# COST OF PRODUCTION & THEORY OF THE FIRM

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1 MICROECONOMICS: UNIT III COST OF PRODUCTION & THEORY OF THE FIRM One of the concepts mentioned in both Units I and II was and its components, total cost and total revenue. In this unit, costs and revenue will be explored in more detail, and then graphed to show relationships. In Unit I, we organized an ice cream factory according to the factors of production. This time, let s of cost. 63

2 64 MICROECONOMICS: UNIT III To review: total revenue is calculated by multiplying price and quantity. Calculating revenue means little, though, without comparing it to costs. Total cost is found by multiplying cost per unit and quantity. Total Cost can be calculated this way, as well; Fixed Cost plus Variable Cost, or TC = FC + VC. Type of cost: Variable Cost Fixed Cost Examples of factor/resource/ input costs for an ice cream factory: cream, fruit, chocolate, nuts, sugar, advertising expenses, workers wages, shipping charges, electricity, etc. factory, freezers, mixing bowls, insurance, real estate taxes, executive salaries, etc. Costs that change according to the cream is produced, more of these variable resources will be needed. ice cream is produced, these costs will stay the same; if no ice cream is produced, these costs will stay the same. simply dividing by quantity: Fixed Cost = FC/Q Variable Cost = VC/Q Total Cost = TC/Q or AFC+AVC Output Fixed Cost Variable Cost Total Cost 0 0 \$ \$ Fixed Cost Variable Cost Total Cost

3 COST OF PRODUCTION & THEORY OF THE FIRM 65 Here are the answers. Refer back to the formulas in the previous paragraphs if you are unsure as to how to calculate the numbers. Output Fixed Cost Variable Cost Total Cost Fixed Cost Variable Cost Total Cost 0 \$10.00 \$0.00 \$10.00 \$0.00 \$0.00 \$ \$ \$10.00 \$10.00 \$ Important concepts to recognize: It is easier to see these relationships on a graph. Plotting the points using quantity on the X axis and price or cost on the Y axis, you will see the shaded data above drawn as cost curves on Graph A. PRICE OR COST (\$) Total Cost Variable Cost Fixed Cost Graph A: Cost Curves

4 66 MICROECONOMICS: UNIT III and price on the Y axis, you will see the following cost curves: PRICE OR COST (\$) Total Cost Variable Cost Fixed Cost Graph B: Cost Curves Some more important concepts to recognize: Regardless of the numbers used, the curves in Graphs A and B will always have the same shapes and relationships. There is another cost that needs to be included in the chart for it to be complete. (or additional cost that is incurred by producing an additional unit. It is calculated by dividing the change in total cost by the change in quantity, or MC DTC = DQ Using the table on page 65, if we add a column for marginal cost, it would look like this:

5 COST OF PRODUCTION & THEORY OF THE FIRM 67 Output (or Quantity) Variable Cost Fixed Cost Variable Cost Total Cost Fixed Cost Total Cost Marginal Cost 0 \$10.00 \$0.00 \$10.00 \$0.00 \$0.00 \$0.00 \$ \$ \$10.00 \$10.00 \$ Again, here is Graph B but now with the MC curve included: PRICE OR COST (\$) Total Cost Variable Cost Graph C: Costs and Fixed Cost Additional important concepts to recognize: example, producing a second unit costs an additional \$7.50, while adding the third unit costs an additional \$5.00. change

6 68 MICROECONOMICS: UNIT III each unit of output. That way, he can determine the exact point when he should cease production: that moment diminishing returns obtained from factory is only so big and there is only so much machinery that can be used at one time (economists call this In order to determine where MB = MC Marginal Revenue additional revenue he receives for selling an additional unit of ice cream, or MR DTR D ^P# Qh = or DQ DQ Assume the ice cream producer sells his ice cream in large containers for \$7.50 apiece. Thus, using the above formula, his MR for each unit is also \$7.50. As stated earlier, costs and revenues by themselves do not mean much. We need to have both revenue and cost information in one place in order to compare. We do this by plotting MR on Graph D. The plotted line is horizontal because the factory can sell as much ice cream as it can produce at \$7.50 per container. PRICE OR COST (\$) \$7.50 \$6.25 Total Cost Marginal Revenue Variable Cost 8 Notice that MC and MR intersect at a price of \$7.50 and a quantity of 8. This intersection is one of the most important relationships in Microeconomics: economists call it the output (do you table by not selling as many containers of ice cream as possible. If she sells more, where MR<MC, well, that

