Total Cost (TC)
The market value of the inputs a firm uses in production. Includes explicit and implicit costs
(TC = FC + VC)
Input costs that require an outlay of money by the firm. e.g., paying wages to workers, interest paid on a loan.
Input costs that do not require an outlay of money by the firm - e.g., The opportunity cost of the owner's time, interest lost from money pulled out of savings.
Total revenue minus total cost, including both explicit and implicit costs.
(Economic Profit = TR-TC(including implicit and explicit costs))
Total revenue minus total explicit cost.
(Accounting Profit = TR - Total explicit costs)
The relationship between quantity of inputs used to make a good and the quantity of output of that good.
The increase in output that arises from an additional unit of input. i.e.- When Farmer Jack hires an extra worker costs rise by the wage he pays the worker and his output rises by MPL.
Diminishing marginal product
The property whereby the marginal product of an input declines as the quantity of the input increases. In general, MPL diminishes as L rises whether the fixed input is land or capital. i.e. - As Farmer Jack adds workers, the average worker has less land to work with and will be less productive.
Fixed costs (FC)
Costs that do not vary with the quantity of output produced. e.g., cost of equipment, loan payments, rent.
Average total cost (ATC)
Total cost divided by the quantity of output. Initially falling AFC pulls ATC down, eventually, rising AVC pulls ATC up.
(ATC = TC/Q) and (ATC = AFC + AVC)
Marginal cost (MC)
The increase in total cost that arises from an extra unit of production.
(MC = ΔTC/ΔQ)
ATC and MTC interaction
When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. The MC curve crosses the ATC curve at the ATC curve's minimum.
Long Run Costs
All inputs are variable (e.g., firms can build more factories, or sell existing ones). 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).
Long run average total cost (LRATC)
The combination of the SRATC curves for a firm with different sizes depending on factory sizes etc.
Economies of scale
LRATC falls as Q increases. Occurs when increasing production allows greater specialization: workers more efficient when focusing on a narrow task. More common when Q is low.
Diseconomies of scale
ATC rises as Q increases. Due to coordination problems in large organizations. E.g., management becomes stretched, can't control costs. More common when Q is high.
Characteristics of Perfect Competition
1. Many buyers and many sellers.
2. The goods offered for sale are largely the same.
3. Firms can freely enter or exit the market.
4. Because of 1 & 2 each buy and seller is a "price taker" - takes the price as given.
Revenue of a Competitive Firm
Total Revenue (TR) = P x Q
Average Revenue (AR) = TR/Q = P
Marginal Revenue (MR) = ΔTR/ΔQ = P
Profit maximization of a Competitive Firm
If MR > MC, then increase Q to raise profit.
If MR < MC, then reduce Q to raise profit.
MR = MC at the profit maximizing Q.
The MC curve is the firm's supply curve.
A short-run decision not to produce anything because of market conditions. If shut down in SR, must still pay FC.
Cost of shutting down: Revenue loss = TR
Benefit of shutting down: cost savings = VC (firm must still pay FC)
Shut down if TR < VC
Divide both sides by Q: TR/Q < VC/Q
Firm's decision rule is: Shut down if P < AVC
A long-run decision to leave the market. If exit in LR zero costs.
Cost of exiting the market: revenue loss = TR
Benefit of exiting the market: cost savings = TC (zero FC in the long run)
So, firm exits if TR < TC
Divide both sides by Q to write the firm's decision rule as:
Exit if P < ATC
A cost that has already been committed and cannot be recovered. Should be irrelevant to decisions; you must pay them regardless of your choice.
FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down, so FC should not matter in the decision to shut down.
New firm's decision to enter market
In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC.
Divide both sides by Q to express the firm's entry decision as:
Enter if P > ATC
Competitive Firm's LR supply curve
The firm's LR supply curve is the portion of its MC curve above LRATC.
Perfect competition 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)
Competitive Firm's SR supply curve
As long as P ≥ AVC, each firm will produce its profit-maximizing quantity, where MR = MC.
At each price, the market quantity supplied is the sum of quantities supplied by all firms.
Competitive firm's entry and exit in the LR
In the LR, the number of firms can change due to entry & exit.
If existing firms earn positive economic profit:
- New firms enter, SR market supply shifts right.
- P falls, reducing profits and slowing entry.
If existing firms incur losses:
- Some firms exit, SR market supply shifts left.
- P rises, reducing remaining firms' losses.
The Zero-Profit Condition (Long-run equilibrium)
The process of entry or exit s complete -- remaining firms earn zero economic profit.
Zero economic profit occurs when P = ATC.
Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC.
Recall that MC intersects ATC at minimum ATC.
Hence, in the long run, P = minimum ATC.
Firms stay in business because economic profit includes implicit costs like opportunity costs of the owner's time and money.
In the zero-profit equilibrium,
- firms earn enough revenue to cover these costs
- accounting profit is positive
Competitive Firm's LR supply curve
In the long run, the typical firm earns zero profit. The LR market supply curve is horizontal at:
P = minimum ATC
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.
If either of these assumptions is not true, then LR supply curve slopes upward.
Competitive Firm's have different costs
As P rises, firms with lower costs enter the market before those with higher costs.
Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases market quantity supplied.
Hence, LR market supply curve slopes upward.
At any P,
- For the marginal firm, P = minimum ATC and
profit = 0.
- For lower-cost firms, profit > 0
Competitive Firm's costs rise as firms enter the market
In some industries, the supply of a key input is limited (e.g., amount of land suitable for farming is fixed).
The entry of a new firms increases demand for input, causing its price to rise.
This increases all firms' costs.
Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-sloping.