Unit III: Costs of Production and Perfect Competition

Unit III: Unit III: Costs of Production and Costs of Production and

Perfect CompetitionPerfect Competition

Accountants vs. Economists

Accountants look at only EXPLICIT COSTS •Explicit costs (out of pocket costs) are payments paid by firms for using the resources of others. •Example: Rent, Wages, Materials, Electricity Bills

Economists examine both the EXPLICIT COSTS and the IMPLICIT COSTS

•Implicit costs are the opportunity costs that firms “pay” for using their own resources•Example: Forgone Wage, Forgone Rent, Time

AnalyzingAnalyzingProductionProduction

Inputs and Outputs• To earn profit, firms must make products

(output)• Inputs (FACTORS) are the resources used to

make outputs.

Marginal Product =Change in Total Product

Change in Inputs

•Marginal Product (MP)- the additional output generated by additional inputs (workers).

•Total Physical Product (TP)- total output or quantity produced

Inputs and Outputs• To earn profit, firms must make something (output)• Inputs are the resources used to produce outputs. • Input resources are also called FACTORS.

Marginal Product =Change in Total Product

Change in Labor Input

•Marginal Product (MP)- the additional output generated by additional inputs.

•Total Physical Product (TP)- total output or quantity produced

•Average Product (AP)- the output per unit of input

Average Product =Total Product

Units of Labor

What is the general relationship between inputs and outputs?

Calculate the MP, identify the three stages, and explain why each stage occurs

# of Workers

(Input)

Total Product(TP) PIZZAS

Marginal Product(MP)

0 0

1 10

2 25

3 45

4 60

5 70

6 75

7 75

8 70


# of Workers

(Input)



0 0 -

1 10 10

2 25 15

3 45 20

4 60 15

5 70 10

6 75 5

7 75 0

8 70 -5


# of Workers

(Input)



0 0 -

1 10 10

2 25 15

3 45 20

4 60 15

5 70 10

6 75 5

7 75 0

8 70 -5

Why does MP start to fall?

The Law of Diminishing Marginal Returns

As successive units of variable resources (workers) are added to fixed resources (machinery, tool, etc.), the

additional output produced from each new worker will eventually fall.

Too many cooks in the kitchen!

Law of Diminishing ReturnsT

ota

l Pro

du

ct, T

P

Quantity of Labor

Ave

rag

e P

rod

uct

, AP

, an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

Stage I: Increasing Marginal Returns

There are three stages of returns.

MarginalProduct

AverageProduct

To

tal P

rod

uct

, TP

Quantity of Labor

Ave

rag

e P

rod

uct

, AP

, an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

Stage II:Diminishing Marginal

Returns

Law of Diminishing ReturnsThere are three stages of returns.

To

tal P

rod

uct

, TP

Quantity of Labor

Ave

rag

e P

rod

uct

, AP

, an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

Stage III: Negative Marginal Returns

Law of Diminishing ReturnsThere are three stages of returns.

MarginalProduct

AverageProduct

Short-Run Production Costs

Fixed CostsFixed costs (costs for fixed resources) DON’T change with the amount producedEx: Rent, Insurance, Managers salaries, etc.

Average Fixed Costs = Fixed CostsQuantity

Variable CostsVariable costs (costs for variable resources) change as more or less is producedEx: raw materials, labor, electricity, etc.

Average Variable Costs = Variable CostsQuantity

Definitions

Total CostSum of Fixed and Variable Costs

Average Total Cost = Total CostsQuantity

Marginal Cost

Marginal Cost = Change in Total CostsChange in Quantity

Additional costs of and additional output.Ex: If the production of another output increases total cost from $100 to $120, the MC is $20.

