This Document Contains Chapters 11 to 12 Chapter 11 Behind the Supply Curve: Inputs and Costs What’s New in the Fifth Edition? • Updated cases Chapter Objectives • Discuss the firm’s production function to define the relationship between the quantity of inputs and the quantity of output. • Explain why production is often subject to diminishing returns to inputs such as labor and capital. • Define the various types of costs the firm faces. • Illustrate the marginal and average total cost curves. • Explain why a firm’s cost may differ in the short run versus the long run. • Explain the concept of increasing returns to scale. Teaching Tips The Production Function Creating Student Interest • A good starting point is to talk about the costs of owning a car. Assume that the car is a fixed input while it is in the garage and a variable input when you drive it. Ask students to think about the fixed cost of owning a car (as it sits in the garage) and the variable costs of owning a car (as you drive the car). The fixed costs are depreciation and registration fees, and the variable expenses are gasoline and maintenance. • Ask students to brainstorm the fixed and variable inputs used at a fast-food restaurant or at the student bookstore. List them on the board. Presenting the Material • Use Handout 11-1 to present the definitions for total product and marginal product, and then to present fixed, variable and total costs. Two Key Concepts: Marginal Cost and Average Cost Creating Student Interest • Explain the difference between average and marginal using one of the following examples. Use the students’ grades to explain average and marginal, tailoring the example to fit your class syllabus. (The students have a lot of practice calculating their grades!) For example, if students have three equally weighted exams that determine their course grade, their average grade is found by totaling the scores from the three exams and dividing the total by the number of exams. An average is always the total divided by the number of items—and this works for costs, too. If, for example, a student has taken two exams and scored a 75 and a 95, the average is (75 + 95)/2 = 170/2 = 85. • Now you can introduce the concept of marginal. If the marginal or next exam score is 90, what will happen to the student’s average? (It will increase to [75 + 95 + 90]/3 = 260/3 = 86.7.) What if the additional, or marginal, exam score is 70? (It will decrease to [75 + 95 + 70]/3 = 240/3 = 80.) Here you can bring in the relationship between average and marginal values—when the marginal value is above the average, the average goes up, and when the marginal value is below the average, it pulls the average down. Students will relate to this in terms of the exam scores—they know they want their marginal exam scores to pull their average up. • Online grocery delivery services charge a flat fee to deliver groceries. Ask students: Why do customers have an incentive to order a lot of groceries? (They want to “spread” the fixed costs over many items, so that average fixed cost falls.) Presenting the Material • Use Handout 11-2 to present the concepts of average costs. Going through the cost calculations with the students is important because it helps them understand the different cost concepts. It is equally important to then take these calculated numbers and graphically illustrate the cost curves to explain how the cost curves are related to each other. The cost curve graph will be used extensively in upcoming chapters. Production and Cost Presenting the Material • Present the material with a hands-on example. Using Handout 11-3, show students how to “produce a widget”—this is done by folding a piece of paper twice and stapling it. Either give each student a copy of the table that follows, or present the table on the board. Tell the students that you are going to collect data and calculate production and cost values and that each production period will last 30 seconds. Assemble the capital at the front of the room and add zero workers. Time 30 seconds and watch the capital produce zero widgets. Enter the data on the worksheet and calculate the various values. Now add a worker (a volunteer from the class). Repeat the process until Handout 11-3 is completed. Note when diminishing returns sets in. You can also have students graph the data to see the extent to which the graph of the data has the expected shapes. Short-Run versus Long-Run Costs Creating Student Interest • Ask students to define “the long run”—is it a week, a month, a year, a decade? To help them see that the long run is not tied to a specific length of time, ask them to consider the long run for a fruit fly (for whom 48 hours is a lifetime) versus that for an elephant (with a gestation period of 22 months and a life span of more than 70 years). Then introduce the difference between opening a nuclear power plant (which might take 25 years or more to come online) and a student’s opening an NCAA national championship T-shirt business for their school (which will have an obsolete product in less than a year, when the next champion is crowned). In the short run, at least one factor is fixed; in the long run, the producer has time to choose the fixed cost appropriate for the desired level of output. This is a longer time for a nuclear power plant than for a T-shirt business. • Ask students to think about two different kinds of hardware stores—the small, local, family-owned store and the large chain stores (Lowe’s, Home Depot). What advantages do they see for each kind of store? What are the benefits of becoming larger? (Buying bulk, spreading fixed costs over larger quantities.) What are the drawbacks of becoming too