7 COST OF PRODUCTION & THEORY OF THE FIRM 69 is never a good thing. No one wants costs to be greater than revenue, neither in the short-run nor the long-run. it one of two ways: ^P # Qh- ^ATC # Qh= ^\$7.50 # 8 unitsh- ^\$6.25 # 8 unitsh= \$ 60 - \$ 50 = \$ 10 or \$ \$6.25 = \$1.25 per unit profit; \$1.25 # 8 units = \$10 and the ATC curves respectively (if you are unsure where these numbers come from, refer back to the for a short while, perhaps by dipping into her savings, but eventually her savings will run out. She also could try to cut costs by laying off workers or paying less for her factors of production. However, unless prices rise or costs fall, she will not be able to sustain her business in the long-run. she produces. PRICE OR COST (\$) Profit Short-run Supply Curve Total Cost Loss Variable Cost Long-run Supply Curve Shut-down Graph E entrepreneur.

8 70 MICROECONOMICS: UNIT III Notice in the previous examples we determined the cut-off points by looking at where the MC determine the points where the producer loses money in the short-run or shuts down production, but also because they determine the producer s supply curve. As the producer will not produce below the point is that part of the MC curve above AVC. The is the MR curve. As long as she charges this price, buyers will buy as much of her output as she is willing to sell. PRICE OR COST (\$) \$7.50 Total Cost Marginal Revenue = Price = Demand Variable Cost 8 Graph F: Firm s Supply and Demand Even more important concepts to recognize: long-run average cost, or LRAC. This be renegotiated, orders can be changed, new equipment can be purchased, etc. The short-run, if three distinct parts: that part where costs are falling due to economies of scale, that part where constant returns to scale diseconomies of scale. Graph G shows this concept.

9 COST OF PRODUCTION & THEORY OF THE FIRM 71 PRICE Economies of Scale Constant Returns to Scale Diseconomies of Scale production can continue temporarily if a business is losing money, in the long-run, if MR falls MR curve above ATC. Since a producer cannot lose money in the long run, his long-run supply curve Graph E Due to increasing returns, costs fall as production increases, but only up to a point. Eventually, production curve by the fact that output increases as workers become more experienced and Graph H shows this relationship. PRICE OR COST (\$) Increasing Returns Cost Diminishing Returns UNITS OF OUTPUT Marginal Product Graph H: Cost Curves and Product Curves Product UNITS OF INPUT

10 72 MICROECONOMICS: UNIT III The previous information is useful for all types of businesses, not just ice cream factories. Economists categorize businesses into four market structures. Each market structure has its own set of characteristics, as shown in the following chart: Market Structure Characteristic: Example Perfect Competition agricultural products Monopolistic Competition Oligopoly Monopoly retail stores, restaurants Type of product homogeneous differentiated in the market/ industry Percentage of market share Barriers to entry phone companies, airlines, car makers differentiated or homogeneous utilities unique thousands hundreds 2 to very small small to large large enough for market power % none some many many Non-price competition Number of substitutes Slope of the demand curve price Price is determined by Long-run Relationship between MR and D curves Consumer and producer surplus no yes yes no many few none perfectly elastic relatively inelastic not applicable more inelastic not applicable the market zero zero yes yes MR < D not applicable at their maximums and equal producer surplus > consumer surplus not applicable MR < D (except pricediscriminating monopoly, where MR producer surplus > consumer surplus; (no consumer surplus in pricediscriminating

11 COST OF PRODUCTION & THEORY OF THE FIRM 73 Deadweight loss none yes not applicable Productive (P = minimum ATC) Allocative (P = MC) yes (except pricediscriminating yes no no no yes no no (except pricediscriminating First, notice that perfect competition and monopoly are at two ends of the spectrum, and that monopolistic competition and oligopoly fall somewhere in between. explain it.

