The Supply Side of the Market The Supply Side of the Market in in - PDF document

Econ Dept, UMR Presents The Supply Side of the Market The Supply Side of the Market in in Three Parts: Three Parts: I. An Introduction to Supply and I. An Introduction to Supply and Producer Surplus Producer Surplus II. The Production Function II. The Production Function III. Cost Functions III. Cost Functions

Starring Starring Supply N Supply N Production O Production O Cost O Cost O Producer surplus N Producer surplus N

Featuring Featuring The Law of Diminishing Marginal Product N The Law of Diminishing Marginal Product N The MP/P Rule N The MP/P Rule N Economic Cost vs. Accounting Cost N Economic Cost vs. Accounting Cost N Economic Profit vs. Accounting Profit N Economic Profit vs. Accounting Profit N The Unimportance of Sunk Cost N The Unimportance of Sunk Cost N

Part III: Cost Functions Part III: Cost Functions

Linking Production to Costs Linking Production to Costs N Each production relationship has a cost Each production relationship has a cost N counterpart counterpart O TP:variable input TP:variable input -- variable cost variable cost -- O O AP:variable input AP:variable input -- average variable cost average variable cost -- O O MP:variable input MP:variable input -- marginal cost -- marginal cost O O Fixed inputs Fixed inputs -- fixed (or sunk) cost fixed (or sunk) cost -- O O MP/P rule MP/P rule -- equal MC rule equal MC rule -- O N The production function and the MP/P rule The production function and the MP/P rule N tells us the minimum cost of producing any tells us the minimum cost of producing any level of output, q: cost = input price times level of output, q: cost = input price times inputs required = P*R inputs required = P*R

Short Run Costs First by definition we have Fixed Costs that do not vary with output FC = iK ; where i is the price FC = iK ; where i is the price of the fixed input, capital (K) of the fixed input, capital (K) FC q/t q 0 q 1 q 2 q 3 Often fixed costs are also sunk costs. Sunk costs are costs already incurred and are beyond recovery.

Second, we have TC Short variable cost. Run Adding TVC and FC TVC + FC = TC TVC + FC = TC gives Total Costs Costs TVC Fixed Costs TVC = wL where w is the price of the variable input, labor (L) FC q/t q 0 q 1 q 2 q 3 Notice the vertical distance between TC and TVC is Fixed Cost Notice the vertical distance between TC and TVC is Fixed Cost

TC Short TVC Run Costs Notice the curvature of TC and TVC is the Fixed Costs same. The slope of both at any output is marginal cost At q 3 , slope of TC = slope of TVC = MC FC MC = ( ˛ ˛ TC/ TC/ ˛ ˛ q) q) MC = ( = ( ˛ ˛ TVC/ TVC/ ˛ ˛ q) q) = ( q/t q 0 q 1 q 2 q 3 The rise over the run is the change in cost, total or The rise over the run is the change in cost, total or variable, divided by the change in output variable, divided by the change in output

TC Short Run TVC Costs Tangency ’ s to show minimum AVC and ATC •q 1 min AVC •q 2 min ATC Note, q 2 > q 1 as long as fixed costs are present. That is the FC output at which AVC is minimized is q/t less than the output q 0 q 1 q 2 q 3 at which ATC is minimized as long (TVC/q) = AVC; (TC/q) = ATC (TVC/q) = AVC; (TC/q) = ATC as FC > 0

Short Short TC Run Run TVC Costs Costs Inflection Points •q 0 min MC At q 0 , the law of diminishing marginal returns sets in FC q/t q 0 q 1 q 2 q 3 At the Inflection Point, TC and TVC stop increasing at a At the Inflection Point, TC and TVC stop increasing at a decreasing rate and start increasing at an increasing rate. decreasing rate and start increasing at an increasing rate. MC falls up to q 0 MC falls up to q 0 then starts to increase. then starts to increase.

Everything Everything Short Short TC Together Together Run Run TVC Costs Costs Tangency’s to show minimum AVC and Fixed Costs ATC Inflection Points •q 0 min MC •q 1 min AVC FC •q 2 min ATC •q 3 slope of TC q/t = slope of TVC q 0 q 1 q 2 q 3 = MC at q 3 TVC + TFC = TC = wL + iK

Per Unit Short Run Costs Per Unit Short Run Costs N Let Let ’ s look now at costs on a per unit basis ’ s look now at costs on a per unit basis N O Average fixed cost, AFC = FC/q Average fixed cost, AFC = FC/q O O Average variable cost, AVC = TVC/q Average variable cost, AVC = TVC/q O O Average total cost, ATC = TC/q Average total cost, ATC = TC/q O O Marginal cost, MC = Marginal cost, MC = ˛ ˛ TC/ TC/ ˛ ˛ q = q = ˛ ˛ TVC/ TVC/ ˛ ˛ q q O

