The Supply Side of the Market in Three Parts -...

The Supply Side of the MarketThe Supply Side of the Marketinin

Three Parts:Three Parts:I. An Introduction to Supply and I. An Introduction to Supply and

Producer Surplus Producer Surplus II. The Production FunctionII. The Production Function

III. Cost FunctionsIII. Cost Functions

Econ Dept, UMR

Presents

StarringStarring

uuSupplySupplyvvProductionProductionvvCostCost

uuProducer surplusProducer surplus

FeaturingFeaturing

uuThe Law of Diminishing Marginal ProductThe Law of Diminishing Marginal ProductuuThe MP/P RuleThe MP/P RuleuuEconomic Cost vs. Accounting CostEconomic Cost vs. Accounting CostuuEconomic Profit vs. Accounting ProfitEconomic Profit vs. Accounting ProfituuThe Unimportance of Sunk CostThe Unimportance of Sunk Cost

Part III: Cost FunctionsPart III: Cost Functions

Linking Production to CostsLinking Production to Costsuu Each production relationship has a cost Each production relationship has a cost

counterpartcounterpartvv TP:variable inputTP:variable input ---- variable costvariable costvv AP:variable input AP:variable input ---- average variable costaverage variable costvv MP:variable input MP:variable input ---- marginal costmarginal costvv Fixed inputsFixed inputs ---- fixed (or sunk) costfixed (or sunk) costvv MP/P rule MP/P rule ---- equal MC ruleequal MC rule

uu The production function and the MP/P rule The production function and the MP/P rule tells us the minimum cost of producing any tells us the minimum cost of producing any level of output, q: cost = input price times level of output, q: cost = input price times inputs required = P*Rinputs required = P*R

FC

q/t

FC = iK ; where i is the price FC = iK ; where i is the price of the fixed input, capital (K)of the fixed input, capital (K)

q0 q1 q2 q3

Short Run

Costs First by definition we have Fixed Costs that do not vary with output

Often fixed costs are also sunk costs. Sunk costs are costs already incurred and are beyond recovery.

FC

Fixed CostsTVC

TC

q/t

TVC + FC = TCTVC + FC = TC

q0 q1 q2 q3

Short Run

Costs

Second, we have variable cost. Adding TVC and FC gives Total Costs

Notice the vertical distance between TC and TVC is Fixed CostNotice the vertical distance between TC and TVC is Fixed Cost

TVC = wL where w is the price of the variable input, labor (L)

FC

Fixed Costs

TVCTC

q/t

MC = (MC = (ÎÎTC/ TC/ ÎÎq) q) = (= (ÎÎTVC/ TVC/ ÎÎq)q)q0 q1 q2 q3

Short Run

Costs Notice the curvature of TC and TVC is the same. The slope of both at any output is marginal cost

The rise over the run is the change in cost, total or The rise over the run is the change in cost, total or variable, divided by the change in outputvariable, divided by the change in output

At q3, slope of TC = slope of TVC = MC

FC

TVC

TC

q/t

(TVC/q) = AVC; (TC/q) = ATC(TVC/q) = AVC; (TC/q) = ATC

Tangency’s to show minimum AVC and

ATC

q0 q1 q2 q3

•q1 min AVC•q2 min ATC

Short Run

Costs

Note, q2 > q1 as long as fixed costs are present. That is the output at which AVC is minimized is less than the output at which ATC is minimized as long as FC > 0

FC

TVC

TC

q/t

Inflection Points

q0 q1 q2 q3

•q0 min MC

Short Short Run Run

CostsCosts

At the Inflection Point, TC and TVC stop increasing at a At the Inflection Point, TC and TVC stop increasing at a decreasing rate and start increasing at an increasing rate. decreasing rate and start increasing at an increasing rate. MC falls up to qMC falls up to q00 then starts to increase.then starts to increase.

