Economics 101: Principles of Economics

1. Lectures on Perfect Competition

Short-Run Costs of Production• A firm’s production costs equal explicit + implicit costs (i.e., the opportunity cost of their

resources -- their value in their next best use)

• Economic cost Accounting cost

Labor explicit cost (w) current expenses

Capital implicit cost (r) historical price & depreciation

• Measures of Short-Run Costs:

• Total Fixed Costs (TFC) are costs that don’t depend on level of output– Costs they can’t adjust in short-run (plant and equipment)

– Even if they shut-down, they have to pay their Fixed costs

• Total Variable Costs (TVC) are costs that do depend on level of output– These can be adjusted in short-run (workers, electricity, raw materials)

– More output leads to greater TVC

• Total Cost = TFC + TVC at each output level– Because TVC increases with Q, so does TC

• Marginal Cost = TC/Q– How much will cost increase if we make one more unit of output?

– How much will a firm save if it makes one fewer unit of output?

Measures of Average Cost

• Average Fixed Cost (AFC) = TFC/Q– As output increases, AFC decreases.

• Average Variable Cost (AVC) = TVC/Q

• Average Total Cost (ATC) = TC/Q

• ATC = AFC + AVC

Short-Run Cost Curves• We typically reverse the axes,

so TC curve has the shape shown.

• TFC is horizontal line.

• TVC is same distance below TC at all output levels.

$

Q

Q

$ 4

4

18

40

49

TC

MC

TVC

TFC• MC curve is derived from TC curve and is U-shaped due to diminishing marginal returns.

• MC = TVC/Q

= L*w/Q

= w/MPL

• Under diminishing marginal returns, each extra worker adds less to Q each extra unit of Q requires more workers each extra unit of Q will cost more

Short-Run Cost Curves• There are 3 average cost curves

• AVC = TVC/Q = wL/Q = w/APL

• Recall that APL rises to a maximum and then falls AVC will fall then rise.

• AVC is slope of ray from origin to a point on the TVC curve

$

Q

Q

$ 4

4

18

40

49

TC

MC

TVC

TFC

AVC

AFC

ATC• AFC = TFC/Q and declines over the

entire range of Q – Fixed costs are spread over more Q

• ATC = AVC + AFC– Its minimum is to right of AVC’s

because when AVC is lowest, AFC still falling, but soon the rising AVC overtakes falling AFC

– Vertical distance between ATC and AVC is AFC, which becomes smaller & smaller as Q increases

Marginal-Average Relationships

• If Marginal < Average, Avg is falling

• If Marginal >Average, Avg is rising

MC = AC at AC’s minimum

$

Q

Q

$ 4

4

18

40

49

TC

MC

TVC

TFC

AVC

ATC

Market Structures

• Continuum of market structures

Competition Monopolistic Competition Oligopoly Monopolymany firms/buyers many smaller firms small # of bigger firms 1 supplier

free entry/exit free entry/exit difficult to enter barriers to entry

product homogeneity differentiated products same or different Q one product

perfect information perfect info imperfect info imperfect info• Examples:

Farmer’s market fast food, clothes, steel , cars, cell phones, local cable

cereals, aspirin, colas ABC/NBC/CBS/Fox local utility

Microsoft?

Demand Curve of a Competitive Firm

-maximization & perfect competition

• Price of the product is determined by market S & D

• Since output is tiny % of market output, no effect on P*mkt

• Competitive firm’s D-curve is horizontal price taker x,Px = ?

• AR = TR/Q = P*Q/Q = P

• MR = TR/ Q = (P*Q)/ Q = P

• When AR is constant, MR = AR

• The price can change, not due to one firm’s actions, but due to changes in Income, Technology, tastes

Short-run Profit Maximization• Total Revenue (TR) curve is new• Profit = TR - TC• Implicit (like owner’s time) & explicit costs are included • < 0 even if shut down (Q = 0)• max occurs where MR = MC

$

Output

Q

$/unit

TC

TFC

MC

AVC

ATC

•Now use per-unit cost curves•ATC = AVC + AFC

• ATCmin > AVCmin • Vertical distance becomes smaller

• Competitive firm’s D-curve is horiz.• max occurs where MR = MC• Profit = (AR - AC)*(Q) [green box] (avg profit per unit)*(# units sold)• max rule does not mean the firm intentionally sets P = MC; price-taker adjust Q ‘til MR = MC