large? (Losing customer service, becoming difficult to manage.) Presenting the Material • Students have difficulty grasping the difference between short-run and long-run average total cost, especially when it comes to the graph. First remind them of the reasons why average total cost is U-shaped. Average total cost diminishes initially because the average fixed cost is high. If a firm is producing on the diminishing portion of ATC, then their fixed cost is high relative to output, and they should shrink the size of their firm. Average total cost increases eventually because of diminishing returns. If a firm is producing on the increasing portion of ATC, then diminishing returns have set in and they will want to increase the size of their firm. Both of these actions have the same result—long-run average total cost will fall. • Use Handout 11-4 to help students understand returns to scale. Common Student Pitfalls • What’s a unit? Students can be confused about how to measure a unit of labor. For example, labor can be measured in hours, days, weeks, or years or as the number of workers. Make sure students understand that the units used to measure labor do not affect the analysis—as long as you are consistent in the units you select. • Marginal versus total product and diminishing returns. Make clear to the students the distinction between declining marginal product and declining total product. Diminishing returns sets in when there is a decrease in the rate at which total product increases (not a decrease in total product). So, total product may continue to rise with diminishing returns. It just rises more slowly. • Average versus marginal costs. Students are often unclear about the difference between average total cost and marginal cost. Give the example of an airline company’s decision to fly the next flight. What are the additional costs of flying the plane? (Salaries of pilots and crew, cost of jet fuel, food, landing fee.) What costs don’t change even if they fly the plane? (Administrative salaries, website maintenance, marketing costs.) Explain that average total cost, or cost per passenger per mile, is calculated by dividing the total costs of the airline (administrative salaries, cost of jets, crew salaries, website maintenance, marketing costs, jet fuel, insurance costs, etc.) by the number of passenger-miles flown. In plotting average and marginal cost curves, remind students that marginal quantities are plotted between the two quantities. • Long run versus short run. Students often confuse diminishing marginal product with decreasing returns to scale. Explain that diminishing marginal product occurs when only one input is varied and all other inputs are fixed; decreasing returns to scale occur when a firm is in a planning horizon in which all inputs can be varied. You might give the example of General Motors building an auto plant that was the size of four football fields. One side of the plant could not communicate properly with the other side. The firm closed the large plant because of decreasing returns to scale. Students are not clear about the meaning of long run in terms of the production period. Explain that it does not refer to a specific time period (say, 3 years), but occurs when managers can vary the size and scale of all inputs used by the firm. Give examples of different local firms or industries and speculate with your students as to how long each firm’s long run might be. A hair salon may have a long run that is just 30 days long, if they have a month-to-month lease. A car manufacturer has a long run that is years long. Chapter Outline Opening Example: The example describes why European farmers are more productive than U.S. farmers in producing wheat: European government policies provide incentives for using more inputs, and with more inputs comes increased productivity. I. The Production Function A. A production function is the relationship between the quantity of inputs a firm uses and the quantity of output it produces. B. Inputs and outputs 1. Inputs can be either fixed or variable. 2. In the long run, all inputs can be changed, but in the short run, at least one variable is fixed. 3. The total product curve shows how the quantity of output depends on the quantity of the variable input for a given amount of the fixed input. 4. The slope of the total product curve is not constant and is equal to the marginal product of the variable input. a. Marginal product of labor = Change in quantity of output produced by one additional unit of labor, or MPL = ∆Q/∆L 5. Diminishing returns to an input exist when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input. a. Diminishing returns only hold if the quantity of all other inputs is fixed. A change in the fixed input will shift the total product curve and the marginal product curve. C. From the production function to cost curves 1. Costs of production are either fixed or variable. a. Total cost = Fixed cost + Variable cost, or TC = FC + VC. 2. The total cost curve shows how total cost depends on the quantity of output. a. The total cost curve becomes steeper as more output is produced due to diminishing returns. This is illustrated in text Figure 11-4, shown next. II. Two Key Concepts: Marginal Cost and Average Cost A. Marginal cost 1. Marginal cost = Change in total cost generated by one additional unit of labor or MC = ∆TC/∆Q 2. Marginal cost rises because there are diminishing returns to inputs when a variable input is increased as quantities of the other inputs are fixed. B. Average total cost 1. Average cost is total cost divided by quantity of output produced. 