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Economics 202: Intermediate Microeconomic Theory

Economics 202: Intermediate Microeconomic Theory. Reminder: Review is due in class on Tuesday. Short-Run Costs of Production. A firm’s production costs equal explicit + implicit costs (i.e., the opportunity cost of their resources -- their value in their next best use)

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Economics 202: Intermediate Microeconomic Theory

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  1. Economics 202: Intermediate Microeconomic Theory • Reminder: Review is due in class on Tuesday

  2. Short-Run Costs of Production • A firm’s production costs equal explicit + implicit costs (i.e., the opportunity cost of their resources -- their value in their next best use) • Economic costAccounting cost Labor explicit cost (w) current expenses Capital implicit cost (r) historical price & depreciation • Measures of Short-Run Costs: • Total Fixed Costs (TFC) are costs that don’t depend on level of output • Costs they can’t adjust in short-run (plant and equipment) • Even if they shut-down, they have to pay their Fixed costs • Total Variable Costs(TVC) are costs that do depend on level of output • These can be adjusted in short-run (workers, electricity, raw materials) • More output leads to greater TVC • Total Cost = TFC + TVC at each output level • Because TVC increases with Q, so does TC • Marginal Cost = TC/Q • How much will cost increase if we make one more unit of output? • How much will a firm save if it makes one fewer unit of output?

  3. Measures of Average Cost • Average Fixed Cost (AFC) = TFC/Q • As output increases, AFC decreases. • Average Variable Cost (AVC) = TVC/Q • Average Total Cost (ATC) = TC/Q • ATC = AFC + AVC

  4. Total Product and Total Variable Cost Q • TVC is total money the firm must spend to get the necessary amount of the variable input. • To get TVC on the x-axis, multiply each quantity of labor by its cost ($10/hour) • Key point: the shape of the TVC curve is determined by the shape of the TP curve (which exhibits diminishing marginal returns) 8 TP 4 8 18 L (hours of labor) Q 8 TVC 4 $80 $180 Total Var Cost ($)

  5. Short-Run Cost Curves • We typically reverse the axes, so TC curve has the shape shown. • TFC is horizontal line. • TVC is same distance below TC at all output levels. TC $ TVC 100 • MC curve is derived from TC curve and is U-shaped due to diminishing marginal returns. • MC = TVC/ q = L*w/ q = w/MPL • Under diminishing marginal returns, each extra worker adds less to Q  each extra unit of Q requires more workers  each extra unit of Q will cost more TFC 20 4 Q $/unit MC 4 Q

  6. Short-Run Cost Curves $ TC • There are 3 average cost curves • AVC = TVC/Q = wL/Q = w/APL • Recall that APL rises to a maximum and then falls  AVC will fall then rise. • AVC is slope of ray from origin to a point on the TVC curve TVC 100 TFC 20 • AFC = TFC/Q and declines over the entire range of Q • Fixed costs are spread over more Q Q 4 $/unit ATC MC AVC • ATC = AVC + AFC AFC 4 Q

  7. Marginal-Average Relationships • If Marginal < Average, Avg is falling • If Marginal >Average, Avg is rising •  MC = AC at AC’s minimum $ TC TVC 100 TFC 20 Q 4 $/unit ATC MC AVC 4 Q

  8. Long-run vs.Short-run Cost curves LAC ($) SAC1 SAC7 SAC6 LAC SAC3 Output • Long-run is a planning horizon. Under uncertainty about future demand, the firm chooses which size plant to build, thus determining their short-run costs, until it’s time to build again. • Pick an output level and build the plant size allowing lowest avg cost • LAC is the lowest average cost attainable when all inputs are variable • If only 7 plant sizes available, LAC is a “wave”-line. • If lots and lots of plant sizes possible, LAC is the smooth line

  9. Competitive Firm Example • Assume firm operates in a perfectly competitive output market and perfectly competitive input markets • Let Q = f(K,L) = K1/3L1/3 • Find conditional factor demand functions. • Find LRTC and the “family” of SRTC functions.

  10. Competitive Firm Example • Assume w = 1, r = 1, K = 27

  11. Competitive Firm Example • Assume w = 1, r = 1, K = 27 & 64

  12. Profit Maximization • max  = TR(q) – TC(q) • max  = TR(K,L) – TC(K,L) • Derive profit-max conditions • Big Picture -- what does the profit maximization condition look like for various possibilities? Input Market Structure Output Mkt Structure:CompetitionMonopsonistic Competition P * MPL = wP * MPL = MEL Monopolistic MR * MPL = w MR * MPL = MEL

  13. Market Structures • Continuum of market structures Perfect CompetitionMonopolistic CompetitionOligopolyMonopoly many firms/buyers many smaller firms small # of bigger firms 1 supplier free entry/exit free entry/exit difficult to enter barriers to entry product homogeneity differentiated products same or different Q one product perfect information perfect info imperfect info imperfect info • Examples: Farmer’s market fast food, clothes, steel , cars, cell phones, local cable cereals, aspirin, colas ABC/NBC/CBS/Fox local utility Microsoft? • Features: Some monopoly power: L > 0 Interdependent actions D-curve is not Dmarket No single oligopoly theory ’s are eroded by entry; econ = 0

  14. Short-run Profit Maximization • Total Revenue (TR) curve is new • Profit = TR - TC • Implicit (like owner’s time) & explicit costs are included •  < 0 even if shut down (Q = 0) • max occurs where MR = MC $ TR TC TFC  • Now use per-unit cost curves • ATC = AVC + AFC • ATCmin > AVCmin • Vertical distance becomes smaller • Competitive firm’s D-curve is horiz. • max occurs where MR = MC • Profit = (AR - AC)*(Q) [green box] • (avg profit per unit)*(# units sold) • max rule does not mean the firm intentionallysets P = MC; price-taker adjust Q ‘til MR = MC Output Q* MC $/unit ATC P P=MR=AR AVC Q* Q

  15. It might be in the best interests of the firm to incur a loss If P < ATC , but P > AVC Can either shut down or operate Ceasing production may be only temporary until D picks up again Loss if Q = Q2* is yellow rectangle Loss if Q = 0 is yellow + green (note that we’re only using the Q* level to compare at same output) Operating at a Loss in the Short-run MC ATC $/unit P1 AVC P2=MR=AR P2 Q2* Q1* Output MC ATC $/unit • Loss if Q = Q3* is yellow area Loss if Q = 0 is purple area • Shutdown point is the minimum of the AVC curve since for any price below that it will be more profitable (less unprofitable) to stop producing AVC P3=MR=AR P3 Q3* Output

  16. Competitive Firm’s Short-run Supply Curve • A perfectly competitive firm’s SR supply curve is the same as its MC curve (above min AVC!) • It shows how much they will supply at any given price • Lower the price  MR < MC • Only above the shutdown point • At P1, produce Q1 (  > 0 ) At P2, produce Q2 (  > 0 ) At P3, produce Q3 (  > 0 ) At P4, produce Q4 (  < 0, but better to still operate ) At P5, produce Q5 = 0 (  < 0, but better to shut down) $/unit MC SS P1 P2 ATC AVC P3 P4 P5 Q5 Q4 Q3 Q2 Q1 Output

  17. Competitive Firm Example • Assume w = 1, r = 1, K = 27, then SRTC = 27 + q3/27 • Find and graph ATC, AVC, AFC, MC. • Find shutdown price and breakeven (zero profit) price • Calculate profit if P = $9

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