Unit III: Unit III: Costs of Production and Costs of Production and
Perfect CompetitionPerfect Competition
Accountants vs. Economists
Accountants look at only EXPLICIT COSTS •Explicit costs (out of pocket costs) are payments paid by firms for using the resources of others. •Example: Rent, Wages, Materials, Electricity Bills
Economists examine both the EXPLICIT COSTS and the IMPLICIT COSTS
•Implicit costs are the opportunity costs that firms “pay” for using their own resources•Example: Forgone Wage, Forgone Rent, Time
AnalyzingAnalyzingProductionProduction
Inputs and Outputs• To earn profit, firms must make products
(output)• Inputs (FACTORS) are the resources used to
make outputs.
Marginal Product =Change in Total Product
Change in Inputs
•Marginal Product (MP)- the additional output generated by additional inputs (workers).
•Total Physical Product (TP)- total output or quantity produced
Inputs and Outputs• To earn profit, firms must make something (output)• Inputs are the resources used to produce outputs. • Input resources are also called FACTORS.
Marginal Product =Change in Total Product
Change in Labor Input
•Marginal Product (MP)- the additional output generated by additional inputs.
•Total Physical Product (TP)- total output or quantity produced
•Average Product (AP)- the output per unit of input
Average Product =Total Product
Units of Labor
What is the general relationship between inputs and outputs?
Calculate the MP, identify the three stages, and explain why each stage occurs
# of Workers
(Input)
Total Product(TP) PIZZAS
Marginal Product(MP)
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 70
Calculate the MP, identify the three stages, and explain why each stage occurs
# of Workers
(Input)
Total Product(TP) PIZZAS
Marginal Product(MP)
0 0 -
1 10 10
2 25 15
3 45 20
4 60 15
5 70 10
6 75 5
7 75 0
8 70 -5
Calculate the MP, identify the three stages, and explain why each stage occurs
# of Workers
(Input)
Total Product(TP) PIZZAS
Marginal Product(MP)
0 0 -
1 10 10
2 25 15
3 45 20
4 60 15
5 70 10
6 75 5
7 75 0
8 70 -5
Why does MP start to fall?
The Law of Diminishing Marginal Returns
As successive units of variable resources (workers) are added to fixed resources (machinery, tool, etc.), the
additional output produced from each new worker will eventually fall.
Too many cooks in the kitchen!
Law of Diminishing ReturnsT
ota
l Pro
du
ct, T
P
Quantity of Labor
Ave
rag
e P
rod
uct
, AP
, an
dM
arg
inal
Pro
du
ct, M
P
Quantity of Labor
Total Product
Stage I: Increasing Marginal Returns
There are three stages of returns.
MarginalProduct
AverageProduct
To
tal P
rod
uct
, TP
Quantity of Labor
Ave
rag
e P
rod
uct
, AP
, an
dM
arg
inal
Pro
du
ct, M
P
Quantity of Labor
Total Product
MarginalProduct
AverageProduct
Stage II:Diminishing Marginal
Returns
Law of Diminishing ReturnsThere are three stages of returns.
To
tal P
rod
uct
, TP
Quantity of Labor
Ave
rag
e P
rod
uct
, AP
, an
dM
arg
inal
Pro
du
ct, M
P
Quantity of Labor
Total Product
Stage III: Negative Marginal Returns
Law of Diminishing ReturnsThere are three stages of returns.
MarginalProduct
AverageProduct
Short-Run Production Costs
Fixed CostsFixed costs (costs for fixed resources) DON’T change with the amount producedEx: Rent, Insurance, Managers salaries, etc.
Average Fixed Costs = Fixed CostsQuantity
Variable CostsVariable costs (costs for variable resources) change as more or less is producedEx: raw materials, labor, electricity, etc.
Average Variable Costs = Variable CostsQuantity
Definitions
Total CostSum of Fixed and Variable Costs
Average Total Cost = Total CostsQuantity
Marginal Cost
Marginal Cost = Change in Total CostsChange in Quantity
Additional costs of and additional output.Ex: If the production of another output increases total cost from $100 to $120, the MC is $20.