2. Average total cost is important because it tells the producer how much the average or typical unit of output costs to produce. Marginal cost tells the producer how much the last unit of output costs to produce. 3. Average fixed cost is the fixed cost per unit of output. 4. Average variable cost is the variable cost per unit of output. 5. Average fixed cost falls as more output is produced. Another way to think of this is that as more output is produced, the fixed cost is spread over more units of output. This is illustrated in text Figure 11-8, shown next. 6. Average total cost is the sum of average fixed cost and average variable cost. It has a U shape because these components move in opposite directions as output rises. a. When the U-shaped average total cost curve slopes downward, the “spreading effect” dominates: Fixed cost is spread over more units of output. b. When the U-shaped average total cost curve slopes upward, the “diminishing returns effect” dominates: An additional unit of output requires more variable inputs. C. Minimum average total cost 1. The minimum-cost output is the quantity of output at which average total cost is lowest—the bottom of the U-shaped average total cost curve. 2. Falling marginal cost pulls the average total cost downward, and rising marginal cost pulls the average total cost upward. This is illustrated in text Figure 11-9, shown next. 3. Three general principles that are always true: a. At minimum-cost output, average total cost is equal to marginal cost. b. At output less than the minimum-cost output, marginal cost is less than average total cost and average total cost is falling. c. At output greater than the minimum-cost output, marginal cost is greater than average total cost and average total cost is rising. D. Does the marginal cost curve always slope upward? 1. Marginal cost curves often slope down as a firm increases its production from zero up to some low level due to gains from specialization. They slope upward only at higher levels of production, when all gains from specialization have been realized. 2. If there are early gains from specialization, the marginal cost curve will have a “swoosh” shape, and the average variable cost curve will be U-shaped. III. Short-Run versus Long-Run Costs A. The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize total cost for each level of output. This is illustrated in text Figure 11-12, shown next. 1. In the long run, when a producer has had time to choose the fixed cost appropriate for its desired level of output, that producer will be on the long-run average total cost curve. 2. If the output level is altered, the firm will no longer be on its long-run average total cost curve and will instead be moving along its current short-run average total cost curve. 3. Once the firm has adjusted its fixed cost, it will operate on a new short-run average total cost curve and on the long-run average total cost curve. B. Returns to scale 1. There are increasing returns to scale, also known as economies of scale, when long-run average total cost declines as output increases. 2. There are decreasing returns to scale, also known as diseconomies of scale, when long-run average total cost increases as output increases. 3. There are constant returns to scale when long-run average total cost is constant as output increases. 4. Scale effects depend on the technology of production. Case Studies in the Text Economics in Action Finding the Optimal Team Size—This EIA applies the concept of diminishing returns to team projects. Ask students the following questions: 1. How does the law of diminishing marginal product apply to teams? (After the fifth worker, additional workers actually have a negative effect on total output.) 2. How does the nature of teamwork lead to diminishing returns? (It has been found that adding a sixth person to a team encourages social loafing, the ability to hide individual lack of effort. Further, larger teams have to spend more time coordinating their activities.) Smart Grid Economics—This EIA explains why the marginal cost of electricity is higher during the day than at night. Smart meters can be used to lower the consumer’s energy bill. Ask students the following questions: 1. Is the marginal cost per kilowatt higher during the day or at night? (During the day because electricity cannot be stored, so when demand is high during the day, smaller, less-efficient production facilities need to operate.) 2. How can a smart meter lower a consumer’s electricity bill? (The smart meter identifies the marginal cost of electricity at different times of day so consumers can choose to reduce their use at high-cost times and increase use at low-cost times.) How the Sharing Economy Reduces Fixed Cost—This EIA explains how the sharing economy reduces fixed costs. Ask students the following questions: 1. How does sharing affect fixed costs? (If a firm can use an asset only when it is needed, the asset becomes a variable cost, not a fixed cost.) 2. How does sharing affect the economy? (Being able to share assets allows smaller firms to compete in markets that would have previously been unprofitable to them.) Global Comparison Wheat Yields Around the World—The global comparison presents the wheat yield per acre of six countries from around the globe. Business Case Amazon’s Invasion of the Bots—This business case discusses the use of people versus robots to fill online orders in the warehouse. Web Resources Highlight the importance and general applicability of the concept of returns to scale by showing students this article from Investopedia: http://www.investopedia.com/articles/03/012703.