ECON 0100 Lecture 5: Lecture 5
Marginal Analysis for Firms
Recall
Marginal analysis is used for "how much" decision
How many units of a good to produce
□
How many units of a good to purchase
□
§
○
For the optimal decision, we need to compare the increasing cost
(marginal costs) and increasing benefits (marginal benefits) associated
with each additional unit.
○
Optimal Choice
The largest quantity such that the marginal benefits are still greater
then or equal to marginal costs.
§
○
•
Costs & Profits
There are 2 types of costs
Explicit Costs
Amount of money paid for a good or service
□
§
Implicit Costs
Like opportunity costs
□
§
○
Unless otherwise specified, "costs" in this class will always include BOTH
implicit and explicit costs.
○
Firm's optimization problem: find the quantity to maximize profit
○
There are 2 types of profit
Accounting Profit
Total Revenue - Explicit Costs
□
§
Economic Profit
Total Revenue - Explicit Costs - Implicit Costs
□
§
○
When making decisions, economic profit is what matters!
In this class, when we talk about profit, we will always mean
economic profit, unless stated otherwise.
§
○
•
Example
Alice made $100 selling crafts on Etsy. She spent $60 on supplies. With
the time she spent making crafts, she could have instead earned $40
working part-time. Find the following:
Explicit Cost:
§
Implicit Cost:
§
Accounting Profit:
§
Economic Profit:
§
○
IMPORTANT!!
$0 economic profit is not a bad deal.
§
Why?
Because it means that you are working as well as your other
best alternative.
□
§
○
•
Marginal Analysis & Firm's Problem
The firm's problem: what quantity to produce to maximize economic profit
is a how much decision.
○
This means we need to apply marginal analysis.
○
Two things to consider
Marginal Revenue (Benefit)
§
Marginal Cost
§
○
Example
○
Quantity
Total Cost
Marginal Cost
Total Revenue
Marginal Revenue
0
1
0
1
6
9
2
12
17
3
19
24
4
27
30
Find the optimal quantity for the firm to produce.
Answer: Q* = _____
□
§
•
Marginal Cost & Marginal Benefit Curves
The graph of marginal costs is called marginal cost curve & the graph of
marginal benefits is called the marginal benefit curve.
○
Example (using data from the table)
○
•
Inputs, Production, & Costs
The production function shows us the mathematical relationship between
the inputs used by a firm and the output produced.
Example: Q = 10LK, where L is labor & K is capital (machines).
§
○
Inputs
The items used to produce a good or service.
§
○
There are two types of inputs:
Fixed Inputs
Quantity cannot be changes in the time horizon considered
□
Examples: machine to produce, rent
□
§
Variable Inputs
Quantity can be changed
□
Examples: labor
□
§
○
Two types of horizon:
Short Run
At least one input fixed
□
§
Long Run
All inputs can be changed
□
§
○
•
Inputs, Production, & Costs EXAMPLE
Bob decided to open a bagel café. He has a yearly lease on the building he
is going to use to run the café. In addition to the building, his inputs are
labor, tools, and ingredients for making bagels (all of them can be easily
adjusted).
What inputs are fixed in the short run?
§
○
What inputs are variable in the short run?
§
How far off is the long run?
§
What inputs are fixed in the long run?
§
•
Total Product Curve
Shows how the quantity of output produced depends on the quantity of a
given variable input (holding the quantity of all other inputs fixed).
○
The Marginal Product of an input is ________________________________.
Example: MP of the 3rd worker is ___, MP of the 4th worker is ____.
§
○
More general: the marginal product of input X is given by
§
○
•
Diminishing Returns to an Input
Occurs when marginal product begins to decrease.
Each unit of input causes les increase in total product than the
previous unit.
§
When the slope starts getting smaller.
§
○
Example
Think about the effectiveness of extra workers in a small café. If
more workers are employed, production could increase but more and
more slowly.
§
○
•
From Inputs to Costs
IDEA
Using what we know about the cost of various inputs and the
production function for a given firm, we can pin down the
relationship between quantities produced (output) and costs.
