Economics Supply Decisions
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Transcript of Economics Supply Decisions
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Lecture 4 the supply decisions
Short-run and long-run costs
Revenues and output
Maximisation of profit
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Outputs vs inputs
Outputs depend on the amount of resources(inputs) and how they are used.
An increase in output requires higher
quantities of inputs. But some inputs cannot be increased within a
given time.
Hence a distinction between fixed andvariable factors and a distinction between theshort run and the long run.
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Fixed vs variable factors
the short run vs the long run
A fixed factor, e.g., buildings, is an input thatcannot be increased within a given time period.
A variable factor, e.g., raw material, can be
increased within a given time period.
The short run is a time period during which atleast one factor of production is fixed. In the short run, then, output can be increased only
by using more variable factors.
The long run is a time period long enough for allinputs to be varied.
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Costs of production
Explicit costs:
Cost of factors that are not owned by the firm
Prices the firm has to pay for them = the money the
firm has to sacrifice to get them = direct payment, so
explicit
Implicit costs:
Costs of factors that are already owned by the firm
Implicit costs are what the factors could earn in some
alternative use
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Costs and output
Costs are a function of output.
The more output, the more factors are
needed.
Productivity of factors: The greater productivity,
the less factors are needed for a given level of
output, hence the lower the cost.
The more inputs, the higher costs. Price of factors: The higher the prices, the higher
the costs of production.
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In the short-run
Fixed cost (that of a fixed factor) (TFC)
Does not vary with output.
Variable cost (TVC) The more that is produced, the more raw materials are
used and hence the higher is variable cost.
Total cost (TC) = TFC + TVC
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0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TC
Output
(Q)
0
12
3
4
5
67
TFC
()
12
1212
12
12
12
1212
TVC
()
0
1016
21
28
40
6091
TC
()
12
2228
33
40
52
72103
TVC
TFC
Total costs for firm X
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0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TC
TVC
TFC
Diminishing marginalreturns set in here
Total costs for firm X
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Production in the short run
Output can be increased only by using more
variable factors given productivity.
However, when increasing amounts of a
variable factor are used with a given amount
of a fixed factor, there will come a point when
each extra unit of the variable factor will produce
less extra output than the previous unit
or the extra output from additional units of the
variable factor will diminish.
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The law of diminishing returns
The extra output from additional units of thevariable factor will diminish.
When the law of diminishing returns sets in,
there is a turning point on TC and TVC. The slopes of TC and TVC increase.
Marginal cost will increase.
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Marginal cost
the change in TC that arises when the quantity producedchanges by one unit, i.e., the cost of producing onemore unit of a good.
marginal cost (MC) and the law of diminishing returns
the relationship between the marginal and total costcurves
Average cost
average fixed cost (AFC)
average variable cost (AVC)
average (total) cost (AC)
relationship betweenACand MC
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Output (Q)
Costs()
AFC
AVC
MC
x
AC
z
y
Average and marginal costs
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The long-run costs
All factors are variable in the long run.
The long-run costs will be affected by the scale of
production and the techniques of production used.
The scale of production:
Constant returns to scale: a given percentage increase in
inputs will lead to the same percentage increase in output.
Increasing returns to scale:
Decreasing returns to scale:
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Short run Long run
Input 1 Input 2 Output Input 1 Input 2 Output
3 1 25 1 1 15
3 2 45 2 2 35
3 3 60 3 3 60
3 4 70 4 4 90
3 5 75 5 5 125
Short-run and long-run increases in output
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Economies of scale
Costs per unit of output (AC) fall as the scaleof production increases.
Other things being equal, it will produce at a
lower average cost. Due to
Specialisation & division of labour: production isbroken down into a number of simpler, more
specialised tasks, thus allowing workers to acquire ahigh degree of efficiency.
Indivisibilities
greater efficiency of large machines
economies of scope
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Diseconomies of scale
Costs per unit of output (AC) increase as the scaleof production increases.
Due to
Managerial complexity Alienation
Industrial relations problems
Disruption if part of complex production chains fail
External economies/diseconomies of scale: costsof per unit of output decrease/increase as thesize of the whole industry grows.
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Revenue
Defining total, average and marginal revenue
TR=P*Q
AR=TR/Q=P*Q/Q=P
MR=TR/Q
TR, AR and MR depend on Q.
The relationship between TR, AR and MR and Q willdepend on the market conditions under which a firmoperates.
