Lecture 5 Studentnotes

HE191 Principles of Economics Lecture 5 N.Chapters GREGO RY ANKIW 13, 14,M15

Principles of Economics, Fourth Edition N.

PowerPoint® Slides Gregory Mankiw by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

In this lecture, look for the answers to these questions:

ƒ What is a production function? What is marginal product?

ƒ What are the various costs, and how are they related to each other and to output?

ƒ What is a perfectly competitive market? ƒ How does a competitive firm determine the quantity that maximizes profits?

ƒ When might a competitive firm shut down in the short run? Exit the market in the long run?

ƒ Why do monopolies arise? ƒ Why is MR < P for a monopolist?

1

Revenue, Cost, Profit ƒ We assume that the firm’s goal is to maximize profit.

Profit = Total revenue – Total cost the amount a firm receives from the sale of its output

the market value of the inputs a firm uses in production

ƒ Explicit costs – require an outlay of money, e.g. paying wages to workers

ƒ Implicit costs – do not require a cash outlay, e.g. the opportunity cost of the owner’s time 2

Explicit vs. Implicit Costs: An Example You need $100,000 to start your business. The interest rate is 5%.

ƒ Case 1: borrow $100,000 • explicit cost = $5000 interest on loan ƒ Case 2: use $40,000 of your savings, borrow the other $60,000 • explicit cost = $3000 (5%) interest on the loan • implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000. In both cases, total (exp + imp) costs are $5000. 3

Economic Profit vs. Accounting Profit

ƒ Accounting profit = total revenue minus total explicit costs

ƒ Economic profit = total revenue minus total costs (including explicit and implicit costs)

ƒ Accounting profit ignores implicit costs, so it’s higher than economic profit.

4

ACTIVE LEARNING:

Economic profit vs. accounting profit The equilibrium rent on office space has just increased by $500/month. Compare the effects on accounting profit and economic profit if a. you rent your office space b. you own your office space

5

A C T I V E L E A R N I N G:

Answers

The rent on office space increases $500/month. a. You rent your office space. Explicit costs ___________________. Accounting profit & economic profit each ____________. b.You own your office space. Explicit costs ____________, so accounting profit ____________. Implicit costs __________________ (opp. cost of using your space instead of renting it), so economic profit _________________. 6

The Production Function ƒ A production function shows the relationship between the quantity of inputs used to produce a good, and the quantity of output of that good.

ƒ It can be represented by a table, equation, or graph.

ƒ Example 1: • Farmer Tan grows durians. • He has 5 acres of land. • He can hire as many workers as he wants. 7

Example 1: Farmer Tan’s Production Function 3,000

Q (no. of

(no. of durians) workers)

Quantity of output

L

2,500

0

0

1

1000

2

1800

3

2400

500

4

2800

0

5

3000

2,000 1,500 1,000

0

1

2

3

4

5

No. of workers 8

EXAMPLE 1: Total & Marginal Product

ƒ The marginal product (MP) of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. L

∆L = 1 ∆L = 1 ∆L = 1 ∆L = 1 ∆L = 1

Q

0

0

1

1000

2

1800

3

2400

4

2800

5

∆Q MPL = ∆L

3000

∆Q = 1000

1000

∆Q = 800

800

∆Q = 600

600

∆Q = 400

400

∆Q = 200

200 9

EXAMPLE 1: MPL = Slope of Prod Function Q

(no. MPL (no. of of workers) durians)

0

0 1000

1

1000 800

2

1800 600

3 4 5

2400 2800 3000

400 200

3,000 MPL

Quantity of output

L

equals the slope of the 2,500 production function. 2,000

Notice that MPL diminishes 1,500 as L increases. 1,000

This explains why 500 the production function gets flatter 0 as L0 increases. 1 2 3 4

5

No. of workers 10

Why MPL Diminishes ƒ Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal) E.g., Farmer Tan’s output rises by a smaller and smaller amount for each additional worker. Why?

ƒ If Tan increases workers but not land and durian trees, the average worker has less land and trees to work with, so will be less productive.

