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BackgroundBackgroundto Supplyto Supply
Background to SupplyBackground to Supply
The Short-run Theory of Production
The Short-run Theory of Production
SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION
• Profits and the aims of the firm
• Long-run and short-run production:
– fixed and variable factors
• The law of diminishing returns
• The short-run production function:
– total physical product (TPP)
– average physical product (APP)
APP = TPP/QV
– marginal physical product (MPP)
MPP = TPP/QV
• Profits and the aims of the firm
• Long-run and short-run production:
– fixed and variable factors
• The law of diminishing returns
• The short-run production function:
– total physical product (TPP)
– average physical product (APP)
APP = TPP/QV
– marginal physical product (MPP)
MPP = TPP/QV
Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)
Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)
Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)
Wheat production per year from a particular farm (tonnes)Wheat production per year from a particular farm (tonnes)
SHORT-RUN THEORY OF PRODUCTIONSHORT-RUN THEORY OF PRODUCTION
• Profits and the aims of the firm
• Long-run and short-run production: – fixed and variable factors
• The law of diminishing returns
• The short-run production function:– total physical product (TPP)
– average physical product (APP)
APP = TPP/QV
– marginal physical product (MPP)
MPP = TPP/QV
– graphical relationship between TPP, APP and MPP
• Profits and the aims of the firm
• Long-run and short-run production: – fixed and variable factors
• The law of diminishing returns
• The short-run production function:– total physical product (TPP)
– average physical product (APP)
APP = TPP/QV
– marginal physical product (MPP)
MPP = TPP/QV
– graphical relationship between TPP, APP and MPP
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of farm workers
Wheat production per year from a particular farmWheat production per year from a particular farmT
onn
es
of w
he
at p
rod
uce
d p
er
yea
r
Number of workers
012345678
TPP 0 310243640424240
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of farm workers
Wheat production per year from a particular farmWheat production per year from a particular farmT
onn
es
of w
he
at p
rod
uce
d p
er
yea
r
Number of workers
012345678
TPP 0 310243640424240
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Number of farm workers
To
nne
s o
f wh
eat
pro
du
ced
pe
r ye
ar TPP
b
Diminishing returnsset in here
d
Maximum output
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Number offarm workers (L)
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
Number offarm workers (L)
TPP = 7
L = 1
MPP = TPP / L = 7
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
MPP
Number offarm workers (L)
Number offarm workers (L)
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
APP = TPP / L
Number offarm workers (L)
Number offarm workers (L)
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
b
b
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
Diminishing returnsset in here
Number offarm workers (L)
Number offarm workers (L)
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
b
d
d
Number offarm workers (L)
Number offarm workers (L)
Maximumoutput
b
c
c
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
b
b
d
d
Number offarm workers (L)
Number offarm workers (L)
Slope = TPP / L= APP
Background to SupplyBackground to Supply
Short-run CostsShort-run Costs
SHORT-RUN COSTSSHORT-RUN COSTS
• Measuring costs of production: opportunity costs
– explicit costs
– implicit costs
• Fixed costs and variable costs
• Total costs
– total fixed cost (TFC)
– total variable cost (TVC)
– total cost (TC = TFC + TVC)
• Measuring costs of production: opportunity costs
– explicit costs
– implicit costs
• Fixed costs and variable costs
• Total costs
– total fixed cost (TFC)
– total variable cost (TVC)
– total cost (TC = TFC + TVC)
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
Output(Q)
01234567
TFC(£)
1212121212121212
Total costs for firm XTotal costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TFC
Output(Q)
01234567
TFC(£)
1212121212121212
Total costs for firm XTotal costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TFC
Total costs for firm XTotal costs for firm XOutput
