Session 5 To 6 - Chp5 Producer Theory

13
5
Background to Supply:
Competitive Firms
PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
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• The goal of a firm:
– to maximize profit
• Profit
– Total revenue minus total cost
What are Costs?
• Total revenue, TR = P × Q
– Amount a firm receives for the sale of its
output
– Quantity of output the firm produces times
the price at which it sells its output
• Total cost, TC
– Market value of the inputs a firm uses in
production
• First, Costs
Production and Costs
• Production function (Technology)
– Relationship between:
• Quantity of inputs used to make a good
• And the quantity of output of that good
Table 1
A Production Function and Total Cost: Caroline’s Cookie Factory
Figure 2
Caroline’s Production Function and Total Cost Curve
Quantity
(a) Production function
of Output
(cookies Production
per hour)
160 function The production function in panel (a)
shows the relationship between the
140
number of workers hired and the quantity
120 of output produced. Here the number of
workers hired (on the horizontal axis) is
100
from the first column in Table 1, and the
80 quantity of output produced (on the
vertical axis) is from the second column.
60
The production function gets flatter as
40 the number of workers increases,
20 reflecting diminishing marginal product.
0 1 2 3 4 5 6 Number of
Workers Hired
• Production function
– Input quantity (e.g., L for labor) on the
horizontal axis;
– Output quantity (usually denoted as Q) on
the vertical axis.
– Gets flatter as production rises
Table 1
• Marginal product
Q
– marginal product of labor: MPL =
L
– In general, marginal product is the

increase in output (Q) that arises from an
additional unit of input
change in total product
MPF =
change in quantity of the factor
• Diminishing marginal product
– Marginal product of an input declines as
the quantity of the input increases
– That’s why the production function gets
flatter as more inputs are being used
Figure 2
Caroline’s Production Function and Total Cost Curve
Quantity
(a) Production function
of Output
(cookies Production
per hour)
160 function The production function in panel (a)
shows the relationship between the
140
number of workers hired and the quantity
120 of output produced. Here the number of
workers hired (on the horizontal axis) is
100
from the first column in Table 1, and the
80 quantity of output produced (on the
vertical axis) is from the second column.
60
The production function gets flatter as
40 the number of workers increases,
20 reflecting diminishing marginal product.
0 1 2 3 4 5 6 Number of
Workers Hired
* Remember, the more you produce, the

more it's gonna cost you...
Table 1
The Costs of Production
• Total-cost curve
– Relationship between: quantity produced
and total costs
– Gets steeper as the amount produced
rises
• “Diminishing marginal product”
• Producing one additional unit of output
requires a lot of additional units of inputs
– Very costly
Figure 2
Caroline’s Production Function and Total-Cost Curve
Quantity Total
(a) Production function (b) Total-cost curve
of Output Cost
(cookies Production $90
per hour) Total-cost curve
160 function 80
140 70
120 60
100 50
80 40
60 30
40 20
20 10
0 1 2 3 4 6 Number of
5 0 20 40 60 80 100 120 140 160 Quantity
Workers Hired of Output
The production function in panel (a) shows the relationship between the number of workers hired and the quantity of
output produced. Here the number of workers hired (on the horizontal axis) is from the first column in Table 1, and
the quantity of output produced (on the vertical axis) is from the second column. The production function gets flatter
as the number of workers increases, reflecting diminishing marginal product. The total-cost curve in panel (b) shows
the relationship between the quantity of output produced and total cost of production. Here the quantity of output
produced (on the horizontal axis) is from the second column in Table 1, and the total cost (on the vertical axis) is
from the sixth column. The total-cost curve gets steeper as the quantity of output increases because of diminishing
marginal product.
Table 1
The Various Measures of Cost
• Fixed costs
– Costs that do not vary with the quantity of
output produced
• Variable costs
– Costs that vary with the quantity of output
produced
• Total cost
= Fixed cost + Variable cost
TC(Q ) = FC + VC (Q )
• Average fixed cost, AFC
– Fixed cost divided by the quantity of
output
FC
AFC (Q ) =
Q
• Average variable cost, AVC

