CH 7: Producers in the short run

Goal of rms:
-all rms are assumed to be pro t maximizers, seeking to make as much pro t for their
owners as possible & each rm is assumed to be a single consistent decision making unit

Accounting pro ts = Revenues - Explicit costs

-explicit costs are the purchases of goods/services by the rm -> hiring workers, rental
equipment, interest payments

Economic pro ts = Revenues - (Explicit costs + Implicit costs)

-implicit costs: the opportunity cost of the worker’s time (salary) & opportunity cost of the
owner’s capital

Economists include both implicit and explicit costs, whereas accounting pro ts include only
explicit costs -> hence economic pro ts are less than accounting pro ts

Opportunity cost of time:

eg: entrepreneur who only pays herself $1000 per month, even though she could be
earning $4000 per month in her next best alternative job -> in this case there’s an implicit cost to
her rm of $3000 per month/ accountants would miss the subtraction of $3000 because they
only measure the explicit cost -> which is her wage of $1000 per month

Constant return to scale:

When doubling all inputs will lead to a doubling of all outputs

Point of diminishing average productivity:

-when the average product reaches a maximum

Point of diminishing marginal productivity:

-when the marginal product reaches a maximum

Diminishing Marginal Products: Law of diminishing returns:

-if increasing quantities of a variable factor (labor) are applied to a given quantity of xed
factors (capital), the marginal product of the variable factor will eventually decrease —> since
each labor will have less and less capital to work with to produce the output —> average
product will decrease too
-is when the amount of only one input increases (all other inputs held constant), leads to
the output increasing too but at a decreasing rate
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When AP is rising, AVC is falling
—> AVC is at its minimum when AP reaches its maximum

When MP is rising, MC is falling

—> MC curve reaches its minium when the MP curve reaches its maximum

When AP > MP, leads to AP to fall, labour to rise

When AP < MP, leads to AP to rise, L to fall

When MC < AVC, leads to AVC to fall

When MC < ATC, leads ATC to fall

When MP is rising, MC is falling

An increase in the price of a variable factor (eg wage rate) shifts the ATC & MC curve upwards
->increase wage rate raises the cost of producing each level of output

3 stages of production function/ process graph:

1st stage:
-TP/ output is increasing at an increasing rate
-MP is rising, Q is rising, MC is falling
2nd stage:
-TP/ output is increasing at a decreasing rate
-MP is falling, MP is more than 0
-MC is rising
3rd stage:
-TP/ output is decreasing
-MP is less than or equal to 0

Stage 1 has too much capital & too less workers

Stage 3 has too less capital & too much workers

Total product (TP):

-the total amount produced by a rm during some time period

Average product (AP):

AP = TP / L
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 Marginal product (MP):
-the change in total output that results from using 1 or more units of a variable factor (eg:
additional unit of labour)
MP = change in TP / change in L

Total cost (TC): TC = TFC + TVC

Total xed cost (TFC)

Total variable cost (TVC)

Variable cost (VC): WxL

Average total cost (ATC): ATC= TC / Q

ATC= AFC + AVC

Average xed cost (AFC): AFC = TFC / Q

Average product (AP): AP = Q / L

Average variable cost (AVC): AVC = TVC / Q

AVC = W / AP

Marginal cost (MC): MC = change in TC / change in Q

MC = W / MP

Marginal product (MP): MP = change in TP(Q) / change in L

Wage (VMPL): VMPL = Price x MP

CH 8: Producers in the Long run

Condition for cost minimization: MP(K) = MP(L)
P (K) = MP (K)
-> if they’re not equalize, rms will adjust it by substitution to equalize K & L

Ch 9: Perfect Competition
- rms have little or no market power
-the more market power the rms have, the less competitive the market structure is
-all rms are price takers
-there’s freedom of entry into and exit from the industry
-the demand curve for the entire industry is negatively sloped
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 -the demand curve for each rm faces a horizontal demand curve because the variations in the
rm’s output has no signi cant effect on the price

