Reviewing
Production
1
Three Stages of Returns
Stage I: Increasing Marginal Returns
MP rising. TP increasing at an increasing rate.
Why? Specialization.
Total
Product
Total
Product
Quantity of Labor
Marginal
and
Average
Product
Average Product
Marginal Product
Quantity of Labor
2
Three Stages of Returns
Stage II: Decreasing Marginal Returns
MP Falling. TP increasing at a decreasing rate.
Why? Fixed Resources. Each worker adds less and less.
Total
Product
Total
Product
Quantity of Labor
Marginal
and
Average
Product
Average Product
Marginal Product
Quantity of Labor
3
Three Stages of Returns
Stage III: Negative Marginal Returns
MP is negative. TP decreasing.
Workers get in each others way
Total
Product
Total
Product
Quantity of Labor
Marginal
and
Average
Product
Average Product
Marginal Product
Quantity of Labor
4
The Law of Diminishing Marginal Returns is NOT
the results of laziness, it is the result of limited
5
fixed resources.
Identify the three stages of returns
# of Workers Total Product(TP)
PIZZAS
(Input)
0
1
2
3
4
5
6
7
8
0
10
25
45
60
70
75
75
70
Marginal
Product(MP)
Average
Product(AP)
-
-
10
10
15
12.5
20
15
15
15
10
14
5
12.5
0
10.71
-5
8.75
6
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
Accounting
Profit
Total
Revenue
Accounting Costs
(Explicit Only)
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
Economic
Profit
Total
Revenue
Economic Costs
(Explicit + Implicit)
7
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
From
all Accounting
“costs” Costs
(Explicit Only)
are automatically
Economists examine both the EXPLICIT COSTS and the
IMPLICIT COSTS
ECONOMIC COSTS
Accounting
Profit
Total
now
on,
Revenue
•Implicit costs are the opportunity costs that firms “pay” for
using their own resources
•Example: Forgone Wage, Forgone Rent, Time
Economic
Profit
Total
Revenue
Economic Costs
(Explicit + Implicit)
8
Different Economic Costs
Total Costs
FC = Total Fixed Costs
VC = Total Variable Costs
TC = Total Costs
Per Unit Costs
AFC = Average Fixed Costs
AVC = Average Variable Costs
ATC = Average Total Costs
MC = Marginal Cost
9
Definitions
Fixed Costs:
Costs for fixed resources that DON’T change
with the amount produced
Ex: Rent, Insurance, Managers Salaries, etc.
Average Fixed Costs = Fixed Costs
Quantity
Variable Costs:
Costs for variable resources that DO change as
more or less is produced
Ex: Raw Materials, Labor, Electricity, etc.
Variable Costs
Average Variable Costs =
Quantity
10
Definitions
Total Cost:
Sum of Fixed and Variable Costs
Average Total Cost =
Total Costs
Quantity
Marginal Cost:
Additional costs of an additional output.
Ex: If the production of two more output
increases total cost from $100 to $120, the MC
$10
is _____.
Change in Total Costs
Marginal Cost =
Change in Quantity
11
TOTAL COSTS GRAPHICALLY
800
Costs (dollars)
700
Combining VC
With FC to get
Total Cost
TC
VC
Fixed Cost
600
500
400
300
What is the TOTAL
COST, FC, and VC
for producing 9
units?
200
100
FC
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
12
Per Unit Costs
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
100
100
100
100
100
100
100
100
TC
100
110
116
121
126
130
136
146
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 40.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
13
Per-Unit Costs (Average and Marginal)
Costs (dollars)
MC
12
11
10
9
8
7
6
5
4
3
2
1
ATC
AVC
How much does the
11th unit costs?
AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Quantity
14
Per-Unit Costs (Average and Marginal)
Costs (dollars)
MC
12
11
10
9
8
7
6
5
4
3
2
1
ATC and AVC get closer
and closer but NEVER
touch
ATC
AVC
Average Fixed
Cost
AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Quantity
15
Per-Unit Costs (Average and Marginal)
At output Q, what
area represents:
TC 0CDQ
VC
0BEQ
FC
0AFQ or BCDE
16
Costs (dollars)
Why is the MC curve U-shaped?
12
11
10
9
8
7
6
5
4
3
2
1
MC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Quantity
17
Marginal Product
Relationship between Production and Cost
Why is the MC curve Ushaped?
MP
Quantity of labor
Costs
MC
Quantity of output
•When marginal product is
increasing, marginal cost falls.
