Firm behaviour

1
Firm behaviour

• A black box theory of the firm in the short
  run

2
What do firms do?
3
Inputs and Cost

• Production in the short run

4
Short-run and long-run

• It can take time to adjust the level of
  production
• inputs may not be available immediately
• e.g. Parcel Delivery Company
• To increase production may need to

• We will define the short and long-run by whether
  or not the quantity of inputs is fixed

5
Short run and long run

• In the short run a firm can change the quantities
  of only some of its inputs.
• In the long run a firm can change the quantities
  of all of its inputs.
• For the moment, well only study the short run.

6
(Short-run) production function

• For now, lets assume a firm uses only two
  inputs labour and capital.
• And lets assume labour is the variable input
  and capital is the fixed input.
• The short-run production function shows how
  varying the variable input affects the quantity
  of output, for a given amount of the fixed input.

7
(Short-run) production function

• Example wheat farm
• Fixed input (land)
• Variable input (labour)
• Well mostly restrict ourselves to two inputs
  (its easy).
• And, well usually think of land as the fixed
  input in the short run,
• and of labour as the variable input in the
  short run.

8
(Short-run) production function
Quantity of labour L Quantity of wheat Q
0 0
1 19
2 36
3 51
4 64
5 75
6 84
7 91
8 96
Land is fixed (10 acres)
9
(Short-run) production function
Quantity of wheat
TP
Land is fixed (10 acres)
Quantity of labour
10
Marginal product of labour
Quantity of labour L Quantity of wheat Q
0 0
1 19
2 36
3 51
4 64
5 75
6 84
7 91
8 96
Marginal product of labour MPL?Q/ ?L








11
Marginal product of labour
Marginal product of labour
Quantity of labour
12
Diminishing returns to an input

• There are diminishing returns to an input if
• Here, there are diminishing returns to labour
• Why do we assume that the returns will begin to
  diminish?

13
Diminishing returns to an input

• In our example of wheat production, the amount of
  land is fixed.
• As the number of workers increases, the land is
  farmed more intensively.
• This result rests on the assumption that at least
  one of the inputs is fixed.

14
From production to cost curves

• Firms are only tangentially (partly) interested
  in the relationship between inputs and output.
• To maximize profits, it would be helpful to know
  about the relationship between output and the
  cost of production.
• To translate the amount of capital and labour
  needed to produce a given level of production to
  the cost of production we need to know the prices
  of the inputs.

15
(Short-run) cost

• The cost that comes from the fixed input is
  called
• The cost that comes from the variable input is
  called
• The sum of fixed cost and variable cost is called
  total cost (TC FC VC).

16
(Short-run) cost
Quantity of labour L
0
1
2
3
4
5
6
7
8
Variable cost VC
0
200
400
600
800
1,000
1,200
1,400
1,600
Total cost TC FC VC




1,200
1,400
1,600
1,800
2,000
Quantity of wheat Q
0
19
36
51
64
75
84
91
96
17
(Short-run) cost
Total cost
TC
Land is fixed (10 acres)
Quantity of wheat
18
(Short-run) marginal cost

• The marginal cost is the additional cost from
  doing one more unit of an activity.
• Example (for convenience) bootmaking
• Fixed cost (FC) 108

19
(Short-run) marginal cost
Variable cost VC
0
12
48
108
192
300
432
588
768
972
1,200
Total cost TC FC VC
108
120
156
216
300
408
540
696
876
1,080
1,308
Quantity of boots Q
0
1
2
3
4
5
6
7
8
9
10
Marginal cost MC ?TC/?Q





132
156
180
204
228
20
(Short-run) marginal cost
Total cost

• (Short-run) total cost
• (Short-run) marginal cost

TC
Marginal cost
Quantity of boots
21
Explaining increasing marginal cost

• Why does the short-run marginal costs increase as
  output expands?

22
(Short-run) average costs

• The average fixed cost is the fixed cost per unit
  of output
• The average variable cost is the variable cost
  per unit of output
• The average total cost is the total cost per unit
  of output

23
(Short-run) average costs
Variable cost VC
0
12
48
108
192
300
432
588
768
972
1,200
Total cost TC
108
120
156
216
300
408
540
696
876
1,080
1,308
Quantity of boots Q
0
1
2
3
4
5
6
7
8
9
10
Average var. cost AVC
-
12
24
36
48
60
72
84
96
108
120
Average total cost ATC
-
120
78
72
75
81.60
90
99.43
109.50
120
130.80
Average fixed cost AFC
-
108
54
36
27
21.60
18
15.43
13.50
12
10.80
24
(Short-run) average costs
Average fixed, variable, total cost
AVC
AFC
Quantity of boots
25
(Short-run) average total cost

• Two effects
• Spreading effect
• Average fixed cost falls, which tends to make
  average total cost fall.
• Diminishing returns effect
• Average variable cost rises, which tends to make
  average total cost rise.

