ECON7002: Lecture 4

Firm Behaviour
&
Perfect Competition
(Part I)

University of Queensland
Semester 1 2021
Outline of Today’s Lecture
1) Technology, Production and Costs
a) Terminology: technology, short run vs. long run
b) The marginal product of labour and marginal cost (the law of diminishing returns)
c) Average costs of production
d) Long run costs and economies of scale

2) Firm Decisions in Perfectly Competitive Markets – Part I

a) What is a perfectly competitive market?
b) The demand curve of a perfectly competitive firm
c) Profit maximization for a perfectly competitive firm
d) The firm’s short run supply curve
Technology and Production Costs
• Firms are usually assumed to be motivated by profit maximization

𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑇𝑇𝑃𝑃𝑃𝑃𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 − 𝑇𝑇𝑃𝑃𝑃𝑃𝑇𝑇𝑇𝑇 𝐶𝐶𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

Motivation
1. We need to have a good understanding of production and costs,
to understand firms’ decisions such as:
• Quantity to Supply; and
• Prices to charge.
2. We have seen so far that the supply curve is the marginal cost curve
• Law of Supply – Supply Curve is upwards sloping
• But why do marginal costs increase with quantity supplied?
Technology: An Economic Definition
• Basic activity of Firms:
• To use Inputs, such as Labour, Machines (Capital) and Natural Resources
• To produce Output of Goods and Services
• A Firm’s Technology – refers to the processes that a firm uses to
convert inputs into output.

Labour

Technology Output
Capital

Natural
Resources
Technology: An Economic Definition
• In economics, Technology refers not only to the types of machines used, but also
how all the inputs are organized and utilized.
• Technology can refers to (as examples):
• Training of the workers
• How the production floor is managed and organized
• The types of machines used etc.
• Technological Change/Progress
• Has occurred if Firms are able to produce More Output with the Same Amount of Inputs.
• i.e. production efficiency has increased.
• Examples of sources of technological progress
• Better (not just more) machinery and equipment
• Better trained or educated workers
• Better organization and management methods.
Example of
Technological Process:
Ford Assembly Line

• Specialization of Labour – each

worker only performs one task
• Moving conveyors for vehicles
and parts – workers stay in the
same stations
• Assembly time dropped from
12 hours to 90 minutes
• Price of each Model T dropped
from $850 to $300.
Time Frame of Analysis:
Long Run versus Short Run
• When considering the relationship between output and production
costs, economists distinguish between the Long Run and the Short
Run.
• In the Short Run, at least one of the inputs is fixed.
• For many firms, the size of the factory, the number of machines is fixed over a
short time frame such as a month, regardless of level of output.
• While the quantity of raw materials used varies with the level of output.
• In the Long Run, the firm can vary the levels of all inputs used.
• Over a decade, a firm can easily change the size of its production facilities by
building new factories, etc.
Time Frame of Analysis:
Long Run versus Short Run
• What is considered the Long-run versus the Short-run depends on
the industry.

• For example:
• It takes >4 years for apple trees to mature and bear fruit.
• This implies that it takes at least 4 years for a Fruit Farm to increase the number of Apple
Trees – an input to producing Apples.
• So Long-Run for an Apple Farm is a period of at least 4 years if not longer.
• An online vendor (on Ebay for example) can easily change all of its inputs
required for online sales.
• Long-run for online sales might be on the scale of months.
Components of Costs: Variable vs. Fixed Costs
• In the Short Run, Total Cost (TC) of production consists of
• Fixed Costs (FC): Cost of Fixed Inputs that does not change with level of
output.
• e.g. Lease for retail/factory space, wages of permanent staff, interest payments for loans
• Variable Costs (VC): Costs of Variable Inputs that changes with quantity
produced.
• e.g. Cost of raw materials, Wages of casual workers, Cost of Electricity
• Since Total Costs and Variable Costs change with Output (Q), we can
write
𝑇𝑇𝐶𝐶 𝑄𝑄 = 𝐹𝐹𝐶𝐶 + 𝑉𝑉𝐶𝐶(𝑄𝑄)
• 𝑇𝑇𝐶𝐶 𝑄𝑄 𝑃𝑃𝑃𝑃 𝑃𝑃𝑡𝑅𝑅 𝑇𝑇𝑃𝑃𝑃𝑃𝑇𝑇𝑇𝑇 𝐶𝐶𝑃𝑃𝑃𝑃𝑃𝑃 𝑤𝑤𝑡𝑅𝑅𝑅𝑅 𝑄𝑄 𝑅𝑅𝑅𝑅𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃 𝑝𝑝𝑃𝑃𝑃𝑃𝑝𝑝𝑅𝑅𝑝𝑝𝑅𝑅𝑝𝑝
• 𝑉𝑉𝐶𝐶 𝑄𝑄 𝑃𝑃𝑃𝑃 𝑃𝑃𝑡𝑅𝑅 𝑉𝑉𝑇𝑇𝑃𝑃𝑃𝑃𝑇𝑇𝑉𝑉𝑇𝑇𝑅𝑅 𝐶𝐶𝑃𝑃𝑃𝑃𝑃𝑃 𝑤𝑤𝑡𝑅𝑅𝑅𝑅 𝑄𝑄 𝑅𝑅𝑅𝑅𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃 𝑝𝑝𝑃𝑃𝑃𝑃𝑝𝑝𝑅𝑅𝑝𝑝𝑅𝑅𝑝𝑝
The Production Function
• Before examining the costs of production, we must first look at the
production function – the relationship between
• The levels (or quantities) of the various inputs used,
• and the maximum level of output that can be produced with the inputs.

• So the Production function tells us the number of drinks (output) that can
be produced for a given level of machines and workers.
• Output function can be represented either
• as Functions for example: 𝑄𝑄 𝐾𝐾, 𝐿𝐿 = 𝐾𝐾 × 𝐿𝐿
– output is the product of the level of capital used (𝐾𝐾) and workers employed (𝐿𝐿)
• Or as a Table/Schedule
Example: The Production Function
• To keep the discussion simple, consider a small café that uses only
• Capital – Expresso Machines
• Labour – Workers
• Ignore all other costs other than the cost of Expresso Machines (leased) and
cost of labour (wages).
• In the Short run, let’s assume that the
• Number of expresso machines (𝐾𝐾) employed by the café is fixed.
• 𝐾𝐾 is a fixed input in the short-run; cost of leasing expresso machines is a fixed cost.
• But the Number of Workers (𝐿𝐿) can be varied
(the workers are Uni students working on a part-time casual basis)
• 𝐿𝐿 is a variable input in the short-run; cost of labour is a variable cost.
Marginal Product of Labour
• A decision facing the café owner might be: “How many workers
should I employ?”
• To answer that question, she needs to consider the value of each
additional worker to the business – i.e. how much can that additional
worker produce – or that worker’s marginal product.

