Highlights for Exam 3
Production Function and Cost Curve
Production Function
Output
180
160
140
120
100
80
60
40
20
0
0
1
2
3
4
# of Workers
5
6
Cost $
90
80
70
60
50
40
30
20
10
0
0
Cost Curve
20 40 60 80 100 120 140 160
Output (Quantity)
Cost Curves
Cost
Why do MC, ATC,
and AVC slope up,
and how do they
relate?
MC
Why does MC cross
ATC and AVC at their
lowest point?
Why does AVC
converge to ATC?
ATC
AVC
Why does AFC decline
to zero?
AFC
Quantity of Output
Cost
Short Run
ATC with
small plant
ATC in Long Run and Short Run
(U Shape for Different Reasons)
Long Run
ATC
Short Run ATC
with medium
plant
Economies
of Scale
Short Run
ATC with
large plant
Diseconomies
of Scale
Constant Returns to Scale
Quantity
Summary of Costs
Type of Cost
Description
Math
Notation
Explicit Cost
Costs that involve an actual payment
Implicit Cost
Costs that don’t involve a payment (opportunity cost)
Fixed Cost
Costs that don’t change with quantity of output
FC
Variable Cost
Costs that depend on quantity of output
VC
Total Cost
Costs of all inputs used by a firm
TC
Average Fixed
Cost
Fixed cost divided by quantity of output
AFC = FC/Q
Average Variable
Cost
Variable cost divided by quantity of output
AVC = VC/Q
Average Total
Cost
Total cost divided by quantity of output
ATC = TC/Q
Marginal Cost
Increase in total cost associated with one more unit
output
MC = ΔTC/ΔQ
Profit Max Decision
Costs
and
Revenue
Producing here
MC > MR so don’t
MC
ATC
MC = MR so profit
maxed
AVC
P = MR
= AR
Producing here
MC < MR so
produce more
Q*
Quantity
MC Curve as Supply Curve
Costs
and
Revenue
MC
ATC
P2
AVC
P1
Q1
Q2
Quantity
Short Run Supply Curve
Costs
ATC
In short run firms produce on
the MC curve if P > AVC
MC
AVC
Quantity
In short run firms shut down if P < AVC
Firm with Profits
Firm with Losses
AVC
AVC
MC
MC
Profit
P
Loss
AVC
AVC
P
Profit Maximizing Q
Q*
Q*
Cost Minimizing Q
Long Run Supply Curve
Costs
ATC
MC
In long run firms produce
on MC curve if P > ATC
Firms exit market if
P<ATC
Quantity
Market Supply Curve
• In short run # of firms fixed
• Each firm supplies where P = MC
• Each firms supply curve is the MC curve above
their AVC curve (otherwise 0)
• For market supply just add up horizontally
S1
S2
+
S - Market
=
Long Run Market Supply
Multiple Firms with identical cost
curves
Add up supply at MC = ATC level for
each to get Market Supply
Price
Price
ATC
MC
P=
Min ATC
Supply
Quantity
Quantity
Some Caveats
P
P
Actual Supply would be more like
this, with holes and dots denoting
when different firms enter. That is it
would not be a smooth line.
And perhaps it could still slope up if
by increasing market size they bid
up the cost of inputs. This would
cause latte entering firms to have
higher cost curves.
Or some firms could just be
better at it, thus having lower
cost curves. But either way LR
flatter than SR.
Q
Q
Demand Curve Faced By
Competitive Firm
Demand Curve Faced By
Monopoly
P
P
Demand
Demand
Q
Q
Since competitive firms are price takers they in effect face a horizontal demand
curve at the market price. Since monopolies are the sole producer they face the
actual market demand curve. If a monopoly wants to sell more they have to
lower the price, competitive firms can sell as much as they want at the market
price. But monopolies can raise the price (and sell less) whereas competitive
firms cannot raise the price.
P
Mathematic reason for MR < Demand:
P = A + B*Q (equation of demand curve)
Revenue = P*Q
Revenue = (A + B*Q)*Q = A*Q + B*Q2
MR = Derivative of Revenue
MR = A + 2*B*Q
So MR curve is twice as steep as the demand
curve so falls twice as fast
MR
Demand
Q
Intuition behind MR < Demand:
Because the price on all units sold must
be lowered to sell more the MR curve
falls faster than the demand curve on
which only the last units price must be
lower.
P
Then that Q up to the
demand curve shows
the price consistent with
that quantity
MC
PM
Monopolist (as all producers)
choose quantity where MR = MC
ATC
Demand
MR
Q*
Q
P
Deadweight
Loss
MC
MR
PM
Note: It is not the fact that the
monopolist charges a higher
price that leads to the
inefficiency, it is that they
produce less than the efficient
quantity.
Demand
QM
QE
Q
Since the monopolist produces less than the efficient level, it
leads to a deadweight loss, because some consumers who
value the good more than the MC don’t get to consume it.
• Monopolistic competition
– Like a monopolist, but not really
– Have to differentiate their product
– Role of advertising
• Oligopoly
– Incentive to collude and act like monopolist
– Also an incentive to cheat
– Strategic interaction
• Game theory (two player game)
– Dominated strategy
– Nash equilibrium
Production Function
Low Marginal Productivity
Quantity
of Output
Production function flattens out
because as more input (labor) is used
it becomes less productive, and so
each new unit of labor leads to less
units of output
High Marginal Productivity
Quantity of
Input (labor)
VMPL
Market
Wage
Rate
Marginal
Benefit
Where MC = MB is
profit max quantity
Value of marginal product
of labor = demand for
labor
(just like demand for any
good is also the value
curve of that good)
Marginal
Cost
Profit Maximizing
Quantity of Labor
Quantity
of Labor
Upward Sloping Labor Supply as a
Community or an Individual
Wage
Worker with low leisure
value enters first even if
wages low.
OR
You’re willing to give up
your first hour of leisure for
lower wage because leisure
not as valuable
Worker with highest
leisure value enters last
only when wages are high.
OR
You only give up your last
(16th) hour of work if the
wage is really high
because the value of that
leisure hour is high.
Quantity
Labor