Microeconomics II

Georgi Georgiev

November 2014

Production, Costs, Revenue and Profit

Main topics

1. Production - TP, AP and MP

2. Costs- FC and VC- TC, AC and MC

3. Revenue - TR, AR and MR

4. Profit – economic and accounting profit and Profit maximization

Production

The total amount of output produced by a firm The total amount of output produced by a firm is a function of the levels of input/factors of is a function of the levels of input/factors of production/ usage by the firmproduction/ usage by the firm

Usually the amount of output is a function of Usually the amount of output is a function of two inputs/production factors/ – Capital and two inputs/production factors/ – Capital and Labour. Labour.

Total Product (TP) function - a short-run Total Product (TP) function - a short-run relationship between the amount of Labour relationship between the amount of Labour and the level of output, and the level of output, ceteris paribusceteris paribus..

Total product (TP)

Law of diminishing returns

As the level of a variable input rises in a production process in which other inputs are fixed, output ultimately increases by progressively smaller increments.

Average product (AP) AP = TP / amount of input/

Quantityof labour TPP APP

0

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-10

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7.86

6.88

6

Marginal product (MP)

the additional output that results from the use of an additional unit of a variable input, holding other inputs constant

measured as the ratio of the change in output (TP) to the change in the quantity of labor (or other input) used

Computation of MP and AP

Note that the MP is positive when an increase in labour results in an increase in output; a negative MP occurs when output falls when additional labour is used.

Quantityof labour TP AP

0

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MP0

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7.86

6.88

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8

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1

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-1

TP

Shape of MP curve

MP rises when TP increases at an increasing rate, and declines when TP increases at a decreasing rate.

MP is negative if TP declines when labor use rises

Relationship of AP and MP

AP rises when MP > AP AP falls when MP < AP AP is maximized when

MP = AP

Cost - Total Costs

Types of costs according to the change in quantity produced: fixed costs – costs that do not vary with the level

of output. Fixed costs are the same at all levels of output (even when output equals zero).

variable costs – costs that vary with the level of output (= 0 when output is zero)

Example

Overall Total Costs - TC

Fixed costs

Variable costs

TC, TVC, and TFC

Average fixed cost

Average fixed cost (AFC) = TFC / Q

Average variable cost

Average variable cost (AVC) = TVC / Q

Average total cost

Average total cost (ATC) = TC / Q ATC = AFC + AVC (since TFC + TVC = TC)

Marginal cost

Marginal cost (MC) = cost of an additional unit of output

Average fixed cost

AVC, ATC, and MC

Note that the MC curve intersects the AVC and ATC at their respective minimum points

Long-run costs In the long run, a firm may change not only the level of

Labour employed but also its level of Capital, and will select a size of firm that provides the lowest level of ATC.

Economies and diseconomies of scale – producing at lowest ATC

Economies of scale – factors that lower average cost as the size of the firm rises in the long run Sources: specialization and division of labor, indivisibilities

of capital, etc. Diseconomies of scale – factors that raise average

cost as the size of the firm rises in the long run Sources: increased cost of managing and coordination as

firm size rises Constant returns to scale – average costs do not

change as firm size changes

Long-run average total cost (LRATC)

Minimum efficient scale

Minimum efficient scale = lowest level of output at which LRATC is minimized

RevenueRevenue

Total Revenue – the overall revenue received from Total Revenue – the overall revenue received from the sale of output the sale of output

TR = Q x pTR = Q x p

Average Revenue = the revenue received from the Average Revenue = the revenue received from the sale of an unit of outputsale of an unit of output

AR=TR/qAR=TR/q

Marginal revenueMarginal revenue

Marginal revenue = additional revenue Marginal revenue = additional revenue received from the sale of an additional unit of received from the sale of an additional unit of output.output.