Definitions

Calculating TC, VC, FC, ATC, AFC, and MC

TP VC FC TC MC AVC AFC ATC

0 0 100 - - - -

1 10

2 16

3 21

4 26

5 30

6 36

7 46



0 0 100 100 - - - -

1 10 100 110

2 16 100 116

3 21 100 121

4 26 100 126

5 30 100 130

6 36 100 136

7 46 100 146



0 0 100 100 - - - -

1 10 100 110 10

2 16 100 116 6

3 21 100 121 5

4 26 100 126 5

5 30 100 130 4

6 36 100 136 6

7 46 100 146 10



0 0 100 100 - - - -

1 10 100 110 10 10 100 110

2 16 100 116 6 8 58

3 21 100 121 5 33.3 40.3

4 26 100 126 5 6.5 25 31.5

5 30 100 130 4 6

6 36 100 136 6 16.67 22.67

7 46 100 146 10 6.6 14.3 20.9



0 0 100 100 - - - -

1 10 100 110 10 10 100 110

2 16 100 116 6 8 50 58

3 21 100 121 5 7 33.3 40.3

4 26 100 126 5 6.5 25 31.5

5 30 100 130 4 6 20 26

6 36 100 136 6 6 16.67 22.67

7 46 100 146 10 6.6 14.3 20.9



0 0 100 100 - - - -

1 10 100 110 10 10 100 110

2 16 100 116 6 8 50 58

3 21 100 121 5 7 33.3 40.3

4 26 100 126 5 6.5 25 31.5

5 30 100 130 4 6 20 26

6 36 100 136 6 6 16.67 22.67

7 46 100 146 10 6.6 14.3 20.9

Quantity

Co

sts

(do

llar

s)

AFC

AVC

ATC

MC

Per-Unit Costs (Average and Marginal)

121110987654321

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Average Fixed Cost

ATC and AVC get closer and closer but

NEVER touch

Converting Average to Total

At output Q, what area represents:

TCVCFC

0CDQ0BEQ0AFQ or BCDE

Quantity

Co

sts

(do

llar

s)

121110987654321

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

MC

Why is the MC curve U-shaped?

Why is the MC curve U-shaped?•The MC curve falls and then rises because of diminishing marginal returns•The additional cost of the first units produced fall when workers have increasing marginal returns.•As production continues, each worker adds less and less to production so the marginal cost for each unit increases.

1.

2.

3.

4.

Shifting Cost Shifting Cost CurvesCurves

Shifting Costs Curves


0 0 100 100 - - - -

1 10 100 110 10 10 100 110

2 16 100 116 6 8 50 58

3 21 100 121 5 7 33.3 30.3

4 26 100 126 3 6.5 25 31.5

5 30 100 130 4 6 20 26

6 36 100 136 6 6 16.67 22.67

7 46 100 146 10 6.6 14.3 20.9

What if Fixed Costs increase to

$200



0 0 100 100 - - - -

1 10 100 110 10 10 100 110

2 16 100 116 6 8 50 58

3 21 100 121 5 7 33.3 30.3

4 26 100 126 5 6.5 25 31.5

5 30 100 130 4 6 20 26

6 36 100 136 6 6 16.67 22.67

7 46 100 146 10 6.6 14.3 20.9



0 0 200 100 - - - -

1 10 200 110 10 10 100 110

2 16 200 116 6 8 50 58

3 21 200 121 5 7 33.3 30.3

4 26 200 126 5 6.5 25 31.5

5 30 200 130 4 6 20 26

6 36 200 136 6 6 16.67 22.67

7 46 200 146 10 6.6 14.3 20.9



0 0 200 200 - - - -

1 10 200 210 10 10 100 110

2 16 200 216 6 8 50 58

3 21 200 221 5 7 33.3 30.3

4 26 200 226 5 6.5 25 31.5

5 30 200 230 4 6 20 26

6 36 200 236 6 6 16.67 22.67

7 46 200 246 10 6.6 14.3 20.9

Which Per Unit Cost Curves Change?



0 0 200 200 - - - -

1 10 200 210 10 10 100 110

2 16 200 216 6 8 50 58

3 21 200 221 5 7 33.3 30.3

4 26 200 226 5 6.5 25 31.5

5 30 200 230 4 6 20 26

6 36 200 236 6 6 16.67 22.67

7 46 200 246 10 6.6 14.3 20.9

ONLY AFC and ATC Increase!



0 0 200 200 - - - -

1 10 200 210 10 10 200 110

2 16 200 216 6 8 100 58

3 21 200 221 5 7 66.6 30.3

4 26 200 226 5 6.5 50 31.5

5 30 200 230 4 6 40 26

6 36 200 236 6 6 33.3 22.67

7 46 200 246 10 6.6 28.6 20.9

ONLY AFC and ATC Increase!



