related to price for 2 reasons:

– As the market price increases,

• 1.) each firm uses its capital more intensively thereby increasing output, but also increasing marginal cost.

• 2.) firms that were previously providing output

but had ceased production, to minimize losses,

will find it profitable to begin production again,

using capital that had been idle.

51

Problem: Perfect Competition.

1. The following tables give the costs and revenue for a firm in perfect competition.

2. What will the firm supply in order to

maximize profits given the various prices in the market?

3. What is the industry supply if there are 100 firms in the industry?

4. What is the Market Price and Output?

52

Total Revenue, Total Cost, & Economic Profit

Quantity

(Q)

(sweaters /day)

Total Revenue

(TR)

(dollars)

Total Cost

(TC)

(dollars)

Economic Profit

(TR - TC)

(dollars)

Average Total Cost

(ATC)

(dollars)

Average Var. Cost

(AVC)

(dollars)

Marginal Cost

(MC)

(dollars)

0 12 34 5 67 89 10 1112 1314

189 2738 45 5463 7281 90 10899 117126

15 2227 3032 33 3436 3944 51 6076 104144

-15 -13-9 -36 12 2027 3337 39 3932 -1813

0 22.00 13.50 10.00 8.006.60 5.675.14 4.884.89 5.10 5.456.33 8.009.21

7.006.00 5.004.25 3.60 3.173.00 3.003.22 3.60 4.095.08 6.859.21

75 32 1 12 35 7 169 2840

Marginal Revenue

(MR)

(dollars)

P=$9.00=MR

9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00