Review of Review of Economic Economic ConceptsConcepts

AGEC 489-689Spring 2010

Key Cost RelationshipsKey Cost RelationshipsThe following cost derivations play a key role in decision-making:

Marginal cost = total cost ÷ output

Key Cost RelationshipsKey Cost RelationshipsThe following cost derivations play a key role in decision-making:

Marginal cost = total cost ÷ output

Averagevariable = total variable cost ÷ output cost

Key Cost RelationshipsKey Cost RelationshipsThe following cost derivations play a key role in decision-making:

Marginal cost = total cost ÷ output

Averagevariable = total variable cost ÷ output cost

Average total = total cost ÷ output cost

Costs associated with levels of outputCosts associated with levels of output

Profit maximizinglevel of output,where MR=MC

Profit maximizinglevel of output,where MR=MC

P=MR=AR $45$45

11.211.2

AverageProfit = $17, or

AR – ATC

AverageProfit = $17, or

AR – ATCP=MR=AR

$45-$28$45-$28

$28$28

Grey area representstotal economic profitif the price is $45…

Grey area representstotal economic profitif the price is $45…

P=MR=AR

11.2 ($45 - $28) = $190.4011.2 ($45 - $28) = $190.40

Zero economic profitif price falls to PBE.Firm would only produceoutput OBE . AR-ATC=0

Zero economic profitif price falls to PBE.Firm would only produceoutput OBE . AR-ATC=0

P=MR=AR

Economic lossesif price falls to PSD.Firm would shut downbelow output OSD

Economic lossesif price falls to PSD.Firm would shut downbelow output OSD

P=MR=AR

Where is the firm’ssupply curve?

Where is the firm’ssupply curve?

P=MR=AR

P=MR=AR

Marginal cost curveabove AVC curve?

Marginal cost curveabove AVC curve?

Key Input RelationshipsKey Input RelationshipsThe following input-related derivations also play a key role in decision-making:

Marginal value = marginal physical product × price product

Key Input RelationshipsKey Input RelationshipsThe following input-related derivations also play a key role in decision-making:

Marginal value = marginal physical product × price product

Marginal input = wage rate, rental rate, etc. cost

5

B

C

D

E

FG

HI

J

Wage rate representsthe MIC for labor

Wage rate representsthe MIC for labor

5

B

C

D

E

FG

HI

J

Use a variable input likelabor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC

Use a variable input likelabor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC

5

The area below thegreen lined MVPcurve and above thegreen lined MICcurve representscumulative net benefit.

The area below thegreen lined MVPcurve and above thegreen lined MICcurve representscumulative net benefit.

B

C

D

E

FG

HI

J

5

If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.

If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.

B

C

D

E

FG

HI

J

5

If you went beyond the point where MVP=MIC, you begin incurring losses.

If you went beyond the point where MVP=MIC, you begin incurring losses.

B

C

D

E

FG

HI

J

Multiple Input Cost Multiple Input Cost RelationshipsRelationships

Output isidentical alongan isoquant

Output isidentical alongan isoquant

Isoquant means “equal quantity”Isoquant means “equal quantity”

Two inputsTwo inputs

Slope of an IsoquantSlope of an Isoquant

The slope of an isoquant is referred to as the Marginal Rate of Technical Substitution, or MRTS. The value of the MRTS in our example is given by:

MRTS = Capital ÷ labor

If output remains unchanged along an isoquant, the loss in output from decreasing labor must be identical to the gain in output from adding capital.

Plotting the Iso-Cost LinePlotting the Iso-Cost Line

Capital

Labor

Firm can afford 100 units oflabor at a wage rate of $10 fora budget of $1,000

Firm can afford 100 units oflabor at a wage rate of $10 fora budget of $1,000

10

100

Firm can afford 10 units ofcapital at a rental rate of $100for a budget of $1,000

Firm can afford 10 units ofcapital at a rental rate of $100for a budget of $1,000

Slope of an Iso-cost LineSlope of an Iso-cost LineThe slope of an iso-cost in our example is given by:

Slope = - (wage rate ÷ rental rate)

or the negative of the ratio of the price of the two Inputs. The slope is based upon the budget constraint and can be obtained from the following equation:

($10 × use of labor)+($100 × use of capital)

Least Cost Decision RuleLeast Cost Decision RuleThe least cost combination of two inputs (labor and capital in our example) occurs where the slope of the iso-cost line is tangent to isoquant:

MPPLABOR ÷ MPPCAPITAL = -(wage rate ÷ rental rate)

