Econ 201
Spring 09
Lecture 4.2
Microeconomics A Firm’s Perspective:
Costs of Production & Supply
1
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
2
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
3
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)
4
How Do These Costs
Vary with Output?
• Fixed Costs
AFC
90
– Independent of level of
output (Q)
– AFC = FC/Q
80
70
60
50
AFC
40
30
20
10
0
• Variable Costs
120
100
80
60
AVC
40
20
45
45
44
80
43
05
40
20
36
25
31
20
25
05
17
80
0
94
5
– Vary with level of
output
– AVC = VC(Q)/Q
AVC
5
Putting It All Together
• Short-run Cost Curve
– ATC = AFC + AVC
160
140
120
100
ATC
80
AFC
60
AVC
40
20
45
45
44
80
43
05
40
20
36
25
31
20
25
05
17
80
94
5
0
6
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)
7
Why is the ATC U-shaped?
• Beyond Q (ideal firm size), additional production will increase perunit costs
– Exceed max efficient scale, communications issues, duplication
of effort, entrepreneurial ability
8
Why is the ATC U-Shaped?
• Economies and diseconomies of scale
9
Constant-returns-to-scale
10
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
11
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
12
What is this Firm’s Supply Curve?
• Will the firm to enter the market at p = $4?
13
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?
14
A Graphical Version
• Firm’s entry decision is based on: TR > TC?
– Between Qs = 4->9: TR > TC
• How much to produce?
15
What is the Profit Maximizing
Output for the Firm?
• http://www.amosweb.com/cgibin/awb_nav.pl?s=wpd&c=dsp&k=perfect
%20competition,%20shortrun%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
16
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%20competitio
n,%20short-run%20production%20analysis
17
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
18
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
19
Short-run Supply Curve
20
Short-run Supply Curve
Firm will supply if P > AVC
21
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
22
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
23
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/econo
mics/economics3.asp
24
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.
•
25
The Production Function
26
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
Q  F (Qk , QL , QE , QM ; T )
– That is, minimize
Total Costs(Q; T )  Pk Qk  PLQL  PEQE  PM QM
27
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/pr
odfunc.htm
28