Definitions
Calculating TC, VC, FC, ATC, AFC, and MC
TP VC FC TC MC AVC AFC ATC
0 0 100 - - - -
1 10
2 16
3 21
4 26
5 30
6 36
7 46
Calculating TC, VC, FC, ATC, AFC, and MC
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110
2 16 100 116
3 21 100 121
4 26 100 126
5 30 100 130
6 36 100 136
7 46 100 146
Calculating TC, VC, FC, ATC, AFC, and MC
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10
2 16 100 116 6
3 21 100 121 5
4 26 100 126 5
5 30 100 130 4
6 36 100 136 6
7 46 100 146 10
Calculating TC, VC, FC, ATC, AFC, and MC
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 58
3 21 100 121 5 33.3 40.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6
6 36 100 136 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Calculating TC, VC, FC, ATC, AFC, and MC
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 40.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Calculating TC, VC, FC, ATC, AFC, and MC
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 40.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Quantity
Co
sts
(do
llar
s)
AFC
AVC
ATC
MC
Per-Unit Costs (Average and Marginal)
121110987654321
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Average Fixed Cost
ATC and AVC get closer and closer but
NEVER touch
Converting Average to Total
At output Q, what area represents:
TCVCFC
0CDQ0BEQ0AFQ or BCDE
Quantity
Co
sts
(do
llar
s)
121110987654321
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
MC
Why is the MC curve U-shaped?
Why is the MC curve U-shaped?•The MC curve falls and then rises because of diminishing marginal returns•The additional cost of the first units produced fall when workers have increasing marginal returns.•As production continues, each worker adds less and less to production so the marginal cost for each unit increases.
1.
2.
3.
4.
Shifting Cost Shifting Cost CurvesCurves
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 30.3
4 26 100 126 3 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
What if Fixed Costs increase to
$200
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 100 - - - -
1 10 200 110 10 10 100 110
2 16 200 116 6 8 50 58
3 21 200 121 5 7 33.3 30.3
4 26 200 126 5 6.5 25 31.5
5 30 200 130 4 6 20 26
6 36 200 136 6 6 16.67 22.67
7 46 200 146 10 6.6 14.3 20.9
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 100 110
2 16 200 216 6 8 50 58
3 21 200 221 5 7 33.3 30.3
4 26 200 226 5 6.5 25 31.5
5 30 200 230 4 6 20 26
6 36 200 236 6 6 16.67 22.67
7 46 200 246 10 6.6 14.3 20.9
Which Per Unit Cost Curves Change?
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 100 110
2 16 200 216 6 8 50 58
3 21 200 221 5 7 33.3 30.3
4 26 200 226 5 6.5 25 31.5
5 30 200 230 4 6 20 26
6 36 200 236 6 6 16.67 22.67
7 46 200 246 10 6.6 14.3 20.9
ONLY AFC and ATC Increase!
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 200 110
2 16 200 216 6 8 100 58
3 21 200 221 5 7 66.6 30.3
4 26 200 226 5 6.5 50 31.5
5 30 200 230 4 6 40 26
6 36 200 236 6 6 33.3 22.67
7 46 200 246 10 6.6 28.6 20.9
ONLY AFC and ATC Increase!
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 200 210
2 16 200 216 6 8 100 108
3 21 200 221 5 7 66.6 73.6
4 26 200 226 5 6.5 50 56.5
5 30 200 230 4 6 40 46
6 36 200 236 6 6 33.3 39.3
7 46 200 246 10 6.6 28.6 35.2
If fixed costs change ONLY AFC and ATC Change!
MC and AVC DON’T change!
Quantity
Co
sts
(do
llar
s)
AFC
AVCATC
MC
Shift from an increase in a Fixed Cost
ATC1
AFC1
Quantity
Co
sts
(do
llar
s)
MC
Shift from an increase in a Fixed Cost
ATC1
AVC
AFC1
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
What if the cost for variable resources
increase
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 110 10 10 100 110
2 18 100 116 6 8 50 58
3 24 100 121 5 7 33.3 30.3
4 30 100 126 5 6.5 25 31.5
5 35 100 130 4 6 20 26
6 43 100 136 6 6 16.67 22.67
7 55 100 146 10 6.6 14.3 20.9
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 111 10 10 100 110
2 18 100 118 6 8 50 58
3 24 100 124 5 7 33.3 30.3
4 30 100 130 3 6.5 25 31.5
5 35 100 135 4 6 20 26
6 43 100 143 6 6 16.67 22.67
7 55 100 155 10 6.6 14.3 20.9
Shifting Costs Curves
Which Per Unit Cost Curves Change?
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 111 11 10 100 110
2 18 100 118 7 8 50 58
3 24 100 124 6 7 33.3 30.3
4 30 100 130 6 6.5 25 31.5
5 35 100 135 5 6 20 26
6 43 100 143 8 6 16.67 22.67
7 55 100 155 12 6.6 14.3 20.9
Shifting Costs Curves
MC, AVC, and ATC Change!
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 111 11 11 100 110
2 18 100 118 7 9 50 58
3 24 100 124 6 8 33.3 30.3
4 30 100 130 6 7.5 25 31.5
5 35 100 135 5 7 20 26
6 43 100 143 8 7.16 16.67 22.67
7 55 100 155 12 7.8 14.3 20.9
Shifting Costs Curves
MC, AVC, and ATC Change!