•When marginal product falls,
marginal costs increase.
MP and MC are mirror images of
each other.
18
Why is the MC curve U-shaped?
•The MC curve falls and then rises because of diminishing
marginal returns.
•Example:
•Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker ($10)
Workers Total Prod Marg Prod Total Cost Marginal Cost
0
0
1
5
2
13
3
19
4
23
5
25
6
26
19
Why is the MC curve U-shaped?
•The MC curve falls and then rises because of diminishing
marginal returns.
•Example:
•Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker ($10)
Workers Total Prod Marg Prod Total Cost Marginal Cost
0
0
1
5
5
2
13
8
3
19
6
4
23
4
5
25
2
6
26
1
20
Why is the MC curve U-shaped?
•The MC curve falls and then rises because of diminishing
marginal returns.
•Example:
•Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker (Wage = $10)
Workers Total Prod Marg Prod Total Cost Marginal Cost
0
0
$20
1
5
5
$30
2
13
8
$40
3
19
6
$50
4
23
4
$60
5
25
2
$70
6
26
1
$80
21
Why is the MC curve U-shaped?
•The MC curve falls and then rises because of diminishing
marginal returns.
•Example:
•Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker ($10)
Workers Total Prod Marg Prod Total Cost Marginal Cost
0
0
$20
1
5
5
$30
10/5 = $2
2
13
8
$40
10/8 = $1.25
3
19
6
$50
10/6 = $1.6
4
23
4
$60
10/4 = $2.5
5
25
2
$70
10/2 = $5
6
26
1
$80
10/1 = $10
22
Why is the MC curve U-shaped?
•The additional cost of the first 13 units produced falls because
workers have increasing marginal returns.
•As production continues, each worker adds less and less to
production so the marginal cost for each unit increases.
Workers Total Prod Marg Prod Total Cost Marginal Cost
0
0
$20
1
5
5
$30
10/5 = $2
2
13
8
$40
10/8 = $1.25
3
19
6
$50
10/6 = $1.6
4
23
4
$60
10/4 = $2.5
5
25
2
$70
10/2 = $5
6
26
1
$80
10/1 = $10
23
Costs (dollars)
Aver
m
RelationshipMP
between Production and Cost
Why is the ATC curve UQuantity of labor
MC
shaped?
ATC
Quantity of output
•When the marginal cost is below
the average, it pulls the average
down.
•When the marginal cost is above
the average, it pulls the average
up.
The MC curve intersects the ATC curve at its lowest point.
Example:
•The average income in the room is $50,000.
•An additional (marginal) person enters the room: Bill Gates.
•If the marginal is greater than the average it pulls it up.
•Notice that MC can increase but still pull down the average.
24
Shifting Cost
Curves
25
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
100
100
100
100
100
100
100
100
TC
100
110
116
121
126
130
136
146
MC
10
6
5
3
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
What if Fixed
Costs increase to
$200
26
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
100
100
100
100
100
100
100
100
TC
100
110
116
121
126
130
136
146
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
27
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
200
200
200
200
200
200
200
200
TC
100
110
116
121
126
130
136
146
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
28
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
200
200
200
200
200
200
200
200
TC
200
210
216
221
226
230
236
246
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
Which Per Unit Cost Curves Change?
29
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
200
200
200
200
200
200
200
200
TC
200
210
216
221
226
230
236
246
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
ONLY AFC and ATC Increase!
30
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
200
200
200
200
200
200
200
200
TC
200
210
216
221
226
230
236
246
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
200
110
8
100
58
7
66.6 30.3
6.5
50
31.5
6
40
26
6
33.3 22.67
6.6
28.6 20.9
ONLY AFC and ATC Increase!
31
Shifting Costs Curves
If fixed costs change ONLY AFC and ATC Change!
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
200
200
200
200
200
200
200
200
TC
200
210
216
221
226
230
236
246
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
200
210
8
100
108
7
66.6 73.6
6.5
50
56.5
6
40
46
6
33.3 39.3
6.6
28.6 35.2
MC and AVC DON’T change!
