Economics Test 2
Economics Test 2 Chapter Six: Every household must make three basic decisions: 1. How much of each product, or output, to demand 2. How much labor to supply 3. How much to spend today and how much to save for the future Several factors influence the quantity of a given good or service demanded by a single household: 1. The price of the product 2. The income available to the household 3. The household’s amount of accumulated wealth 4. The prices of other products available to the household 5. The household’s tastes and preferences 6. The household’s expectations about future income, wealth, and prices Recall that demand schedules and demand curves express the relationship between quantity demanded and price. A change in price leads to a movement along a demand curve. A change in income, in other prices, or in preferences shift demand curves to the left or the right – “changes in demand.” The Budget Constraint Budget Constraint – the limits imposed on household choices by income, wealth, and product prices. Opportunity Set or Choice Set – the set of options that is defined and limited by a budget constraint. As long as a household faces a limited budget – and all households ultimately do – the real cost of any good or service is the value of the other goods and services that could have been purchased with the same amount of money. The real cost is its opportunity cost and opportunity cost is determined by relative prices. If a price or a set of prices falls but income stays the same, the opportunity set gets bigger and the household is better off.
Real Income – set of opportunities to purchase real goods and services. The Equation of Budget Constraint:
P X X + P y Y =I
Where, Px = Price of X; Py = price of Y; X = the quantity of X consumed; Y = the quantity of Y consumed. When the price of a good decreases, the budget constraint swivels to the right, increasing the opportunities available and expanding choice. (Figure 6.2 pg 125). The Basics of Choice: Utility Utility – the satisfaction a product yields. Marginal utility (MU) – the additional satisfaction gained by the consumption or use of one more unit of a good or service. Total Utility – the total amount of satisfaction obtained from consumption of a good or service. The difference between Marginal Utility and Total Utility is that MU comes only from the last unit consumed; total utility comes from all units consumed. The Law of Diminishing Marginal Utility – the more of any one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good. When marginal utility is zero, total utility stops rising. When two activities cost different amounts you must find the marginal utility per dollar spend on each activity. The Utility Maximizing Rule – equating the ratio of the marginal utility of a good to its price for all goods. The Equation for Utility Maximizing Rule:
MUx MUy = , for all goods. Px Py
Diminishing Marginal Utility and Downward-Sloping Demand: The concept of diminishing marginal utility leads us to conclude that demand curves slope downward. Income and Substitution Effects: Income and substitution effects give an explanation for downward-sloping demand curves that does not rely on the concept of utility or the assumption of diminishing marginal utility.
The Income Effect: We first assume that households confine their choices to products that improve their well being, then a decline in the price of an product, will make the household unequivocally better off. The Substitution Effect of Price Change – when the price of a product falls, that product also becomes relatively cheaper. That is, becomes more attractive relative to potential substitutes. A fall in the price of product X might cause a household to shift its purchasing pattern away from substitutes toward X. The Substitution Effect – when the price of a product rises, that item becomes more expensive relative to potential substitutes and the household is likely to substitute other goods for it. Both of these effects imply a negative relationship between price and quantity demanded – in other words, a downward sloping demand. The Price of Leisure: “Buying” more leisure means reallocating time between work and nonwork activities. For each hour of labor you decide to consume, you give up one hour’s wages. Thus, wage rate is the price of leisure. Income and Substitution Effects of a Wage Change: Labor Supply Curve – a curve that shows the quantity of labor supplied at different wage rates. Its shape depends on how households react to changes in the wage rate. An increase in income will lead to a higher demand for leisure and a lower labor supply. This is the income effect of a wage increase. There is also a potential substitution effect of a wage increase. A higher wage rate means that leisure is more expensive. This means working more, or a lower quantity demanded of leisure and a higher quantity of labor supplied. In the labor market, the income and substitution effects work in opposite directions when leisure is a normal good. A. Substitution Effect Dominates
B. Income Effect Dominates
Wage rate
Units of Labor
Units of Labor
