Firm’s decisionsFirm’s decisions
Lecture 26 – academic year 2014/15Introduction to Economics
Fabio Landini
What do we do today:What do we do today:
• A firm and its costsA firm and its costs
• Total, fixed and variable costsTotal, fixed and variable costs
• Average and marginal revenueAverage and marginal revenue
• How firm set optimal QHow firm set optimal Q
Firm behaviourFirm behaviour
We want to study firm behaviour in in presence of We want to study firm behaviour in in presence of different market structures (in this case mainly different market structures (in this case mainly perfect competition).perfect competition).
Firm’s aimFirm’s aim
The main objective of a firm is toThe main objective of a firm is to
maximize profitmaximize profit
ProfitProfit:: Total revenueTotal revenue (TR) minus (TR) minus
Total costTotal cost (TC) (TC)
Profit: revenue - costs Profit: revenue - costs
• RevenueRevenue:: amount that a firm earns amount that a firm earns through salesthrough sales
• CostsCosts:: Amount that a firm spends for Amount that a firm spends for factors of productionfactors of production
Opportunity costsOpportunity costs
Production costs include both Production costs include both explicit costsexplicit costs and and implicit costsimplicit costs::
• Explicit costsExplicit costs: monetary costs that are : monetary costs that are necessary to hire factors of production.necessary to hire factors of production.
• Implicit costsImplicit costs: costs that do not require any : costs that do not require any direct cash outlay.direct cash outlay.
Taken together we have Taken together we have opportunity costsopportunity costs
EconomistsEconomists: look at opportunity costs: look at opportunity costsAccountantsAccountants: look at explicit costs, but often : look at explicit costs, but often
neglect implicit costsneglect implicit costs
When the revenue is higher than both When the revenue is higher than both explicit costs and implicit costs the firm explicit costs and implicit costs the firm makes economic profitmakes economic profit
Opportunity costsOpportunity costs
• Average taxes paid by undergraduate students during the first 4 years (data 2003-04): 2.178 euro.
• Other direct expenses to follow classes and write exams: 3.273 .• Foregone income (comparison with non-Univ. students): 65.838.• Total expenses: 71.739.• Income differential for university degree (wit respect to non-Univ. students,
computed during the first 40 years of activity): 134.000. • Value of university degree neat of its cost: (134.000-71.739) = 62.408• Average annual return of university degree: 9,9 %.
Source: Moro-Bisin, La laurea: un ottimo investimento, www.LaVoce.info, 24/10/2005.
Example: Is University enrolment a good investment in Italy?
Production functionProduction function
LabourLabour ProductionProduction
00 00
11 5050
22 9090
33 120120
44 140140
55 150150 0
20
40
60
80
100
120
140
160
0 1 2 3 4 5 6
It shows the relationship between the quantity of It shows the relationship between the quantity of production factors “efficiently employed” and the production factors “efficiently employed” and the quantity produced.quantity produced.
Important: it does not describe all possible Important: it does not describe all possible combinations between the quantity of production combinations between the quantity of production factors and final product.factors and final product.
But only. those without useless “waste”.But only. those without useless “waste”.
Example: if I can produce Example: if I can produce 10 units10 units of a good with of a good with 5 5 workersworkers or only or only 2 workers2 workers, the only point in the , the only point in the production function is (10, 2) (product=10, work=2), production function is (10, 2) (product=10, work=2), and not (10, 5).and not (10, 5).
(10, 5) is inefficient with respect to (10, 2)(10, 5) is inefficient with respect to (10, 2) ..
Production functionProduction function
• Marginal product (of labour)Marginal product (of labour)
Q obtained through L of Q obtained through L of one unitone unit
• Previous table:Previous table:
L=0 -> L=1 produces Q = 50L=0 -> L=1 produces Q = 50
L=1 -> L=2 produces L=1 -> L=2 produces Q = 40Q = 40
L=2 -> L=3 produces Q=30L=2 -> L=3 produces Q=30
And so on….And so on….
