Costs, Competition & Organization of the Business Firm

1. Costs, Competition & Organization of the Business Firm

2. Utility

3. Utility • Utility • Satisfaction or pleasure derived from consuming a good or service. • Law of Diminishing Utility • Added satisfaction declines as additional units are used or consumed

4. Substitution Effect • Effect of a change in price on the relative utility of a product and the quantity demanded. • MUA/PA = MUB/PB

5. Prospect Theory • Behavioral analysis of negative occurrences. • Factors • Status quo • Loss Aversion • Market applications • Package sizing • Framing • Anchoring

6. Types of Business Structures

7. Three Types of Business Firms • Proprietorship: • owned by a single individual • make up 72% of the firms in the market, but account for only 4% of total business revenue

8. Three Types of Business Firms • Partnership: • owned by two or more persons • 8% of the firms; 12% of business revenues

9. Three Types of Business Firms • Corporation: • owned by stockholders • In contrast to the unlimited liability of proprietorships and partnerships, the owners’ liability is limited to their explicit investment. • 20% of the firms; 84% of business revenue

10. The Economic Way of Thinking about Costs

11. Implicit & Explicit Costs • Explicit • Monetary Payments • Accounting Profits • Implicit • Opportunity Costs • Economic Profits

12. Sunk Costs • Sunk Costs are historical costs associated with past decisions that can’t be changed. • Sunk costs may provide information, but are not relevant to current choices. • Current choices should be made on current and expected future costs and benefits.

13. Economies of Scale • As output (plant size) is increased, per-unit costs will follow one of three possibilities: • Economies of Scale: Reductions in per unit costs as output expands. This can occur for three reasons: • mass production • specialization • improvements in production as a result of experience • Diseconomies of Scale: increases in per unit costs as output expands • Constant Returns to Scale: unit costs are constant as output expands

14. Short-Run and Long-Run Time Periods

15. The Short Run • The short run is a period of time so short that the firm’s level of plant and heavy equipment (capital) is fixed. • In the short run, output can only be altered by changing the usage of variable resources such as labor and raw materials.

16. The Long Run • The long run is a period of time sufficient for the firm to alter all factors of production. • In the long run, firms can freely enter and exit the industry. • The time duration of the short run and the long run will differ across industries.

17. Categories of Cost

18. Fixed & Variable Costs • Fixed Costs : costs that remain unchanged regardless on the amount produced. • EG – Rent or the purchase of machinery. • Variable Costs: Fixed costs depend on the amount produced. • EG – Electricity to run a machine or inputs for production

19. Total and Average Fixed Costs • Total Fixed Costs (TFC): costs that remain unchanged in the short run when output is altered • Examples: • insurance premiums • property taxes • the opportunity cost of fixed assets • Average Fixed Costs (AFC): Fixed costs per unit (i.e. FC / output). • decline as output expands

20. Total and Average Variable Costs • Total Variable Costs (TVC):sum of costs that increase as output expands • Examples: • cost of labor • raw materials • Average Variable Costs (AVC): variable costs per unit (i.e. TVC / output)

21. Total Cost • Total Costs (TC): Total Fixed Cost + Total Variable Cost • TC=FC+VC • Average Total Costs (ATC): Average Fixed Cost + Average Variable Cost • ATC=AVC+AFC

22. Marginal Cost • Marginal Cost (MC): the increase in Total Cost associated with a one-unit increase in production • Typically, MC will decline initially, reach a minimum, and then rise. • MC = (Change in TC)/(Change in Q)

23. Revenues

24. Revenues • TR = Total Revenue • AR = Average Revenue • AR = TR / Q • Marginal Revenue is the added revenue associated with an increase of one unit of output • MR = TRN – TRN-1 • MR = ∆TR / ∆Q

25. Profits & Equilibrium

26. Profits & Equilibrium • Profits • Π = TR – TC • Π = (P – ATC) * Q • Equilibrium Pricing • MC = MR • Shut-down price • P < AVCMIN

27. Cost and Supply • When making output decisions in the short run, it is the firm’s marginal costs that are most important. • Additional units will not be supplied if they do not generate additional revenues that are sufficient to cover their marginal costs. • For long-run output decisions, it is the firm’s average total costs that are most important. • Firms will not continue to supply output in the long run if revenues are insufficient to cover their average total costs.