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186 Handout 11-1 Date _________ Name ______________________ Class ________ Professor ________________ Fast Food Production Complete the marginal product of labor column. Quantity of labor (workers) Total production of hamburgers per hour Marginal product of labor 0 0 1 55 2 120 3 190 4 230 5 240 6 245 When does diminishing marginal product set in? Assume the fixed cost per hour is $100 (to cover rent on the building and other overhead expenses such as electricity), each worker is paid $10 per hour, and each hamburger requires $1 of material inputs to produce. Complete the columns for fixed cost, variable cost, and total cost in the following table. Quantity of labor Production of hamburgers Fixed cost Variable cost Total cost 0 0 1 55 2 120 3 190 4 230 5 240 6 245 Answers Quantity of labor (workers) Total production of hamburgers per hour Marginal product of labor 0 0 1 55 55 2 120 65 3 190 70 4 230 40 5 240 10 6 245 5 When does diminishing marginal product set in? Diminishing marginal product occurs after the third worker. The total production function rises at an increasing rate through the third worker and rises at a slower rate after the third worker. Assume the fixed cost per hour is $100 (to cover rent on the building and other overhead expenses such as electricity), each worker is paid $10 per hour, and each hamburger requires $1 of material inputs to produce. Complete the columns for fixed cost, variable cost, and total cost in the following table. Quantity of labor Production of hamburgers Fixed cost Variable cost Total cost 0 0 $100 $0 $100 1 55 100 ($10 x 1) + (55 x $1) = 65 165 2 120 100 ($10 x 2) + ($1 x 120) = 140 240 3 190 100 220 320 4 230 100 270 370 5 240 100 290 390 6 245 100 305 405 Handout 11-2 Date_________ Name____________________________ Class________ Professor________________ Average, Fixed, Variable, and Marginal Costs Complete the average variable costs, average fixed costs, average total costs, and marginal cost columns in the table below. Quantity of toys produced (in thousands) Variable costs of production Fixed costs of production (per hour) Total costs of production Average variable cost (VC/Q) Average fixed cost (FC/Q) Average total cost (TC/Q) Marginal cost of production ΔTC/ΔQ 0 $0 $30 $30 1 10 30 40 10 30 40 $10 2 25 30 55 12.5 15 27.5 15 3 45 30 75 15 10 25 20 4 70 30 100 17.5 7.50 25 25 5 100 30 130 20 6 26 30 6 135 30 165 22.5 5 27.5 35 1. At what rate of production is average total cost at a minimum? 2. Why is it important for a company to know what its average total cost per item is? 3. Why does average fixed cost always fall? Answers Complete the average variable costs, average fixed costs, average total costs, and marginal costs columns in the table below. Quantity of toys produced (in thousands) Variable costs of production Fixed costs of production (per hour) Total costs of production Average variable cost (VC/Q) Average fixed cost (FC/Q) Average total cost (TC/Q) Marginal cost of production ΔTC/ΔQ 0 $0 $30 $30 1 10 30 40 10 30 40 $10 2 25 30 55 12.5 15 27.5 15 3 45 30 75 15 10 25 20 4 70 30 100 17.5 7.50 25 25 5 100 30 130 20 6 26 30 6 135 30 165 22.5 5 27.5 35 1. At what rate of production is average total cost at a minimum? (Between 3,000 and 4,000 toys. You will need to point out that the ATC is not flat between 3,000 and 4,000 but without further information—a marginal cost curve—we don’t know the precise minimum of ATC.) 2. Why is it important for a company to know what its average total cost per item is? (Because firms calculate their profit per unit from that amount and often price their products in relation to average total cost.) 3. Why does average fixed cost always fall? (Because you are dividing a fixed dollar amount by an increasing quantity. You are “spreading” the fixed costs over more toys produced.) Handout 11-3 Date _________ Name ____________________ Class ________ Professor ________________ Widget Production Widget Production Production and Cost Inputs: capital—paper, work surface, and stapler (fixed); labor (variable) To produce: widgets—fold paper twice, staple Assume: price of capital = $10/unit, price of labor = $5/unit K L O APL MP FC VC TC MC AFC AVC ATC 1 _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ 1 _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ 1 _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ 1 _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ 1 _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ 1 _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ 1 _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ 1 _____ _____ _____ _____ _____ _____ _____ _____ _____ Handout 11-4 Date _________ Name _______________________ Class ________ Professor ________________ Returns to Scale Calculate ATC for Firm A, Firm B, and Firm C. Quantity Firm A TC Firm A ATC Firm B TC Firm B ATC Firm C TC Firm C ATC 1 $60 $11 $21 2 70 24 34 3 80 39 49 4 90 56 66 5 100 75 85 6 110 96 106 7 120 119 129 1. Which firm has increasing returns to scale as output increases? 2. Which firm has decreasing returns to scale as output increases? 3. Which firm has increasing returns to scale first, and then decreasing returns to scale, as output increases? Answers Calculate ATC for Firm A, Firm B, and Firm C. Quantity Firm A TC Firm A ATC Firm B TC Firm B ATC Firm C TC Firm C ATC 1 $60 $60 $11 $11 $21 $21 2 70 35 24 12 34 17 3 80 26.7 39 13 49 16.3 4 90 22.5 56 14 66 16.5 5 100 20 75 15 85 17 6 110 18.7 96 16 106 17.7 7 120 17.1 119 17 129 18.4 1. Which firm has increasing returns to scale as output increases? (Firm A.) 2. Which firm has decreasing returns to scale as output increases? (Firm B.) 3. Which firm has increasing returns to scale first, and then decreasing returns to scale, as output increases? (Firm C.) Handout 11-5 Date _________ Name ____________________ Class ________ Professor ________________ Coca-Cola and the Price of Sugar In 1985, the Coca-Cola Company was faced with soaring prices for cane sugar. A 1-cent increase in the price of cane sugar raised its total cost by $20 million. Rather than raise the price, the company looked for a cheaper input and replaced cane sugar with corn sugar. Because corn was more plentiful in the United States, it was cheaper to produce. Answer the following questions: 1. Why couldn’t the Coca-Cola Company simply raise the price? 