– Variable cost divided by the quantity of
output VC (Q )
AVC (Q ) =
Q
• Average total cost, ATC
– Total cost divided by the quantity of
output
TC(Q ) FC + VC (Q )
ATC(Q ) = = = AFC (Q ) + AVC (Q )
Q Q
– Cost of a typical unit of output

• If total cost is divided evenly over all the
units produced
• Marginal Cost, MC
– Increase in total cost arising from an
extra unit of production
– Marginal cost = Change in total cost /
Change in quantity
TC
MC =
Q
– Increase in total cost

• From producing an additional unit of output
The Various Measures of Costs
• Exercise
When a firm is able to put idle equipment to use by hiring
another worker,
a. variable costs will rise.
b. variable costs will fall.
c. fixed costs will fall.
d. fixed costs and variable costs will rise.
• Exercise
At Bert's Bootery, the total cost of producing twenty pairs
of boots is $400. The marginal cost of producing the
twenty-first pair of boots is $83. We can conclude that the
a. average variable cost of 21 pairs of boots is $23.
b. average total cost of 21 pairs of boots is $23.
c. average total cost of 21 pairs of boots is $15.09.
d. marginal cost of the 20th pair of boots is $20.
• Exercise
Quantity Total Fixed Variable Marginal Average Average Average
Cost Cost Cost Cost Fixed Variable Total
Cost Cost Cost
0 $50 $50 $0 -- -- -- --
1 $150 A B C D E F
2 G H I $120 J K L
3 M N O P Q $120 R
What is the value of A?

a. $25
b. $50
c. $100
d. $200
• Exercise
Cost Cost Cost
0 $50 $50 $0 -- -- -- --
1 $150 $50 B C D E F
2 G H I $120 J K L
3 M N O P Q $120 R
What is the value of B?

a. $25
b. $50
c. $100
d. $200
• Exercise
Cost Cost Cost
0 $50 $50 $0 -- -- -- --
1 $150 $50 $100 C D E F
2 G H I $120 J K L
3 M N O P Q $120 R
What is the value of C?

a. $25
b. $50
c. $100
d. $200
• Exercise
Cost Cost Cost
0 $50 $50 $0 -- -- -- --
1 $150 $50 $100 $100 D E F
2 G H I $120 J K L
3 M N O P Q $120 R
What is the value of G?

a. $30
b. $120
c. $220
d. $270
• Exercise
Cost Cost Cost
0 $50 $50 $0 -- -- -- --
1 $150 $50 $100 $100 D E F
2 $270 H I $120 J K L
3 M N O P Q $120 R
What is the value of L?

a. $60
b. $135
c. $240
d. $270
• Exercise
Cost Cost Cost
0 $50 $50 $0 -- -- -- --
1 $150 $50 $100 $100 D E F
2 $270 H I $120 J K $135
3 M N O P Q $120 R
What is the value of O?

a. $40
b. $140
c. $360
d. $410
• Exercise
Cost Cost Cost
0 $50 $50 $0 -- -- -- --
1 $150 $50 $100 $100 $50 $100 $150
2 $270 $50 $220 $120 $25 $110 $135
3 $410 $50 $360 $140 $16.6 $120 $136.6
• (Usually) Rising marginal cost curve
– Because of diminishing marginal product
• U-shaped average total cost curve
– ATC = AVC + AFC
– AFC – always declines as output rises
– AVC – typically rises as output increases
• Because of diminishing marginal product
– The bottom of the U-shape
• At quantity that minimizes average total cost
• Relationship between MC and ATC
– When MC < ATC: average total cost is
falling
– When MC > ATC: average total cost is
rising
– The marginal-cost curve crosses the
average-total-cost curve at its minimum
Figure 5
Cost Curves for a Typical Firm
Costs Many firms