Chapter Seven: The Behavior of Profit Maximizing Firms: All firms must make several basic decisions to achieve what we assume to be their primary objective – maximum profits: 1. How much output to supply (quantity) 2. Which production technology to use 3. How much of each input to demand Changing the technology of a production will change the relationship between input and output quantities. Profits and Economic Costs: Profit is the difference between total revenue and total cost. Profit = TR – TC Total revenue – the amount received from the sale of the product; it is equal to the number of units sold (q) time this price received per unit (p) Total Cost is defined as: 1. Out of pocket costs and 2. Opportunity cost of all inputs of factors of production. The most important opportunity cost that is included in economic cost is the opportunity cost of capital. The way we treat the opportunity cost of capital is to add a normal rate of return to capital as part of economic cost Rate of return is the annual flow of net income generated by an investment as expressed as a percentage of the total investment. Normal Rate of Return – the rate that is just sufficient to keep owners and investors satisfied. If the rate of return were to fall below normal, it would be difficult or impossible for managers to raise resources needed to purchase new capital. For relatively risk-free firms, it should be nearly the same as the interest rate on risk free government bonds. The Production Process: Production technology – the quantitative relationship between inputs and outputs Labor-intensive Technology – technology that relies heavily on human labor instead of capital Capital Intensive Technology – technology that relies heavily on capital instead of human labor
Production Function or Total Product Function – the relationship between inputs and outputs (production technology) expressed numerically or mathematically. Marginal Product – is the additional output that can be produced by hiring one more unit of specific input, holding all other inputs constant. The Law of Diminishing Returns – states that after a certain point, when additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines. Diminishing returns always occur in the short run and in the short run, every firm will face diminishing returns. This means every firm finds it progressively more difficult to increase its output as it approaches capacity production. Marginal Product versus Average Product Average product is the average amount produced by each unit of a variable factor of production. average product of labor=
total product total units of labor
Marginal and Average product curves can be derived from total product curves. Average product is at its maximum at the point of intersection with marginal product. Choice of Technology: Capital enhances the productivity of labor. Similarly, labor enhances the productivity of capital. Inputs can also be substituted for one another. Two things that determine the cost of Production: 1. Available technologies 2. Price of Input To chose a production technique the firm must look to input markets to learn the current market P prices of labor and capital. What is the wage rate ( l ) and what is the cost per hour of capital, P ¿ ¿ ). ¿ Profit maximizing firms will choose the technology that minimizes the cost of production given current market input prices.
Chapter 8: Decisions
Are Based on
Information
1. The quantity of output to supply
The price of output
2. What technology to use
Techniques of production available
3. The quantity of each input to demand
The price of inputs
Costs in the Short Run: Fixed Costs – any cost that does not depend of the firms’ level of output. These costs are incurred even if the firm stops producing. There are no fixed costs in the long run. Variable Costs – a cost that depends on the level of production chosen Total Costs – total fixed costs plus total variable costs. TC = TFC+TVC The Total Fixed Cost is sometimes called the overhead. It is the total of all costs that do not change with output even if output is zero. Because TFC does not change with output, the graph is simply a horizontal line. Average fixed cost is TFC dived by number of units of output (q):
total AFC =¿ cost (TFC ) ¿ q
Average fixed cost falls as output rises because the same total is being spread over, or divided by, a larger number of units. This is called spreading overhead. A. Total Fixed Cost TFC
B. Average Fixed Cost AFC
Units of Output
Units of Output
Variable Costs: Total Variable Cost (TVC) is the sum of those costs that vary with the level of output in the short run Total Variable Cost Curve is a graph that shows the relationship between TVC and the level of the firm’s output (q). At any given level of output total variable cost depends on: 1. The techniques of production that are available and 2. The prices of the inputs required by each technology Total Variable Cost Equation TVC
TVC=( K × Pk ) +( L × P L ) (x axis = units of output)
Marginal Cost: Marginal Cost is the increase in total cost that results from the production of ONE more unit of input. Marginal costs reflect changes in variable costs because they vary when output changes. The Shape of The Marginal Cost Curve in the Short Run: •
Diminishing returns, or decreasing marginal product, imply increasing marginal cost.
