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Wrapping up supply

Wrapping up supply. Today: More on profit maximization, determinants of supply, and surplus. Today…. We make this graph make intuitive sense We will see that: Profits are positive at price P 1 Profits are negative at prices P 2 and P 3 Firms will shut down when price is P 3.

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Wrapping up supply

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  1. Wrapping up supply Today: More on profit maximization, determinants of supply, and surplus

  2. Today… • We make this graph make intuitive sense • We will see that: • Profits are positive at price P1 • Profits are negative at prices P2 and P3 • Firms will shut down when price is P3

  3. Profit maximization • Remember that this is our goal • For the most part, we will implement MB/MC analysis again • Exception: Shutdown condition • If a firm can lose less by closing than opening, it will close

  4. Costs • Cost to hire an employee is $100/day • Assume $1000 in fixed costs for a phone manufacturer per day • Note average fixed cost (AFC) decreases as the number of phones increases

  5. Our output example for today

  6. Increasing returns? • Notice that the marginal productivity for the 1st worker is 20; 2nd worker, 25 • Why? • Specialization • Assembly line can help increase marginal productivity up to a certain point • Marginal productivity eventually decreases

  7. Cost table

  8. How to calculate MC • Marginal cost (MC) is how much additional cost is necessary to produce an additional phone • For example, each additional phone from the 1st worker is • cost to hire worker / # of phones produced • ($100/day) / (20 phones/day) = $5/phone

  9. Cost table

  10. Suppose that phones sell for $18 each • How many people should be hired? • Hire the next worker if the MB of the next phone produced is at least as much as the MC • This is the same as finding the number of workers that maximizes profits

  11. Marginal analysis: Hire 4 employees/day

  12. How much profit? –$266

  13. Shutdown condition • Finally, we must check to see if the firm is better off shutting down when profits are negative • If total revenue is less than total variable cost for all levels of output (Q), then the firm should shut down • This is equivalent to the firm making worse profits for all Q > 0 than for Q = 0

  14. Shutdown condition check • Profits are better when 4 employees are hired (–$266) than when the firm shuts down (–$1000) • This firm stays in business

  15. Back to our graph • We have finished a discrete example • Now, we will see how we get the marginal cost (MC), average total cost (ATC), and average variable cost (AVC) curves

  16. Marginal cost • MC starts by decreasing, then increases sharply

  17. Average total cost • ATC falls initially, then eventually increases

  18. Average variable cost • AVC falls initially, then eventually increases

  19. ATC and AVC costs converge • Note ATC = AVC + AFC • Since AFC is decreasing as Q increases, the difference between ATC and AVC gets smaller as Q increases • Thus, ATC and AVC curves get closer as Q increases

  20. MC curve • Remember: Marginal means for an additional unit produced • If marginal is below average, this brings the average down • If marginal is above average, this brings the average up

  21. MC curve • Marginal cost curve tells us how average cost curves (ATC and AVC) move • MC curve is below average cost curve when average cost curve is decreasing • MC curve is above average cost curve when average cost curve is increasing

  22. Back to the graph • All curves decrease initially, but eventually increase • MC curve tells us which direction ATC and AVC curves are going

  23. Back to the graph • At P1 positive profits, since TR > TC (P Q > ATC  Q) • At P2 negative profits • At P3 firm shuts down (TR is less than VC for all Q)

  24. Warning! • Look at red circle • This is a point where P3 and MC curves intersect • Ignore these points on the MC curve that are downward-sloping, since profit is minimized here

  25. Determinants of supply • Technology • Input prices • The number of suppliers • Expectations of future prices • Changes in the price of other relevant products

  26. Some examples • If technology improves or input prices decrease, production becomes less costly • If the number of suppliers increases, we can horizontally add the additional supply to the market • If the price of calculators increases, some phone suppliers may devote more of its capital to producing calculators

  27. Producer surplus • Producer surplus is similar conceptually to consumer surplus • For a unit or service sold, producer surplus is the difference between the price paid and the minimum payment the seller is willing to accept for it

  28. Example of producer surplus • When P = 25 per unit, shaded area is approximate producer surplus • Area is a triangle, one-half times length times height: 0.5  10  25 = 125

  29. Why are CS and PS important? • Consumer surplus (CS) and producer surplus (PS) are important since these measures give us a crude measure of the total benefits to society • Next week, we will see situations in which total surplus can be reduced

  30. This concludes supply • Important things to remember with supply • Individual and market supply • Steps to profit maximization • Useful to know individual firm supply, production function, FC, VC, TC, MC, AFC, AVC, ATC, shutdown condition • Determinants of supply • Producer surplus

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