COSTS OF
PRODUCTION
Chapters 11
Short-Run vs. Long Run
• Firms typically have several types of inputs that they can
adjust to adjust production.
• Long-run - When firms are able to adjust all of their inputs
including physical plant.
• Short-run – When firms are able to adjust only some of
their inputs (usually energy, labor, and raw material costs).
Productivity
• Average Productivity of Labor is output per work.
Total Product
APL 
Labor
• Marginal Productivity of Labor is the extra production that
is obtained from an extra unit of labor.
TP
MPL 
Labor
Short Run Production Function
MPL is the slope of the production
function which gets flatter as labor is
added.
Total
Product
ΔTP
ΔLabor
ΔTP
TP
MPL 
Labor
ΔLabor
Labor
Production in the Short-Run
• Given a set of fixed inputs (like plant and capital equipment),
a firm can vary other inputs (typically labor) and to vary
production.
• Typically, as you add workers, you get more output.
• Up to a point each additional worker adds synergy and
adding more workers leads to more and more extra pay-off.
• But at some point, capacity constraints bind, diminishing
returns sets in, and the addition of extra workers will
generate less and less extra production.
Bakery
35
30
Loaves
25
20
15
10
5
0
Hours
Productivity
• Labor productivity depends on the number of workers
• First, increasing, then, decreasing
• Average product of labor begins decreasing when
marginal product of labor drops below average.
Note: Marginal Product crosses through average product at
the peak of average product.
As long as the next worker adds more product than the
average worker, they will increase the average.
Once diminishing returns set in, additional workers may add
less to output than the average worker, reducing the overall
average.
MPL, APL
MPL
APL
L
Small Scale Schedule
Hours
Average
Product
Loaves
0
Marginal
Product
0
0.10
2
0.20
0.10
0.32
4
0.83
0.21
0.58
6
2
0.33
1
8
4
0.5
3
10
10
1
Large Scale Schedule
Hours
0
Average
Product
Output
Marginal
Product
0
1
10
10
1
0.333333
40
20
0.5
0.2
90
30 0.333333
0.142857
160
40
0.25
0.111111
250
50
0.2
0.090909
360
60 0.166667
Fixed Costs vs. Variable Costs
• In short-run, we distinguish between the costs that are
adjustable as production is adjusted (variable costs) and
costs that are unchanged regardless of production (fixed
costs).
• Variable costs (Wages of production workers, supply and raw
materials costs)
• Fixed costs (Depreciation costs, Financial costs, wages of nonproduction workers).
Types of Costs
• Total Fixed Costs – Invariant to the number of goods
produced (in the short-run)
• Average Fixed Costs – Decreasing in the number of goods
produced.
• Total Variable Costs- Increasing in the number of goods
produced.
• Total Costs: Fixed Costs + Variable Costs
Cost Shares
Various 4 Digit Industry
(USA, 1991-1996)
Production
Nonproduction
Industry
Workers
Energy
Materials Workers
Cement
9.02% 17.83% 43.21%
4.23%
Typesetting
28.17%
0.96% 18.96% 13.07%
Oil Refinery
1.65%
2.62% 83.80%
1.07%
Automobiles
5.41%
0.37% 71.97%
1.06%
Furniture
18.03%
1.62% 47.86%
5.56%
Mens Clothes
20.20%
1.23% 40.08%
7.67%
NBER Productivity Database
Labor Intensity
34.00%
51.50%
20.09%
23.38%
46.68%
47.49%
Output
(Loaves)
2.00
Fixed
Costs
1000
Workers
Wheat
6
Bakers
Wages
60
10.00
Variable
Costs
70.00
Total
Costs
1070.00
10.00
1000
10
100
50.00
150.00
1150.00
20.00
1000
40
400
100.00
500.00
1500.00
30.00
1000
90
900
150.00
1050.00
2050.00
40.00
1000
160
1600
200.00
1800.00
2800.00
50.00
1000
250
2500
250.00
2750.00
3750.00
60.00
1000
360
3600
300.00
3900.00
4900.00
Bakery: Wages $10 per Worker, $5 Wheat
per Loaf
Total Variable Costs are increasing at an accelerating rate.
