ECONOMICS FOR BUSINESS

PRODUCERS IN THE MARKET PLACE

Marco Merelli

Mumbai | India
CONTENTS:

• The Production function

• The Total-cost curve
• The Average and the Marginal cost
• Cost models: from the short-run to the long-run
• Economies and diseconomies of scale.
• Firms as price-taker
• Costs and the supply curve
• Market equilibrium in the short and in the long run

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THE FIRM’S OBJECTIVE

Assumption: the economic goal of the firm is to maximize profits.

Profit = Total Revenue (TR) - Total Cost (TC)

Total cost includes all opportunity cost:

• Explicit costs (there is a direct outlay of money)
• Implicit costs (without a direct outlay of money): they are measured by
the value of the benefits that are forgone.

3
ACCOUNTING PROFIT VERSUS ECONOMIC PROFIT

You invest $50,000 (depreciation

10% per year) to start a business First
year: other explicit costs $60,000,
revenues 100,000$.
Accounting profit = 35,000$

That same year you could have

earned $20,000 had you been
employed and 4% of your capital
used in the best alternative way.
Economic profit =
35,000$ - 22,000$ = 13,000$

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 PRODUCTION

• The production function: the relationship between quantity of inputs used to

make a good and the quantity of output.
• The marginal product of any input is the increase in output that arises from an
additional unit of that input.
• The diminishing marginal productivity: marginal product of an input declines as
the quantity of the input increases holding the levels of all other inputs fixed.
• Example: as more and more workers are hired, each additional worker
contributes less and less to production because the firm has a limited amount of
equipment.

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PRODUCTION FUNCTION

Quantity of
Output
(cookies
per hour) Production function
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10

0 1 2 3 4 5 Number of Workers Hired

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FROM THE PRODUCTION FUNCTION TO THE TOTAL-COST
CURVE

• The relationship between the quantity a firm can produce and its costs determines
pricing decisions.
• Fixed costs (FC) are those costs that do not vary with the quantity of output
produced.
• Variable costs (VC) are those costs that do vary with the quantity of output
produced.

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PRODUCTION FUNCTION AND TOTAL COST

8
TOTAL-COST CURVE
Cost ($)

$80
Total-cost curve

70

60

50 Variable costs

40

30 Fixed costs

20

10

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity

of Output (cookies per hour)
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 FROM TOTAL COST TO AVERAGE COSTS

The average cost is the cost of each typical unit of product.

Average Total Costs (ATC) = Total Cost (TC) / Quantity of Output (Q)
Average Fixed Costs (AFC) = Fixed Cost (FC) / Quantity of Output (Q)
Average Variable Costs (AVC) = Variable Cost (VC) / Quantity of Output (Q)

By definition ATC = AFC + AVC

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AVERAGE-COST CURVES

ATC

AVC
AFC

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 MARGINAL COST

– The Marginal cost is the answer to the following question:

“How much does it cost to produce an additional unit of output?”

– Marginal cost (MC) measures the increase in total cost that arises from an extra
unit of production.

(change in total cost) ∆TC

MC = =
(change in quantity) ∆Q

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 COST COST CURVES AND THEIR SHAPES

• The MC curve rises with the amount of output produced, this is due to the
diminishing marginal product.
• The ATC curve is U-shaped:
• At very low levels of output is high because Fixed Costs are spread over only
a few units.
• Then ATC starts rising because AVC rises substantially.
• The bottom of the U-shaped ATC curve is the ATC curve’s minimum point: it
is the lowest possible per-unit cost.
• The quantity At ATC curve’s minimum point this point defines the efficient
quantity of production.

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THE RELATIONSHIP BETWEEN ATC AND MC CURVES

Cost of unit

If marginal cost is
MC
below average ATC
total cost, average
total cost is falling.
B
2
A
1
Min ATC: lowest A
B
1 If marginal cost is
possible per-unit cost 2
above average total
cost, average total
cost is rising.

Quantity
Efficient quantity
14
that min per-unit cost
COSTS IN THE SHORT RUN AND IN THE LONG RUN

• In the short run, fixed cost is completely outside the control of a firm. But all
inputs are variable in the long run.
• The division of total costs between fixed and variable costs depends on the
time horizon being considered.
• The firm will choose its fixed cost in the long run based on the level of output it
expects to produce.

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 CHOOSING A COST MODEL
Let’s compare two cost models for our business:
a) Low fixed cost and high variable cost.
b) High fixed cost and low variable cost.
a) b)

At low output At high output levels,

levels, low fixed high fixed cost yields
Cost
cost yields lower lower average total cost
$250 average total cost

200

150 Low fixed cost

ATC1
100
ATC2
50 High fixed cost

0 1 2 3 4 5 6 7 8 9 10

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THE LONG-RUN AVERAGE TOTAL COST CURVE

Average
Total
Cost

The long-run average total cost

curve (LR ATC) shows the
relationship between output
and ATC when Fixed Cost has
been chosen to minimize ATC
for each output level.

Efficient scale of production: the quantity

that minimize the long-run per-unit cost 17
LRATC AND ECONOMIES OF SCALE

• Increasing returns to scale (also known as “economies of scale”):

LR ATC falls as the quantity of output increases.
• Constant returns to scale: LR ATC stays the same as the quantity of output increases
• Decreasing returns to scale (also known as “diseconomies of scale”):
LR ATC rises as the quantity of output increases due to:
• communication breakdown,
• lack of motivation,
• lack of coordination,
• loss of focus by the management and employees,
• constraints on productive inputs
• …

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INCREASING AND DECREASING RETURNS TO SCALE

Diseconomies of
scale (Decreasing
returns to scale)

Constant returns to
scale

Economies of
scales (increasing
return to scale)
Quantity

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 PRODUCERS IN A COMPETITIVE MARKET

1. There are many sellers (and many buyers) in the market, none of whom have a
large market share.
2. The goods offered by the various sellers are largely the same. Consumers regard
the products of all producers as equivalent: the good is a standardized product, a
commodity.
3. Firms can freely enter or exit the market. The producers in an industry cannot
artificially keep other firms out.