At q0, the law of diminishing marginal returns sets in

FC

Fixed Costs

TVC

TC

q/t

TVC + TFC = TC = wL + iK

Tangency’s to show minimum AVC and

ATCInflection Points

q0 q1 q2 q3

•q0 min MC•q1 min AVC•q2 min ATC•q3 slope of TC = slope of TVC = MC at q3

Short Short Run Run

CostsCosts

Everything Everything TogetherTogether

Per Unit Short Run CostsPer Unit Short Run Costs

uu LetLet’’s look now at costs on a per unit basiss look now at costs on a per unit basisvv Average fixed cost, AFC = FC/qAverage fixed cost, AFC = FC/qvv Average variable cost, AVC = TVC/qAverage variable cost, AVC = TVC/qvv Average total cost, ATC = TC/qAverage total cost, ATC = TC/qvvMarginal cost, MC = Marginal cost, MC = ÎÎTC/TC/ÎÎq = q = ÎÎTVC/TVC/ÎÎqq

AFC = FC/qAFC = FC/q

AFCq/tq0 q1 q2

Short Run Short Run Per Unit Per Unit CostsCosts First, Average Fixed Costs declines

throughout the range of output. This is because you are dividing a constant, FC, with an ever increasing quantity.

AFC = FC/qAFC = FC/q

AVC = TVC/qAVC = TVC/q

ATC = AFC + AVC = TC/qATC = AFC + AVC = TC/q

ATC

AFC

AVC

q/tq0 q1 q2

Short Run Short Run Per Unit Per Unit CostsCosts

In the short run, the average curves take on a “U” shape driven by the law of diminishing marginal returns

Notice the vertical distance between ATC and AVC is AFC

Also note, q2 > q1 as long as fixed costs are present



ATC

AVC

q/tq0 q1 q2

Short Run Per Unit Costs

AFC is not very important, so it is often not drawn with the other per unit curves

Notice the minimum AVC at q1, occurs when the average product of the variable input is maximized

MC ATC

AVC

q/tq0 q1 q2


MC = MC = ÎÎTC/TC/ÎÎq q = = ÎÎTVC/TVC/ÎÎqq

Notice MC is “U” shaped too with its minimum point, at q0, coinciding with the output where the marginal product of the variable input is maximized

AFC = TFC/qAFC = TFC/q



MC ATC

AFC

AVC

q/tq0 q1 q2

Everything Everything TogetherTogether


MC = MC = ÎÎTC/TC/ÎÎq q = = ÎÎTVC/TVC/ÎÎqq

Before Going to the Long RunBefore Going to the Long Run

uu Review what we mean by Review what we mean by “costs”“costs”vv Costs are opportunity costsCosts are opportunity costsvv Or, costs are benefits foregoneOr, costs are benefits foregone--the benefits the benefits

of the next best alternative given upof the next best alternative given upvvMarket prices are often good measures of Market prices are often good measures of

opportunity costsopportunity costs

Opportunity CostOpportunity Cost

uu In economics, costs are always the value In economics, costs are always the value of the benefits given upof the benefits given up----opportunity opportunity costcost

uu Sometimes these opportunity costs are Sometimes these opportunity costs are monetary, e.g., Wages paid labormonetary, e.g., Wages paid labor

uu Sometimes these opportunity costs are Sometimes these opportunity costs are nonmonetary, e.g., Value of time usednonmonetary, e.g., Value of time used

Economic CostsEconomic Costs

uu Total costTotal cost (TC) (TC) -- the total opportunity the total opportunity cost of all resources used in productioncost of all resources used in productionvv TC = monetary costs + Nonmonetary costsTC = monetary costs + Nonmonetary costs

Economic vs. Accounting Economic vs. Accounting Concepts of Costs and ProfitsConcepts of Costs and Profitsuu In economics costs are opportunity costsIn economics costs are opportunity costsuu In accounting costs are defined according to In accounting costs are defined according to

accepted accounting rules designed for tax accepted accounting rules designed for tax and public disclosure purposesand public disclosure purposes

uu Since the definitions of cost differ so do the Since the definitions of cost differ so do the definitions of profitsdefinitions of profitsvv Economic profit = total revenue Economic profit = total revenue -- opportunity opportunity

costscostsvv Accounting profit = total revenue Accounting profit = total revenue -- accounting accounting

costscosts

Illustration of Accounting Illustration of Accounting Profit vs. Economic ProfitProfit vs. Economic Profit

Assume:Assume:Monetary costs (explicit costs) for a month =$15,000Monetary costs (explicit costs) for a month =$15,000NonNon--monetary costs for a month = $ 4,000monetary costs for a month = $ 4,000

