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Review: Costs of Production, Theory of the Firm

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  • 1. REVIEW COSTS OF PRODUCTION,THEORY OF THE FIRM
  • 2. ECONOMIC COSTS Profits to an Profits to an Economist Accountant TEconomic (opportunity) Costs Economic O Profit T A Accounting L Profit Implicit costs (including a R normal profit) E V Explicit Accounting E Costs N costs (explicit U costs only) E
  • 3. SHORT-RUN PRODUCTION RELATIONSHIPSLaw of Diminishing Returns Total Product, TP Total Product Increasing MarginalAverage Product, AP, and Quantity of Labor Marginal Product, MP Returns Average Product Marginal Quantity of Labor Product
  • 4. SHORT-RUN PRODUCTION RELATIONSHIPSLaw of Diminishing Returns Total Product, TP Total Product Diminishing MarginalAverage Product, AP, and Quantity of Labor Returns Marginal Product, MP Average Product Marginal Quantity of Labor Product
  • 5. SHORT-RUN PRODUCTION RELATIONSHIPSLaw of Diminishing Returns Total Product, TP Total Product Negative MarginalAverage Product, AP, and Quantity of Labor Marginal Product, MP Returns Average Product Marginal Quantity of Labor Product
  • 6. PRODUCTIVITY AND COST CURVES Average product and marginal product AP MP Quantity of labor MC Costs (dollars) AVC Quantity of output
  • 7. LONG-RUN PRODUCTION COSTSUnit Costs Output
  • 8. LONG-RUN PRODUCTION COSTSUnit Costs Output
  • 9. LONG-RUN PRODUCTION COSTS The long-run ATC just “envelopes” all of the short-run ATC curves.Unit Costs Output
  • 10. LONG-RUN PRODUCTION COSTSUnit Costs long-run ATC Output
  • 11. ECONOMIES AND DISECONOMIES OF SCALE•Labor Specialization•Managerial Specialization•Efficient Capital• Other FactorsDiseconomies of ScaleConstant Returns to Scale graphically presented...
  • 12. ECONOMIES AND DISECONOMIES OF SCALE Economies of scaleUnit Costs long-run ATC Output
  • 13. ATC decreases as ATC is constant as Output increases Output increases Economies Constant returns of scale to scaleUnit Costs long-run ATC Output
  • 14. ATC decreases as ATC is constant as ATC increases as Output increases Output increases Output increases Economies Constant returns Diseconomies of scale to scale of scaleUnit Costs long-run ATC Output
  • 15. MARGINAL REVENUE-MARGINAL COST APPROACH Profit Maximization Position $200 Economic Profit MC 150 Cost and Revenue $131.00 MR ATC 100 AVC $97.78 50 0 1 2 3 4 5 6 7 8 9 10
  • 16. MARGINAL REVENUE-MARGINAL COST APPROACH Profit Maximization Position $200 Economic Profit MC 150 Cost and Revenue $131.00 MRMR = MC ATC 100 AVCOptimum $97.78Solution 50 0 1 2 3 4 5 6 7 8 9 10
  • 17. MARGINAL REVENUE-MARGINAL COST APPROACH Short-Run Shut Down Point $200 MC 150 Cost and Revenue ATC 100 AVC $71.00 MR 50 Minimum AVC is the Shut-Down Point 0 1 2 3 4 5 6 7 8 9 10
  • 18. SHORT-RUN COMPETITIVE EQUILIBRIUM The Competitive Firm “Takes” its Price from the Industry Equilibrium S= MCs P P Economic ATC Profit S=MC$111 D $111 AVC D 8 Q 8000 Q Firm Industry (price taker)
  • 19. SHORT-RUN COMPETITIVE EQUILIBRIUM The Competitive Firm “Takes” its Price from the Industry Equilibrium S= MCs P P Economic ATC Profit S=MC$111 How about the D $111 long-run? AVC D 8 Q 8000 Q Firm Industry (price taker)
  • 20. PROFIT MAXIMIZATION IN THE LONG RUNTemporary profits and the reestablishmentof long-run equilibrium S1 P P MC ATC$60 $60 50 50 40 MR 40 D1 100 Q 100,000 Q Firm Industry (price taker)
  • 21. PROFIT MAXIMIZATION IN THE LONG RUNAn increase in demand increases profits… Economic S1 P Profits P MC ATC$60 $60 50 50 40 MR 40 D2 D1 100 Q 100,000 Q Firm Industry (price taker)
  • 22. PROFIT MAXIMIZATION IN THE LONG RUNNew competitors increase supply, and lowerprices decrease economic profits. Zero Economic S1 P P S2 Profits MC ATC$60 $60 50 50 40 MR 40 D2 D1 100 Q 100,000 Q Firm Industry (price taker)
  • 23. PROFIT MAXIMIZATION IN THE LONG RUNDecreases in demand, losses, and thereestablishment of long-run equilibrium S1 P P MC ATC$60 MR $60 50 50 40 40 D1 100 Q 100,000 Q Firm Industry (price taker)
  • 24. PROFIT MAXIMIZATION IN THE LONG RUNA decrease in demand creates losses… Economic S1 P Losses P MC ATC$60 MR $60 50 50 40 40 D1 D2 100 Q 100,000 Q Firm Industry (price taker)
