44
REVIEW COSTS OF PRODUCTION, THEORY OF THE FIRM
REVIEW COSTS OF
PRODUCTION, THEORY OF THE
FIRM
EconomicProfit
Implicit costs(including a
normal profit)
ExplicitCosts
Accountingcosts (explicit
costs only)
AccountingProfit
Ec
on
om
ic (
op
po
rtu
nit
y) C
os
ts
TOTAL
REVENUE
Profits to anEconomist
Profits to anAccountant
ECONOMIC COSTS
Law of Diminishing Returns
SHORT-RUN PRODUCTIONRELATIONSHIPS
Tota
l Pro
du
ct, T
P
Quantity of Labor
Ave
rag
e P
rod
uct
, AP,
an
dM
arg
inal
Pro
du
ct, M
P
Quantity of Labor
Total Product
MarginalProduct
AverageProduct
IncreasingMarginalReturns
Law of Diminishing Returns
SHORT-RUN PRODUCTIONRELATIONSHIPS
Tota
l Pro
du
ct, T
P
Quantity of Labor
Ave
rag
e P
rod
uct
, AP,
an
dM
arg
inal
Pro
du
ct, M
P
Quantity of Labor
Total Product
MarginalProduct
AverageProduct
DiminishingMarginalReturns
Law of Diminishing Returns
SHORT-RUN PRODUCTIONRELATIONSHIPS
Tota
l Pro
du
ct, T
P
Quantity of Labor
Ave
rag
e P
rod
uct
, AP,
an
dM
arg
inal
Pro
du
ct, M
P
Quantity of Labor
Total Product
MarginalProduct
AverageProduct
NegativeMarginalReturns
PRODUCTIVITY AND COST CURVES
Co
sts
(d
olla
rs)
Ave
rag
e p
rod
uct
an
dm
arg
inal
pro
du
ct
Quantity of labor
Quantity of output
MPAP
MCAVC
LONG-RUN PRODUCTION COSTSU
nit
Co
sts
Output
LONG-RUN PRODUCTION COSTS
Un
it C
ost
s
Output
LONG-RUN PRODUCTION COSTS
The long-run ATC just “envelopes”all of the short-run ATC curves.
Un
it C
ost
s
Output
LONG-RUN PRODUCTION COSTSU
nit
Co
sts
Output
long-run ATC
ECONOMIES ANDDISECONOMIES OF SCALE
• Labor Specialization• Managerial
Specialization• Efficient Capital• Other FactorsDiseconomies of ScaleConstant Returns to Scale
graphically presented...
ECONOMIES ANDDISECONOMIES OF SCALE
Un
it C
ost
s
Output
long-run ATC
Economiesof scale
Un
it C
ost
s
Output
long-run ATC
Economiesof scale
Constant returnsto scale
ATC decreases as Output increases
ATC is constant as Output increases
Un
it C
ost
s
Output
long-run ATC
Economiesof scale
Diseconomiesof scale
Constant returnsto scale
ATC decreases as Output increases
ATC is constant as Output increases
ATC increases as Output increases
$200
150
100
50
0
Co
st a
nd
Rev
enu
e
1 2 3 4 5 6 7 8 9 10
MC
MR
AVCATC
Economic Profit
$131.00
$97.78
MARGINAL REVENUE-MARGINAL COST APPROACH
Profit Maximization Position
$200
150
100
50
0
Co
st a
nd
Rev
enu
e
1 2 3 4 5 6 7 8 9 10
MC
MR
AVCATC
Economic Profit
$131.00
$97.78
MARGINAL REVENUE-MARGINAL COST APPROACH
MR = MCOptimumSolution
Profit Maximization Position
$200
150
100
50
0
Co
st a
nd
Rev
enu
e
1 2 3 4 5 6 7 8 9 10
MC
MR
AVCATC
$71.00
MARGINAL REVENUE-MARGINAL COST APPROACH
Short-Run Shut Down Point
Minimum AVCis the Shut-Down
Point
P
Q
S=MC
AVC
ATC
8
D
P
Q8000
D
S= MCs
IndustryFirm(price taker)
EconomicProfit
$111$111
SHORT-RUN COMPETITIVE EQUILIBRIUM
The Competitive Firm “Takes” itsPrice from the Industry Equilibrium
P
Q
S=MC
AVC
ATC
8
D
P
Q8000
D
S= MCs
IndustryFirm(price taker)
EconomicProfit
$111$111
SHORT-RUN COMPETITIVE EQUILIBRIUM
The Competitive Firm “Takes” itsPrice from the Industry Equilibrium
How about thelong-run?
Temporary profits and the reestablishmentof long-run equilibrium
S1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
PROFIT MAXIMIZATION IN THE LONG RUN
MR
D1
An increase in demand increases profits…
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
PROFIT MAXIMIZATION IN THE LONG RUN
D2
EconomicProfits
S1
New competitors increase supply, and lowerprices decrease economic profits.
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
PROFIT MAXIMIZATION IN THE LONG RUN
D2
Zero EconomicProfits
S1
S2
Decreases in demand, losses, and the reestablishment of long-run equilibrium
S1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
PROFIT MAXIMIZATION IN THE LONG RUN
D1
MR
A decrease in demand creates losses…
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
PROFIT MAXIMIZATION IN THE LONG RUN
D2
EconomicLosses
S1
MR
D1
MCATC
P
Q100
P
Q100,000
IndustryFirm(price taker)
$60
50
40
$60
50
40
PROFIT MAXIMIZATION IN THE LONG RUN
D2
Return to ZeroEconomic Profits
S1
S3
Competitors with losses decrease supply, andprices return to zero economic profits.