Total costs Total costs =$19,000=$19,000Economic profit = total revenue (TR) Economic profit = total revenue (TR) -- total costs (TC)total costs (TC)If total revenue for this month is equal to $19,000 then: If total revenue for this month is equal to $19,000 then:

there is no economic profit, but there would be a there is no economic profit, but there would be a $4,000 accounting profit. Accounting profit does not $4,000 accounting profit. Accounting profit does not count noncount non--monetary costs as a cost thus profit would monetary costs as a cost thus profit would be reported as $4,000be reported as $4,000

Suppose:Suppose:uu Monthly costs include:Monthly costs include:

vv Owner’s time and expertiseOwner’s time and expertise $2,000$2,000vv Land already owned but could Land already owned but could $3,000 $3,000

be rented be rented vv Payroll expenses Payroll expenses $9,000$9,000vv Utility bills Utility bills $1,000$1,000

uu Total economic costs Total economic costs $15,000$15,000uu Total accounting costs $10,000Total accounting costs $10,000

The difference between accounting and economic costs are non-monetary costs are not included in the accounting costs

Economic Profit OverviewEconomic Profit Overview

uu TR = TC the opportunity costs are TR = TC the opportunity costs are covered and there is no economic profitcovered and there is no economic profit

uu TR > TC revenue exceeds opportunity TR > TC revenue exceeds opportunity costs and there is an economic profitcosts and there is an economic profit

uu TR < TC opportunity costs exceed TR < TC opportunity costs exceed revenues and there is economic lossrevenues and there is economic loss

Consider Hooey and Dewie, Who Consider Hooey and Dewie, Who Opened a Business Selling Turquoise Opened a Business Selling Turquoise Belts in the Denver Airport.Belts in the Denver Airport.uu Display Cart Costs $10,000 and Is Paid by Withdrawing Display Cart Costs $10,000 and Is Paid by Withdrawing

Hooey and DewieHooey and Dewie’’s Savings That Was Earning 5% Per s Savings That Was Earning 5% Per Year. The Cart Will Last One Year and Has No Salvage Year. The Cart Will Last One Year and Has No Salvage Value.Value.

uu Belts Cost $20.00 Each From the Supplier.Belts Cost $20.00 Each From the Supplier.uu Sales Are Estimated to Be 1,000 Belts Per Year.Sales Are Estimated to Be 1,000 Belts Per Year.uu The Price of the Belts Is $60.00.The Price of the Belts Is $60.00.uu The Cart Clerk Is Paid $14,000.The Cart Clerk Is Paid $14,000.uu Hooey and Dewie Will Put in 2000 Hours of Labor Hooey and Dewie Will Put in 2000 Hours of Labor

During the Year.During the Year.QUESTION: Is This Business Going to Make a Profit, or QUESTION: Is This Business Going to Make a Profit, or

Should Hooey and Dewie Move Back in With Uncle Should Hooey and Dewie Move Back in With Uncle Donald?Donald?

Hooey and Dewie Have a Hooey and Dewie Have a Total Revenue of $60,000 for Total Revenue of $60,000 for the Yearthe Year

uu Total revenues.............................$60,000Total revenues.............................$60,000vv P*q = $60*1,000P*q = $60*1,000

Hooey and Dewie Have Hooey and Dewie Have Accounting Costs of Accounting Costs of $44,000 for the Year$44,000 for the Year

Total Revenues. . . . . . . . . . . . . . . . . . . . . . . .Total Revenues. . . . . . . . . . . . . . . . . . . . . . . .$60,000$60,000Total Accounting Costs (Monetary Cost)Total Accounting Costs (Monetary Cost)

Belts From Supplier. . . . . . . .$20,000Belts From Supplier. . . . . . . .$20,000Clerk Cost . . . . . . . . . . . . . . . 14,000Clerk Cost . . . . . . . . . . . . . . . 14,000Cart Cost. . . . . . . . . . . . . . . . . Cart Cost. . . . . . . . . . . . . . . . . 10,00010,000

$44,000$44,000Acct’ingAcct’ing Profit = Total Revenue Profit = Total Revenue –– Acct’ingAcct’ing CostsCosts

= 60,000 = 60,000 -- 44,000 = $16,000 44,000 = $16,000 (And We Are Ignoring Taxes) (And We Are Ignoring Taxes)

