3.8.2. Supply Analysis: The Firm
2.2 Marginal Returns and Productivity The cost of producing a given level of output can fall as a result of:
A decline in the cost of inputs, and/or An increase in input productivity. An improvement in labor productivity occurs when, given a fixed amount of capital, fewer units of labor are required to produce the same output.
A firm's shutdown point occurs at the quantity of output where: P < AVC P < ATC P < AFC
A firm would shut down in the short run if price were less than average variable cost. In this case the firm would cease operations and incur a loss equal to total fixed cost in the short run.
2.8.2 Monopoly Analysis (see Figure 2.9)
A monopoly faces a downward-sloping demand curve. As a result, the MR and demand curves are not identical. The profit-maximizing level of output occurs at the point where MC equals MR. This point is denoted by Q*. Once the profit-maximizing level of output has been determined, the optimal price is obtained from the demand curve at P*. The monopolist is earning positive economic profit, as P is greater than ATC. Further, the monopolist can continue to earn positive economic profits in the long run due to high barriers to entry.
Diseconomies of scale or decreasing returns to scale occur in the upward-sloping region of the LRAC curve.
A typical reason for an increase in average costs as output levels rise is an increase in bureaucratic inefficiencies as effective management, supervision, and communication become difficult in large organizations.
Economies of scale or increasing returns to scale refer to reductions in the firm's average costs that are associated with the use of larger plant sizes to produce large quantities of output. They are present over the range of output when the LRAC curve is falling.
Economies of scale occur because mass production is more economical, the specialization of labor and equipment improves productivity, and costs such as advertising can be spread across more units of output.
2.4 Breakeven and Shutdown Analysis 2.4.1 Accounting Profit versus Economic Profit 2.4.1.1 Accounting Profit
Accounting profit (also known as net profit, net income, and net earnings) equals revenue less all accounting (or explicit) costs. Accounting costs are payments to non-owner parties for goods and services supplied to the firm, and do not necessarily require a cash outlay. Accountingprofit(loss)= = Total revenue − Total accounting costs
2.4.1.2 Economic Profit and Normal Profit Economic profit (also known as abnormal profit or supernormal profit) is calculated as revenue less all economic costs. Economic costs equal the sum of total accounting costs and implicit opportunity costs. The opportunity cost of any particular decision refers to the benefit forgone by not implementing the next best alternative.
Alternatively, economic profit can be calculated as accounting profit less all implicit opportunity costs that are not included in total accounting costs. Economic profit = Total revenue − Total economic costs Economic profit = Tot rev −(Explicit costs + Implicit costs) Economic profit = AccT profit − Tot implicit opp'y costs
2.3 Total, Average, and Marginal Product of Labor In Table 2.1 we assume that in the short run, the firm invests in 2 units of capital, which comprise its fixed costs. The only factor of production whose quantities it can vary is labor.
As more units of labor are employed to work with 2 units of capital, total output increases.
Total costs (TC) equal total fixed costs (TFC) plus total variable costs (TVC). Initially, TC increases at a decreasing rate (green portion of TC curve in Figure 2.5).
As production approaches full capacity, TC increases at an increasing rate (gray portion of TC curve in Figure 2.5). At zero production, TC equals TFC as TVC equals 0.
Important takeaways: In imperfect competition (where price and quantity are inversely related):
As quantity increases, the rate of increase in TR (as measured by MR) decreases. AR equals price at each output level. MR is also downward sloping with a slope that is steeper than that of AR (demand). TR reaches its maximum point when MR equals 0.
Costs are directly related to input prices and inversely related to productivity. If the wage rate were to rise, costs would also rise, but if labor productivity were to improve, costs would fall. This relationship can be captured by the expression: MC = w/MPL. Similarly, if wages rise, AVC also rises, but if labor productivity were to improve, AVC would fall. Therefore, AVC = w/APL.
As the firm benefits from increasing marginal returns, MPL increases and MC declines. However, as more and more labor is added to a fixed amount of capital, diminishing marginal returns set in and MPL falls, causing MC to rise.
In the horizontal portion of the LRAC curve, when an increase in output does not result in any change in average costs, a firm realizes constant returns to scale.