Reason: Diminishing returns to variable inputs.
Cost Schedule
6000
5000
4000
3000
2000
1000
0
2.00
10.00
20.00
Fixed Costs
30.00
Variable Costs
40.00
Total Costs
50.00
60.00
Costs: Average vs. Marginal
• Total Costs are the sum of all relevant costs for a firm.
• Average Costs: Costs per unit of output.
• Marginal Cost: Extra Cost per Extra Unit of Output.
Cost Schedules
Output
(Loaves)
2.00
Total
Costs
1070.00
Average
Fixed
Costs
500
Average Average
Variable
Total
Costs
Costs
35
535
Marginal
Costs
10.00
10.00
1150.00
100
15
115
35.00
20.00
1500.00
50
25
75
55.00
30.00
2050.00 33.33333
35
68
75.00
40.00
2800.00
25
45
70
95.00
50.00
3750.00
20
55
75
115.00
60.00
4900.00 16.66667
65
82
Average and Marginal Costs
Average Fixed Costs
decreases as production
increases
Cost Curve
140
120
100
MC equals AVC and ATC
when each of the latter are
at their minimum level.
80
$
AVC, ATC, MC all
increase as
diminishing returns
kick in
60
40
20
0
AFC
AVC
ATC
MC
2.00
35
35.00
10.00
100
15
115
10.00
20.00
50
25
75
35.00
30.00
33.333333
35
68
55.00
40.00
25
45
70
75.00
50.00
20
55
75
95.00
60.00
16.666667
65
82
115.00
Long Run Costs
• In the short-run, the size of a firms physical plant is a fixed
factor.
• Over-time, the plant size can adjust.
• In the bakery example, extra ovens can be added.
Minimizing Costs in the Long Run
• Consider average total cost schedules at different
numbers of ovens.
• Each oven will have a production level that generates the
minimum average total cost.
• To minimize average costs in the long-run, choose the
number of ovens which will have the lowest, minimum
average total cost.
Connect the Dots Long Run Average Total Costs
228
208
1 Oven
188
2 Ovens
168
3 Ovens
148
4 Ovens
128
5 Ovens
6 Ovens
108
7 Ovens
88
8 Ovens
68
Output
120
110
100
90
80
70
60
50
40
30
20
10
48
If we adjust capital scale continuously, the
collection of minimum points is the Long Run
Average Total cost cuve
Short-run ATC
LR ATC
Economies of Scale
• When firms are able to adjust all of their inputs, they
can choose a size that will minimize costs.
• If a firm is able to achieve some economies of
scale, increasing size will reduce the average total
cost.
• Sources of Economies of Scale
• Production requires major expenditure on items needed to
produce even zero products
• Ex. Software, pharmaceuticals
• Production requires many specific steps which can be
most efficiently done through specialization
• Ex. Airplanes, automobiles
Long Run ATC increasing returns to scale.
LR ATC
Costs
Economies of Scale
Output
Returns to Scale
• Scale Economies is not always likely to
characterize production.
• If each production unit can act autonomously with
identical costs then we may experience constant
returns to scale.
• Firms at some point experience diseconomies of
scale or increasing long run average total costs.
• Sources of diseconomies of scale
• Limits of managerial attention.
• Limits of some other fixed resource.
Long Run ATC decreasing returns to
scale.
LR ATC
Costs
Constant Returns
Scale
Diseconomies
Output
Overall Cost Function
LR ATC
Minimum Efficient
Scale
MES and Market Structure
• If MES is relatively large in comparison with the market
demand:
$
The market is most
efficiently served by a
single firm---natural
monopoly!
D
LRAC
Q
MES and Market Structure
• If MES is relatively small in comparison with market
demand:
Many “small” firms
in the market.
$
Q
Learning Outcomes
Students should be able to
• Define and calculate various types of economic
costs.
• Fixed, variable, total, average, marginal.
• Describe the shape of various relevant cost
curves
• Average Total (in LR and SR), Average Fixed, Marginal Costs
• Describe the relationship between production,
productivity (marginal and average) and the law
of diminishing returns.