But Hooey and Dewie Have But Hooey and Dewie Have nonmonetary Costs Toononmonetary Costs TooTotal RevenuesTotal Revenues $60,000$60,000Total Accounting Costs (Monetary Cost)Total Accounting Costs (Monetary Cost)

Belts From SupplierBelts From Supplier $20,000$20,000Clerk CostClerk Cost 14,00014,000Cart CostCart Cost 10,00010,000

$44,000$44,000Total Nonmonetary CostTotal Nonmonetary Cost

Interest Foregone on $10,000Interest Foregone on $10,000 $ 500$ 500Opportunity Cost of 2000 HoursOpportunity Cost of 2000 Hours XX

Economic CostsEconomic Costs $44,500 + X$44,500 + XEconomic Profits = Total Revenue Economic Profits = Total Revenue -- Economic Costs Economic Costs

= 60,000 = 60,000 -- 44,500 44,500 -- X = $15,500 X = $15,500 -- XX

Hooey and Hooey and Dewie’sDewie’s AdventureAdventureuu Did they make a profit?Did they make a profit?uu It depends on the value they place on their It depends on the value they place on their

time, the 2000 hourstime, the 2000 hoursvv They cleared $16,000 according to the accountant They cleared $16,000 according to the accountant

and would be asked to pay taxes on this amount and would be asked to pay taxes on this amount (after figuring loopholes)(after figuring loopholes)

vv But the opportunity cost of their savings and time But the opportunity cost of their savings and time were not taken into accountwere not taken into account

uu $500 for foregone interest lowers profit by $500$500 for foregone interest lowers profit by $500uu If they value their time less than $7.50 per hour If they value their time less than $7.50 per hour

(= $15,500/2000) they made a profit otherwise, (= $15,500/2000) they made a profit otherwise, they didnthey didn’’t and should move back in with uncle t and should move back in with uncle DonaldDonald

Before Moving to the Long Before Moving to the Long Run, LetRun, Let’’s Reviews Reviewuu Total cost conceptsTotal cost conceptsuu Per unit cost conceptsPer unit cost conceptsuu The shape of cost curvesThe shape of cost curvesvv Due to the law of diminishing marginal Due to the law of diminishing marginal

returnsreturnsuu The relationship between marginal and The relationship between marginal and

averageaverageuu Efficiency in getting what we wantEfficiency in getting what we want

Total Cost ConceptsTotal Cost Concepts

uu Total fixed costTotal fixed cost (FC) (FC) -- costs which do not vary costs which do not vary with outputwith outputvv The costs of fixed inputs, e.g., CapitalThe costs of fixed inputs, e.g., Capital

uu Total variable costsTotal variable costs (TVC) (TVC) -- any cost that any cost that varies with the quantity of output producedvaries with the quantity of output producedvv The costs of variable inputs, e.g., LaborThe costs of variable inputs, e.g., Labor

uu Total costTotal cost (TC) (TC) -- sum of all costs of sum of all costs of productionproductionvv TC = fixed costs + total variable costsTC = fixed costs + total variable costs

Per Unit Cost ConceptsPer Unit Cost Concepts

uu Marginal costMarginal cost (MC) (MC) -- the additional cost the additional cost of producing one more unit of outputof producing one more unit of outputvvMC = MC = ∆∆TC / TC / ∆∆qq

uu Average variable costAverage variable cost (AVC) = TVC/q(AVC) = TVC/quu Average fixed costAverage fixed cost (AFC) = FC/q(AFC) = FC/quu Average total costAverage total cost (ATC) = TC/q(ATC) = TC/q

Shape of Cost CurvesShape of Cost Curvesuu Total cost and total variable costTotal cost and total variable cost

vv Eventually steeper due to law of diminishing Eventually steeper due to law of diminishing marginal returnsmarginal returns

uu Marginal costMarginal costvv Eventually upward sloping due to law of Eventually upward sloping due to law of

diminishing marginal returnsdiminishing marginal returnsuu Average fixed costAverage fixed cost

vv Downward sloping always: a fixed number (FC) is Downward sloping always: a fixed number (FC) is divided by increasing q as output risesdivided by increasing q as output rises

uu Average total cost and average variable costAverage total cost and average variable costvv “U”“U” shaped butshaped but eventually upward sloping due to eventually upward sloping due to