• The Marginal Product of Labour (MPL): The additional output that

the firm can produce as a result of hiring one more worker.
Example: Short Run Production
• The Production Function of the Café is presented as a Table below.
• Complete the column for Marginal Product of Labour (MPL)
Quantity of Quantity of Output (Q) Marginal Product
Workers (L) Machines (K) of Labour
0 2 0 -
1 2 20
2 2 60
3 2 120
4 2 170
5 2 200
6 2 210
Short Run Production
• The Production Function of the Café is presented as a Table below.
• Complete the column for Marginal Product of Labour (MPL)
Quantity of Quantity of Output (Q) Marginal Product
Workers (L) Machines (K) of Labour
0 2 0 -
1 2 20 20
2 2 60 40
3 2 120 60
4 2 170 50
5 2 200 30
6 2 210 10
Gains to Marginal Product of Labour from
Specialization and Division of Labour
Notice that
• When the number of workers employed is low, Increasing the number
of workers increases the Marginal Product of Labour
• i.e. each additional worker adds more output than the worker before.
• For example:
• If there is only one worker, that worker can only produce 20 drinks
𝑀𝑀𝑃𝑃𝐿𝐿(1) = 20
• The second worker increases output by 40 drinks
𝑀𝑀𝑃𝑃𝐿𝐿 2 = 40
• Why?
Gains to Marginal Product of Labour from
Specialization and Division of Labour
Intuitively:
• If there is only one worker – that worker has to do everything
• Answer the phone, reply to, emails, order new coffee beans, write the menu,
make coffee, prepare food, etc.
• When the 2nd worker is employed
• The workers can split up their tasks (Division of Labour)
– Jane can focus on Drink preparation while John can focus on the logistical
tasks
• Division of Tasks – cuts down on the wasted time moving from one task to
another – task increasing efficiency.
• Hence 2 workers can produce more than twice of what 1 worker can produce
Gains to Marginal Product of Labour from
Specialization and Division of Labour
• Furthermore, Division of Labour allows Specialization
• For example, if there are 3 workers:
• Jane and John can focus on food preparation
• Jeanette can focus on logistical and management tasks, such as ordering produce,
preparing menus, answering phones and email queries etc.
• Each worker performs the same task over and over again
• Learns quickly how to be efficient at that task.
• Thus, when the level of labour (workers) is low, the marginal product
of labour increases as additional workers are employed, due to
• Specialization and Division of Tasks
Law of Diminishing Returns
• But notice that at a certain point, adding more workers results in
decreasing marginal product of labour
• In our example, after the 3rd worker, the marginal product of additional workers
started to decrease.
• This is an example of the Law of Diminishing Returns which states:
Adding more of a variable input (such as labour) to the same amount of
fixed inputs (expresso machines) will eventually cause marginal product of
that variable input to decrease.
• For example:
• If there are 2 expresso machines and 1 person focused on making coffees, adding one more
worker allows the 2nd expresso machine to be used more efficiently.
• If there are 10 workers and 2 expresso machines, many of the workers will be waiting to use
the expresso machines to make coffee – adding one more worker is not going to increase the
number of drinks produced much (if at all).
Graphing the Marginal Product of Labour
Marginal
Product of Division of Labour and
Specialization result in increasing But Law of Diminishing Returns kicks in
Labour when level of Labour Input is high
MPL when Labour Input is Low

MPL Decreasing as
MPL Increasing as Labour Input
Labour Input increases increases

Number of Workers
Marginal Cost of Production
• Recall that the marginal cost is the additional cost to a firm of
producing one more unit of a good or service.
• We calculate Marginal Cost for a particular increase in output as
follows:
Δ𝑇𝑇𝐶𝐶
𝑀𝑀𝐶𝐶 =
Δ𝑄𝑄
• Δ𝑇𝑇𝐶𝐶 is the change in total cost
• Δ𝑄𝑄 is the change in quantity
Example: Costs of Production
• Suppose the cost of
• Each espresso machine is $15
• Each worker is $10
• Complete the table in the following slide
Example: Costs of Production

Quantity of Quantity of Output (Q) Fixed Cost Variable Cost Total Cost Marginal
Workers (L) Machines (K) (FC) (VC) (TC) Cost (MC)
0 2 0 30 0 30 -
1 2 20
2 2 60
3 2 120
4 2 170
5 2 200
6 2 210
 FC = number of machines x cost per
Example: Fixed Cost machine

Quantity of Quantity of Output (Q) Fixed Cost Variable Cost Total Cost Marginal
Workers (L) Machines (K) (FC) (VC) (TC) Cost (MC)
0 2 0 30 0 30 -
1 2 20 30
2 2 60 30
3 2 120 30
4 2 170 30
5 2 200 30
6 2 210 30
 VC = number of workers x cost per
Example: Variable Cost worker

Quantity of Quantity of Output (Q) Fixed Cost Variable Cost Total Cost Marginal
Workers (L) Machines (K) (FC) (VC) (TC) Cost (MC)
0 2 0 30 0 30 -
1 2 20 30 10
2 2 60 30 20
3 2 120 30 30
4 2 170 30 40
5 2 200 30 50
6 2 210 30 60
 TC = Fixed Cost + Variable Cost
Example: Total Cost

Quantity of Quantity of Output (Q) Fixed Cost Variable Cost Total Cost Marginal
Workers (L) Machines (K) (FC) (VC) (TC) Cost (MC)
0 2 0 30 0 30 -
1 2 20 30 10 40
2 2 60 30 20 50
3 2 120 30 30 60
4 2 170 30 40 70
5 2 200 30 50 80
6 2 210 30 60 90
Example: Marginal Cost MC =
Δ𝑇𝑇𝑇𝑇
Δ𝑄𝑄
=
Δ𝑉𝑉𝑇𝑇
Δ𝑄𝑄