32
Shift from an increase in a Fixed Cost
MC
Costs (dollars)
ATC1
ATC
AVC
AFC1
AFC
Quantity
33
Shift from an increase in a Fixed Cost
MC
Costs (dollars)
ATC1
AVC
AFC1
Quantity
34
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
100
100
100
100
100
100
100
100
TC
100
110
116
121
126
130
136
146
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
What if the cost for
variable resources
increase
35
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
10
16
21
26
30
36
46
FC
100
100
100
100
100
100
100
100
TC
100
110
116
121
126
130
136
146
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
36
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
11
18
24
30
35
43
55
FC
100
100
100
100
100
100
100
100
TC
100
110
116
121
126
130
136
146
MC
10
6
5
5
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
37
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
11
18
24
30
35
43
55
FC
100
100
100
100
100
100
100
100
TC
100
111
118
124
130
135
143
155
MC
10
6
5
3
4
6
10
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
Which Per Unit Cost Curves Change?
38
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
11
18
24
30
35
43
55
FC
100
100
100
100
100
100
100
100
TC
100
111
118
124
130
135
143
155
MC
11
7
6
6
5
8
12
AVC AFC ATC
10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
MC, AVC, and ATC Change!
39
Shifting Costs Curves
TP
0
1
2
3
4
5
6
7
VC
0
11
18
24
30
35
43
55
FC
100
100
100
100
100
100
100
100
TC
100
111
118
124
130
135
143
155
MC
11
7
6
6
5
8
12
AVC AFC ATC
11
100
110
9
50
58
8
33.3 30.3
7.5
25
31.5
7
20
26
7.16 16.67 22.67
7.8
14.3 20.9
MC, AVC, and ATC Change!
40
Shifting Costs Curves
If variable costs change MC, AVC, and ATC Change!
TP
0
1
2
3
4
5
6
7
VC
0
11
18
24
30
35
43
55
FC
100
100
100
100
100
100
100
100
TC
100
111
118
124
130
135
143
155
MC
11
7
6
6
5
8
12
AVC AFC ATC
11
100
111
9
50
59
8
33.3 41.3
7.5
25
32.5
7
20
27
7.16 16.67 23.83
7.8
14.3 22.1
41
Shift from an increase in a Variable Costs
MC1
Costs (dollars)
MC
ATC1
AVC1
ATC
AVC
AFC
Quantity
42
Shift from an increase in a Variable Costs
MC1
Costs (dollars)
ATC1
AVC1
AFC
Quantity
43
44
4 Market
Structures
Candy Markets Simulation
45
FOUR MARKET STRUCTURES
Perfect
Competition
Monopolistic
Competition
Oligopoly
Pure
Monopoly
Every product is sold in a market that can be
considered one of the above market
structures.
For example:
1. Market for restaurants in Lancaster area
2. Market for American Cars
3. Market for oil in 1900
4. Market for Strawberries
5. Market for Cereal
46
Perfect
Competition
47
FOUR MARKET STRUCTURES
Perfect
Competition
Monopolistic
Competition
Oligopoly
Pure
Monopoly
Imperfect Competition
Characteristics of Perfect Competition:
Examples of Perfect Competition: Avocado farmers,
sunglass huts, and hammocks in Mexico
• Many small firms
• Identical products (perfect substitutes)
• No Control over Price (“Price Takers”)
• Easy for firms to enter and exit the industry
• Symmetric (same) information
Firms in ANY market structure will choose to
profit maximize
48
Law of One Price
In an efficient, perfectly competitive market, all
identical goods must have only one price.
Result: Each firm is a price taker. Firms have no
control of the price
Traffic Analogy
When there is heavy traffic,
why do all lanes seem to go the
same speed?
Cars leave slower lanes and
enter faster lanes.
Similarly, what happens in
perfectly competitive markets
if firms earn excessive profit?49
50
Perfectly Competitive Firms
Example:
• Say you go to Mexico to buy a hammock.
• After visiting at few different shops you find that
the buyers and sellers always agree on $15.
• This is the market price (where demand and
supply meet)
1. Is it likely that any shop can sell hammocks for $20?
2. Is it likely that any shop will sell hammocks for $10?
3. What happens if a shop prices hammocks too high?
4. Do you think that these firms make a large profit off
of hammocks? Why?
These firms are “price takers” because the sell their
products at a price set by the market.
51
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 for each firm is…
Perfectly Elastic Demand
(A Horizontal straight line)
52
The Competitive Firm is a Price Taker
Price is set by the Industry
P
S
P
$15
Demand
$15
D
5000
Industry
Q
Q
Firm
(price taker)
53
The Competitive Firm is a Price Taker
Price is set by the Industry
What is the additional
revenue for selling an P
additional unit?
