 TOPIC 3- PRODUCTION, COSTS, PROFITS - Custom Scholars
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# TOPIC 3- PRODUCTION, COSTS, PROFITS

question
WHAT ARE COSTS?
The firm's goal is to maximise profit. This is simply the total revenue that it receives from selling its product minus the total cost of producing that product:
Profit = Total revenue - Total cost
Where total revenue = Price × Quantity sold
While total revenue is relatively straightforward, total cost is more complex. To an economist, cost means opportunity cost. It includes the explicit costs or money outlays that comprise accounting costs, of course, but it also includes implicit costs whenever resources that could have been used elsewhere are used by the firm. A small business that shows an accounting profit actually may be losing money in an economic sense, if we deduct all of the implicit costs of resources that the owner ties up in the firm rather than using elsewhere. The owner's labour, for example, is a real cost of operating the business even if there is no actual salary paid. The cost is the lost earnings from giving up the opportunity to work for someone else rather than the owner's actual salary from his or her own business. Similarly, the lost interest income on money the owner invests in the business is a real cost of doing business even though it is not an accounting cost. It is important to understand the following relationships:
Economic cost = Explicit costs + Implicit costs = Total opportunity cost
Accounting cost = Explicit cost
Economic profit = Total revenue - Total economic cost
Accounting profit = Total revenue - Explicit costs
question
PRODUCTION COSTS
For the following discussion we assume that the size of the production facility (factory) is fixed in the short run. Therefore this analysis describes production decisions in the short run.
A firm's costs reflect its production process. The production function shows the relationship between inputs and outputs. To simplify the discussion we will assume that the only variable input is labour. In the short run, this means looking at the relationship between the amount of labour used and the amount of output because we define the short run as a time period too short to allow increases in other inputs.
The marginal product of any input is the increase in output that arises from an additional unit of that input. Adding additional labour increases output, although at some point additional workers are subject to diminishing marginal product, which means that the last unit of labour hired adds less to total output than did the previous one. Diminishing marginal product occurs when workers are added without any change to fixed factors of production such as capital or land. Production functions exhibit diminishing marginal product. The slope of a production function gets flatter as more and more inputs are added to the production process.
As marginal product diminishes, the firm's total cost begins to rise at a more rapid rate because additional units of output cost more to produce (the same wage per worker results in less additional output, so the cost per additional unit produced rises). The total cost curve (showing the relationship between the quantity of output produced and the total cost of production) will therefore become steeper as the amount produced increases.
In the long run, expansion need not result in diminishing marginal product because land, labour and capital can be increased simultaneously.
question
VARIOUS MEASURES OF COST
If total cost is known for the various levels of output, it is possible to calculate all other measures of cost. The relationships between the cost measures are as follows:
Total cost (TC) = Fixed cost (FC) + Variable cost (VC)
Average fixed cost (AFC) = FC/Q
Average variable cost (AVC) = VC/Q
Average total cost (ATC) = Total cost (TC)/Quantity of output (Q)
also:
ATC = AFC + AVC
Marginal cost (MC) = ∆TC/ ∆Q = ∆VC/ ∆Q
where ∆ = 'change in'.
Marginal cost (MC) rises with output as soon as the point of diminishing marginal product is reached. The average total cost (ATC) curve is U-shaped. It declines initially because of the dominance of average fixed cost (AFC), which always declines as the fixed cost is spread over more units of output. Eventually, however, diminishing returns cause an increase in average variable costs (AVC), which in turn begin to increase ATC. The efficient scale of the firm is the quantity of output that minimises average total cost. The MC curve crosses the ATC curve at the efficient scale.
Often production first exhibits increasing marginal product and decreasing marginal cost at very low levels of output as the addition of workers allows for specialisation of skills. At higher levels of output, diminishing returns eventually set in and marginal costs begin to rise, causing the following relationships to hold:
· Marginal cost eventually rises with the quantity of output.
· The average total cost curve is 'U' shaped.
· The marginal cost curve crosses the average total cost curve and the average variable cost curve at the minimum points on these curves.
question
COSTS IN THE SHORT & LONG RUN
Because we define the long run as the time period long enough to vary capital and all other inputs, all costs become variable in the long run. As a result, diminishing marginal product is no longer a problem. There are no fixed inputs. Given enough time, firms can vary their scale of operation by acquiring more land and building additional factories in addition to hiring more labour (or they can cut back on their use of all inputs). This eliminates a major reason for the U-shaped ATC curve: the existence of fixed inputs. As a result, the long-run ATC curve is likely to be flatter than the short-run curve. To the extent that it is still U-shaped, the decreasing part of the curve is an area of economies of scale, in which increasing all inputs actually lowers long run ATC. The increasing part of the curve exhibits diseconomies of scale, a range in which increasing all inputs raises the long run average total cost. If there is a horizontal range, this is the area of constant returns to scale, in which increasing all inputs causes a proportionate increase in output, keeping ATC constant.
question
Distinguish between the Short Run and the Long Run.
The short run refers to a period of time when at least one factor is fixed, not to a
specific calendar time. It can vary in length of time, depending on the industry. For
example, the building on a new factory cannot be achieved overnight if you wished to
establish a steel manufacturing plant, whereas a dog walking service can be
established almost overnight. The long run refers to a period of time in which the
quantities of all inputs can be varied.
question
Problem 2: Your aunt is thinking about opening a hardware store. She estimates it
would cost \$500,000 per year to rent the store and buy the stock. In addition, she would
have to quit her \$50,000 per year job as an accountant

