Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run
BUSINESSES AND THE COSTS OF PRODUCTION
Economic profit
Accounting Profit – Implicit
Costs
** Economic or pure profits are total revenue less all costs
(explicit and implicit including a normal profit). Economic profit
will always be smaller than an accounting profit, which excludes
implicit costs.
Short Run and Long Run
Short run a period of time that is too brief for a firm to alter its plant
capacity, but can change output somewhat by increasing or
decreasing its variable inputs.
Short-Run Production Relationships
Total Product (TP)
Marginal Product (MP)
CHANGE IN TOTAL PRODUCT
CHANGE IN LABOR INPUT
Average Product (AP)
TOTAL PRODUCT
UNIT OF LABOUR
Long Run a period of time that is long enough for the firm to adjust
the plant size as well as enter or leave the industry.
Total Cost Data
Average Cost Data
Marginal
Cost
(1)
(2)
(3)
(4)
(5)
(6)
Total
Total
Total
Total Cost
Average
Average
(TC)
Fixed
Product Fixed Variable
(Q)
Cost
Cost
TC=TFC+TVC
(TFC) (TVC)
Cost
(AFC)
AFC =
Variable
Cost
(AVC)
(7)
(8)
Average Marginal
Total
Cost
(ATC)
Cost
(MC)
MC
ATC = =ΔTC/ΔQ
TFC/Q AVC=TVC/Q
TC/Q
0
$100
$0
$100
1
100
90
190
$100.00
$90.00
$190.00
$90
2
100
170
270
50.00
85.00
135.00
80
3
100
240
340
33.33
80.00
113.33
70
4
100
300
400
25.00
75.00
100.00
60
5
100
370
470
20.00
74.00
94.00
70
6
100
450
550
16.67
75.00
91.67
80
7
100
540
640
14.29
77.14
91.43
90
8
100
650
750
12.50
81.25
93.75
110
9
100
780
880
11.11
86.67
97.78
130
10
100
930
1030
10.00
93.00
103.00
150
Fixed Costs (TFC)
Costs do not vary with output
Variable Costs (TVC)
Costs vary with output
Total Costs (TC)
Sum of TFC and TVC
TC = TFC + TVC
Average fixed costs (AFC)
FC/Q
Average variable costs (AVC)
AVC = VC/Q
Average total costs (ATC)
ATC = TC/Q or ATC = AFC + AVC
Marginal cost (MC)
MC = ΔTC/ΔQ
Long-Run Production Costs
The firm can change all input amounts, including plant size.
All costs are variable in the long run.
Combined from different short run ATCs
Economies of scale refer to the idea that, for a time, larger plant sizes will
lead to lower unit costs.
Labor specialization
Managerial Specialization
Efficient Capital
Economies and Diseconomies of Scale
Diseconomies of scale results from
Control and coordination problems
Communication problem
Worker Alienation as contact reduced
Shirking or avoiding work increase
Applications and Illustrations
Rising gasoline prices
Successful start-up firms
Verson stamping machine
The daily newspaper ( high FC)
Aircraft and concrete plants
Pure Competition in the Short Run
Market Structure
The competitive environment in which the buyers and sellers of the product
operate
Four Market Models
Pure competition
Pure monopoly
Monopolistic competition
Oligopoly
Pure Competition: Characteristics
Very large numbers of sellers
Standardized product
“Price takers”
A firm or individual who takes the price determined by market
supply and demand as given
Free entry and exit
perfectly elastic demand curve is a horizontal line at the price.
Average, Total, and Marginal Revenue
Average Revenue
AR = TR/Q = P
Total Revenue
TR = P X Q
Marginal Revenue
MR = ΔTR/ΔQ = (Δ P X Δ Q) ΔQ = P
Demand = AR = MR = Price
FIRM’S
DEMAND
SCHEDULE
(AVERAGE
REVENUE)
Q
0
1
2
3
4
5
6
7
8
9
10
P
$131
131
131
131
131
131
131
131
131
131
131
FIRM’S
REVENUE
DATA
TR MR
$0
$131
131
131
262
131
393
131
524
131
655
131
786
131
917
131
1048
131
1179
1310 131
Profit Maximization: TR-TC Approach
Profit Maximization: TR-TC Approach
Profit Maximization: MR-MC Approach
Loss-Minimizing Case
If P < ATC, firm is under loss.