PERFECT COMPETITION
Chapter 12
Costs and Supply Decisions
• How much should a firm supply?
• Firms and their managers should attempt to maximize profits
(Profits = Revenues – Costs)
• Select a pricing strategy that induces a demand for a product that
generates highest revenue relative to the cost of production of that
level of supply.
• Profits depends on response of revenues to changes in
production quantities.
Perfect Competition/ Price Taking
• We think of some markets as characterized by perfect
competition
• In competitive markets, no firm has the market power to set their
own price.
• Firms in perfectly competitive markets take their price as
given.
China Price Download
Characteristics of Competitive
Markets
• Non-differentiated goods
• Large number of firms
• All firms are small relative to the market
• Free entry and exit.
Name some uncompetitive
markets
Name some competitive
markets in HK
MES and Market
Structure
$
•
•
•
•
Non-differentiated goods
Large number of firms
All firms are small relative to the market
Free entry and exit.
Many “small” firms
in the market.
Q
• If MES is relatively small in comparison with market demand:
Revenues and Perfect
Competition
• Revenues = Price * Quantity
• Average Revenue = Price
• Marginal Revenue is the extra revenue generated by
selling an extra good.
• If production by a firm doesn’t shift the price, marginal revenue is
the price.
Profit Maximization:
Short Run
• In the short-run, firm may only have a limited number of
avenues along which they may vary production.
• Cost of producing each good is likely to increase. But as long
as the extra revenue that the good brings in exceeds the
extra cost, it will be profitable to produce it.
• Maximize profits by producing up to that point that price is
equal to marginal cost. Beyond that, producing more goods
only subtracts from profits.
Accounting vs. Economic Profits
• Profits are revenues less costs.
• Economic profits are revenues less explicit and
implicit costs.
• Economic profits attract competition so they typically
don’t last.
• Accountants do not fully incorporate all implicit
costs including cost of equity capital or owner’s
contribution of time or expertise.
• Accountants do incorporate some implicit costs (such
as depreciation) into their profit& loss statements.
Increase Production until
marginal cost reaches the price level.
MC
P
P
Profits
ATC
Revenues
Costs
Q*
Revenues are price × quantity
Q
Profits = Revenues - Costs
Profit Maximization: Price is 80
Output
Average
Total
(Loaves)
Costs
2.00
535
10.00
115
20.00
75
30.00
68
40.00
70
50.00
75
60.00
82
Marginal
Marginal
Costs Revenues Revenues Profits
160.00
-910.00
15.00
80.00
800.00
-350.00
35.00
80.00
1600.00
100.00
55.00
80.00
2400.00
350.00
75.00
80.00
3200.00
400.00
95.00
80.00
4000.00
250.00
115.00
80.00
4800.00
-100.00
What if prices drop?
MC
P
P
Breakeven point
ATC
-Profits
Costs
P'
Revenues
Q**
Q
Q*
• The average total cost of production (when marginal
cost equals price) is above the new lower price.
• If the firm sets production at a level such that price equals marginal cost,
but that is the best they can do in the short run.
• Firms only decision is to vary production costs along those dimensions
that are available.
• Should the firm shut down?
• No. The firm has paid costs which cannot be retrieved [SUNK COSTS].
Since the firm cannot change this, they should ignore these sunk costs in
making their marginal decision.
• As long as prices exceeds variable costs, produce.
Profit Maximization: Price is 60
Output
Average
Total
(Loaves)
Costs
2.00
535
Average
Variable
Costs
35
10.00
115
15
20.00
75
25
30.00
68
35
40.00
70
45
50.00
75
55
60.00
82
65
Marginal
Marginal
Costs Revenues Revenues Profits
120.00
-950.00
10.00
60.00
600.00
-550.00
35.00
60.00
1200.00
-300.00
55.00
60.00
1800.00
-250.00
75.00
60.00
2400.00
-400.00
95.00
60.00
3000.00
-750.00
115.00
60.00
3600.00
-1300.00
When should the firm
stop production in the short-run?