What is your aunt's opportunity cost of running a hardware store for a year? If
your aunt thought she could sell \$510,000 worth of merchandise in a year,
should she open the store? Explain.

@ The opportunity cost of running the hardware store is \$550,000, consisting of
\$500,000 to rent the store and buy the stock and a \$50,000 opportunity cost, since
your aunt would quit her job as an accountant to run the store. Since the total
opportunity cost of \$550,000 exceeds revenue of \$510,000, your aunt shouldn't open
the store, as her profit would be negative. She would lose money
A cost that does not depend on the quantity produced is a __fixed cost__.

In the ice-cream industry in the short run, _variable costs__ includes the cost of
cream and sugar, but not the cost of the factory.

Profits equal total revenue less ___ total cost ___.

The cost of producing an extra unit of output is __ marginal cost ___.

Define opportunity cost.

The opportunity cost of the value of the next best alternative, which must be forgone
to acquire (or consume) it.
question
WHAT IS A COMPETITIVE MARKET?
In a perfectly competitive market, there are so many buyers and sellers of a standardised good that no individual buyer or seller can influence price. That is, buyers and sellers are all price takers. This means that firms within a competitive market have no market power. In addition, competitive markets have no barriers to entry, so firms can enter or exit the industry easily in response to changing market conditions. Free entry and exit guarantees that competitive firms cannot earn economic profit in the long run
question
PROFIT MAXIMISATION & THE COMPETITIVE FIRM'S SUPPLY CURVE
Just like other firms, competitive firms desire to maximise profit. Remember that rational people make decisions at the margin. Everyone, from individuals to firms to societies, maximises wellbeing by following a general decision-making rule:
Do anything as long as marginal benefit is greater than or equal to marginal cost.

· The corollary to this rule is that firms maximise profit by comparing marginal revenue and marginal cost.
- For the competitive firm, marginal revenue is fixed at the price of the good and marginal cost is increasing as output rises.
- Note that fixed costs are irrelevant for making future decisions. Economists refer to fixed costs as sunk costs, because once they are incurred they cannot be recovered. A firm determines how much output to produce by equating marginal revenue and marginal cost, neither of which is affected by fixed cost.
· The profit-maximising firm needs to consider the following revenue measures:
Average revenue = Total revenue / Quantity
Marginal revenue = ∆Total revenue / ∆Quantity where ∆ = 'change in'.
· For the competitive firm, all sales occur at the market price, which does not change as the firm increases output. As a result, in perfect competition:
Average revenue = Marginal revenue = Price

· Hence to maximise profit using marginal analysis, the perfectly competitive firm produces until:
Marginal revenue = Price = Marginal cos

There are three general rules for profit maximisation:

1. If marginal revenue exceeds marginal cost, the firm should increase output to increase profit.

2. If marginal cost exceeds marginal revenue, the firm should decrease output to increase profit.

3. At the profit maximising level of output, marginal revenue and marginal cost are exactly equal.

From these three general rules we can see that at any price level, the firm will choose the quantity supplied by looking at the marginal cost curve, remembering that marginal revenue equals price in perfect competition. That is, the firm's marginal cost curve determines how much the firm is willing to supply at any price. This makes the marginal cost curve the firm's supply curve. The only qualification is that firms will not sell at a price below average variable cost. If price is below average variable cost, the firm is losing more money than if it were to shut down. Therefore, the competitive firm's supply curve in the short run is the portion of its marginal cost curve that lies above the average variable cost curve.
The shutdown rule:
In the short run, the firm shuts down if P < AVC (or if TR < TVC)

The analysis is similar in the long run, except that all costs are variable. Remember that in the long run all inputs and costs are variable. Consequently, the profit-maximising firm in the long run will not produce below average total cost (ATC). With P < ATC, the firm is incurring losses and will go out of business. On the other hand, if P > ATC, the firm will earn an economic profit, encouraging it to stay in business and encouraging other firms to enter the industry. The competitive firm's long run supply curve is the portion of its marginal cost curve that lies above its average total cost curve.
The exit rule:
In the long run, the firm exits if P < ATC (or if TR < TC)