Quantity of Quantity of Output (Q) Fixed Cost Variable Cost Total Cost Marginal Cost
Workers (L) Machines (K) (FC) (VC) (TC) (MC)
0 2 0 30 0 30 -
10 1
1 2 20 30 10 40 = = 0.50
20 2
10 1
2 2 60 30 20 50 = = 0.25
40 4
10 1
3 2 120 30 30 60 60
= 6 = 0.17
10 1
4 2 170 30 40 70 = = 0.20
50 5
10 1
5 2 200 30 50 80 30
= 3=0.33
10
6 2 210 30 60 90 10
=1
Inverse Relationship between MC and MPL
𝑊𝑊𝑇𝑇𝑊𝑊𝑅𝑅
𝑀𝑀𝐶𝐶 =
𝑀𝑀𝑃𝑃𝐿𝐿
• Increases in MPL result in decreases in MC and vice versa.
• For small levels of Labour (and hence small levels of output)
• Specialization and Division of Labour increases MPL as Labour and Output increases.
• Implying that for small levels of output, MC is decreasing in output.
• For high levels of Labour and Output
• The law of diminishing returns means that MPL decreases as output increases
• Implying that for high levels of output, MC is increasing in output
• Takeaway: The Marginal Cost Curve is U-shaped!
Shape of the Marginal Cost Curve
Increase in Output decreases Increase in Output increases
Marginal Cost due to specialization Marginal Cost due to diminishing
and division of labour returns to labour

MC(Q)

Shortly, we’ll learn why firms

will only supply where the MC
curve is upward sloping, i.e.
why the Supply curve is
upward sloping.

Output (Q)
Average Costs of Production
𝑇𝑇𝐶𝐶 𝑄𝑄
𝐴𝐴𝑅𝑅𝑅𝑅𝑃𝑃𝑇𝑇𝑊𝑊𝑅𝑅 𝑇𝑇𝑃𝑃𝑃𝑃𝑇𝑇𝑇𝑇 𝐶𝐶𝑃𝑃𝑃𝑃𝑃𝑃 = 𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄 = = 𝐴𝐴𝐹𝐹𝐶𝐶 + 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄)
𝑄𝑄

𝑉𝑉𝐶𝐶 𝑄𝑄
𝐴𝐴𝑅𝑅𝑅𝑅𝑃𝑃𝑇𝑇𝑊𝑊𝑅𝑅 𝑉𝑉𝑇𝑇𝑃𝑃𝑃𝑃𝑇𝑇𝑉𝑉𝑇𝑇𝑅𝑅 𝐶𝐶𝑃𝑃𝑃𝑃𝑃𝑃 = 𝐴𝐴𝑉𝑉𝐶𝐶 𝑄𝑄 =
𝑄𝑄

𝐹𝐹𝐶𝐶
𝐴𝐴𝑅𝑅𝑅𝑅𝑃𝑃𝑇𝑇𝑊𝑊𝑅𝑅 𝐹𝐹𝑃𝑃𝐹𝐹𝑅𝑅𝑝𝑝 𝐶𝐶𝑃𝑃𝑃𝑃𝑃𝑃 = 𝐴𝐴𝐹𝐹𝐶𝐶(𝑄𝑄) = = 𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄 − 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄)
𝑄𝑄
 AFC = FC / Q
Example: Average Fixed Costs
Workers Machine Output Fixed Variable Total Marginal AFC AVC ATC
(L) s (K) (Q) Cost (FC) Cost (VC) Cost (TC) Cost
(MC)
0 2 0 30 0 30 - -
1 2 20 30 10 40 0.50 1.50
2 2 60 30 20 50 0.25 0.50
3 2 120 30 30 60 0.17 0.25
4 2 170 30 40 70 0.20 0.18
5 2 200 30 50 80 0.33 0.15
6 2 210 30 60 90 1 0.14

Notice that AFC are very high at low levels of output but decline as Q increases.
 Example: Average Costs AVC = VC / Q ATC = TC / Q

Workers Machine Output Fixed Variable Total Marginal AFC AVC ATC
(L) s (K) (Q) Cost (FC) Cost (VC) Cost (TC) Cost
(MC)
0 2 0 30 0 30 - - - -
1 2 20 30 10 40 0.50 1.50 0.50 2
2 2 60 30 20 50 0.25 0.50 0.33 0.83
3 2 120 30 30 60 0.17 0.25 0.25 0.50
4 2 170 30 40 70 0.20 0.18 0.23 0.41
5 2 200 30 50 80 0.33 0.15 0.25 0.40
6 2 210 30 60 90 1 0.14 0.29 0.43

• Both AVC and ATC are U-shaped (like MC), but the turning points are different
• ATC and AVC get closer together as Q increases
Average Total Cost
• Since 𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄 = 𝐴𝐴𝐹𝐹𝐶𝐶(𝑄𝑄) + 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄)
• At low levels of output, ATC will be very high since AFC are high
• At higher levels of output, 𝐴𝐴𝐹𝐹𝐶𝐶 will be low but 𝑉𝑉𝐶𝐶 might be high, so ATC
might be high as well
• But at intermediate levels of output, A𝑉𝑉𝐶𝐶 and 𝐴𝐴𝐹𝐹𝐶𝐶 might be both be low
• Takeaway – the ATC curve is often U-shaped.
• Question – is there anyway to predict when the ATC is minimized?
Shape of Average Total Cost Curve

ATC(Q)

Min. ATC

Output (Q)
Relationship between ATC and MC
• If 𝐴𝐴𝑇𝑇𝐶𝐶 < 𝑀𝑀𝐶𝐶
• 𝐴𝐴𝑇𝑇𝐶𝐶 must be increasing (Δ𝐴𝐴𝑇𝑇𝐶𝐶 > 0)
• The ATC curve is sloping up

• If 𝐴𝐴𝑇𝑇𝐶𝐶 > 𝑀𝑀𝐶𝐶

• 𝐴𝐴𝑇𝑇𝐶𝐶 must be decreasing (Δ𝐴𝐴𝑇𝑇𝐶𝐶 < 0)
• The ATC curve is sloping down

• If 𝐴𝐴𝑇𝑇𝐶𝐶 = 𝑀𝑀𝐶𝐶
• 𝐴𝐴𝑇𝑇𝐶𝐶 is neither increasing nor decreasing (for a very small change in Q)
• i.e. the ATC curve is neither sloping up nor down.
• Why?
Relationship between ATC and MC
• Intuitive Example:
• If your current Grade Point Average is 7
(i.e. the average of all your course grades to date)
• You received a 6 in your next course – will your average go up or down?
Relationship between ATC and MC
• Implications
• Whenever the ATC curve is above the MC curve (ATC>MC)
• The ATC curve is sloping down
• Whenever the ATC curve is below the MC curve (ATC<MC)
• The ATC curve is sloping up
• Where the ATC curve intersects the MC curve (ATC=MC)
• The ATC curve is neither sloping up nor down
• We have found the level out output at which ATC is minimized!
• The same relationship exists between AVC and MC as well!
Relationship between ATC, AVC and MC
$
ATC(Q)
MC(Q) AVC(Q)