ƒ In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc.). 11

EXAMPLE 1: Farmer Tan’s Costs Fixed cost Variable cost L Q cost of (no. of (no.of land with workers) durians) trees

cost of labor

Total Cost

0

0

$1,000

$0

$1,000

1

1000

$1,000

$2,000

$3,000

2

1800

$1,000

$4,000

$5,000

3

2400

$1,000

$6,000

$7,000

4

2800

$1,000

$8,000

$9,000

5

3000

$1,000 $10,000

$11,000 12

EXAMPLE 1: Farmer Tan’s Total Cost Curve $12,000

total cost fixed cost

$10,000

cost of labor

$8,000

$6,000

$4,000

$2,000

$0 -300

200

700

1200

1700

2200

2700

3200

13

Example 1: Total and Marginal Cost

ƒ Marginal Cost (MC) is the increase in Total Cost from producing one more unit Q

∆Q = 1000 ∆Q = 800 ∆Q = 600 ∆Q = 400

Total Cost 0

1000 1800 2400 2800

∆Q = 200

$1,000 $3,000 $5,000 $7,000

MC = ∆TC = $2000

$2.00

∆TC = $2000

$2.50

∆TC = $2000

$3.33

∆TC = $2000

$5.00

∆TC = $2000

$10.00

$9,000

3000 $11,000

∆TC ∆Q

14

EXAMPLE 1: The Marginal Cost Curve

0

TC

MC

$1,000 $2.00

1000

$3,000 $2.50

1800

$5,000 $3.33

2400

$7,000

$10

Marginal Cost ($)

Q (bushels of wheat)

$12

$8

MC usually rises as Q rises, as in this example.

$6 $4 $2

$5.00 2800

$9,000

3000 $11,000

$10.00

$0 0

1,000

2,000

3,000

Q 15

Average costs

ƒ Average fixed cost (AFC) is fixed cost divided by the quantity of output: AFC = FC/Q

ƒ Average variable cost (AVC) is variable cost divided by the quantity of output: AVC = VC/Q

ƒ Average total cost (ATC) equals total cost divided by the quantity of output: ATC = TC/Q

ƒ Also, ATC = AFC + AVC

16

EXAMPLE 2: Costs Q

FC

VC

TC

$800

FC

$700

VC TC

$0 $100

$600

1

100

70

170

$500

2

100 120

220

3

100 160

260

4

100 210

310

5

100 280

380

6

100 380

480

7

100 520

620

Costs

0 $100

$400 $300 $200 $100 $0 0

1

2

3

4

5

6

7

Q 17

Example 2 Q

FC

VC

TC

AFC

AVC

ATC

0 $100

$0

$100

n.a.

n.a.

n.a.

1

100

70

170

$100

$70

$170

2

100 120

220

_____ _____

_____

3

100 160

260

33.33

53.33

86.67

4

100 210

310

25

52.50

77.50

5

100 280

380

20

56.00

76

6

100 380

480

16.67

63.33

80

7

100 520

620

14.29

74.29

88.57

8

100 720

820

12.50

90 102.50

MC $70 50 40 50 70 100 140 200 18

EXAMPLE 2: The Various Cost Curves Together $200 $175

ATC AVC AFC MC

Costs

$150 $125 $100 $75 $50 $25 $0 0

1

2

3

4

5

6

7

Q 19

EXAMPLE 2: Why ATC Is Usually U-Shaped As Q rises:

$200

Initially, falling AFC pulls ATC down.

$175

Costs

Eventually, rising AVC pulls ATC up.

$150 $125 $100 $75 $50 $25 $0 0

1

2

3

4

5

6

7

Q 20

EXAMPLE 2: ATC and MC When MC < ATC, ATC is falling.

The MC curve crosses the ATC curve at the ATC curve’s minimum.

$175 $150 Costs

When MC > ATC, ATC is rising.

ATC MC

$200

$125 $100 $75 $50 $25 $0 0

1

2

3

4

5

6

7

Q 21

Costs in the Short Run & Long Run ƒ Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC.

ƒ Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones)

ƒ In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC). 22

EXAMPLE 3: LRATC with 3 factory Sizes Firm can choose from 3 factory sizes: S, M, L. Each size has its own SRATC curve. The firm can change to a different factory size in the long run, but not in the short run.

Avg Total Cost

ATCS

ATCM

ATCL

Q

23

EXAMPLE 3: LRATC with 3 factory Sizes To produce less Avg than QA, firm will Total choose size S Cost in the long run. To produce between QA and QB, firm will choose size M in the long run. To produce more than QB, firm will choose size L in the long run.

ATCS

ATCM

ATCL

LRATC

QA

QB

Q

24

A Typical LRATC Curve In the real world, factories come in many sizes, each with its own SRATC curve.

ATC LRATC

So a typical LRATC curve looks like this: Q

25

How ATC Changes As the Scale of Production Changes Economies of scale: ATC falls as Q increases.

ATC LRATC

Constant returns to scale: ATC stays the same as Q increases. Diseconomies of scale: ATC rises as Q increases.

Q

26

How ATC Changes As the Scale of Production Changes

ƒ Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task. • More common when Q is low.

ƒ Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, can’t control costs. • More common when Q is high. 27

Market structure: A Scenario ƒ Three years after graduating, you run your own business.

ƒ You have to decide how much to produce, what price to charge, how many workers to hire, etc.