Total revenue (TR): TR = P x Q

Average revenue (AR): AR = TR / Q

AR = TR (PXQ) / Q = P
-> is the market price where all units are sold at the same price

Marginal revenue (MR): MR = change in TR / change in Q

-> the change in rm’s total revenue when there’s a change in its sales

Since rms are price takers, AR = MR = P

-price doesn’t change, thus MR & AR doesn’t change either

In the short run:

- rm shouldn’t produce at all if TVC > TR

- rm shouldn’t produce at all if price is below AVC

- rm will produce to maximize pro ts so that MR = MC

MC = P
P = MR = AR
P is higher or equal to AVC
Shut down price:
-when price = AVC
-if price is below AVC —> rm will shut down
-if price = min. AVC —> rm will still operate
-when rm can barely just cover its AVC, and is indifference between producing and not
producing

-if rm’s MR > MC —> rm should expand its output

-if rm’s MR < MC —> rm should reduce its output
-if rm’s MR = MC —> rm should leave output unaltered

Pro its: = TR - TC
=(P - ATC) x Q

-to produce, price needs to be above AVC

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 -if price is below ATC —> negative pro t
-if price is equal to ATC —> zero pro t
-if price is above ATC —> positive pro t

-if negative pro ts: (price below ATC, price above AVC)
-since rm is suffering losses, it’s worthwhile for the rm to keep reproducing but not
worth it for the rm to replace capital equipment when it wears out
-needs to keep producing to cover its xed costs

-zero pro ts (break even point): P = ATC

- rm is just covering its ATC, so its worth it for the rm to replace capital as it wears out
—> because the rm is covering the full opportunity cost of its capital

shut down point:

-when the market price is above AVC
- rm is only able to cover AVC and not ATC
- rm is indifferent between opening and shutting down temporarily

In the long run:

1. Positive pro ts in a competitive industry are a signal for the entry of new rms, attracts new
rms into the market

2. Entry of new rms will lead the industry to an increase in supply and a reduction price —>
supply curve shifts right, price goes down

3. Each rm will produce less output than before due to more rms, more supply in total

4. The industry will expand as new rms enter, leads to pushing down the market price until
economic pro ts fall to zero

5. Firm’s supply curve is their MC curve that’s above AVC

6. If the market price falls below the rm’s min. of AVC —> rms will shut down and exit the
industry

7. If the rm are making losses, but the market price is above shut down point (above AVC),
rms will still exit the industry, but it’ll be gradual
—> If rm is just covering AVC, but not covering their ATC, they’ll gradually exit
—> the return on their capital is less than the opportunity cost of capital —> they won’t
replace old capital (plants, equipment) as they wear out
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 —>the longer it takes for the rm’s capital to wear out or become too costly to operate,
the longer they’ll remain the industry even though they’re earning losses
—> if the rm’s xed costs are mostly sunk costs, the process of exiting the industry will
be slow
—> if the rm’s xed costs are mostly non-sunk costs, the process of exit will be faster

8. In the end, as rms exit the industry, the supply curve will shift left wards, and the market
price will rise

9. Firms will continue to exit, and market prices will continue to rise until the remaining rms
can cover their ATC
—> remaining rms will produce more output, but a smaller supply in total for the
industry

In the very long run:

-the very long-run equilibrium is when rms are earning 0 pro ts

In order to be in the very long run equilibrium:

1. in the SR, the rm’s MC must equal to P, MC = market Price
2. rms must not be suffering losses —> if their suffering losses, then they wont replace their
capital and hence they’ll exit the industry slowly
3. rms must not be earning pro ts —> if their earning pro ts, then new rms will enter
4. rms must be at the min. point of its long run average cost

-if a rm is not at the min. point of its long run average cost, then it’s not maximizing its long run
pro ts

minimum ef cient scale (MES):

-when the rm is producing at the min. point of its long run average cost curve
-when its just covering its costs

Technology & exiting the rm:

-low cost rms (old technology) will exist with high cost rms
-the older rms will continue to operate as long as their revenues cover their AVC
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