Review Midterm (Chap 1314)

N.
Gregory Mankiw
Principles of
Economics Sixth Edition
13
The Costs of Production
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EXAMPLE 1: Farmer Jack’s Production Function
L Q 3,000
(no. of (bushels
workers) of wheat) 2,500
Quantity of output
0 0 2,000
1 1000 1,500
2 1800 1,000
3 2400 500
4 2800 0
0 1 2 3 4 5
5 3000
No. of workers
2
Marginal Product
 If Jack hires one more worker, his output rises
by the marginal product of labor.
 The marginal product of any input is the
increase in output arising from an additional unit
of that input, holding all other inputs constant.
 Notation:
∆ (delta) = “change in…”
Examples:
∆Q = change in output, ∆L = change in labor
 Marginal product of labor (MPL) = ∆Q
∆L
3
EXAMPLE 1: Total & Marginal Product
L Q
(no. of (bushels
MPL
workers) of wheat)
0 0
∆L = 1 ∆Q = 1000 1000
1 1000
∆L = 1 ∆Q = 800 800
2 1800
∆L = 1 ∆Q = 600 600
3 2400
∆L = 1 ∆Q = 400 400
4 2800
∆L = 1 ∆Q = 200 200
5 3000
4
EXAMPLE 1: MPL = Slope of Prod Function
L Q MPL
3,000 equals the
(no. of (bushels MPL
slope of the
workers) of wheat) 2,500
production function.
Quantity of output
0 0 2,000
Notice that
1000
1 1000 MPL diminishes
1,500
800 as L increases.
2 1800 1,000
600 This explains why
3 2400 the
500 production
400 function gets flatter
4 2800 0
200 as L0 increases.
1 2 3 4 5
5 3000
No. of workers
5
Why MPL Diminishes
 Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why?
 As Jack adds workers, the average worker has
less land to work with and will be less productive.
 In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
 Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
6
EXAMPLE 2: The Various Cost Curves Together
$200
$175
$150
ATC
$125
Costs
AVC
$100
AFC
MC $75
$50
$25
$0
0 1 2 3 4 5 6 7
Q
7
EXAMPLE 2: Why ATC Is Usually U-Shaped
As Q rises: $200
Initially, $175
falling AFC $150
pulls ATC down. $125
Costs
Eventually, $100
rising AVC $75
pulls ATC up.
$50
Efficient scale:
$25
The quantity that
$0
minimizes ATC.
0 1 2 3 4 5 6 7
Q
8
EXAMPLE 2: ATC and MC
When MC < ATC, $200 ATC
ATC is falling. MC
$175
When MC > ATC, $150
ATC is rising. $125
Costs
The MC curve $100
crosses the $75
ATC curve at
$50
the ATC curve’s
$25
minimum.
$0
0 1 2 3 4 5 6 7
Q
9
EXAMPLE 3: LRATC with 3 factory sizes
Firm can choose
from three factory Avg
sizes: S, M, L. Total
Cost ATCS ATCM
Each size has its ATCL
own SRATC curve.
The firm can

change to a
different factory
size in the long Q
run, but not in the
short run.
10
EXAMPLE 3: LRATC with 3 factory sizes
To produce less
than QA, firm will Avg
Total
choose size S
Cost ATCS ATCM
in the long run. ATCL
To produce
between QA
LRATC
and QB, firm will
choose size M
in the long run.
To produce more Q
QA QB
than QB, firm will
choose size L
in the long run.
11
A Typical LRATC Curve
In the real world,
factories come in ATC
many sizes,
each with its own LRATC
SRATC curve.
So a typical
LRATC curve
looks like this:
12
How ATC Changes as
the Scale of Production Changes
Economies of ATC
scale: ATC falls
as Q increases.
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
Q
scale: ATC rises
as Q increases.
13
N. Gregory Mankiw
Principles of
Economics Sixth Edition
14
Firms in Competitive Markets
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Profit Maximization
 What Q maximizes the firm’s profit?
 To find the answer, “think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
 If MR > MC, then increase Q to raise profit.
 If MR < MC, then reduce Q to raise profit.
15
Profit Maximization
(continued from earlier exercise)
Q TR TC Profit MR MC
Profit =
At any Q with MR – MC
MR > MC,
0 $0 $5 –$5
increasing Q $10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5
16
MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR. Costs

So, increase Q MC
to raise profit.
At Qb, MC > MR.
So, reduce Q
P1 MR
to raise profit.
At Q1, MC = MR.
Changing Q Q
would lower profit. Qa Q1 Qb
17
MC and the Firm’s Supply Decision
If price rises to P2,
then the profit- Costs
maximizing quantity MC
rises to Q2.
P2 MR2
The MC curve
determines the
firm’s Q at any price. P1 MR
Hence,
the MC curve is the
firm’s supply curve. Q
Q1 Q2
18
A Firm’s Short-run Decision to Shut Down
 Cost of shutting down: revenue loss = TR