§
○
Two types of costs
Fixed Costs
Doesn't change as Q changes
□
Cost of fixed inputs
□
§
Variable Costs
Changes as Q changes
□
§
○
Total Costs = Fixed Costs + Variable Costs
○
Using the same product function as before, we have the following
information
Weekly wages are $200/worker
§
Rent (a fixed cost) is $400/week
§
Number of
Workers
Quantity
Produced
Variable
Cost
Fixed
Cost
Total
Cost
0
0
1
20
2
50
3
70
4
85
5
90
The TC curve eventually becomes steeper as quantity increases as a
result of diminishing marginal returns to labor
§
○
More generally, the marginal cost could be calculated by the following
○
•
§
Understanding the shape of the MC curve:
When there are DECREASING returns to an input, _________________.
That is because decreasing returns means that each additional
unit we produce takes more inputs to produce than the
previous one.
□
§
When there are INCREASING returns to an input, _________________.
At low quantities of production due to increasing specialization.
□
§
When there are CONSTANT returns to an input, ___________________.
§
○
Example of a Marginal Cost Curve
•
Average Costs
Average Variable Cost (AVC)
The variable cost per unit of output produced
§
○
Average Fixed Cost (AFC)
The fixed cost per unit of output produced
§
○
Average Total Cost (ATC)
The total cost per unit of output produced
§
○
•
What affects the shape of ATC?
Spreading Effect
As Q INCREASE, FC is spread over more and more units causing AFC
to DECREASE, thus ATC DECREASES.
§
○
Diminishing Returns Effect
As Q INCREASES, more and more variable inputs are needed to
produce an additional unit (die to diminishing returns), causing AVC
to INCREASE, thus ATC INCREASES
§
○
•
Putting It All Together
MC ___ at first, and then ___ once diminishing returns set in.
○
MC goes through __________________.
○
AFC is the vertical distance between _____ and _____.
○
Since AFC ___ for all Q, AFC get ________ together as Q ___.
○
•
Practice Problem
Use the graph and what you know about costs to do the following.
○
•
Cost in the Long Run
In the long run, no inputs are fixed and firms will be able to choose their
fixed cost based on the output they expect to produce in the near future.
○
As an example, think of a firm choosing different factory sizes:
Small Factory:
§
Large Factory:
§
○
•
Short-Run & Long-Run ATC Curves
•
Increasing Return to Scale:
○
Constant Return to Scale:
○
Decreasing Return to Scale:
○
PROFIT MAXIMIZING RULE:
Produce where ________
Number of
Workers
Quantity
Produced
0
0
1
20
2
50
3
70
4
85
5
90
Notice, that MC goes through the minimum
point of the ATC curve.
If MC<ATC, additional unit decrease ATC.
○
If MC>ATC, additional unit increase ATC.
○
•
Mark the quantity when
diminishing returns set in.
•
What is the TC when Q = 6?
•
What is the AFC when Q = 6?
•
What is the total FC?
•
Perfect Competition
In the perfect competition market, all consumers and all producers are
_____________. This means that, no single individual's actions can affect the
market price.
○
Conditions for Perfect Competition:
Many buyers and sellers
No individual seller has a large market share.
□
§
Standardizing product (i.e. commodity)
Consumers regard products of different producers as the same good.
□
Example (Commodity):
□
Example (Not a Commodity):
□
§
Free Entry and exit
Nothing preventing producers from entering
□
No additional cost associating with exit
□
§
○
•
Marginal Revenue for a Perfect Competitive Firm
Recall: Marginal Revenue is the ___________.
○
Perfect competitive firms are _______________. Thus, these firms receive the
_______ regardless of how much they sell.
○
As a result, the marginal revenue for a perfect competitive firm is equal to
_______ for all quantity produces.
○
Thus, there is a CONSTANT MR for a perfect competitive firm.
○
•
Decision Making for a Perfectly Competitive Firm: Short-Run
Firms decision: select __________ to maximize ___________.
○
Remember the Profit Maximizing Rule:
Optimal quantity is the largest quantity such that MR ≥ MC
§
○
For perfectly competitive firms, this means ____________.
○
•
Using Marginal Analysis to Find Profit-Maximizing Quantity
•
Perfectly Competitive Firm's Profit
In order to learn more about our representative firm, we need to add more
information to our graph. This is where the additional cost curves become
useful.
