Variable Costs
Variable costs are incurred when labor, raw materials, or other variable inputs are used. Variable costs depend on the level of production and are incurred when output is produced.
Average Costs
Costs can also be broken down into per unit or average costs. Dividing costs by output permits easy calculation of average fixed costs (AFC), average variable costs (AVC) and average total costs (ATC). Average fixed costs (AFC) are fixed costs per unit of output, and are calculated as TFC/Q.
The AVC, ATC, and MC curves are all U-shaped because of diminishing marginal returns. At first all three curves fall as labor productivity initially rises, but diminishing marginal returns set in, and all three cost curves begin to rise as less output is produced by each additional worker. The MC curve intersects the AVC and ATC curves at their minimum points, and "pulls" both curves down when MC is below them, and "pulls" both curves up when MC is above them. Average fixed costs (AFC) continually decline because constant TFC are "spread out" across increasing amounts of output.
Average variable costs (AVC) are variable costs per unit of output, and are calculated as TVC/Q.
Average total costs (ATC) are total costs per unit of output, and are calculated as TC/Q or AFC + AVC.
Marginal cost (MC) is the change in total cost associated with producing an additional unit of output, and is calculated as ΔTC/ΔQ or ΔTVC/ΔQ.
Costs in the Long Run
As owner and chief operations officer of Radical Rollerblades, you can choose the resource combination your firm will use in the long run. Labor and capital are your only productive resources, which makes things relatively easy, but how do you determine the optimal combination? The first thing you need to know is how much labor and capital you can acquire for a given total cost.
Isocost Lines
The consumer budget lines you encountered in Chapters 3 and 4 have a parallel when we analyze production costs. An isocost line connects all combinations of two productive inputs that can be purchased for a given total cost.
Cost Minimization
The resource combination that minimizes the cost of a given output, or alternatively, that maximizes output for a given cost, is given by the tangency of an isocost line to an isoquant.
An important implication of the firm choosing a profit-maximizing production plan is that there is no way to produce the same amounts of outputs at a lower total input cost. Thus, cost minimization is a necessary condition for profit maximization.
6. Types of industrial markets. The model of perfect competition.
There are Four Market Models. From most competitive to least competitive:
1 Pure Competition (Involves very large numbers of firms producing identical products, standardized product, free Entry and Exit, No control over the price: "Price Takers", The individual firm has very little to no impact on the market, Demand is perfectly elastic).
2 Monopolistic Competition (Involves large number of firms, but not as many as in pure competition, Produces differentiated products (ie. clothing, furniture, books), Nonprice competition, Focuses mostly on advertising, brand names, and trademarks, Firms can easily enter or leave this market, although not as easily as firms in a purely competitive market, Limited control over prices, Imperfect Competition).
3 Oligopoly (Involves a few firms that exert considerable influence over the industry, Produces either standardized or differentiated products, NONPRICE COMPETITION: emphasis on product differentiation, Existing firms are strong rivals and affects each other's price and output, Control over price limited by mutual interdependence, Harder for a firm to enter or exit, A great deal of nonprice competition, especially with differentiated products).
4 Pure Monopoly: (Only one firm is involved, Products are unique with no substitutes, NONPRICE COMPETITION: mostly public relations, Entry of additional firms is not possible - one firm constitutes the entire industry, Entry to the industry is often blocked by government, It requires patent or licenses, Since the monopolist produces a unique product, it makes no effort to differentiate its product, Imperfect Competition, There is total control over price "Price Makers")
The model of perfect competition.
Demand as Seen by a Purely Competitive Seller:
Perfectly Elastic Demand:
Single Firm= small fraction of total output. Hence they are price-takers as they cannot influence market price. MANY firms TOGETHER can affect market price by changing industry output. Graphically perfectly elastic demand for single firm - horizontal line. ONLY ONE MARKET PRICE. Market demand for entire industry - downsloping curve. Firms can choose to produce at different market prices. If price changes at all it drastically affects quantity purchased i.e. price > equilibrium price causes quantity to go to zero and vice versa. A perfectly elastic demand means that the firm can produce as much as they want at that price and it will still be sold. Purchasers will be willing to buy any quantity at that price.
Average, Total, and Marginal Revenue:
Average Revenue (AR) schedule = demand schedule. Price per unit to buyer = revenue per unit to seller. Average revenue=price. Total Revenue (TR)= Price x Quantity (increases by constant amount – constant price). TR = P x Q. Straight upward sloping line – constant slope (= price). The area formed by the rectangle with coordinates (0,0), (0,P), (0,Q), (P,Q). Marginal Revenue (MR) = Change in Total Revenue from selling ONE additional unit of output. Same as price. MR = ∆ TR from selling 1 more unit of output = price. The reason MR=D=AR=P is because in a purely competitive firm the price carries over from the industry and thus that equals the demand. At this demand each additional output increases by the same degree and the average revenue at any point is the same price. Even with changes in the marketplace, the line may move vertically but the values will always be equal. Price line is the same as the average revenue or marginal revenue since the price is fixed.