law of diminishing marginal returnslaw of diminishing marginal returns

Law of Diminishing Marginal Law of Diminishing Marginal Returns and Cost CurvesReturns and Cost Curvesuu If each unit of labor produces less additional If each unit of labor produces less additional

output eventually, then in order to produce output eventually, then in order to produce each additional unit of output we need to hire each additional unit of output we need to hire increasing amounts of inputs (labor) increasing amounts of inputs (labor) eventually (law of diminishing marginal eventually (law of diminishing marginal returns)returns)vv Tells us total product eventually gets flatter and Tells us total product eventually gets flatter and

marginal product eventually declinesmarginal product eventually declinesvv Tells us total costs eventually gets steeper and Tells us total costs eventually gets steeper and

marginal costs eventually risemarginal costs eventually rise

AverageAverage--marginal Rulemarginal Ruleuu The marginal cost and average cost curves The marginal cost and average cost curves

have to obey the averagehave to obey the average--marginal rulemarginal ruleuu The averageThe average--marginal rule says that if marginal rule says that if

marginal is above average, then average must marginal is above average, then average must be risingbe rising

uu If marginal is below average, then average If marginal is below average, then average fallingfalling

uu This implies the MC curve crosses the ATC This implies the MC curve crosses the ATC and AVC curves at the bottom of both, and and AVC curves at the bottom of both, and that the MP curve must cross the AP curve at that the MP curve must cross the AP curve at the top of APthe top of AP

AverageAverage--marginal Rulemarginal Ruleuu For example, your grade point average For example, your grade point average

(GPA) is an average. The marginal (GPA) is an average. The marginal grade is the next grade you getgrade is the next grade you get

uu If your next grade (marginal grade) is If your next grade (marginal grade) is above your average (GPA), then your above your average (GPA), then your GPA risesGPA rises

uu If your next grade (marginal grade) is If your next grade (marginal grade) is below your average (GPA), then your below your average (GPA), then your GPA fallsGPA falls

Minimum Cost ConditionMinimum Cost Conditionuu We saw earlier the rationale of the MP/P rule: We saw earlier the rationale of the MP/P rule:

to minimize cost of any level of activity, a to minimize cost of any level of activity, a supplier must mix variable inputs in such a supplier must mix variable inputs in such a way their marginal product divided by their way their marginal product divided by their price are equalprice are equal

uu If input and output prices are taken as given, If input and output prices are taken as given, and suppliers are profit maximizers, the and suppliers are profit maximizers, the marginal costs of suppliers will be equal marginal costs of suppliers will be equal (MC(MC11 = MC= MC22 = = …… = MC= MCjj for all j suppliers). for all j suppliers). This is a necessary condition for insuring This is a necessary condition for insuring industry output is produced at minimum costindustry output is produced at minimum cost

Now We Move to Costs in the Now We Move to Costs in the Long RunLong Runuu Long runLong run -- period of time in which period of time in which allall

inputs are variableinputs are variableuu Capital and labor, all inputs, can changeCapital and labor, all inputs, can changeuu Think of the long run as a planning Think of the long run as a planning

periodperiodvv Firm can estimate costs based on various Firm can estimate costs based on various

plant sizes, number of machines, etcplant sizes, number of machines, etcvv Once it makes a decision and builds the Once it makes a decision and builds the

plant, buys the machines, etc., It moves into plant, buys the machines, etc., It moves into the short run and are stuck with their the short run and are stuck with their decision for a whiledecision for a while

Costs in the Long RunCosts in the Long Runuu Long run average total costLong run average total cost (LRATC) (LRATC) --

ATC of producing a given level of ATC of producing a given level of output when all inputs can varyoutput when all inputs can vary

uu LRATC curve is constructed as an LRATC curve is constructed as an envelope of all possible short run cost envelope of all possible short run cost curvescurves

uu NOTE NOTE -- no AFC in longno AFC in long--runrunvv In long run all inputs are variable, so no In long run all inputs are variable, so no

fixed costsfixed costsvv LRATC is equal to long run AVC since all LRATC is equal to long run AVC since all

costs are variablecosts are variable

Long Run and Short Run ATCLong Run and Short Run ATCuu Consider what happens to the short run Consider what happens to the short run