•
In the short run, every firm is constrained by some fixed factor of production. A fixed factor implies diminishing returns and a limited capacity to produce. As that limit is approached, marginal costs rise.
Marginal Product
Marginal Cost ($)
Units of Labor
Units of Output
Graphing Total Variable Costs and Marginal Costs: More output costs more than less output. Total Variable Costs always increase when output increases. Thus, total variable cost always has a positive slope. The slope of a total variable cost curve is the change in total variable cost divided by the change in output. Because marginal cost is by definition the change in total variable cost resulting from an increase in output, marginal cost actually is the slope of the total variable cost curve. slope of TVC =
∆ TVC ∆ TVC = =∆ TVC =MC (marginal cost) ∆q 1
Average Variable Costs & Graphing AVCs and Marginal Costs: Average variable Cost is total variable cost divided by the number of units of output (q): AVC =
TVC q
The relationship between average variable cost and marginal cost can be illustrated graphically. When marginal cost is below average variable cost, AVC declines toward it. When marginal cost is above AVC, average variable cost increases toward it. Rising marginal cost intersects average variable cost at the minimum point of average variable cost. Cost per Unit ($)
Units of Output Blue = Marginal Cost; Red = Average Variable Cost; Intersect at minimum point of AVC Total Costs: Remember, TC = TFC + TVC Average Total Cost is total cost divided by the number of units of output ATC =
TC q
Another, more revealing, way of deriving average total cost is to add average fixed cost and average variable together: ATC = AFC + AVC Adding TFC to TVC means adding the same amount of total fixed cost to every level of total variable cost. Thus, the total cost curve has the same shape as the variable cost curve; it is simply higher by an amount equal to TFC. (pg. 175, graph 8.7) Average Total Cost = Average Variable Cost + Average Fixed Cost: To get average total cost, we add average fixed and average variable costs at all levels of output. Because average fixed cost falls with output, an ever declining amount is added to AVC. Thus, AVC and ATC get closer together as output increases, but the two lines never meet. (pg. 176 figure 8.8) Output Decisions: Revenues, Costs, and Profit Maximization Perfect Competition – exists in an industry that contains many relatively small firms producing identical products. In a perfectly competitive industry, no single firm has any control over prices and new competitors can freely enter and exit the market. Homogeneous Products – undifferentiated products; products that are identical to, or indistinguishable from, one another. We assume easy entry, and easy exit. Total Revenue and Marginal Revenue Profit is the difference between total revenue and total cost. Total Revenue is the total amount that a firm takes in from the sale of its product. Total Revenue equals price times quantity TR = P x q Marginal Revenue is the added revenue that a firm takes when it increases output by ONE additional unit. In a perfectly competitive market P = MR. This marginal revenue can also be thought of as the demand curve facing the firm, meaning that the horizontal line on a graph is the MR. (P=d=MR) Comparing Costs and Revenues to Maximize Profit If price is about marginal cost, profits can be increased by raising output; each additional unit increases revenues by more than its costs to produce the additional output. Beyond the MR line added output will reduce profits. Profit-maximizing output is thus, q, the point at which P=MC. Important Note: The key idea is that firms will produce as long as marginal revenue exceeds marginal costs. Chapter Nine:
Short Run Conditions and Long-Run Directions When we say a firm is suffering a loss, we mean that it is earning a rate of return that is below normal. Investors will not be attracted to this industry. A firm that is breaking even, or earning a zero level of profit, is one that is earning exactly a normal rate of return. New investors are not attracted, but current ones are not running away. With these distinctions we can say one of three conditions holds: 1. The firm is making positive profits 2. The firm is suffering losses 3. The firm is breaking even Profitable firms will want to maximize their profits in the short run, while firms suffering losses will want to minimize those losses in the short run. Maximizing Profits: Blue velvet carwash example (in notes and in book pg 190). A profit-maximizing perfectly competitive firm will produce up to point where P=MC. Profit is the difference between total revenue and total cost. A profit that is earning a positive profit in the short run and expects to continue doing so has an incentive to expand its scale of operation in the long run. Minimizing Losses: A firm that is not earning a positive profit or breaking even is suffering a loss. Firms suffering losses fall into two categories: 1. Those that find it advantageous to shut down operations immediately and bear losses equal to total fixed costs 2. Those that continue to operate in the short run to minimize their losses The most important thing to remember is that firms cannot exit the industry in the short run. The firm can shut down, but cannot get rid of its fixed costs by going out of business. Because a firm must bear fixed costs whether or not it shuts down, its decision depends solely on whether total revenue from operating is sufficient to cover total variable cost. If total revenue exceeds total variable cost, the excess revenue can be used to offset fixed costs and reduce losses, and it will pay the firm to keep operating.