Graphs: MR = AR = Demand = Price (represented by the horizontal line). This is because firms in a Purely Competitive Market are price-takers in that they MUST go with the industry equilibrium price (which is the intersection of S and D curve). См. график ниже:
Profit Maximization in the Short-run: TR/TC Approach.
Firm = price taker → firms can only adjust output to maximize profit. Short-run = fixed plant → firms can only adjust amount of variable resource such as labor and materials.
Should we produce this product? Profit → Yes; Loss→ No. In what amount? Output level where economic profit is maximized TR– TC = (P x Q) - (FC + VC) = economic profits. Break-even point = when normal profit is satisfied. Intersection of TC + TR (TR covers all TC). No economic profit – only normal. There are 2 break-even points on graph – any point in between is economic profits. Profit is maximized on a graph where the vertical distance between TR and TC is the greatest.
At break even point 1: the industry should PRODUCE MORE! At profit max point: the vertical distance between TR and TC is at its greatest, meaning the firm is earning maximum economic profits; therefore, industry should keep producing at this level of output, because more profits can still be made! At break even point 2: STOP PRODUCING! or REDUCE the quantity producing! TR and TC are equal, meaning the firm is now only earning a normal profit.
Profit Maximization in Short-run: MR/MC Approach.
Profit-maximizing case:
As long as MRDARP > AVC at the point where MC = MR, profit is maximized and production should continue. At any point where MR>MC, keep producing!! You can still profit more. At any point where MR<MC, reduce production. It only makes sense to produce less, because your costs are already more than what you're gaining. Firms must sell at the market price because
1) demand is perfectly elastic so higher price drops quantity consumed to zero
2) if price is decreased, ATC and AVC still remain unaffected, and economic profit decreases.
If Qpm = optimal outputs, then economic profit = Q(P-ATC)
Loss-minimizing case:
Even though the firm is not earning any economic profit, it is earning enough to pay their laborers (AVC), and thus it incurs less loss compared to the whole of average fixed cost.
In this situation, the company should continue producing the product. P = MR > AVC , P = MR < ATC --> point where MC = MR minimize its loss. Economic loss = Q (ATC - P). When AVC < P < ATC, the firm can stay open as long as they can cover the AVC. If a firm can cover all of the AVC and even part of the fixed costs, they will lose less than shutting down, as MR < ATC. Shutting down would mean losing everything and still have to pay for fixed costs, while in the loss minimizing case, costs are still covered.
Shut-down case:
This is when the amount of lost revenue that a firm gets from producing a unit is even greater than the cost of shutting down the company. (P = MR < AVC < ATC). The only time when a company should shut down! All the costs are above the equilibrium price line, meaning that the company will just lose money by producing its goods.
Profit-Maximization in the Long-run
Assumptions:
Entry and exit only: The only long-run adjustment is the entry or exit of firms. Short-run adjustments are ignored in order to concentrate on the effects of the long-run adjustments. Identical costs. All firms in the industry have identical cost curves. This assumption lets us discuss and "average" or "representative," firm, knowing that all other firms in the industry are similarly affected by any long-run adjustments that occur. Constant-cost industry. The industry is a constant-cost industry. This means that the entry and exit of firms does not affect resource prices or, consequently, the locations of the average-total-cost curves of individual firms.
Long-run Supply for a constant cost industry:
industry expansion or contraction will not affect resource prices and therefore production costs. Any long-run supply curve for a constant cost industry is a horizontal line due to the fact that the entry and exit in a purely competitive market does not affect the price of a product. Long run supply curve is perfectly elastic. The demand curve for any industry is a downward sloping curve that intersects the supply curve at any point. All equilibrium prices will then be the same for all industries and firms.
LR supply for an increasing cost industry:
This is the case for most industries. When a new firm enters the industry, the resource prices increase so the long run cost curve increases as well. The entire ATC curve shifts upwards. Result: higher equilibrium price than the original price, which is why the increasing-cost industry graph at the right (second graph) is an upward sloping line. Industry produces as larger output at a higher product price because the industry expansion has increased resource prices and the minimum ATC. Thus, a higher price is required to induce more production, because costs per unit of output increase as production rises.
LR supply for a decreasing-cost industry:
Firms experiences lower costs as the industry expands, indicated by the third graph of the figure at the right (the title of that graph should be DECREASING-cost industry rather than "increasing").An example is the personal computer industry, in which the supply of personal computers increases by more than demand, causing the price of personal computers to decline. This decline in price is because the component producers (the makers of RAM, or the CPU, etc) can achieve economies of scale.
decreasing-cost industry
