Overview

Key Phrases / Concepts Guiding Questions

Economic profits - What is the difference between accounting profits

Perfect competition and economic profits?
Price taking firm - How does a firm choose the quantity of output that
Break-even price maximizes profits?
Profit maximizing output - How does a firm decide whether to shutdown
Long run supply curve operation in the short run?
- How does a firm decide whether to enter or exit in
the long run?
- What are the short-run and long-run adjustments of
a change in market demand?

Costs in the short and long-run

● When Paolo wants to increase production from 150 to 200 pizzas per day, he
has no choice in the short run, but to hire more workers with only two
factories. Because of diminishing marginal product, average total cost rises
from €6 to €10 per pizza.
● In the long run, however, Paolo can expand both his capacity and his
workforce by building or acquiring a third factory, and average total cost
returns to €6 per pizza.
● Because many decisions are fixed in the short run but variable in the long run,
a firm’s long-run cost curves differ from its short-run cost curves.
 ● The long-run average total cost curve is a much flatter U-shape than the
short-run average total cost curve
● All the short-run curves lie on or above the long-run curve
○ These properties arise because firms have greater flexibility in the long
run
● In essence, in the long run, the firm chooses which short-run curve it wants to
use
○ But in the short-run, it has to use whatever short-run curve it chose in
the past

Return to Scale

Constant returns to scale Economies of scale Diseconomies of scale

→ Long-run average total → Increasing R.T.S → Long-run average total
cost stays the same as the → Long-run average total cost rises as q of output
q of output changes cost falls as q output inc. increases

Example…Assume Paolo currently employs 50 workers & 10 machines in a factory w/

a floor space of 1,000m2 and currently produces 2,000 pizzas/day. Total cost of
producing these 2,000 pizzas/day is €4,000. Average cost of e/pizza is €4,000/2,000
= €2 each. Paolo doubles input of all factors of production, result → employs 100
workers, 20 machines and has 2,000m2 of capacity.
● Scenario #1 → If the TC of production also doubled to €8,000 and output also
doubled to 4,000, the average cost of each pizza would still be €2. The firm is
said to be experiencing constant returns to scale.
● Scenario #2 →If TC of production at the new scale of production increased to
€6,000 and output doubled to 4,000, the average cost of each pizza would
now fall to €1.50 each. In this case the firm will experience increasing returns
to scale.
● Scenario #3 →If the doubling of factor inputs leads to an increase in TC (to
€10,000, for example) which is greater than the increase in output (assume
this is 4,000) the firm is said to experience decreasing returns to scale. In this
situation the average cost per pizza would now be €2.50 each.

So….How much to produce?

The Revenue of a Competitive Firm
● The Gonzalez Farm produces a quantity of milk Q and sells each unit at the
market price P. The farm’s total revenue is P × Q.
● Because the Gonzalez Farm is small compared with the world market for milk,
it takes the price as given by market conditions. P of milk does not depend on
the quantity of output that the Gonzalez Farm produces and sells.
● Total Revenue is proportional to the amount of output

Quantity (Q) Price (Euros, P) Total Revenue (PxQ,

euros)

1 litre 6 6

2 6 12

3 6 18

4 6 24

5 6 30

6 6 36

7 6 42

8 6 48

Average & Marginal Revenue

● How much revenue does the farm receive for the typical litre of milk?

● How much additional revenue does the farm receive if it increases production
of milk by 1 litre?
Quantity (Q) Price (Euros, P) Total Revenue Average Revenue Marginal Revenue
(PxQ, euros) (TR/Q) (change
TR/changeQ)

1 litre 6 6 6 6

2 6 12 6 6

3 6 18 6 6

4 6 24 6 6

5 6 30 6 6

6 6 36 6 6

7 6 42 6 6

8 6 48 6 6

2 important lessons
● For all firms, average revenue equal the price of good (ALWAYS)
● Because the price is fixed and competitive firms are price takers, the marginal
revenue also equals the price of the good. (ONLY COMPETITIVE FIRMS)

The Maximizing Profit Assumption

● Profit = total revenue - total cost
 Economics Accounting

Economic profits for a firm = 0, the firm is doing pretty well

Total revenue – all opportunity cost

→ Suppose you produce pizzas. A friend of yours told you that since demand for
pizzas in your area is Inelastic, you should increase the price to increase profits.
Should you follow your friend's advice?
a. Yes
b. No
c. Maybe

Competitive market
● Many buyers and sellers (X market power)
● Homogenous good/.service
● All agents are price takers
● There is free entry and exit

Maximize profit
Option 1 → Choose the quantity that Compare Marginal Cost to Marginal revenue: MR – MC
makes profit as large as possible When MR = MC Profit Maximizing output