Production functionProduction function
Marginal productMarginal product
From the table you can see that the marginal product is From the table you can see that the marginal product is always positive,always positive, but decreasing but decreasing
That is: if L increases:That is: if L increases:
• The level of production always increases(The level of production always increases(positivepositive marginal product), marginal product),
• However such an increase is smaller at the margin However such an increase is smaller at the margin ((decreasing decreasing marginal product)marginal product)
Why?Why?
Presence of fixed factors (e.g. congestion effects in using Presence of fixed factors (e.g. congestion effects in using a machine)a machine)
From production to costsFrom production to costsLabourLabour ProductionProduction Fixed Fixed
cost(maccost(machine)hine)
Variable Variable cost cost
(labour)(labour)
00 00 3030 00
11 5050 3030 1010
22 9090 3030 2020
33 120120 3030 3030
44 140140 3030 4040
55 150150 3030 5050
Total Total costcost
3030
4040
5050
6060
7070
8080
Curve of total costCurve of total cost
20
30
40
50
60
70
80
90
0 20 40 60 80 100 120 140 160
Produzione
Co
sto
to
tale
Total and marginal costTotal and marginal cost
• Marginal costMarginal cost
Total cost that derive from Q of Total cost that derive from Q of one unitone unit
Q -> total cost (i.e. marginal cost is Q -> total cost (i.e. marginal cost is positivepositive))
Moreover: the Total cost is greater at the Moreover: the Total cost is greater at the margin (marginal cost is margin (marginal cost is increasingincreasing))
Explanation: it depends on the structure of the Explanation: it depends on the structure of the production function (fixed factors)production function (fixed factors)
Relationship between MP and MCRelationship between MP and MC
0
10
20
30
40
50
60
0 1 2 3 4 5 6
Lavoro
Prodo
tto m
argina
le
0.00
0.20
0.40
0.60
0.80
1.00
1.20
0 20 40 60 80 100 120 140 160
Produzione
Costo
marg
inale
Average cost and marginal costAverage cost and marginal cost
• Average costAverage cost: FC, VC, TC over Q: FC, VC, TC over Q – Average fixed cost (AVFC)Average fixed cost (AVFC)– Average variable cost (AVVC)Average variable cost (AVVC)– Average total cost (AVC)Average total cost (AVC)
• Marginal costMarginal cost– Increase in TC if ΔQ=1Increase in TC if ΔQ=1– Equal to: ΔCT/ΔQEqual to: ΔCT/ΔQ
• The firm consider both The firm consider both AVC AVC andand MC MC to take to take her production decisionher production decision
Co
st (
in e
uro
)
Quantity
The U-shaped AVCThe U-shaped AVC
AVC
Q*
Costs (pp. 220)Costs (pp. 220)
Produz.Produz. FCFC
VCVC
00 33 00
11 33 0,30,3
22 33 0,80,8
3…3… 33 1,51,5
……88 33 8,08,0
99 33 9,99,9
TCTC
33
3,33,3
3,83,8
4,54,5
11,011,0
12,912,9
AVFCAVFC
--
33
1,51,5
11
0,380,38
0,330,33
AVVCAVVC
--
0,30,3
0,40,4
0,50,5
1,01,0
1,11,1
Costs (pp. 220)Costs (pp. 220)
MCMC
0,30,3
0,50,5
0,70,7
1,71,7
1,91,9
AVCAVC
3,33,3
1,91,9
1,51,5
1,381,38
1,431,43
Produz.Produz. FCFC
VCVC
00 33 00
11 33 0,30,3
22 33 0,80,8
3…3… 33 1,51,5
……88 33 8,08,0
99 33 9,99,9
TCTC
33
3,33,3
3,83,8
4,54,5
11,011,0
12,912,9
Shape of AVCShape of AVCWhy is AVC U-shaped?Why is AVC U-shaped?