$3.00 experience
increasing marginal
2.50 product before
MC
diminishing
2.00 marginal product.
As a result, they
have cost curves
1.50 ATC shaped like those
in this figure. Notice
1.00 AVC that marginal cost
and average
0.50 variable cost fall for
AFC a while before
starting to rise.
0 2 4 6 8 10 12 14
Quantity of Output
• Example to try at home:
– The cost curves of Conrad’s coffee chop
Table 2
The Various Measures of Cost: Conrad’s Coffee Shop
Figure 4
Conrad’s Average-Cost and Marginal-Cost Curves
Costs
This figure shows the average
$3.50 total cost (ATC), average fixed
3.25 cost (AFC), average variable
3.00 cost (AVC), and marginal cost
2.75
(MC) for Conrad’s Coffee
2.50
2.25 Shop. All of these curves are
2.00 obtained by graphing the data
1.75 in Table 2. These cost curves
1.50 show three features that are
1.25
typical of many firms: (1)
1.00
0.75 Marginal cost rises with the
0.50 quantity of output. (2) The
0.25 AFC average-total-cost curve is U-
0 1 2 3 4 5 6 7 8 9 10
shaped. (3) The marginal-cost
curve crosses the average-
Quantity of Output (cups of coffee per hour) total-cost curve at the
minimum of average total cost.
Figure 4
Costs
2.75
2.50
1.75 in Table 2. These cost curves
1.25
AVC typical of many firms: (1)
1.00
0 1 2 3 4 5 6 7 8 9 10
Figure 4
Costs
2.75
2.50
1.75 ATC in Table 2. These cost curves
1.25
1.00
0 1 2 3 4 5 6 7 8 9 10
Figure 4
Costs
2.75
2.50
2.25
MC Shop. All of these curves are
1.75 ATC in Table 2. These cost curves
1.25
1.00
0 1 2 3 4 5 6 7 8 9 10
• Next: Firms in Competitive Markets
Markets and Competition
• Perfectly competitive market
– Goods offered for sale are all exactly the
same
– Buyers and sellers are so numerous, that
• No single buyer or seller has any influence
over the market price
• “Price takers”
– Firms can freely enter or exit the market
What is a Competitive Market?
• Exercise
If the market elasticity of demand for potatoes is 0.3 in a
perfectly competitive market, then the elasticity of
demand that is faced by an individual farmer in the
potato market
a. will also be 0.3.
b. depends on how large a crop the farmer produces.
c. will range between 0.3 and 1.0.
d. Close to infinite.
• Firm in a competitive market
– Tries to maximize profit
• Profit
– Total revenue minus total cost
• Total revenue, TR = P ˣ Q
– Price times quantity
– Proportional to the amount of output
• Total cost: what we just talked about
• Average revenue, AR = TR / Q
– Total revenue divided by the quantity sold
– Equals price of the output good
• Marginal revenue, MR = ∆TR / ∆Q
– Change in total revenue from an additional
unit sold
• For competitive firms
– Marginal revenue is also the output price
(Why?)
Table 1
Total, Average, and Marginal Revenue for a Competitive Firm
• Exercise
Suppose that a firm operating in perfectly competitive market sells
100 units of output. Its total revenues from the sale are $500.
Which of the following statements is correct?
i) Marginal revenue equals $5.
ii) Average revenue equals $5.
iii) Price equals $5.
a. i) only
b. iii) only
c. i) and ii) only
d. i), ii), and iii)
• Exercise
Suppose a firm in a competitive market produces and
sells 8 units of output and has a marginal revenue of
$8.00. What would be the firm's total revenue if it instead
produced and sold 4 units of output?
a. $4
b. $8
c. $32
d. $64
Profit Maximization
• Firm's Objective:
– To maximize profit
– Produce quantity where total revenue
minus total cost is greatest
Table 2
Profit Maximization: A Numerical Example
Profit Maximization
• To maximize profit
– Compare marginal revenue with marginal
cost
• If MR > MC: increase production
• If MR < MC: decrease production
– Maximize profit: produce the quantity
that makes MR = MC !
Profit Maximization
• The marginal-cost curve and the firm’s
supply decision
– MC curve is upward sloping
– ATC curve is U-shaped
– MC curve crosses the ATC curve at the
minimum of ATC curve
– The price line is horizontal:
– P = AR = MR (why?)
Figure 1
Profit Maximization for a Competitive Firm
Costs
The firm maximizes profit by producing
and the quantity at which marginal cost
Revenue equals marginal revenue.
MC
MC2 ATC
P=AR=MR
P=MR1=MR2
AVC
MC1
0 Q1 QMAX Q2 Quantity
This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and the average-
variable-cost curve (AVC). It also shows the market price (P), which for a competitive firm equals both
marginal revenue (MR) and average revenue (AR). At the quantity Q 1, marginal revenue MR1 exceeds
marginal cost MC1, so raising production increases profit. At the quantity Q 2, marginal cost MC2 is above
marginal revenue MR2, so reducing production increases profit. The profit-maximizing quantity QMAX is
found where the horizontal line representing the price intersects the marginal-cost curve.
Profit Maximization
• Exercise
Quantity Total Total Cost
In order to maximize profit, the Revenue
firm will produce a level of output 0 $0 $10
where marginal cost is equal to
1 $9 $14
a. $6. 2 $18 $19
b. $7. 3 $27 $25

