The producer’s problem

Miller UN1105
How would an ethanol subsidy
affect ethanol producers?
Perfectly competitive market
1. No buyer or seller in the market is big
enough to influence the market price.

2. Sellers in the market produce identical

goods

3. There is free entry and exit in the market

Free entry and exit in the market

Sellers can always respond to potential profits or

losses by entering or exiting the market.
Profit maximization
Assume that firms have a single goal: maximize
profits
To do this, any seller has to think about 3 issues:

1. How to make the product

2. What is the cost of making the product?

3. How much can the seller get for the product in

the market?
What is a firm?
The short run
Period of time when some of the firm’s inputs
cannot be changed
The long run
Period of time when all of the firm’s inputs can
be changed
Factors of production
Variable factors of production
Inputs that can be changed in a certain period of
time; need more to produce more output
Fixed factors of production
Inputs that cannot be changed in the short-run
Production data for the Wisconsin
Cheeseman
(1) (2) (3)
Output per Number of Marginal Product
Day Workers
0 0 Blank
100 1 100
207 2 107
321 3 114
444 4 123
558 5 114
664 6 106
762 7 98
854 8 92
... ... ...
1,934 38 10
1,834 39 –100
Behavior of the marginal product
Workers are more efficient when they specialize in
particular production tasks; called specialization or
division of labor.

Eventually, marginal product falls

= law of diminishing returns
At some point, each additional worker contributes
less output than the worker before, when there
are some fixed factors of production.
Eventually, marginal product can even be
negative
How many workers should the Cheeseman
hire?
The short-run production function for
the Cheeseman
Costs
Short-run: Total Cost = Variable Cost + Fixed Cost

Variable Cost
The cost associated with the variable factors of
production. Variable costs change as the level of
output changes.
Fixed Cost
The cost associated with the fixed factors of
production. Fixed costs do not change as output
changes.
More costs:

Opportunity (or implicit) costs

Sunk costs
 Cost of Production
(10)
(1) (4) (6) (7) (8) (9)
(3) (5) Marginal
(2) Variable Total Cost Average Average Average
Output Marginal Fixed Cost (MC)
# Cost (TC) Total Cost Fixed Cost Variable
Per Product Cost (FC) = change in
Empl (VC) = (4) + (ATC) (AFC) Cost (AVC)
Day (6)/ change
(5) = (6)/(1) = (5)/(1) = (4)/(1)
in (1)

0 0 $0 $200 $200
100 1 100 $72 $200 $272 $2.72 $2.00 $0.72 $0.72
207 2 107 $144 $200 $344 $1.66 $0.97 $0.70 $0.67
321 3 114 $216 $200 $416 $1.29 $0.62 $0.67 $0.63
444 4 123 $288 $200 $488 $1.10 $0.45 $0.65 $0.59
558 5 114 $360 $200 $560 $1.00 $0.36 $0.65 $0.63
664 6 106 $432 $200 $632 $0.95 $0.30 $0.65 $0.68
762 7 99 $504 $200 $704 $0.92 $0.26 $0.66 $0.73
854 8 92 $576 $200 $776 $0.91 $0.23 $0.67 $0.79
Cost curves
How much of the product to make?
What additional information is needed?

What is the market price?

Revenue
The amount of money the firm brings in from the
sale of its product

Total revenue = Price x Quantity Sold

 The market versus The Wisconsin
Cheeseman

MR is Marginal Revenue
and here MR =Price = $1.13
What does a firm want to do?

Profit = Total Revenues – Total Costs

What kind of profit?
Accounting profit
Total revenue – Total costs (explicit only)

Economic profit
Total revenue – Total costs (explicit + implicit)
(1) Output (2) (5) (6) (7) Average (9) (10)
Per Day # Employed Fixed Cost Total Cost Total Cost Average Marginal
(FC) (TC) (ATC) Variable Cost (MC)
Cost (AVC)
0 0 $200 $200
100 1 $200 $272 $2.72 $0.72 $0.72
207 2 $200 $344 $1.66 $0.70 $0.67
321 3 $200 $416 $1.29 $0.67 $0.63
444 4 $200 $488 $1.10 $0.65 $0.59
558 5 $200 $560 $1.00 $0.65 $0.63
664 6 $200 $632 $0.95 $0.65 $0.68
762 7 $200 $704 $0.92 $0.66 $0.73
854 8 $200 $776 $0.91 $0.67 $0.79
939 9 $200 $848 $0.90 $0.69 $0.84
1019 10 $200 $920 $0.90 $0.71 $0.91
1092 11 $200 $992 $0.91 $0.73 $0.98
1161 12 $200 $1,064 $0.92 $0.74 $1.05
1225 13 $200 $1,136 $0.93 $0.76 $1.13
1284 14 $200 $1,208 $0.94 $0.79 $1.21
1339 15 $200 $1,280 $0.96 $0.81 $1.31
1390 16 $200 $1,352 $0.97 $0.83 $1.40
Condition for profit maximization