Min ATC
AFC(Q)=ATC(Q)-AVC(Q)
Min AVC Notice that as Q increases,
AFC decreases

Output (Q)
Costs in the Long Run
• The Long-run refers to a period of time sufficiently long for the firm to
be able to vary all inputs.
• For example:
• once a firm’s lease for its factory building runs out, it is free to choose to rent a bigger or
smaller building.
• Over a period of more than 4 years, apple farmers can increase the number of fruit
bearing apple trees they own.
• So in the Long Run – all inputs and hence all costs are variable.
• There are no fixed costs in the Long Run
𝑇𝑇𝑃𝑃𝑃𝑃𝑇𝑇𝑇𝑇 𝐶𝐶𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑉𝑉𝑇𝑇𝑃𝑃𝑃𝑃𝑇𝑇𝑉𝑉𝑇𝑇𝑅𝑅 𝐶𝐶𝑃𝑃𝑃𝑃𝑃𝑃
• There is no distinction between ATC and AVC – so we simply use
Average Cost (AC).
Long Run Decisions
• Firms often engage in decision making for the Long Run and Short
Run simultaneously.
• For example, consider a Car Manufacturer:
• Short Run Decisions: How can the firm make use of the fixed inputs that
cannot be varied in the SR, such as size of factory, number of metal presses,
number of qualified engineers, etc, to maximize profits?
• Long Run Decisions: Will the firm be more profitable if it changes the size of
its factory, invests into more metal presses, changes the number of
engineers?
• i.e. should the firm plan to change the SR Fixed Inputs?
• Can the firm be more profitable by changing its scale of production?
Long Run Average Cost Curve
• Short Run Average Total Cost (ATC) curves shows how ATC changes
with output, when some inputs are fixed.

• Long Run Average Cost (LRAC) Curve shows the lowest possible
Average Cost of production, when all inputs are allowed to vary.

• The Long Run Average Cost Curve is determined by the Short Run
ATCs when the “fixed” inputs are varied.
Example: Long Run Average Cost Curve
• Suppose a Firm is deciding on the size of the factory space to lease:
• Option 𝐴𝐴: Rent a Small Factory (10,000 𝑚𝑚2 )
• Option 𝐵𝐵: Rent a Medium Factory (20,000 𝑚𝑚2 )
• Option 𝐶𝐶: Rent a Large Factory (40,000 𝑚𝑚2 )
• Option 𝐷𝐷: Rent a Ginormous Factory (100,000 𝑚𝑚2 )

• Once it has made a decision and entered into a 2 year lease agreement, it
cannot change the factory size until the lease expires
• In the short run (<2 years), factory size is a fixed input
• In the long run (>2 years), factory size can be varied.

• Side Note:2 The options stated above are just for simplicity of explanation. The firm can choose any floor area it desires (i.e.
42,112 𝑚𝑚 is an option).
Example: Long Run Average Cost Curve
$

𝑆𝑆𝑅𝑅𝐴𝐴𝑇𝑇𝐶𝐶 𝑆𝑆𝑅𝑅𝐴𝐴𝑇𝑇𝐶𝐶 𝑆𝑆𝑅𝑅𝐴𝐴𝑇𝑇𝐶𝐶

𝑆𝑆𝑅𝑅𝐴𝐴𝑇𝑇𝐶𝐶
𝑂𝑂𝑝𝑝𝑃𝑃𝑃𝑃𝑃𝑃𝑅𝑅 𝐴𝐴 𝑂𝑂𝑝𝑝𝑃𝑃𝑃𝑃𝑃𝑃𝑅𝑅 𝐶𝐶 𝑂𝑂𝑝𝑝𝑃𝑃𝑃𝑃𝑃𝑃𝑅𝑅 𝐷𝐷
𝑂𝑂𝑝𝑝𝑃𝑃𝑃𝑃𝑃𝑃𝑅𝑅 𝐵𝐵

Long Run Average Cost

Output (Q)
Economies of Scale
• We say that a Firm experiences:
• Economies of Scale (or Increasing Returns to Scale):
If LR-AC Decreases as Scale of Production (or Output) Increases
• Diseconomies of Scale (or Decreasing Returns to Scale):
If LR-AC Increases as Scale of Production (or Output) Increases
• Constant Returns to Scale:
If LR-AC is Unchanged by changes to Scale of Production (or Output)

• Efficient Scale of Production: Scale of Production (Output) at which Long

Run Average Cost is minimized.
• Minimum Efficient Scale: The smallest possible Output at which LRAC is
minimized – i.e. the smallest possible efficient scale.
Long Run Average Cost Curve
Diseconomies of Scale
Economies of Scale LRAC increasing
LRAC decreasing
Long Run Average Cost (LRAC)

Constant Returns to Scale

LRAC remains unchanged

Min LRAC

Output (Q)
Minimum Efficient Scale
Reasons for Economies of Scale
Why do firms experience economies of scale
• a decrease in LRAC as outputs increase / as the firm gets larger.

1. Specialization of Labour – a larger number of employees allows

employees to specialize in specific tasks.
• Increasing some fixed inputs like floor space allows more workers to be
employed. This in turn allows specialization of labour.
2. Overhead costs may not scale linearly with output
• For example, a small factory producing 100 units per month may use 1000
kwh of electricity a day, but a large factory producing 1000 units per month
may only use 2000 kwh of electricity a day.
Reasons for Economies of Scale
3. Bargaining power with suppliers:
As scale of production increases, quantity of materials purchased
from suppliers will increase. If the firm is one of the few large
purchasers of the raw material, the firm may be able to negotiate
better prices from suppliers.

4. Lower Interest Rates on Loans

Large firms tend to be perceived to be more credit worthy. Banks
may be willing to offer lower interest rates as there is a lower risk of
loan default.
Reasons for Diseconomies of Scale
Why do firms experience diseconomies of scale
• a Increase in LRAC as outputs increase / as the firm gets larger.

• Increasing complexity of management and organization structure.