0 0 200 200 - - - -

1 10 200 210 10 10 200 210

2 16 200 216 6 8 100 108

3 21 200 221 5 7 66.6 73.6

4 26 200 226 5 6.5 50 56.5

5 30 200 230 4 6 40 46

6 36 200 236 6 6 33.3 39.3

7 46 200 246 10 6.6 28.6 35.2

If fixed costs change ONLY AFC and ATC Change!

MC and AVC DON’T change!

Quantity

Co

sts

(do

llar

s)

AFC

AVCATC

MC

Shift from an increase in a Fixed Cost

ATC1

AFC1

Quantity

Co

sts

(do

llar

s)

MC

Shift from an increase in a Fixed Cost

ATC1

AVC

AFC1



0 0 100 100 - - - -

1 10 100 110 10 10 100 110

2 16 100 116 6 8 50 58

3 21 100 121 5 7 33.3 30.3

4 26 100 126 5 6.5 25 31.5

5 30 100 130 4 6 20 26

6 36 100 136 6 6 16.67 22.67

7 46 100 146 10 6.6 14.3 20.9

What if the cost for variable resources

increase


0 0 100 100 - - - -

1 10 100 110 10 10 100 110

2 16 100 116 6 8 50 58

3 21 100 121 5 7 33.3 30.3

4 26 100 126 5 6.5 25 31.5

5 30 100 130 4 6 20 26

6 36 100 136 6 6 16.67 22.67

7 46 100 146 10 6.6 14.3 20.9



0 0 100 100 - - - -

1 11 100 110 10 10 100 110

2 18 100 116 6 8 50 58

3 24 100 121 5 7 33.3 30.3

4 30 100 126 5 6.5 25 31.5

5 35 100 130 4 6 20 26

6 43 100 136 6 6 16.67 22.67

7 55 100 146 10 6.6 14.3 20.9



0 0 100 100 - - - -

1 11 100 111 10 10 100 110

2 18 100 118 6 8 50 58

3 24 100 124 5 7 33.3 30.3

4 30 100 130 3 6.5 25 31.5

5 35 100 135 4 6 20 26

6 43 100 143 6 6 16.67 22.67

7 55 100 155 10 6.6 14.3 20.9


Which Per Unit Cost Curves Change?


0 0 100 100 - - - -

1 11 100 111 11 10 100 110

2 18 100 118 7 8 50 58

3 24 100 124 6 7 33.3 30.3

4 30 100 130 6 6.5 25 31.5

5 35 100 135 5 6 20 26

6 43 100 143 8 6 16.67 22.67

7 55 100 155 12 6.6 14.3 20.9


MC, AVC, and ATC Change!


0 0 100 100 - - - -

1 11 100 111 11 11 100 110

2 18 100 118 7 9 50 58

3 24 100 124 6 8 33.3 30.3

4 30 100 130 6 7.5 25 31.5

5 35 100 135 5 7 20 26

6 43 100 143 8 7.16 16.67 22.67

7 55 100 155 12 7.8 14.3 20.9


MC, AVC, and ATC Change!


0 0 100 100 - - - -

1 11 100 111 11 11 100 111

2 18 100 118 7 9 50 59

3 24 100 124 6 8 33.3 41.3

4 30 100 130 6 7.5 25 32.5

5 35 100 135 5 7 20 27

6 43 100 143 8 7.16 16.67 23.83

7 55 100 155 12 7.8 14.3 22.1

Shifting Costs CurvesIf variable costs change MC, AVC, and ATC Change!

Quantity

Co

sts

(do

llar

s)

AFC

AVCATC

MCATC1

AVC1

Shift from an increase in a Variable CostsMC1

Quantity

Co

sts

(do

llar

s)

AFC

ATC1

AVC1

Shift from an increase in a Variable CostsMC1

Long-Run Long-Run Cost CurvesCost Curves

Short-Run vs. Long-Run

• The short-run is a period in which at least one resource is fixed.– Plant capacity/size is NOT changeable

• In the long-run ALL resources are variable– NO fixed resources

– Plant capacity/size is changeable

Long Run ATCWhat happens to the average total costs of a

product when a firm increases its plant capacity?