26
(Short-run) ATC and MC
Average total cost, marginal cost
ATC
Quantity of boots
27
(Short-run) ATC and MC

• Marginal cost always goes through the minimum
  average total cost.
• If marginal cost is below average total cost,
  average total cost is falling.
• If marginal cost is above average total cost,
  average total cost is rising.
• Like grades in this class!

28
More realistic cost curves
Total cost

• (Short-run) total cost
• (Short-run) ATC, AVC, MC

TC
Marginal cost
MC
ATC
AVC
Quantity
29
Perfect Competition and Short-Run Supply

• Why unrealistic models can be useful.

30
Perfect competition

• In a perfectly competitive industry
• There are many producers, each with a small
  market share.
• Firms produce homogeneous goods.
• There is free entry and exit
• All producers are price-takers.

31
Production decisions

• Production decisions are how much decisions.
• We study how much decisions by using marginal
  analysis
• Compare marginal costs and marginal benefits.
• Produce output up to the point where MR MC.
• This optimal output rule has got to be true for
  any producer.

32
Price-taking and marginal revenue

• Price-taking means that regardless of how much
  the firm produces, for each additional unit
  produced it gets the same price.

P
33
Price-taking and optimization

• This implies that marginal revenue is constant.
• Marginal revenue is the additional revenue from
  selling one more unit of output.
• For price-taking producers only, the optimal
  output rule therefore becomes

34
(Short-run) costs and MR

• Example tomato production.
• Price P 18 (MR P).

Variable cost VC
0
16
22
30
42
58
78
102
Total cost TC
14
30
36
44
56
72
92
116
Quantity of tomatoes Q
0
1
2
3
4
5
6
7
Marginal cost MC



12
16
20
24
Marginal revenue MR
18
18
18
18
18
18
18
ProfitTR - TC
Total revenue TR
0
18
38
54
72
90
108
126
35
(Short-run) MC and MR
Price, marginal cost
MC
MR P
Quantity of tomatoes
36
Profit or no?

• A producer makes positive profit when total
  revenue is greater than total cost.
• TR gt TC
• Now divide both sides by output (Q).
• TR/Q gt TC/Q
• So a producer is profitable when

37
(Short-run) average costs
Variable cost VC
0
16
22
30
42
58
78
102
Total cost TC
14
30
36
44
56
72
92
116
Quantity of tomatoes Q
0
1
2
3
4
5
6
7
Average var. cost AVC
-
16
11
10
10.50
11.60
13
14.57
Average total cost ATC
-


14.67
14
14.40
15.33
16.57
38
Profit (P gt ATC)
Price, marginal cost
MC
MR P
Quantity of tomatoes
39
Profit or loss, graphically

• Profit is total revenue minus total cost
• Profit TR TC
• Divide and multiply by output (Q)
• Profit
• Profit
• Profit

40
Profit (P gt ATC)
Price, marginal cost
MC
MR P
ATC
Quantity of tomatoes
41
Loss (P lt ATC)
Price, marginal cost
MC
ATC
MR P
Quantity of tomatoes
42
Breaking even (P ATC)
Price, marginal cost
MC
ATC
MR P
Quantity of tomatoes
43
Produce or no?

• If a producer makes negative profit (a loss),
  will it automatically want to shut down (i.e.
  stop producing)?
• Remember were in the short run!
• When a producer shuts down, she still has to pay
  the fixed cost, so that her profit is - FC.
• That is, a producer wants to shut down only if

44
Produce or no?

• Shut down if
• Profit (producing) lt profit (shutting down)
• TR (VC FC) lt 0 FC
• lt
• lt
• lt
• lt

45
Produce, with profit
Price, marginal cost
MC
MR P
ATC
AVC
Quantity of tomatoes
46
Produce, with loss
Price, marginal cost
MC
ATC
AVC
MR P
Quantity of tomatoes
47
Shut-down price
Price, marginal cost
MC
ATC
AVC
MR P
Quantity of tomatoes
48
Summary of producer decisions
Price, marginal cost
MC
ATC
AVC
Quantity of tomatoes
49
Summary of producer decisions

• The short-run individual supply curve summarizes
  the production (supply) decisions of one
  individual, perfectly competitive, producer.
• The short-run industry supply curve summarizes
  the supply decisions by all producers in a
  perfectly competitive industry.