MC
P
Breakeven point
ATC
P
AVC
P'
Dropout point
Q**
Q
Profit Maximization: Price is < 10
Output
Average
Total
(Loaves)
Costs
2.00
535
Average
Variable
Costs
35
10.00
115
15
20.00
75
25
30.00
68
35
40.00
70
45
50.00
75
55
60.00
82
65
Dropout!
Marginal
Marginal
Costs Revenues Revenues Profits
20.00
-1050.00
10.00
10.00
100.00
-1050.00
35.00
10.00
200.00
-1300.00
55.00
10.00
300.00
-1750.00
75.00
10.00
400.00
-2400.00
95.00
10.00
500.00
-3250.00
115.00
10.00
600.00
-4300.00
Adjustment in the Long Run
• In the longer run, firms are able to adjust the size
of their plant. (adjust the number of machines in
the factory, adjust the number of oil rigs).
• If profits are positive. Firms will seek to build new
equipment as they compete for profits.
• If profits are negative, firms will shut down
equipment and sell it, or possibly go out of
business.
• Firms will adjust their physical plant until they are
making profits again.
Profit maximization and the supply curve
• In the short-run, firms produce up to that point
where price equal marginal cost.
• Supply curve is the sum of the supply curves of
the different firms in the market.
• In the long-run, capacity will be adjusted to the
point where profits are zero (i.e. where marginal
cost equals average total cost).
• Long run ATC curve is collection of points where
MC = ATC and is the long-run supply curve.
Firm Level Supply Curve:
Short Run
P
SFirm 1
SR ATC
P*
MC
Output
In the short run, MC curve is the relationship between firm price and production
Firm Level Supply Curve:
Short Run
P
SFirm 2
SR ATC
P*
MC
Output
Industry Level Supply Curve:
Short Run
P
SFirm 1
+SFirm 2 +SFirm 3
SIndustry
Output
In the short run, the sum of the MC curves is the relationship between price and industry
production
Short Run Response to Increase in Demand
Increase Variable Inputs
P
D
SIndustry
2
P**
1
P*
D'
Q*
Q**
Output
Firm Level Supply Curve: Short Run
Short-run profits attract new entrants
P
2
P**
SFirm 1
SR ATC
Profits
1
P*
MC
q* q**
Output
In the short run, MC curve is the relationship between price and firm production
New Entrants in the Long Run
Supply Increases and Price Drops
P
D
SIndustry+SFirm N+ 1
2
P**
P***
3
1
P*
D'
Q* Q** Q***
Output
Firm Level Response
to New Entrants: Reduce Output
P
2
SFirm 1
P**
SR ATC
3
P***
Profits
1
P*
MC
q* q*** q**
Output
But as long as price is above minimum of ATC, there will still be profits and entry.
New Entrants as Long as Profits at MES
Supply Increases and Price Drops
P
D
+SFirm N+ 1 +…+SFirm N+ J
SIndustry
2
P**
3
P**
P*
1
4
D'
Q* Q** Q*** Q**** Output
Firm Level Response to New
Entrants: Reduce Output
P
2
SFirm 1
P**
3
SR ATC
P***
1,4
P*
MC
q* q***q**
Output
In the short run, MC curve is the relationship between firm price and production
Long Run, Supply is Flat along MES of New Entrants
P
D
SIndustry
+SIndustry
2
P**
P**
P*
1
4
D'
SLR
Q* Q** Q*** Q****Output
Long Run Supply Curve
• If all firms are exactly the same, then new firms have
same MES as old firms and supply curve is flat.
• In some cases, like oil drilling, new firms may have higher
MES than old firms and supply curve is upward sloping.
• Long run supply curve is flatter, more elastic than shortterm supply curve.
Long Run Equilibrium
• Firms are making zero profits.
• Firms will be producing at their minimum efficient scale
and at a minimum of ATC
Learning Outcomes
Students should be able to
• Characterize a perfectly competitive market.
• Calculate total revenue, marginal revenue and
profit for a firm in a competitive market.
• Describe the supply curve in a competitive market
in both the short and long run.
MONOPOLY
Chapter 13
Market Power
• Market power is the ability of a firm to affect the
market price of a good to their advantage. In
declining order.
• Monopoly – A single producer without competition
• Oligopoly Power – A small number of producers
sometimes acting in concert.