In mathematical terms:In mathematical terms:

MR & MC

the additional revenue resulting from the sale the additional revenue resulting from the sale of an additional unit of output is called of an additional unit of output is called marginal revenue (MR)marginal revenue (MR)

the additional cost resulting from the sale of the additional cost resulting from the sale of an additional unit of output is called marginal an additional unit of output is called marginal cost (MC)cost (MC)

MR > MCMR > MC

If marginal revenue exceeds marginal cost, If marginal revenue exceeds marginal cost, the production of an additional unit of output the production of an additional unit of output adds more to revenue than to costs.adds more to revenue than to costs.

In this case, a firm is expected to increase its In this case, a firm is expected to increase its level of production to increase its profits.level of production to increase its profits.

MR < MCMR < MC

If marginal cost exceeds marginal revenue, the If marginal cost exceeds marginal revenue, the production of the last unit of output costs more production of the last unit of output costs more than the additional revenue generated by the than the additional revenue generated by the sale of this unit.sale of this unit.

In this case, firms can increase their profits by In this case, firms can increase their profits by producing less.producing less.

A profit-maximizing firm will produce more output A profit-maximizing firm will produce more output when MR > MC and less output when MR < MC.when MR > MC and less output when MR < MC.

MR = MCMR = MC

If MR = MC, however, the firm has no If MR = MC, however, the firm has no incentive to produce either more or less incentive to produce either more or less output. output.

The firm's profits are maximized at the level The firm's profits are maximized at the level of output at which MR = MC. of output at which MR = MC.

Profit maximization

Profit = (profit per unit) x No of units

= (P – ATC) x Q

Or

Profit = (TR – TC)

Profit maximizationProfit maximization

Economic profit = total revenue - all Economic profit = total revenue - all economic costseconomic costs

Economic costs include all opportunity costs Economic costs include all opportunity costs (explicit and implicit).(explicit and implicit).

Economic vs. accounting Economic vs. accounting profitprofit

economic profit = total revenue - all economic economic profit = total revenue - all economic costscosts

accounting profit = total revenue - all accounting profit = total revenue - all accounting costsaccounting costs

accounting costs include only current or accounting costs include only current or historical explicit costs, not implicit costshistorical explicit costs, not implicit costs

Economic vs. accounting Economic vs. accounting profitprofit

the difference between economic cost and the difference between economic cost and accounting cost is the opportunity cost of accounting cost is the opportunity cost of resources supplied by the firm's owner. resources supplied by the firm's owner.

the opportunity cost of these owner-supplied the opportunity cost of these owner-supplied resources is called resources is called normal profitnormal profit..

normal profit is a cost of production.normal profit is a cost of production.

Economic vs. accounting Economic vs. accounting profitprofit

If the owners of a firm gain economic profits, If the owners of a firm gain economic profits, they are receiving a rate of return on the use they are receiving a rate of return on the use of their resources that exceeds that which of their resources that exceeds that which can be received in their next-best use.can be received in their next-best use.

In this situation, we'd expect to see other In this situation, we'd expect to see other firms entering the industry (unless barriers to firms entering the industry (unless barriers to entry exist). entry exist).

Economic vs. accounting Economic vs. accounting profitprofit

If a firm is receiving economic losses If a firm is receiving economic losses (negative economic profits), the owners are (negative economic profits), the owners are receiving less income than could be received receiving less income than could be received if their resources were employed in an if their resources were employed in an alternative use.alternative use.

In the long run, we'd expect to see firms In the long run, we'd expect to see firms leave the industry when this occurs.leave the industry when this occurs.

Economic profits = 0Economic profits = 0

If economic profits equal zero, then:If economic profits equal zero, then: owners receive a payment equal to their owners receive a payment equal to their

opportunity costs (what could be received in their opportunity costs (what could be received in their next-best alternative),next-best alternative),

no incentive for firms to either enter or leave this no incentive for firms to either enter or leave this industry,industry,

accounting profit = normal profit.accounting profit = normal profit.