TR

P=MR=AR

P

Q*

Q*

Operating at a Loss in the Short-run• It might be in the best interests of the

firm to incur a loss • If P < ATC , but P > AVC• Can either shut down or operate• Ceasing production may be only

temporary until D picks up again• Loss if Q = Q2* is yellow rectangle

Loss if Q = 0 is yellow + green

(note that we’re only using the Q2* level to compare at same output) Output

$/unit MC

AVC

ATC

P2=MR=AR

Q2*

P2

Output

$/unit MC

AVC

ATC

P3=MR=AR

Q3*

P3

• Loss if Q = Q3* is yellow area

Loss if Q = 0 is purple area

• Shutdown point is the minimum of the AVC curve since for any price below that it will be more profitable (less unprofitable) to stop producing

P1

Q1*

Perfectly Competitive Industries

• Short-run vs. Long-run effects of increases/decreases in Demand for

• Increasing-cost industry

• Decreasing-cost industry

• Constant-cost industry

Long-Run Costs of Production• All inputs are variable

• Firm’s costs can be represented by an Iso-Cost line, which identifies all the combinations of (L,K) that can be purchased for a given total cost.

• TC = wL + rK

• Rewrite to get: K = (-w/r)L + (TC/r)

• Y-intercept is TC/r

• X-intercept is TC/w

• Slope indicates the relative prices of the inputs (slope = -2 says hiring 1 more L, means must buy 2 less K)

• Analogy with consumer’s budget line

• Exception? – Consumers are stuck with feasible set

– Firms can increase TC by hiring more inputs and paying for them by selling more output

Labor

Capital (K)TC3/r

TC2/r

TC1/r

TC1/w

TC2/w

TC3/w

slope = -w/r

• Assumptions– Homogeneous labor and capital

– Perfectly competitive input markets

Least Cost/Max Output• At the tangency point, slope of

the isoquant = slope of the isocost line

• MPL/ MPK = w/r

• Two ways to interpret:

1. “Least-cost way to produce a given Q”

If firm decides to produce Q2, the cost-minimizing way is TC2.

2. “Maximum output possible for a given TC”

If firm decides to spend TC1, Q1 is the most they can produce.

Labor

Capital (K)TC3/r

TC2/r

TC1/r

TC1/w

TC2/w

TC3/w

slope = -w/r

Q1=3Q2=6

Q3=9A

Output Maximization• Let’s rearrange the equation

MPL/ MPK = w/r as follows:

MPL = MPK

w r• This says that the firm should use

K & L in such a way that the additional output per dollar spent on L = additional output per dollar spent on K

• Firm decides to spend TC2. What’s the most Q they can make?

• At point A:

MPL= 100 widgets, w = $20 MPK= 25 widgets, r = $25

• MPL/w = 5 widgets/dollar

MPK/r = 1 widget/dollar

Labor

Capital (K)

TC2/r

TC2/w

Q1

Q2

A

M

• Firm can increase Q and keep the same total cost: A M• Spend $1 less on K lose 1 widget

Spend $1 more on L gain 5 widgets

Cost Minimization• Interpretation #2, rearrange another

way: w = r

MPL MPK • This says that the last widget made

using L should cost the same as the last widget made using K.

• Firm decides to make Q1 widgets. What’s the least-cost way to do it?

• MPL= 10 widgets, w = $20 MPK= 8 widgets, r = $10

• w/MPL = $2/ widget

r/MPK = $1.25/ widget

• Firm can decrease TC and still produce Q1 widgets: B N

Labor

Capital (K)

TC2/r

TC2/w

Q1

B

N

• Produce 1 less widget using L save $2

Produce 1 more widget using K costs only $1.25 more

TC1/w

TC1/r

“Why the Necks are Thicker in New Haven”• Yale vs. Harvard in college hockey

• Harvard recruits small, scrawny, wimps who can skate fast

• Yale opts for bigger, huskier, smarter players who skate a bit more slowly (so what, they got skills)

• Rink characteristics are important.

Harvard’s pond is larger & the arena colder (for “faster” ice).

• Assume there are two inputs to winning: speed & brawn

Optimization requires that MPspeed/ Pspeed = MPbrawn/Pbrawn

• Playing at Ingall’s rink in New Haven, MPspeed and MPbrawn

Hire the Most Productive Worker?• Why is the answer sometimes “No”?

• Let’s suppose a firm wants to hire another worker. It can hire a higher-skilled or low-skilled worker.

• MPhigh skilled = 2 MPlow skilled

• But productivity is not the only consideration

• Phigh skilled = 3Plow skilled

• Optimization requires that MPhigh / Phigh = MPlow/Plow

• However, MPhigh / Phigh < MPlow/Plow

• Therefore, the firm should hire the lower-skilled worker because he or she has higher output per dollar.