4 $36 $32
c. $8.
5 $45 $40
d. $9.
6 $54 $49
7 $63 $59
8 $72 $70
9 $81 $82
Profit Maximization
• Exercise
Quantity Total Total Cost
At which quantity of output is the Revenue
firm maximizing profits? 0 $0 $10
a. 3 1 $9 $14
2 $18 $19
b. 6
3 $27 $25
c. 8
4 $36 $32
d. 9 5 $45 $40
6 $54 $49
7 $63 $59
8 $72 $70
9 $81 $82
Profit Maximization
• Rules for profit maximization:
– If MR > MC, firm should increase output
– If MR < MC, firm should decrease output
– If MR = MC, profit-maximizing level of
output
• Graphically, since P=MR, the MC curve
– Determines the quantity of the good the
firm is willing to supply at any price
– IS the supply curve
Figure 2
Marginal Cost as the Competitive Firm’s Supply Curve
Price
MC
P2
ATC
P1 AVC
0 Q1 Q2 Quantity
An increase in the price from P1 to P2 leads to an increase in the firm’s profit-

maximizing quantity from Q1 to Q2. Because the marginal-cost curve shows the
quantity supplied by the firm at any given price, it is the firm’s supply curve.
Figure 2
Marginal Cost as the Competitive Firm’s Supply Curve
Price
MC
P2
ATC
P1 AVC
??
0 Q1 Q2 Quantity
An increase in the price from P1 to P2 leads to an increase in the firm’s profit-

maximizing quantity from Q1 to Q2. Because the marginal-cost curve shows the
quantity supplied by the firm at any given price, it is the firm’s supply curve.
Profit Maximization
• Exit
– Long-run decision to leave the market
– Once left, doesn’t have to pay costs
anymore
• Shutdown
– Short-run decision not to produce anything
– Caused by current market conditions
– Fixed costs already paid
– Firm still has to pay variable costs
Profit Maximization
• Measuring profit
– If P > ATC
• Profit = TR – TC = (P – ATC) ˣ Q
– If P < ATC
• Negative profit
• Or, loss = TC - TR = (ATC – P) ˣ Q
Figure 5
Profit as the Area between Price and Average Total Cost
(a) A firm with profits (b) A firm with losses
Price Price
MC
MC
Profit ATC ATC

Loss
P
ATC P=AR=MR ATC
P
P=AR=MR
0 Q Quantity 0 Q Quantity
(profit-maximizing quantity) (loss-minimizing quantity)
The area of the shaded box between price and average total cost represents the firm’s
profit. The height of this box is price minus average total cost (P – ATC), and the width
of the box is the quantity of output (Q). In panel (a), price is above average total cost,
so the firm has positive profit. In panel (b), price is less than average total cost, so the
firm incurs a loss.
Profit Maximization
• Firm’s long-run decision
– Exit the market if
• TR < TC
• Or: P < ATC
– (If outside the market:) Enter the market if
• TR > TC
• Or: P > ATC
• Competitive firm’s long-run supply curve
– The portion of its marginal-cost curve that
lies above average total cost
Figure 4
The Competitive Firm’s Long-Run Supply Curve
Costs 1. In the long run, the firm

produces on the MC curve MC
if P>ATC,...
ATC
2. ...but
exits if
P<ATC
0 Quantity
In the long run, the competitive firm’s supply curve is its marginal-cost
curve (MC) above average total cost (ATC). If the price falls below average total cost,
the firm is better off exiting the market.
Profit Maximization
• The firm’s short-run decision to shut down
– Compares revenue with variable cost only
– Shut down temporally if TR < VC
– or, dividing both side by Q, if P < AVC
– If TR>VC, stay open even if incur a loss
• Competitive firm’s short-run supply curve
– The portion of its marginal-cost curve that
lies above the average variable cost curve
Figure 3
The Competitive Firm’s Short-Run Supply Curve
Costs 1. In the short run, the

