INTRODUCTORY
MICROECONOMICS
Instructor:
Filip Vesely
22
U-Shaped Curves
Why the average total cost curve
(ATC) is U-shaped
Average total cost, ATC, is the sum
of average fixed cost, AFC, and
average variable cost, AVC.
The shape of the ATC curve
combines the shapes of the AFC
and AVC curves.
The U shape of the average total
cost curve arises from the influence
of two opposing forces:
•Spreading total fixed cost over a
larger output
•Decreasing marginal returns
The marginal cost curve (MC) is
also U-shaped and intersects the
average variable cost curve and the
average total cost curve at their
minimum points.
Cost Curves and Product Curves
The technology that a firm uses determines
its costs.
At low levels of employment and output, as
the firm hires more labor, marginal product
and average product rise, and marginal cost
and average variable cost fall.
Then, at the point of maximum marginal
product, marginal cost is a minimum.
As the firm hires more labor, marginal
product decreases and marginal cost
increases.
But average product continues to rises, and
average variable cost continues to fall.
Then, at the point of maximum average
product, average variable cost is a
minimum.
As the firm hires even more labor, average
product decreases and average variable
cost increases.
Cost Curves and Product Curves
A firm’s average variable cost curve is
linked to its average product curve.
If average product rises, average variable
cost falls.
If average product is a maximum,
average variable cost is a minimum.
At low outputs, MP and AP rise and
MC and AVC fall.
At intermediate outputs, MP falls and MC
rises; and AP rises and AVC falls.
At high outputs, MP and AP fall and MC
and AVC rise.
Shifts in Cost Curves
Technology
A technological change that increases productivity shifts the total
product curve upward. It also shifts the marginal product curve and
the average product curve upward.
With a better technology, the same inputs can produce more
output, so an advance in technology lowers the average and
marginal costs and shifts the short-run cost curves downward.
Prices of Factors of Production
An increase in the price of a factor of production increases costs
and shifts the cost curves.
• A change in rent or some other component of fixed cost shifts the
fixed cost curves (TFC and AFC) upward and shifts the total cost
curve (TC) upward but leaves the variable cost curves (AVC and
TVC) and the marginal cost curve (MC) unchanged.
• A change in wage rates or some other component of variable cost
shifts the variable curves (TVC and AVC) and the marginal cost curve
(MC) upward but leaves the fixed cost curves (AFC and TFC)
unchanged.
LONG-RUN COST
Plant Size and Cost
When a firm changes its plant size, its cost of producing a given output
changes.
Will the average total cost of producing a gallon of smoothie fall, rise,
or remain the same?
Each of these three outcomes arise because when a firm changes the
size of its plant, it might experience:
• Economies of scale
• Diseconomies of scale
• Constant returns to scale
Economies of scale exist if when a firm increases its plant size and labor
employed by the same percentage, its output increases by a larger
percentage and average total cost decreases.
The main source of economies of scale is greater specialization of both labor
and capital.
Diseconomies of scale exist if when a firm increases its plant size and
labor employed by the same percentage, its output increases by a smaller
percentage and average total cost increases.
They arise from the difficulty of coordinating and controlling a large enterprise.
Eventually, management complexity brings rising average total cost.
Constant returns to scale exist if when a firm increases its plant size
and labor employed by the same percentage, its output increases by the
same percentage and average total cost remains constant.
Constant returns to scale occur when a firm is able to replicate its existing
production facility including its management system.
The short-run average cost curve shows the lowest average cost at
which it is possible to produce each output with a given plant size.
SRAC
The long-run average cost curve shows the lowest average cost at
which it is possible to produce each output when the firm has had
sufficient time to change both its plant size and labor employed.
Minimum efficient scale is the smallest quantity of output at which
the long-run average cost reaches its lowest level.
Constant returns to scale
Economies of scale
SRAC1
SRAC2
SRAC3
LRAC
Diseconomies of scale
CHAPTER 11 – PERFECT COMPETITION
ƒ Explain how price and output are determined in perfect
competition
ƒ Explain why firms sometimes shut down temporarily and
lay off workers
ƒ Explain why firms enter and leave the industry
ƒ Predict the effects of a change in demand and of a
technological advance
ƒ Explain why perfect competition is efficient
Competition
Perfect competition is an industry in which:
ƒ Many firms sell identical products to many buyers.
ƒ There are no restrictions to entry into the industry.
