ECON 110 Introductory Microeconomics

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ECON 110Introductory Microeconomics

• Lecture 11
• Fall, 2009
• William Chow

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Highlights

• Cost Curves
• Relationship with Product Curves
• Short and Long Run Cost Curves
• Perfect Competition
• Identifying optimal decision of a perfectly
  competitive firm

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Short Run Costs

• Total Cost
• A firms total cost (TC) is the cost of all
  resources used.
• Total fixed cost (TFC) is the cost of the firms
  fixed inputs. Fixed costs do not change with
  output.
• Total variable cost (TVC) is the cost of the
  firms variable inputs. Variable costs do change
  with output.
• Total cost equals total fixed cost plus total
  variable cost. That is
• TC TFC TVC

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Short Run Costs

• Total variable cost increases as output
  increases.
• Total cost, which is the sum of TFC and TVC, also
  increases as output increases.

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Short Run Costs

• The total variable cost curve gets its shape from
  the total product curve.
• Notice that the TP curve becomes steeper at low
  output levels and then less steep at high output
  levels.
• In contrast, the TVC curve becomes less steep at
  low output levels and steeper at high output
  levels.

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Short Run Costs
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Short Run Costs

• If you exchange the axes of the RHS diagram so
  that Cost is plotted on the y-axis and Output on
  the x-axis, the TVC curve is exactly as what we
  have seen.
• Adding a fixed amount (TFC) to each level of TVC
  gives the TC curve.
• Thus the shapes of TC and TVC are similar.

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Short Run Costs

• Marginal cost (MC ?TC/?Q) is the increase in
  total cost that results from a one-unit increase
  in total product.
• Over the output range with increasing marginal
  returns, marginal cost falls as output increases.
• Over the output range with diminishing marginal
  returns, marginal cost rises as output increases.

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Short Run Costs

• Average cost (AC) measures can be derived from
  each of the total cost measures
• Average fixed cost (AFC) is total fixed cost per
  unit of output.
• Average variable cost (AVC) is total variable
  cost per unit of output.
• Average total cost (ATC TC/Q) is total cost per
  unit of output.
• ATC AFC AVC

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Short Run Costs

• The AFC curve shows that average fixed cost falls
  as output increases.
• The AVC curve is U-shaped. As output increases,
  average variable cost falls to a minimum and then
  increases.

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Short Run Costs

• The ATC curve is also U-shaped.
• The MC curve is very special.
• Where AVC is falling, MC is below AVC.
• Where AVC is rising, MC is above AVC.
• At the minimum AVC, MC equals AVC.

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Short Run Costs

• Similarly, where ATC is falling, MC is below ATC.
• Where ATC is rising, MC is above ATC.
• At the minimum ATC, MC equals ATC.

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Why the Average Total Cost Curve Is U-Shaped

• Initially, marginal product exceeds average
  product, which brings rising average product and
  falling AVC.
• Eventually, marginal product falls below average
  product, which brings falling average product and
  rising AVC.
• The ATC curve is U-shaped for the same reasons.
  In addition, ATC falls at low output levels
  because AFC is falling steeply.

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Short Run Costs

• MC is at its minimum at the same output level at
  which marginal product is at its maximum.
• AVC is at its minimum at the same output level at
  which average product is at its maximum.

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Shifts in Cost Curves

• Technological change influences both the
  productivity curves and the cost curves.
• An increase in productivity shifts the average
  and marginal product curves upward and the
  average and marginal cost curves downward.
• If a technological advance brings more capital
  and less labor into use, fixed costs increase and
  variable costs decrease.
• In this case, average total cost increases at low
  output levels and decreases at high output levels.

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Shifts in Cost Curves

• Changes in the prices of resources shift the cost
  curves.
• An increase in a fixed cost shifts the total cost
  (TC ) and average total cost (ATC ) curves upward
  but does not shift the marginal cost (MC ) curve.
• An increase in a variable cost shifts the total
  cost (TC ), average total cost (ATC ), and
  marginal cost (MC ) curves upward.

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Long Run Costs

• In the Long Run, firms can change also the level
  of capital used.
• The marginal product of capital is the increase
  in output resulting from a one-unit increase in
  the amount of capital employed, holding constant
  the amount of labor employed.
• A firms production function exhibits diminishing
  marginal returns to labor (for a given plant
  size) as well as diminishing marginal returns to
  capital (for a quantity of labor).
• For each plant size, diminishing marginal product
  of labor creates a set of short-run, U-shaped
  cost curves for MC, AVC, and ATC.

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Long Run Costs

• The average cost of producing a given output
  varies and depends on the firms plant size.
• The larger the plant size, the greater is the
  output at which ATC is at a minimum.

