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Topics of Discussion

- Conditions of perfect competition
- Classification of inputs
- Important production relationships (assume one variable input in this chapter)
- Assessing short-run business costs
- Economics of short-run decisions

Conditions for Perfect Competition

- Homogeneous products
- No barriers to entry or exit
- Large number of sellers
- Perfect information

Page 86

Classification of Inputs

- Land:includes renewable (forests) and non-renewable (minerals) resources
- Labor:all owner and hired labor services, excluding management
- Capital:manufactured goods such as fuel, chemicals, tractors and buildings
- Management:production decisions designed to achieve specific economic goal

Pages 86-87

Production Function

Output = f(labor|capital, land,

and management)

Start with

one variable

input

Page 88

Production Function

Output = f(labor|capital, land,

and management)

Start with

one variable

input

assume all other inputs

fixed at their current

levels…

Page 112

Law of DiminishingMarginal Returns

“As successive units of a variable

input are added to a production

process with the other inputs held

constant, the marginal physical

product (MPP) eventually declines”

Page 93

Other Physical Relationships

The following derivations of the TPP curve play

An important role in decision-making:

Marginal

Physical = Output ÷ Input

Product

Pages 90

Other Physical Relationships

The following derivations of the TPP curve play

An important role in decision-making:

Marginal

Physical = Output ÷ Input

Product

Average

Physical = Output ÷ Input

Product

Pages 90-91

Total Physical Product (TPP) Curve

Marginal physical product is .45 as labor is increased from 16 to 20

output

input

Page 89

Total Physical Product (TPP) Curve

Average physical product is .31 if

labor use is 26

output

input

Page 89

Change from point A to point B on the production function is an MPP of 0.33

Page 91

Marginal physical

product falls below the

average physical

product in Stage II

Page 91

Economic Dimensions

- We need to account for the price of the product
- We also need to account for the cost of the inputs

Key Cost Relationships

The following cost derivations play a key

role in decision-making:

Marginal cost = total cost ÷ output

Page 117-120

Key Cost Relationships

The following cost derivations play a key

role in decision-making:

Marginal cost = total cost ÷ output

Average

variable = total variable cost ÷ output

cost

Page 117-120

Key Cost Relationships

The following cost derivations play a key

role in decision-making:

Marginal cost = total cost ÷ output

Average

variable = total variable cost ÷ output

cost

Average

fixed = total fixed cost ÷ output

cost

Average

total = total cost ÷ output = AVC+AFC

cost

Pages 94-96

Notice the price in column (2) is identical to marginal revenue in column (7). What about average revenue, or AR? What do you see if you divide total revenue in column (3) by output in column (1)? Yes, $45. Thus, P = MR = AR under perfect competition.

Page 98

total economic profit

if the price is $45…

P=MR=AR

11.2 ($45 - $28) = $190.40

Page 99

Zero economic profit

if price falls to PBE.

Firm would only produce

output OBE . AR-ATC=0

Page 99

The previous graph indicated that profit is maximized at 11.2

units of output, where MR ($45) equals MC ($45). This occurs

between lines G and H on the table above, where at 11.2 units

of output profit would be $190.40. Let’s do the math….

Page 98

Doing the math….

Produce 11.2 units of output (OMAX on p. 123)

Price of product = $45.00

Total revenue = 11.2 × $45 = $504.00

Doing the math….

Produce 11.2 units of output

Price of product = $45.00

Total revenue = 11.2 × $45 = $504.00

Average total cost at 11.2 units of output = $28

Total costs = 11.2 × $28 = $313.60

Profit= $504.00 – $313.60 = $190.40

Produce 11.2 units of output

Price of product = $45.00

Total revenue = 11.2 × $45 = $504.00

Average total cost at 11.2 units of output = $28

Total costs = 11.2 × $28 = $313.60

Profit= $504.00 – $313.60 = $190.40

Average profit = AR – ATC = $45 – $28 = $17

Profit = $17 × 11.2 = $190.40

Profit at Price of $45?

$

MC

Revenue = $45 11.2 = $504.00

Total cost = $28 11.2 = $313.60

Profit = $504.00 – $313.60 = $190.40

Since P = MR = AR

Average profit = $45 – $28 = $17

Profit = $17 11.2 = $190.40

P =45

ATC

28

AVC

Q

11.2

$

Revenue = $45 11.2 = $504.00

Total cost = $28 11.2 = $313.60

Profit = $504.00 – $313.60 = $190.40

Since P = MR = AR

Average profit = $45 – $28 = $17

Profit = $17 11.2 = $190.40

MC

P =45

$190.40

ATC

28

AVC

Q

11.2

Price falls to $28.00….

Produce 10.3 units of output (OBE on p. 123)

Price of product = $28.00

Total revenue = 10.3 × $28 = $288.40

Price falls to $28.00….

