Whoever claims that economic competition represents 'survival of the fittest' in the sense of the law of the jungle, provides the clearest possible evidence of his lack of knowledge of economics. -George Reisman
To maximize profits a firm must consider how increased production will affect costs as well as revenues.
Producers are saddled with certain costs in the short-run. Short-run the period in which the quantity (and quality) of some inputs cannot be changed
TC = TFC + TVC (total cost) (total fixed cost) (total variable cost )
20 ATC 1 ATC 2 ATC 3 ATC 4 9 8 7 0 5 10 13 15 20 25 Output (sweaters per day)
20 ATC 1 ATC2 ATC 3 ATC 4 9 8 LRAC 7 Plant 1 least cost Plant 2 least cost Plant 3 least cost Plant 4 least cost 0 5 10 13 15 20 25 Output (sweaters per day)
Variable costs: Labor, $25 / day wage Fixed costs: Capital goods, $25 Labor (L) Output TFC TVC (LxW) TC a 0 0 $25 $25 b 1 4 $25 $25 $50 c 2 10 $25 $50 $75 d 3 13 $25 $75 $100 e 4 15 $25 $100 $125 f 5 16 $25 $125 $150
Cost (dollars per day) 150 100 50 TFC 0 5 10 15 Output (sweaters per day)
Cost (dollars per day) 150 TC TVC 100 50 TFC 0 5 10 15 Output (sweaters per day)
Fixed costs are incurred even if no output is produced. Fixed costs costs of production that do not change when the rate of output is altered, e.g., the cost of the basic plant and equipment
Once a firm starts producing output, it incurs variable costs as well. Variable costs costs of production that change when the rate of output is altered, e.g. labor and material costs
Total Cost (dollars per time period) Total cost z Total costs escalate due to the law of diminishing returns Fixed cost Output (units per time period)
The shape of the total cost curve reflects increasing marginal costs and the law of diminishing returns. Marginal cost is the increase in total costs associated with a oneunit increase in production. Marginal costs decrease initially, but eventually increase due to the law of diminishing returns
Average fixed cost (AFC) is total fixed cost per unit of output. Average variable cost (AVC) is total variable cost per unit of output. Average total cost (ATC) is total cost per unit of output.
TC = TFC + TVC TC TFC TVC = + Q Q Q OR ATC = AFC + AVC
Cost (dollars per sweater) 15 ATC = AFC + AVC 10 ATC AVC 5 AFC 0 5 10 15 Output (sweaters per day)
Cost (dollars per sweater) 15 MC: intersects AVC and ATC at minimum points. 10 ATC AVC 5 0 5 10 15 Output (sweaters per day)
The primary objective of the producer is to find that one particular rate of output that maximizes profits.
Revenues Or Costs (dollars per period) Total cost Total revenue r s f g h Output (units per period)
The best single rule for maximizing short-run profits is straightforward: Never produce a unit of output that costs more than it brings in.
The contribution to total revenue of an additional unit of output is called marginal revenue. For perfectly competitive firms, price equals marginal revenue. price = marginal revenue
Marginal revenue (MR) is the change in total revenue that results from a one-unit increase in the quantity sold. marginal revenue change in total revenue = ----------------------------------- change in output
Rate of Output Price Total Revenue 0 $13 $ 0 Marginal Revenue 1 $13 $13 $13 2 $13 $26 $13 3 $13 $39 $13 4 $13 $52 $13 5 $13 $65 $13
A firm s goal is not to maximize revenues, but to maximize profits. Marginal revenue is compared to marginal costs to determine the best level of output.
What one additional unit of output brings in is its marginal revenue (MR). What one additional unit of output costs to produce is its marginal cost (MC).
Rate of Output Total Cost 0 $10 Marginal Cost Average Cost 1 $15 $ 5 $15.00 2 $22 $7 $11.00 3 $31 $9 $10.33 4 $44 $13 $11.00 5 $61 $17 $12.20
If MR > MC, the extra revenue exceeds the extra cost. increase output to increase profit If MR < MC, the extra revenue is less than the extra cost. decrease output
When MR = MC economic profit is maximized
Marginal revenue & marginal cost (dollars per day) MC 30 25 MR 20 10 Profit-maximizing quantity 8 9 10 Quantity (sweaters per day)
Marginal revenue & marginal cost (dollars per day) MC 30 25 MR 20 10 Profit-maximizing quantity 8 9 10 Quantity (sweaters per day)
1. A firm chooses the quantity where marginal cost = price 2. A supply curve shows quantity supplied at alternative prices 3. The firm s marginal cost curve is ITS SUPPLY CURVE
Price & marginal cost (dollars per day) MC = S 31 25 17 7 9 10 Quantity (sweaters per day)
According to the profit-maximization rule a firm should produce at that rate of output where marginal revenue equals marginal cost. MR = MC