50
Individual and industry S curves
Price

• Short-run individual supply curve

• Short-run industry supply curve
• when the industry consists of 100 producers
• Market supply curve

Price
S
Quantity of boots
51
The long run

• Perfect competition means no profits

52
Long-run costs

• In the short-run the shape of the cost curves was
  determined by the fact that there was a fixed
  factor of production
• In the long-run
• The shape of the long-run cost curves will not
  necessarily be the same as those in the short-run

53
Long-run total cost (LRTC)

• The LRTC represents
• The shape of the LRTC curve depends on how costs
  vary with the scale of the firm
• For some firms the cost of producing another unit
  of output decreases with the scale (size) of the
  firm
• For other firms the cost of another unit of
  output increases with scale

54
Perfect competition

• The relationship between costs and scale is
  determined by whether the firms long-run
  production function exhibits
• Lets examine what is meant by each of these and
  what they imply about the shape of the long-run
  cost curves

55
Constant returns to scale

• Since the price of inputs are fixed
• What will the cost curves look like for this firm?

LRMC/LRAC Curves
?
500
10
20
56
Increasing Returns to Scale

• Doubling inputs more than doubles outputs,
• This is sometimes referred to as Economies of
  Scale

57
Increasing Returns to Scale

• Could be cost savings from size
• Could be cost savings from technology
• What will the cost curves look like here?

LRMC/LRAC Curves
?
500
10
20
58
Decreasing Returns to Scale

• Doubling inputs less than doubles outputs,
• This is sometimes referred to as Diseconomies of
  Scale

59
Decreasing Returns to Scale

• Could result because of Bureaucratic
  Inefficiency
• Coordination failure is costly
• What will the cost curves look like here?

LRMC/LRAC Curves
500
10
20
60
Long-run average cost curve

• Economists believe that that long-run costs
  exhibit
• Relatively small firms are likely to realize
  economies of scale
• Larger firms will eventually experience
  bureaucratic inefficiencies

61
Long-run average cost curve

• This implies that the long-run average cost curve
  will have the following shape

• Between 0 and Q
• At Q
• Q and above

Q
62
Long and short-run costs

• Will the costs of production be higher or lower
  in the long-run?
• In the long-run the firm can alter both capital
  and labour (more flexible)
• Exception there will be one level of output for
  which the level of capital (fixed cost) in the
  short-run will be the optimal level in the
  long-run

63
Long and short-run costs

• Thus, the long and short-run average costs curves
  will look as follows

• SRAC0 is short-run average cost if the producer
  chose the level of capital to minimize costs at
  Q0
• The SRAC curve will be above the LRAC curve
  except at Q0

LRAC
Q0
64
Long and short-run costs

• The shapes of the long-run and short-run cost
  curves look very similar
• It is important to note, however, that these
  shapes mean something very different in the
  long-run than they do in the short-run
• Long-Run
• Short-Run

65
Envelope theorem

• There is a different set of short-run cost curves
  (different optimal level of capital) for each
  level of output
• Each of the SRAC curves will equal the LRAC curve
  at one level of output

• The scale which minimizes LRAC is called the
  Efficient Scale

66
Perfect competition in the long-run

• So far, we have studied perfect competition in
  the short-run.
• A perfectly competitive firm
• Produces the quantity at which P MC
• Shuts down if P lt AVC
• Makes (positive) profit if P gt ATC
• If the price happened to be above the break-even
  price, a perfectly competitive firm in the short
  run made (positive) profit.
• Can those profits persist in the long run?

67
Long-run equilibrium
Individual firm
Market
P
P
MC
E1
P1
P1
ATC
P2
E2
P2
P3
P3
E3
D
Qfirm
Q1f
Qmarket
Q1m
Q2m
Q2f
Q3m
Q3f
68
Long-run equilibrium

• Whats good about long-run equilibrium in a
  perfectly competitive industry?
• Other properties

69
Long-run supply curve

• The long-run supply curve in a perfectly
  competitive industry is perfectly elastic.

P
P
MC
ATC
P2
E2
P2
E1
E3
P3
P1
P1
D1
Qfirm
Qmarket
Q1m
Q2m
Q2f
Q3m
Q1f