12 74 MICROECONOMICS: UNIT III Perfect Competition The set of graphs for perfect competition should look familiar: PRICE OR COST (\$) Supply PRICE OR COST (\$) MC ATC P eq ATC Profit AVC MR = P = AR = D Q eq Market / Industry Demand Q eq Firm PRICE OR COST (\$) P eq Supply PRICE OR COST (\$) ATC Loss MC ATC AVC MR = P = AR = D Demand Q eq Market / Industry Q eq Firm It is the combination of two graphs already discussed: the supply and demand graph from Unit II and the cost curves graph discussed previously in this unit. The supply and demand graph illustrates the market;

13 COST OF PRODUCTION & THEORY OF THE FIRM 75 Quantity Price Total Revenue Revenue Marginal Revenue 0 \$ Consumer and producer surpluses are at their maximum, and deadweight loss does not exist. PRICE OR COST (\$) Supply PRICE OR COST (\$) Total Cost P eq MR = P = AR = D Monopoly Q eq Market / Industry Demand Q eq Firm existence of barriers to entry

14 76 MICROECONOMICS: UNIT III other lessening competition. Examples of barriers to entry are economies of scale, control over natural resources, legal barriers such as patents and licenses, pricing strategies such as underbidding or dumping, brand loyalty, mergers and/or takeovers, and the ability to conduct research and development. The result of this lack of competition is that a monopoly is able to charge a price greater than Graph K. PRICE OR COST (\$) Profit Total Cost P eq ATC MC = MR Demand = Revenue Q eq Graph K: Monopoly Marginal Revenue same shape. However, there are some important differences between the graphs of the two market structures. for a monopoly s product, and thus the curves are more inelastic. The result of this is that if the have to lower his price. This is shown in the price column of the table on the next page. marginal revenue curve has a steeper slope than the demand curve. This is proven mathematically in the table on the next page.

15 COST OF PRODUCTION & THEORY OF THE FIRM 77 Quantity Price Total Revenue Revenue Marginal Revenue the X axis. Monopolists will not produce beyond this point voluntarily, as they will lose money on each unit produced. If this mandated level of output causes the monopolist to lose money, the government will often subsidize the production of the good. socially optimal point fair return PRICE OR COST (\$) P eq Socially Optimal Point Total Cost P so P fr Fair Return Point Q eq Q so Q fr Graph L: Monopoly Demand = Revenue Marginal Revenue

16 78 MICROECONOMICS: UNIT III greatest level. PRICE OR COST (\$) Demand = Revenue Marginal Revenue TOTAL REVENUE Total Revenue Graph M: Marginal vs. Total Revenue Graph N shows these concepts.

17 COST OF PRODUCTION & THEORY OF THE FIRM 79 PRICE OR COST (\$) Elastic Unit Elastic Inelastic Demand = Revenue Marginal Revenue Graph N: Monopoly and Elasticity Another type of monopoly is a price-discriminating monopoly. The main advantage a pricediscriminating monopolist has over a single-priced, non-regulated monopolist is the opportunity to earn prices that different customers are willing to pay and charge them accordingly. Consumers who are willing to pay more, do; those who want to pay less, do so as well. This is possible for three reasons: segment the market accordingly. PRICE OR COST (\$) Total Cost Demand = Marginal Revenue Q

18 80 MICROECONOMICS: UNIT III Notice that in Graph O, the demand and marginal revenue curves are the same. For a price-discriminating Quantity Price Total Revenue Revenue Marginal Revenue as in the table on page 77, in order to sell an additional unit, the monopolist must lower his price. However, he does not have to lower his price for all buyers; because he is able to segment his market, each consumer pays according to his own assessment of what the good or service is worth. PRICE OR COST (\$) ATC Profit Marginal Cost Total Cost Dead Weight Loss Demand = Revenue PRICE OR COST (\$) ATC Profit Marginal Cost Total Cost Demand = Marginal Revenue Q Marginal Revenue Q Single-priced Non-regulated Monopoly Price Discriminating Monopoly discriminating monopolist. The areas shaded in Graph P show this difference. A natural monopoly little sense to have competing electric companies provide service to the same market area. This would result in each company s wires being strung all over town, which is cumbersome and aesthetically undesirable. The same used to be true for telephone companies; however, the proliferation of wireless phones has made the telephone industry more competitive. Graph Q shows a natural monopoly.