Firm can still produce if P > min AVC
Shut down point: P = AVC
Shut down condition: P < AVC
Shutdown Case
Marginal Cost and Short-Run Supply
Firm and Industry: Equilibrium
Quantity demanded equals quantity supplied
Pure Competition in the Long Run
Profit Maximization in the Long Run
 Easy entry and exit
 Identical costs
 Constant-cost industry
Long-Run Equilibrium
 Firms enter/exit
 Supply increases/decrease
 Price falls/rises
Pure Competition and Efficiency
–
–
–
–
–
–
–
Productive efficiency
Producing at the least cost way.
Producing where P = min. ATC
Allocate efficiency
Producing the mix of goods most desired by society
Producing where P = MC
P= min, ATC = MC does not occur in decreasing cost industry.
Pure Monopoly
Pure Monopoly
A single firm is the sole producer of a product which there is no close
substitute.
Natural Gas
Electricity
Water
Barriers to Entry
Economies of Scale
 Legal Barriers: Patents and Licenses
 Ownership of Essential Resources
 Pricing
Marginal revenue is less than price P > MR
Down sloping demand curve
MONOPOLY DEMAND
*Price will exceed marginal revenue because the
monopolist must lower the price to sell the additional unit.
Marginal Revenue < Price
Output and Price Determination
 Total revenue (TR) increases at a decreasing rate, reaches a
maximum, and then declines.
 TR is increasing and hence MR is positive. (When TR reaches its
maximum, MR is zero.)
 The MR = MC rule will tell the monopolist where to find its
profit-maximizing output level.
 The pure monopolist has no supply curve because there is no
unique relationship between price and quantity supplied.
MISCONCEPTIONS OF MONOPOLY PRICING
• Not highest price (set the price at MC=MR)
• Total profit (set at MC=MR)
• Possibility of losses (monopoly can go under losses)
Economic Effects of Monopoly
Pure competition is efficient
 Price (Pc) equals marginal cost (MC) at the minimum
average total-cost output where Qc is produced
 P = minimum ATC
Monopoly is inefficient
 MR curve lies below the demand curve
 MR = MC
 Creates an efficiency loss
Regulated Monopoly
 Socially optimal price (price = marginal cost)
 Fair return price (price = ATC)
Price Discrimination
Charging different buyers different prices, not based on cost differences







Business travel
Electric utilities
Movie theaters
Golf courses
Railroad companies
Coupons
International trade
Monopolistic Competition and Oligopoly
Monopolistic Competition
–
Large number of sellers
–
Differentiated products
–
Easy entry and exit
–
Advertising
–
Industry concentration
Four-firm concentration ratios
output of four largest firms
Total output in the industry
Herfindahl index
Sum of squared market shares
Price and Output in Monopolistic Competition




Demand is highly elastic but downward sloping.
MR=MC (Short run)
Inefficient
Normal profit in Long run (equilibrium is at P = ATC,
breakeven with revenue)
Monopolistic Competition: Efficiency
Productive inefficiency
P ≠min ATC
Allocative inefficiency
P ≠ MC
Product Variety
– Monopolistically competitive producers may be able to
postpone the long-run outcome of just normal profits
through product development, improvement, and
advertising.
– Product differentiation is at the heart of the trade-off
between consumer choice and productive efficiency.
– The greater number of choices the consumer has, the
greater the excess capacity problem.
Oligopoly
Homogeneous
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Steel and oil markets
differentiated oligopolies
Breakfast cereal, beverages, and automobiles
Control over price is limited
Entry barriers are more substantial than in monopolistic
competition
Mergers
Some firms rely on merging as a strategy in creating market
power.
Oligopolistic Industries
Four-firm concentration ratio
At least 40%
 Localized markets
 Inter-industry competition
 World price
 Dominant firms
High Concentration Industries
3 Oligopoly Models
 Kinked Demand Curve
 Collusive Pricing
 Price Leadership
Kinked-Demand Theory
non collusive oligopolies
Explain their behaviors and pricing strategies
Uncertainty about rivals reactions
 Rivals match any price reduction
 Rivals ignore any price increase
Criticisms
 It never actually explained how the current price was
determined.
 Prices in oligopolies are not rigid.
 Changing prices could result in a price war.
Cartels and Other Collusion
Overt Collusion
Cartels
A group of firms or nations that collude
OPEC
Obstacles to Collusion
Demand and cost differences
Number of firms
Cheating
Recession
New entrants
Legal obstacles
Price Leadership Model
An economic model where a dominant firm initiates price
changes and the others in the industry follow the leader
use limit pricing to block entry of new firms
The leader is never certain that the other firms will follow and
there is always the threat of a price war.