ƒ What factors should affect these decisions?

• Your costs (studied in preceding chapter) • How much competition you face ƒ We begin by studying the behavior of firms in perfectly competitive markets.

28

Characteristics of Perfect Competition 1. 1. Many Many buyers buyers and and many many sellers sellers 2. 2. The The goods goods offered offered for for sale sale are are largely largely the the same. same. 3. 3. Firms Firms can can freely freely enter enter or or exit exit the the market. market.

ƒ Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given.

29

The Revenue of a Competitive Firm

ƒ Total revenue (TR)

TR = P x Q

ƒ Average revenue (AR)

TR =P AR = Q

ƒ Marginal Revenue (MR): The change in TR from selling one more unit.

∆TR MR = ∆Q

30

Example 4: Total Revenue, Average Revenue and Marginal Revenue Q

P

TR = P x Q

0

$10

$0

AR =

TR Q

MR =

∆TR ∆Q

n.a. $10

1

$10

$10

$10 $10

2

$10

$20

$10 $10

3

$10

$30

$10 $10

4

$10

$40

$10 $10

5

$10

$50

$10 31

Example 4: Profit Maximization:

At any Q with MR > MC, increasing Q raises profit. At any Q with MR < MC, reducing Q raises profit.

Q

TR

TC

Profit MR MC

0

$0

$5

–$5

1

10

9

1

2

20

15

5

3

30

23

7

4

40

33

7

5

50

45

5

ΔProfit = MR – MC

$10 $4

$6

10

6

4

10

8

2

10

10

0

10

12

–2

32

Example 4: Profit Maximization: A competitive firm Costs, P profit per unit = P – ATC = $10 – 8.25 = $1.75

MC MR ATC

P = $10

profit $8.25

Total profit = (P – ATC) x Q = $1.75 x 4 = $7

4

Q

33

MC and the Firm’s Supply Decision If price rises to P2,then the profit-maximizing quantity rises to Q2. If price rises to P3, then the profitmaximizing quantity rises to Q3. The MC curve determines the firm’s Q at any price.

Costs MC P3

MR3

P2

MR2

P1

MR

Hence,

the MC curve is the firm’s supply curve.

Q1 Q2 Q3

Q 34

Shutdown vs. Exit ƒ Shutdown: A short-run decision not to produce anything because of market conditions.

ƒ Exit: A long-run decision to leave the market.

ƒ A firm that shuts down temporarily must still pay its fixed costs. A firm that exits the market does not have to pay any costs at all, fixed or variable.

35

A Firm’s Short-run Decision to Shut Down

ƒ If firm shuts down temporarily,

• revenue falls by TR • costs fall by VC ƒ So, the firm should shut down if TR < VC. ƒ Divide both sides by Q: TR/Q < VC/Q ƒ So we can write the firm’s decision as: Shut down if P < AVC

36

A Competitive Firm’s SR Supply Curve The firm’s SR supply curve is the portion of its MC curve above AVC. If P > AVC, then firm produces Q where P = MC. If P < AVC, then firm shuts down (produces Q = 0).

Costs MC ATC AVC

Q 37

A Firm’s Long-Run Decision to Exit

ƒ If firm exits the market,

• revenue falls by TR • costs fall by TC ƒ So, the firm should exit if TR < TC. ƒ Divide both sides by Q to rewrite the firm’s decision as: Exit if P < ATC

38

A New Firm’s Decision to Enter Market

ƒ In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC.

ƒ Divide both sides by Q to express the firm’s entry decision as: Enter if P > ATC

39

The Competitive Firm’s Supply Curve The firm’s LR supply curve is the portion of its MC curve above LRATC.

Costs MC LRATC

Q 40

Market Supply: Assumptions 1) All existing firms and potential entrants have identical costs. 2) Each firm’s costs do not change as other firms enter or exit the market. 3)The number of firms in the market is • fixed in the short run (due to fixed costs) • variable in the long run (due to free entry and exit)

41

The SR Market Supply Curve Example: 1000 identical firms. At each P, market Qs = 1000 x (one firm’s Qs) P

One firm MC

P

P3

P3

P2

P2

AVC

P1

Market S

P1 10 20 30

Q (firm)

Q (market) 10,000

20,000 30,000 42

Entry & Exit in the Long Run ƒ In the LR, the number of firms can change due to entry & exit.

ƒ If existing firms earn positive economic profit,

• New firms enter. • SR market supply curve shifts right. • P falls, reducing firms’ profits. • Entry stops when firms’ economic profits have been driven to zero.

43

Entry & Exit in the Long Run ƒ In the LR, the number of firms can change due to entry & exit.