Example of various plant sizes:•I make looms out of my garage with one saw•I rent out building, buy 5 saws, hire 3 workers•I rent a factory, buy 20 saws and hire 40 workers•I build my own plant and use robots to build looms.•I create plants in every major city in the U.S.

Long Run ATC curve is made up of all the different short run ATC curves of various plant

sizes.

Un

it C

ost

s

Output

Long Run ATC

5 Various Plant Capacities

The long-run ATC is the result of all of the short-run ATC curves.

Un

it C

ost

s

Output

Long Run ATC

Un

it C

ost

s

Output

LRATC

Why is LRATC U Shaped?The law of diminishing marginal returns doesn’t apply in the long run because all

resources are variable.

Three Areas on the LRATC CurveU

nit

Co

sts

Output

long-run ATC

Economiesof scale

Economies of Scale- LRATC is falling as mass production techniques can be utilized.

Un

it C

ost

s

Output

long-run ATC

Economiesof scale

Constant returnsto scale

Three Areas on the LRATC CurveConstant Returns to Scale- The average total

cost is as low as it can get.

Un

it C

ost

s

Output

long-run ATC

Economiesof scale

Diseconomiesof scale

Constant returnsto scale

Three Areas on the LRATC CurveDiseconomies of Scale- The LRATC is

increasing as the firm gets too big and difficult to manage.

Perfect Perfect CompetitionCompetition

Market Structure Continuum

PureCompetition

PureMonopoly

MonopolisticCompetition Oligopoly

FOUR MARKET MODELSCharacteristics of Pure Competition:

• Many small firms• Identical products (perfect substitutes)• Firms are “Price Takers”• Easy for firms to enter and exit the industry • No control over price. • No need to advertise

Examples: Corn or Avocado farmers, TJ hammocks

Demand for Perfectly Competitive Firms

Why are they Price Takers?•If a firm charges above the market price, NO ONE will buy. They will go to other firms•There is no reason to price low because consumers will buy just as much at the market price.

Since the price is the same at all quantities demanded, the demand curve and MR for each

firm is…

Perfectly Elastic (A Horizontal straight line)

MaximizingMaximizingPROFITPROFIT

MaximizingMaximizingPROFITPROFIT

Profit Maximizing RuleMR = MC

Draw a FIRM making a profit

P

MR

Q

MCATC

Quantity

Pri

ce

Draw a FIRM making a profit

Profit

Draw a FIRM making a loss

Draw a FIRM making a loss

P MR

Q

MC

ATC

Quantity

Pri

ce

Loss

Total Revenue =$63

$9

8

7

6

5

4

3

2

1

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

AVCATC

•How much output should be produced?•How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much?

MR=Price

Total Cost=$45

Profit = $18

Don’t forget that averages

show PER UNIT COSTS

the MR=MC rule still applies

What would happen if the price is lowered from $7 to $5…

…but the output changes.

Loss Minimization Position

Total Revenue=$35

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

AVC

ATC

•How much output should be produced?•How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much?

MR=Price

Total Cost = $42

Loss =$7

$9

8

7

6

5

4

3

2

1

What would happen if the price is lowered from $5 to $4…

…the firm must SHUT-Down

This is called the… Shutdown Point

•When the price falls below AVC then the firm should minimize its losses by shutting down.

•Even though they are losing money, they are still paying some of their fixed costs.

•A firm should continue to produce as long as the price is above the AVC.

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

AVC

ATC

SHUT DOWN! Produce Zero

$9

8

7

6

5

4

3

2

1

Minimum AVC is shut down

point

Total Cost

Total Revenue

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

AVC

ATC

SHUT DOWN! Producing nothing is cheaper than staying open.