ƒ Established firms have no advantages over new ones.
ƒ Sellers and buyers are well informed about prices.
Perfect competition arises:
ƒ When firm’s minimum efficient scale is small relative to market
demand so there is room for many firms in the industry.
ƒ And when each firm is perceived to produce a good or service that
has no unique characteristics, so consumers don’t care which firm
they buy from.
Competition
Price Takers
In perfect competition, each firm is a price taker.
A price taker is a firm that cannot influence the price of a good or service.
(No single firm can influence the price—it must “take” the equilibrium
market price.)
Each firm’s output is a perfect substitute for the output of the other firms,
so the demand for each firm’s output is perfectly elastic.
Economic Profit and Revenue
The goal of each firm is to maximize economic profit, which equals
total revenue minus total cost. (Total cost is the opportunity cost of
production, which includes normal profit.)
A firm’s total revenue equals price, P, multiplied by quantity sold, Q,
equals P × Q.
A firm’s marginal revenue is the change in total revenue that results from
a one-unit increase in the quantity sold. In perfect competition MR = P.
Firm’s Revenue in Perfect Competition
Market demand and
supply determine the price
that the firm must take.
Firm’s total revenue
curve is given by
Price x Q.
Because in perfect
competition the price remains
the same as the quantity sold
changes, firms marginal
revenue equals price.
The Firm’s Decisions in Perfect
Competition
The perfectly competitive firm faces two constraints:
ƒ A market constraint summarized by
the market price and the firm’s revenue curves
ƒ A technology constraint summarized by firm’s
product curves and cost curves
The perfectly competitive firm makes two decisions in the short run:
ƒ Whether to produce or to shut down.
ƒ If the decision is to produce, what quantity to produce.
The perfectly competitive firm makes two decisions in the long-run:
ƒ Whether to stay in the industry or leave it.
ƒ If the decision is to stay, whether to increase or decrease its plant size.
The Firm’s Decisions
in Perfect Competition
Profit-Maximizing Output
A perfectly competitive firm
chooses the output that
maximizes its economic profit.
One way to find the profit
maximizing output is to look at
the firm’s the total revenue and
total cost curves.
Next figure looks at these
curves along with the firm’s
total profit curve.
The Firm’s Decisions
in Perfect Competition
Part (a) shows the total revenue, TR,
curve and the total cost curve, TC.
Total revenue minus total cost is
profit (or loss), shown in part (b).
The Firm’s Decisions
in Perfect Competition
Part (a) shows the total revenue, TR,
curve and the total cost curve, TC.
Total revenue minus total cost is
profit (or loss), shown in part (b).
Profit is maximized when the firm
produces 9 sweaters a day.
At low output levels, the firm incurs an
economic loss—it can’t cover its fixed
costs.
The Firm’s Decisions
in Perfect Competition
Part (a) shows the total revenue, TR,
curve and the total cost curve, TC.
Total revenue minus total cost is
profit (or loss), shown in part (b).
Profit is maximized when the firm
produces 9 sweaters a day.
At low output levels, the firm incurs an
economic loss—it can’t cover its fixed
costs.
At intermediate output levels, the firm
earns an economic profit.
At high output levels, the firm again
incurs an economic loss—now it faces
steeply rising costs because of
diminishing returns.
The Firm’s Decisions
in Perfect Competition
The firm can use marginal analysis to determine the
profit-maximizing output.
Because marginal revenue is
constant and marginal cost
eventually increases as output
increases, profit is maximized by
producing the output at which
marginal revenue, MR,
equals marginal cost, MC.
If MR > MC, economic profit
increases if output increases.
If MR < MC, economic profit
decreases if output increases.
If MR = MC, economic profit decreases if output changes in either
direction, so economic profit is maximized.
The Firm’s Decisions
in Perfect Competition
Profits and Losses
in the Short Run
Maximum profit is not always a
positive economic profit.
To determine whether a firm is
earning an economic profit or
incurring an economic loss, we
compare the firm’s average
total cost, ATC, at the profit
maximizing output with the
market price.
The Firm’s Decisions in Perfect
Competition
If price equals ATC then
the firm earns
zero economic profit
(that is normal profit only).
If price exceeds ATC then
the firm earns a
positive economic profit.
If price is less than ATC
then the firm incurs an
economic loss—economic
profit is negative and the
firm does not even earn
normal profit.
RECALL THAT IN PERFECT COMPETITION P = MR