Supply & Costs of Production
Diminishing Marginal Returns
As more and more of a variable input is added to
a fixed input, the resulting additional output
eventually decreases.
If there were not
diminishing marginal
returns, we could
feed the world from
a single flower pot.
Here’s why...
We have
 fixed
inputs: the flower pot and the soil
 variable inputs: seeds and fertilizer
We start with a few seeds and a little fertilizer.
We get some food from the plant.
Then we double the amount of seeds and
fertilizer. We get more food but probably
not twice as much as before.
If there were not
diminishing marginal
returns, we could just
keep adding more seeds
and fertilizer until eventually we have
enough to feed the world.
Accounting Costs
Costs as defined by accountants are explicit
costs.
Explicit costs: the value of resources used in
production for which explicit payments are
made.
Economic Costs
Costs as defined by economists include both
explicit and implicit costs.
Implicit costs: the value of resources used in
production for which no explicit payments
are made.
Examples of Implicit Costs


the salary that the owners would have
made if they worked for someone else.
the interest the owners would have made
if they had invested their money elsewhere
instead of using it to start up the company.
Accounting Profits & Economic Profits
Accounting Profits
= Total Revenue - Accounting Costs
= Total Revenue - Explicit Costs
Economic Profits
= Total Revenue - Economic Costs
= Total Revenue - (Explicit and Implicit Costs)
Zero Accounting Profits
& Zero Economic Profits
Zero Accounting Profits means that revenues
are just covering explicit costs.
Zero Economic Profits means that revenues
are just covering all explicit and implicit
costs.
Normal Accounting Profits
Suppose that a typical firm earns $100,000 per
year in accounting profits. Then we say that
a normal accounting profit is $100,000
per year.
When a firm has zero economic profits,
the firm is doing no better and no worse
than other firms.
In other words, a zero economic profit is
equivalent to a normal accounting profit.
Positive and Negative
Economic Profits
If a firm has positive economic profits, the firm is
doing better than other firms. It is making more
than a normal accounting profit.
If a firm has negative economic profits, the firm is
doing worse than other firms. It is making less
than a normal accounting profit.
Short Run and Long Run
Short run: a time period in which some inputs are
fixed.
For example, you can’t build a factory overnight.
Long run: a time period long enough for all things
to change.
All inputs are variable in the long run. You can
sell off a business and start up a new one if you
have enough time.
Short Run Equilibrium
and Long Run Equilibrium
Recall equilibrium means no tendency to change.
Things are in balance.
Previously discussed equilibrium condition:
quantity demanded = quantity supplied.
This condition is sufficient for short run equilibrium.
For long run equilibrium, we need more.
Note: In the following discussion, we assume that
barriers to entering a industry are minimal.
Positive Profits
Suppose firms in industry A have positive
economic profits. That means that those firms
are making more than the normal accounting
profit. They are doing better than other
industries.
Then people will want to leave the other
industries and enter industry A.
In the short run, firms have leases and other
commitments that prevent them from
leaving an industry.
In the long run, however, firms can be closed
down and new ones started.
When people start to enter the more profitable
industry A, prices in A will fall, and profits
will fall as well.
People will continue to enter A until
economic profits fall to zero. Then there
will no longer be an incentive for people to
move.
Positive Economic Profit
more than normal
accounting profit
(positive economic profit)
normal accounting
profit (zero
economic profit)
Negative Profits:
Suppose firms in industry B have negative
economic profits (or losses). That means that
those firms are making less than the normal
accounting profit. They are doing worse than
other industries.
Then people will want to leave industry B and
enter other industries.
In the long run, when people can start to leave
industry B, prices in B will rise, and profits
will rise as well.
People will continue to leave B until
economic profits rise to zero. Then there
will no longer be an incentive for people to
move.
Negative Economic Profit
less than normal
accounting profit
(negative economic
profit)
normal accounting
profit (zero
economic profit)
Zero Profits:
Suppose firms in all industries have zero
economic profits. That means that everyone is
making the normal accounting profit. No one is
doing any better or worse than anyone else.
There is no incentive for anyone to change
industries.
Zero Economic Profit
normal accounting
profit (zero
economic profit)
normal accounting
profit (zero
economic profit)
Long Run Equilibrium
Conditions:
(1) Quantity Demanded = Quantity Supplied
(no tendency for price to change)
(2) Zero Economic Profits
(no tendency for firms to start up or close
down)
The Long Run ATC Curve
(or the planning curve)
shows the least per unit cost at which any
output can be produced after the firm has
had time to make all appropriate
adjustments in its plant size.
Cost
SRATC1
At a relatively low output level, in the short run, the firm might
have SRATC1 curve as its short run average cost curve.
Quantity of output
Cost
SRATC2
At a slightly higher output level, in the short run, the firm might
have SRATC2 curve as its short run average cost curve.
Quantity of output
Cost
SRATC3
At a still higher output level, in the short run, the firm might have
SRATC3 curve as its short run average cost curve.
Quantity of output
Cost
LRATC
SRATC1
SRATC5
SRATC2
SRATC3
SRATC4
In the long run, the firm can pick any appropriate plant size. At
each output level, the firm picks the plant that has the SRATC
curve with the lowest value. So, the LRATC curve is made up of
segments of the SRATC curves.
Quantity of output
In many industries, the number of possible
plant sizes is virtually unlimited.
Then the long-run ATC curve is made up of
points of tangency of the theoretically
unlimited number of short-run ATC curves.
Then the long run ATC curve is smooth.
Cost
LRATC
SRATC1
SRATC5
SRATC2
SRATC4
SRATC3
Quantity of output
Why is the downward-sloping
section of the Long Run ATC curve
downward-sloping?
Economies of Scale
Economies of Scale:
As plant size increases, there are factors
which lead to lower average costs of production.
1.
2.
3.
Labor Specialization: Jobs can be subdivided and
workers performing very specialized tasks can become
very efficient at their jobs.
Managerial Specialization: Management can also
specialize in a larger firm (in areas such as marketing,
personnel, or finance).
Equipment that is technologically efficient but only
effectively utilized with a large volume of production
can be used.
Why is the upward-sloping section
of the Long Run ATC curve
upward-sloping?
Diseconomies of Scale
Diseconomies of Scale:
As plant size increases, there are factors
which lead to higher average costs of production.
Expansion of the management hierarchy leads to
problems of communication, coordination, and
bureaucratic red tape, and the possibility that
decisions will fail to mesh. (“The left hand
doesn’t seem to know what the right hand is
doing.”) The result is reduced efficiency.
2. In large facilities, workers may feel alienated
and may shirk (not work as much as they
should). Then additional supervision may be
required and that adds to costs.
1.
Constant Returns to Scale
when long-run ATC is constant
Minimum Efficient Scale (MES)
the smallest level of output at which a firm
can minimize long-run average costs.
Some Industry Possibilities
Cost
When there is an extended range of
constant returns to scale, we may
find the industry populated by firms
of many different sizes.
LRATC
Minimum efficient scale MES
Quantity of output
Cost
When economies of scale continue up
to a very high level of output, average
cost may be minimized by having a
single firm produce all of the output.
This is called natural monopoly.
LRATC
Quantity of output
Cost
LRATC
Minimum efficient scale MES
When economies
of scale are few
and diseconomies
are quickly
encountered, MES
occurs at a small
level of output.
We would then see
a large number of
small firms.
Quantity of output
Comment
Industry structure does not depend on cost
conditions alone.
Other factors, such as government policies,
geographic size of a market, and managerial
ability may influence the structure of an
industry.