Introduction to Microeconomics
Production, cost and profit in the
short-run
Key ideas
You should understand how
• Opportunity cost shapes supply
• Law of diminishing marginal returns is related to marginal and average
product.
•
•
•
•
•
Total, average, and marginal product are related
To identify the short-run profit point
The firm decides on how much to produce and how many employees to
hire.
To show the maximum profit point graphically
How costs and the availability of inputs affect short-run supply curve
and elasticity of supply.
Learning Objectives
Ch5-2
Copyright © 2012 McGrawHill Ryerson Limited
This chapter rests on two assumptions
1. The firm operates under perfect competition
• Buyers and sellers are fully informed
• There are many buyers and sellers – no market participant can
influence supply
• This means that firms are “price-takers”
2. Short-run decisions (Short-run is an imprecise idea, but means that
businesses cannot adjust equipment, leases and is stuck with other
contracts
Opportunity cost
• For this class, today … the value of the next best way to spend your
time
• For a business … the value of what could be produced using the
resources available
Short-run for a business
• Must work within the equipment and contracts available now
• The time period over which a business can change equipment and
contracts, starts to define the line between short and longer-run.
Profit Maximization
• Firms are believed to maximize profits as a
primary goal.
• Price taker
– A firm that has no influence over the price at
which it sells its product.
• Profit
– Total revenue (price x the quantity) minus all
costs of production.
LO2: Law of Diminishing Marginal Product andCopyright
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and Marginal Product
Key terms
• Factor of Production
– An input used in the production of a good or service.
– Four categories: land labour, capital, or
entrepreneurship.
• Intermediate input
– an input that is used up in the production process
– natural resources
• Other?
• Innovation?
• Energy?
Law of Diminishing Marginal Returns (for labour)
Given that all other inputs and technology are fixed, the marginal product of labour
increases, and then decreases as successively more units of labour are employed.
Cost and Benefit principle
Costs of production will increase as output increases, but since the price remains
the same – at some point the additional (marginal) cost of producing one more
unit will start to exceed the additional (marginal) revenue gained from the sale of
that additional unit.
Profit maximization means that
Marginal cost = marginal revenue
Total output
of bottles
Marginal product – additional
output per worker/day
A Short Run Production Function of
Acme Glass Limited
Maximum MP
Maximum AP
Average product – total output
per worker/day
Average product
Marginal product
LO3: Graphing the
Relationships among Total,
Average and Marginal
Ch5-7
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Total Output, Marginal Product, and
Average Product for a Glass-Bottle
Maker
Maximum TP
•
•
•
•
•
When total product reaches
maximum, marginal product is
equal to 0.
Maximum marginal product occurs
to the left of maximum average
product.
Marginal product intersects
average product at its maximum.
If marginal product exceeds
average product, then average
product is rising.
If marginal product is less than
average product, then average
product is falling.
Total product of labour
Maximum MP
Maximum AP
Average product
Marginal product
MP = 0
LO3: Graphing the
Relationships among Total,
Average and Marginal
Ch5-8
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Employment, Output, Revenue, Costs, and Profit of Acme Glass
Limited
Employee wage rate = $10/day; Price of bottles = $35/hundred = $0.35/bottle
Profit maximization choice
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LO4: Maximizing Short Run Profit
Ch5-15
Marginal Revenue and Marginal Cost
Principle I
• Under perfect competition, marginal revenue is
equal to the price level of the product.
• Marginal cost is the cost of the additional labour
and marginal productivity of that labour.
– Consider increasing output from 200 to 300
bottles/day
MC 
change in total wage paid $20
W


 0.20
change in total output
100 MPL
– Marginal cost of a bottle is $0.20 (and marginal cost of
100 bottles is $20)
Copyright
LO5: Firm’s Cost and Decision on Quantity Supplied
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Hiring
Marginal Revenue and Marginal Cost
Principle II
• Whenever MR > MC the firm increases profit
by producing and selling more output.