2. Is sugar a fixed or variable input? 3. Did the switch in the input lower TC? VC? FC? ATC? AFC? AVC? Answers 1. Why couldn’t the Coca-Cola Company simply raise the price? (Demand was too price-elastic.) 2. Is sugar a fixed or variable input? (It is a variable input.) 3. Did the switch in the input lower TC? (Yes.) VC? (Yes.) FC? (No.) ATC? (Yes.) AFC? (No.) AVC? (Yes.) Handout 11-6 Date _________ Name _______________________ Class ________ Professor ________________ Cost Calculation Puzzle Fill in the missing numbers using the information provided. Output VC TC AVC AFC ATC MC 0 100 — — — — 1 25 2 20 3 53.3 4 17.5 5 90 6 30 7 265 8 41.3 9 35.0 10 425 Hint: Fixed cost = _____ Answers: Fill in the missing numbers using the information provided. Output VC TC AVC AFC ATC MC 0 0 100 — — — — 1 25 125 25 100 125 125 2 45 145 22.5 50 72.5 20 3 60 160 20 33.3 53.3 15 4 70 170 17.5 25 42.5 10 5 90 190 18 20 38 20 6 120 220 20 16.67 36.67 30 7 165 265 23.57 14.28 37.85 45 8 230.4 330.4 28.8 12.5 41.3 65.4 9 315 415 35.0 11.11 46.11 84.6 10 425 525 42.5 10 52.5 110 Hint: Fixed cost = _100_ Chapter 12 Perfect Competition and the Supply Curve What’s New in the Fifth Edition? • Updated cases • Handouts to use in the classroom Chapter Objectives • Define the characteristics of a perfectly competitive market. • Explain how a price-taking producer determines the profit-maximizing quantity of output. • Explain how to determine whether a firm is profitable. • Explain why an unprofitable firm may continue to operate in the short run. • Explain why industries behave differently in the short run and the long run. • Define the industry supply curve in the short run and the long run. Teaching Tips Perfect Competition Creating Student Interest • Have students imagine that they have decided to help pay for their summer school tuition by growing tomatoes in their backyard and selling them at the nearby farmers’ market. Ask the students if they think the venture will be successful and why. Do the students think they are capable of starting this kind of business and what would they need to do in order to start? Will they be able to leave the business when school starts in the fall? How much will they charge for their tomatoes? (The going rate at the farmers’ market.) How many other producers will there be in the market? How much market power will each have? (There will probably be many producers, each with a small share of the market.) Will their tomatoes be different from others’ tomatoes? (Homegrown tomatoes are basically the same product.) Use this discussion to get students thinking about operating in a competitive market and set up the discussion of the characteristics of perfect competition. You can return to this example as you go through the chapter material. Presenting the Material • Since this is the first market structure model, start by explaining the concept of a market structure and present market structures as a spectrum, with monopoly on one end and perfect competition on the other end. Remind students that a model is a representation of reality. The market structures studied in economics are representations of the way a type of industry will behave. Each market structure assumes certain characteristics about the environment in which firms operate (for example, the number and size of firms; firms’ ability to control price, entry, and exit). In the real world, not all industries will fall clearly into one market structure—they lie somewhere on the spectrum. As an example, looking at the number of firms in an industry, the smallest number is 1 (because with 0, the industry does not exist). If you ask students to name the market structure characterized by one firm, they usually know it is called a monopoly. They also generally figure out that an industry with two firms is a duopoly (though they might guess it is called a biopoly). If you tell them that “oli” means “few,” they can figure out that an industry with a few firms is an oligopoly. When there are many firms competing in an industry, they will know it is competition (you can add the “perfect”). And monopolistic competition becomes easy to see when it is shown as falling between monopoly and competition. You can use the following diagram to show the spectrum and add the market structure models as the discussion progresses. • When considering perfect competition, some students may be skeptical that such a market structure exists. As is generally the case with perfection, perfect competition is hard to find in the real world. Some would argue that no industry is truly perfectly competitive. Emphasize that it is nevertheless important to study the perfect competition model. Explain that, just as perfect competition can lead to several beneficial and important results (which will come to light as you study the model), market structures on the other end of the spectrum can have certain drawbacks. Therefore, we are interested in seeing how close to perfect competition an industry can come, and in preventing movement toward the other end of the spectrum. So economists (and economics students) study the perfect competition model as an “ideal” to