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 WHAT IS A PERFECTLY COMPETITIVE MARKET?

As a result of its characteristics, the perfectly competitive market has the following
outcomes:
• The actions of any single buyer or seller in the market have a negligible impact
on the market price.
• Buyers and sellers must accept the price the market determines: each buyer and
seller is a price taker.

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REVENUE AND COMPETITIVE MARKETS

Total Revenue (TR) = P × Q

Marginal revenue (MR) is the change in total revenue from an

additional unit sold = ∆TR / ∆Q

Average revenue (AR) = TR/Q

For competitive firms

AR = MR = P

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THE PRICE-TAKING FIRM’S OPTIMAL OUTPUT RULE
TO MAXIMIZE PROFITS

“How much” decision: marginal analysis.

The profit is maximized by producing the quantity of output at

which the marginal cost of the last unit produced is equal to (or not
higher than) the market price.

MC = P

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 … BUT IS PRODUCTION PROFITABLE?

If TR > TC (or AR > ATC), the firm is profitable.

If TR = TC (or AR = ATC), the firm breaks even (Economic) Profits = 0

If TR < TC (or AR < ATC), the firm incurs a loss.

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 COSTS AND THE SUPPLY CURVE

• The portion of the marginal cost curve (MC) that lies above average cost (AC) is the
competitive firm’s supply curve.
• In the long-run, if P< ATC the firm exits, i.e. the price it would get from producing is
less than its ATC.
• In the short-run, the firm shuts down if P<AVC, i.e. the price it gets from producing is
less than the AVC.
• The firm must pay its fixed costs, regardless of whether it produces any output.
Hence, the firm's fixed costs are considered sunk costs and will not have any bearing
on whether the firm decides to shut down. Thus, in the short run, the firm will focus
on its AVC to determine whether to shut down.

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THE COMPETITIVE FIRM’S LONG-RUN SUPPLY CURVE

Costs
Firm’s long-run
supply curve MC = long-run S

Firm
enters if
P > ATC ATC

Break-even price

Firm Minimum average total cost

exits if
P < ATC

Quantity
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Copyright © 2004 South-Western
THE COMPETITIVE FIRM’S SHORT-RUN SUPPLY CURVE

Costs
Firm’s short-run
If P > ATC, the firm supply curve MC
will continue to
produce at a profit.

ATC
If P > AVC, firm will
AVC
continue to produce in
the short run.

Shut-down price
Minimum average
variable cost
Firm
shuts
down if
P < AVC Quantity
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Copyright © 2004 South-Western
THE LONG-RUN: MARKET SUPPLY WITH ENTRY AND EXIT

1. Firms will enter or exit the market until profit is driven to zero.
2. In the long run, the price equals the minimum of the average total cost.
3. The long-run market supply curve is horizontal at this price.

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THE LONG RUN: MARKET SUPPLY WITH ENTRY AND EXIT

Firm Market Supply

Price Price

MC
ATC
Supply
P= minimum
ATC

0 Quantity (firm) 0 Quantity (market)

Copyright © 2004 South-Western

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THE PRICE-TAKING FIRM’S OPTIMAL OUTPUT RULE
TO MAXIMIZE PROFITS

Price Market Price = $18

Minimum average
MC
total cost
ATC
E
$18 MR=P
14.40 Profit
Break-even price 14 Z
C

0 10 20 30 40 50 60 70
30
Quantity
FROM THE SHORT RUN TO THE LONG-RUN EQUILIBRIUM

Price
(a) Market (b) Individual Firm
Price
S1 MC
S3
$18 EMKT $18
E

DMKT
D ATC
B
14.40
Break Z
14 CMKT 14
-even C
D
0 5,000 10,000 price 0 30 40 45 50 60
Quantity Quantity

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THE EFFECT OF AN INCREASE IN DEMAND IN THE SHORT-RUN
AND THE LONG-RUN
(b) Short-Run and Long- (c) Existing Firm Response
(a) Existing Firm Response to Run Market Response to to New Entrants
Increase in Demand Increase in Demand

Price, Long-run industry Higher industry output from

Price Price,
cost supply curve new entrants drive price and
An increase in cost
profit back down.
demand raises
price and profit. S S MC
MC 1 2

$18 Y ATC Y ATC

Y
14 MKT
X X Z D2 Z
MKT MKT
D
1

0 Quantity 0 QXQY QZQuantity 0 Quantity

Increase in output from new entrants
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THE EFFICIENCY OF THE LONG-RUN MARKET EQUILIBRIUM

1. At the end of the process of entry and exit, firms that remain must be making
zero economic profit.
2. The process of entry and exit ends only when P = min ATC
3. Long-run equilibrium must have firms operating at their efficient scale.

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WHY DO COMPETITIVE FIRMS STAY IN BUSINESS IF
THEY MAKE ZERO PROFIT?

1. Profit equals total revenue minus total cost

2. Total cost includes all the opportunity costs of the firm
3. In the zero-profit equilibrium, the firm’s revenue compensates the owners for
the time and money they expend to keep the business going.

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CAN THE LONG-RUN SUPPLY CURVE SLOPE UPWARD
OR DOWNWARD?

1. If some resources used in production are available only in limited quantities the long
run supply curve can slope upward.
2. If an industry (not a single firm!) faces increasing return to scale (for example
because of better knowledge/skills) the long run supply curve can slope downward.

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