• If MR < MC the firm will reduce profit by
producing more output
• Why might a firm choose to accept a lower
profit (think of the assumptions)?
Copyright
LO5: Firm’s Cost and Decision on Quantity Supplied
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Hiring
TABLE 5.3: Employment, Output, Revenue, Costs, and Profit at
Acme Glass Limited
Example 5.2: Employee wage rate = $10/day; Price of bottles = $0.45/bottle
Profit maximization choice
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Limited
LO5: Firm’s Cost and Decision on Quantity
Supplied and Hiring
Ch5-12
TABLE 5.4: Employment, Output, Revenue, Costs, and Profit at
Acme Glass Limited
Example 5.3: Employee wage rate = $14/day; Price of bottles = $0.35/bottle
Profit maximization choice
LO5: Firm’s Ch5-13
Cost and Decision on Quantity
Supplied and Hiring
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Acme’s Marginal Cost of Production
The firm’s cost goes up by
$20 when it expands
production from 200 to 300
bottles/day.
–
The firm’s cost goes up by $20 when it expands production from 200 to 300 bottles/day. The marginal cost
of the increased output is thus $20. By convention we plot that value at a point midway between 200 and
300 bottles/day.
LO5: Firm’s Cost and
Decision on Quantity
Supplied and Hiring
Ch5-14
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Acme’s Marginal Cost of Production
Price =$35
P =MC, profit maximizing
supply rule
–
The firm’s cost goes up by $20 when it expands production from 200 to 300 bottles/day. The marginal cost
of the increased output is thus $20. By convention we plot that value at a point midway between 200 and
300 bottles/day.
LO5: Firm’s Cost and
Decision on Quantity
Supplied and Hiring
Ch5-15
Copyright © 2012 McGrawHill Ryerson Limited
A Shift of the Marginal
Cost Curve
Labour cost increases from
$10 to $14/day and causes
MC to shift to MC .
LO5: Firm’s Cost and
Decision on Quantity
Supplied and Hiring
Ch5-16
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TABLE 5.5: The Law of Diminishing Marginal Returns and ShortRun Costs for Acme Glass (at a daily wage of $10)
Law of diminishing marginal returns
∆(2)/∆(1)
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Limited
LO6: Short Run Cost and Product Curve
Ch5-17
Short-run Costs
•
•
•
•
•
MC = ∆TC/∆Q
TC = Variable costs + Fixed Costs
AVC = TVC/Q
AFC = TFC/Q
ATC = AFC + AVC
– Short-run cost-minimizing quantity of output :
• the quantity of output at which a factory reaches
minimum average total cost.
Ch5-18
LO6: Short Run
Cost and Product Curve
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FIGURE 5.5: The Relationship
between Product Curves and Cost
Curves
Maximum marginal product
Maximum average product
•
•
•
When marginal product reaches
its maximum, marginal cost is at
its minimum. And when average
product reaches its maximum,
average variable cost is at its
minimum.
Marginal product intersects
average product at maximum
average product, marginal cost
intersects average variable cost at
minimum average variable cost.
The two sets of curves are mirror
images of each other.
Average product
Marginal product
Marginal cost
Average
variable cost
Minimum average variable cost
Minimum marginal cost
Ch5-19
LO6: Short Run
Cost and Product Curve
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Wage rate = $10/day
Short-Run Average and Marginal Cost Curves for Acme Glass
Limited
and total
fixed cost =
$40/day. The firm’s
short-run supply curve is
given by the short-run
marginal cost above
minimum average
variable cost.