 Benefit of shutting down: cost savings = VC
(firm must still pay FC)
 So, shut down if TR < VC
 Divide both sides by Q: TR/Q < VC/Q
 So, firm’s decision rule is:
Shut down if P < AVC
19
A Competitive Firm’s SR Supply Curve
If P > AVC:
Case 1: Keep on producing
Costs
- TR = P1 x Q1 FC = TC - VC
MC
- TC = ATC1 x Q1
- Profit loss: The red rectangle ATC
(TR – TC)
ATC1 AVC
Case 2: Shut-down
P1 P=MR1
- No TR & VC AVC1
- FC is still there Q
- Profit loss: The blue rectangle Q1
– Fixed cost
20
If P < AVC:
Case 1: Keep on producing
Costs
- TR = P1 x Q1
MC
- TC = ATC1 x Q1
- Profit loss: The red rectangle ATC
(TR – TC)
ATC1 AVC
Case 2: Shut-down
- No TR & VC AVC1
P1 MR1
- FC is still there Q
- Profit loss: The blue rectangle Q1
– Fixed cost
21
The firm’s SR
supply curve is Costs
the portion of MC
its MC curve
If P > AVC, then
above AVC.
firm produces Q ATC
where P = MC.
AVC
If P < AVC, then

firm shuts down
(produces Q = 0). Q
22
The Irrelevance of Sunk Costs
 Sunk cost: a cost that has already been committed and cannot
be recovered
 Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
 FC is a sunk cost: The firm must pay its fixed costs whether it
produces or shuts down.
 So, FC should not matter in the decision to shut down.
23
A Firm’s Long-Run Decision to Exit
 Cost of exiting the market: revenue loss = TR
 Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
 So, firm exits if TR < TC
 Divide both sides by Q to write the firm’s decision rule as:
Exit if P < ATC
24
A New Firm’s Decision to Enter Market
 In the long run, a new firm will enter the market if it is profitable to
do so: if TR > TC.
 Divide both sides by Q to express the firm’s entry decision as:
Enter if P > ATC
25
The Competitive Firm’s Supply Curve
The firm’s
Costs
LR supply curve
is the portion of MC
its MC curve
above LRATC. LRATC
26
Market Supply: Assumptions
1) All existing firms and potential entrants have identical costs.
2) Each firm’s costs do not change as other firms enter or exit the
market.
3) The number of firms in the market is
 fixed in the short run
(due to fixed costs)
 variable in the long run
(due to free entry and exit)
27
The SR Market Supply Curve
 As long as P ≥ AVC, each firm will produce its profit-maximizing
quantity, where MR = MC.
 Recall from Chapter 4:
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.
28
The SR Market Supply Curve
Example: 1000 identical firms
At each P, market Qs = 1000 x (one firm’s Qs)
One firm Market

P MC P S
P3 P3
P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)
10,000 20,000 30,000

29
Entry & Exit in the Long Run
 In the LR, the number of firms can change due to entry & exit.
 If existing firms earn positive economic profit,
 new firms enter, SR market supply shifts right.
 P falls, reducing profits and slowing entry.
 If existing firms incur losses,
 some firms exit, SR market supply shifts left.
 P rises, reducing remaining firms’ losses.
30
The Zero-Profit Condition
 Long-run equilibrium:
The process of entry or exit is complete—
remaining firms earn zero economic profit.
 Zero economic profit occurs when P = ATC.
 Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
 Recall that MC intersects ATC at minimum ATC.
 Hence, in the long run, P = minimum ATC.
31
Why Do Firms Stay in Business
if Profit = 0?
 Recall, economic profit is revenue minus all costs, including

implicit costs like the opportunity cost of the owner’s time and
money.
 In the zero-profit equilibrium,
 firms earn enough revenue to cover these costs
 accounting profit is positive
EP = Revenues – Total costs = Revenues – (ex.cost + im.cost) = 0

=> Revenues – ex.cost = im. Costs = accounting profit
32
The LR Market Supply Curve
In the long run, The LR market supply
the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.
One firm Market

P MC P
LRATC
P=
long-run
min. supply
ATC
Q Q
(firm) (market)
33
SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits
in demandinduce entry,
raises P,…
andfirm.
profits for the restoring long-run
shifting eq’m.
S to the right, reducing P…
P One firm P Market

MC S1
S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
34
Why the LR Supply Curve Might Slope Upward
 The LR market supply curve is horizontal if

1) all firms have identical costs, and
2) costs do not change as other firms enter or exit the market.
 If either of these assumptions is not true,
then LR supply curve slopes upward.
35

Review Midterm (Chap 1314)

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Review Midterm (Chap 1314)

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N.

The firm can

At Qa, MC < MR. Costs

 Cost of shutting down: revenue loss = TR

Shut down if P < AVC

If P < AVC, then

Exit if P < ATC

Enter if P > ATC

One firm Market

10,000 20,000 30,000

 Recall, economic profit is revenue minus all costs, including

EP = Revenues – Total costs = Revenues – (ex.cost + im.cost) = 0

One firm Market

P One firm P Market

 The LR market supply curve is horizontal if

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