Economics of Raising & Razing Buildings• Sometimes it’s the Price, rather than MP,

that changes from one location to another

• Parking garage construction uses two inputs Concrete & Land

• Initially equating MPC/ PC = MPLand/Pland in suburban America

• If producing parking in downtown urban areas, PLand higher, ceteris paribus MPC/ PC > MPLand/Pland

• Builder shifts toward Concrete and we see high-rise parking structures in cities

• Building demolition: dynamite vs. axes

MPDynamite/ PDynamite ? MPLabor/PLabor

• Which method in Hong Kong vs. USA?

Plabor much lower in Hong Kong Hong Kong demolition firms substitute toward L

Firm’s Short-run Supply Curve• A perfectly competitive firm’s SR

supply curve is the same as its MC curve (above min AVC!)

• It shows how much they will supply at any given price

• Lower the price MR < MC

• Only above the shutdown point

• At P1, produce Q1 ( > 0 )

At P2, produce Q2 ( > 0 )

At P3, produce Q3 ( > 0 )

At P4, produce Q4

( < 0, but better to still operate )

At P5, produce Q5 = 0

( < 0, but better to shut down)

Output

$/unitMC

AVC

ATC

Q4

P4

P1

Q1

P2

P3

P5

Q2Q3Q5

SS

Changes in the Firm’s Supply• What effects SR supply?

1. Changes in price of the product– P2 to P3, produce less

2. Changes in input prices (cost of making the product)– if the price of labor or capital falls,

then MC falls

– at Q4, MC was $10 per unit (=MR)

– After wage, at Q4, MC now 6.

– MR > MC increase output and expand along new MC’ curve until MR = MC again at Q3

– Capture the profit in the blue triangle

Output

$/unitMC

Q4

$10

P2

P3

$6

Q2Q3

MC’

P = MR

Industry Short-run Supply Curve• A perfectly competitive firm’s SR

supply curve is the same as its MC curve (above min AVC!)

• The industry supply curve is found by horizontally summing quantity supplied at different prices

• Below P0, nobody produces

At P0, firm C jumps in

At P1, firm A jumps in

At P2, firm B jumps in

• Short-run Industry supply slopes up because the MC curves slope up (& they slope up because?)

• Put in Industry Demand equil.

• If greater D higher price causes firms to supply more (moving up along MCA,B,C , & along Industry S)

Output

$/unitMCC

P3

QC

P2

P1

P0

QBQA

MCAMCB

Long-run vs.Short-run Cost curves

• Long-run is a planning horizon. Under uncertainty about future demand, the firm chooses which size plant to build, thus determining their short-run costs, until it’s time to build again.

• Pick an output level and build the plant size allowing lowest avg cost

• LAC is the lowest average cost attainable when all inputs are variable

• If only 7 plant sizes available, LAC is a “wave”-line.

• If lots and lots of plant sizes possible, LAC is the smooth line

Output

$/unit

LAC

SAC1

SAC3

SAC7

SAC6

Shape of Long-run AC curves

• Many are “U-shaped”, but some are “L-shaped”

• L-shape IRS/economies of scale are quickly exhausted, & CRS exist over a wide range of output

• Result: both small & large firms can exist in same industry

• LAC of small hospitals is 29% more than for large ones declining LAC

Output

$/unit

LAC

LAC

• Industry LACsm/LAClg

hospitals 129%

electric power 112 banking 102

airlines 100

trucking 95• Result: small banks & big

banks exist

Market Structure & Long-run AC curves

• Minimum Efficient Scale is the production scale at which ATC is a minimum.

• This will vary by industry because production technology differs and technology is in part responsible for declining LAC.

• Key question: Where does LAC reach minimum compared to total demand?

• If very low (.05Qtotal), then lots of firms in that industry.

• If relatively high (.5Qtotal), then very few firms in that industry.

• LAC tech 1: coffee shops, breweries LAC tech 2: cars, law firms, cola, planes

Output

$/unit

LAC tech 2

LAC tech 1

30K

D industry

.05Qtotal .5Qtotal Qtotal

Long-run Equilibrium

• Short-run -maximizing equilibrium is only temporary

• If Price stays at $12, then they start making plans to build larger plant (q5)

Output

$/unit

LAC

SMC1 SAC1

SAC5

LMC

$12P = MR = AR

short-run

q1 q5q2

$7

• If price is expected to fall to $7 in the long-run, most profitable output is q2

• What is at this output?• We call this zero economic profit, because LAC includes opp. costs of using the

inputs in some other endeavor. The firm is getting a “normal” rate of return on its inputs. There is positive accounting profit.

long-run

LR Supply Curve

• LR Supply curve is FLAT when firms face same costs. Upward-sloping?