If total revenue is smaller than total variable cost, the firm that operates will suffer losses in excess of fixed costs. In this case, the firm can minimize its losses by shutting down. (Revisit Blue Velvet example, notes and Pg 193) Shutdown Point – the lowest point on the average variable cost curve. When price falls below the minimum point on AVC , total revenue is insufficient to cover variable costs and the firm will shut down and bear losses equal to fixed costs.
Dollars
sht down pt (mkt $) Units of Output Red = MC
Green = ATC
Blue = AVC The short-run supply curve of a competitive firm is the part of its marginal cost that lies above average variable cost curve. (Red curve above blue curve) The Short Run Industry Supply Curve The Short-run industry supply curve is the sum of the individual firm supply curves, that is, the marginal cost curves (above AVC) of all the firms in the industry. Two things cause the industry supply curve to shift. In the short run, the industry supply curve shifts if something (a decrease in the price of some input, for instance) shifts the marginal cost curves of all the individual firms simultaneously. In the long run, an increase or decrease in the number of firms, shifts the total industry supply curve. Ex: If there are only three firms in the industry, the industry supply curve is simply the sum of all products supplied by the three firms at each price. For example, at $6 each firm supplies 150 units; for a total industry supply of 400. Long Run Directions: A Review
Profits
Short-Run Condition
Short-Run Decision
Long-Run Decision
TR>TC
P=MC: Operate
Expand: New firms
enter Losses
Losses
1. TR greater than/equal to TVC
P=MC: Operate
2.TR
Real Income – set of opportunities to purchase real goods and services. The Equation of Budget Constraint:
P X X + P y Y =I
Where, Px = Price of X; Py = price of Y; X = the quantity of X consumed; Y = the quantity of Y consumed. When the price of a good decreases, the budget constraint swivels to the right, increasing the opportunities available and expanding choice. (Figure 6.2 pg 125). The Basics of Choice: Utility Utility – the satisfaction a product yields. Marginal utility (MU) – the additional satisfaction gained by the consumption or use of one more unit of a good or service. Total Utility – the total amount of satisfaction obtained from consumption of a good or service. The difference between Marginal Utility and Total Utility is that MU comes only from the last unit consumed; total utility comes from all units consumed. The Law of Diminishing Marginal Utility – the more of any one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good. When marginal utility is zero, total utility stops rising. When two activities cost different amounts you must find the marginal utility per dollar spend on each activity. The Utility Maximizing Rule – equating the ratio of the marginal utility of a good to its price for all goods. The Equation for Utility Maximizing Rule:
MUx MUy = , for all goods. Px Py
Diminishing Marginal Utility and Downward-Sloping Demand: The concept of diminishing marginal utility leads us to conclude that demand curves slope downward. Income and Substitution Effects: Income and substitution effects give an explanation for downward-sloping demand curves that does not rely on the concept of utility or the assumption of diminishing marginal utility.