As firms get larger, it becomes more difficult to monitor the activities
of employees and to maintain control of production processes. Firms
respond by increasing management layers, which in turn increases
overhead costs.
• This is an interesting part of Industrial Economics
Implications of Economies of Scale
• Most firms try to build factories/scale production facilities so that
they produce at least at the minimum efficient scale
• In order to obtain the lowest possible average cost of production.
• But not so large as to experience diseconomies of scale.
• This is why you very often see startups (e.g. Amazon) willing to suffer a few
years of losses in order to quickly grow the business to efficient scales.
• Minimizing average cost of production confers pricing advantages
versus competitors.
Outline of Today’s Lecture
1) Technology, Production and Costs
a) Terminology: technology, short run vs. long run
b) The marginal product of labour and marginal cost (the law of diminishing returns)
c) Average costs of production
d) Long run costs and economies of scale

2) Firm Decisions in Perfectly Competitive Markets – Part I

a) What is a perfectly competitive market?
b) The demand curve of a perfectly competitive firm
c) Profit maximization for a perfectly competitive firm
d) The firm’s short run supply curve
Copyright © 2019 Pearson Australia (a division of Pearson Australia Group Pty Ltd)
9781488616983 / Hubbard / Essentials of Economics 4e
A Perfectly Competitive Market is
Characterized by the Following Features:
• Many Buyers and Sellers: Each of whom is small relative to the
market.
• Example: Total market quantity is 100 Million, but each consumer only buys at
most 10 units and each seller can sell at most 100 units.
• Perfect Information: Every firm and consumer knows the prices
charged by each firm. Every firm and potential market entrants knows
the production costs, profits and losses of every firm in the industry.
• Each Firm sells an identical product: Every firm’s product is a perfect
substitute for every other firms’.
• Free Market Entry: There are no barriers to entry, new firms can
easily enter the market in the long run.
Perfectly Competitive Markets
• No industry in the real world is Perfectly Competitive – due to
• Product Differentiation: different firms often sell similar but not identical
products.
• e.g. In the market for cars, the models offered by each firm are slightly different - BMW
340i has an in-line 6 cylinder engine while the Mercedes C43 AMG has a V6 engine.
• Barriers to Entry: difficult for new firms to enter the market
• e.g. Difficult for new firms to enter the Commercial Passenger Aircraft Industry due to
high startup costs, access to qualified engineers, access to technology protected by
patents, onerous certification requirements etc.
Examples of Close to Perfectly Competitive
Markets
• Stock Markets
• Many different Sellers (Brokers) and Buyers
• Each broker can sell the same company’s shares – e.g. any broker can sell
Telstra shares – identical products from different sellers.
• Each brokers’ price is publicly available (Perfect Information)
• However, Barriers to Entry exists – Stock Brokers must be Licensed and
licenses might be difficult to get.
Examples of Close to Perfectly Competitive
Markets
• Markets for Commodities such as Coal
• Many different Mining Companies and Buyers
• Market Price of Coal is publicly available (Perfect Information)
• However, different grades of coal exist and each mining company may
produce different types of coal.
• And Barriers to Entry and Exit exist
• Numerous environmental impact studies and licenses required to start a new coal mine.
• Closing Coal Mines is also costly – Coal extraction results in toxic waste products that are
typically stored onsite. Owners responsible for clean up costs if they choose to shut the
mine down, as they are usually required to rehabilitate the mine site. (No surprise –
many mining firms choose to dodge these obligations…)
Examples of Close to Perfectly Competitive
Markets
• Many examples of close to perfectly competitive markets
• Agricultural commodities such as rice, wheat, etc.
• Foreign Exchange markets
• But important to note that most industries are NOT perfectly
competitive (or even close to it).
• But perfectly competitive markets are still a useful model/benchmark
to consider how markets can help
• Determine which goods and services are produced and who will receive
them. (Allocative efficiency)
• Determine how goods and services will be produced (Productive efficiency)
Price Taking Buyers and Sellers
• In a perfectly competitive market, the Market Price is determined by
the interaction of Demand and Supply.
• Each Buyer and Seller is “small” relative to the market.
Each individual’s decisions will not affect the market price.
• For example:
• If a Café choose to buy more coffee beans this week, this will not influence the global
price of coffee beans.
• If an individual coffee farmer chooses to sell less beans this year, this will not influence
the global price of coffee beans either.
• Every Buyer and Every Seller has to buy and sell at the market price,
and cannot influence the market price unilaterally.
• We say that they are price-takers (as opposed to price-makers)
Demand Curve facing Individual Firms
• Suppose a Firm, “Happy Hamsters”, operates in a perfectly
competitive market.
• In this market, the equilibrium market price is 𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 50,
with equilibrium market quantity 𝑄𝑄𝐷𝐷 𝑃𝑃∗ = 50000.
• The Market Demand Curve is obviously downward sloping.
• What does the Demand for the Firm’s output look like?
Example: Market Demand and Equilibrium
𝑃𝑃𝑃𝑃𝑃𝑃𝑝𝑝𝑅𝑅 ($)
Market Supply

𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 50

Market Demand

50,000 𝑄𝑄𝑅𝑅𝑇𝑇𝑅𝑅𝑃𝑃𝑃𝑃𝑃𝑃𝑄𝑄
Demand Curve facing Individual Firms
• What does the Demand for the Firm’s output look like?
• Strictly speaking, the Firm has the ability to charge any price 𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹
it wants – i.e. not illegal to charge a price other than the market price
that every other firm is charging.
• But every other firm is selling at the market price 𝑃𝑃∗ = 50.
• So if the firm charges 𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 > 𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
• The firm will be the most expensive seller in the market
• No buyer will buy from the firm.
• Hence 𝑄𝑄𝐷𝐷𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 = 0 for all 𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 > 𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
Demand Facing the Individual Firm
𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹

𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 > 𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀

Results in 𝑄𝑄𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 = 0
demanded from the firm

𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 = 𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 50

The Firm can sell as much as it

likes at the market price.

𝑄𝑄𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹
500
Demand Curve facing Individual Firms
• Note that in this scenario:
• If 𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 = 50.001, 𝑄𝑄𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 = 0
• If 𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 = 49.999, 𝑄𝑄𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 = 50010
• The Demand Curve facing the firm is (almost) perfectly elastic at the market
price.
• Takeaway (the main thing you must know):
The demand curve facing the Firm is horizontal at the Market Price
• Intuitively, the firm can sell as much as it likes at the market price
Copyright © 2019 Pearson Australia (a division of Pearson Australia Group Pty Ltd)
9781488616983 / Hubbard / Essentials of Economics 4e
What Price should the Firm charge?
• No matter how many units the Firm wants to sell 𝑄𝑄𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 ≥ 0
• Charging 𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 = 𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 is best.
• Charging 𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 > 𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 results in 0 sales
• Charging 𝑃𝑃𝐹𝐹𝐹𝐹𝑀𝑀𝐹𝐹 < 𝑃𝑃𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 lowers total revenue compared to charging the market
price.