Keep in mind the difference between economic and accounting profit. Economic profit includes all opportunity costs of time and capital. When a firm has zero economic profit it is enjoying a normal accounting profit. It is for this reason that firms are willing to continue to produce at a point of zero economic profit. In addition, any positive economic profit provides an incentive for firms to enter the industry
question
SUPPLY CURVE IN COMPETITIVE FIRM
Market supply is the summation of all of the individual supply curves. Long-run market supply includes potential as well as current competitors. If economic profits exist, new firms will enter the market, increasing supply and driving down price until the economic profits disappear in the long run. If economic losses exist, firms will exit the industry, decreasing supply and resulting in rising prices until economic losses disappear in the long run. The situation stabilises in the long run only when economic profit equals zero, which means that price equals average total cost. This long-run equilibrium occurs at minimum average total cost, with each firm operating at its efficient scale. Competitive firms stay in business even though they are making zero economic profits in the long run. Recall that economists define total costs to include all the opportunity costs of the firm, so the zero-profit equilibrium is compensating the owners of the firm for their time and their money invested in the business.
Although the standard case is one where the long-run market supply curve is perfectly elastic, the long-run market supply curve might be upward sloping for two reasons:
· If an input necessary for production is in limited supply, an expansion of firms in that industry will raise the costs for all existing firms and increase the price as output supplied increases.
· If firms have different costs (some are more efficient than others) in order to induce new less efficient firms to enter the market, the price must increase to cover the less efficient firm's costs. In this case, only the marginal firm earns zero economic profits while more efficient firms earn profits in the long run.
Regardless of this, because firms can enter and exit more easily in the long run than in the short run, the long-run market supply curve is more elastic than the short-run market supply curve.
question
Questions for Review 4: Under what conditions will a firm shut down temporarily?
Explain
A firm will shut down temporarily if the revenue it would get from producing is less
than the variable cost of production. This occurs if price is less than average variable
cost (P < AVC)
question
Questions for Review 5: Under what conditions will a firm exit a market? Explain.
A firm will exit a market if the revenue it would get if it stayed in business is less
than its total cost. This occurs if price is less than average total cost (P < AT
question
Problem 1: What are the characteristics of a competitive market? Which of the
following drinks do you think is best described by these characteristics? Why aren't the
others?
a) Tap water
b) Bottled mineral water
c) Cola
d) Beer
A competitive market is one in which:
(1) there are many buyers and many sellers in the market;
(2) the goods offered by the various sellers are largely the same; and
(3) usually firms can freely enter or exit the market.
Of these goods, bottled mineral water is probably the closest to a competitive
market. Tap water is a natural monopoly because there is usually only one seller (the
price is much lower because the market is highly regulated). Cola and beer aren't
perfectly competitive because every brand is slightly different. Note: The same
argument holds for mineral water. In practice large price variations are a good
indicator of imperfect competition.
1 of 12
question
WHAT ARE COSTS?
The firm's goal is to maximise profit. This is simply the total revenue that it receives from selling its product minus the total cost of producing that product:
Profit = Total revenue - Total cost
Where total revenue = Price × Quantity sold
While total revenue is relatively straightforward, total cost is more complex. To an economist, cost means opportunity cost. It includes the explicit costs or money outlays that comprise accounting costs, of course, but it also includes implicit costs whenever resources that could have been used elsewhere are used by the firm. A small business that shows an accounting profit actually may be losing money in an economic sense, if we deduct all of the implicit costs of resources that the owner ties up in the firm rather than using elsewhere. The owner's labour, for example, is a real cost of operating the business even if there is no actual salary paid. The cost is the lost earnings from giving up the opportunity to work for someone else rather than the owner's actual salary from his or her own business. Similarly, the lost interest income on money the owner invests in the business is a real cost of doing business even though it is not an accounting cost. It is important to understand the following relationships:
Economic cost = Explicit costs + Implicit costs = Total opportunity cost
Accounting cost = Explicit cost
Economic profit = Total revenue - Total economic cost
Accounting profit = Total revenue - Explicit costs
question
PRODUCTION COSTS
For the following discussion we assume that the size of the production facility (factory) is fixed in the short run. Therefore this analysis describes production decisions in the short run.
A firm's costs reflect its production process. The production function shows the relationship between inputs and outputs. To simplify the discussion we will assume that the only variable input is labour. In the short run, this means looking at the relationship between the amount of labour used and the amount of output because we define the short run as a time period too short to allow increases in other inputs.
The marginal product of any input is the increase in output that arises from an additional unit of that input. Adding additional labour increases output, although at some point additional workers are subject to diminishing marginal product, which means that the last unit of labour hired adds less to total output than did the previous one. Diminishing marginal product occurs when workers are added without any change to fixed factors of production such as capital or land. Production functions exhibit diminishing marginal product. The slope of a production function gets flatter as more and more inputs are added to the production process.
As marginal product diminishes, the firm's total cost begins to rise at a more rapid rate because additional units of output cost more to produce (the same wage per worker results in less additional output, so the cost per additional unit produced rises). The total cost curve (showing the relationship between the quantity of output produced and the total cost of production) will therefore become steeper as the amount produced increases.
In the long run, expansion need not result in diminishing marginal product because land, labour and capital can be increased simultaneously.
question
VARIOUS MEASURES OF COST
If total cost is known for the various levels of output, it is possible to calculate all other measures of cost. The relationships between the cost measures are as follows:
Total cost (TC) = Fixed cost (FC) + Variable cost (VC)
Average fixed cost (AFC) = FC/Q
Average variable cost (AVC) = VC/Q
Average total cost (ATC) = Total cost (TC)/Quantity of output (Q)
also:
ATC = AFC + AVC
Marginal cost (MC) = ∆TC/ ∆Q = ∆VC/ ∆Q
where ∆ = 'change in'.
Marginal cost (MC) rises with output as soon as the point of diminishing marginal product is reached. The average total cost (ATC) curve is U-shaped. It declines initially because of the dominance of average fixed cost (AFC), which always declines as the fixed cost is spread over more units of output. Eventually, however, diminishing returns cause an increase in average variable costs (AVC), which in turn begin to increase ATC. The efficient scale of the firm is the quantity of output that minimises average total cost. The MC curve crosses the ATC curve at the efficient scale.
Often production first exhibits increasing marginal product and decreasing marginal cost at very low levels of output as the addition of workers allows for specialisation of skills. At higher levels of output, diminishing returns eventually set in and marginal costs begin to rise, causing the following relationships to hold:
· Marginal cost eventually rises with the quantity of output.
· The average total cost curve is 'U' shaped.
· The marginal cost curve crosses the average total cost curve and the average variable cost curve at the minimum points on these curves.
question
COSTS IN THE SHORT & LONG RUN
Because we define the long run as the time period long enough to vary capital and all other inputs, all costs become variable in the long run. As a result, diminishing marginal product is no longer a problem. There are no fixed inputs. Given enough time, firms can vary their scale of operation by acquiring more land and building additional factories in addition to hiring more labour (or they can cut back on their use of all inputs). This eliminates a major reason for the U-shaped ATC curve: the existence of fixed inputs. As a result, the long-run ATC curve is likely to be flatter than the short-run curve. To the extent that it is still U-shaped, the decreasing part of the curve is an area of economies of scale, in which increasing all inputs actually lowers long run ATC. The increasing part of the curve exhibits diseconomies of scale, a range in which increasing all inputs raises the long run average total cost. If there is a horizontal range, this is the area of constant returns to scale, in which increasing all inputs causes a proportionate increase in output, keeping ATC constant.
question
Distinguish between the Short Run and the Long Run.
The short run refers to a period of time when at least one factor is fixed, not to a
specific calendar time. It can vary in length of time, depending on the industry. For
example, the building on a new factory cannot be achieved overnight if you wished to
establish a steel manufacturing plant, whereas a dog walking service can be
established almost overnight. The long run refers to a period of time in which the
quantities of all inputs can be varied.
question
Problem 2: Your aunt is thinking about opening a hardware store. She estimates it
would cost \$500,000 per year to rent the store and buy the stock. In addition, she would
have to quit her \$50,000 per year job as an accountant