firm produces on the MC MC
curve if P>AVC,...
ATC
AVC
2. ...but
shuts down
if P<AVC.
0 Quantity
In the short run, the competitive firm’s supply curve is its marginal-cost curve (MC)
above average variable cost (AVC). If the price falls below average variable cost, the
firm is better off shutting down temporarily.
Profit Maximization
Exercise
19
Price When the market price is at 10, what
18 MC quantity will the profit maximizing firm
17
16 produce?
15
14 a. 5
13
12 b. 15
11
10 ATC c. 35
9
8 d. 50
7
6
5
4
3
2
1
1 2 3 4 5 6 7 8 Quantity
Profit Maximization
Exercise
19
Price When the market price is at 10, what is the
18 MC total cost of the firm?
17
16 a. 5
15
14 b. 15
13
12 c. 35
11
10 ATC d. 50
9
8
7
6
5
4
3
2
1
1 2 3 4 5 6 7 8 Quantity
Profit Maximization
Exercise
19
Price When the market price is at 10, what is the
18 MC profit of the profit maximizing firm?
17
16 a. 5
15
14 b. 15
13
12 c. 35
11
10 ATC d. 50
9
8
7
6
5
4
3
2
1
1 2 3 4 5 6 7 8 Quantity
Profit Maximization
Price
Exercise MC
ATC
P5
AVC
P4
P3
P2
P1
Q1 Q2 Q3 Q4 Quantity
Firms will be encouraged to enter this market for all prices that exceed
a. P1.
b. P2.
c. P3.
d. None of the above is correct.
Profit Maximization
Price
Exercise MC
ATC
P5
AVC
P4
P3
P2
P1
Firms will be earning losses in the short run but will stay open if the market price
a. exceeds P3.
b. is less than P1.
c. is greater than P1 but less than P3.
d. exceeds P2.
Profit Maximization
Price
Exercise MC
ATC
P5
AVC
P4
P3
P2
P1
Firms will shut down in the short run if the market price
a. exceeds P3.
b. is less than P1.
c. is greater than P1 but less than P3.
d. exceeds P2.
Profit Maximization
• Exercise
A firm in a competitive market has the Output Total Cost
following cost structure. If the market price is
$16, this firm will 0 $5
a. produce four units in the short run and 1 $10

exit in the long run.
b. produce five units in the short run and exit 2 $12

in the long run.
3 $15
c. produce five units in the short run and
face competition from new market 4 $24
entrants in the long run.
5 $40
d. shut down in the short run and exit in the
long run.
Supply Curve
• Short run: market supply with a fixed
number of firms
– Short run: number of firms is fixed
– Each firm supplies quantity where P = MC
• For P > AVC: supply curve is MC curve
– Market supply
• Add up quantity supplied by each firm
Figure 6
Short-Run Market Supply
(a) Individual firm supply (b) Market supply
Price Price
MC Supply
$2.00 $2.00
1.00 1.00
0 100 200 Quantity 0 100,000 200,000 Quantity

