Behind the Supply Curve: Profit, Production, and Costs. Unit 4

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1 Behind the Supply Curve: Profit, Production, and Costs Unit 4

2 Total Revenue (TR) Price of the output times the quantity sold. P x Q $0 $4 $6 $6 $4 $0 TR

3 Profit Money/revenue remaining after paying all expenses. Total Cost TR - TC Total Revenue -$12 $0 $10 $16

4 Explicit Cost A cost that requires an outlay of money. Implicit Cost A cost that does not require an outlay of money; it is measured by the value, in dollar terms, of benefits that are forgone.

5 Implicit Cost of Capital The opportunity cost of the capital used by a business. The income the owner could have realized from that capital if it had been used in its next best alternative way.

6 Accounting Profit Total revenue minus explicit costs and depreciation. (Depreciation is the reduction in value of equipment) TR - Total Explicit Cost Economic Profit Total revenue minus the total opportunity cost. Will usually be less than the accounting profit. TR - (Total Explicit Cost + Total Implicit Cost) Normal Profit A zero economic profit. TR = TC (explicit + implicit)

7 Marginal Revenue (MR) The change in total revenue generated by an additional unit of output. TR / Q MR 2 $36 $18 $18 $18 $18 $18 $18 $18

8 Marginal Cost (MC) The change in total cost generated by an additional unit of output. TC / Q MC 2 $32 $16 $6 $8 $12 $16 $20 $24

9 Optimal Output Rule Profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost. Principle of Marginal Analysis: Every action should continue until marginal benefit equals marginal cost. If MR > MC, then increasing production will increase profit. If MR < MC, then increasing production will decrease profit. If MR = MC, then profits are maximized. MR = MC

10 Optimal Output Rule $18 $18 $18 $18 $18 $18 $18 $16 $6 $8 $12 $16 $20 $24 -$24 $0 $20 $32 $36 $32 $20 MC MR Q = TR = $252 $108 $180 $216 $144 $36 $72 TC = $184 $232 $112 $144 $60 $72 $88

11 INPUTS Production Function The relationship between the quantity of inputs a firm uses and the quantity of output it produces. *A firm's production function underlies its cost curves. Revenue OUTPUT COST

12 Fixed Input An input whose quantity is fixed for a period of time and cannot be varied. The best example of a fixed input is the factory, building, equipment, or other capital used in production.

13 Variable Input An input whose quantity the firm can vary at any time. The best example of a variable input is the labor or workers who work in the factory or operate the equipment. Raw materials used for production can also be a variable input.

14 Short Run The time period in which at least one input is fixed.

15 Long Run The time period in which all inputs can be varied.

16 Total Product (TP) Total quantity, or total output, of a good produced at each quantity of labor employed. Q TP L

17 Marginal Product (MP) The additional quantity of output produced by using one more unit of an input. Note: Marginal Physical Product (MPP) is the same thing as Marginal Product (MP). If MP were to reach 0, then TP would be at its peak. TP / L (L represents labor, however I could be used for change in input.)

18 Marginal Product (MP) MP

19 MP is the slope of TP

20 Diminishing Returns An increase in the quantity of an input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input. Law of diminishing marginal productivity: In the short run, as variable inputs are applied to fixed inputs, production first increases at an increasing rate; then, production increases at a decreasing rate. MP =

21 Diminishing Returns Why does this happen? Production initially increases at an increasing rate because of specialization. If variable inputs are being added to a fixed input, there becomes less and less to specialize in, resulting in diminishing returns. Negative returns occur when the variable inputs begin to obstruct one another.

22 Diminishing Returns MP is the slope of TP. On the above graph when do diminishing marginal returns begin? When the 4 th worker is hired.

23 Average Product (AP) A measure of average labor productivity. Total product divided by the amount of labor employed. Q / L or TP / I (L represents labor, however I could be used for any input.) Relationship between marginal and average curves: If marginal > avg, the avg is rising If marginal < avg, the avg is falling

24 Average Product (AP) AP/ MP AP

25 Relationship between MP and MC If marginal product is rising, marginal cost is falling. If marginal product is falling, marginal cost is rising. (Explains shape of MC curve) Simply because MP is declining (diminishing returns) and MC is rising does not necessarily mean the firm should discontinue production. Why? Because the goal of the firm is to maximize profit. Thus, the firm should only discontinue production if MC > MR.