• Takeaway: A Firm operating in a Perfectly Competitive Market is always

better off charging the Market Price.
𝑷𝑷𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 = 𝑷𝑷𝑴𝑴𝑴𝑴𝑭𝑭𝑴𝑴𝑴𝑴𝑴𝑴
Maximizing Profit in a Perfectly Competitive
Market: REVENUE
• Profit = Total Revenue (TR) – Total Cost (TC)
• Total Revenue is the total amount of money a firm earns from sales of
its output: 𝑇𝑇𝑅𝑅 𝑄𝑄 = 𝑃𝑃 ⋅ 𝑄𝑄
𝑇𝑇𝑇𝑇 𝑄𝑄
• Average Revenue: 𝐴𝐴𝑅𝑅 𝑄𝑄 = = 𝑃𝑃
𝑄𝑄
Δ𝑇𝑇𝑇𝑇
• Marginal Revenue: 𝑀𝑀𝑅𝑅 𝑄𝑄 =
Δ𝑄𝑄
• MR can be interpreted as the additional revenue earned from the production
and sale of one additional unit (the 𝑄𝑄𝑀𝑀𝑡 unit)
Example: Suppose a Firm operating in a Perfectly
Competitive Market faces a Market Price of $10
• Complete the following Table
Quantity TR AR 𝚫𝚫𝚫𝚫 𝚫𝚫𝚫𝚫𝚫𝚫 MR
0 0 - - - -
10
20
40
70
Example: Suppose a Firm operating in a Perfectly
Competitive Market faces a Market Price of $10
• Complete the following Table
Quantity TR AR 𝚫𝚫𝚫𝚫 𝚫𝚫𝚫𝚫𝚫𝚫 MR
0 0 - - - -
10 100 100 10 − 0 100 100
= 10 = 10
10 = 10 10
20 200 200 20 − 10 100 100
= 10 = 10
20 = 10 10
40 400 400 40 − 20 200 200
= 10 = 10
40 = 20 20
70 700 700 70 − 40 300 300
= 10 = 10
70 = 300 30
Average and Marginal Revenue for a Perfectly
Competitive Firm
• Hence for a Perfectly Competitive Firm (but not necessarily for Firms
operating in other market structures like monopolies), it is always the
case that:
𝐴𝐴𝑅𝑅𝑅𝑅𝑃𝑃𝑇𝑇𝑊𝑊𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = 𝑀𝑀𝑇𝑇𝑃𝑃𝑊𝑊𝑃𝑃𝑅𝑅𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = 𝑀𝑀𝑇𝑇𝑃𝑃𝑀𝑀𝑅𝑅𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑝𝑝𝑅𝑅
Profit Maximization
• All firms (regardless of market structure) are assumed to be profit-
maximizers:

Π 𝑄𝑄 = 𝑃𝑃 ⋅ 𝑄𝑄 − 𝑇𝑇𝐶𝐶(𝑄𝑄)
where
• Π(𝑄𝑄) is profit given the firm’s output 𝑄𝑄
• 𝑃𝑃 ⋅ 𝑄𝑄 is the firm’s total revenue given Price 𝑃𝑃 and Output 𝑄𝑄
• 𝑇𝑇𝐶𝐶(𝑄𝑄) is the firm’s total cost given output 𝑄𝑄
Example: Profit Maximization
• Suppose a Firm faces a Market Price of 𝑃𝑃 = $10.
• Complete the Table below and identify the firm’s profit maximizing
level of output, using Marginal Costs and Revenue

Quantity TR TC 𝚷𝚷 𝑴𝑴𝑴𝑴 𝐌𝐌𝐌𝐌 𝑴𝑴𝚷𝚷

0 0 2 -2 - - -
1 7
2 16
3 28
4 45
Example: Profit Maximization
• Suppose a Firm faces a Market Price of 𝑃𝑃 = $10.
• Complete the Table below and identify the firm’s profit maximizing
level of output, using Marginal Costs and Revenue

Quantity TR TC 𝚷𝚷 𝑴𝑴𝑴𝑴 𝐌𝐌𝐌𝐌 𝑴𝑴𝚷𝚷

0 0 2 -2 - - -
1 10 7 3 10 5 5
𝑸𝑸∗ = 𝟐𝟐 20 16 4 10 9 1
3 30 28 2 10 12 -2
4 40 45 -5 10 17 -7
Marginal Analysis
• Marginal Profits 𝑀𝑀Π 𝑄𝑄 can be interpreted as the additional profits
earned from the production of one additional unit.
• The additional (marginal) profit earned on one additional unit (the
𝑄𝑄 𝑀𝑀𝑡 unit) is the difference between the Marginal Revenue for that
unit and the Marginal Cost of producing that unit.
ΔΠ
• This can be written as: 𝑀𝑀Π 𝑄𝑄 = = 𝑀𝑀𝑅𝑅(𝑄𝑄) − 𝑀𝑀𝐶𝐶(𝑄𝑄)
Δ𝑄𝑄
Marginal Profit 𝑀𝑀Π 𝑄𝑄
• Suppose for some 𝑄𝑄 𝑀𝑀𝑡 unit, 𝑀𝑀𝑅𝑅 𝑄𝑄 > 𝑀𝑀𝐶𝐶(𝑄𝑄)
• Then the marginal profit on the 𝑄𝑄𝑀𝑀𝑡 unit is 𝑀𝑀Π 𝑄𝑄 = 𝑀𝑀𝑅𝑅 𝑄𝑄 − 𝑀𝑀𝐶𝐶 𝑄𝑄 > 0
• Producing that unit (Δ𝑄𝑄 > 0) will result in an increase in profits ΔΠ > 0.
• Takeaway: A profit maximizing firm should always produce units for
which marginal profits is positive (𝑀𝑀Π > 0)
• Equivalently: Whenever 𝑀𝑀𝑅𝑅 > 𝑀𝑀𝐶𝐶 (such that MΠ > 0),
the firm can increase profits by increasing output (Δ𝑄𝑄 > 0)
Marginal Profit 𝑀𝑀Π 𝑄𝑄
• Suppose for some 𝑄𝑄 𝑀𝑀𝑡 unit, 𝑀𝑀𝑅𝑅 𝑄𝑄 < 𝑀𝑀𝐶𝐶(𝑄𝑄)
• Then the marginal profit on the 𝑄𝑄𝑀𝑀𝑡 unit is 𝑀𝑀Π 𝑄𝑄 = 𝑀𝑀𝑅𝑅 𝑄𝑄 − 𝑀𝑀𝐶𝐶 𝑄𝑄 < 0
• Producing that unit (Δ𝑄𝑄 > 0) will result in an decrease in profits ΔΠ < 0.
• Takeaway: A profit maximizing firm should never produce units for
which marginal profits is negative (𝑀𝑀Π < 0)
• Equivalently: Whenever 𝑀𝑀𝑅𝑅 < 𝑀𝑀𝐶𝐶 (such that MΠ < 0), the firm can
increase profits by decreasing output (Δ𝑄𝑄 < 0)
Marginal Profit and Profit Maximization
• If 𝑀𝑀𝑅𝑅 > 𝑀𝑀𝐶𝐶, then 𝑀𝑀Π > 0
• The profit-maximizing firm can Increase output to increase profits.
• If 𝑀𝑀𝑅𝑅 < 𝑀𝑀𝐶𝐶, then 𝑀𝑀Π < 0
• The profit-maximizing firm can Decrease output to increase profits.
• Hence, Profits are Maximized (i.e. the firm cannot increase profits by
either increasing or decreasing output) only when
𝑀𝑀𝑅𝑅 = 𝑀𝑀𝐶𝐶 𝑃𝑃𝑅𝑅𝑝𝑝𝑡 𝑃𝑃𝑡𝑇𝑇𝑃𝑃 𝑀𝑀Π = 0
Profit Maximization for a Perfectly
Competitive Firm
Π 𝑄𝑄 = 𝑃𝑃 ⋅ 𝑄𝑄 − 𝑇𝑇𝐶𝐶(𝑄𝑄)

