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MBEC 6001 Pre-MBA Economics L3(1).pdf

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MBEC 6001 Pre-MBA Economics L3(1).pdf

  1. 1. MBEC 6001 Pre-Economics L3: The Costs of Production + Market Structures Part 1
  2. 2. Thought Experiment • Imagine that after graduating you decided to run your own business. • You must decide how much to produce, what price to charge, how many workers to hire, etc. • What factors should affect these decisions?  Your costs  How much competition you face • The level of competition will be determined by the type of market structure.
  3. 3. Market Structures
  4. 4. Market Structures • Markets may be characterized by different degrees of competition: High Competition Low Competition Perfect Competition Monopoly Oligopoly Monopolistic Competition Perfect Competition Monopolistic Competition Oligopoly Monopoly Number of Sellers Many Many Few One Products Sold by Firms Identical Differentiated (similar, but not identical) Differentiated or identical Unique Market Power Held by Firms No market power (Price Takers) Some market power Some market power Complete market power (Price Maker) Barriers to Entry Low to no barriers Low to no barriers Some barriers High barriers
  5. 5. Examples of Market Structures
  6. 6. Perfect Competition
  7. 7. 7 Characteristics of Perfect Competition 1. Many buyers and many sellers. 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market. Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given.
  8. 8. Decisions Faced by Perfectly Competitive Firm • Profit maximizing decision: How does a competitive firm determine the quantity that maximizes profits? • Shut down decision: When might a competitive firm shut down in the short run? • Exit decision: When might a competitive firm exit the market in the long run?
  9. 9. Profit Maximization
  10. 10. The Costs of a Competitive Firm • The total costs faced by different can be categorized into two types: Total Costs (TC) TC = FC +VC Fixed Costs (FC) Costs that do not vary with the quantity of output produced. Variable Costs (VC) Costs that vary with the quantity produced. E.g. Wages, costs of materials, etc. E.g. Rent, cost of equipment, loan payments
  11. 11. Fixed vs. Variable Costs 7 6 5 4 3 2 1 620 480 380 310 260 220 170 $100 520 380 280 210 160 120 70 $0 100 100 100 100 100 100 100 $100 0 TC VC FC Q $0 $100 $200 $300 $400 $500 $600 $700 $800 0 1 2 3 4 5 6 7 Q Costs FC VC TC Notice that the TC curve is parallel to the VC curve but is higher by the amount FC.
  12. 12. The Costs of a Competitive Firm • The per unit costs of production are given by:  Average total cost (ATC)  Average variable cost (AVC)  Average fixed cost (AFC) ∆TC ∆Q MC = TC Q ATC = VC Q AVC = FC Q AFC = • Marginal cost (MC) of production is given by the change in TC that arises from producing one more unit.
  13. 13. Initially when a firm increases its output, TC & VC start to increase at a diminishing rate. This is why marginal cost falls until it reaches a minimum. Then, as output rises, the marginal cost increases. Marginal Cost 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 MC TC Q 140 100 70 50 40 50 $70 $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs
  14. 14. Average Fixed Cost 100 7 100 6 100 5 100 4 100 3 100 2 100 1 14.29 16.67 20 25 33.33 50 $100 n/a $100 0 AFC FC Q Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units. $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs
  15. 15. Average Variable Cost 520 7 380 6 280 5 210 4 160 3 120 2 70 1 74.29 63.33 56.00 52.50 53.33 60 $70 n/a $0 0 AVC VC Q As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises. $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs
  16. 16. Average Total Cost 88.57 80 76 77.50 86.67 110 $170 n/a ATC 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 74.29 14.29 63.33 16.67 56.00 20 52.50 25 53.33 33.33 60 50 $70 $100 n/a n/a AVC AFC TC Q Notice that: ATC = AFC + AVC $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs Usually, as in this example, the ATC curve is U- shaped.
  17. 17. Economies of Scale Economies of Scale: • Occur when an increase in a firm’s level of output lowers the average costs of production. • Results from: • Specialization of labour • Spreading of fixed costs • Bulk purchase of factor inputs Diseconomies of Scale: • Occur when an increase in a firm’s level of output raises the average costs of production. • Results from: • Bureaucracy • Higher labour costs • Spreading specialized resources too thin
  18. 18. The Various Cost Curves Together AFC AVC ATC MC $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs
  19. 19. Use AFC = FC/Q Use AVC = VC/Q Use MC = Δ TC/ Δ Q Use ATC = TC/Q First, deduce FC = $50 and use TC = FC + VC 380 280 210 120 70 VC 80 63.33 16.67 480 6 56 5 77.50 25 310 4 86.67 53.33 33.33 260 3 220 2 $170 $70 1 n/a n/a n/a $100 0 MC ATC AVC AFC TC Q 100 40 $70 Exercise: The Costs of a Competitive Firm Fill in the below cost structure for a perfectly competitive firm:
  20. 20. Use AFC = FC/Q Use AVC = VC/Q Use MC = Δ TC/ Δ Q Use ATC = TC/Q First, deduce FC = $50 and use TC = FC + VC 380 280 210 160 120 70 $0 VC 80 63.33 16.67 480 6 76 56 20 380 5 77.50 52.50 25 310 4 86.67 53.33 33.33 260 3 110 60 50 220 2 $170 $70 $100 170 1 n/a n/a n/a $100 0 MC ATC AVC AFC TC Q 100 70 50 40 50 $70 Exercise: The Costs of a Competitive Firm Fill in the below cost structure for a perfectly competitive firm:
  21. 21. The Revenues of a Competitive Firm • Total revenue (TR) • Average revenue (AR) • Marginal revenue (MR) The change in TR from selling one more unit. ∆TR ∆Q MR = TR = P x Q TR Q AR = = P
  22. 22. Exercise: The Revenues of a Competitive Firm $50 $10 5 $40 $10 4 $10 3 $10 2 $10 $10 1 n/a $10 0 TR P Q MR AR $10
  23. 23. 23 $50 $10 5 $40 $10 4 $10 3 $10 $10 $10 $10 $10 2 $10 $10 1 n/a $30 $20 $10 $0 $10 0 TR = P x Q P Q ∆TR ∆Q MR = TR Q AR = $10 $10 $10 $10 $10 Notice that MR = P Exercise: The Revenues of a Competitive Firm
  24. 24. MR = P for a Competitive Firm • A competitive firm can keep increasing its output without affecting the market price. • So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P. MR = P is only true for firms in competitive markets.
  25. 25. Profit Maximization • What Q maximizes the firm’s profit? • To find the answer, “think at the margin”. ➢If increase Q by one unit, revenue rises by MR, cost rises by MC. • If MR > MC, then increase Q to raise profit. • If MR < MC, then reduce Q to raise profit.
  26. 26. Profit Maximization Rule: The profit-maximizing Q occurs when: MR = MC If this is not satisfied, choose Q where: MR ≈ MC but MR > MC
  27. 27. Profit Maximization 50 5 40 4 30 3 20 2 10 1 45 33 23 15 9 $5 $0 0 Profit = MR – MC MC MR Profit TC TR Q At any Q with MR > MC, increasing Q raises profit. 5 7 7 5 1 –$5 10 10 10 10 –2 0 2 4 $6 12 10 8 6 $4 $10 At any Q with MR < MC, reducing Q raises profit.
  28. 28. Shut-down & Exit Decision
  29. 29. Shutdown vs. Exit • Shutdown: A short-run (SR) decision not to produce anything because of market conditions. • Exit: A long-run (LR) decision to leave the market. • A key difference:  If firms shut down in the SR, they must still pay FC (Fixed costs).  If firms exit in the LR, they incur zero costs.
  30. 30. A Firm’s Short-run Decision to Shut Down • Cost of shutting down: Revenue loss = TR • Benefit of shutting down: Cost savings = VC (Variable Cost) (firms must still pay FC) • So, shut down if TR < VC • Divide both sides by Q: TR/Q < VC/Q • So, firm’s decision rule is: Shut down if P < AVC
  31. 31. The Irrelevance of Sunk Costs • Sunk cost: A cost that has already been committed and cannot be recovered • Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice. • FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down. • So, FC should not matter in the decision to shut down.
  32. 32. A Firm’s Long-Run Decision to Exit the Market • Cost of exiting the market: Revenue loss = TR • Benefit of exiting the market: Cost savings = TC (zero FC in the long run) • So, firm exits if TR < TC • Divide both sides by Q to write the firm’s decision rule as: Exit if P < ATC
  33. 33. A New Firm’s Decision to Enter the Market • In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC. • Divide both sides by Q to express the firm’s entry decision as: Enter if P > ATC
  34. 34. Case Study: Near-empty Restaurants • To decide whether to stay open for lunch, the restaurant should rationally compare the benefits vs. the costs of closing for lunch (i.e. a temporary shut-down): • Cost of shutting down: Revenue lost = TR • Benefit of shutting down: Cost savings = VC (Only VC is relevant, FC is sunk) Shut down if revenues from lunch < variable cost Stay open if revenues from lunch > variable cost There are many restaurants that remain open during lunch hour even though the majority of their business occurs during the evening. What determines their decision to stay open for lunch?
  35. 35. Determining Profits & Loses
  36. 36. • Determine this firm’s total profit. • Identify the area on the graph that represents the firm’s profit. Q Costs, P MC ATC P = $10 MR 50 $6 A competitive firm Determining a Firm’s Profits
  37. 37. profit Q Costs, P MC ATC P = $10 MR 50 $6 A competitive firm Profit per unit = P – ATC = $10 – 6 = $4 Total profit = (P – ATC) x Q = $4 x 50 = $200 Determining a Firm’s Profits
  38. 38. • Determine this firm’s total loss, assuming AVC < $3. • Identify the area on the graph that represents the firm’s loss. Q Costs, P MC ATC A competitive firm $5 P = $3 MR 30 Determining a Firm’s Loss
  39. 39. loss MR P = $3 Q Costs, P MC ATC A competitive firm loss per unit = $2 Total loss = (ATC – P) x Q = $2 x 30 = $60 $5 30 Determining a Firm’s Loss
  40. 40. Exercise: Determining a Firm’s Loss A. What is the firm’s profit maximizing quantity? B. What is the total profits at this profit maximizing quantity?
  41. 41. Conclusion: The Efficiency of a Competitive Market • Profit-maximization: MC = MR • Perfect competition: P = MR • So, in the competitive eq’m: P = MC • Recall, MC is cost of producing the marginal unit. P is value to buyers of the marginal unit. • Therefore, the competitive equilibrium is efficient.

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