(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TVC
Output(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
TFC
Total costs for firm XTotal costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TVC
TFC
Total costs for firm XTotal costs for firm XOutput
(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
TC(£)
12222833405272
103
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TCOutput
(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
TC(£)
12222833405272
103
TVC
TFC
Total costs for firm XTotal costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TC
TVC
TFC
Total costs for firm XTotal costs for firm X
Diminishing marginalreturns set in here
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
SHORT-RUN COSTSSHORT-RUN COSTS
Average and marginal physical productAverage and marginal physical productO
utp
ut
Quantity of the variable factor
MPP
bDiminishing returns
set in here
Ou
tpu
t
Quantity of the variable factor
MPP
b
c
APP
Average and marginal physical productAverage and marginal physical product
Output (Q)
Co
sts
(£)
MC
x
Diminishing marginalreturns set in here
Marginal costMarginal cost
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
SHORT-RUN COSTSSHORT-RUN COSTS
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TC
TVC
TFC
Total costs for firm XTotal costs for firm X
Bottom ofthe MC curve
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
SHORT-RUN COSTSSHORT-RUN COSTS
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
– average fixed cost (AFC)
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
– average fixed cost (AFC)
SHORT-RUN COSTSSHORT-RUN COSTS
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
SHORT-RUN COSTSSHORT-RUN COSTS
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
SHORT-RUN COSTSSHORT-RUN COSTS
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
– relationship between AC and MC
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between the marginal and total cost curves
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
– relationship between AC and MC
SHORT-RUN COSTSSHORT-RUN COSTS
Output (Q)
Co
sts
(£)
AFC
AVC
MC
x
AC
z
y
Average and marginal costsAverage and marginal costs
Background to SupplyBackground to Supply
The Long-run Theory of Production
The Long-run Theory of Production
LONG-RUN THEORY OF PRODUCTIONLONG-RUN THEORY OF PRODUCTION
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
Short-run and long-run increases in outputShort-run and long-run increases in output
• Economies of scale– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
– economies of scope
• Economies of scale– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
– economies of scope
LONG-RUN THEORY OF PRODUCTIONLONG-RUN THEORY OF PRODUCTION
• Diseconomies of scale
• External economies and diseconomies of scale
• Optimum combination of factors
MPPa/Pa = MPPb/Pb ... = MPPn/Pn
• Diseconomies of scale
• External economies and diseconomies of scale
• Optimum combination of factors
MPPa/Pa = MPPb/Pb ... = MPPn/Pn
LONG-RUN THEORY OF PRODUCTIONLONG-RUN THEORY OF PRODUCTION
Background to SupplyBackground to Supply
Isoquant–Isocost Analysis
Isoquant–Isocost Analysis
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
• Isoquants
– their shape
Unitsof K402010 6 4
Unitsof L 512203050
Point ondiagram
abcde
Units of labour (L)
Un
its o
f ca
pita
l (K
)An isoquantAn isoquant
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
Unitsof K402010 6 4
Unitsof L 512203050
Point ondiagram
abcde
a
Units of labour (L)
Un
its o
f ca
pita
l (K
)
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
An isoquantAn isoquant
Unitsof K402010 6 4
Unitsof L 512203050
Point ondiagram
abcde
a
b
Units of labour (L)
Un
its o
f ca
pita
l (K
)
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
An isoquantAn isoquant
Unitsof K402010 6 4
Unitsof L 512203050
Point ondiagram
abcde
a
b
c
de
Units of labour (L)
Un
its o
f ca
pita
l (K
)
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25 30 35 40 45 50
An isoquantAn isoquant
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
– diminishing marginal rate of substitution
• Isoquants
– their shape
– diminishing marginal rate of substitution
Un
its o
f ca
pita
l (K
)
Units of labour (L)
g
hK = 2
L = 1
isoquant
MRS = 2 MRS = K / L
Diminishing marginal rate of factor substitutionDiminishing marginal rate of factor substitution