1st unit earns $15
2nd unit earns $15
Marginal revenue is $15
constant at $15
Notice:
• Total revenue increases
at a constant rate
• MR equal Average
Revenue
Demand
MR=D=AR=P
Q
Firm
(price taker)
54
The Competitive Firm is a Price Taker
Price is set by the Industry
What is the additional
revenue for selling an P
additional unit?
1st unit
earnsPerfect
$15
For
Competition:
2nd unit earns $15
MR =is D$15= AR = P Demand
Marginal revenue
constant at $15
MR=D=AR=P
Notice:
• Total revenue increases
at a constant rate
• MR equal Average
Revenue
Q
Firm
(price taker)
55
Maximizing
PROFIT!
56
Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
•To maximum profit, firms must make the right
output
•Firms should continue to produce until the
additional revenue from each new output
equals the additional cost.
Example (Assume the price is $10)
• Should you produce…
…if the additional cost of another unit is $5
…if the additional cost of another unit is $9
…if the additional cost of another unit is $11
57
Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
•To maximum profit firms must make the right
output
•Firms should continue to produce until the
additional revenue from each new output
equals the additional cost.
Example (Assume the price is $10)
• Should you produce…
…if the additional cost of another unit is $5
…if the additional cost of another unit is $9
…if the additional cost of another unit is $11
Profit Maximizing Rule
MR=MC
58
Lets put costs and revenue together
on a graph to calculate profit.
59
•How much output should be produced?
•How much is Total Revenue? How much is Total Cost?
•Is there profit or loss? How much?
P
$9
MC
8
7
6
5
4
3
2
1
MR=D=AR=P
Profit = $18
ATC
AVC
Total Cost=$45
Total Revenue =$63
1 2 3 4 5 6 7 8 9 10 Q
Don’t forget
that averages
show PER
UNIT COSTS
60
Suppose the market demand falls. What
would happen if the price is lowered from
$7 to $5?
The MR=MC rule still applies but now the
firm will make an economic loss.
The profit maximizing rule is also the
loss minimizing rule!!!
61
Cost and Revenue
•How much output should be produced?
•How much is Total Revenue? How much is Total Cost?
•Is there profit or loss? How much?
MC
$9
8
ATC
7
6
AVC
Loss =$7
5
MR=D=AR=P
4
3
2 Total Cost = $42
Total Revenue=$35
1
1 2 3 4 5 6 7 8 9 10 Q
62
Assume the market demand falls even
more. If the price is lowered from $5 to $4
the firm should stop producing.
Shut Down Rule:
•A firm should continue to produce as long
as the price is above the AVC
•When the price falls below AVC then the
firm should minimize its losses by shutting
down
•Why? If the price is below AVC the firm is
losing more money by producing than they
would have to pay to shut down.
63
Cost and Revenue
SHUT DOWN! Produce Zero
MC
$9
8
7
6
5
4
3
2
1
ATC
AVC
Minimum AVC
is shut down
point
1 2 3 4 5 6 7 8 9 10 Q
64
P<AVC. They should shut down
Cost and Revenue
Producing nothing is cheaper than staying open.
MC
$9
8
7
6
5
4
3
2
1
ATC
Fixed Costs=$10
AVC
TC=$35
MR=D=AR=P
TR=$20
1 2 3 4 5 6 7 8 9 10 Q
65
Profit Maximizing Rule
MR = MC
Three Characteristics of MR=MC Rule:
1. Rule applies to ALL markets
structures (PC, Monopolies, etc.)
2. The rule applies only if price is
above AVC
3. Rule can be restated P = MC for
perfectly competitive firms (because
MR = P)
66
Practice
67
#1
Should the firm produce? Yes
What output should the firm produce? 10
What is TR at that output? What is TC? TR=$140
TC=$100
How much profit or loss? Profit=$40
$20
Cost and Revenue
MC
15
14
MR=D=AR= P
ATC
10
AVC
6
5
0
6 7
10
Q
68
#2
What output should the firm produce? Zero Shutdown
(Price below AVC)
What is TR at MR=MC point?$45
What is TC at MR=MC point?$55
How much profit or loss? Loss=Only Fixed Cost $5
Cost and Revenue
$20
MC
ATC
AVC
15
11
10
9
MR=D=AR=P
5
0
5
7
Q
69
What output should the firm produce? 6
What is TR at that output? $90
What is TC? $120
How much profit or loss? Loss= $30
#3
$40
Cost and Revenue
MC
30
ATC
20
19
15
10
0
AVC
MR=D=AR=P
6
8
Q
70