  • 25. PROFIT MAXIMIZATION IN THE LONG RUNCompetitors with losses decrease supply, andprices return to zero economic profits.S3 Return to Zero S1 P Economic Profits P MC ATC$60 MR $60 50 50 40 40 D1 D2 100 Q 100,000 Q Firm Industry (price taker)
  • 26. MARGINAL REVENUE-MARGINAL COST APPROACH Loss Minimization Position $200 Economic Loss MC 150 Cost and Revenue ATC 100 AVC $91.67 $81.00 MR 50 0 1 2 3 4 5 6 7 8 9 10
  • 27. MONOPOLY REVENUES & COSTS Elastic $200 150 Dollars 200 50 MR D Q T 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 $750 Dollars 500 TR 250 Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
  • 28. MONOPOLY REVENUES & COSTS Elastic Inelastic $200 150 Inelastic Dollars Portion 200 MR is NegativeA Monopolist will 50 MR Dalways operate on Qthe Elastic Portion 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18of the Demand $750Curve Dollars 500 TR 250 Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
  • 29. OUTPUT AND PRICE DETERMINATIONProfit Maximization Under Monopoly Remember the MR=MC Rule? 200 175 Profit Per UnitPrice, costs, and revenue 150 MC $122 125 $94 100 Profit ATC 75 D 50 25 MR = MC MR Q 0 1 2 3 4 5 6 7 8 9 10
  • 30. OUTPUT AND PRICE DETERMINATIONProfit Maximization Under Monopoly 200 175 Profit Per UnitPrice, costs, and revenue 150 MC $122 125 $94 100 Profit ATC 75 D 50 25 MR = MC MR Q 0 1 2 3 4 5 6 7 8 9 10
  • 31. OUTPUT AND PRICE DETERMINATION Loss Minimization Under Monopoly 200 Loss Since Pm exceeds AVC, Per Unit 175 the firm will producePrice, costs, and revenue 150 MC A ATC 125 Loss Pm AVC 100 V 75 D 50 25 MR = MC MR Q 0 1 2 3 4 5 6 7 8 9 10 Qm
  • 32. OUTPUT AND PRICE DETERMINATION Loss Minimization Under Monopoly 200 Loss Per Unit What are the 175Price, costs, and revenue 150 MC Economic Effects AVC A Pm125 Loss ATC of Monopoly? V 100 75 D 50 25 MR = MC MR Q 0 1 2 3 4 5 6 7 8 9 10 Qm
  • 33. INEFFICIENCY OF PURE MONOPOLY P An industry in pure competition S = MC sells where supply and demand are equal At MR=MC A monopolist will sell less units at aPm higher price than inPc competition D MR Q Qm Qc
  • 34. INEFFICIENCY OF PURE MONOPOLY P S = MC At MR=MC A monopolist will sell less units at aPm higher price than inPc competition Monopoly pricing effectivelycreates an income transfer from buyers to the seller! D MR Q Qm Qc
  • 35. REGULATED MONOPOLY P Dilemma of Regulation MR = MC Which Price? Fair-Return PricePrice and Costs Pm Socially-Optimum Price Pf ATC Pr MC D MR Qm Qf Qr Q
  • 36. MONOPOLISTIC COMPETITION AND EFFICIENCY Long-Run Equilibrium MC Price is Not = Minimum ATC ATC P3 = A3Price and Costs Price  MC D MR Q3 Quantity
  • 37. MONOPOLISTIC COMPETITION AND EFFICIENCY• Not Productively Efficient  Minimum ATC• Not Allocatively Efficient Price  MC• Excess Capacity Graphically…
  • 38. OLIGOPOLY BEHAVIOR A Game-Theory Overview RareAir’s Price Strategy High Low A $12 B $15 HighUptown’s Price Strategy $12 $6 C $6 D $8 Low $15 $8
  • 39. OLIGOPOLY BEHAVIOR A Game-Theory Overview RareAir’s Price Strategy High Low A $12 B $15 Greatest Combined High ProfitUptown’s Price Strategy $12 $6 C $6 D $8 Low $15 $8
  • 40. OLIGOPOLY BEHAVIOR A Game-Theory Overview RareAir’s Price Strategy High Low A $12 B $15 Independent Actions High StimulateUptown’s Price Strategy $12 $6 Response C $6 D $8 Low $15 $8
  • 41. OLIGOPOLY BEHAVIOR A Game-Theory Overview RareAir’s Price Strategy High Low A $12 B $15 Independent Actions High StimulateUptown’s Price Strategy $12 $6 Response Gravitating C $6 D $8 to the Low Worst Case $15 $8
  • 42. OLIGOPOLY BEHAVIOR A Game-Theory Overview RareAir’s Price Strategy High Low Collusion A $12 B $15 Invites a Different High Solution.Uptown’s Price Strategy $12 $6 C $6 D $8 Low $15 $8
  • 43. OLIGOPOLY BEHAVIOR A Game-Theory Overview RareAir’s Price Strategy High Low Collusion A $12 B $15 Invites a Different High Solution.Uptown’s Price Strategy $12 $6 C $6 D $8 Low $15 $8
  • 44. OLIGOPOLY BEHAVIOR A Game-Theory Overview RareAir’s Price Strategy High Low Collusion A $12 B $15 Invites a Different High Solution.Uptown’s Price Strategy $12 $6 But, the incentive to cheat C $6 D $8 is very real. Low $15 $8