19 COST OF PRODUCTION & THEORY OF THE FIRM 81 PRICE OR COST (\$) Unregulated Monopoly Price Fair Return Price Socially Optimal Price LRAC Demand = Revenue Q Marginal Revenue Graph Q: Natural Monopoly The concepts of consumer surplus and deadweight loss affect the monopoly graph differently depending on whether it is a price-discriminating monopoly or a single price, non-regulated monopoly. setting power. This higher price and lower quantity sold means that there is deadweight loss, as the market Graph R for an illustration of this difference.

20 82 MICROECONOMICS: UNIT III PRICE Consumer Surplus Deadweight Loss Total Cost PRICE Producer Surplus Total Cost Product Surplus Demand = Marginal Revenue Q Marginal Revenue Single Price Non-regulated Monopoly Q Price-discriminating Monopoly Graph R: Comparing Surplus Oligopoly Oligopolies are similar to monopolies in terms of price-setting power and the ability to price-discriminate. times, leads to collusion monopoly power. Such cartels are illegal since this behavior harms the consumer. Collusion is easiest when the product is homogeneous. Oligopolies, though, spend much time and effort attempting to differentiate their products from their competitors through non-price competition. There is no agreed-upon graph for an oligopoly. Unique to oligopoly, though, is the concept of game theory strategy. Game theory uses a matrix that shows two players payoffs given certain behaviors. destinations, and both are interdependent because they must take into consideration their competitor s price Air Snowboard Ski Airlines \$140 per ticket \$135 per ticket \$140 per ticket \$65/\$62 \$64/\$64 \$135 per ticket \$74/\$55 \$63/\$60

21 COST OF PRODUCTION & THEORY OF THE FIRM 83 Notice that a dominant strategy the other competitor does. If Air Snowboard charges \$140 per ticket, Ski Airlines should charge \$135 dominant strategy is \$135. Air Snowboard does not have a dominant strategy, however. If Ski Airlines charges \$140, Air always dependent on that of Ski Airlines. the other is honoring the \$140 price is too great. This is why cartels usually fail. resources would cause harm to one or more participants. A Nash Equilibrium exists when no participant off than he is currently and thus a dominant strategy does not exist. Monopolistic competition Monopolistic competition is the most common market structure, as most retail businesses fall into this are focused on product differentiation via non-price competition. One of the preferred types of non-price competition is advertising, where the goal is to develop brand loyalty and gain a market niche. only selling jeans, which can be bought elsewhere are various prices. Graph S on page 84 shows the

22 84 MICROECONOMICS: UNIT III PRICE OR COST (\$) Total Cost P eq ATC Profit Demand = Revenue Monopolistic Competition Gaining a Profit PRICE OR COST (\$) ATC Q eq Marginal Revenue Total Cost P eq Loss Demand = Revenue Monopolistic Competition Earning a Loss Q eq Marginal Revenue PRICE OR COST (\$) ATC = P Q Total Cost Marginal Revenue Demand = Revenue Graph S: Monopolistic Competition Monopolistic Competition Long-run Equlibrium

23 COST OF PRODUCTION & THEORY OF THE FIRM 85 Notice that monopolistic competition and single-price monopoly graphs look very similar. However, unlike a monopoly, because there are few barriers to entry, the result is a long-run graph that shows no Types of Business Ownership These market structures can exist as one of three types of entities; a sole proprietorship, where the owner partnership, where one or more corporation, where a state-registered are not held liable for any losses if the corporation is sued. In the next unit, we ll graph the factors of production that make it possible for these market structures to exist.

