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Econ 201Spring 09

Lecture 4.2Microeconomics -

A Firm’s Perspective:

Costs of Production & Supply

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Firm’s Objectives

• Maximize Profits– Total Revenues – Total Costs of Production

• Assume (for the time being)– Firm is a price-taker (no market power)

» Price is constant and independent of the level of the firm’s output

» TR = P x Qs

– Firm can choose (variable):• Types and quantities of inputs• Level of output

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Long-run vs. Short-run

• In the long-run all inputs and costs are variable – Before entering the market, no costs are incurred– Decisions are: (1) to enter the market; (2) and how

much to produce

• In the short-run at least one input is fixed (Sunk costs)– Typically capital– Decision is how much to produce

• Zero is an option

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Types of Costs

• In the short-run– Fixed (sunk) costs

• Costs that are incurred, regardless of the level of output– E.g., Capital equipment – machinery, computers, buildings

– Variable costs• Costs that vary with the level of output

– E.g., labor, fuel and materials

– Total Costs(Q) = Fixed Costs + Variable Costs(Q)

• In the long-run – All costs are variable (dependent on entry decision)

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How Do These Costs Vary with Output?

• Fixed Costs – Independent of level of

output (Q)– AFC = FC/Q

• Variable Costs– Vary with level of

output– AVC = VC(Q)/Q

AFC

0

10

20

30

40

50

60

70

80

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AFC

AVC

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40

60

80

100

120

945

1780

2505

3120

3625

4020

4305

4480

4545

AVC

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Putting It All Together

• Short-run Cost Curve– ATC = AFC + AVC

0

20

40

60

80

100

120

140

160

ATC

AFC

AVC

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Why Is the ATC U-shaped?

• Economies of Scale and Scope• Increase in output from Q to Q2 causes a decrease in the average

cost of each unit from C to C1.– Indivisibility of resources, specialization, bargaining power

(CostCo)

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Why is the ATC U-shaped?

• Beyond Q (ideal firm size), additional production will increase per-

unit costs – Exceed max efficient scale, communications issues, duplication

of effort, entrepreneurial ability

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Why is the ATC U-Shaped?

• Economies and diseconomies of scale

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Constant-returns-to-scale

                                                                                            

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Long-run vs. Short-run Decisions

• Firm’s decision to enter the market:– Are Total Revenues > Total Costs?

• At point of entry -> all costs are variable• Costs also include opportunity costs

– Opp. Costs for resources are signaled by market prices for inputs

– Opp. Costs of money invested -> “normal rate of return” – Opp. Costs for your (owner’s) labor -> what you could have

earned elsewhere

• In the short-run decision on how much to produce:– Are Revenues > Variable Costs?– Fixed Costs are “sunk” and irrelevant to production

decision

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Will the Firm Enter the Market?

• Assume– Firm is a price-taker/has no market power

• So no matter how much the firm is willing to supply, its decision has no impact on the market demand price

– Firm’s revenues then are:• TR = P x Qs• Assume market price is $4 per zuke

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What is this Firm’s Supply Curve?

• Will the firm to enter the market at p = $4?

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What is this Firm’s Supply Curve?

• What are the firm’s fixed costs?• What is the minimum Qs at $4 per zuke?• What is the maximum Qs at $4 per zuke?

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A Graphical Version

• Firm’s entry decision is based on: TR > TC?– Between Qs = 4->9: TR > TC

• How much to produce?

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What is the Profit Maximizing Output for the Firm?

• http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=perfect%20competition,%20short-run%20production%20analysis

• When the firm is a price-taker: profits are max’ed when TR-TC are greatest– Largest vertical difference between the TR

and TC curve

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Firm Chooses How Much to Supply By Maximizing Its Profits

• When the firm is a price-taker: profits are max’ed when TR-TC are greatest– Largest vertical difference between the TR and TC curve

• http://www.amosweb.com/cgibin/awb_nav.pl?s=wpd&c=dsp&k=perfect%20competition,%20short-run%20production%20analysis

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What is this Firm’s Supply Curve?

• Firm’s profit maximizing output is at Q =7– Rule is profit maximizing output is MR = MC– Since firm is a price-taker: MR = P => P = MC

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Firm’s Supply Curve

• Firm’s supply curve– Marginal Cost curve

• In the long-run:– P >= MC– TR >= TC (=TFC + TVC)

• In the short-run– P >= MC– TR >= Total Variable Costs (TVC)

– There is a price below which a firm can not afford to supply any of the good

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Short-run Supply Curve

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Short-run Supply Curve

Firm will supply if P > AVC

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Factors that Shift Supply Curves

• Individual Firms and Market Supply– Prices of Inputs

• Qs goes down if price of inputs goes up – Supply curve shifts to the left

• SC shifts right if price of inputs goes down

– Technology• Technological improvement -> inputs are more productive

– Same as input prices going down -> shift to the right of SC

• Market Supply Only– Number of firms

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Firm and Market Supply Curves

• Similar to Individual and Market Demand Curves– Market supply curve = sum of all of the

individual firm supply curves

• Graphically– Horizontal sum of the quantities supplied by

each firm at a given price

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Useful Websites

– Understanding differences between factors that cause shifts in demand or supply

– http://hspm.sph.sc.edu/COURSES/ECON/SD/SD.html

– http://www.investopedia.com/university/economics/economics3.asp

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Supply Curves• First law of supply•

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.

•

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The Production Function

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Firm’s Objective

• Once the firm has decided to enter the market– Objective will to be minimize the costs of

producing a given level of output

– That is, minimize( ; ) k k L L E E M MTotal Costs Q T PQ P Q P Q P Q

( , , , ; )k L E MQ F Q Q Q Q T

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The Production Function

• the production function, summarizes the process of conversion of factors into a particular commodity. – first proposed by Philip Wicksteed (1894):

• Q = F(K,L,E,M;T)• relates a output y to a series of factors of

production K, L, E, M – given current technology T.

• http://cepa.newschool.edu/het/essays/product/prodfunc.htm