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Long Run Costs

• The long-run average cost curve is made up from
  the lowest ATC for each output level.
• We want to decide which plant has the lowest
  cost for producing each output level.

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Long Run Costs

• The long-run average cost curve is the
  relationship between the lowest attainable
  average total cost and output when both the plant
  size and labor are varied.
• The long-run average cost curve is a planning
  curve that tells the firm the plant size that
  minimizes the cost of producing a given output
  range.
• Once the firm has chosen that plant size, it
  incurs the costs that correspond to the ATC curve
  for that plant.

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Long Run Costs
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Long Run Costs

• Economies of scale are features of a firms
  technology that lead to falling long-run average
  cost as output increases.
• Diseconomies of scale are features of a firms
  technology that lead to rising long-run average
  cost as output increases.
• Constant returns to scale are features of a
  firms technology that lead to constant long-run
  average cost as output increases.
• If the long-run average cost curve is U-shaped,
  the minimum point identifies the minimum
  efficient scale output level.

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Perfect Competition

• Perfect competition is an industry in which
• Many firms sell identical products to many
  buyers.
• There are no restrictions to entry into (and
  exit) the industry.
• Established firms have no advantages over new
  ones.
• Sellers and buyers are well-informed about prices.

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Perfect Competition

• Perfect competition arises
• When a firms minimum efficient scale is small
  relative to market demand (diseconomies of scale
  set in at small output levels) so there is room
  for many firms in the industry.
• And when each firm is perceived to produce a good
  or service that has no unique characteristics, so
  consumers dont care which firm they buy from.

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Perfect Competition

• Important observations
• In perfect competition, each firm is a price
  taker.
• A price taker is a firm that cannot influence the
  price of a good or service.
• No single firm can influence the priceit must
  take the equilibrium market price.
• Each firms output is a perfect substitute for
  the output of the other firms, so the demand for
  each firms output is perfectly elastic.

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Perfect Competition

• Recap
• The goal of each firm is to maximize economic
  profit, which equals total revenue minus total
  cost.
• Total cost is the opportunity cost of production,
  which includes normal profit.
• A firms total revenue equals price, P,
  multiplied by quantity sold, Q, or PQ.

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Perfect Competition

• New working tools that we need ---
• Marginal Revenue (MR) A firms marginal revenue
  is the change in total revenue that results from
  a one-unit increase in the quantity sold.
• ?TR / ?Q
• Average Revenue (AR) This is just total revenue
  (TR) divided by the output, or TR/Q. This equals
  to
• PQ/Q P. In other words, the AR is the same as
  the firms demand curve.

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Perfect Competition
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Perfect Competitive Firms Decision

• The perfectly competitive firm makes two
  decisions in the short run
• Whether to produce or to shut down.
• If the decision is to produce, what quantity to
  produce.
• A firms long-run decisions are
• Whether to increase or decrease its plant size.
• Whether to stay in the industry or leave it.

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Perfect Competitive Firms Decision

• At the same time, a perfectly competitive firm
  faces two constraints
• A market constraint summarized by the market
  price and the firms revenue curves.
• A technology constraint summarized by the firms
  product curves and cost curves (like those in
  Chapter 10).
• A perfectly competitive firm chooses the output
  that maximizes its economic profit.
• One way to find the profit-maximizing output is
  to look at the firms the total revenue and total
  cost curves.

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Perfect Competition

• At low output levels, the firm incurs an economic
  lossit cant cover its fixed costs.
• At intermediate output levels, the firm earns an
  economic profit.
• At high output levels, the firm again incurs an
  economic lossnow it faces steeply rising costs
  because of diminishing returns.

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Perfect Competitive Firms Decision

• A better view of the situation can be obtained
  using marginal analysis.
• The firm can use marginal analysis to determine
  the profit-maximizing output.
• Because marginal revenue is constant and marginal
  cost eventually increases as output increases,
  profit is maximized by producing the output at
  which marginal revenue, MR, equals marginal cost,
  MC.

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Perfect Competitive Firms Decision

• If MR gt MC, economic profit increases if output
  increases.
• If MR lt MC, economic profit decreases if output
  increases.
• If MR MC, economic profit decreases if output
  changes in either direction, so economic profit
  is maximized.

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Perfect Competitive Firms Decision

• Maximum profit (the point at which MRMC) is not
  always a positive economic profit.
• To determine whether a firm is earning an
  economic profit or incurring an economic loss, we
  compare the firms average total cost, ATC, at
  the profit-maximizing output with the market
  price (AR).
• 3 possible cases in the Short Run 0 economic
  profit, positive economic profit and negative
  economic profit.

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Perfect Competitive Firms Decision