What is your aunt's opportunity cost of running a hardware store for a year? If
your aunt thought she could sell \$510,000 worth of merchandise in a year,
should she open the store? Explain.

@ The opportunity cost of running the hardware store is \$550,000, consisting of
\$500,000 to rent the store and buy the stock and a \$50,000 opportunity cost, since
your aunt would quit her job as an accountant to run the store. Since the total
opportunity cost of \$550,000 exceeds revenue of \$510,000, your aunt shouldn't open
the store, as her profit would be negative. She would lose money
A cost that does not depend on the quantity produced is a __fixed cost__.

In the ice-cream industry in the short run, _variable costs__ includes the cost of
cream and sugar, but not the cost of the factory.

Profits equal total revenue less ___ total cost ___.

The cost of producing an extra unit of output is __ marginal cost ___.

Define opportunity cost.

The opportunity cost of the value of the next best alternative, which must be forgone
to acquire (or consume) it.
question
WHAT IS A COMPETITIVE MARKET?
In a perfectly competitive market, there are so many buyers and sellers of a standardised good that no individual buyer or seller can influence price. That is, buyers and sellers are all price takers. This means that firms within a competitive market have no market power. In addition, competitive markets have no barriers to entry, so firms can enter or exit the industry easily in response to changing market conditions. Free entry and exit guarantees that competitive firms cannot earn economic profit in the long run
question
PROFIT MAXIMISATION & THE COMPETITIVE FIRM'S SUPPLY CURVE
Just like other firms, competitive firms desire to maximise profit. Remember that rational people make decisions at the margin. Everyone, from individuals to firms to societies, maximises wellbeing by following a general decision-making rule:
Do anything as long as marginal benefit is greater than or equal to marginal cost.

· The corollary to this rule is that firms maximise profit by comparing marginal revenue and marginal cost.
- For the competitive firm, marginal revenue is fixed at the price of the good and marginal cost is increasing as output rises.
- Note that fixed costs are irrelevant for making future decisions. Economists refer to fixed costs as sunk costs, because once they are incurred they cannot be recovered. A firm determines how much output to produce by equating marginal revenue and marginal cost, neither of which is affected by fixed cost.
· The profit-maximising firm needs to consider the following revenue measures:
Average revenue = Total revenue / Quantity
Marginal revenue = ∆Total revenue / ∆Quantity where ∆ = 'change in'.
· For the competitive firm, all sales occur at the market price, which does not change as the firm increases output. As a result, in perfect competition:
Average revenue = Marginal revenue = Price

· Hence to maximise profit using marginal analysis, the perfectly competitive firm produces until:
Marginal revenue = Price = Marginal cos

There are three general rules for profit maximisation:

1. If marginal revenue exceeds marginal cost, the firm should increase output to increase profit.

2. If marginal cost exceeds marginal revenue, the firm should decrease output to increase profit.

3. At the profit maximising level of output, marginal revenue and marginal cost are exactly equal.

From these three general rules we can see that at any price level, the firm will choose the quantity supplied by looking at the marginal cost curve, remembering that marginal revenue equals price in perfect competition. That is, the firm's marginal cost curve determines how much the firm is willing to supply at any price. This makes the marginal cost curve the firm's supply curve. The only qualification is that firms will not sell at a price below average variable cost. If price is below average variable cost, the firm is losing more money than if it were to shut down. Therefore, the competitive firm's supply curve in the short run is the portion of its marginal cost curve that lies above the average variable cost curve.
The shutdown rule:
In the short run, the firm shuts down if P < AVC (or if TR < TVC)

The analysis is similar in the long run, except that all costs are variable. Remember that in the long run all inputs and costs are variable. Consequently, the profit-maximising firm in the long run will not produce below average total cost (ATC). With P < ATC, the firm is incurring losses and will go out of business. On the other hand, if P > ATC, the firm will earn an economic profit, encouraging it to stay in business and encouraging other firms to enter the industry. The competitive firm's long run supply curve is the portion of its marginal cost curve that lies above its average total cost curve.
The exit rule:
In the long run, the firm exits if P < ATC (or if TR < TC)

Keep in mind the difference between economic and accounting profit. Economic profit includes all opportunity costs of time and capital. When a firm has zero economic profit it is enjoying a normal accounting profit. It is for this reason that firms are willing to continue to produce at a point of zero economic profit. In addition, any positive economic profit provides an incentive for firms to enter the industry
question
SUPPLY CURVE IN COMPETITIVE FIRM
Market supply is the summation of all of the individual supply curves. Long-run market supply includes potential as well as current competitors. If economic profits exist, new firms will enter the market, increasing supply and driving down price until the economic profits disappear in the long run. If economic losses exist, firms will exit the industry, decreasing supply and resulting in rising prices until economic losses disappear in the long run. The situation stabilises in the long run only when economic profit equals zero, which means that price equals average total cost. This long-run equilibrium occurs at minimum average total cost, with each firm operating at its efficient scale. Competitive firms stay in business even though they are making zero economic profits in the long run. Recall that economists define total costs to include all the opportunity costs of the firm, so the zero-profit equilibrium is compensating the owners of the firm for their time and their money invested in the business.
Although the standard case is one where the long-run market supply curve is perfectly elastic, the long-run market supply curve might be upward sloping for two reasons:
· If an input necessary for production is in limited supply, an expansion of firms in that industry will raise the costs for all existing firms and increase the price as output supplied increases.
· If firms have different costs (some are more efficient than others) in order to induce new less efficient firms to enter the market, the price must increase to cover the less efficient firm's costs. In this case, only the marginal firm earns zero economic profits while more efficient firms earn profits in the long run.
Regardless of this, because firms can enter and exit more easily in the long run than in the short run, the long-run market supply curve is more elastic than the short-run market supply curve.
question
Questions for Review 4: Under what conditions will a firm shut down temporarily?
Explain
A firm will shut down temporarily if the revenue it would get from producing is less
than the variable cost of production. This occurs if price is less than average variable
cost (P < AVC)
question
Questions for Review 5: Under what conditions will a firm exit a market? Explain.
A firm will exit a market if the revenue it would get if it stayed in business is less
than its total cost. This occurs if price is less than average total cost (P < AT
question
Problem 1: What are the characteristics of a competitive market? Which of the
following drinks do you think is best described by these characteristics? Why aren't the
others?
a) Tap water
b) Bottled mineral water
c) Cola
d) Beer
A competitive market is one in which:
(1) there are many buyers and many sellers in the market;
(2) the goods offered by the various sellers are largely the same; and
(3) usually firms can freely enter or exit the market.
Of these goods, bottled mineral water is probably the closest to a competitive
market. Tap water is a natural monopoly because there is usually only one seller (the
price is much lower because the market is highly regulated). Cola and beer aren't
perfectly competitive because every brand is slightly different. Note: The same
argument holds for mineral water. In practice large price variations are a good
indicator of imperfect competition.

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