24 86 MICROECONOMICS: UNIT III New Terms Total revenue Total cost Fixed cost Variable cost Total cost variable cost total cost Marginal cost Economies of scale Constant returns to scale Diseconomies of scale Long-run average cost Perfect competition Monopoly Monopolistic competition Oligopoly Barriers to entry Non-price competition Natural monopoly Price-discriminating monopoly Fair return price Socially optimal price Game theory Dominant strategy Nash Equilibrium Sole proprietorship Partnership Corporation

25 MICROECONOMICS: UNIT III MULTIPLE-CHOICE QUESTIONS Fixed Cost Variable Cost Questions 2-6 refer to the table below: Output Total Revenue Variable Cost Fixed Cost Total Cost \$ Based on the information in the table above, the total cost of producing 5 units of output is: 87

26 88 MICROECONOMICS: UNIT III 3. Based on the information in the table, the marginal cost of producing the 4th unit of output is:

27 COST OF PRODUCTION & THEORY OF THE FIRM 89 \$ /UNIT Total Cost Marginal Cost Variable Cost \$ /UNIT Total Cost \$ /UNIT Variable Cost Total Cost (A) Variable Cost (B) (C) \$ /UNIT Total Cost Fixed Cost \$ /UNIT Marginal Cost Total Cost Variable Cost (D) (E)

28 90 MICROECONOMICS: UNIT III PRICE Total Cost Marginal Revenue and Demand OUTPUT

29 COST OF PRODUCTION & THEORY OF THE FIRM 91 Questions 9-11 refer to the table below: High Price Charles Low Price High Price Anne Profits \$15 Charles Profits \$15 Anne Profits \$30 Charles Profits \$10 Anne Low Price Anne Profits \$10 Charles Profits \$20 Anne Profits \$25 Charles Profits \$25 9. Based on the information in the payoff matrix box depicted above, we can conclude that in the absence of collusion 10. Based on the information in the payoff matrix box depicted above, we can conclude that dominant strategy.

30 92 MICROECONOMICS: UNIT III 11. If Charles and Anne can successfully collude and agree to a binding enforceable agreement, what 12. The three basic forms of business organization are 13. Firms in all market structures seek to maximizing behavior. Output Price

31 COST OF PRODUCTION & THEORY OF THE FIRM 93 \$ /UNIT Total Cost Variable Cost Price 16. Marginal cost is calculated by 17. Which of the following correctly ranks market structures from least to most competitive?

32 94 MICROECONOMICS: UNIT III I. Subdivide the market II. Prevent resale III. Monopoly power ( \$ /UNIT Price B A Total Cost C D E Quantity Marginal Revenue Revenue Fair Return, or Break-Even Point Socially Optimum Point (A) A B C (B) E C B (C) C D E (D) B C D

33 COST OF PRODUCTION & THEORY OF THE FIRM Which of the following is true for both a perfect competitor and a monopolistic competitor in long-run Perfect Competitor (B) Is allocatively efficient (C) Is productively efficient (D) Produces at P = MC Monopolistic Competitor Is allocatively efficient Is productively efficient Produces at P = MC Plan A Karen Plan B Plan A Lauren \$500 Karen \$500 Lauren \$600 Karen \$400 Lauren Plan B Lauren \$400 Karen \$700 Lauren \$700 Karen \$600

34 96 MICROECONOMICS: UNIT III Questions \$ /UNIT F D E C B A V Z T R Y X W Total Cost U Revenue = Demand Marginal Revenue

35 COST OF PRODUCTION & THEORY OF THE FIRM 97 Questions \$ /UNIT Total Cost Variable Cost D EF M N Q C Price P S B A R G H I J K

36 98 MICROECONOMICS: UNIT III Questions \$ /UNIT D C E B F A L G O K J I Marginal Revenue H Revenue = Demand the area: represented by the area:

37 COST OF PRODUCTION & THEORY OF THE FIRM 99 is: Questions PRICE Supply \$ /UNIT Marginal Cost Total Cost Variable Cost Price A Demand B

38 100 MICROECONOMICS: UNIT III

39 MICROECONOMICS: UNIT III FREE-RESPONSE QUESTIONS market. 101

40 102 MICROECONOMICS: UNIT III 2. \$ /UNIT short-run equilibrium. long-run equilibrium.

41 COST OF PRODUCTION & THEORY OF THE FIRM Julie s Pricing Strategy High Low Scott s Pricing Strategy High Low Scott s Profits \$200 Scott s Profits \$150 Julie s Profits \$200 Julie s Profits \$75 Scott s Profits \$50 Scott s Profits \$75 Julie s Profits \$150 Julie s Profits \$50

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