26 Fixed and Variable Costs Fixed Cost (FC) A cost that does not depend on the quantity of output produced. It is the cost of the fixed input. Total Fixed Cost (TFC) = Sum of all fixed costs. Variable Cost (VC) A cost that depends on the quantity of output produced. It is the cost of the variable input. Total Variable Cost (TVC) = Sum of all variable costs. Imagine setting up a successful lemonade stand on your street corner. You are able to sell 1,000 cups a month for $1 each. You have to rent a table from your parents for $75 a month, lemons, sugar and cups cost you $300 a month, and a monthly vendor s license cost $25 a month. $1 1,000 $1,000 $75 $25 $100 $300 $300 $100 $300 $400 $1,000 $400 $600

27

28 Total Cost (TC) The total cost of producing a given quantity of output is the sum of the fixed cost and the variable cost of producing that quantity of output. TFC + TVC Note: Change in total cost is reflected dollar for dollar in change in variable costs.

29 Total Cost (TC) TC $0 $200 $400 $600 $800 $1,000 $1,200 $1,400 $1,600 $400 $400 $400 $400 $400 $400 $400 $400 $400 $400 $600 $800 $1,000 $1,200 $1,400 $1,600 $1,800 $2,000

30 Average Total Cost (ATC) Total cost divided by quantity of output produced. TC / Q or AFC + AVC $400 $600 $800 $1,000 $1,200 $1,400 $1,600 $1,800 $2,000 $33.33 $20.00 $18.18 $18.46 $19.17 $20.51 $22.50 $24.69 ATC

31 Average Fixed Cost (AFC) The fixed cost per unit of output. TFC / Q Spreading Effect AFC declines as fixed costs are spread over a larger Q. $22.22 $10.00 $7.27 $6.15 $5.48 $5.13 $5.00 $4.94 AFC

32 Average Variable Cost (AVC) The variable cost per unit of output. TVC / Q Diminishing Returns Effect AVC rises as MP declines for each additional input added. $11.11 $10.00 $10.91 $12.31 $13.70 $15.38 $17.50 $19.75 AVC

33 Explaining the U-shaped Average Total Cost Curve Spreading effect: The larger the output, the greater the quantity of output over which fixed cost is spread, leading to lower average fixed cost. Spreading Effect Diminishing Returns Effect Diminishing returns effect: The larger the output, the greater amount of variable inputs required to produce additional units, leading to higher average variable cost. Spreading Effect >Diminishing Returns Effect Diminishing Returns Effect > Spreading Effect

34 Minimum-cost Output / Minimum Efficient Scale The quantity of output at which average total cost is lowest. It corresponds to the bottom of the U- shaped average total cost curve. Relationship between marginal and average curves: If marginal < avg, the avg is falling If marginal > avg, the avg is rising

35 Long-Run Average Total Cost Curve (LRATC) Shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output. Note: Each Short-run Average Total Cost Curve (SRATC) represents a fixed cost that can be chosen.

36 Economies of Scale / Increasing Returns to Scale When long-run average total cost declines as output increases. Economies of scale can result from increasing returns to scale, which exist when output increases more than in proportion to an increase in all inputs (doubling the inputs would more than double the output).

37

38 Constant Returns to Scale When output increases directly in proportion to an increase in all inputs (doubling the inputs results in doubling the outputs).

39 Diseconomies of Scale / Decreasing Returns to Scale When long-run average total cost increases as output increases. Diseconomies of scale can result from decreasing returns to scale, which exist when output increases less than in proportion to an increase in all inputs (doubling the inputs would result in less than double the output).

40 Sunk Cost A cost that has already been incurred and is nonrecoverable. A sunk cost should be ignored in a decision about future actions.

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