Profit per Bottle=0.45-0.30 = 0.15
0.50
Average total cost
0.45
Total Daily Profit = 0.15 X 500 = $75.00
0.40
Marginal cost
$/bottle
Minimum average
total cost
0.30
0.26
0.22
0.20
Average
variable cost
Minimum average
variable cost
0.08
0.10
Average
fixed cost
Minimum marginal
cost
0
100
200
300
400
500
Output (bottles/day)
Ch5-20Maximum Profit
LO7: Price Takers
Copyright © 2012 McGrawHill Ryerson Limited
The Shut-Down Rule
– If price drops below minimum average variable
cost, the firm will minimize its losses by shutting
down.
– What this means is that if the costs of variable
inputs (wages, supplies, etc.) per unit of output
cannot be covered by price per unit, send
everyone home…it is cheaper.
Ch5-21Maximum Profit
LO7: Price Takers
Copyright © 2012 McGrawHill Ryerson Limited
Price Elasticity of Supply
• The percentage change in the quantity
supplied that will occur in response to a onepercent change in its price
– % change in Q is: ΔQ/Q
– % change in P is: ΔP/P
• So the price elasticity of supply is:
Q/Q  P  Q   P  1 

Price elasticity of supply 
  
   
P/P  Q  P   Q  slope 
LO8: The Price Elasticity of
Supply
Ch5-22
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Unique and Essential Inputs: The
Ultimate Supply Bottleneck
• Fertile agricultural land is a historically scarce resource.
Is this true?
• Since it makes sense to use the most fertile land first, as the
amount of land under cultivation expands, eventually less
fertile land will have to be used.
Then why are cities often on the best land?
• Cost of production will rise as farmers start to use less
fertile land.
What options exist?
• When an essential input into production is inherently
limited in availability, the supply curve will be upward
sloping, even in the long run.
LO8: The Price Elasticity of
Supply
Ch5-23
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Thomas Malthus 1776 - 1834
Food production increases linearly (as we plant more
acres)
Population increases exponentially
Therefore, population growth will exceed our capacity
feed people, and population will be controlled by
famine, disease, war…
• “Must it not then be acknowledged by an attentive examiner
of the histories of mankind, that in every age and in every
State in which man has existed, or does now exist, that the
increase of population is necessarily limited by the means of
subsistence,
• That population does invariably increase when the means of
subsistence increase, and,
• That the superior power of population is repressed, and the
actual population kept equal to the means of subsistence, by
misery and vice.”
Malthusian trap
• Population has risen many times since Malthus’ day
• Yet we have been able to feed people
• Why
Other “Malthusian” Statements
• Over-fishing – certain species are either close to extinct or is
short supply (essentially fixed)
– As demand expands ( think tuna and sushi) the price of tuna
and sushi rises
– Other fish are substituted
– Some consumers switch (price and income substitution)
• Peak oil - the world is running out of oil
– What will we do?
The Green Revolution
• Price/cost increases pinch profit margins
• Innovation is spurred
• The “green revolution” refers to advances in
farming technology (Techniques, fertilization,
pesticide, herbicide, new species).
• Genetically modified organisms (GMO)
technology
GMO
• Genetic engineering, also called genetic
modification, is the direct manipulation of an
organism's genome using biotechnology. New
DNA may be inserted in the host genome by
first isolating and copying the genetic material
of interest using molecular cloning methods to
generate a DNA sequence, or by synthesizing
the DNA, and then inserting this construct into
the host organism.
http://en.wikipedia.org/wiki/Genetic_engineering (accessed Oct 14, 2012)
Traditional vs. GMO methods
•
•
Classical plant breeding uses deliberate interbreeding (crossing) of closely or
distantly related individuals to produce new crop varieties or lines with desirable
properties. Plants are crossbred to introduce traits/genes from one variety or line
into a new genetic background.
– Advantage is that it is time tested (used for many centuries) to change crops
and animals to have desirable traits
• Higher milk production
• Resistance to disease
– Disadvantage is that it is slow, and requires many cycles and trial and error to
breed in the desirable trait
Genetic engineering is more precise and faster.
– Fears exist that these are not safe
– Few understand the process
– Tends to vests a lost of control in a few large multinationals (Monsanto)