Week 4: The Supply

Side: Importance of
Costs
UMUC HMGT 435

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Key Learning Objectives Week 4
• Understand difference between accounting vs. economic costs
• Understand characteristics of cost in short-run vs. long-run and impact
on:
• Average vs. marginal
• Input specialization
• Diminishing returns
• Understand what costs matter for a firm’s pricing decision
• Breakeven vs. shut-down prices
• Understand what factors constitute a “perfectly competitive” market

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Accounting vs. Economic Costs and Profits
• Economic costs include the “opportunity” cost of inputs used in the
production process
Economic Cost = Explicit cost + Implicit Cost
Accounting Cost = Explicit cost
• Explicit cost : actual monetary payments for inputs
• Implicit cost: opportunity cost of inputs that do not require a monetary
payment
• Applies to Profit Equation as Well
• Economic Profit = Total Revenue minus Costs (Explicit + Implicit)
• Accounting Profit = TR minus C (Explicit only)

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Factors of Production in Healthcare
• From Week 1 introduced the concept of factors of production also
called input into the production process
• Labor- Doctors, nurses, administrative staff, etc.
• Physical capital – Hospitals, doctor’s offices, medical technology, etc.
• Natural Resources and Raw Materials – land for the capital to be built, energy sources
(oil and gas), raw materials for pharmaceuticals
• Entrepreneurship – scientists who develop cures for cancer, drug companies who develop
new drugs.
• Production Function: Relationship between Inputs (e.g. labor,
capital) to and Outputs (e.g. patient care) from the production process

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The Production Function and Time
• Production Function and Time
• Short-run: period of time in which firms are able to vary one of the inputs to
production
• Long-run: period of time in which firms can vary all inputs to production
• All inputs are variable in long-run, you can hire and fire labor, you can build more
physicians offices and hospitals
• Thus, the production function is largely a short-run decision
• Within the Short-Run timeframe, firms do face different stages of
production based on how much output (and marginal product) they
can get from a given input (e.g. labor).

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The Stages of Production
• Increasing returns (Marginal Product (MP) > Average Product (AP)
• Each additional worker contributes more to their output.
• Example: New physician office with a number of exam rooms and one physician and one admin
staff. Adding another physician and admin staff can allow the office to see more patients in a
day.
• Diminishing returns (MP = AP)
• As firm increases workers, output increases but at a diminishing rate.
• Example: Too many physicians for same amount of office space means that they will start
bumping into each other and rate of growth in patient care will decline
• Negative (or decreasing) returns (MP < AP)
• As firms add workers, output declines
• Example: waiting room and exam rooms at full capacity, so cannot see any more partients even
if add physicians, only solution is a long-run option to expand office space.

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Short-Run Costs
• Total Costs = Fixed Costs + Variable Costs
• Fixed costs do not vary with quantity produced
• Variable costs vary with quantity produced
• In the long-run, all costs are variable
• Distinguish between Average and Marginal Costs
• Average Costs = Total Costs/Quantity
• Marginal Costs = Change in Total Costs resulting from a one-unit increase in
output
• Principle of Diminishing Returns
• As more variable inputs are added, in the SR, MC must eventually be increasing
• Example: Crowded hospital waiting room

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Supply Curve of A Perfectly Competitive Firm
• Characteristics of a perfectly competitive market:
• Many sellers (large number of firms) and buyers
• Homogeneous product (identical and no branding)
• No barriers to entry
• Firms in Perfectly Competitive Market must determine:
• What price to charge?
• How much to produce?

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What Price Does Perfectly Competitive (PC) Firm Charge?
• PC firm is a “price taker” accepts
market price (no influence over
market price)
• P=MR for the firm
• Demand curve is horizontal at
the market P (perfectly elastic)
• A price above market price,
demand would drop to zero and
everyone would go to competitors

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How Much Does a PC Firm Produce?
• Total Revenue = Price (times)
Quantity
• Economic Profit = Total Revenue
(minus) total economic cost
• Marginal revenue:
• Increase in revenue from selling one
more unit
• P = MR in Perf. Comp. market
• Using Marginal Principal choose Q
where MR = MC

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Firm’s Shut Down Decision
• Total Cost = FC + VC
• A firm must cover it’s variable cost (also
thought of as operating cost) to be viable
• It still must cover it’s fixed cost.
• Shutdown P = AVC = MC
• Point where firm indifferent between
operating or not
• Any point where P > AVC the firm can
still operate
• A firms would shutdown if P<AVC

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Fixed Costs and Decision to Shut-down
• Fixed or Sunk Cost
• A cost a firm has already committed to and cannot be
recovered
• If firm produces nothing it will have a loss equal to fixed costs
• The decision to operate or not ignores any fixed costs
• Only the relationship between revenue and variable costs is
important for SR decision to shut-down or not

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Factors Leading to A Shift in Supply Curve
• Change in Inputs (e.g. labor and capital)
• Number of producers/suppliers
• Change in Technology (which impacts productivity)
• Government Regulation/Taxes/ Subsidies
• Future expectations

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Shifts in Demand or Supply in Perfectly Competitive Market
• How does the market react to events that influence the
demand for or supply of medical services in perfectly
competitive market
• Recall that changes in factors other than output price will
cause the demand or supply curve to shift
• An increase in consumer income will cause the demand curve for
physician visits to shift to the right
• An increase in the wage of nurses will cause the supply curve for
hospital stays to shift to the left

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 Effect on Equilibrium

• These shifts in the demand or supply curves will

lead to a change in equilibrium price and quantity

• Predicting such changes is referred to as

comparative static analysis

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 Comparative Static Analysis
• Case Study: In the mid-1980s, the AIDs epidemic
led to an increase in the demand for latex gloves
among health care workers

• The epidemic led to a shift to the right in the

demand curve for latex gloves
• Excess demand for gloves developed, leading to a
temporary shortage of gloves

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 Comparative Analysis (Long run)
Dollars
per pair S

E F
P0

D1
D0

Q0 Market output of
latex gloves (Q)
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Excess demand
 Comparative Analysis (Long run)
• The shortage of gloves led buyers to bid the price
of gloves upwards

• As the price bid for gloves rose, suppliers increased

their quantity supplied of gloves
• This process continued until a new short-run
equilibrium was reached
• From 1986 to 1990, annual sales of latex gloves
increased by ~58%

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 Comparative Analysis (Long run)
Dollars
per pair S

P1

P0

D1
D0

Q0 Q1 Market output of
latex gloves (Q)
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 Entry of Firms in Long-Run
• Other medical suppliers made plans to build new
manufacturing plants to make gloves, in the hopes
of making profits
• In 1988, 116 permits were pending in Malaysia for
building latex glove factories

• Entry of the new plants into the market increased

the supply of latex gloves in the long run
• The supply curve for gloves shifted out

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 Comparative Analysis (Long run)
Dollars
per pair S0 S1

P1

P0

D1
D0

Q0 Q1 Q2 Market output of
latex gloves (Q)
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 Effect on Long-Run Price in Perfectly Competitive Markets

• As the supply curve for gloves shifts out, the price

of gloves begins to fall
• Note that the quantity of gloves sold on the market also
increases

• As the price of gloves fall, profits also fall

• The process continues, until the price of gloves falls
back to P0, where profits for all glove makers are
again equal to 0

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