use as a benchmark for evaluating industries in the real world. • Introduce the characteristics of perfect competition and give a few examples of industries that fit this structure. Market structure: Perfect competition 1. Many sellers, each with a small market share 2. Consumers see all the products in the market as identical 3. Easy entry and exit of firms Examples: Agricultural markets such as dairy farming and organic tomato farming Production and Profits Creating Student Interest • Ask students, “What is the goal of a firm?” You will probably get a response like, “to make money.” Push them to be more specific: “What do you call the money that a firm makes?” Here you need to make sure they distinguish between revenue and profit. Finally, make sure they understand the goal is to maximize profit—not just earn some. (Be sure to note that some firms may have other goals—nonprofit firms or firms that also have social goals.) But point out that many (most?) firms have the goal of maximizing profits and that is the assumption of our models. • Now ask students to imagine they are opening a business. How should they decide what and where to produce? Some students are likely to suggest producing a good in some location where they can make a profit or where there is not a lot of competition. This can serve as a preview for the idea that firms will enter industries in which existing firms are earning a positive profit. Next ask students what happens if profit is zero or negative? Many are sure to have forgotten about accounting versus economic profit and will interpret zero or negative profit as bad. Remind students of the difference between economic and accounting profit before moving on. For example, accounting profit can be positive even though economic profit is negative. Presenting the Material • Use Handout 12-1 to helps students see the process of finding the profit maximizing quantity of output. • In the following graph, the maximum profit quantity is shown where marginal cost is equal to price. • Show the students that at marginal units, like the 2nd or the 3rd, that MR is greater than MC, so that the addition to TR is greater than the addition to TC by producing and selling that unit, increasing profit (a good thing). Show that this happens until MR = MC, where the addition to profit is 0. Then show the 5th unit, where MR MC, and will stop producing before MC > MR. • Minimizing losses versus maximizing profits. Students may be unclear about the three separate issues in this section. The first is how firm profitability is determined. The second issue is whether a firm should stay in business or shut down in the short run, even if facing a loss. The last issue is whether a firm should enter or exit a specific industry in the long run, when a firm can choose a level of fixed costs. Students often memorize the MR = MC optimal output rule but do not really understand its underlying logic. Review the idea that the optimal amount of any activity is when the marginal benefits are equal to the marginal costs. Students may wonder why a firm will stay in business at all if price falls below minimum average cost. Explain that in this case, price greater than AVC produces revenue that covers all variable costs and some fixed costs, so in the short run the firm will have a smaller loss if it produces than if it shuts down. In the long run, the firm will exit the industry. Students are often unclear in determining the profitability of a firm from a cost curve graph. Explain that the graph shows price, marginal cost, and average total cost per unit. Total profit is shown on the graph as the area of the rectangle where the width is the optimal quantity and the height is the profit per unit. • Long-run entry and exit. Remind students of the meaning of equilibrium (no tendency for change). Also remind them of the difference between the short run and the long run (in the long run, all factors may vary). In perfect competition in the long run, the number of firms may vary. That is, economic profits will draw firms into the industry and economic losses will push firms out of the industry. In the long run, the industry will reach equilibrium with firms earning a zero economic profit. Chapter Outline Opening Example: The opening story explains why selling Christmas trees in parking lots and garden centers has become a profitable business. I. Perfect Competition A. In perfect competition, price-taking producers’ and price-taking consumers’ actions have no effect on the market price of the goods they buy. B. Defining perfect competition 1. A perfectly competitive market is a market in which all market participants are price-takers. 2. The model of a perfectly competitive market is representative of some but not all markets. C. Two necessary conditions for perfect competition 1. For an industry to be perfectly competitive, it must contain many producers, none of whom has a large market share. 2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent, so the good must be a standardized product, also known as a commodity. D. Free entry and exit 1. Most perfectly competitive industries are also characterized by free entry and exit. II. Production and Profits A. Total revenue, TR, is equal to the market price multiplied by the quantity of output, or TR = P × Q. B. Profit equals the difference between total revenue and total cost, or Profit = TR – TC. C. Using marginal analysis to choose the profit-maximizing quantity of output 1. Marginal revenue is the change in total revenue generated by an additional unit of output. or MR =∆TR/∆Q 2. The optimal output rule says that profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost. a. MR = MC at the optimal quantity of output. 