Figure 1
Economists versus accountants
> Normal ROR
= Normal ROR
Economists include all opportunity costs when analyzing a firm, whereas
accountants measure only explicit costs. Therefore, economic profit is smaller
than accounting profit
1
The Various Measures of Cost
• Fixed costs (short-run)
– Do not vary with the quantity of output
produced
• Variable costs (short and long-run)
– Vary with the quantity of output produced
• Average fixed cost (AFC)
– Fixed cost divided by the quantity of output
• Average variable cost (AVC)
– Variable cost divided by the quantity of
output
2
EXHIBIT 5.1
Daily Costs of Manufacturing Pine Lumber
5-3
EXHIBIT 5.2
The Marginal Cost of Manufacturing Pine
Lumber
5-4
EXHIBIT 5.3
The Cost Curves
5-5
The Various Measures of Cost
• Cost curves and their shapes
• U-shaped average total cost: ATC = AVC + AFC
– AFC – always declines as output rises
– AVC – typically rises as output increases
• Diminishing marginal product
• At the minimum of ATC or AVC
– The bottom (lowest point) of the U-shaped
curve
– MC = min(ATC) and MC = min(AVC)
6
The Various Measures of Cost
• Cost curves and their shapes
• Efficient scale
– Quantity of output that minimizes average
total cost
• Relationship between MC and ATC
– When MC < ATC: average total cost is falling
– When MC > ATC: average total cost is rising
– The marginal-cost curve crosses the averagetotal-cost curve at its minimum
7
Figure
 FIGURE 9.2 Short-Run Supply Curve of a Perfectly Competitive Firm
At prices below average variable cost, it pays a firm to shut down rather than continue
operating.
Thus, the short-run supply curve of a competitive firm is the part of its marginal cost curve
that lies above its average variable cost curve.
Costs in Short Run and in Long Run
• Many decisions
– Some inputs are fixed (unalterable)in the
short run
– All inputs are variable in the long run,
• Firms – greater flexibility in the long-run
– Long-run cost curves
• Differ from short-run cost curves
• Much flatter than short-run cost curves
– Short-run cost curves
• Lie on or above the long-run cost curves
9
Figure 6
Average total cost in the short and long runs
Average
Total
Cost
ATC in short
run with
small factory
ATC in short
run with
medium factory
ATC in short
run with
large factory
ATC in long run
$12,000
10,000
Economies
of scale
0
Constant returns to scale
1,000
1,200
Diseconomies
of scale
Quantity of Cars per Day
Because fixed costs are variable in the long run, the average-total-cost curve in the short run
differs from the average-total-cost curve in the long run.
10
Costs in Short Run and in Long Run
• Economies of scale
– Long-run average total cost falls as the
quantity of output increases
– Increasing specialization
• Constant returns to scale
– Long-run average total cost stays the same as
the quantity of output changes
11
Costs in Short Run and in Long Run
• Diseconomies of scale
– Long-run average total cost rises as the
quantity of output increases
– Increasing coordination problems
12
(Economic) Profit Maximization
Calculating Profit
• To find profit, we need to know revenues and
costs
– For a perfectly competitive firm, revenues can be
found by looking at the price (determined by the
market) and the quantity sold
– Costs are determined by the quantity sold
• For the firm,
  q  P  ATC 
• Intuition: Profit = (units sold) ×(average profit per unit)
When to Operate
or Shut Down
Profit and Loss in the Short Run
Condition
Outcome
P > ATC
The firm makes a profit
ATC > P > AVC
The firm will operate to
minimize loss
AVC > P
The firm will temporarily
shut down
Short Run Supply Curve
Long Run Supply Curve
Long Run Shut Down Criteria
Condition
Outcome
P > ATC
The firm makes a profit
P < ATC
The firm should shut down
Long-run Profitability
• Positive economic profit cannot be
sustained
– Entry of new firms causes:
• Market supply curve to shift to the
right
• Lowering the market equilibrium
price and
• Lowering each firm’s demand
curve (or constant price)
– In the long run, the firm will make only
normal profit (zero economic profit).
Its horizontal demand curve will touch
its average total cost curve at its lowest
point
2
In the long-run, entry will dissipate short-run
economic profits
2