200901 Eco The Money Supply And The Federal Reserve System

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ECO 240 - 6

Costs in the Short Run

Reading: SLO Chapter 5

Short run: run A period of time so short that some of the firm’s inputs are fixed in total supply.

Costs and Output Decisions There are several ways to categorize short-run costs...

Fixed Costs (FC) Any cost that a firm bears in the short run that does not depend on its level of output ...

Variable Costs (VC) Variable costs are any costs that a firm bears that depends on the level of production chosen.

Sometimes called sunk costs because firms have no control over fixed costs in the short run

Costs

The TFC, TVC, and TC Curves

Total Costs (TC)

TC TVC

Total Costs = Total Fixed Costs + Total Variable Costs TFC

TC = TFC + TVC

Units of output

1

Average Variable Costs

Average Fixed Costs AFC = Total Fixed Costs quantity of output

AVC = Total Variable Costs quantity of output

Average Costs

Average Total Costs

AFC = Total Fixed Costs quantity of output AVC = Total Variable Costs quantity of output

ATC = Total Costs quantity of output ATC = AFC + AVC

Marginal costs reflect changes in variable costs.

The marginal cost curve is closely related to the marginal product curve:

Marginal cost ($)

Marginal costs represent the increase in total cost that results from producing one more unit of output

Total Costs quantity of output ATC = AFC + AVC

Marginal product

Marginal Costs (MC)

ATC =

Units of labor

Units of output

2

When marginal product begins to fall, marginal cost begins to rise:

Units of labor

TVC

Total variable costs

Diminishing returns set in.

Marginal cost ($)

Marginal product

Diminishing returns set in.

Given the law of diminishing returns, the total variable cost curve has a distinctive shape:

Diminishing returns set in where TVC begins to increase at an increasing rate. Units of output

Units of output

Total fixed costs are constant at every level of output... Total variable costs

Given the law of diminishing returns, the total variable cost curve has a distinctive shape: Total variable costs

TVC Marginal costs are minimized at this level of output.

TVC

TFC

Units of output

Output TFC TVC (Q) (£) (£)

100

0 1 2 3 4 5 6 7

80

60

12 12 12 12 12 12 12 12

0 10 16 21 28 40 60 91

TC (£)

Units of output

Total costs for firm X TC

12 22 28 33 40 52 72 103

Total costs for firm X TC

100

TVC

TVC 80

Diminishing marginal returns set in here

60

40

40

20

20

TFC

TFC

0 0

1

2

3

4

5

6

7

8

0 0

1

2

3

4

5

6

7

8

3

Average and marginal physical product

But average fixed costs decline as output increases.

b

Output

Average fixed costs

c

AFC = Total Fixed Costs quantity of output

APP

MPP

AFC Units of output

Marginal cost

MC

Quantity of the variable factor

Total costs for firm X

100

TC TVC

Costs (£)

80

Diminishing marginal returns set in here

Bottom of the MC curve

60

40

20

x

TFC 0

Output (Q)

Short-Run Costs  Marginal cost

– marginal cost (MC) and the law of diminishing returns – the relationship between the marginal and total cost curves

0

1

2

3

4

5

6

7

8

Average total and average variable costs are also affected by the law of diminishing returns. $$

MC

ATC

AVC

 Average cost

– average fixed cost (AFC) – average variable cost (AVC) – average (total) cost (AC) – relationship between AC and MC

Units of output

4

Average and marginal costs MC

AC AVC

Some important points about cost curves:  Average total cost equals marginal cost

Costs (£)

where average total cost is minimized.  Average variable cost equals marginal cost

where average variable cost is minimized.

z

 The slope of the total variable cost curve

y x AFC

Output (Q)

describes the change in TVC when output increases by one unit.  The slope of the total variable cost curve is equal to marginal cost.

Consider this shortshort-run cost data for a hypothetical firm:

Consider this shortshort-run cost data for a hypothetical firm:

q TVC MC AVC TFC 0 $ 0 $1000 1 10 1000 2 18 1000 3 24 1000 4 32 1000 5 42 1000

q TVC MC AVC TFC TC 0 $ 0 $-$-- $1000 $1000 1 10 10 10 1000 1010 2 18 8 9 1000 1018 3 24 6 8 1000 1024 4 32 8 8 1000 1032 5 42 10 8.4 1000 1042

TC

AFC ATC

Can you fill in the missing columns?