MR=Price

Fixed Costs

$9

8

7

6

5

4

3

2

1

Supply Revisited

Co

st a

nd

Rev

enu

e, (

do

llar

s) MC

MR1

AVC

ATC

Quantity Supplied

MR2

MR3

MR4

MR5

P1

P2

P3

P4

P5

Q2 Q3 Q4 Q5

Marginal Cost & Supply

Do notProduce –

Below AVC

Break-even Point(No Economic Profit)

Marginal Cost & Supply

Co

st a

nd

Rev

enu

e, (

do

llar

s)MC

MR1

Quantity Supplied

MR2

MR3

MR4

MR5

P1

P2

P3

P4

P5

Q2 Q3 Q4 Q5

This is theSupply Curve

Supply=

Supply = Marginal Cost above AVC

Marginal Cost & Short-Run Supply

AVC2

MC2

What if variable costs increase?

Co

st a

nd

Rev

enu

e, (

do

llar

s)MC1

AVC1

Quantity Supplied

S1

S2

Supply Curve shifts to the Left

Marginal Cost & Short-Run Supply

AVC2

MC2

Lower Costs Movethe Supply Curve

to the Right

Co

st a

nd

Rev

enu

e, (

do

llar

s)MC1

AVC1

Quantity Supplied

S1

S2

Perfect Competition in the Long-Run

In the Long-run…•Firms will enter if there is profit•Firms will leave if there is loss•All firms break even, they make NO economic profit(No Economic Profit=Normal Profit) •In long run equilibrium the firm is efficient.

(Price = Minimum ATC)

P MR

Q

MCATC

Quantity

Pri

ce

Price = MC = Minimum ATCFirm making a normal profit

LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM

When at Long-Run Equilibrium, there is no

incentive to enter or leave the industry.

P MR

Q

MCATC

Quantity

Pri

ce

LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM

What happens when there is a change

in price?

Changes in the long-run equilibrium

S1

MCATC

P

Q100

P

Q100,000

IndustryFirm(price taker)

$60

50

40

$60

50

40

PROFIT MAXIMIZATION IN THE LONG RUN

MR

D1

What happens when demand increases?

MR

D1

MCATC

P

Q100

P

Q100,000


$60

50

40

$60

50

40

D2

EconomicProfits

S1


New competitors enter. This increases supply and lowers price back to equilibrium.

MR

D1

MCATC

P

Q100

P

Q100,000


$60

50

40

$60

50

40

D2

Zero EconomicProfits

S1

S2


Result is Long-Run Equilibrium Again.The ONLY change is the industry’s output

MR

D1

MCATC

P

Q100

P

Q100,000


$60

50

40

$60

50

40

D2


S1

S2

Decreases in demand, losses, and the reestablishment of long-run equilibrium

S1

MCATC

P

Q100

P

Q100,000


$60

50

40

$60

50

40

D1

MR


A decrease in demand creates losses…

MR

D1

MCATC

P

Q100

P

Q100,000


$60

50

40

$60

50

40

D2

EconomicLosses

S1


MR

D1

MCATC

P

Q100

P

Q100,000


$60

50

40

$60

50

40

D2

Return to ZeroEconomic Profits

S1

S3

Competitors with losses leave, decrease supply, andprices return to zero economic profits.


Result is Long-Run Equilibrium Again.

MR

D1

MCATC

P

Q100

P

Q100,000


$60

50

40

$60

50

40

D2


S1

S2


Efficiency

PURE COMPETITION AND EFFICIENCY

•Perfect Competition forces producers to use limited resources to their fullest.•Inefficient firms have higher costs and are the first to leave the industry.•Perfectly competitive industries are extremely efficient

In general, efficiency is the optimal use of societies scarce resources

1. Productive Efficiency2. Allocative Efficiency

There are two kinds of efficiency:

Productive Efficiency

Price = Minimum ATC

The production of a good in a least costly way. (Minimum amount of resources are being used)

Graphically it is where…


Allocative Efficiency

Price(Marginal Benefit) = MC

The distribution of resources towards the production of products most wanted by society.

Graphically it is where…


P MR

Q

MCATC

Quantity

Pri

ce

Productive Efficiency in the Long-Run

The marginal benefit to society

(as measured by the price) equals the marginal cost.

Long-Run Equilibrium

Optimal amount being produced

PMR

Q

MCATC

Quantity

Pri

ce

P = Minimum ATC = MC

Long-Run Equilibrium

In long run

equilibrium perfectly

competitive firms have

both productive

and allocative

efficiency

Documents

Unit III: Costs of Production and Perfect Competition