4 Nov 2010


Costs are a critical concept
Costs represent a burden sustained to carry
out activities
◦ Carry out production
◦ Meet certain goals


Costs determine production and pricing
Understand costs and you will understand the
supply curve




Profit = Total Revenue – Total Cost
Total Revenue = Price x Quantity
Total Costs = Explicit Costs + Implicit Costs
Implicit Costs
◦ Value of owner’s time (entrepreneurial value)
 Difficult to quantify
◦ Opportunity cost of invested capital
 Interest rates foregone


Economic Profit= Total Revenue –
Opportunity Costs
Opportunity Costs = Implicit + Explicit Costs
Examination of Production Process and the
Total Cost
Workers
Output
Marginal
Product of
Labor
Cost of
Facility
Cost of
Total Cost
Employees
(per hour)
0
0
0
$50
0
$50
1
12.5
12.5
$50
$10
$60
2
37.5
25
$50
$20
$70
3
75
37.5
$50
$30
$80
4
125
50
$50
$40
$90
5
168.75
43.75
$50
$50
$100
6
206.25
37.5
$50
$60
$110
7
237.5
31.25
$50
$70
$120
OUTPUT
250
Number of Drinks
200
Inflection Point
150
OUTPUT
100
50
0
0
1
2
3
4
5
6
7
8
Number of workers
Marginal Product of Labor
60
50
40
30
Marginal Product of Labor
20
10
0
0
2
4
6
8
Total Cost
Total Cost $140
$120
$100
$80
Total Cost
$60
$40
$20
$0
0
50
100
150
200
250
Output

Fixed Costs
◦ Costs that do not vary with the quantity of output

Variable Costs
◦ Costs that vary with the quantity of output
produced

In our previous example
◦ Fixed Cost: $50 per hour for the Starbucks facility
◦ Variable Cost: $10 per hour wage



How do costs vary as the level of production
varies?
How much does it cost to run the store?
How much does it cost when I increase the
number of drinks/output?

Average Total Cost
◦ Total cost / output

Average Fixed Cost
◦ Fixed cost/output

Average Variable Cost
◦ Variable cost/output

Marginal Cost
◦ Increase in total cost that arises from one more unit
 MC = (TC2-TC1) / (Q2-Q1)
Number
of Drinks
Total
Cost
Fixed
Cost
0
$50.00
12.5
37.5
Variable
Cost
Average
Fixed
Costs
Average
Variable
Costs
Average
Total
Cost
$50.00
$0.00
$0.00
0
0
0
$65.00
$50.00
$15.00
$4.00
$1.20
$5.20
$1.20
$84.00
$50.00
$34.00
$1.33
$0.91
$2.24
$0.76
75
$107.00 $50.00
$57.00
$0.67
$0.76
$1.43
$0.61
125
$134.00 $50.00
$84.00
$0.40
$0.67
$1.07
$0.54
168.75 $165.00 $50.00 $115.00
$0.30
$0.68
$0.98
$0.71
206.25 $200.00 $50.00 $150.00
$0.24
$0.73
$0.97
$0.93
237.5
$0.21
$0.80
$1.01
$1.25
$239.00 $50.00 $189.00
Marginal
Cost
COST CURVES FOR STARBUCKS
$6.00
$5.00
$4.00
Average Fixed Costs
Average Variable Costs
$3.00
Average Total Cost
Marginal Cost
$2.00
$1.00
$0.00
0
50
100
150
200
250


The increase in efficiency of production as
the number of goods being produced
increases.
Typically, a company that achieves economies
of scale lowers the average cost per unit
through increased production
◦ fixed costs are shared over an increased number of
goods.
Decisions Behind the Supply Curve



Many buyers and sellers - individual firms
have little effect on the price.
Goods offered are very similar - demand is
very elastic for individual firms.
Firms can freely enter or exit the industry no substantial barriers to entry.

Market Price (P) is given
◦ Firms are “Price Takers”


Profit = Total Revenue (TR) – Total Cost (TC)
How much does the Firm receive for a “typical
unit”?
◦ AVERAGE REVENUE
 Total Revenue / Quantity Sold

TR/Q = (P x Q)/Q = Price

TR/Q = PRICE

How much additional revenue does the firm
get if it sells one more unit?
◦ MARGINAL REVENUE
 Change in Total Revenue/ Change in Quantity
 MARGINAL REVENUE IS ALSO EQUAL TO PRICE!!
 SEE NEXT SLIDE
Quantity (Q)
Total Revenue
(TR = P X Q)
Price (P)
Average Revenue
AR = TR/Q
Marginal Revenue =
CHANGE IN TR/CHANGE
IN Q
1
$131.00
$131.00
$131.00
2
$131.00
$262.00
$131.00
$131.00
3
$131.00
$393.00
$131.00
$131.00
4
$131.00
$524.00
$131.00
$131.00
5
$131.00
$655.00
$131.00
$131.00
6
$131.00
$786.00
$131.00
$131.00
7
$131.00
$917.00
$131.00
$131.00
8
$131.00
$1,048.00
$131.00
$131.00
9
$131.00
$1,179.00
$131.00
$131.00
10
$131.00
$1,310.00
$131.00
$131.00
QUANTITY
TOTAL REVENUE
TOTAL COST
PROFIT
(TR-TC)
MARGINAL
REVENUE
(CHANGE TC/
CHANGE IN Q)
MARGINAL COST
CHANGE IN
PROFIT MR- MC
0
$0.00
$15.00
-$15.00
$131.00
1
$131.00
$115.00
$16.00
$131.00
$100.00
$31.00
2
$262.00
$219.00
$43.00
$131.00
$104.00
$27.00
3
$393.00
$327.00
$66.00
$131.00
$108.00
$23.00
4
$524.00
$439.00
$85.00
$131.00
$112.00
$19.00
5
$655.00
$555.00
$100.00
$131.00
$116.00
$15.00
6
$786.00
$675.00
$111.00
$131.00
$120.00
$11.00
7
$917.00
$799.00
$118.00
$131.00
$124.00
$7.00
8
$1,048.00
$927.00
$121.00
$131.00
$128.00
$3.00
9
$1,179.00
$1,059.00
$120.00
$131.00
$132.00
-$1.00
10
$1,310.00
$1,195.00
$115.00
$131.00
$136.00
-$5.00