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14 16 18 20 22
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14 16 18 20
Un
its o
f ca
pita
l (K
)
Units of labour (L)
g
h
j
k
K = 2
L = 1
K = 1
L = 1
isoquant
MRS = 2
MRS = 1
MRS = K / L
Diminishing marginal rate of factor substitutionDiminishing marginal rate of factor substitution
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
– diminishing marginal rate of substitution
– an isoquant map
• Isoquants
– their shape
– diminishing marginal rate of substitution
– an isoquant map
0
10
20
30
0 10 20
I1I2
I3
I4
I5
Un
its o
f ca
pita
l (K
)
Units of labour (L)
An isoquant mapAn isoquant map
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
0
10
20
30
0 10 20
I1I2
I3
I4
I5
Un
its o
f ca
pita
l (K
)
Units of labour (L)
An isoquant mapAn isoquant map
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
0
2
4
6
8
10
12
14
0 2 4 6 8 10 12 14 16 18 20
Un
its o
f ca
pita
l (K
)
Units of labour (L)
g
h
j
k
K = 2
L = 1
K = 1
L = 1
isoquant
MRS = 2
MRS = 1
MRS = K / L
Diminishing marginal rate of factor substitutionDiminishing marginal rate of factor substitution
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isocosts
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isocosts
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isocosts
– slope and position of the isocost
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isocosts
– slope and position of the isocost
Units of labour (L)
Un
its o
f ca
pita
l (K
)
Assumptions
PK = £20 000 W = £10 000
TC = £300 000
An isocostAn isocost
0
5
10
15
20
25
30
0 5 10 15 20 25 30 35 40
Units of labour (L)
Un
its o
f ca
pita
l (K
)
TC = £300 000
a
b
c
d
Assumptions
PK = £20 000 W = £10 000
TC = £300 000
0
5
10
15
20
25
30
0 5 10 15 20 25 30 35 40
An isocostAn isocost
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isocosts
– slope and position of the isocost
– shifts in the isocost
• Isoquants
– their shape
– diminishing marginal rate of substitution
– isoquants and returns to scale
– isoquants and marginal returns
• Isocosts
– slope and position of the isocost
– shifts in the isocost
• Least-cost combination of factors for a given output
– point of tangency
• Least-cost combination of factors for a given output
– point of tangency
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
Units of labour (L)
Un
its o
f ca
pita
l (K
)
Assumptions
PK = £20 000W = £10 000
TC = £200 000
TC = £300 000
TC = £400 000
TC = £500 000
Finding the least-cost method of productionFinding the least-cost method of production
0
5
10
15
20
25
30
35
0 10 20 30 40 50
0
5
10
15
20
25
30
35
0 10 20 30 40 50
Units of labour (L)
Un
its o
f ca
pita
l (K
)
TPP1
TC = £400 000
TC = £500 000
r
s
t
Finding the least-cost method of productionFinding the least-cost method of production
• Least-cost combination of factors for a given output
– point of tangency
– comparison with marginal productivity approach
• Least-cost combination of factors for a given output
– point of tangency
– comparison with marginal productivity approach
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
• Least-cost combination of factors for a given output
– point of tangency
– comparison with marginal productivity approach
• Highest output for a given cost of production
• Least-cost combination of factors for a given output
– point of tangency
– comparison with marginal productivity approach
• Highest output for a given cost of production
ISOQUANT- ISOCOST ANALYSISISOQUANT- ISOCOST ANALYSIS
TPP2
TPP3
TPP4
TPP5
Un
its o
f ca
pita
l (K
)
Units of labour (L)
OTPP1
Finding the maximum output for a given total costFinding the maximum output for a given total cost
O
Isocost
Un
its o
f ca
pita
l (K
)
Units of labour (L)
TPP2
TPP3
TPP4
TPP5
TPP1
Finding the maximum output for a given total costFinding the maximum output for a given total cost
O
s
u
Un
its o
f ca
pita
l (K
)
Units of labour (L)
TPP2
TPP3
TPP4
TPP5
r
v
TPP1
Finding the maximum output for a given total costFinding the maximum output for a given total cost
O
K1
L1
Un
its o
f ca
pita
l (K
)
Units of labour (L)
TPP2
TPP3
TPP4
TPP5
r
v
s
u
TPP1
t
Finding the maximum output for a given total costFinding the maximum output for a given total cost
Background to SupplyBackground to Supply
Long-run CostsLong-run Costs
LONG-RUN COSTSLONG-RUN COSTS
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
