Short Run Costs

1. Short Run Costs

2. Production Processes X-Box Production http://www.youtube.com/watch?v=dzJUSFr5EvQ&feature=related KTM Factory http://www.youtube.com/watch?v=jihqmdX0jkM 1939 River Rouge Plant http://www.youtube.com/watch?v=TcXfk0op6JA Scorpion Factory http://www.youtube.com/watch?v=hMCyqyyh5MA

3. Short Run versus Long Run? • short run - a period of time where some inputs are fixed (capital = building, equipment, etc.) • long run - a period of time in which all inputs can be varied (no inputs are fixed)

4. Short Run Cost Function Definition: • A function that defines the minimum possible cost of producing each output level when variable factors are employed in the cost-minimizing fashion. (Based on the inability to change the fixed factors)

5. In this case, what is your total product/output (Q)? • Number of Paninis (for simplicity assume that Panera only produces a single product). • In general a firm uses capital, labor and materials to produce the product/output where capital is often fixed in the short run.

6. In Short Run, how does the number of Paninis produced change as you change the number of workers?

7. How does output change if you hire one more person? • Depends on how many workers you currently have. Output increases by 5 paninis when you hire the 1st worker, increases by 7 paninis when you hire the 2nd worker, …., and increases 3 paninis when you hire the 5th worker.

8. What happens to “productivity” as the first few employees are hired? • Specialize and marginal product increases. Marginal Product is the change in total output attributable to the last unit of an input.

9. What would happen to “productivity” if you continued to hire more and more workers? • Marginal product would start to fall because some inputs are fixed in the short run. • Law of diminishing marginal returns OR Law of diminishing marginal product.

10. What costs would you have to pay even if you didn’t produce a single panini? • Fixed Costs, FC (or Total Fixed Costs, TFC) (often involves building and equipment) Fixed Costs = Costs that do not change with changes in output

11. What costs would you have to pay only if you produced paninis? • Variable Costs, VC(or Total Variable Costs, TVC) (often assumed to be labor and material) Variable Costs = Costs that change with changes in output

12. What costs would increase if we wanted to produce one more panini? • Variable Costs (such as labor and materials)

13. If you hired more and more employees • and the store became more and more crowded until the marginal product of a worker started to fall, what would happen to the cost of producing one more panini (marginal cost)? Marginal cost = cost of producing an additional unit of output

14. Costs Fixed costs do not vary with output (150-100)/1= Variable costs increase by 50 from 0 to 1 unit of output and increases by 30 from 1 to 2 units. Average Variable Costs (AVC) = Variable Costs/Q so at an output of 2, AVC=80/2=40. Average Fixed Costs (AFC) = Fixed Costs/Q so at an output of 2, AFC=100/2=50. Average Total Costs (ATC) = Total Costs/Q so at an output of 2, ATC=180/2=90 or AFC+ATC.

15. Costs

16. TC= ATC*Q What is happening to TC as Q increases? Increases! 150 180 480

17. What are total fixed costs in this example? AFC*Q 100*1=100

18. Spreading a fixed number out over a larger and larger Q Why are AFC diminishing?

19. Why is AVC getting closer to ATC? Because ATC = AVC+AFC and AFC is getting close to 0

20. Where does the law of diminishing marginal product set in and how do you know? Where MC starts increasing! Why does this happen? An input is fixed in the short run!

21. Where does MC cross ATC?Where does MC cross AVC? At their minimums What is the relationship between MC and ATC? MC and AVC? If MC<ATC, ATC is decreasing If MC>ATC, ATC is increasing Same for AVC

22. How do you know this is the short run? There are fixed costs

23. Fixed Cost versus Sunk Cost Fixed Cost = costs that do not change with changes in output Sunk Cost= a cost that is forever lost after it has been paid • Does profit maximizing output depend on whether cost if fixed or sunk given that you produce paninis? • Does the decision whether to produce any paninis depend on whether cost is fixed or sunk? No Yes

24. Short Run versus Long Run? • short run - a period of time where some inputs are fixed (capital = building, equipment, etc.) • long run - a period of time in which all inputs can be varied (no inputs are fixed) UQM Technologies http://www.youtube.com/watch?v=UvnHQz6lDQ8&feature=related

25. Profit Maximization

26. Profit Maximization assuming: • Firm must charge every consumer the same price (i.e., no price discrimination) • No Strategic Interaction among Firms We will consider three industry structures: • Price taking Firms • Monopoly • Monopolistic Competition

27. Price Taking Firm’s Short Run Costs

28. Price Taking Firm’s Short Run Costs

29. What output maximizes profits if the marginal revenue (MR) for each unit the firm sells is $55? What are these profits? 8 55*8-43.75*8=90

30. What output maximizes profits if the marginal revenue for each unit the firm sells is $35? What are these profits? 6 35*6-43.33*6=-50 Produce an output of 6 in short-run if fixed costs are sunk.