3. The price-taking firm’s optimal output rule says that a price-taking firm’s profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to the market price. a. For a perfectly competitive industry, P = MC at the price-taking firm’s optimal quantity of output. This is illustrated in text Figure 12-1, shown here. 4. Whenever a firm is a price-taker, its marginal revenue curve (MR) is a horizontal line at the market price. D. When is production profitable? 1. If TR > TC, the firm is profitable. If TR = TC, the firm breaks even. If TR ATC, the firm is profitable. If P = ATC, the firm breaks even. If P < ATC, the firm incurs a loss. 4. Total profit can be expressed in terms of profit per unit. a. Profit = TR – TC = (TR/Q – TC/Q) × Q. b. Equivalently, Profit = (P – ATC) × Q. 5. The break-even price of a price-taking firm is the market price at which it earns zero profits. This is illustrated in text Figure 12-2, shown next. 6. The rule for determining whether a producer of a good is profitable depends on a comparison of the market price of the good to the producer’s break-even price—its minimum average total cost. a. Whenever market price exceeds minimum average total cost, the producer is profitable. b. Whenever the market price equals minimum average total cost, the producer breaks even. c. Whenever market price is less than minimum average total cost, the producer is unprofitable. E. The short-run production decision 1. Fixed cost is irrelevant to the firm’s optimal short-run production. 2. A firm will cease production in the short run if the market price falls below the shut-down price, which is equal to minimum average variable cost. 3. When market price exceeds a firm’s minimum average variable cost, the price-taking firm produces the quantity of output at which marginal cost equals price. 4. The short-run individual supply curve shows how an individual producer’s optimal output quantity depends on the market price, taking fixed cost as given. a. The short-run individual supply curve corresponds to the marginal cost curve at market prices above the shut-down price. F. Changing fixed cost 1. Fixed cost matters in the long run. 2. In most perfectly competitive industries, the number of producers, although fixed in the short run, changes in the long run as firms enter or leave an industry. 3. In the long run, a firm will exit the industry if price is less than minimum average total cost. If price exceeds minimum average total cost, a firm will remain in the industry; in addition, other firms will enter. III. The Industry Supply Curve A. The industry supply curve shows the relationship between the price of a good and the total output of the industry as a whole. B. The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price, given a fixed number of producers. 1. There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given. C. The long-run industry supply curve 1. A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur. a. In the long-run market equilibrium, no producer has an incentive to enter or exit. 2. The long-run industry supply curve shows how the quantity supplied responds to the price once producers have had time to enter or exit the industry. a. The long-run industry supply curve is often horizontal, although it may be upward sloping when a necessary input is in limited supply. b. The long-run industry supply curve is always more elastic than the short-run industry supply curve because of the entry and exit of producers. 3. In practice, we see that an increase in demand initially leads to a large price increase. However, if the long-run industry supply curve is horizontal, prices return to their initial level once new firms have entered the industry. 4. In reverse, a fall in demand reduces prices in the short run. If the long-run industry supply curve is horizontal, prices return to their initial level as producers exit the industry. D. The cost of production and efficiency in long-run equilibrium 1. In a perfectly competitive industry in equilibrium, the value of marginal cost is the same for all firms. 2. In a perfectly competitive industry with free entry and exit, each firm will have zero economic profits in long-run equilibrium. 3. The long-run market equilibrium of a perfectly competitive industry is efficient. Case Studies in the Text Economics in Action Pay for Delay—This EIA uses the pharmaceutical industry to illustrate what happens when a market becomes competitive (a drug patent expires). Ask students the following questions: 1. Why are the prices of generic drugs so much cheaper after they come off a patent? (The entry of new producers shifts the supply curve to the right, causing the market price to fall.) 2. Pharmaceutical firms often attempt to extend a patent period for a specific good. Why? (To maintain positive profits.) Farmers Know How—This EIA uses the corn market and ethanol production as examples of how perfectly competitive markets respond to changes in the market. Ask students the following questions: 1. How did farmers respond to increases in the price of corn as a result of the 2005 Energy Policy Act? (They planted corn rather than other crops like cotton.) 2. In the long run, how did the Energy Policy Act affect individual farmers’ profits? (Both marginal cost and price went up.) Thirsty? From Global Wine Glut to Shortage—This EIA discusses oversupply in the wine industry from 2004–2010, followed by a shortage in 2012. Ask students the following questions: 1. Why was there an oversupply of wine from 2004–2010? (Large global harvest and decline in demand due to the Great Recession.) 