Alternative long-run average cost curvesAlternative long-run average cost curves
OutputO
Co
sts
LRAC
Economies of Scale
OutputO
Co
sts
LRAC
Alternative long-run average cost curvesAlternative long-run average cost curves
Diseconomies of Scale
OutputO
Co
sts
LRAC
Alternative long-run average cost curvesAlternative long-run average cost curves
Constant costs
A typical long-run average cost curveA typical long-run average cost curve
OutputO
Co
sts
LRAC
A typical long-run average cost curveA typical long-run average cost curve
OutputO
Co
sts
LRACEconomiesof scale
Constantcosts
Diseconomiesof scale
LONG-RUN COSTSLONG-RUN COSTS
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
Long-run average and marginal costsLong-run average and marginal costs
OutputO
Co
sts
LRAC
LRMC
Economies of Scale
OutputO
Co
sts
LRAC
Long-run average and marginal costsLong-run average and marginal costs
LRMC
Diseconomies of Scale
OutputO
Co
sts
LRAC
Long-run average and marginal costsLong-run average and marginal costs
= LRMC
Constant costs
OutputO
Co
sts
Long-run average and marginal costsLong-run average and marginal costs
LRMC
LRAC
Initial economies of scale,then diseconomies of scale
LONG-RUN COSTSLONG-RUN COSTS
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs
LONG-RUN COSTSLONG-RUN COSTS
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
Deriving long-run average cost curves: factories of fixed sizeDeriving long-run average cost curves: factories of fixed size
SRAC3
Co
sts
OutputO
SRAC4
SRAC5
5 factories
4 factories3 factories2 factories
1 factory
SRAC1 SRAC2
SRAC1
SRAC3
SRAC2 SRAC4
SRAC5
LRAC
Co
sts
OutputO
Deriving long-run average cost curves: factories of fixed sizeDeriving long-run average cost curves: factories of fixed size
Deriving a long-run average cost curve: choice of factory sizeDeriving a long-run average cost curve: choice of factory sizeC
ost
s
OutputO
Examples of short-runaverage cost curves
LRAC
Co
sts
OutputO
Deriving a long-run average cost curve: choice of factory sizeDeriving a long-run average cost curve: choice of factory size
LONG-RUN COSTSLONG-RUN COSTS
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice
LONG-RUN COSTSLONG-RUN COSTS
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice– the evidence
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice– the evidence
LONG-RUN COSTSLONG-RUN COSTS
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice– the evidence
– minimum efficient plant size
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice– the evidence
– minimum efficient plant size
• Derivation of long-run costs from an isoquant map
– derivation of long-run costs
• Derivation of long-run costs from an isoquant map
– derivation of long-run costs
LONG-RUN COSTSLONG-RUN COSTS
Un
its o
f ca
pita
l (K
)
O
Units of labour (L)
TC1
100TC
2
200
At an output of 200LRAC = TC2 / 200
Deriving an LRAC curve from an isoquant mapDeriving an LRAC curve from an isoquant map
Un
its o
f ca
pita
l (K
)
O
Units of labour (L)
TC1
TC2
TC3
TC4
TC5
TC6
TC7
100 200300
400500
600
700
Note: increasing returnsto scale up to 400 units;
decreasing returns toscale above 400 units
Deriving an LRAC curve from an isoquant mapDeriving an LRAC curve from an isoquant map
• Derivation of long-run costs from an isoquant map
– derivation of long-run costs
– the expansion path
• Derivation of long-run costs from an isoquant map
– derivation of long-run costs
– the expansion path
LONG-RUN COSTSLONG-RUN COSTS
Un
its o
f ca
pita
l (K
)
O
Units of labour (L)
TC1
TC2
TC3
TC4
TC5
TC6
TC7
100 200300
400500
600
700
Expansion path
Deriving an LRAC curve from an isoquant mapDeriving an LRAC curve from an isoquant map
Background to SupplyBackground to Supply
RevenueRevenue
REVENUEREVENUE
• Defining total, average and marginal revenue
• Revenue curves when firms are price takers (horizontal demand curve)
– average revenue (AR)
– marginal revenue (MR)
• Defining total, average and marginal revenue
• Revenue curves when firms are price takers (horizontal demand curve)
– average revenue (AR)
– marginal revenue (MR)
O O
Pri
ce (
£)
AR
, MR
(£
)
Q (millions) Q (hundreds)
Pe
S
D
(a) The market (b) The firm
Deriving a firm’s AR and MR: price-taking firmDeriving a firm’s AR and MR: price-taking firm
O O
Pri
ce (
£)
AR
, MR
(£
)
Pe
S
D
D = AR= MR
Q (millions) Q (hundreds)
(a) The market (b) The firm