• Because it is the sum of AVFC and AVVCBecause it is the sum of AVFC and AVVC– AVFC is decreasing with respect to QAVFC is decreasing with respect to Q– AVVC is increasing with respect to QAVVC is increasing with respect to Q
Co
sto
(in
eu
ro)
Quantità
AVC
AVVC
AVFC
Production in perfect competitionProduction in perfect competition
• Given this cost structure, how does a firm decide Given this cost structure, how does a firm decide the quantity to be produced?the quantity to be produced?
• Let’s study this problem in a perfectly competitive Let’s study this problem in a perfectly competitive marketmarket
• Characteristics:Characteristics: Many sellers and buyersMany sellers and buyers
Product are perfect substituteProduct are perfect substitute
Free entryFree entry
• Consequences:Consequences: firms are firms are price takerprice taker
Price and revenuePrice and revenue
QQ PricePrice TR = PxQTR = PxQAVR=AVR=
TR/QTR/Q
11 66 66 66
22 66 1212 66
33 66 1818 66
44 66 2424 66
MR = MR = ΔTR/ΔQΔTR/ΔQ
66
66
66
66
Firm’s revenue in perfect Firm’s revenue in perfect competitioncompetition
In a perfectly competitive market:In a perfectly competitive market:
MR = priceMR = price
NB: This is not true in other market structuresNB: This is not true in other market structures
Profit maximizationProfit maximization
Firm’s objective = max profitFirm’s objective = max profit i.e.: set Q such that the difference between TR i.e.: set Q such that the difference between TR and TC is max and TC is max
• This happens when the firm set Q such that This happens when the firm set Q such that MR = MCMR = MCIf If MR > MCMR > MC,, an increase in an increase in Q Q increases profitincreases profit
If If MR < MCMR < MC, , an increase in an increase in Q Q reduces profitreduces profit
If If MR = MCMR = MC, , profit is maxprofit is max
Firm production decisionFirm production decision
Quantity0
Price
AVCMC
Firm production decisionFirm production decision
Quantity0
Price
AVCMC
P = AVR = MRP
Firm production decisionFirm production decision
Quantity0
Price
AVCMC
P = AVR = MRP
Profit max Q
Q
Firm production decisionFirm production decision
Quantity0
Price
AVCMC
P = AVR = MRP
AVC
Profit max Q
Q
Firm production decisionFirm production decision
Quantity0
Price
AVCMC
P = AVR = MRP
AVC
Profit max Q
Q
Profit
What happens in with free entry?What happens in with free entry?
Quantity0
Price
AVCMC
P = AVR = MRP
Q
The existence of a positive profit will lead more The existence of a positive profit will lead more firm to enter -> in supply -> pricefirm to enter -> in supply -> price
Quantity0
Price
AVCMC
P = AVR = MRP
Q
The existence of a positive profit will lead more The existence of a positive profit will lead more firm to enter -> in supply -> pricefirm to enter -> in supply -> price
Quantity0
Price
AVCMC
P = AVR = MRP
Q
P’ = AVR’ = MR’P’
Q’
The existence of a positive profit will lead more The existence of a positive profit will lead more firm to enter -> in supply -> pricefirm to enter -> in supply -> price
Quantity0
Price
AVCMC
P = AVR = MRP
Q
P’ = AVR’ = MR’P’
Q’
P’’ = AVR’’ = MR’’P’’
Q’’
As soon as profit=0 no firm will enter any more… As soon as profit=0 no firm will enter any more…
Quantity0
Price
AVCMC
P = AVR = MRP
Q
P’ = AVR’ = MR’P’
Q’
P’’ = AVR’’ = MR’’P’’
Q’’
ConclusionConclusion
We studied tools that firms use to take We studied tools that firms use to take decisiondecision
Firms set profit set Q so that MR=MC, i.e. max Firms set profit set Q so that MR=MC, i.e. max profitprofit
If there is free entry in the market profit tends If there is free entry in the market profit tends to zero in the long periodto zero in the long period