Aside from the shape illustrated in Figure 2.13, the LRAC curve may also take one of the shapes described in Figure 2.14.
Figure 2.10 illustrates the breakeven point for a firm under perfect competition and a firm that is a monopolist.
At the profit-maximizing level of output (where MC = MR), price equals ATC. Economic profits, therefore, equal zero, and the firms earn normal profits.
Notice in Figure 2.5 that the TC and TVC increase at a decreasing rate at low levels of output, and increase at an increasing rate at higher levels of output. The difference between TC and TVC equals TFC.
Average total cost (ATC) is simply total cost (TC) divided by total product (TP). Average fixed cost (AFC) equals TFC divided by TP. Average variable cost (AVC) equals TVC divided by TP.
Consider the following statements: Statement 1: In perfect competition MR = AR = P Statement 2: In imperfect competition MR < AR = P Which of the following is most likely? Both statements are correct. Both statements are incorrect. Only one statement is correct.
Both statements are correct In perfect competition the firm can sell as many units of output as it desires at the given market price. Therefore MR equals price. In imperfect competition, the firm can increase the quantity sold by reducing prices for all units sold. Therefore, marginal revenue (MR) declines faster than average revenue (AR). Note that AR always equals price as long as all units of output are sold at a uniform price.
If price is less than average total cost but greater than average variable cost, in the short run, the firm is most likely to:
Continue to Produce As long as price exceeds average variable cost, in the short run the firm will continue production so that total losses are less than total fixed costs. The firm would exit immediately if price were less than average variable cost. The firm would make economic profits if price were greater than average total cost.
The upward-sloping region of a firm's planning curve most likely represents the existence of:
Diseconomies of scale. A firm's planning curve is its long-run average cost curve. Diseconomies of scale occur along the upward-sloping region of the long-run average total cost curve, where average costs rise as output increases.
Prices are determined by demand and supply in the market. Once market price is determined, a firm in perfect competition can sell as many units of output as it desires at this price.
From Table 2.3 notice the following: Total revenue (TR) simply equals price times quantity sold. TR at 4 units is calculated as 4 × $8 = $32. Marginal revenue (MR) is defined as the increase in total revenue from selling one more unit. It is calculated as the change in total revenue divided by the change in quantity sold. MR from selling Unit 4 is calculated as ($32 − $24)/(4 − 3) = $8. Average revenue (AR) equals total revenue divided by quantity sold. AR at 4 units of output is calculated as $32/4 = $8.
It is important to bear in mind that MC illustrates the slope of the TC curve at a particular level of output. MC initially decreases (see Figure 2.6) because of the benefits from specialization.
However, MC eventually increases because of diminishing marginal returns. To produce more output given the same amount of capital, more and more units of labor must be employed because each additional unit of labor is less productive than the previous one. Since more workers are required to produce one more unit of output, the cost of producing that additional unit (the marginal cost) increases.
In the long run, quantities of all factors of production can be varied. Output can be increased by employing more labor, acquiring more machinery, or even buying a whole new plant.
However, once a long-run decision has been made (e.g., the acquisition of a new plant), it cannot be easily reversed.
When the marginal cost curve lies above the average cost curve, it is most likely that: Average cost is rising. Average cost is at its minimum. Average cost is falling.
If marginal cost is greater than average cost, average cost rises.
A firm should shut down immediately if it does not expect revenues to exceed variable costs of production.
If the firm continues to operate in such an environment, it would suffer a loss greater than just total fixed cost. (See Figure 2.11)
Important takeaways: In a perfectly competitive environment (where price is constant regardless of the quantity sold by the firm): MR always equals AR, and they both equal market price.
If there is an increase in market demand, the market price increases, which results in both MR and AR shifting up (to MR1 and AR1 in Figure 2.3) and TR pivoting upward (to TR1 in Figure 2.3).
We mentioned earlier that for a firm that sells at a uniform price, average revenue will equal price.
In Table 2.4 we have assumed that in order to increase quantity demanded and sold from 3 to 4 units, the firm must bring down its price from $11 to $9. The lower price ($9) is applicable not only on the additional unit sold (the 4th unit) but also on all units that were previously selling for $11. Only if the firm were a perfect monopolist would it be able to charge $11 each for the first 3 units sold and $9 for the 4th unit.