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 111 11 11 100 111
2 18 100 118 7 9 50 59
3 24 100 124 6 8 33.3 41.3
4 30 100 130 6 7.5 25 32.5
5 35 100 135 5 7 20 27
6 43 100 143 8 7.16 16.67 23.83
7 55 100 155 12 7.8 14.3 22.1
Shifting Costs CurvesIf variable costs change MC, AVC, and ATC Change!
Quantity
Co
sts
(do
llar
s)
AFC
AVCATC
MCATC1
AVC1
Shift from an increase in a Variable CostsMC1
Quantity
Co
sts
(do
llar
s)
AFC
ATC1
AVC1
Shift from an increase in a Variable CostsMC1
Long-Run Long-Run Cost CurvesCost Curves
Short-Run vs. Long-Run
• The short-run is a period in which at least one resource is fixed.– Plant capacity/size is NOT changeable
• In the long-run ALL resources are variable– NO fixed resources
– Plant capacity/size is changeable
Long Run ATCWhat happens to the average total costs of a
product when a firm increases its plant capacity?
Example of various plant sizes:•I make looms out of my garage with one saw•I rent out building, buy 5 saws, hire 3 workers•I rent a factory, buy 20 saws and hire 40 workers•I build my own plant and use robots to build looms.•I create plants in every major city in the U.S.
Long Run ATC curve is made up of all the different short run ATC curves of various plant
sizes.
Un
it C
ost
s
Output
Long Run ATC
5 Various Plant Capacities
The long-run ATC is the result of all of the short-run ATC curves.
Un
it C
ost
s
Output
Long Run ATC
Un
it C
ost
s
Output
LRATC
Why is LRATC U Shaped?The law of diminishing marginal returns doesn’t apply in the long run because all
resources are variable.
Three Areas on the LRATC CurveU
nit
Co
sts
Output
long-run ATC
Economiesof scale
Economies of Scale- LRATC is falling as mass production techniques can be utilized.
Un
it C
ost
s
Output
long-run ATC
Economiesof scale
Constant returnsto scale
Three Areas on the LRATC CurveConstant Returns to Scale- The average total
cost is as low as it can get.
Un
it C
ost
s
Output
long-run ATC
Economiesof scale
Diseconomiesof scale
Constant returnsto scale
Three Areas on the LRATC CurveDiseconomies of Scale- The LRATC is
increasing as the firm gets too big and difficult to manage.
Perfect Perfect CompetitionCompetition
Market Structure Continuum
PureCompetition
PureMonopoly
MonopolisticCompetition Oligopoly
FOUR MARKET MODELSCharacteristics of Pure Competition:
• Many small firms• Identical products (perfect substitutes)• Firms are “Price Takers”• Easy for firms to enter and exit the industry • No control over price. • No need to advertise
Examples: Corn or Avocado farmers, TJ hammocks
Demand for Perfectly Competitive Firms
Why are they Price Takers?•If a firm charges above the market price, NO ONE will buy. They will go to other firms•There is no reason to price low because consumers will buy just as much at the market price.
Since the price is the same at all quantities demanded, the demand curve and MR for each
firm is…
Perfectly Elastic (A Horizontal straight line)
MaximizingMaximizingPROFITPROFIT
MaximizingMaximizingPROFITPROFIT
Profit Maximizing RuleMR = MC
Draw a FIRM making a profit
P
MR
Q
MCATC
Quantity
Pri
ce
Draw a FIRM making a profit
Profit
Draw a FIRM making a loss
Draw a FIRM making a loss
P MR
Q
MC
ATC
Quantity
Pri
ce
Loss
Total Revenue =$63
$9
8
7
6
5
4
3
2
1
Co
st a
nd
Rev
enu
e
1 2 3 4 5 6 7 8 9 10
MC
AVCATC
•How much output should be produced?•How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much?
MR=Price
Total Cost=$45
Profit = $18
Don’t forget that averages
show PER UNIT COSTS
the MR=MC rule still applies
What would happen if the price is lowered from $7 to $5…
…but the output changes.
Loss Minimization Position
Total Revenue=$35
Co
st a
nd
Rev
enu
e
1 2 3 4 5 6 7 8 9 10
MC
AVC
ATC
•How much output should be produced?•How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much?
MR=Price
Total Cost = $42
Loss =$7
$9
8
7
6
5
4
3
2
1
What would happen if the price is lowered from $5 to $4…
…the firm must SHUT-Down
This is called the… Shutdown Point
•When the price falls below AVC then the firm should minimize its losses by shutting down.
•Even though they are losing money, they are still paying some of their fixed costs.
•A firm should continue to produce as long as the price is above the AVC.