Profit is Maximized where Marginal Revenue
is equal to Marginal Cost
Marginal Cost is always rising
When MR > MC
◦ Revenue is increasing faster than costs
◦ Firm should increase production

When MR < MC
◦ revenue from the additional unit is less than
additional cost
◦ the firm should decrease production.

A firm maximizes profits when MR = MC.
MC
Costs/
Rev
ATC
P=AR=MR
Q*
Quantity
$160.00
$140.00
$120.00
$100.00
MR
$80.00
MC
ATC
$60.00
$40.00
$20.00
$0.00
0
2
4
6
8
10
12



Since MC is upward sloping, as price
increases, quantity produced will increase
too.
As price falls, quantity produced falls.
In each case, the marginal cost curve
determines how much the firm is willing to
produce at each price
◦ So it translates into the supply curve
Total Costs = Variable Costs + Fixed Costs
If a business shuts down it will only incur FIXED COSTS
(it will not have any revenue either)


Company should produce if it can cover its
variable costs
Total Revenue > Total Variable Costs
◦ Or how about….AR > AVC
 It means the same thing, we are just adjusting the
inequality for quantity

Shut down would occur if/when Price falls
below the level of the Average Variable Cost
◦ Rember: PRICE is also AVERAGE REVENUE
MC
COSTS
ATC
AVC
Shut down: P < AVC
QUANTITY

In the long run, all costs are variable

If Total Revenue is less than Total Costs
◦ Or if Average Revenue is less than Average Total
Cost
◦ Firm will shut down
COSTS
MC
ATC
P = AR
QUANTITY




In the long run, a firm will enter or exit the
market until profit is zero
Profit = TR – TC
Total Cost includes all the opportunity costs
of the firm
ZERO PROFIT is EQUILIBRIUM CONDITION
◦ Even if profit is zero, the firm has met satisfaction
of opportunity costs
Monopolistic Competition


One and only one firm that produces a good
(or offers a unique service)
Characteristics
◦ Barriers to entry
◦ No close substitutes


PRICE MAKERS!
Recall from our previous discussion that
competitive firms are price takers





DeBeers Diamonds
ALCOA (Aluminum)
The cable company
Utilities (gas, electric, etc)
Morton Salt

Monopoly’s power exists in its power to sell
◦ In other words, its profits depend upon DEMAND
◦ The market demand and company demand curve
are one and the same

Like a competitive firm, a monopoly’s profits
are maximized where
◦ MR = MC

However, monopoly price will be well above
the point where MR = MC
MC
ATC
PROFIT
MAX
DEMAND
MR


Government regulation to attack efficiency
loss of monopoly
Break up monopolies
◦ AT&T


Prevent mergers?
Fining companies that collude or price
discriminate
◦ Walmart




More than one buyer/sellers (several…could
be numerous)
Differentiated products (substitutes)
Firms have sufficient knowledge (do not act
as if in a vacuum)
Free entry and exit




Limited competition at first
Products that are in the market are close, but
not exact substitutes
“Every firm has a monopoly of its own
product” (British Economist Joan Robinson)
Example: Portable Media PLayer
◦ iPOD AAC mP4
◦ 80% market share
MC
Costs
ATC
D = AR
MR
Quantity

Firms that produce close substitutes enter
market
◦ There is a profit to be made
◦ As long as:
 P > MR=MC
◦
P > ATC!
MC
ATC
D = AR
MR
ZERO ECONOMIC PROFIT
P = ATC

Inefficiency
◦ Price is always greater than marginal cost

Excess capacity
◦ Firm not producing at bottom of ATC
◦ Underserving market

Advertising/non-Price Competition
◦ Advertises to attract customers rather than cutting
price
◦ Advertising is seen as wasteful
Few Sellers/Similar or Identical Products

Game Theory
◦ Psychologists call it theory of social situations
 After all, Economics is a social science
◦ Cooperative Game Theory
◦ Non-Cooperative Game Theory



Rules are enforced within the group
Groups of firms form coalitions and collude
Ever watch “Survivor”?



Players make decisions independently
Cooperation is self-enforcing
Does not exist
SUSPECT 1/SUSPECT 2
Not Confess
RAT
5, 5
-4, 10
10, -4
1, 1
Not Confess
RAT


“Ratting”
It is the best strategy to pursue, individually,
regardless of the strategies pursued by the
other player(s)



Construction of a Bridge
Great for society!
Best for each individual as long as someone
else builds the bridge

It would be great for both firms to set a high
price
◦ (e.g., not confess)

The firm who “cheats” by undercutting his
competitor with a lower price gets a high
payoff

A Nash Equilibrium is a set of mixed
strategies for finite, non-cooperative games
between two or more players
◦ No player can improve his or her payoff by
changing their strategy.
◦ Each player's strategy is an 'optimal' response
based on the anticipated rational strategy of the
other player(s) in the game.

Nash equilibrium does not necessarily mean
the best cumulative payoff for all the players
involved

Neither suspect confesses
◦ Each derives one (1) measure of utility