Slope of an isoquant

Slope of an isoquant

Slope of iso- cost line

Slope of iso- cost line

Least Cost Decision RuleThe least cost combination of labor and capital in out example also occurs where:

MPPLABOR ÷ wage rate = MPPCAPITAL ÷ rental rate

MPP per dollar spent on labor

MPP per dollar spent on labor

MPP per dollar spent on capitalMPP per dollar spent on capital=

Least Cost Decision RuleLeast Cost Decision RuleThe least cost combination of labor and capital in out example also occurs where:

MPPLABOR ÷ wage rate = MPPCAPITAL ÷ rental rate

MPP per dollar spent on labor

MPP per dollar spent on labor

MPP per dollar spent on capitalMPP per dollar spent on capital=

This decision rule holds for a larger number of inputs as well…

Least Cost Input Choice for 100 UnitsLeast Cost Input Choice for 100 Units

At the point of tangency, we know that:slope of isoquant = slope of iso-cost line, or…MPPLABOR ÷ MPPCAPITAL = - (wage rate ÷ rental rate)

At the point of tangency, we know that:slope of isoquant = slope of iso-cost line, or…MPPLABOR ÷ MPPCAPITAL = - (wage rate ÷ rental rate)

Firm can afford toproduce only 75 units of output using C3 unitsof capital and L3 unitsof labor

Firm can afford toproduce only 75 units of output using C3 unitsof capital and L3 unitsof labor

What Inputs to Use for a Specific Budget?What Inputs to Use for a Specific Budget?

The Planning CurveThe Planning Curve

The long run average cost (LAC) curve reflects points of tangency with a series of short run average total cost (SAC) curves. The point on the LAC where the following holds is the long run equilibrium position (QLR) of the firm:

SAC = LAC = PLR

where MC represents marginal cost and PLR represents the long run price, respectively.

What can we say about the fourfirm sizes in this graph?

What can we say about the fourfirm sizes in this graph?

Size 1 would losemoney at price P

Size 1 would losemoney at price P

Q3

Firm size 2, 3 and 4would earn a profitat price P….

Firm size 2, 3 and 4would earn a profitat price P….

Q3

Firm size #2’s profit would be the area shown below…

Firm size #2’s profit would be the area shown below…

Q3

Firm size #3’s profit would be the area shown below…

Firm size #3’s profit would be the area shown below…

Q3

Firm size #4’s profit would be the area shown below…

Firm size #4’s profit would be the area shown below…

If price were to fall to PLR, only size 3 would not lose money; it would break-even. Size 4 would have to down down sizesize its operations!

If price were to fall to PLR, only size 3 would not lose money; it would break-even. Size 4 would have to down down sizesize its operations!

Optimal inputcombinationfor output=10

Optimal inputcombinationfor output=10

How to Expand Firm’s CapacityHow to Expand Firm’s Capacity

How to Expand Firm’s CapacityHow to Expand Firm’s Capacity

Two options: 1. Point B ?

Two options: 1. Point B ?

How to Expand Firm’s CapacityHow to Expand Firm’s Capacity

Two options: 1. Point B?2. Point C?

Two options: 1. Point B?2. Point C?

Optimal inputcombinationfor output=10with budget DE

Optimal inputcombinationfor output=10with budget DE

Optimal inputcombination for output=20with budget FG

Optimal inputcombination for output=20with budget FG

Expanding Firm’s CapacityExpanding Firm’s Capacity

This combinationcosts more toproduce 20 units of output sincebudget HI exceedsbudget FG

This combinationcosts more toproduce 20 units of output sincebudget HI exceedsbudget FG

Expanding Firm’s CapacityExpanding Firm’s Capacity

Market Price Discovery #1

Perfect Perfect CompetitionCompetition

P=MR=AR

Remember the firm’ssupply curve?

Remember the firm’ssupply curve?

Firm’s supply curvestarts at shut downlevel of output

Firm’s supply curvestarts at shut downlevel of output

P=MR=AR

Profit maximizing firm will desire to producewhere MC=MR

Profit maximizing firm will desire to producewhere MC=MR

P=MR=AR

Economic losses will occurbeyond output OMAX, whereMC > MR

Economic losses will occurbeyond output OMAX, whereMC > MR

P=MR=AR

Forecasting Future Commodity Price TrendsForecasting Future Commodity Price Trends

D

S

$4

10

$1

$7

D = a – bP + cYD + eXD = a – bP + cYD + eX

Ownprice

Ownprice

Disposableincome

Disposableincome

Otherfactors

Otherfactors

D

S

$4

10

$1

$7

S = n + mP – rC + sZS = n + mP – rC + sZ

Ownprice

Ownprice

Inputcosts

Inputcosts

Forecasting Future Commodity Price TrendsForecasting Future Commodity Price Trends