The Income Effect: We first assume that households confine their choices to products that improve their well being, then a decline in the price of an product, will make the household unequivocally better off. The Substitution Effect of Price Change – when the price of a product falls, that product also becomes relatively cheaper. That is, becomes more attractive relative to potential substitutes. A fall in the price of product X might cause a household to shift its purchasing pattern away from substitutes toward X. The Substitution Effect – when the price of a product rises, that item becomes more expensive relative to potential substitutes and the household is likely to substitute other goods for it. Both of these effects imply a negative relationship between price and quantity demanded – in other words, a downward sloping demand. The Price of Leisure: “Buying” more leisure means reallocating time between work and nonwork activities. For each hour of labor you decide to consume, you give up one hour’s wages. Thus, wage rate is the price of leisure. Income and Substitution Effects of a Wage Change: Labor Supply Curve – a curve that shows the quantity of labor supplied at different wage rates. Its shape depends on how households react to changes in the wage rate. An increase in income will lead to a higher demand for leisure and a lower labor supply. This is the income effect of a wage increase. There is also a potential substitution effect of a wage increase. A higher wage rate means that leisure is more expensive. This means working more, or a lower quantity demanded of leisure and a higher quantity of labor supplied. In the labor market, the income and substitution effects work in opposite directions when leisure is a normal good. A. Substitution Effect Dominates
B. Income Effect Dominates
Wage rate
Units of Labor
Units of Labor
Chapter Seven: The Behavior of Profit Maximizing Firms: All firms must make several basic decisions to achieve what we assume to be their primary objective – maximum profits: 1. How much output to supply (quantity) 2. Which production technology to use 3. How much of each input to demand Changing the technology of a production will change the relationship between input and output quantities. Profits and Economic Costs: Profit is the difference between total revenue and total cost. Profit = TR – TC Total revenue – the amount received from the sale of the product; it is equal to the number of units sold (q) time this price received per unit (p) Total Cost is defined as: 1. Out of pocket costs and 2. Opportunity cost of all inputs of factors of production. The most important opportunity cost that is included in economic cost is the opportunity cost of capital. The way we treat the opportunity cost of capital is to add a normal rate of return to capital as part of economic cost Rate of return is the annual flow of net income generated by an investment as expressed as a percentage of the total investment. Normal Rate of Return – the rate that is just sufficient to keep owners and investors satisfied. If the rate of return were to fall below normal, it would be difficult or impossible for managers to raise resources needed to purchase new capital. For relatively risk-free firms, it should be nearly the same as the interest rate on risk free government bonds. The Production Process: Production technology – the quantitative relationship between inputs and outputs Labor-intensive Technology – technology that relies heavily on human labor instead of capital Capital Intensive Technology – technology that relies heavily on capital instead of human labor
Production Function or Total Product Function – the relationship between inputs and outputs (production technology) expressed numerically or mathematically. Marginal Product – is the additional output that can be produced by hiring one more unit of specific input, holding all other inputs constant. The Law of Diminishing Returns – states that after a certain point, when additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines. Diminishing returns always occur in the short run and in the short run, every firm will face diminishing returns. This means every firm finds it progressively more difficult to increase its output as it approaches capacity production. Marginal Product versus Average Product Average product is the average amount produced by each unit of a variable factor of production. average product of labor=
total product total units of labor
Marginal and Average product curves can be derived from total product curves. Average product is at its maximum at the point of intersection with marginal product. Choice of Technology: Capital enhances the productivity of labor. Similarly, labor enhances the productivity of capital. Inputs can also be substituted for one another. Two things that determine the cost of Production: 1. Available technologies 2. Price of Input To chose a production technique the firm must look to input markets to learn the current market P prices of labor and capital. What is the wage rate ( l ) and what is the cost per hour of capital, P ¿ ¿ ). ¿ Profit maximizing firms will choose the technology that minimizes the cost of production given current market input prices.