○
•
Recall:
Profit =
Total Revenue =
Total Cost =
Lecture 5
Monday,*June*4,*2018
3:05*PM
Marginal Analysis for Firms
Recall
Marginal analysis is used for "how much" decision
How many units of a good to produce
□
How many units of a good to purchase
□
§
○
For the optimal decision, we need to compare the increasing cost
(marginal costs) and increasing benefits (marginal benefits) associated
with each additional unit.
○
Optimal Choice
The largest quantity such that the marginal benefits are still greater
then or equal to marginal costs.
§
○
•
Costs & Profits
There are 2 types of costs
Explicit Costs
Amount of money paid for a good or service
□
§
Implicit Costs
Like opportunity costs
□
§
○
Unless otherwise specified, "costs" in this class will always include BOTH
implicit and explicit costs.
○
Firm's optimization problem: find the quantity to maximize profit
○
There are 2 types of profit
Accounting Profit
Total Revenue - Explicit Costs
□
§
Economic Profit
Total Revenue - Explicit Costs - Implicit Costs
□
§
○
When making decisions, economic profit is what matters!
In this class, when we talk about profit, we will always mean
economic profit, unless stated otherwise.
§
○
•
Example
Alice made $100 selling crafts on Etsy. She spent $60 on supplies. With
the time she spent making crafts, she could have instead earned $40
working part-time. Find the following:
Explicit Cost:
§
Implicit Cost:
§
Accounting Profit:
§
Economic Profit:
§
○
IMPORTANT!!
$0 economic profit is not a bad deal.
§
Why?
Because it means that you are working as well as your other
best alternative.
□
§
○
•
Marginal Analysis & Firm's Problem
The firm's problem: what quantity to produce to maximize economic profit
is a how much decision.
○
This means we need to apply marginal analysis.
○
Two things to consider
Marginal Revenue (Benefit)
§
Marginal Cost
§
○
Example
○
Quantity
Total Cost
Marginal Cost
Total Revenue
Marginal Revenue
0
1
0
1
6
9
2
12
17
3
19
24
4
27
30
Find the optimal quantity for the firm to produce.
Answer: Q* = _____
□
§
•
Marginal Cost & Marginal Benefit Curves
The graph of marginal costs is called marginal cost curve & the graph of
marginal benefits is called the marginal benefit curve.
○
Example (using data from the table)
○
•
Inputs, Production, & Costs
The production function shows us the mathematical relationship between
the inputs used by a firm and the output produced.
Example: Q = 10LK, where L is labor & K is capital (machines).
§
○
Inputs
The items used to produce a good or service.
§
○
There are two types of inputs:
Fixed Inputs
Quantity cannot be changes in the time horizon considered
□
Examples: machine to produce, rent
□
§
Variable Inputs
Quantity can be changed
□
Examples: labor
□
§
○
Two types of horizon:
Short Run
At least one input fixed
□
§
Long Run
All inputs can be changed
□
§
○
•
Inputs, Production, & Costs EXAMPLE
Bob decided to open a bagel café. He has a yearly lease on the building he
is going to use to run the café. In addition to the building, his inputs are
labor, tools, and ingredients for making bagels (all of them can be easily
adjusted).
What inputs are fixed in the short run?
§
○
What inputs are variable in the short run?
§
How far off is the long run?
§
What inputs are fixed in the long run?
§
•
Total Product Curve
Shows how the quantity of output produced depends on the quantity of a
given variable input (holding the quantity of all other inputs fixed).
○
The Marginal Product of an input is ________________________________.
Example: MP of the 3rd worker is ___, MP of the 4th worker is ____.
§
○
More general: the marginal product of input X is given by
§
○
•
Diminishing Returns to an Input
Occurs when marginal product begins to decrease.
Each unit of input causes les increase in total product than the
previous unit.
§
When the slope starts getting smaller.
§
○
Example
Think about the effectiveness of extra workers in a small café. If
more workers are employed, production could increase but more and
more slowly.
§
○
•
From Inputs to Costs
IDEA
Using what we know about the cost of various inputs and the
production function for a given firm, we can pin down the
relationship between quantities produced (output) and costs.