2.9.2 Economies and Diseconomies of Scale Economies and diseconomies of scale are long-run concepts. They relate to conditions of production when all factors of production are variable.
In contrast, increasing and diminishing marginal returns are short-run concepts, applicable only when the firm has one variable factor of production.
2.5 Total, Average, and Marginal Revenue We will study the various market structures in detail in the next reading. For the purposes of illustrating the different revenue terms we introduce perfect competition and imperfect competition at this point:
In perfect competition, each individual firm faces a perfectly elastic demand curve (i.e., it can sell as many units of output as it desires at the given market price). The firm has no impact on market price, and is referred to as a price-taker. In imperfect competition, the firm has at least some control over the price at which it sells its output. The demand curve facing the firm is downward sloping so in order to increase units sold, the firm must lower its price. Stated differently, price and quantity demanded are inversely related. Firms operating in imperfect competition are referred to as price-searchers.
2.6 Total, Average, Marginal, Fixed, and Variable Costs
Total product (TP) is the maximum output a given quantity of labor can produce when working with a given quantity of capital units. Product terms (including total product) are discussed in detail later in the reading.
Note the following:
Total product is simply an indication of a firm's output volume and potential market share. Average product and marginal product are better measures of productivity, as they can reveal competitive advantage through production efficiency. Average product is the preferred measure of productivity when workers perform tasks collectively, as individual worker productivity is not easily measurable.
2.9 Understanding Economies and Diseconomies of Scale 2.9.1 Short Run and Long Run Production Functions
We defined the short run and long run in the previous section. Stated briefly, at least one factor of production is fixed in the short run, while no factors of production are fixed in the long run.
The average product (AP) curve (see Figure 2.2) shows output per worker, which equals total product divided by total quantity of labor.
Observe two important relationships from the AP and MP curves: 1. MP intersects AP from above through the maximum point of AP. 2. When MP is above AP, AP rises, and when MP is below AP, AP falls. An interesting way to remember the relationship stated in Point 2 is by analyzing the historical returns earned by a fund manager. If her 5-year average return is 10%, and she earns 15% this year (marginal return), her average would rise. If, however, she were to earn only 5% this year, her average would fall.
Figure 2.4 illustrates
TR, MR, and AR for a firm in imperfect competition.
The optimal output level for each plant is when its ATC curve is at its minimum. The long-run average cost (LRAC) curve illustrates the relationship between the lowest attainable average total cost and output when all factors of production are variable.
The LRAC curve is also known as a planning curve because it shows the expected per-unit cost of producing various levels of output using different combinations of factors of production.
The marginal product (MP) curve (see Figure 2.2) shows the change in total product from hiring one additional unit of labor. The MP curve is simply the slope of the TP curve. Recall that MP is calculated as the change in TP (change on y-axis) divided by the change in labor units (change on x-axis).
The MP curve rises initially, (over the first two units of labor when TP is increasing at an increasing rate) and then falls (as the 3rd, 4th, and 5th units of labor are employed and TP increases at a decreasing rate). If the 6th unit is employed, MP turns negative and TP falls.
From Table 2.1, notice that TP continues to increase until the 6th unit of labor is employed.
The firm would obviously not hire a unit with negative productivity, so only the first 5 units of labor are considered for employment.
Average product (AP) equals total product of labor divided by the quantity of labor units employed. AP is a measure of overall labor productivity.
The higher a firm's AP, the more efficient it is. AP and MP provide valuable insights into labor productivity. However, when individual worker productivity is difficult to monitor, (e.g., when tasks are performed collectively) AP is the preferred measure of labor productivity.
2.4.2 Economic Costs versus Accounting Costs Example: Depreciation Accounting depreciation distributes the historical cost of fixed capital among units of production for financial reporting purposes.
The historical cost of fixed capital is typically a sunk cost. Sunk costs refer to expenses that cannot be altered, and therefore have no role to play in making optimal forward-looking decisions.
Economies and diseconomies of scale can occur at the same time.
The impact on long-run average total cost (LRAC) depends on which dominates.