Otherfactors

Otherfactors

Projecting Commodity PriceProjecting Commodity Price

D = SD = S

D

S

$4

10

$1

$7

D = 10 – 6P + .3YD + 1.2XD = 10 – 6P + .3YD + 1.2X

S = 2 + 4P – .2C + 1.02ZS = 2 + 4P – .2C + 1.02Z

Substitute the demand and supplyequations into the the equilibriumcondition and solve for price

Substitute the demand and supplyequations into the the equilibriumcondition and solve for price

Firm is a “Price Taker” Firm is a “Price Taker” Under Perfect Competition Under Perfect Competition

Price

Quantity

D S

PE

QE

Price

OMAX

AVC MC

The MarketThe Market The FirmThe Firm

If Demand Increases……If Demand Increases……

Price

Quantity

D S

PE

QE

Price

AVC MC

The MarketThe Market The FirmThe Firm

10 11

D1

If Demand Decreases……If Demand Decreases……

Price

Quantity

D S

PE

QE

Price

AVC MC

The MarketThe Market The FirmThe Firm

9 10

D2

Firm is a “Price Taker” in Firm is a “Price Taker” in the Input Market the Input Market

Price

Quantity

D S

PE

QE

Price

LMAX

MVP

MIC

Labor MarketLabor Market The FirmThe Firm

Price

Quantity

D S

PE

QE

Price

LMAX

MVP

MIC

Labor MarketLabor Market The FirmThe Firm

If Demand Increases……If Demand Increases……

MarketPrice Discovery #2

Imperfect Imperfect CompetitionCompetition

Monopolistic CompetitorsMonopolistic Competitors

Many sellersAbility to differentiate

product by advertising and sales promotions

Profits can exist in the short run, but others bid them away in the long run

Equate MC with MR, but price off the downward sloping demand curve

Short run profits. The firmproduces QSR where MR=MC atE above, but prices its products at PSR by reading off the demand curve which reveals consumer willingness to pay

Short run profits. The firmproduces QSR where MR=MC atE above, but prices its products at PSR by reading off the demand curve which reveals consumer willingness to pay

Short run loss. The firm suffers a loss in the current period following the same strategy of operating at QSR given by MC=MR at point E.

Short run loss. The firm suffers a loss in the current period following the same strategy of operating at QSR given by MC=MR at point E.

At quantity QSR, average total cost (ATCSR) is greater than PSR, which creates the loss depicted above…

At quantity QSR, average total cost (ATCSR) is greater than PSR, which creates the loss depicted above…

In the long run, profits are bid away as more firms enter the market. Or losses will no longer exist as firms leave the market. At QLR, the remaining firms are just breaking even as shownby the lack of gap between the demand curve and ATC curve.

In the long run, profits are bid away as more firms enter the market. Or losses will no longer exist as firms leave the market. At QLR, the remaining firms are just breaking even as shownby the lack of gap between the demand curve and ATC curve.

MonopoliesMonopoliesOnly seller in the market.Entry of other firms is

restricted by patents, etc.They have absolute power

over setting market price.They produce a unique

product.They can make economic

profits in the long run because they can set price without competition.

Total revenue is equalto the area 0PECQE,which forms the bluebox to the left…

Notice the monopoly,like the previous formsof imperfect competition,produces where MC=MR(point A), but then reads up to the demand curve (point C) when setting price PE.

Total revenue is equalto the area 0PECQE,which forms the bluebox to the left…

Notice the monopoly,like the previous formsof imperfect competition,produces where MC=MR(point A), but then reads up to the demand curve (point C) when setting price PE.

Total variable costs forthe monopolist is equalto area 0NAQE, or theyellow box to the left.

Total variable costs forthe monopolist is equalto area 0NAQE, or theyellow box to the left.

Total fixed costs for themonopolist is equal toarea NMBA, or the greenbox to the left…

Total fixed costs for themonopolist is equal toarea NMBA, or the greenbox to the left…

Total cost is therefore equalto area 0MBQE, or thegreen box plus the yellowbox to the left.

Total cost is therefore equalto area 0MBQE, or thegreen box plus the yellowbox to the left.

Finally, the economic profitearned by the monopolist isequal to area MPECB, ortotal revenue (blue box) minus total costs (green boxplus yellow box).

Finally, the economic profitearned by the monopolist isequal to area MPECB, ortotal revenue (blue box) minus total costs (green boxplus yellow box).