Economic profitEconomic profit

Economic profit = total revenue - economic costsEconomic profit = total revenue - economic costs

when output rises, both total revenue and total costs when output rises, both total revenue and total costs increase (with a few exceptions that will be increase (with a few exceptions that will be discussed in later chapters)discussed in later chapters)

profits increase when output increases if total profits increase when output increases if total revenue rises by more than total costs.revenue rises by more than total costs.

profits decrease when output rises if total costs rise profits decrease when output rises if total costs rise by more than total revenueby more than total revenue

Demand and MR for a firm facing a downward sloping demand curve

Profit maximization

Main Types of Market Main Types of Market StructuresStructures

Main topics

1.1. Perfect competitionPerfect competition

2.2. MonopolyMonopoly

3.3. Monopolistic competition Monopolistic competition

4.4. OligopolyOligopoly

Perfect competition – main Perfect competition – main characteristicscharacteristics

a very large number of buyers and sellers,a very large number of buyers and sellers, easy entry,easy entry, a standardized product, anda standardized product, and each buyer and seller has no control over the each buyer and seller has no control over the

market price (this means that each firm is a market price (this means that each firm is a price taker that faces a horizontal demand that faces a horizontal demand curve for its product).curve for its product).

Demand curve facing a single firm no individual firm can affect the market price demand curve facing each firm is perfectly elastic

Profit maximization

produce where MR = MC

P = MR

Profit-maximizing level of output

Economic Profits > 0

Economic profit

Loss minimization and the shut-down rule

Suppose that P < ATC. Since the firm is experiencing a loss, should it shut down?

Loss if shut down = fixed costs Shut down in the short run only if the loss that

occurs where MR = MC exceeds the loss that would occur if the firm shuts down (= fixed cost)

Stay in business if TR > VC. This implies that P > AVC. Shut down if P < AVC.

Economic loss (AVC<P< ATC)

Loss if shut down

Break-even price

If price = minimum point on ATC curve, economic profit = 0.

Owners receive normal profit.

No incentive for firms to either enter or leave the market.

Long run

Firms enter if economic profits > 0 market supply increases price declines profit declines until economic profit equals zero (and entry

stops)

Firms exit if economic losses occur market supply decreases price rises losses decline until economic profit equals zero

Monopoly – main Monopoly – main characteristicscharacteristics

a single seller producing a product with no close a single seller producing a product with no close substitutes,substitutes,

effective barriers to entry into the market, effective barriers to entry into the market,

andand the firm is a the firm is a price makerprice maker, also called a price , also called a price

searcher because it faces a downward sloping searcher because it faces a downward sloping demand curve for its product (in fact, note that this demand curve for its product (in fact, note that this demand curve is the market demand curve).demand curve is the market demand curve).

Barriers to entry

economies of scale/economic barriers/ actions by firms actions by government/legislative barriers/

Natural monopolyNatural monopoly

a monopoly that arises because of the a monopoly that arises because of the existence of economies of scale over the existence of economies of scale over the entire relevant range of output. entire relevant range of output.

a larger firm will always be able to produce a larger firm will always be able to produce output at a lower cost than could a smaller output at a lower cost than could a smaller firm. firm.

only a single firm can survive in a long-run only a single firm can survive in a long-run equilibrium.equilibrium.

Economies of scale – natural monopolies

Natural monopolies are often regulated monopolies

Actions by firms to create and protect monopoly power

patents and copyrights, high advertising expenditures result in high

sunk costs (costs that are not recoverable on exit), and

illegal actions designed to restrict competition

Monopolies created by government action

patents and copyrights, government created franchises, and licensing.

Local monopoly

Local monopoly – a monopoly that exists in a local geographical area (e.g., local newspapers)

Price elasticity and MR

As noted earlier, since the demand curve facing a monopoly firms is downward sloping, MR < P

MR > 0 when demand is elastic MR = 0 when demand is unit elastic MR < 0 when demand is inelastic

Average revenue

As in all other market structures, AR=P (note that AR = TR/Q = (PxQ) / Q = P)

The price given by the demand curve is the average revenue that the firm receives at each level of output.