Economic depreciation considers opportunity costs of using the plant and equipment (which have already been paid for) for one more period of time to produce output.
It specifically asks the question: What else could be done with that fixed capital if it were not used to produce our output?
LOS: Describe the phenomenon of diminishing marginal returns.
LOS: Determine and describe breakeven and shutdown points of production. LOS: Describe how economies of scale and diseconomies of scale affect costs.
Figure 2.1 illustrates the firm's total product (TP) curve. In the initial stages (as the first and second units of labor are employed), total product increases at an increasing rate. The slope of the total product curve is relatively steep at this stage.
Later, as more units of labor are employed to work with the fixed 2 units of capital, total output increases at a decreasing rate, and the slope of the TP curve becomes flatter.
Which of the following most accurately describes the relationship between marginal product (MP) and average product (AP)? As the quantity of labor increases: Initially MP exceeds AP, and later AP exceeds MP. Initially AP exceeds MP, and later MP exceeds AP. MP intersects AP from above through its minimum point.
MP intersects the AP curve from above through its maximum point. Initially when MP is greater than AP, AP rises, and at higher levels of output when MP is less than AP, AP falls.
Through some algebra, we can prove that MR equals price plus Q multiplied by the slope of the demand curve.
MR = P + Q(ΔP/ΔQ) or MR = P + Q * Slope of demand curve -Under perfect competition, the slope of the demand curve is zero. Therefore, MR = P. -Under imperfect competition, the slope of the demand curve is negative. As a result, MR is less than price.
Which of the following cost curves is least likely to shift if there is an increase in the firm's fixed costs? TC MC AFC
Marginal cost (MC) remains unchanged when there is a change in the firm's fixed costs of production.
Total product (TP) is the maximum output that a given quantity of labor can produce when working with a fixed quantity of capital units. While TP provides an insight into the company's size relative to the overall industry, it does not show how efficient the firm is in producing its output.
Marginal product (MP) (also known as marginal return) equals the increase in total product brought about by hiring one more unit of labor, while holding quantities of all other factors of production constant. MP measures the productivity of the individual additional unit of labor.
The effect of diminishing marginal returns to labor is obvious. (see table 2.8 in text book)
Marginal product declines as more and more units of labor are added to each plant
Total revenue (TR) simply equals price times quantity sold. TR at 4 units is calculated as 4 × $9 = $36. Average revenue (AR) equals total revenue divided by quantity sold. AR at 4 units of output is calculated as $36/4 = $9.
Marginal revenue (MR) is defined as the increase in total revenue from selling one more unit. It is calculated as the change in total revenue divided by the change in quantity sold. MR from selling Unit 4 is calculated as ($36 − $33)/(4 − 3) = $3. Under imperfect competition, in order to sell the 4th unit, the firm must entice further consumption by reducing its price to $9. Moreover, not only does the buyer of the 4th unit pay a reduced price of $9, but the 3 previous consumers also benefit from reduced prices and now only pay $9 instead of $11. On one hand, revenue increases by selling a larger quantity (4th unit sells for $9 resulting in an increase in TR of $9). On the other hand, revenue falls (from selling the first three units at the new lower market price) by ($11 − $9) × 3 = $6. The net increase in total revenue from selling the 4th unit equals $9 − $6 = $3.
2.5.2 Total, Average, and Marginal Revenue under Imperfect Competition Note: Under imperfect competition, MR does not equal price. The MR curve has a steeper slope than the demand curve.
Note that since the firm is a price-searcher, price and quantity are inversely related.
2.5.1 Total, Average, and Marginal Revenue Under Perfect Competition Table 2.3 presents total, average, and marginal revenue for a firm that is a price-taker at each quantity of output (faces a perfectly elastic demand curve).
Note that since the firm is a price-taker, price is fixed at $8 at all quantities of output sold.
Under perfect competition, given the different SRAC options available to the firm, SRACMES embodies the optimal combination of technology, plant capacity, capital, and labor that minimizes the firm's average costs in the long run.
The lowest point on the LRAC curve is called the firm's minimum efficient scale. In the long run, all firms in perfect competition operate at their minimum efficient scale as price equals minimum average cost (see next section).