AFC $-1000 500 333 250 200

ATC $-1010 509 341 258 208

Were you correct?

Long-run Average Cost

LRAC

 Inputs are variable, therefore all costs

 LRAC is U-shaped / basin-shaped. Each

are variable.  Assumptions: 1. Factor prices are given 2. The state of technology and factor quality are given 3. Firms choose the least-cost combination of factors for each output

SRAC sits on it or is tangent to it.  The LRAC consists a series of alternative SRAC.  The firm can build in the LR any one of the different sized plants. It can also alter the size of plant

5

Relationship: LRAC & SRAC

LRAC

 LR a firm can build more factories, thus

 LRAC can take various shapes:

experiencing economies of scale, the expansion enables / allows firm to produce with a new lower SRAC curve.  Each SRAC corresponds to a particular amount of the factor that is fixed in the short-run.  Given time, the several expansions at various time period, enable a series of SRACs – From these curves an envelope curve is developed.

1. Economies of scale – LRAC will fall as the

scale of production increases 2. Diseconomies of scale – LRAC will rise as output increases 3. Constant returns to scale /constant cost – LRAC will be horizontal

A typical long-run average cost curve

Costs

Technical Optimum

O

Economies of scale

Constant costs

Diseconomies of scale

 It is the point where AC for the plant size LRAC

equals the MC of producing an extra unit. It is the least cost point.  Where a firm’s MC < AC, increase in output will lower AC.  Where a firm’s MC > AC, increase in output will make AC higher I.e. each extra unit of production is costing more

Output

Economies of large scale production

Economies of large scale production i.e.

 A firm can enjoy economies of large scale

 More specialization of labour and

production when an increase in the size of the operations reduces the cost per unit i.e. increasing returns to scale flowing from internal economies of scale.  The firm uses input more efficiently and is considered as a cost advantage  Factors that bring about internal economies of scale are as follows: (next slide please)

management  Better capital equipment  Improved management  Better use of raw materials  Greater use of by product and recycling  The introduction of new technology

Internal Economies of scale

6

Internal Economies of Scale (cont’d)

External Economies of Scale -a cost advantage

 Large scale production can also bring

 It is caused by factors outside the direct control of the

firm.When services provided by other firms or the government lead to an increase in the firm’s output that is more than proportional to the inputs. Factors:

increase efficiencies in marketing, advertising, the distribution of the finished product and the bulk purchase of inputs because the costs are spread over a much larger output. The cost per unit is less.

 1. Increase in the size of the market

2. Access to more infrastructure such as roads and railways 3. Development of similar industries to give advantages offered by the localization of industries 4. More research and development by industries

Long-run average and marginal costs

Diseconomies of large scale production This is an increase in output causing a firm’s cost to ruse more than proportionately with revenue. Average costs increase. Factors caused

1. Removal of management from the productive process 2. Loss of personal contact with staff 3. Loss contact with the market & changes in the market 4. An imbalance between the fixed and variable inputs in the short run caused by rapid expansion 5. Inflexible decision-making

Deriving long-run average cost curves: factories of fixed size SRAC1 SRAC 2

SRAC3

Initial economies of scale, then diseconomies of scale

LRMC

LRAC

Costs



O

Output

Deriving long-run average cost curves: factories of fixed size

SRAC5 SRAC4

SRAC1 SRAC 2

SRAC3

SRAC5 SRAC4

O

Output

5 factories

Costs

Costs

LRAC 1 factory 2 factories 3 factories4 factories

O

Output

7

Output Decisions, Revenues, Costs, and Profit Maximization

Revenue

Remember:  Firms operate in perfectly competitive output markets.  In perfectly competitive industries, prices are determined in the market and firms are price takers.  The demand curve for the firm is perfectly elastic.