31. What output maximizes profits if the marginal revenue for each unit the firm sells is $25? What are these profits? 5? 25*5-46*5=-105 Better off producing 0 so profits=-FC=-100

32. Short-Run Profit Maximizing Rule • Produce at an Output where Marginal Revenue = Marginal Cost (MR) (MC) if Total Revenue > Variable Cost [When the firm cannot price discriminate, this is the same thing as saying as long as Price > AVC (from P*Q > AVC*Q) ]

33. Monopoly Characteristics • There is a single seller • There are no close substitutes for the good • There are extremely high barriers to entry

34. Monopolist Marginal Revenue (with no price discrimination) +9 +7 +5 +3 +1 -1 Q -3 -5 MR -7 Note that Marginal Revenue for a given unit is plotted at the midpoint of that unit. -9

35. Use Calculus to Obtain MR curve for Linear Demand Curve Slope of D • Demand Curve: • P=a-bQ • TR • = (a-bQ)Q • =aQ-bQ2 • MR • =ΔTR/ ΔQ=∂TR/ ∂Q • =a-2bQ [In prior graph, a=10 and b=1] Slope of MR

36. Monopoly • If the firm’s goal were to maximize total revenue, where would it produce? • P=$5; TR=$25 • Will a monopolist ever charge a price less than $5? • What price will the monopolist charge? Q MR

37. Monopoly Maximizing Profits • If the monopolist maximizes profits, where would it produce? • At an output where MR=MC as long as P>AVC. • This is at an output of Q=4 so a price of P=6. Q MR

38. MATH BEHIND: Maximizing Profits being where MR=MC MaxQ Profits = MaxQ TR(Q)-TC(Q) so profits are maximized where Or where, Applies when Q>0

39. Monopoly Maximizing Profits TR Profits • At Q=4 and P=6, what is Total Revenue? TR=P*Q=6*4=24 • At Q=4, what are Total Costs? TC=ATC*Q=4.5*4=18 • At Q=4 and P=6, what are Profits? Profits=TR-TC=24-18=6 Or Profits=P*Q-ATC*Q =(P-ATC)*Q =(6-4.5)*4=6 Q TC MR

40. Monopolist in Long Run Profits • What should this monopolist do in the Long Run assuming that the monopolist thinks his costs will not change and neither will demand? Keep producing Q=4 or change plant size depending if there is a plant size that would result in greater profits. Q MR

41. Monopolist in Long Run Profits • What should this monopolist do in the Long Run assuming that the monopolist thinks his costs will not change and neither will demand? Exit the industry or change plant size depending if there is a plant size that would result in positive profits given demand curve. MR

42. Monopolistic Competition Characteristics • There are many buyers and seller • Each firm in the industry produces a differentiated product • There is free entry into and exit from the industry [Think bakery or coffee shop in big city.]

43. Bakery in a Monopolistically Competitive Industry Maximizing Profits in the Short Run • If bakery maximizes profits, where would it produce? Where MR=MC which is at an output of Q=3.5 so a price of P=8. • What are the bakery’s profits? TR-TC=P*Q-ATC*Q =8*3.5 - 6.25*3.5 = 6.12 MR

44. Bakery in a Monopolistically Competitive Industry Maximizing Profits in the Long Run • In long-run if the bakery is making positive economic profits, we would expect other bakeries to enter causing a reduction in demand. • What are maximum profits when demand is D’? Q=3 so a price of P=6.67. Profits=P*Q-ATC*Q =6.67*3-6.67*3=0 D’ MR

45. Review of Profit Maximization (when setting a single price)

46. Marginal Revenue from 5th Unit is just the shaded area below. This area is $11. When the MR curve is linear, the area under the MR curve can be obtained by just taking the MR at the midpoint of the quantities – in this case at 4.5. The orange area is the same as the purple area. MR

47. Marginal Cost of 5th Unit is just the shaded area below. This area is $9. When the MC curve is linear, the area under the MC curve can be obtained by taking the MC at the midpoint of the quantities – in this case at 4.5. The purple area is the same as the red area MR

48. Change in Profits associated with producing 5 Units rather than 4 units. Yellow area is change in profits associated with producing 5 units rather than 4 units. This area is $2. Subtract MC of 5th unit from MR of 5th unit– brown area from purple. MR

49. Review of Profit Maximization (when setting a single price)

50. PROFIT MAXIMIZATION Profits are maximized at an output where MR=MC which is Q=5. Price is 15 and ATC is 11.2 at Q=5. Profits are then 15*5-11.2*5=19 15 11.2 MR