Co
st a
nd
Rev
enu
e
1 2 3 4 5 6 7 8 9 10
MC
AVC
ATC
SHUT DOWN! Produce Zero
$9
8
7
6
5
4
3
2
1
Minimum AVC is shut down
point
Total Cost
Total Revenue
Co
st a
nd
Rev
enu
e
1 2 3 4 5 6 7 8 9 10
MC
AVC
ATC
SHUT DOWN! Producing nothing is cheaper than staying open.
MR=Price
Fixed Costs
$9
8
7
6
5
4
3
2
1
Supply Revisited
Co
st a
nd
Rev
enu
e, (
do
llar
s) MC
MR1
AVC
ATC
Quantity Supplied
MR2
MR3
MR4
MR5
P1
P2
P3
P4
P5
Q2 Q3 Q4 Q5
Marginal Cost & Supply
Do notProduce –
Below AVC
Break-even Point(No Economic Profit)
Marginal Cost & Supply
Co
st a
nd
Rev
enu
e, (
do
llar
s)MC
MR1
Quantity Supplied
MR2
MR3
MR4
MR5
P1
P2
P3
P4
P5
Q2 Q3 Q4 Q5
This is theSupply Curve
Supply=
Supply = Marginal Cost above AVC
Marginal Cost & Short-Run Supply
AVC2
MC2
What if variable costs increase?
Co
st a
nd
Rev
enu
e, (
do
llar
s)MC1
AVC1
Quantity Supplied
S1
S2
Supply Curve shifts to the Left
Marginal Cost & Short-Run Supply
AVC2
MC2
Lower Costs Movethe Supply Curve
to the Right
Co
st a
nd
Rev
enu
e, (
do
llar
s)MC1
AVC1
Quantity Supplied
S1
S2
Perfect Competition in the Long-Run
In the Long-run…•Firms will enter if there is profit•Firms will leave if there is loss•All firms break even, they make NO economic profit(No Economic Profit=Normal Profit) •In long run equilibrium the firm is efficient.
(Price = Minimum ATC)
P MR
Q
MCATC
Quantity
Pri
ce
Price = MC = Minimum ATCFirm making a normal profit
LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM
When at Long-Run Equilibrium, there is no
incentive to enter or leave the industry.
P MR
Q
MCATC
Quantity
Pri
ce
LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM
What happens when there is a change
in price?
Changes in the long-run equilibrium
S1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
PROFIT MAXIMIZATION IN THE LONG RUN
MR
D1
What happens when demand increases?
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
D2
EconomicProfits
S1
PROFIT MAXIMIZATION IN THE LONG RUN
New competitors enter. This increases supply and lowers price back to equilibrium.
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
D2
Zero EconomicProfits
S1
S2
PROFIT MAXIMIZATION IN THE LONG RUN
Result is Long-Run Equilibrium Again.The ONLY change is the industry’s output
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
D2
Zero EconomicProfits
S1
S2
Decreases in demand, losses, and the reestablishment of long-run equilibrium
S1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
D1
MR
PROFIT MAXIMIZATION IN THE LONG RUN
A decrease in demand creates losses…
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
D2
EconomicLosses
S1
PROFIT MAXIMIZATION IN THE LONG RUN
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
D2
Return to ZeroEconomic Profits
S1
S3
Competitors with losses leave, decrease supply, andprices return to zero economic profits.
PROFIT MAXIMIZATION IN THE LONG RUN
Result is Long-Run Equilibrium Again.
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
D2
Zero EconomicProfits
S1
S2
PROFIT MAXIMIZATION IN THE LONG RUN
Efficiency
PURE COMPETITION AND EFFICIENCY
•Perfect Competition forces producers to use limited resources to their fullest.•Inefficient firms have higher costs and are the first to leave the industry.•Perfectly competitive industries are extremely efficient
In general, efficiency is the optimal use of societies scarce resources
1. Productive Efficiency2. Allocative Efficiency
There are two kinds of efficiency:
Productive Efficiency
Price = Minimum ATC
The production of a good in a least costly way. (Minimum amount of resources are being used)
Graphically it is where…
PURE COMPETITION AND EFFICIENCY
Allocative Efficiency
Price(Marginal Benefit) = MC
The distribution of resources towards the production of products most wanted by society.
Graphically it is where…
PURE COMPETITION AND EFFICIENCY
P MR
Q
MCATC
Quantity
Pri
ce
Productive Efficiency in the Long-Run
The marginal benefit to society
(as measured by the price) equals the marginal cost.
Long-Run Equilibrium
Optimal amount being produced
PMR
Q
MCATC
Quantity
Pri
ce
P = Minimum ATC = MC
Long-Run Equilibrium
In long run
equilibrium perfectly
competitive firms have
both productive
and allocative
efficiency