§
○
Two types of costs
Fixed Costs
Doesn't change as Q changes
□
Cost of fixed inputs
□
§
Variable Costs
Changes as Q changes
□
§
○
Total Costs = Fixed Costs + Variable Costs
○
Using the same product function as before, we have the following
information
Weekly wages are $200/worker
§
Rent (a fixed cost) is $400/week
§
Number of
Workers
Quantity
Produced
Variable
Cost
Fixed
Cost
Total
Cost
0
0
1
20
2
50
3
70
4
85
5
90
The TC curve eventually becomes steeper as quantity increases as a
result of diminishing marginal returns to labor
§
○
More generally, the marginal cost could be calculated by the following
○
•
§
Understanding the shape of the MC curve:
When there are DECREASING returns to an input, _________________.
That is because decreasing returns means that each additional
unit we produce takes more inputs to produce than the
previous one.
□
§
When there are INCREASING returns to an input, _________________.
At low quantities of production due to increasing specialization.
□
§
When there are CONSTANT returns to an input, ___________________.
§
○
Example of a Marginal Cost Curve
•
Average Costs
Average Variable Cost (AVC)
The variable cost per unit of output produced
§
○
Average Fixed Cost (AFC)
The fixed cost per unit of output produced
§
○
Average Total Cost (ATC)
The total cost per unit of output produced
§
○
•
What affects the shape of ATC?
Spreading Effect
As Q INCREASE, FC is spread over more and more units causing AFC
to DECREASE, thus ATC DECREASES.
§
○
Diminishing Returns Effect
As Q INCREASES, more and more variable inputs are needed to
produce an additional unit (die to diminishing returns), causing AVC
to INCREASE, thus ATC INCREASES
§
○
•
Putting It All Together
MC ___ at first, and then ___ once diminishing returns set in.
○
MC goes through __________________.
○
AFC is the vertical distance between _____ and _____.
○
Since AFC ___ for all Q, AFC get ________ together as Q ___.
○
•
Practice Problem
Use the graph and what you know about costs to do the following.
○
•
Cost in the Long Run
In the long run, no inputs are fixed and firms will be able to choose their
fixed cost based on the output they expect to produce in the near future.
○
As an example, think of a firm choosing different factory sizes:
Small Factory:
§
Large Factory:
§
○
•
Short-Run & Long-Run ATC Curves
•
Increasing Return to Scale:
○
Constant Return to Scale:
○
Decreasing Return to Scale:
○
PROFIT MAXIMIZING RULE:
Produce where ________
Number of
Workers
Quantity
Produced
0
0
1
20
2
50
3
70
4
85
5
90
Notice, that MC goes through the minimum
point of the ATC curve.
If MC<ATC, additional unit decrease ATC.
○
If MC>ATC, additional unit increase ATC.
○
•
Mark the quantity when
diminishing returns set in.
•
What is the TC when Q = 6?
•
What is the AFC when Q = 6?
•
What is the total FC?
•
Perfect Competition
In the perfect competition market, all consumers and all producers are
_____________. This means that, no single individual's actions can affect the
market price.
○
Conditions for Perfect Competition:
Many buyers and sellers
No individual seller has a large market share.
□
§
Standardizing product (i.e. commodity)
Consumers regard products of different producers as the same good.
□
Example (Commodity):
□
Example (Not a Commodity):
□
§
Free Entry and exit
Nothing preventing producers from entering
□
No additional cost associating with exit
□
§
○
•
Marginal Revenue for a Perfect Competitive Firm
Recall: Marginal Revenue is the ___________.
○
Perfect competitive firms are _______________. Thus, these firms receive the
_______ regardless of how much they sell.
○
As a result, the marginal revenue for a perfect competitive firm is equal to
_______ for all quantity produces.
○
Thus, there is a CONSTANT MR for a perfect competitive firm.
○
•
Decision Making for a Perfectly Competitive Firm: Short-Run
Firms decision: select __________ to maximize ___________.
○
Remember the Profit Maximizing Rule:
Optimal quantity is the largest quantity such that MR ≥ MC
§
○
For perfectly competitive firms, this means ____________.
○
•
Using Marginal Analysis to Find Profit-Maximizing Quantity
•
Perfectly Competitive Firm's Profit
In order to learn more about our representative firm, we need to add more
information to our graph. This is where the additional cost curves become
useful.
○
•
Recall:
Profit =
Total Revenue =
Total Cost =
Lecture 5
Monday,*June*4,*2018
3:05*PM