From Figure 2.6, also notice that: As output levels rise, total fixed costs are spread over more and more units and AFC continues to fall at a decreasing rate. The average total cost curve is U-shaped. It falls initially as fixed costs are spread over an increasing number of units. Later, however, the effect of falling AFC is offset by diminishing marginal returns so ATC starts rising.
The vertical distance between the AVC and ATC curves equals AFC. This vertical distance between the AVC and ATC curves gets smaller as output increases because AFC decreases as output expands. The minimum point of the AVC does not correspond to the minimum point of ATC. The firm's profit-maximizing quantity does not necessarily occur at the point where ATC is minimized, even though profit per unit may be maximized at this point.
Note: Under perfect competition, MR = Price.
Therefore, the MR curve is the same as the demand curve.
2.1 Productivity In the short run, at least one factor of production is fixed. Usually we assume that labor is the only variable factor of production in the short run.
Therefore, the only way that a firm can respond to changing market conditions in the short run is by changing the quantity of labor that it employs. In hard times, firms lay off labor, and in good times, firms employ more labor. However, the quantities of capital and land employed remain fixed. A firm cannot increase output in the short run by acquiring more machinery or equipment.
Fixed costs include sunk costs.
They also include quasifixed costs (e.g., utilities) that remain the same over a particular range of production, but move to another constant level outside of that range of production.
2.8.3 Breakeven Analysis A firm is said to break even if its TR equals its TC. At the breakeven quantity of production, price (or AR) equals ATC.
This is true under perfect and imperfect competition. Breaking even implies that the firm is covering all of its economic costs (total accounting costs and implicit opportunity costs), so while it is not earning positive economic profits, the firm is at least covering the opportunity cost of all of its factors of production, including capital. In other words, the firm is earning normal profit.
In the short run, a firm incurs fixed and variable costs of production. If the firm decides to shut down, it will still incur fixed costs (that are sunk costs) in the short run and make a loss equal to total fixed cost.
This loss can be reduced by continuing production and earning revenues that are greater than the variable costs of production. This surplus (excess of revenues over variable costs) would serve to meet some of the fixed costs that the firm is stuck with in the short run.
2.6.1 Important Relationships between Average and Marginal Cost Curves MC intersects ATC and AVC from below at their respective minimum points.
When MC is below AVC, AVC falls, and when MC is above AVC, AVC rises. When MC is below ATC, ATC falls, and when MC is above ATC, ATC rises.
2.7 Marginal Revenue, Marginal Cost, and Profit Maximization When we talk about profit maximization, note that we are referring to economic profit. Profits are maximized when the difference between TR and TC is at its highest. The level of output at which this occurs is the point where (1) marginal revenue equals marginal cost (MC = MR) and (2) MC is not falling.
When MR > MC, the firm should increase production, as the last unit produced added more to revenue that it did to costs. When MR < MC, the firm should reduce production, as the last unit produced added more to costs than it did to revenue. Recall that MC = w/MPL, so if MC is falling, MP would be rising. If an additional unit of labor causes MC to fall, the firm would want to add that unit of labor until MC is upward sloping.
Other reasons include duplication of business functions and product lines, and high resource prices due to supply constraints.
When a firm is operating in the diseconomies of scale region of the LRAC curve (see Figure 2.13), it should aim to downsize and reduce costs to increase competitiveness.
Other reasons include discounted prices as a result of bulk purchasing of resources and the ability to adopt more expensive but more efficient technology.
When a firm is operating in the economies of scale region of the LRAC curve (see Figure 2.12), it should aim to expand capacity to enhance competitiveness and efficiency.
At price levels below AVC (e.g., Point A where P < AVC), the firm will not be willing to produce, as continued production would only extend losses beyond simply total fixed costs. Any quantity to the left of Point X (with quantity QSD) would define a shutdown point for the firm.
When price lies between AVC and ATC (e.g., Point B where AVC < P < ATC), the firm will remain in production in the short run as it meets all variable costs and covers a portion of its fixed costs. To remain in business in the long run, the firm must break even or cover all costs (revenues should meet total costs). Therefore, Point Y defines the firm's breakeven point. In the long run, at any price lower than PBE, the firm will exit the industry. Once prices exceed ATC (e.g., Point C where P > ATC), the firm makes economic profits.