Deriving a firm’s AR and MR: price-taking firmDeriving a firm’s AR and MR: price-taking firm
REVENUEREVENUE
• Defining total, average and marginal revenue
• Revenue curves when firms are price takers (horizontal demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
• Defining total, average and marginal revenue
• Revenue curves when firms are price takers (horizontal demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
Total revenue for a price-taking firmTotal revenue for a price-taking firmT
R (
£)
Quantity
Quantity(units)
0200400600800
10001200
Price = AR= MR (£)
5555555
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
(£
)
Quantity
Quantity(units)
0200400600800
10001200
Price = AR= MR (£)
5555555
TR(£)
0100020003000400050006000
Total revenue for a price-taking firmTotal revenue for a price-taking firm
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
TR
(£
)
Quantity
Quantity(units)
0200400600800
10001200
Price = AR= MR (£)
5555555
TR(£)
0100020003000400050006000
Total revenue for a price-taking firmTotal revenue for a price-taking firm
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
TR
(£
)
Quantity
Total revenue for a price-taking firmTotal revenue for a price-taking firm
• Revenue curves when price varies with output (downward-sloping demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
• Revenue curves when price varies with output (downward-sloping demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
REVENUEREVENUE
Revenues for a firm facing adownward-sloping demand curve
Revenues for a firm facing adownward-sloping demand curve
Revenues for a firm facing adownward-sloping demand curve
Revenues for a firm facing adownward-sloping demand curve
Revenues for a firm facing adownward-sloping demand curve
Revenues for a firm facing adownward-sloping demand curve
-4
-2
0
2
4
6
8
1 2 3 4 5 6 7
AR and MR curves for a firm facing a downward-sloping D curveAR and MR curves for a firm facing a downward-sloping D curve
Q(units)
1234567
P =AR(£)8765432
ARAR
, MR
(£
)
Quantity
-4
-2
0
2
4
6
8
1 2 3 4 5 6 7
Q(units)
1234567
P =AR(£)8765432
TR(£)
8141820201814
MR(£)
6420
-2-4
MR
AR
, MR
(£
)
Quantity
AR and MR curves for a firm facing a downward-sloping D curveAR and MR curves for a firm facing a downward-sloping D curve
AR
• Revenue curves when price varies with output (downward-sloping demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
• Revenue curves when price varies with output (downward-sloping demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
REVENUEREVENUE
0
4
8
12
16
20
0 1 2 3 4 5 6 7
TR curve for a firm facing a downward-sloping D curveTR curve for a firm facing a downward-sloping D curve
Quantity
TR
(£
)
Quantity(units)
1234567
P = AR(£)
8765432
TR(£)
8141820201814
0
4
8
12
16
20
0 1 2 3 4 5 6 7
TR curve for a firm facing a downward-sloping D curveTR curve for a firm facing a downward-sloping D curve
TR
Quantity
TR
(£
)
Quantity(units)
1234567
P = AR(£)
8765432
TR(£)
8141820201814
• Revenue curves when price varies with output (downward-sloping demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
– revenue curves and price elasticity of demand
• Revenue curves when price varies with output (downward-sloping demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
– revenue curves and price elasticity of demand
REVENUEREVENUE
0
4
8
12
16
20
0 1 2 3 4 5 6 7
TR curve for a firm facing a downward-sloping D curveTR curve for a firm facing a downward-sloping D curve
TR
Elasticity = -1
Elast
ic
Inelastic
Quantity
TR
(£
)
-4
-2
0
2
4
6
8
1 2 3 4 5 6 7
Elasticity = -1
Elastic
Inelastic
AR
, MR
(£
)
Quantity
AR and MR curves for a firm facing a downward-sloping D curveAR and MR curves for a firm facing a downward-sloping D curve
MR
AR
• Revenue curves when price varies with output (downward-sloping demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
– revenue curves and price elasticity of demand
• Shifts in revenue curves
• Revenue curves when price varies with output (downward-sloping demand curve)
– average revenue (AR)
– marginal revenue (MR)
– total revenue (TR)
– revenue curves and price elasticity of demand
• Shifts in revenue curves
REVENUEREVENUE
Background to SupplyBackground to Supply
Profit Maximisation
Profit Maximisation
PROFIT MAXIMISATIONPROFIT MAXIMISATION
• Using total curves
– maximising difference between TR and TC
• Using total curves
