Costs & Market Structure

8/3/2019 Costs & Market Structure

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COSTS & MARKET STRUCTURE


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Costs in the Short Run

The short run is a period of time for whichtwo conditions hold:

1. The firm is operating under a fixed scale (fixed

factor) of production, and

2. Firms can neither enter nor exit an industry.

In the short run, all firms have costs that

they must bear regardless of their output.These kinds of costs are calledfixedcosts.


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Costs in the Short Run

Fixedcostis any cost that does not depend onthe firms level of output. These costs are

incurred even if the firm is producing nothing.

Variable costis a cost that depends on thelevel of production chosen.

TC TFC TVC ! Total Cost = Total Fixed + Total Variable

Cost Cost


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Fixed Costs

Firms have no control over fixed costs inthe short run. For this reason, fixed costsare sometimes called sunk costs.

Average fixed cost (AFC) is the total fixedcost (TFC) divided by the number of units ofoutput (q):

AFCTFC

q!


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Short-Run Fixed Cost (Total and

Average) of a Hypothetical Firm

AFC falls as output rises;a phenomenon

sometimes called

spreading overhead.

(1)(1)qq

(2)(2)TFCTFC

(3)(3)AFC (TFC/q)AFC (TFC/q)

00 $1,000$1,000 $$

11 1,0001,000 1,0001,000

22 1,0001,000 50050033 1,0001,000 333333

44 1,0001,000 250250

55 1,0001,000 200200


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Variable Costs

The totalvariable cost curve is a graph thatshows the relationship between total

variable cost and the level of a firms output.

The total variableThe total variablecost is derived fromcost is derived fromproductionproduction

requirements andrequirements andinput prices.input prices.


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Marginal Cost

Marginalcost (MC) is the increase in totalcost that results from producing one more

unit of output.

Marginal cost reflects changes in variablecosts.

MC TCQ

TFCQ

TVCQ

! !

(

(

(

(

(

(


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Derivation of Marginal Cost from

Total Variable Cost

UNITS OF OUTPUTUNITS OF OUTPUT

TOTAL VARIABLE COSTSTOTAL VARIABLE COSTS

($)($)MARGINAL COSTSMARGINAL COSTS

($)($)

00 00 00

11 1010 1010

22 1818 8833 2424 66

Marginalcostmeasures the additionalcost

of inputs required to produce eachsuccessive unit of output.


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The Shape of the Marginal Cost Curve

in the Short Run

The fact that in the short run every firm isconstrained by some fixed input means that:

1. The firm faces diminishing returns to variable

inputs, and

2. The firm has limited capacity to produce output.

As a firm approaches that capacity, it

becomes increasingly costly to produce

successively higher levels of output.


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The Shape of the Marginal Cost Curve

in the Short Run

Marginal costs ultimately increase withoutput in the short run.


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Graphing Total Variable Costs and

Marginal Costs

Total variable costs alwaysincrease with output. The

marginal cost curve shows

how total variable cost

changes with single unit

increases in total output.

Below 100 units of output,Below 100 units of output, TVCTVCincreases at aincreases at a decreasing ratedecreasing rate..

Beyond 100 units of output,Beyond 100 units of output, TVCTVCincreases at anincreases at an increasing rate.increasing rate.


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Average Variable Cost

Average variable cost (AVC) is the totalvariable cost divided by the number of

units of output.

Marginal cost is the cost ofone additionalunit. Average variable cost is the average

variable cost per unit ofall the units being

produced.

Average variable costfollows marginal cost,but lags behind.


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Relationship Between Average Variable

Cost and Marginal Cost

When marginal cost is belowaverage cost, average cost is

declining.

When marginal cost is aboveWhen marginal cost is aboveaverage cost, average cost isaverage cost, average cost isincreasing.increasing.

Rising marginal cost intersectsRising marginal cost intersects

average variable cost at theaverage variable cost at theminimum point ofminimum point ofAVCAVC.. At 200 units of output, AVC isAt 200 units of output, AVC is

minimum, andminimum, and MCMC== AVCAVC..