28. P MC • Marginal Costs: rise sharply as the plant’s production capacity (q) is approached. Q q P ATC • Average Total Costs: will be a U-shaped curve since AFC will be high for small rates of output and MC will be high as the plant’s production capacity (q) is approached. Q q Short-Run Cost Curves

29. Output and Costs In the Short Run

30. Total Cost Schedule • Output TFC TVC TC • 0 50 0 50 • 1 50 15 65 • 2 50 25 75 • 3 50 34 84 • 4 50 42 92 • 5 50 52 102 • 6 50 64 114 • 7 50 79 129 • 8 50 98 148 • 9 50 122 172 • 10 50 152 202

31. TC TVC 50 50 TFC 50 50 50 50 Short Run Total Cost Curves • Note that total fixed costsare flat – they are constant at all output levels. Totalcosts • Note that total variable costsincrease as more variable inputs are utilized. 200 • As total costsare the combination of TVCand TFC, they are everywhere positive and increase sharply with output 150 = Outputper day + TC TVC TFC 100 0 0 50 2 25 75 4 42 92 50 6 64 114 8 98 148 10 152 202 Output 2 4 8 6 10

32. Average Cost Schedule • Output AFC AVC ATC • =(TFC/Output) =(TVC/Output) =(TC/Output) • 1 50 15 65 • 2 25 12.5 37.5 • 3 16.7 11.3 28 • 4 12.5 10.5 23 • 5 10 10.4 20.4 • 6 8.3 10.7 19 • 7 7.1 11.3 18.4 • 8 6.25 12.25 18.5 • 9 5.6 13.6 19.2 • 10 5 15.2 20.2

33. Costper unit 60 40 AVC 20 Output 2 4 8 6 10 Short Run Cost Curves • The average variable cost curve (AVC) is the total variable cost (TVC) divided by the output level. It is higher either for a few or a lot of units and has some minimal point between the two where, when graphed later, marginal costs (MC) will cross. / Outputper day = AVC TVC ---- 0 0 15 1 $ 15.00 25 2 $ 12.50 42 4 $ 10.50 64 6 $ 10.67 98 8 $ 12.25 AFC 152 10 $ 15.20

34. Marginal Cost Schedule • Output VC ∆VC=MC • 0 0 • 1 15 =15-0 15 • 2 25 =25-15 10 • 3 34 =34-25 9 • 4 42 =42-34 8 • 5 52 =52-42 10 • 6 64 =64-52 12 • 7 79 =79-64 15 • 8 98 =98-79 19 • 9 122 =122-98 24 • 10 152 =152-122 30

35. Short-Run Cost Curves • To calculate the marginal cost curve (MC) we take the change in TC (TC) and divide that by the change in output. Note: our increments for increasing output here are 1 ( 1). Costper unit Note: MC always crosses AVC at its minimum point. 60 MC 40 1 1 1 20 1 1 Output 2 4 8 6 10 1 Short Run Cost Curves • Note that MC starts low and increases as output increases. It also crosses AVCat its minimum point. / TC = TC MC Output 50 15 $ 15.00 65 10 $ 10.00 75 AVC 84 8 $ 8.00 92 102 AFC 12 $ 12.00 114 129 148 19 $ 19.00 172 30 $ 30.00 202