– maximising difference between TR and TC
-8
-4
0
4
8
12
16
20
24
1 2 3 4 5 6 7
TR
, TC
, T
(£
)
Quantity
Finding maximum profit using total curvesFinding maximum profit using total curves
-8
-4
0
4
8
12
16
20
24
1 2 3 4 5 6 7
TR
, TC
, T
(£
)
TR
Quantity
Finding maximum profit using total curvesFinding maximum profit using total curves
-8
-4
0
4
8
12
16
20
24
1 2 3 4 5 6 7
TR
, TC
, T
(£
)
TR
TC
Quantity
Finding maximum profit using total curvesFinding maximum profit using total curves
PROFIT MAXIMISATIONPROFIT MAXIMISATION
• Using total curves
– maximising difference between TR and TC
– the total profit curve
• Using total curves
– maximising difference between TR and TC
– the total profit curve
-8
-4
0
4
8
12
16
20
24
1 2 3 4 5 6 7
TR
, TC
, T
(£
)
T
TR
TC
Quantity
Finding maximum profit using total curvesFinding maximum profit using total curves
-8
-4
0
4
8
12
16
20
24
1 2 3 4 5 6 7
TR
, TC
, T
(£
)
T
TR
TC
a
b
c d
Quantity
Finding maximum profit using total curvesFinding maximum profit using total curves
-8
-6
-4
-2
0
2
4
6
8
10
12
14
16
18
20
22
24
1 2 3 4 5 6 7
TR
, TC
, T
(£
)
T
TR
TC
d
e
f
Quantity
Finding maximum profit using total curvesFinding maximum profit using total curves
PROFIT MAXIMISATIONPROFIT MAXIMISATION
• Using total curves
– maximising difference between TR and TC
– the total profit curve
• Using marginal and average curves
• Using total curves
– maximising difference between TR and TC
– the total profit curve
• Using marginal and average curves
PROFIT MAXIMISATIONPROFIT MAXIMISATION
• 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
• 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
-4
0
4
8
12
16
1 2 3 4 5 6 7Quantity
Co
sts
and
rev
enu
e (
£)
Finding the profit-maximising output using marginal curvesFinding the profit-maximising output using marginal curves
-4
0
4
8
12
16
1 2 3 4 5 6 7Quantity
Co
sts
and
rev
enu
e (
£)
MCFinding the profit-maximising output using marginal curvesFinding the profit-maximising output using marginal curves
-4
0
4
8
12
16
1 2 3 4 5 6 7Quantity
Co
sts
and
rev
enu
e (
£)
e
MR
MC
Profit-maximisingoutput
Finding the profit-maximising output using marginal curvesFinding the profit-maximising output using marginal curves
PROFIT MAXIMISATIONPROFIT MAXIMISATION
• 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
– stage 2:using AR and AC curves to measure maximum profit
• 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
– stage 2:using AR and AC curves to measure maximum profit
-4
0
4
8
12
16
1 2 3 4 5 6 7Quantity
Co
sts
and
rev
enu
e (
£)
Measuring the maximum profit using average curvesMeasuring the maximum profit using average curves
MR
MC
-4
0
4
8
12
16
1 2 3 4 5 6 7Quantity
Co
sts
and
rev
enu
e (
£)
MR
MC
AR
Measuring the maximum profit using average curvesMeasuring the maximum profit using average curves
6.00
4.50
-4
0
4
8
12
16
1 2 3 4 5 6 7
T O T A L P R O F I TT O T A L P R O F I T
MR
Quantity
Co
sts
and
rev
enu
e (
£)
MC
AC
AR
b
a
Total profit =£1.50 x 3 = £4.50
Measuring the maximum profit using average curvesMeasuring the maximum profit using average curves
• Some qualifications
– long-run profit maximisation
– the meaning of profit
• What if a loss is made?
– loss minimising: still produce where MR = MC
• Some qualifications
– long-run profit maximisation
– the meaning of profit
• What if a loss is made?
– loss minimising: still produce where MR = MC
PROFIT MAXIMISATIONPROFIT MAXIMISATION
LOSSLOSS
O
Co
sts
and
rev
enu
e (
£)
Quantity
MC
AC
AR
MR
Q
AC
AR
Loss-minimising outputLoss-minimising output
• Some qualifications
– long-run profit maximisation
– the meaning of profit
• What if a loss is made?
– loss minimising: still produce where MR = MC
– short-run shut-down point:P = AVC
• Some qualifications
– long-run profit maximisation
– the meaning of profit
• What if a loss is made?
– loss minimising: still produce where MR = MC
– short-run shut-down point:P = AVC
PROFIT MAXIMISATIONPROFIT MAXIMISATION
The short-run shut-down pointThe short-run shut-down point
O
Co
sts
and
rev
enu
e (
£)
Quantity
AR
AVC
ACP =AVC
Q
• Some qualifications
– long-run profit maximisation
– the meaning of profit
• 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
• Some qualifications
– long-run profit maximisation
– the meaning of profit
• 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
PROFIT MAXIMISATIONPROFIT MAXIMISATION