Total variable costs (TVC) are the sum of all variable costs. TVC is directly related to quantity produced (TP), and the shape of the TVC curve mirrors that of the TC curve.
Whenever a firm looks to downsize or cut costs, its variable costs are the first to be considered for reduction as they vary directly with output.
Note that economic depreciation is forward looking, while accounting depreciation is backward looking.
While both are useful—one for making operating decisions and the other for reporting and tax purposes—there isn't necessarily a direct link between the two.
Productivity is important because a firm that lags behind the industry in productivity is at a competitive disadvantage
and is likely to face decreases in future earnings and shareholder wealth.
For any firm that sells all its output at a uniform price,
average revenue will equal price regardless of the shape of the demand curve.
Diminishing marginal returns may also set in as the most productive units of labor are hired initially, and then as the firm seeks to increase production,
less competent units of labor must be employed.
Table 2.7 presents the decisions to operate, shut down, or exit the market in both the short run and the long run.
see image
2.8.4 The Shutdown Decision In the long run, a firm will continue to operate in the industry only if it earns at least a normal profit or zero economic profits.
In the short run, it may choose to continue to operate even if it does not earn a normal profit (and makes an economic loss), as we will now see.
Typically, the marginal product of labor
Increases initially, then reaches its peak, and later declines. The marginal product curve increases initially, reaches a peak at some point, and then decreases as additional units of labor are added to fixed quantities of other factors of production.
The firm benefits from increasing marginal returns over the first two units of labor (as MP increases) and then suffers from decreasing (or diminishing) marginal returns over the next four units of labor (as MP decreases).
Increasing marginal returns occur because of specialization and division of labor, while decreasing marginal returns set in because of inefficiency, over-crowdedness, and underemployment of some units of labor given the fixed amount of capital.
A firm's breakeven point occurs where:
P = ATC A firm breaks even where total revenues equal total cost. This occurs when P = ATC.
If employment of the last unit of labor increases total product (TP), it implies that the marginal product (MP) of that unit of labor is:
Positive As long as the marginal product is positive, total product will increase. Based on the given information, we cannot determine whether MP is increasing or decreasing. To make that decision, we would need to know whether TP is increasing at an increasing rate (MP rising) or at a decreasing rate (MP falling).
2.8 Profit-Maximization, Breakeven, and Shutdown Points of Production 2.8.1 Perfect Competition Analysis (see Figure 2.8): The firm's profit-maximizing quantity is Q*, where: --MR (which equals P and AR) equals MC. --MC is rising.
Q is not the profit-maximizing level of production, because MC is still falling at that stage. If P were to rise, the firm's demand and MR curves would shift higher, and the new profit-maximizing level of output would lie to the right of Q*. If P were to fall, the firm's demand and MR curves would move lower, and the new profit-maximizing level of output would lie to the left of Q*. At Q*, the firm is earning positive economic profits because P exceeds ATC. Economic profits are possible only in perfect competition in the short run. In the long run, more firms will enter the industry, taking market prices down to a level where they equal ATC.
Economists distinguish between short-run marginal cost (SMC) and long-run marginal cost (LMC).
SMC is the additional cost of the variable input, labor, that must be incurred to increase the level of output by one unit. LMC is the additional cost of all inputs necessary to increase the level of output, allowing the firm the flexibility of changing both labor and capital inputs in a way that maximizes efficiency.
When we map the average cost curves for all 4 plants on one graph (see Figure 2.12), notice that:
Short-run ATC curves are U-shaped. The larger the plant, the greater the output at which short-run ATC is at its minimum.
Marginal cost (MC) equals the increase in total costs brought about by the production of one more unit of output. It equals change in total costs divided by the change in output (TP).
Since TFC is fixed, MC can also be calculated as the change in TVC divided by the change in TP. Though not clearly visible from Figure 2.6, we should emphasize that the MC curve is shaped like a "J."
Total fixed costs (TFC) equal the sum of all expenses that remain constant regardless of production levels.
Since they cannot be arbitrarily reduced when production falls, fixed costs are the last expenses to be trimmed when a firm considers downsizing. Note that normal profit is also included in fixed cost.