Chapter 8: Decisions
Are Based on
Information
1. The quantity of output to supply
The price of output
2. What technology to use
Techniques of production available
3. The quantity of each input to demand
The price of inputs
Costs in the Short Run: Fixed Costs – any cost that does not depend of the firms’ level of output. These costs are incurred even if the firm stops producing. There are no fixed costs in the long run. Variable Costs – a cost that depends on the level of production chosen Total Costs – total fixed costs plus total variable costs. TC = TFC+TVC The Total Fixed Cost is sometimes called the overhead. It is the total of all costs that do not change with output even if output is zero. Because TFC does not change with output, the graph is simply a horizontal line. Average fixed cost is TFC dived by number of units of output (q):
total AFC =¿ cost (TFC ) ¿ q
Average fixed cost falls as output rises because the same total is being spread over, or divided by, a larger number of units. This is called spreading overhead. A. Total Fixed Cost TFC
B. Average Fixed Cost AFC
Units of Output
Units of Output
Variable Costs: Total Variable Cost (TVC) is the sum of those costs that vary with the level of output in the short run Total Variable Cost Curve is a graph that shows the relationship between TVC and the level of the firm’s output (q). At any given level of output total variable cost depends on: 1. The techniques of production that are available and 2. The prices of the inputs required by each technology Total Variable Cost Equation TVC
TVC=( K × Pk ) +( L × P L ) (x axis = units of output)
Marginal Cost: Marginal Cost is the increase in total cost that results from the production of ONE more unit of input. Marginal costs reflect changes in variable costs because they vary when output changes. The Shape of The Marginal Cost Curve in the Short Run: •
Diminishing returns, or decreasing marginal product, imply increasing marginal cost.
•
In the short run, every firm is constrained by some fixed factor of production. A fixed factor implies diminishing returns and a limited capacity to produce. As that limit is approached, marginal costs rise.
Marginal Product
Marginal Cost ($)
Units of Labor
Units of Output
Graphing Total Variable Costs and Marginal Costs: More output costs more than less output. Total Variable Costs always increase when output increases. Thus, total variable cost always has a positive slope. The slope of a total variable cost curve is the change in total variable cost divided by the change in output. Because marginal cost is by definition the change in total variable cost resulting from an increase in output, marginal cost actually is the slope of the total variable cost curve. slope of TVC =
∆ TVC ∆ TVC = =∆ TVC =MC (marginal cost) ∆q 1
Average Variable Costs & Graphing AVCs and Marginal Costs: Average variable Cost is total variable cost divided by the number of units of output (q): AVC =
TVC q
The relationship between average variable cost and marginal cost can be illustrated graphically. When marginal cost is below average variable cost, AVC declines toward it. When marginal cost is above AVC, average variable cost increases toward it. Rising marginal cost intersects average variable cost at the minimum point of average variable cost. Cost per Unit ($)
Units of Output Blue = Marginal Cost; Red = Average Variable Cost; Intersect at minimum point of AVC Total Costs: Remember, TC = TFC + TVC Average Total Cost is total cost divided by the number of units of output ATC =
TC q
Another, more revealing, way of deriving average total cost is to add average fixed cost and average variable together: ATC = AFC + AVC Adding TFC to TVC means adding the same amount of total fixed cost to every level of total variable cost. Thus, the total cost curve has the same shape as the variable cost curve; it is simply higher by an amount equal to TFC. (pg. 175, graph 8.7) Average Total Cost = Average Variable Cost + Average Fixed Cost: To get average total cost, we add average fixed and average variable costs at all levels of output. Because average fixed cost falls with output, an ever declining amount is added to AVC. Thus, AVC and ATC get closer together as output increases, but the two lines never meet. (pg. 176 figure 8.8) Output Decisions: Revenues, Costs, and Profit Maximization Perfect Competition – exists in an industry that contains many relatively small firms producing identical products. In a perfectly competitive industry, no single firm has any control over prices and new competitors can freely enter and exit the market. Homogeneous Products – undifferentiated products; products that are identical to, or indistinguishable