Chapter 5, Section 2

Essential QuestionEssential Question

CH5: SUPPLY• How do firms/suppliers decide what goods

and services to offer?

Chapter 5, Section 2

ObjectivesObjectives

1. Analyze the production costs of a firm.

2. Explain how a firm chooses its profit-maximizing output

3. Explain how firms decide how much labor to hire in order to produce a certain level of output.

4. Identify the factors that a firm must consider before shutting down a profitable business.

Chapter 5, Section 2

IntroductionIntroduction

• How can a firm/producer maximize profits if it can’t change the price?

– producers think about the revenue and the cost involved in producing/selling one more unit of a good.

– Firms must incur costs for inputs to production (land, labor, capital)

– There are two major production costs:• Fixed cost• Variable cost

– Marginal cost is part of variable cost

– Fixed + Variable = Total cost

Chapter 5, Section 2

Fixed CostsFixed Costs

• Fixed costs mainly involve the production facility and include:– Rent

– Machinery repair

– Property taxes

– Worker’s salaries

– Startup costs

– Physical Capital

• They are costs you pay no matter how much you sell

Chapter 5, Section 2

Variable CostsVariable Costs

• Variable costs include:– Price of raw materials– Some labor– Electricity and heating

bills

• Variable costs are based on marginal costs, which is the cost of producing one more unit of a good

Chapter 5, Section 2

Fixed vs. Variable CostsFixed vs. Variable Costs

• Let’s brainstorm Fixed and Variable costs for some businesses

FIXED VARIABLE1.

2.

3.

Chapter 5, Section 2

Labor, Cost and OutputLabor, Cost and Output

• Why should you hire more workers?

• How many workers should you hire?– More workers will

increase production– More workers will

increase costs – Marginal Product of

Labor is the change in output from hiring one additional worker

Chapter 5, Section 2

Specialization: Increasing Marginal Returns to LaborSpecialization: Increasing Marginal Returns to Labor

• The addition of more workers to a firm allow for a greater amount of specialization.

– Specialization increases the output and the firm enjoys increasing marginal returns.

Chapter 5, Section 2

Diminishing Marginal Returns to LaborDiminishing Marginal Returns to Labor

• Eventually, though, the benefits of specialization end and the addition of more workers increases total output but at a diminishing rate. – A firm with diminishing

marginal returns will produce less and less output from each additional unit of labor.

Chapter 5, Section 2

Profit-Maximizing Output:Marginal Revenue = Marginal CostProfit-Maximizing Output:Marginal Revenue = Marginal Cost• the marginal cost of production at each level is the additional

cost of producing one more unit.

• Marginal cost initially decreases from specialization. Eventually, the diminishing marginal returns to inputs means marginal cost increases with quantity supplied– Law of supply and marginal cost are similar: quantity

supplied increases when price increases and when marginal cost increases

– Think of the pen and paper demo

• The profit-maximizing output is where marginal cost is equal to marginal revenue, or the additional income from selling one more unit of a good.– If marginal revenue (price) is greater than marginal cost,

we will keep producing– If marginal revenue (price) is less than marginal cost, we

will stop producing

Chapter 5, Section 2

Profit-Maximizing Output:Marginal Revenue = Marginal CostProfit-Maximizing Output:Marginal Revenue = Marginal Cost• Let’s assume our producer/firm is a price-taker: they

don’t set prices on things, they compete and have to use the market price

Pri

ce/

Marginal revenue = price

MR > MC

Keep producing

MR < MC

Stop producing

Profit-Maximizing Output: Q*

MR = MC

Chapter 5, Section 2

Cost, Profit, Profit-Maximizing OutputHow to Calculate It AllCost, Profit, Profit-Maximizing OutputHow to Calculate It All

Where is profit maximized? What do you notice at the profit-maximizing output?

Chapter 5, Section 2

Cost, Profit, Profit-Maximizing OutputHow to Calculate It AllCost, Profit, Profit-Maximizing OutputHow to Calculate It All

• Marginal Cost = Additional cost of producing one more good; = Difference of Variable Cost

• Variable Cost = Sum of Marginal Cost• Total Cost = Fixed Costs + Variable Cost• Marginal Revenue = Price• Total Revenue = Sum of Marginal Revenue

• Profit = Total Revenue – Total Cost

• Profit-Maxiziming Output where MR = MC

TC = FC + VC

MR = P

TR = Price * Quantity = PQ

Profit = TR – TC

π = PQ – (FC+VC)

π = PQ – FC - VC

Q* where MR = MC

Chapter 5, Section 2

Shut Down the Factory:Fixed Costs are Sunk CostsShut Down the Factory:Fixed Costs are Sunk Costs

• Sometimes, even though a factory is producing at the profit-maximizing output, the market price is so low that the factory’s total revenue is still less than its total cost.

– This is true if fixed costs are high and price/variable costs are low

• If a firm shuts the factory down it still has to pay all of its fixed costs so it would have money going out but nothing coming in.

• The firm would lose an amount equal to its fixed costs.

– For this reason, Fixed Costs are often called Sunk Costs

Chapter 5, Section 2

Key TermsKey Terms

• marginal product of labor: the change in output from hiring one additional unit of labor

• increasing marginal returns: a level of production in which the marginal product of labor increases as the number of workers increases

• diminishing marginal returns: a level of production in which the marginal product of labor decreases as the number of workers increases

• fixed cost: a cost that does not change, no matter how much of a good is produced.

• sunk cost: a cost that you cannot recover. Fixed costs are sometimes called sunk costs because you have to pay them, even if you sell nothing or go out of business.

Chapter 5, Section 2

Key Terms, cont.Key Terms, cont.

• variable cost: a cost that rises and falls depending on the quantity produced

• total cost: the sum of fixed costs plus variable costs

• marginal cost: the cost of producing one more unit of a good

• marginal revenue: the additional income from selling one more unit of a good

• average cost: the total cost divided by the quantity produced