• Monopolistic Competition – Firms selling
differentiated products.
Price effects
• There is a demand curve relating the quantity of a product
that can be sold at a given price.
• Invert the concept: For each quantity, there is a price that
the market may bear.
• Change the quantity and change that price
• Marginal revenue
Marginal Revenue
• For price taking firm, marginal revenue is equal to price.
• For a firm with market power, marginal revenue must
include the change in the price that results from a change
in quantity.
P
MR  P 
QP
Q
MR  P 
P
Q
P P  P(1 
Q
1
)  P(1  1 )
eD
Demand Elasticity
Example
Demand,
Revenue,
Marginal
Revenue
Output
Price
Revenue
Marginal Revenue
10,000.00
33.0 330,000.0
13.7
20,000.00
23.3 466,690.5
10.5
30,000.00
19.1 571,576.8
8.8
40,000.00
16.5 660,000.0
7.8
50,000.00
14.8 737,902.4
7.0
60,000.00
13.5 808,331.6
6.5
70,000.00
12.5 873,097.9
6.0
80,000.00
11.7 933,381.0
5.7
90,000.00
11.0 990,000.0
5.4
100,000.00
10.4 1,043,551.6
P 35.0
Example
Demand
30.0
25.0
20.0
15.0
MR
10.0
5.0
0.0
10
20
30
40
Price
50
60
70
80
Marginal Revenue
90
Q
Monopolist
• Maximize Revenues by choosing an output level such that
marginal revenue equals marginal cost.
• Price will exceed marginal cost. Monopolists will make
greater profits than a competitive firm.
• Monopolists will charge higher prices and produce less output than a
competitive industry.
• Profits should attract new entrants to the market.
• Monopoly can only survive if there are some barriers to entry.
Monopolist: Constant Cost
Price
P*
Profit
MC = ATC
Revenues
D
Cost
MR
QMono
QPC
Output
Price
10,000
33.0
20,000
23.3
30,000
19.1
40,000
16.5
50,000
14.8
60,000
13.5
70,000
12.5
80,000
11.7
90,000
11.0
Marginal
Marginal
Revenue Revenue Cost
Cost
Profit
330000
80000
250000
13.66905
8
466690.5
160000
306690.5
10.48863
8
571576.8
240000
331576.8
8.842323
8
660000
320000
340000
7.790243
8
737902.4
400000
337902.4
7.042918
8
808331.6
480000
328331.6
6.476632
8
873097.9
560000
313097.9
6.028302
8
933381
640000
293381
5.661905
8
990000
720000
270000
Monopolist: General Case
MC
Price
ATC
P*
Profits
Revenues
D
MR
Costs
Q*
Output
Monopolist’s Schedule
• The more elastic the demand curve, the higher the market
power.
• The greater the market power, the greater the markup.
• Firm has more pricing power if good has fewer
substitutes.
Barriers to Entry
• Total Control over Vital Resource
• Alcoa in the aluminum market
• DeBeers in Diamond market
• Patents or Secret Formula:
• Xerox: Controlled photocopying
• Regulations: Jockey Club, SDTM
• Gambling is a legally restricted monopoly
• Returns to Scale:
• TownGas is an regulated monopoly supplier of a particular type of
piped natural gas (may have competition from LNG)
Price Discrimination
• Demand curve is the price customers are willing to pay.
• Some customers are willing to pay a very high price. If
monopolists could tailor a price to each customer they
could make maximum profits.
Monopolist: Price Discriminatation
Price
P1*
P2*
Profit
Profit
MC
MR2
MR
Q1 +Q2
D
Output
Natural Monopoly
• In markets with a natural monopoly there may be one firm.
• Economies of scale indicate that at marginal cost pricing
firms make a loss.
• Efficient production involves 1 firm. Firm will naturally charge
markup and earn profits.
Monopolist: High Fixed Costs
Profits under Monopoly
Price
Under perfect
competition, price equals
marginal cost and the firm
incurs losses.
P*
Profits
ATC
MC
Losses
D
MR
QMono
QPC
Output
Regulation
• Government may step in, usually to put a
maximum price level. Should be minimum
amount necessary to get the firm to operate small
decisions that lead to a competitive outcome.