ATC curve when we increase fixed ATC curve when we increase fixed costs:costs:vv The average cost of making a small amount The average cost of making a small amount

of product risesof product risesvv The average cost of making a large amount The average cost of making a large amount

goes downgoes downvv For instance, we increase the size of an For instance, we increase the size of an

assembly line assembly line -- the ATC of making 1000 the ATC of making 1000 cars is now higher, but the ATC of 250,000 cars is now higher, but the ATC of 250,000 cars is lesscars is less

Long Run ATC CurveLong Run ATC Curve

$

q/t0

SRATC1

SRATC2

Higher ATC with higher Fixed Cost (Higher Fixed

Costs)

Lower ATC with higher Fixed Cost

The Shape of the LRATCThe Shape of the LRATC

uu We draw the LRATC as We draw the LRATC as “U”“U” shaped shaped similar to the similar to the “U”“U” shape of the short run shape of the short run average cost curvesaverage cost curves

uu But the AVC and ATC were But the AVC and ATC were “U”“U” shaped shaped due to the law of diminishing marginal due to the law of diminishing marginal returns which doesnreturns which doesn’’t apply in the long t apply in the long run (all inputs are variable)run (all inputs are variable)

uu What gives?What gives? A:A: returns to scale returns to scale

Returns to ScaleReturns to Scaleuu Changing all inputs in the same proportion is Changing all inputs in the same proportion is

a a “scale”“scale” change, e.g., increase all by 10%, change, e.g., increase all by 10%, decrease all by 5%decrease all by 5%

uu The The “U”“U” shape of the LRATC is due to the shape of the LRATC is due to the possibility of three types of returns to scale:possibility of three types of returns to scale:vv Increasing returns to scale: %Increasing returns to scale: %ÎÎq>%q>%ÎÎrrvv Constant returns to scale: % Constant returns to scale: % ÎÎq=%q=%ÎÎrrvv Decreasing returns to scale: %Decreasing returns to scale: %ÎÎq<%q<%ÎÎr (where R is r (where R is

all resources)all resources)uu Cost curves in the long run are based on the Cost curves in the long run are based on the

underlying production technology, i.e., underlying production technology, i.e., Returns to scaleReturns to scale

Returns to Scale, ExamplesReturns to Scale, Examplesuu IRTS: doubling all inputs leads to an IRTS: doubling all inputs leads to an

increase of 125% in q (LRATC falls)increase of 125% in q (LRATC falls)uu DRTS: an increase in all inputs by 5% DRTS: an increase in all inputs by 5%

leads to a 3% increase in q (LRATC rises)leads to a 3% increase in q (LRATC rises)uu CRTS: a decrease in all inputs by 10% CRTS: a decrease in all inputs by 10%

lead to a 10% fall in q (LRATC is lead to a 10% fall in q (LRATC is constant)constant)

uu If all inputs are decreased by 5% and If all inputs are decreased by 5% and output falls by 7%, %output falls by 7%, %ÎÎq>%q>%ÎÎr, therefore r, therefore IRTSIRTS

What If All Inputs Change but What If All Inputs Change but Not in the Same Proportion?Not in the Same Proportion?uu If the %If the %ÎÎq>%q>%ÎÎcosts we use the term costs we use the term

economies of scaleeconomies of scaleuu If the %If the %ÎÎq<%q<%ÎÎcosts we use the term costs we use the term

diseconomies of scalediseconomies of scaleuu IRTS implies economies of scale but IRTS implies economies of scale but

economies of scale do not imply IRTSeconomies of scale do not imply IRTSuu The same is true for the relationship The same is true for the relationship

between diseconomies of scale and DRTSbetween diseconomies of scale and DRTSuu Reasons for economies and diseconomies Reasons for economies and diseconomies

of scale are given in Part IIof scale are given in Part II

Linking the Short Run to the Linking the Short Run to the Long RunLong Runuu Suppose you have four choices for a stock Suppose you have four choices for a stock

of fixed inputs, e.g., 4 different sizes of of fixed inputs, e.g., 4 different sizes of office buildings to build or leaseoffice buildings to build or lease

uu There are tradeoffs apparent:There are tradeoffs apparent:vv Smaller fixed costs are associated with higher Smaller fixed costs are associated with higher

variable costsvariable costsvv Economies and diseconomies of scale are Economies and diseconomies of scale are

apparentapparentuu The output you expect to sell is The output you expect to sell is

paramount, but that depends on demand paramount, but that depends on demand conditions we will consider next chapterconditions we will consider next chapter