(firm) (market)
In the short run, the number of firms in the market is fixed. As a result, the market
supply curve, shown in panel (b), reflects the individual firms’ marginal-cost curves,
shown in panel (a). Here, in a market of 1,000 firms, the quantity of output supplied to
the market is 1,000 times the quantity supplied by each firm.
Supply Curve
• Long run
– Firms can enter and exit the market
– If P > ATC, firms make positive profit
• New firms enter the market
– If P < ATC, firms make negative profit
• Firms exit the market
Supply Curve
• Long run
– Process of entry and exit ends when
• Firms still in market make zero economic
profit, that is, P = ATC
• (MC = ATC)
Supply Curve
• Why do competitive firms stay in
business if they make zero profit?
– Profit = total revenue – total cost
– Total cost includes all opportunity
costs
– Zero-profit equilibrium
• Economic profit is zero
• Accounting profit is positive
Supply Curve
• Market in long run equilibrium
– Zero economic profit
• Increase in demand
– Demand curve shifts to the right
– Short run
• Higher quantity
• Higher price: P > ATC – positive economic
profit
Figure 8
An Increase in Demand in the Short Run and Long Run (a)
(a) Initial Condition
Market Firm
Price Price
1. A market begins in 2. …with the firm
long-run equilibrium… earning zero profit.
Short-run supply, S1 MC
ATC
A Long-run
P1 P1
supply
Demand, D1
0 Q1 Quantity 0 Quantity
(market) (firm)
The market starts in a long-run equilibrium, shown as point A in panel (a). In this
equilibrium, each firm makes zero profit, and the price equals the minimum average
total cost.
Figure 8
An Increase in Demand in the Short Run and Long Run (b)
(b) Short-Run Response
Market Firm
Price Price
3. But then an increase in
4. …leading to
demand raises the price…
short-run profits.
S1 MC
ATC
B
P2 P2
A Long-run
P1 P1
supply
D2
D1
0 Q1 Q 2Quantity 0 Quantity
(market) (firm)
Panel (b) shows what happens in the short run when demand rises from D1 to D2. The
equilibrium goes from point A to point B, price rises from P1 to P2, and the quantity sold
in the market rises from Q1 to Q2. Because price now exceeds average total cost, each
firm now makes a profit, which over time encourages new firms to enter the market.
Figure 8
An Increase in Demand in the Short Run and Long Run (c)
(c) Long-Run Response
Market Firm
Price Price 6. …restoring long-run
5. When profits induce entry, supply
increases and the price falls,… equilibrium.
S1 MC
S2 ATC
B
P2
A C Long-run
P1 P1
supply
D2
D1
0 Q1 Q2 Q3
Quantity 0 Quantity
(market) (firm)
This entry shifts the short-run supply curve to the right from S1 to S2, as shown in panel
(c). In the new long-run equilibrium, point C, price has returned to P1 but the quantity
sold has increased to Q3. Profits are again zero, and price is back to the minimum of
average total cost, but the market has more firms to satisfy the greater demand.
Supply Curve
• Positive economic profit in short run
– Long run – firms enter the market
– Short run supply curve – shifts right
– Price – decreases back to minimum ATC
– Quantity – increases
• Because there are more firms in the market
Supply Curve
• Exercise Price Price
(a) MC (b) S0 S1
ATC
B
P2 P2
A C
P1 P1
D
P0 P0
D1
D0
Q1 Q2 Quantity QA QBQD QC Quantity
Assume that the market starts in equilibrium at point A in panel (b) and that panel (a)
illustrates the cost curves facing individual firms. Suppose that demand increases from
D0 to D1. Which of the following statements is correct?
a. Points A, B, and C represent both short-run and long-run equilibria points.
b. Points A, B, C, and D represent short-run equilibria points.
c. Points A and B represent long-run equilibria points.
d. Points A and C represent long-run equilibria points.
Supply Curve
• Exercise
A competitive market is in long-run equilibrium. If demand decreases,
we can be certain that price will
a. fall in the short run. All firms will shut down, and some of them will
exit the industry. Price will then rise to reach the new long-run
equilibrium.
b. fall in the short run. No firms will shut down, but some of them will
exit the industry. Price will then rise to reach the new long-run
equilibrium.
c. fall in the short run. All, some, or no firms will shut down, and some
of them will exit the industry. Price will then rise to reach the new
long-run equilibrium.
d. not fall in the short run because firms will exit to maintain the price.

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PowerPoint Slides prepared by:

– In general, marginal product is the

* Remember, the more you produce, the

• Average variable cost, AVC

– Cost of a typical unit of output

– Increase in total cost

What is the value of A?

What is the value of B?

What is the value of C?

What is the value of G?

What is the value of L?

What is the value of O?

Costs Many firms

c. i) and ii) only

d. i), ii), and iii)

b. $7. 3 $27 $25

An increase in the price from P1 to P2 leads to an increase in the firm’s profit-

An increase in the price from P1 to P2 leads to an increase in the firm’s profit-

Profit ATC ATC

Costs 1. In the long run, the firm

Costs 1. In the short run, the

a. produce four units in the short run and 1 $10

b. produce five units in the short run and exit 2 $12

0 100 200 Quantity 0 100,000 200,000 Quantity

Q1 Q2 Quantity QA QBQD QC Quantity

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