MR=MC

For a competitive firm, MR= market price, so:

Price = MC
The Wisconsin Cheeseman’s profits
Profits = Total Revenues – Total Costs

Total Revenue = P x Q

Total Cost = ATC x Q

Profit = (P x Q) – (ATC x Q) = (P – ATC) x Q

= (P – ATC) x Q
In our example:
P = $1.13
Q = 1,225
ATC = $0.93
So, Profit = ($1.13 – 0.93) x 1,225
= $245

…and the firm will be happy with any economic

profit, because TC includes best alternative use
of resources
(1) Output (2) (5) (6) (7) Average (9) (10)
Per Day # Employed Fixed Cost Total Cost Total Cost Average Marginal
(FC) (TC) (ATC) Variable Cost (MC)
Cost (AVC)
0 0 $200 $200
100 1 $200 $272 $2.72 $0.72 $0.72
207 2 $200 $344 $1.66 $0.70 $0.67
321 3 $200 $416 $1.29 $0.67 $0.63
444 4 $200 $488 $1.10 $0.65 $0.59
558 5 $200 $560 $1.00 $0.65 $0.63
664 6 $200 $632 $0.95 $0.65 $0.68
762 7 $200 $704 $0.92 $0.66 $0.73
854 8 $200 $776 $0.91 $0.67 $0.79
939 9 $200 $848 $0.90 $0.69 $0.84
1019 10 $200 $920 $0.90 $0.71 $0.91
1092 11 $200 $992 $0.91 $0.73 $0.98
1161 12 $200 $1,064 $0.92 $0.74 $1.05
1225 13 $200 $1,136 $0.93 $0.76 $1.13
1284 14 $200 $1,208 $0.94 $0.79 $1.21
1339 15 $200 $1,280 $0.96 $0.81 $1.31
1390 16 $200 $1,352 $0.97 $0.83 $1.40
Price changes and the firm decision
Price elasticity of supply
How responsive producers are to
changes in the market price

% change in quantity supplied/%change in price

Elastic Supply - any percentage change in price
causes a greater percentage change in quantity
supplied (εs > 1)
Inelastic Supply - any percentage change in
price causes a smaller percentage change in
quantity supplied (εs < 1)
Unit-Elastic Supply – change in prices leads to
equal percentage change in quantity (εs = 1)
Possible supply curves
Some factors that will increase
supply elasticity
• The more inventory the firm has
• The more easily the firm can hire workers (or
more generally, how many factors are variable
and how easily variable)
• The longer the time horizon
If I raised a crop of, say, strawberries, when
would I be willing to let it rot in the field?
The short-term operating decision
Options:
1. Stay open
What costs do you pay?
Fixed + Variable
2. Close
What costs do you pay?
Fixed
Should I harvest?
If price (MR) isn’t high enough to cover the
costs to pay workers to harvest then it
doesn’t make sense to harvest

This is a shutdown in the short run

Short-run shutdown
The decision to stop producing in the short
run occurs if price falls below AVC
The Wisconsin Cheeseman’s
shutdown decision
MC = Supply

But is that always the case?

Is it true for all prices?

Short-Run Supply Curve: Portion of
the MC Above AVC
Producer surplus
The difference between the price the firm
would be willing to accept and the market
price
The difference between the market price and
the supply curve
Measuring producer surplus
Producer
Surplus is
the area
below price
but above
supply (MC)
Producer surplus for trucking services
Short run = some factors are fixed.

Change labor (e.g.)

Long run = all factors variable.

How to change output? Change all

input factors (e.g. capital)

Long-run supply curves
Economies of scale
ATC falls as output increases
Example: if all inputs double, output more
than doubles

Why? Could be:

• Large set-up costs
• Worker specialization
Constant returns to scale
ATC constant as output increases
Example: if all inputs double, output doubles

Why?

• Gains from specialization all realized

• Replication
Diseconomies of scale
ATC increases as output increases
Example: inputs double, output less than double

Why?

• Fixed factors

• Top-heavy firm (too much

management)
Long-Run Supply Curves
Long run: firms can enter or exit an
industry
Wholesale cheese entry decision
Firm entry in the long-run
Firms exit after demand shifts
leftward
Why the long-run supply curve is
(often) horizontal
Profits in the long-run
If the industry structure is such that in the long-
run price=ATC, what are profits?

What does this mean for firms who are not

maximizing profit?
Number of ethanol plants and number
of plants under construction