• Firms can influence their Profits by choosing Price and/or Output.

• We have seen that a firm operating in a perfectly competitive market
effectively cannot choose the price to charge for its products.
• Should always charge the market price
• But has no ability to influence the market price
• So a perfectly competitive firm can only maximize its profits by
choosing the optimal level of output 𝑄𝑄 ∗ .
Profit Maximization for a Perfectly
Competitive Firm
• For a Perfectly Competitive Firm,
𝑀𝑀𝑅𝑅 𝑄𝑄 = 𝑃𝑃
• So the Perfectly Competitive Firm should produce every 𝑄𝑄 𝑀𝑀𝑡 unit for
which 𝑃𝑃 ≥ 𝑀𝑀𝐶𝐶(𝑄𝑄)
• At the profit maximizing level 𝑄𝑄 ∗ , we should expect that the marginal
cost of the last unit produced equals the market price:

𝑃𝑃 = 𝑀𝑀𝐶𝐶(𝑄𝑄 ∗ )
• As stated earlier, if there does not exist any level of output for which 𝑃𝑃 = 𝑀𝑀𝐶𝐶,
the firm should produce every unit for which 𝑃𝑃 ≥ 𝑀𝑀𝐶𝐶.
Illustrating Profit Maximizing Output
and Profits
Average Profits
• Average Profits (𝐴𝐴Π ):
Π 𝑃𝑃 ⋅ 𝑄𝑄 − 𝑇𝑇𝐶𝐶
𝐴𝐴Π = = = 𝑃𝑃 − 𝐴𝐴𝑇𝑇𝐶𝐶
𝑄𝑄 𝑄𝑄
• Since Total Profits: Π = (𝑃𝑃 − 𝐴𝐴𝑇𝑇𝐶𝐶) ⋅ 𝑄𝑄:
• If 𝑃𝑃 > 𝐴𝐴𝑇𝑇𝐶𝐶, then Π > 0 (the firm makes a profit)
• If 𝑃𝑃 < 𝐴𝐴𝑇𝑇𝐶𝐶, then Π < 0 (the firm makes a loss)
• If 𝑃𝑃 = 𝐴𝐴𝑇𝑇𝐶𝐶, then Π = 0 (the firm breaks even)
• We can illustrate Profits on the Cost curves as the area between 𝑃𝑃
and 𝐴𝐴𝑇𝑇𝐶𝐶 up to the output quantity 𝑄𝑄
Profits
• When will a Firm make a Profit?
• At what price will a Firm make >0 profit?
• Whenever the Market Price (𝑃𝑃) is greater than the Minimum ATC
𝑃𝑃 > 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑇𝑇𝐶𝐶
• Since the MC and ATC intersect at 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑇𝑇𝐶𝐶, there is always a part of
the MC curve that lies above the ATC Curve.
• Hence if 𝑃𝑃 > 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑇𝑇𝐶𝐶, there will always be some level of output 𝑄𝑄 ∗
at which 𝑃𝑃 = 𝑀𝑀𝐶𝐶 𝑄𝑄 ∗ > 𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄 ∗ that will result in an economic
profit Π > 0.
Short-Run Decision: Produce or Shutdown
when Faced with Losses?
• If the Firm chooses to Shutdown production and produce 𝑄𝑄 = 0
• Total Revenue and Variable Costs will equal 0.
• But Fixed Costs still need to be paid in the short run
(for example: Rent for facilities, Wages of permanent staff)
• Fixed Costs are incurred regardless of output.
• Profits when Shutdown Occurs:

Π 0 = 𝑃𝑃 ⋅ 0 − 𝑉𝑉𝐶𝐶(0) − 𝐹𝐹𝐶𝐶 = −𝐹𝐹𝐶𝐶

Short-Run Decision: Produce or Shutdown
• If the Firm Choose not to Shutdown, then it should produce the Loss-
minimizing level of output 𝑄𝑄 ∗ > 0 at which
𝑃𝑃 = 𝑀𝑀𝐶𝐶(𝑄𝑄 ∗ )
• If the Firm produces 𝑄𝑄 ∗ > 0, then Total Revenue and Variable Costs
will be more than 0.
• Total profits will then be