36. Costper unit Note: MC always crosses ATC at its minimum point. 60 40 ATC 20 Output 2 4 8 6 10 Short Run Cost Curves • The average total cost curve (ATC) is simply TC divided by the output. • When outputis low, ATCis high because AFC is high. Also,ATC is high when output is large as MC grows large when output is high. MC • These two relationships explain the distinct U–shape of the ATCcurve. / Outputper day = ATC TC ---- 50 0 65 1 $ 65.00 $ 37.50 2 75 AVC 92 4 $ 23.00 AFC 114 6 $ 19.00 148 8 $ 18.50 202 10 $ 20.20

37. MarginalRevenue = (MR) Marginal Revenue • Marginal Revenue is the change in total revenue divided by the change in output. Change in Revenue TRi-TR(i-1) • In a perfectly competitive market, marginal revenue (MR) = market price, because all units are sold at the same price (market price).

38. P=MC Price Profit P C A P<MC P>MC increase q decrease q Output Profit Maximization when the Firm is a Price Taker • In the short run, the price taker will expand output until the marginal revenue (MR) is just equal to marginal cost (MC). MC • This will maximize the firm’s profits (rectangle PBAC). ATC B d(P = MR) • When P > MC,production of the unit adds more to revenues than costs. In order for the firm to maximize its profits it will expand output until MC= P. • When P < MC,the unit adds more to costs than revenues. A profit maximizing firm will not produce in this output range. It will reduce output until MC= P. q

39. . . . . . . . . . . . . Profit MaximumP= MR= MC MR / MC Approach • At low output levels MR>MC. • After some point, additional units cost more than the MR realized from selling them. • Profit is maximized where P= MR=MC. MC MarginalCost(MC) Profit(TR - TC) MarginalRevenue(MR) Price and cost per Unit Output 9 ---- ---- - 25.00 0 $ 3.95 - 23.75 5 2 7 MR 8 - 8.00 5 $ 1.50 5 - .25 10 $ 1.00 5 6.75 $ 1.75 5 12 3 5 14 10.75 $ 3.50 $ 4.75 11.00 5 15 1 16 10.00 5 $ 6.00 Output 18 $ 8.25 4.50 5 $ 13.00 20 - 8.00 5 2 4 8 10 6 16 12 14 20 18

40. MC=MR • Output MC MR • 0 • 1 15 10 • 2 10 10 • 3 9 10 • 4 8 10 • 5 10 10 • 6 12 10 • 7 15 10 • 8 19 10 • 9 24 10 • 10 30 10 MC=MR

41. Profits (π) • Output TR=Q*P TC π=TR-TC • 0 • 1 10 65 (55) • 2 20 75 (55) • 3 30 84 (54) • 4 40 92 (52) • 5 50 102 (52) • 6 60 114 (54) • 7 70 129 (59) • 8 80 148 (68) • 9 90 172 (82) • 10 100 202 (102) Max. π

42. If MC = MR at a fractional point, always choose the last level of output where MR > MC.

43. Output and Costs In the Long Run

44. Short-Run & Long-Run Cost Curves • Each potential plant has a cost curve (SRAC). • The choices of each plant’s short-run curves combine to create a long-run curve (LRAC).

45. Market Structures 1 – Perfectly Competitive Markets 2 – Monopolies 3 – Monopolistic Competition 4 – Oligopolies

46. 1 – Perfectly Competitive Markets

47. Perfectly Competitive Markets • Perfect Competition • Many buyers & sellers • No single buyer or seller exerts influence on the market • Informed buyers • Identical products • Easy market entry & exit

48. Demand from Seller’s Perspective • Perfectly elastic • P = MR = AR = D

49. Firm vs. Industry in Perfect Competition P ΣMC P MC P D=MR=AR=P D Q Q QFirm QIndustry Single Firm Industry

50. Short-Run in Perfectly Competitive Markets • MC = MR • Provided MR > Minimum AVC • Loss Minization • MR > AVC but MR < ATC • Operation reduces losses • Shut-down Situation • If MR < AVCmin, operating increases losses