Four Short Run ATC Curve Four Short Run ATC Curve ChoicesChoices$

q/t0

SRATC1

SRATC2

SRATC3

SRATC4

q4q1 q2 q3

Selection of Fixed Input StockSelection of Fixed Input Stockuu If you expect business to support If you expect business to support

output qoutput q11 you select the input stock you select the input stock associated with associated with SRATCSRATC11

uu And so on, e.g., If you expect to sell qAnd so on, e.g., If you expect to sell q33then you will select the input stock then you will select the input stock associated with associated with SRATCSRATC33

uu With only 4 possible input stock sizes, With only 4 possible input stock sizes, the LRATC is the heavy sections of the the LRATC is the heavy sections of the short run curves outlined in blue on the short run curves outlined in blue on the next slidenext slide

Four Short Run ATC Curve Four Short Run ATC Curve Choices and Their LRATCChoices and Their LRATC$

q/t0

SRATC1

SRATC2

SRATC3

SRATC4

q4q1 q2 q3

LRATC Curve When There Are LRATC Curve When There Are Many Input Stocks to Select FromMany Input Stocks to Select From

$

q/t0

SRATC1

SRATC2

SRATC3

SRATC4

LRATC

: Minimum SRATC : Tangency of SRATC and LRATC

q1 q2 q3 q4

Reviewing the Shape of LRATCReviewing the Shape of LRATCuu Explained by economies and Explained by economies and

diseconomies of scalediseconomies of scaleuu Typically firms will make efforts to Typically firms will make efforts to

expand to take advantage of economies expand to take advantage of economies of scale and take caution not to get too of scale and take caution not to get too big so as to experience diseconomies of big so as to experience diseconomies of scalescale

uu We find for most industries, firms We find for most industries, firms operating at constant ATC over a operating at constant ATC over a considerable range of outputconsiderable range of output

Long Run ATC CurveLong Run ATC Curve(Economies of Scale)(Economies of Scale)

$

q/t0

Economies of Scale

Long Run ATC CurveLong Run ATC Curve(Diseconomies of Scale)(Diseconomies of Scale)

$

q/t0

Diseconomies of Scale

Long Run ATC CurveLong Run ATC Curve(Constant Average Costs)(Constant Average Costs)

$

q/t0

Constant Average Costs

Typical LRATCTypical LRATC$

q/t0

Constant Average Total Costs

Sort of like a Frying Pan

What If a Mistake Is Made?What If a Mistake Is Made?uu You select SRATCYou select SRATC11, expecting to sell q, expecting to sell q11

per period, but things are better than per period, but things are better than expected, you sell qexpected, you sell q22

uu Your ATC are higher than they need have Your ATC are higher than they need have been (represented by a level rather been (represented by a level rather than shown on a couple of slides back)than shown on a couple of slides back)

uu But your decision has been made and you But your decision has been made and you have to live with it for nowhave to live with it for now

uu It is important to learn that sunk costs are It is important to learn that sunk costs are not important (if your fixed inputs can be not important (if your fixed inputs can be sold their costs are not sunk)sold their costs are not sunk)

Sunk CostSunk Costuu Sunk costs are fixed costs, but FC may Sunk costs are fixed costs, but FC may

not be sunk if there are valuable not be sunk if there are valuable alternatives. If the capital equipment alternatives. If the capital equipment may be sold then the capital cost is not may be sold then the capital cost is not sunksunk

uu Economics has an important message Economics has an important message about sunk costabout sunk cost----they don’t matterthey don’t matter

uu The proverb to remember is The proverb to remember is ““let bygones let bygones be bygonesbe bygones””

Sunk CostsSunk Costs

uu A good poker player A good poker player ““knows when to knows when to holdhold’’emem, knows when to fold, knows when to fold’’emem””----the the money in the pot is not importantmoney in the pot is not important

uu You ought not stay in a major because You ought not stay in a major because you have almost completed the degreeyou have almost completed the degree----the decision must be based on expected the decision must be based on expected benefits and costs of the change, not benefits and costs of the change, not costs already experiencedcosts already experienced

The End The End

The Supply Side of the Market in Three Parts -...

Documents

Transcript of The Supply Side of the Market in Three Parts -...