ƒ If existing firms incur losses,

• Some will exit the market. • SR market supply curve shifts left. • P rises, reducing remaining firms’ losses. • Exit stops when firms’ economic losses have been driven to zero.

44

The Zero-Profit Condition ƒ Long-run equilibrium: The process of entry or exit is complete – remaining firms earn zero economic profit.

ƒ Zero economic profit occurs when P = ATC. ƒ Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC.

ƒ Recall that MC intersects ATC at minimum ATC. ƒ Hence, in the long run, P = minimum ATC. ƒ Why Do Firms Stay in Business if Profit = 0? • Recall, economic profit is revenue minus all costs –

•

including implicit costs, like the opportunity cost of the owner’s time and money. In the zero-profit equilibrium, firms earn enough revenue to cover these costs.

45

The LR Market Supply Curve The LR market supply curve is horizontal at P = minimum ATC.

In the long run, the typical firm earns zero profit. P

One firm MC

P

Market

LRATC P= min. ATC

long-run supply

Q (firm)

Q (market) 46

SR & LR Effects of an Increase in Demand

P

One firm MC Profit

Market

P

S1 S2

ATC P2

P2 P1

P1

Q (firm)

B A

C

long-run supply D1

Q1 Q2

Q3

D2

Q (market) 47

Why the LR Supply Curve Might Slope Upward

ƒ The LR market supply curve is horizontal if 1) all firms have identical costs, and 2) costs do not change as other firms enter or exit the market.

ƒ If either of these assumptions is not true, then LR supply curve slopes upward.

48

1) Firms Have Different Costs

ƒ As P rises, firms with lower costs enter the market before those with higher costs.

ƒ Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases market quantity supplied.

ƒ Hence, LR market supply curve slopes upward. ƒ At any P,

•

For the marginal firm, P = minimum ATC and profit = 0.

•

For lower-cost firms, profit > 0. 49

2) Costs Rise as Firms Enter the Market

ƒ In some industries, the supply of a key input is limited (e.g., there’s a fixed amount of land suitable for farming).

ƒ The entry of new firms increases demand for this input, causing its price to rise.

ƒ This increases all firms’ costs. ƒ Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-sloping.

50

Monopoly ƒ A monopoly is a firm that is the sole seller of a product without close substitutes.

ƒ Monopoly firm vs competitive firm: • A monopoly firm has market power, the ability

•

to influence the market price of the product it sells. A competitive firm has no market power; A monopoly firm is the only seller, so it faces the downward-sloping market demand curve. A competitive firm is a price taker and has a horizontal demand curve.

51

Why Monopolies Arise The main cause of monopolies is barriers to entry – other firms cannot enter the market. Three sources of barriers to entry: 1. A single firm owns a key resource. E.g., DeBeers owns most of the world’s diamond mines 2. The govt gives a single firm the exclusive right to produce the good. E.g., patents, copyright laws 52

Why Monopolies Arise 3. Natural monopoly: a single firm can produce the entire market Q at lower ATC than could several firms. Example: 1000 homes need electricity. ATC is lower if one firm services all 1000 homes than if two firms each service 500 homes.

Cost

Electricity Economies of scale due to huge FC

$80 $50

ATC 500

1000

Q 53

A C T I V E L E A R N I N G 1:

A monopoly’s revenue

Moonbucks is Q P the only seller of cappuccinos in town. 0 $4.50 The table shows the 1 market demand for 2 cappuccinos. 3 Fill in the missing spaces of the table. 4

4.00

What is the relation 5 between P and AR? 6 Between P and MR?

2.00

MR = TR= PxQ

AR = TR/Q

∆TR ∆Q

MR = ∆TR/ ∆Q

n.a.

3.50 3.00 2.50

1.50 54

Moonbuck’s D and MR Curves P, MR $5 4 3 2 1 0 -1 -2 -3 0

Demand curve (P)

MR

1

2

3

4

5

6

7

Q 55

Profit-Maximization ƒ Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC.

ƒ Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity.

ƒ It finds this price from the D curve.

56

Profit-Maximization 1. The profitmaximizing Q is where MR = MC.

Costs and Revenue

MC

P

2. Find P from the demand curve at this Q.

D MR

Q

Quantity

Profit-maximizing output 57

The Monopolist’s Profit Costs and Revenue

As with a competitive firm, the monopolist’s profit equals

MC

P

ATC

ATC D

(P – ATC) x Q

MR

Q

Quantity

58

A Monopoly Does Not Have an S Curve A competitive firm ƒ takes P as given ƒ has a supply curve that shows how its Q depends on P A monopoly firm ƒ is a “price-maker,” not a “price-taker” ƒ Q does not depend on P; rather, Q and P are jointly determined by MC, MR, and the demand curve. So there is no supply curve for monopoly. 59