2. Why was there a shortage in 2012? (A decline in wine production capacity, a bad weather year, and an increase in demand.) For Inquiring Minds What’s a Standardized Product?—This FIM explains what it means for a product to be “standardized.” The definition of a standardized product is contrasted with the definition of a differentiated product. Business Case Bricks-and-Mortar Retailers Go Toe to Toe with Mobile Shopping Apps—This business case discusses apps like BuyVia and Google Shopping which allow you to immediately compare the price in the store with the price of the same good at other locations and to purchase the product online. The practice of “showrooming,” where customers look at goods in the store and then buy online to get a cheaper price, has led stores to adopt new marketing strategies in order to encourage consumers to buy in the store rather than online. Web Resources Investopedia gives students an overview of market structure basics from an investment perspective: http://www.investopedia.com/university/economics/economics6.asp. This website provides a “free, multiplayer, online, business strategy game.” http://www.perfectcompetition.net/. Handout 12-1 Date _________ Name ____________________ Class ________ Professor ________________ Maximizing Profit Part 1 Complete column (1) in the table below. Q TR (1) MR TC (2) MC (3) Total profit 0 0 — 20 — 1 30 40 2 60 56 3 90 76 4 120 105 5 150 130 6 180 170 1. What do the abbreviations Q, TR, and TC stand for? 2. How much is the company’s fixed cost? 3. What price does the company face in the market? 4. Calculate total profits at every output level. 5. What quantity will maximize profits? Part 2 Complete columns (2) and (3) in the table above. 1. What do the abbreviations MR and MC stand for? 2. Define MR and MC. 3. Calculate MR and MC to complete the table. 4. Based on the optimal output rule, what quantity will maximize profits? Answers Part 1 Complete column (1) in the table below. Q TR (1) MR TC (2) MC (3) Total profit 0 0 — 20 — –20 1 30 30 40 20 –10 2 60 30 56 16 +4 3 90 30 76 20 14 4 120 30 105 29 19 5 150 30 130 30 20 6 180 30 170 40 10 1. What do the abbreviations Q, TR, and TC stand for? Quantity, Total Revenue, and Total Cost 2. How much is the company’s fixed cost? $20 3. What price does the company face in the market? $30 4. Calculate total profits at every output level. See table 5. What quantity will maximize profits? Q = 5 Part 2 Complete columns (2) and (3) in the table above. 1. What do the abbreviations MR and MC stand for? Marginal Revenue and Marginal Cost 2. Define MR and MC. Marginal revenue is the change in total revenue generated by an additional unit of output. Marginal cost is the change in total cost generated by an additional unit of output. 3. Calculate MR and MC to complete the table. See table. 4. Based on the optimal output rule, what quantity will maximize profits? Q = 5 Handout 12-2 Date _________ Name _______________________ Class ________ Professor ________________ A Perfectly Competitive Industry? Are the following industries perfectly competitive? Why or why not? • Fast-food industry • Cellular telephone service • The U.S. stock market • Wholesale flowers • eBay Answers • Fast-food industry (There are many sellers, but consumers view each seller’s product as unique.) • Cellular telephone service (There are a few sellers in this market.) • The U.S. stock market (There are thousands of sellers of a particular company’s common stock, and each share of a company’s common stock is the same, so the market is perfectly competitive.) • Wholesale flowers (The market is perfectly competitive because there are many sellers, and buyers view the products as identical.) • eBay (eBay is one firm among other online auction sites and is therefore not an industry. It allows sellers to auction off a variety of products for a fee. Within most product categories, the items have distinguishing features.) Handout 12-3 Date _________ Name _____________________ Class ________ Professor ________________ Constructing an Industry Supply Curve A competitive firm has the following short-run total cost. Quantity Total cost Marginal cost Variable cost Average variable cost SR Industry Supply 0 $10 1 20 2 26 3 36 4 50 5 68 6 90 The market demand for this product is as follows: Price Quantity demanded Firm supply SR industry supply $12 200 3 300 10 300 3 300 8 400 2 200 6 500 2 200 4 600 0 0 1. Complete the table on costs. 2. How much is the fixed cost? 3. Calculate the firm’s supply at each possible price. 4. There are 100 firms in this industry and all have identical costs. Construct the short-run industry supply curve. In the same diagram, draw in the demand curve. 5. What is the market price? Equilibrium quantity? 6. Will there be entry or exiting of firms? Answers A competitive firm has the following short-run total cost. Quantity Total cost Marginal cost Variable cost Average variable cost 0 $10 -- 0 1 20 10 10 10 2 26 6 16 8 3 36 10 26 8.67 4 50 14 40 12.50 5 68 18 58 13.6 6 90 22 80 15 The market demand for this product is as follows: Price Quantity demanded Firm supply SR industry supply $12 200 3 300 10 300 3 300 8 400 2 200 6 500 2 200 4 600 0 0 1. Complete the table on costs. See table. 2. How much is the fixed cost? ($10.) 3. Calculate the firm’s supply at each possible price. 4. There are 100 firms in this industry and all have identical costs. Calculate the short-run industry supply curve. 5. What is the market price? Equilibrium quantity? ($10; 300.) 6. Will there be entry or exiting of firms? (Firms will exit because each firm earns a loss of $2 per unit: $10 minus ATC of $12 per unit.) Instructor Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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