AFC = FC/q AFC = FC/q Short Run Short Run Per Unit Per Unit First, Average Fixed Costs declines Costs Costs throughout the range of output. This is because you are dividing a constant, FC, with an ever increasing quantity . AFC q/t q 0 q 1 q 2

In the short run, the average Short Run Short Run curves take on a “U” shape Per Unit Per Unit driven by the law of diminishing Costs Costs marginal returns ATC AVC Notice the vertical distance between ATC and AVC is AFC AFC q/t q 0 q 1 q 2 AFC = FC/q AFC = FC/q Also note, q 2 > q 1 as long as AVC = TVC/q AVC = TVC/q fixed costs are present ATC = AFC + AVC = TC/q ATC = AFC + AVC = TC/q

AFC is not very important, so Short Run it is often not drawn with the Per Unit other per unit curves Costs ATC AVC Notice the minimum AVC at q 1 , occurs when the average product of the variable input is maximized q/t q 0 q 1 q 2 AVC = TVC/q AVC = TVC/q ATC = AFC + AVC = TC/q ATC = AFC + AVC = TC/q

Notice MC is “U” shaped too with its Short Run Short Run minimum point, at q 0 , coinciding with Per Unit Per Unit the output where the marginal product of the variable input is Costs Costs maximized ATC MC AVC q/t q 0 q 1 q 2 MC = ˛ ˛ TC/ TC/ ˛ ˛ q q MC = = ˛ ˛ TVC/ TVC/ ˛ ˛ q q =

Everything Everything Short Run Short Run Together Together Per Unit Per Unit Costs Costs ATC MC AVC AFC q/t q 0 q 1 q 2 AFC = TFC/q AFC = TFC/q MC = ˛ ˛ TC/ TC/ ˛ ˛ q q MC = AVC = TVC/q AVC = TVC/q = ˛ ˛ TVC/ TVC/ ˛ ˛ q q = ATC = AFC + AVC = TC/q ATC = AFC + AVC = TC/q

Before Going to the Long Run Before Going to the Long Run N Review what we mean by Review what we mean by “costs” “costs” N O Costs are opportunity costs Costs are opportunity costs O O Or, costs are benefits foregone Or, costs are benefits foregone- -the benefits the benefits O of the next best alternative given up of the next best alternative given up O Market prices are often good measures of Market prices are often good measures of O opportunity costs opportunity costs

Opportunity Cost Opportunity Cost N In economics, costs are always the value In economics, costs are always the value N of the benefits given up-- --opportunity opportunity of the benefits given up cost cost N Sometimes these opportunity costs are Sometimes these opportunity costs are N monetary, e.g., Wages paid labor monetary, e.g., Wages paid labor N Sometimes these opportunity costs are Sometimes these opportunity costs are N nonmonetary, e.g., Value of time used nonmonetary, e.g., Value of time used

Economic Costs Economic Costs N Total cost Total cost (TC) (TC) - - the total opportunity the total opportunity N cost of all resources used in production cost of all resources used in production O TC = monetary costs + Nonmonetary costs TC = monetary costs + Nonmonetary costs O

Economic vs. Accounting Economic vs. Accounting Concepts of Costs and Profits Concepts of Costs and Profits N In economics costs are opportunity costs In economics costs are opportunity costs N N In accounting costs are defined according to In accounting costs are defined according to N accepted accounting rules designed for tax accepted accounting rules designed for tax and public disclosure purposes and public disclosure purposes N Since the definitions of cost differ so do the Since the definitions of cost differ so do the N definitions of profits definitions of profits O Economic profit = total revenue Economic profit = total revenue - - opportunity opportunity O costs costs O Accounting profit = total revenue Accounting profit = total revenue - - accounting accounting O costs costs

Illustration of Accounting Illustration of Accounting Profit vs. Economic Profit Profit vs. Economic Profit Assume: Assume: Monetary costs (explicit costs) for a month =$15,000 Monetary costs (explicit costs) for a month =$15,000 Non- -monetary costs for a month = $ 4,000 monetary costs for a month = $ 4,000 Non Total costs =$19,000 Total costs =$19,000 Economic profit = total revenue (TR) Economic profit = total revenue (TR) - - total costs (TC) total costs (TC) If total revenue for this month is equal to $19,000 then: If total revenue for this month is equal to $19,000 then: there is no economic profit, but there would be a there is no economic profit, but there would be a $4,000 accounting profit. Accounting profit does not $4,000 accounting profit. Accounting profit does not count non- -monetary costs as a cost thus profit would monetary costs as a cost thus profit would count non be reported as $4,000 be reported as $4,000