from, one another. We assume easy entry, and easy exit. Total Revenue and Marginal Revenue Profit is the difference between total revenue and total cost. Total Revenue is the total amount that a firm takes in from the sale of its product. Total Revenue equals price times quantity TR = P x q Marginal Revenue is the added revenue that a firm takes when it increases output by ONE additional unit. In a perfectly competitive market P = MR. This marginal revenue can also be thought of as the demand curve facing the firm, meaning that the horizontal line on a graph is the MR. (P=d=MR) Comparing Costs and Revenues to Maximize Profit If price is about marginal cost, profits can be increased by raising output; each additional unit increases revenues by more than its costs to produce the additional output. Beyond the MR line added output will reduce profits. Profit-maximizing output is thus, q, the point at which P=MC. Important Note: The key idea is that firms will produce as long as marginal revenue exceeds marginal costs. Chapter Nine:
Short Run Conditions and Long-Run Directions When we say a firm is suffering a loss, we mean that it is earning a rate of return that is below normal. Investors will not be attracted to this industry. A firm that is breaking even, or earning a zero level of profit, is one that is earning exactly a normal rate of return. New investors are not attracted, but current ones are not running away. With these distinctions we can say one of three conditions holds: 1. The firm is making positive profits 2. The firm is suffering losses 3. The firm is breaking even Profitable firms will want to maximize their profits in the short run, while firms suffering losses will want to minimize those losses in the short run. Maximizing Profits: Blue velvet carwash example (in notes and in book pg 190). A profit-maximizing perfectly competitive firm will produce up to point where P=MC. Profit is the difference between total revenue and total cost. A profit that is earning a positive profit in the short run and expects to continue doing so has an incentive to expand its scale of operation in the long run. Minimizing Losses: A firm that is not earning a positive profit or breaking even is suffering a loss. Firms suffering losses fall into two categories: 1. Those that find it advantageous to shut down operations immediately and bear losses equal to total fixed costs 2. Those that continue to operate in the short run to minimize their losses The most important thing to remember is that firms cannot exit the industry in the short run. The firm can shut down, but cannot get rid of its fixed costs by going out of business. Because a firm must bear fixed costs whether or not it shuts down, its decision depends solely on whether total revenue from operating is sufficient to cover total variable cost. If total revenue exceeds total variable cost, the excess revenue can be used to offset fixed costs and reduce losses, and it will pay the firm to keep operating.
If total revenue is smaller than total variable cost, the firm that operates will suffer losses in excess of fixed costs. In this case, the firm can minimize its losses by shutting down. (Revisit Blue Velvet example, notes and Pg 193) Shutdown Point – the lowest point on the average variable cost curve. When price falls below the minimum point on AVC , total revenue is insufficient to cover variable costs and the firm will shut down and bear losses equal to fixed costs.
Dollars
sht down pt (mkt $) Units of Output Red = MC
Green = ATC
Blue = AVC The short-run supply curve of a competitive firm is the part of its marginal cost that lies above average variable cost curve. (Red curve above blue curve) The Short Run Industry Supply Curve The Short-run industry supply curve is the sum of the individual firm supply curves, that is, the marginal cost curves (above AVC) of all the firms in the industry. Two things cause the industry supply curve to shift. In the short run, the industry supply curve shifts if something (a decrease in the price of some input, for instance) shifts the marginal cost curves of all the individual firms simultaneously. In the long run, an increase or decrease in the number of firms, shifts the total industry supply curve. Ex: If there are only three firms in the industry, the industry supply curve is simply the sum of all products supplied by the three firms at each price. For example, at $6 each firm supplies 150 units; for a total industry supply of 400. Long Run Directions: A Review
Profits
Short-Run Condition
Short-Run Decision
Long-Run Decision
TR>TC
P=MC: Operate
Expand: New firms
enter Losses
Losses
1. TR greater than/equal to TVC
P=MC: Operate
2.TR