Π 𝑄𝑄 ∗ = 𝑃𝑃 ⋅ 𝑄𝑄 ∗ − 𝑉𝑉𝐶𝐶 𝑄𝑄 ∗ − 𝐹𝐹𝐶𝐶
Short-Run Decision: Produce or Shutdown
• A Profit Maximizing Firm should choose to Shutdown production only if it is
able to minimize losses by doing do.
• i.e. Optimal to Shutdown if
Π 0 > Π 𝑄𝑄∗
⇒ −𝐹𝐹𝐶𝐶 > 𝑃𝑃 ⋅ 𝑄𝑄∗ − 𝑉𝑉𝐶𝐶 𝑄𝑄 ∗ − 𝐹𝐹𝐶𝐶
⇒ 𝑃𝑃 ⋅ 𝑄𝑄∗ < 𝑉𝑉𝐶𝐶 𝑄𝑄∗
⇒ 𝑃𝑃 < 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄∗ )
• Intuitively, the Firm should Shutdown if revenue from production is
insufficient to cover variable costs of production i.e. if 𝑇𝑇𝑅𝑅 𝑄𝑄 < 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄∗ )
∗
• Because Shutting down production will result in smaller losses for the firm.
• Shutdown Condition: A Firm should choose∗ to Shutdown production if
𝑃𝑃 < 𝐴𝐴𝑉𝑉𝐶𝐶 𝑄𝑄
 When a Firm SHOULD Shutdown:
∗ ∗
If 𝑃𝑃 = 𝑀𝑀𝐶𝐶(𝑄𝑄 ) < 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄 )
ATC(Q) Profits if Shutdown:
MC(Q) Π 0 = −𝐹𝐹𝐶𝐶
= 𝐴𝐴𝐹𝐹𝐶𝐶 𝑄𝑄 ∗ × 𝑄𝑄 ∗
AVC(Q) = −𝐴𝐴𝑃𝑃𝑅𝑅𝑇𝑇(𝐴𝐴)

𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄 ∗ Profits if Produce 𝑄𝑄∗ output

Π 𝑄𝑄∗ = 𝑇𝑇𝑅𝑅 𝑄𝑄∗ − 𝑇𝑇𝐶𝐶 𝑄𝑄∗
𝐴𝐴𝐹𝐹𝐶𝐶 𝑄𝑄∗ = = 𝑃𝑃 ⋅ 𝑄𝑄∗ − 𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄∗
A 𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄∗ − 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄∗ ) = 𝐴𝐴𝑃𝑃𝑅𝑅𝑇𝑇 𝐶𝐶
−𝐴𝐴𝑃𝑃𝑅𝑅𝑇𝑇 𝐴𝐴 + 𝐵𝐵 + 𝐶𝐶
𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄∗ ) = −𝐴𝐴𝑃𝑃𝑅𝑅𝑇𝑇(𝐴𝐴 + 𝐵𝐵)
B
𝑃𝑃
C The Firm Should Shutdown.

Q
𝑄𝑄∗
 When a Firm should NOT Shutdown
∗ ∗
if 𝑃𝑃 = 𝑀𝑀𝐶𝐶 𝑄𝑄 > 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄 )
ATC(Q) Profits if Shutdown:
MC(Q) Π 0 = −𝐹𝐹𝐶𝐶
= 𝐴𝐴𝐹𝐹𝐶𝐶 𝑄𝑄 ∗ × 𝑄𝑄 ∗
AVC(Q) = −𝐴𝐴𝑃𝑃𝑅𝑅𝑇𝑇 𝐴𝐴 + 𝐵𝐵

Profits if 𝑄𝑄∗ is produced

𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄 ∗ Π 𝑄𝑄∗ = 𝑇𝑇𝑅𝑅 𝑄𝑄∗ − 𝑇𝑇𝐶𝐶 𝑄𝑄∗
A = 𝑃𝑃 ⋅ 𝑄𝑄∗ − 𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄∗
𝑃𝑃
𝐴𝐴𝐹𝐹𝐶𝐶 𝑄𝑄∗ = = 𝐴𝐴𝑃𝑃𝑅𝑅𝑇𝑇 𝐵𝐵 + 𝐶𝐶
B 𝐴𝐴𝑇𝑇𝐶𝐶 𝑄𝑄∗ − 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄∗ )
𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄∗ ) −𝐴𝐴𝑃𝑃𝑅𝑅𝑇𝑇 𝐴𝐴 + 𝐵𝐵 + 𝐶𝐶
= −𝐴𝐴𝑃𝑃𝑅𝑅𝑇𝑇(𝐴𝐴)

Q
𝑄𝑄∗
Competitive Firm’s Short Run Supply Curve
• Let 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶 refer to the minimum Average Variable Cost.
• The lowest possible level of AVC
• For every level of output 𝑄𝑄, it must be that 𝐴𝐴𝑉𝑉𝐶𝐶 𝑄𝑄 ≥ 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶
• If 𝑃𝑃 < 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶, then no matter the level of output 𝑄𝑄 ∗ , it must be
that
𝑃𝑃 < 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶 ≤ 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄 ∗ )
• The Firm Should SHUTDOWN
• If 𝑃𝑃 ≥ 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶, it must be that 𝑀𝑀𝐶𝐶 𝑄𝑄 ∗ > 𝐴𝐴𝑉𝑉𝐶𝐶 𝑄𝑄 ∗ since the MC
and AVC curves intersect at 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶.
• So the Firm should always produce 𝑄𝑄∗ at which 𝑃𝑃 = 𝑀𝑀𝐶𝐶(𝑄𝑄 ∗ ) whenever 𝑃𝑃 >
𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶.
Competitive Firm’s Short Run Supply Curve
• Let 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶 refer to the minimum Average Variable Cost.
• The lowest possible level of AVC
• For every level of output 𝑄𝑄, it must be that 𝐴𝐴𝑉𝑉𝐶𝐶 𝑄𝑄 ≥ 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶
• If 𝑃𝑃 < 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶,
then no matter the level of output 𝑄𝑄 ∗ , it must be∗ that
𝑃𝑃 < 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶 ≤ 𝐴𝐴𝑉𝑉𝐶𝐶(𝑄𝑄 )
• The Firm Should SHUTDOWN, and supply 𝑄𝑄 = 0.
• If 𝑃𝑃 ≥ 𝑀𝑀𝑃𝑃𝑅𝑅. 𝐴𝐴𝑉𝑉𝐶𝐶,
it must be that 𝑀𝑀𝐶𝐶 𝑄𝑄∗ (= 𝑃𝑃) > 𝐴𝐴𝑉𝑉𝐶𝐶 𝑄𝑄 ∗
So the Firm should always supply 𝑄𝑄∗ at which 𝑃𝑃 = 𝑀𝑀𝐶𝐶(𝑄𝑄∗ )

• Takeaway: The Firm’s Short run supply curve is the portion of the MC Curve
that lies above the AVC Curve.
Firm’s Short-Run Supply Curve