 Defining total, average and marginal

revenue  Revenue curves when firms are price takers

(horizontal demand curve) – average revenue (AR) – marginal revenue (MR)

 Total revenue is the amount of revenue the firm takes in from the sale of its product. TR = price x quantity sold  Marginal revenue is the additional revenue that a firm takes in when it increases output by one additional unit. MR = TR / q

Market

$ 5

S

$ 5

Firm

D=MR

Market

$ 5

Firm

D=MR

$ 5

Units of output

Units of output

The firm maximizes profits by producing where MR = MC : Market

$ 5

S

$ 5

D Units of output

S

D

Price per unit

Price per unit

Comparing Costs and Revenues to Maximize Profit :

In a perfectly competitive market, the firm’s demand curve is the firm’s marginal revenue curve: Price per unit

Total and Marginal Revenue

Firm

D=MR

D Units of output

Units of output

q* Units of output

8

Why is q=300 the profitprofit-maximizing level of output for the firm? Firm

$$

What will be the firm’s profit level at the profit--maximizing level of output? profit

MC

Firm

$$

MC

ATC $5

ATC $5

D=MR

D=MR

$3.50

0

100 250 300 340 Units of output

The firm’s profit at q=300 is $1.50 per unit, or $450. Firm

$$

MC ATC

$5

D=MR

$3.50

0

Consider the following data for a hypothetical firm: q TFC TVC MC 0 $10 $ 0 $-1 10 10 2 10 15 3 10 20 4 10 30 5 10 50 6

100 250 300 340 Units of output

10

TR

TC TR-TC

15

The Competitive Firm’s Short Run Supply Curve $$

TR $-15 30 45 60 75 90

80

P=MR $15 15 15 15 15 15

Can you fill in the missing columns?

What is the firm’s profit maximizing level of output? q TFC TVC MC P=MR 0 $10 $ 0 $-- $15 1 10 10 10 15 2 10 15 5 15 3 10 20 5 15 4 10 30 10 15 5 10 50 20 15 6 10 80 30 15

100 250 300 340 Units of output

0

TC TR-TC $10 $ -10 20 - 5 25 5 30 15 40 20 60 15 90 0

MC = S ATC P=MR and the firm produces where MC=P=MR. Thus the firm’s supply curve is its marginal cost curve - above AVC.

0

Units of output

9

TR curve for a firm facing a downward-sloping D curve

If price falls below AVC, the firm should produce no output. $$

Elasticity = -1 20

MC

16

TR

ATC

TR (£)

12

8

This will be explored more carefully in the

4

Why? 0

0

Units of output

0

1

2

3

4 Quantity

5

6

7

AR and MR curves for a firm facing a downward-sloping D curve

Profit

8

Elastic Elasticity = -1

AR, MR (£)

6

4

Profit

Inelastic

2

AR

Maximization

0 1

2

3

4

5

6

7

Quantity

-2

MR

-4

Finding maximum profit using total curves

d

12

16

TR

e

12 8

f

4 0

Costs and revenue (£)

TR, TC, TΠ (£)

20

8

4

Profit-maximising output

e

0

1

2

3

4

5

6

-4 -8

Finding the profit-maximising output using marginal curves 16 MC

TC

24

1

7



2

3

4

5

6

7

Quantity

Quantity -4

MR

10

Measuring the maximum profit using average curves 16

MC

Profit Maximization

Total profit = £1.50 x 3 = £4.50 12

Costs and revenue (£)

 Using total curves

– maximising difference between TR and TC – the total profit curve  Using marginal and average curves

– stage 1: profit maximised where MR = MC

Profits maximised at the output where MC = MR

AC

8

a

6.00 TOTAL PROFIT b 4.50 4

AR 0

– stage 2: using AR and AC curves to measure maximum profit

1

3

4

The short-run shut-down point The firm will shut down in the short run if it cannot cover variable costs.

Costs and revenue (£)

AC

LOSS AR

If AVC is higher or AR lower than that shown, the firm will shut down.

P= AVC

O

Q

Quantity

Quantity

Loss Minimization  What if a loss is made? – loss minimising: still produce where MR = MC

– short-run shut-down point: P = AVC

– long-run shut-down point: P = LRAC

AC AVC

AR

AR MR

7

MR

AC

Q

6

-4

MC

O

5

Quantity

Loss-minimising output

Costs and revenue (£)

2

Review Terms & Concepts  Average fixed cost (AFC)

 Total cost (TC)

 Average total cost (ATC)

 Total fixed cost (TFC)

 Average variable cost

 Total revenue (TR)

    

(AVC) Fixed cost Marginal cost (MC) Marginal revenue (MR) Spreading overhead Sunk costs

 Total variable cost (TVC)  Total variable cost curve  Variable cost

11

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