$200
150
100
50
0
Co
st a
nd
Rev
enu
e
1 2 3 4 5 6 7 8 9 10
MC
MRAVCATC
Economic Loss
$81.00$91.67
MARGINAL REVENUE-MARGINAL COST APPROACH
Loss Minimization Position
T
MONOPOLY REVENUES & COSTS
Do
llar
sD
oll
ars
$200
150
200
50
$750
500
250
MR
Elastic
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
DQ
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
TR
Q
MONOPOLY REVENUES & COSTS
Q
Do
llar
sD
oll
ars
$200
150
200
50
$750
500
250
TR
MR D
InelasticElastic
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18Q
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
A Monopolist will always operate on the Elastic Portion of the Demand Curve
Inelastic PortionMR is Negative
Profit Maximization Under Monopoly
D
MC
ATC
MR
$94
$122
Profit
MR = MC
ProfitPer Unit
OUTPUT AND PRICE DETERMINATION
Q
200
175
150
125
100
75
50
25
0 1 2 3 4 5 6 7 8 9 10
Pri
ce,
cost
s, a
nd
rev
enu
eRemember the MR=MC Rule?
Profit Maximization Under Monopoly
D
MC
ATC
MR
$94
$122
Profit
MR = MC
ProfitPer Unit
OUTPUT AND PRICE DETERMINATION
Q
200
175
150
125
100
75
50
25
0 1 2 3 4 5 6 7 8 9 10
Pri
ce,
cost
s, a
nd
rev
enu
e
What About
Loss Minimization?
Loss Minimization Under Monopoly
D
MCATC
MR
A
Pm
Loss
MR = MC
LossPer Unit
OUTPUT AND PRICE DETERMINATION
Q
200
175
150
125
100
75
50
25
0 1 2 3 4 5 6 7 8 9 10
Pri
ce,
cost
s, a
nd
rev
enu
e
AVC
Qm
V
Since Pm exceeds AVC,the firm will produce
Loss Minimization Under Monopoly
D
MCATC
MR
A
Pm
Loss
MR = MC
LossPer Unit
OUTPUT AND PRICE DETERMINATION
Q
200
175
150
125
100
75
50
25
0 1 2 3 4 5 6 7 8 9 10
Pri
ce,
cost
s, a
nd
rev
enu
e
AVC
Qm
V
What are theEconomic Effectsof Monopoly?
Q
INEFFICIENCY OF PURE MONOPOLYP
DMR
S = MC
Pc
Pm
QcQm
At MR=MCA monopolistwill sell lessunits at ahigher pricethan incompetition
An industry in pure competitionsells where supply anddemand are equal
Q
INEFFICIENCY OF PURE MONOPOLYP
DMR
S = MC
Pc
Pm
QcQm
At MR=MCA monopolistwill sell lessunits at ahigher pricethan incompetition
Monopoly pricing effectivelycreates an income transfer from
buyers to the seller!
REGULATED MONOPOLY
Q
D
MR
MCATC
PP
rice
an
d C
ost
sMR = MC
Fair-Return Price
Socially-OptimumPrice
Qm Qf Qr
Dilemma of RegulationWhich Price?
Pm
Pf
Pr
D
MR
MC
P3 = A3
ATC
Pri
ce a
nd
Co
sts
Q3
Quantity
Long-Run EquilibriumPrice is Not= Minimum
ATC
Price MC
MONOPOLISTIC COMPETITIONAND EFFICIENCY
MONOPOLISTIC COMPETITIONAND EFFICIENCY
• Not Productively Efficient Minimum ATC
• Not Allocatively EfficientPrice MC
• Excess CapacityGraphically…
OLIGOPOLY BEHAVIORA Game-Theory Overview
High
Low
High Low
Up
tow
n’s
Pri
ce S
trat
egy
RareAir’s Price Strategy
BA
DC
$12 $15
$12 $6
$6 $8
$8$15
OLIGOPOLY BEHAVIORA Game-Theory Overview
High
Low
High Low
Up
tow
n’s
Pri
ce S
trat
egyRareAir’s Price Strategy
BA
DC
$12 $15
$12 $6
$6 $8
$8$15
GreatestCombined
Profit
OLIGOPOLY BEHAVIORA Game-Theory Overview
High
Low
High LowU
pto
wn
’s P
rice
Str
ateg
y
RareAir’s Price Strategy
BA
DC
$12 $15
$12 $6
$6 $8
$8$15
IndependentActions
StimulateResponse
OLIGOPOLY BEHAVIORA Game-Theory Overview
High
Low
High LowU
pto
wn
’s P
rice
Str
ateg
y
RareAir’s Price Strategy
BA
DC
$12 $15
$12 $6
$6 $8
$8$15
IndependentActions
StimulateResponse
Gravitatingto the
Worst Case
OLIGOPOLY BEHAVIORA Game-Theory Overview
High
Low
High LowU
pto
wn
’s P
rice
Str
ateg
yRareAir’s Price Strategy
BA
DC
$12 $15
$12 $6
$6 $8
$8$15
CollusionInvites aDifferentSolution.
OLIGOPOLY BEHAVIORA Game-Theory Overview
High
Low
High LowU
pto
wn
’s P
rice
Str
ateg
yRareAir’s Price Strategy
BA
DC
$12 $15
$12 $6
$6 $8
$8$15
CollusionInvites aDifferentSolution.
OLIGOPOLY BEHAVIORA Game-Theory Overview
High
Low
High LowU
pto
wn
’s P
rice
Str
ateg
y
RareAir’s Price Strategy
BA
DC
$12 $15
$12 $6
$6 $8
$8$15
But, theincentiveto cheat
is very real.
CollusionInvites aDifferentSolution.