Produce 10.3 units of output

Price of product = $28.00

Total revenue = 10.3 × $28 = $288.40

Average total cost at 10.3 units of output = $28

Total costs = 10.3 × $28 = $288.40

Profit= $288.40 – $288.40 = $0.00

Price falls to $28.00….

Produce 10.3 units of output

Price of product = $28.00

Total revenue = 10.3 × $28 = $288.40

Average total cost at 10.3 units of output = $28

Total costs = 10.3 × $28 = $288.40

Profit= $288.40 – $288.40 = $0.00

Average profit = AR – ATC = $28 – $28 = $0

Profit = $0 × 10.3 = $0.00

Profit at Price of $28?

$

Revenue = $28 10.3 = $288.40

Total cost = $28 10.3 = $288.40

Profit = $288.40 – $288.40 = $0

Since P = MR = AR

Average profit = $28 – $28 = $0

Profit = $0 10.3 = $0 (break even)

MC

45

ATC

P=28

AVC

Q

10.3

11.2

Price falls to $18.00….

Produce 8.6 units of output (OSD on p. 123)

Price of product = $18.00

Total revenue = 8.6 × $18 = $154.80

Price falls to $18.00….

Produce 8.6 units of output

Price of product = $18.00

Total revenue = 8.6 × $18 = $154.80

Average total cost at 8.6 units of output = $28

Total costs = 8.6 × $28 = $240.80

Profit= $154.80 – $240.80 = – $86.00

Price falls to $18.00….

Produce 8.6 units of output

Price of product = $18.00

Total revenue = 8.6 × $18 = $154.80

Average total cost at 8.6 units of output = $28

Total costs = 8.6 × $28 = $240.80

Profit= $154.80 – $240.80 = – $86.00

Average profit = AR – ATC = $18 – $28 = – $10

Profit = – $10 × 8.6 = – $86.00

Profit at Price of $18?

$

MC

Revenue = $18 8.6 = $154.80

Total cost = $28 8.6 = $240.80

Profit = $154.80 – $240.80 = -$86

Since P = MR = AR

Average profit = $18 – $28 = –$10

Profit = –$10 8.6 = –$86 (Loss)

45

ATC

28

AVC

P=18

Q

8.6

10.3

11.2

Price falls to $10.00….

Produce 7.0 units of output (below OSD on p. 123)

Price of product = $10.00

Total revenue = 7.0 × $10 = $70.00

Price falls to $10.00….

Produce 7.0 units of output

Price of product = $10.00

Total revenue = 7.0 × $10 = $70.00

Average total cost at 7.0 units of output = $30

Total costs = 7.0 × $30 = $210.00

Profit = $70.00 – $210.00 = – $140.00

Average variable costs = $19

Total variable costs = $19 × 7.0 = $133.00

Revenue –variable costs = –$63.00 !!!!!

(not covering variable costs)

Profit at Price of $10?

$

Revenue = $10 7.0 = $70.00

Total cost = $30 7.0 = $210.00

Profit = $70.00 – $210.00 = $140.00

Since P = MR = AR

Average profit = $10 – $30 = –$20

Profit = –$20 7.0 = –$140

Average variable cost = $19

Variable costs = $19 7.0 = 133.00

Revenue – variable costs = –$63

Not covering variable costs!!!!!!

MC

45

ATC

28

AVC

18

P=10

Q

8.6

10.3

11.2

7.0

Key Input Relationships

The following input-related derivations also play a key role in decision-making:

Marginal

value = marginal physical product × price

product

Page 100

Key Input Relationships

The following input-related derivations also play a key role in decision-making:

Marginal

value = marginal physical product × price

product (MVP)

Marginal

input = wage rate, rental rate, etc.

cost (MIC)

Page 100

labor up to the point where the value received from the market equals the cost of another unit of

input, or MVP=MIC

D

C

E

B

F

G

5

I

H

J

Page 101

The area below the

green lined MVP

curve and above the

red lined MIC

curve represents

cumulative net benefit.

C

E

B

F

G

5

I

H

J

Page 101

Page 100

=

Marginal net benefit in column (5)

is equal to MVP in column (3) minus

MIC of labor in column (4)

Page 100

column (6) is equal to the sum

of successive marginal net benefit

in column (5)

Page 100

If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.

C

E

B

F

G

5

I

H

J

Page 101

A Final Thought

One final relationship needs to be made. The level

of profit-maximizing output (OMAX) in the graph on

page 99 where MR = MC corresponds directly with

the variable input level (LMAX) in the graph on page

101 where MVP = MIC.

Going back to the production function on page 88,

this means that:

OMAX = f(LMAX|capital, land and management)

In Summary…

- Features of perfect competition
- Factors of production (Land, Labor, Capital and Management)
- Key decision rule: Profit maximized at output MR=MC
- Key decision rule:Profit maximized where MVP=MIC

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