• Average cost pricing
• Information Problem. A single decision maker
may not have full access to enough information.
.
Monopoly
P
600
D
500
Average
Cost
Pricing
ATC
400
MC
300
200
MR
Competition
100
0
0
50
100
150
200
250
Q
MONOPOLISTIC COMPETITION
AND PRODUCT
DIFFERENTIATION
Chapter 14
Monopolistic Competition
• Most firms produce a good that is (to a certain extent)
unique. No other good has the exact same properties.
• Coke, Pepsi, President’s Choice
• To the extent that you are a unique producer, you will have
some market power.
• Price elasticity of individual products are larger than total
category. But not infinite as in the case of commodity
goods.
Monopolistic Competition: Short-term
Price
MC
ATC
P*
D
MR
Q*
Output
Characteristics of Monopolistically
Competitive Markets
• Differentiated Products Download
• Free Entry into very similar markets.
• Fixed costs of setting up production
• Individual firms face downward sloping demand curve and
a falling average total cost curve.
• They would sell more if they could at the going rate but lowering
their prices to sell more would lead to losses.
No Barriers to Entry
• What happens if new firms can enter?
• If there are profits to be had, entrepreneurs will enter
markets to provide close substitutes for profit making
goods.
• New goods splitting the market and better substitutes
means lower, flatter demand curve.
Monopolistic Competition: Entry of Competitors
Price
MC
ATC
P*
P**
Profits
MR
MR′ D′
Q**
Q*
D
Output
Monopolistic Competition vs. Perfect
Competition
• On a market-by-market basis, perfect competition will
offer greater efficiency both in terms of minimizing
deadweight losses and encouraging an efficient
production scale.
• Monopolistic Competition only occurs with differentiated
products.
• Greater variety generated by this market may compensate for loss
of efficiency.
Monopolistic Competition: Long-term
Price
MC
ATC
Profits
P*
D′
MR′′
Q*
D′′
Output
MR′
Monopolistic Competition vs. Perfect
Competition
• Similar: Both have many firms, both have zero profits and
P = ATC.
• Different:
• P > MC : On the margin, monopolistically competitive firms want
more customers. Greater variety generated by this market may
compensate for loss of efficiency.
• MC < ATC: Firm is operating at a level that does not minimize total
costs.
Variety and Monopolistic Competition
• Given that most markets have the “feel” of monopolistic
competition, do we have too many firms or is variety it’s
own reward?
• Does advertising create phony differentiation or provide
information?
Monopolistic Competition and
Entrepreneurship
• New markets are frequently developed.
• For many goods, the only barriers to entry is imagination.
• Entrepreneurs develop new ideas for new goods. The
pay-off for entrepreneurship are short-run monopoly
profits. (Ted Turner and CNN). Only in rare cases will
firms be able to make long-term monopolistic profits.
Unprofitable Monopolistic Competition:
Short-term
Price
MC
ATC
P*
MR
Q*
D
Output
Consequences of Market Power
• One clear consequence of the existence of market power is
that prices are higher than marginal cost and output is
smaller than perfect competition.
• Additional consequences of the presence of market power
may be:
• Complacency by firms managers (i.e. standard corporate governance
measures do not generate efficiency)
• Rent-seeking: Firms may put effort into constructing artificial barriers
to entry rather than producing goods.
Learning Outcomes
• Define marginal revenue.
• Characterize the relationship between price, marginal
revenue, marginal cost, average total cost, and profits in a
monopolistic market.
• Measure the degree of market power with the Lerner
index.
• Describe 4 barriers to entry that may enable monopoly
power.
Final Exam (TBA)
• When: Sunday, February 8th. TBA.
• Where: TBA
• What: Cover Materials in lectures on Supply& Demand,
Macro Indicators, Exchange Rates, Loanable Funds,
Business Cycles, Monetary Policy, Industrial Organization.
• How: Format similar to practice final.
• Bring writing materials, calculator, 1 A4 paper with
handwritten notes on both sides.
• Office Hours: Thursday, January 29th 7-8pm, Downtown
campus; February 7th, 12:30-2pm.