Monopolist receiving positive profits

Monopoly price setting

There is a unique profit-maximizing price and output level for a monopoly firm.

It is optimal to produce at the level of output at which MR = MC and to charge the price given by the demand curve at this output level.

Charging a higher (or lower) price results in lower profits.

Monopolistic competition – Monopolistic competition – main characteristicsmain characteristics

a large number of firms,a large number of firms, the product is differentiated (i.e., each firm the product is differentiated (i.e., each firm

produces a similar, but not identical product),produces a similar, but not identical product), entry is relatively easy, andentry is relatively easy, and the firm is a price maker that faces a the firm is a price maker that faces a

downward sloping demand curve. downward sloping demand curve.

Relationship to other market models

Monopolistic competition is similar to perfect competition in that: There are many buyers and sellers There are no barriers to entry or exit

Monopolistic competition is similar to monopoly in that: Each firm is the sole producer of a particular product

(although there are close substitutes) The firm faces a downward sloping demand curve for its

product

Demand curve facing a monopolistically competitive firm

The firm’s demand curve and entry and exit

As firms enter a monopolistically competitive market, the demand facing a typical firm declines and becomes more elastic.

Short-run equilibrium in a monopolistically competitive industry

Economic profits lead to entry and a reduction in the demand facing a typical firm.

Long-run equilibrium in a monopolistically competitive industry

Entry continues until economic profit equals zero for a typical firm.

This equilibrium is often referred to as a “tangency equilibrium.”

Monopolistic competition vs. perfect competition

A monopolistically competitive firm, in the long run, has “excess capacity” – (i.e., it produces a level of output that is below the least-cost level).

This is a cost of product variety.

Monopolistic competition and efficiency

As the number of firms rises, a monopolistically competitive firm’s demand curve becomes more elastic.

As the number of firms in a market expands, the market approaches a perfectly competitive market.

Thus, economic inefficiency may be smaller when there is a large number of firms in a monopolistically competitive market.

Product differentiation and advertising

Monopolistically competitive firms may receive short-run economic profit from successful product differentiation and advertising.

These profits are, however, expected to disappear in the long run as other firms copy successful innovations.

Location decisions

Monopolistically competitive firms often locate near each other to appeal to the “median” customer in a geographical region. (e.g., fast food restaurants and car dealerships)

Oligopoly – main Oligopoly – main characteristicscharacteristics

a small number of firms produce most output,a small number of firms produce most output, the product may be either standardized or the product may be either standardized or

differentiated,differentiated, there are significant barriers to entry, andthere are significant barriers to entry, and recognized interdependence exists (i.e., each recognized interdependence exists (i.e., each

firm realizes that its profitability depends on the firm realizes that its profitability depends on the actions and reactions of rival firms). actions and reactions of rival firms).

Real-world marketsReal-world markets

Most output is produced and sold in oligopoly Most output is produced and sold in oligopoly and monopolistically competitive industries.and monopolistically competitive industries.

Strategic behaviour

Strategic behaviour occurs when the best outcome for one party depends upon the actions and reactions of other parties.

Game theory – prisoners’ dilemma

Examines the payoffs associated with alternative choices of each participant in the “game.”

Game theory examples

Prisoners’ dilemma Duopoly pricing game

Dominant strategy

A dominant strategy is one that provides the highest payoff for an individual for each and every possible action by rivals.

Confession is the dominant strategy in the prisoners’ dilemma game. A low price is the dominant strategy in the duopoly pricing game

It is more difficult to predict the outcome when no dominant strategy exists or when the game is repeated with the same players.

Cartels

Cartels are legal in some countries A cartel arrangement can maximize industry

profits Each firm can increase its profits by violating

the agreement Cartel agreements have generally been

unstable.

Imperfect information

Brand name identification – serves as a signal of product quality. Customers are willing to pay a higher price for products produced by firms that they recognize.

Product guarantees also serve as a signal of product quality