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Short-Run Costs of a Hypothetical Firm

(1)(1)qq

(2)(2)TVCTVC

(3)(3)MCMC

(((( TVCTVC))

(4)(4)AVCAVC

((TVC/qTVC/q))(5)(5)

TFCTFC

(6)(6)TCTC

((TVCTVC++TFCTFC))

(7)(7)AFCAFC

((TFCTFC//qq))

(8)(8)ATCATC

(TC/q(TC/qororAFC + AVC)AFC + AVC)

00 $$ 00 $$ $$ $$1,0001,000 $$ 1,0001,000 $$ $$

11 1010 1010 1010 1,0001,000 1,0101,010 1,0001,000 1,0101,010

22 1818 88 99 1,0001,000 1,0181,018 500500 509509

33 2424 66 88 1,0001,000 1,0241,024 333333 341341

44 3232 88 88 1,0001,000 1,0321,032 250250 258258

55 4242 1010 8.48.4 1,0001,000 1,0421,042 200200 208.4208.4

500500 8,0008,000 2020 1616 1,0001,000 9,0009,000 22 1818


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Total Costs

Adding TFCto TVCmeansadding the same amount of

total fixed cost to every level

of total variable cost.

Thus, the total cost curve has theThus, the total cost curve has thesame shape as the total variablesame shape as the total variablecost curve; it is simply higher by ancost curve; it is simply higher by anamount equal toamount equal to TFCTFC..

TC TFC TVC !


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Average Total Cost

Average total cost (ATC) istotal cost divided by thenumber of units of output (q).

ATC AFC AVC!

ATCTC

q

TFC

q

TVC

q

! !

BecauseBecauseAFCAFCfalls with output, anfalls with output, aneverever--declining amount is added todeclining amount is added toAVCAVC..


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Relationship Between Average Total

Cost and Marginal Cost

If marginal cost is belowaverage total cost, averagetotal cost will decline towardmarginal cost.

If marginal cost is aboveaverage total cost, averagetotal cost will increase.

Marginal cost intersectsaverage total cost and

average variable cost curvesat their minimum points.


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Output Decisions: Revenues, Costs,

and Profit Maximization

In the short run, a competitive firm faces a demandcurve that is simply a horizontal line at the market

equilibrium price.


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Total Revenue (TR) and

Marginal Revenue (MR)

Totalrevenue (TR) is the total amount that a firmtakes in from the sale of its output.

TR P q! v

MRTR

q!

(

(!

P q

q

( )(

(

Marginalrevenue (MR)Marginalrevenue (MR) is the additional revenue that a firm takesis the additional revenue that a firm takesin when it increases output by one additional unit.in when it increases output by one additional unit.

In perfect competition,In perfect competition,P= MRP= MR..

! P


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Comparing Costs and Revenues to

Maximize Profit

The profit-maximizing level of output for allfirms is the output level where MR = MC.

In perfect competition, MR = P, therefore,the profit-maximizing perfectly competitivefirm will produce up to the point where theprice of its output is just equal to short-runmarginal cost.

The key idea here is thatfirms will produceas long as marginal revenue exceedsmarginal cost.


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Profit Analysis for a Simple Firm

(1)(1)qq

(2)(2)TFCTFC

(3)(3)TVCTVC

(4)(4)MCMC

(5)(5)PP== MRMR

(6)(6)TRTR

((PPxxqq))

(7)(7)TCTC

((TFCTFC++ TVCTVC))

(8)(8)PROFITPROFIT

((TRTR TCTC))

00 $$ 1010 $$ 00 $$ $$ 1515 $$ 00 $$ 1010 $$ --1010

11 1010 1010 1010 1515 1515 2020 --55

22 1010 1515 55 1515 3030 2525 55

33 1010 2020 55 1515 4545 3030 1515

44 1010 3030 1010 1515 6060 4040 2020

55 1010 5050 2020 1515 7575 6060 1515

66 1010 8080 3030 1515 9090 9090 00


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The Short-Run Supply Curve

At any market price, the marginal cost curve shows the output level thatmaximizes profit. Thus, the marginal cost curve of a perfectly competitive

profit-maximizing firm is the firms short-run supply curve.

Costs & Market Structure

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