Oligopoly and Advertising
Positive Effects of Advertising
 Reduces buyers search time and minimizes the cost
 Diminishes monopoly power resulting in greater
economic efficiency
 Successful DD will increase and reduce LR (ATC)
Negative Effects of Advertising
 Can be manipulated rather than inform buyers
 Can lead to self cancelling
Oligopoly and Efficiency
 Economic efficiency of oligopolies is hard to evaluate
 Productively inefficient P > min ATC
 Allocate inefficient P > MC
Qualification
 Foreign competitions made many oligopolists much more
competitive
 Limit price
 Technological advance
The Demand for Resources
Resource Pricing
 A major factor in determining the income of households
 Impact over production cost
 Firms demand resources
Produce at the profit-maximizing output with the least costly
combination of resources
The importance of resource price
– Money-income determination
– Cost minimization
– Resource allocation
– Policy issues
Resource Demand
The demand for a resource is derived from the demand for the products that
the resource helps to produce.
 strength of the demand
o Productivity of resource (MP)
o Price of the good it helps produce (P)
 Marginal revenue product (MRP)
Change in TR resulting from unit change in resource (labor)
Rule for employing resources
1. MRP = MRC
2.
3.
MRP as Resource Demand
The resource demand curve (the solid line in the
graph) slopes downward because both marginal
product and product price fall as output rises.
Determinants of Resource Demand
Changes in product demand
The demand for a product will increase the demand for a resource
used
Changes in productivity
– Quantities of other resources
– Technological advance
– Quality of the variable resource
Changes in the price of substitute resources
Affect the demand for a specific resource
– The substitution effect
– The output effect
**Netting the two together will determine the final total change
Occupational Employment Trends
Changes in labor demand
Have a significant effect on wage rates and employment in specific
occupations.
– fastest growing occupations (service occupations)
– declining employment (textiles and apparel)
Elasticity of Resource Demand
 Several factors determine the elasticity of resource demand
– The ease of the resource substitutability
– Elasticity of product demand
– Ratio of resource cost to total cost
Optimal Combination of Resources
Long run all resource inputs are variable
A firm will produce a specific output with the least-cost combination
of resources in order to maximize profit
The Least Cost Rule
Minimize the cost of producing a given output in order to
maximize profits
Profit Maximizing Rule
• MRP of each resource equals its price
Income Distribution
Income payments = based on marginal revenue product
provide a fair and equitable distribution of society’s income.
• Paid according to value of service
– Workers
– Resource owners
• Inequality
– Productive resources unequally distributed
• Market imperfections
Wage Determination
Labor, Wages, and Earnings
Labor any types of worker
Blue-collar, white-collar, hourly, salaried, professional
Wages
the price paid for labor
Fringe benefits like vacations and health insurance
nominal wage the amount of money received per hour,
day, or year
real wage the quantity of goods and services a worker
can obtain with nominal wages “purchasing power”
**Wage rates differ greatly among nations, regions,
occupations, and individuals
Role of Productivity
 The demand for labor depends on its productivity.
 highly productive labor → Advanced economies
 plentiful capital
 access to abundant natural
resources
 advanced technology
 the quality of the labor
 other factors
Social and political environment
Real Wages and Productivity
o The long-run trend
Competitive Labor Market
o What determines the wage rate?
o Market demand for labor
The horizontal sum of the labor demand curves
o market supply for labor
Upward-sloping supply curve, employers must pay
higher wage rates to obtain more workers
o The labor market equilibrium
The intersection of the market labor demand curve and
the market labor supply curve
Competitive Labor Market
The labor supply and
labor demand in a
purely competitive labor
market and a single
competitive firm
**The firm will maximize profits by hiring workers up to
where MRP = MRC
Equilibrium in the Labor Market
Monopsony Model
Only one buyer for labor
“Wage maker” = the wage rate it must pay varies directly
with the number of workers available
The firm’s labor supply curve will be upward sloping
and the MRC will be higher than the wage rate
maximize profit
Employ the quantity of labor at which MRC and
MRP are equal
Monopsony Power
maximize profit
• hiring smaller number of workers
• paying a lower wage than the competitive
market
Nurses, Professional Athletes, Teachers
workers unionize