A price-taker or a price-maker
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O O
Price()
AR,MR()
Pe
S
D
D = AR
= MR
Q(millions) Q(hundreds)
(a) The market (b) The firm
Deriving a firms ARand MR: price-taking firm
Total re en e for a price taking firm
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0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
TR()
Quantity
Quantity
(units)
0200
400
600
800
1000
1200
Price =AR
= MR()
55
5
5
5
5
5
TR
()
01000
2000
3000
4000
5000
6000
Total revenue for a price-taking firm
Revenues for a firm facing a
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Q(units)
P = AR()
TR()
MR()
1 8 8
62 7 14
43 6 18
24 5 20
0
5 4 202
6 3 184
7 2 14
Revenues for a firm facing a
downward-sloping demand curve
AR d MR f fi f i d d l i D
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-4
-2
0
2
4
6
8
1 2 3 4 5 6 7
Q
(units)
1
23
4
5
6
7
P =AR
()
8
76
5
4
3
2
TR
()
8
1418
20
20
18
14
MR
()
64
2
0
-2
-4
MR
AR,M
R()
Quantity
AR
ARand MRcurves for a firm facing a downward-sloping Dcurve
TR f fi f i d d l i D
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0
4
8
12
16
20
0 1 2 3 4 5 6 7
TR
Quantity
TR()
Quantity
(units)
1
2
3
4
56
7
P = AR
()
8
7
6
5
43
2
TR
()
8
14
18
20
2018
14
TRcurve for a firm facing a downward-sloping Dcurve
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MR vs. PD
If PD>1, Q>|P|
an increase in revenue. MR>0.
If PD
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-2
0
2
4
6
8
1 2 3 4 5 6 7
Elasticity = -1
Elastic
Inelastic
AR,M
R()
Quantity
MR
AR
ARand MRcurves for a firm facing a downward-sloping Dcurve
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Profit maximisationthe case of a down-ward sloping demand curve
Using MR=MC to locate at which quantity
profit will be maximised.
Profits () maximise where MR=MC
Using AR and AC curves to measure maximum
profit
To find how much profit is at this output
T=Q*(AR-AC)=Q*A
R t d fit f Fi X
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Q
(units)
P = AR
()
TR
()
MR
()
TC
()
AC
()
MC
()
T
()
A
()
0 9 0 6 6
8 4
1 8 8 10 10 2 2
6 2
2 7 14 12 6 2 1
4 2
3 6 18 14 42/3 4 1
1/3
2 4
4 5 20 18 41/2 2
1/2
0 7
5 4 20 25 5 5 1
2 11
6 3 18 36 6 18 3
4 20
7 2 14 56 8 42 6
Revenue, cost and profit for Firm X
Finding maximum profit using marginal curves
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-4
0
4
8
12
16
1 2 3 4 5 6 7
Quantity
Costsandre
venue()
e
MR
MC
Profit-maximisingoutput
Finding maximum profit using marginal curves
At MR>MC: TR>TC, Total profit can be
increased by increasing QAt MRTR, total profit can be
increased by decreasing Q
Measuring maximum profit using average curves
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6.00
4.50
-4
0
4
8
12
16
1 2 3 4 5 6 7
T O T A L P R O F I T
MR
Quantity
Costsandre
venue()
MC
AC
AR
ba
Total profit =
1.50 x 3 = 4.50
Profits maximised at the
output where MC = MR
Measuring maximum profit using average curves
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Some qualifications
Long-run profit maximisation at MR=MC
The meaning of profit:
Normal profit to cover the opportunity cost of staying in thebusiness
= minimum return the owners must make
= interest rate forgone + a risk premium
Supernormal profit, over and above the normal profit
What if a loss is made?
AC>AR, no profit can be made at any output
Still produce where MR=MC to minimise loss
Short-run & long-run shut-down points
SR: variable costs cannot be covered: P=AVC
LR: LRAC cannot be covered: P=LRAC
Loss-minimising output
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LOSS
O
Costsand
revenue()
Quantity
MC
AC
AR
MR
Q
AC
AR
Loss minimising output
The short-run shut-down point
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O
Costsandr
evenue()
Quantity
AR
AVC
ACP =
AVC
Q
IfAVCis higher orAR
lower than that shown,
the firm will shut down.
The firm will shut down in
the short run if it cannot
cover variable costs.
The short run shut down point