Reviewing

Production
1

Three Stages of Returns

Stage I: Increasing Marginal Returns

MP rising. TP increasing at an increasing rate.
Why? Specialization.
Total
Product
Total
Product

Quantity of Labor
Marginal
and
Average
Product

Average Product

Marginal Product

Quantity of Labor

Three Stages of Returns

Stage II: Decreasing Marginal Returns

MP Falling. TP increasing at a decreasing rate.
Why? Fixed Resources. Each worker adds less and less.
Total
Product
Total
Product

Quantity of Labor
Marginal
and
Average
Product

Average Product

Marginal Product

Quantity of Labor

Three Stages of Returns

Stage III: Negative Marginal Returns
MP is negative. TP decreasing.
Workers get in each others way

Total
Product
Total
Product

Quantity of Labor
Marginal
and
Average
Product

Average Product

Marginal Product

Quantity of Labor

The Law of Diminishing Marginal Returns is NOT

the results of laziness, it is the result of limited
5
fixed resources.

Identify the three stages of returns

# of Workers Total Product(TP)
PIZZAS
(Input)

0
1
2
3
4
5
6
7
8

0
10
25
45
60
70
75
75
70

Marginal
Product(MP)

Average
Product(AP)

10

10

15

12.5

20

15

15

15

10

14

12.5

10.71

-5

8.75

Accountants vs. Economists

Accountants look at only EXPLICIT COSTS
Explicit costs (out of pocket costs) are payments paid by
firms for using the resources of others.
Example: Rent, Wages, Materials, Electricity Bills
Accounting
Profit

Total
Revenue

Accounting Costs
(Explicit Only)

Economists examine both the EXPLICIT COSTS and the

IMPLICIT COSTS
Implicit costs are the opportunity costs that firms pay for
using their own resources
Example: Forgone Wage, Forgone Rent, Time

Economic
Profit

Total
Revenue

Economic Costs
(Explicit + Implicit)

Accountants vs. Economists

Accountants look at only EXPLICIT COSTS
Explicit costs (out of pocket costs) are payments paid by
firms for using the resources of others.
Example: Rent, Wages, Materials, Electricity Bills
Accounting
Profit

Total
now
on,
Revenue

From
all Accounting
costs Costs
(Explicit Only)
are automatically
Economists examine both the EXPLICIT COSTS and the
IMPLICIT COSTS
ECONOMIC COSTS

Implicit costs are the opportunity costs that firms pay for
using their own resources
Example: Forgone Wage, Forgone Rent, Time

Economic
Profit

Total
Revenue

Economic Costs
(Explicit + Implicit)

Different Economic Costs

Total Costs
FC = Total Fixed Costs
VC = Total Variable Costs
TC = Total Costs
Per Unit Costs
AFC = Average Fixed Costs
AVC = Average Variable Costs
ATC = Average Total Costs
MC = Marginal Cost

Definitions

Fixed Costs:
Costs for fixed resources that DONT change
with the amount produced
Ex: Rent, Insurance, Managers Salaries, etc.
Average Fixed Costs = Fixed Costs
Quantity
Variable Costs:
Costs for variable resources that DO change as
more or less is produced
Ex: Raw Materials, Labor, Electricity, etc.
Variable Costs
Average Variable Costs =
Quantity

10

Definitions
Total Cost:
Sum of Fixed and Variable Costs
Average Total Cost =

Total Costs
Quantity

Marginal Cost:
Additional costs of an additional output.
Ex: If the production of two more output
increases total cost from $100 to $120, the MC
$10
is _____.
Change in Total Costs
Marginal Cost =
Change in Quantity

11

TOTAL COSTS GRAPHICALLY

800
Costs (dollars)

700
600
500
400
300

Combining VC
With FC to get
Total Cost

TC
VC
Fixed Cost
What is the TOTAL
COST, FC, and VC
for producing 9
units?

200
100

FC

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
12

Per Unit Costs

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
100
100
100
100
100
100
100
100

TC
100
110
116
121
126
130
136
146

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 40.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
13

Per-Unit Costs (Average and Marginal)

Costs (dollars)

MC
12
11
10
9
8
7
6
5
4
3
2
1

ATC
AVC
How much does the
11th unit costs?

AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity

14

Per-Unit Costs (Average and Marginal)

Costs (dollars)

MC
12
11
10
9
8
7
6
5
4
3
2
1

ATC and AVC get closer

and closer but NEVER
touch

ATC
AVC
Average Fixed
Cost

AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity

15

Per-Unit Costs (Average and Marginal)

At output Q, what
area represents:
TC 0CDQ
VC
0BEQ
FC
0AFQ or BCDE

16

Costs (dollars)

Why is the MC curve U-shaped?

12
11
10
9
8
7
6
5
4
3
2
1

MC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity

17

Marginal Product

Relationship between Production and Cost

Why is the MC curve Ushaped?

MP
MC

Costs

Quantity of labor

Quantity of output

When marginal product is

increasing, marginal cost falls.
When marginal product falls,
marginal costs increase.
MP and MC are mirror images of
each other.

18

Why is the MC curve U-shaped?

The MC curve falls and then rises because of diminishing

marginal returns.
Example:
Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker ($10)
Workers Total Prod Marg Prod Total Cost Marginal Cost
0

13

19

23

25

26

19

Why is the MC curve U-shaped?

The MC curve falls and then rises because of diminishing

marginal returns.
Example:
Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker ($10)
Workers Total Prod Marg Prod Total Cost Marginal Cost
0

13

19

23

25

26

20

Why is the MC curve U-shaped?

The MC curve falls and then rises because of diminishing

marginal returns.
Example:
Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker (Wage = $10)
Workers Total Prod Marg Prod Total Cost Marginal Cost
0

$20

$30

13

$40

19

$50

23

$60

25

$70

26

$80

21

Why is the MC curve U-shaped?

The MC curve falls and then rises because of diminishing

marginal returns.
Example:
Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker ($10)
Workers Total Prod Marg Prod Total Cost Marginal Cost
0

$20

$30

10/5 = $2

13

$40

10/8 = $1.25

19

$50

10/6 = $1.6

23

$60

10/4 = $2.5

25

$70

10/2 = $5

26

$80

10/1 = $10

22

Why is the MC curve U-shaped?

The additional cost of the first 13 units produced falls because
workers have increasing marginal returns.
As production continues, each worker adds less and less to
production so the marginal cost for each unit increases.
Workers Total Prod Marg Prod Total Cost Marginal Cost
0

$20

$30

10/5 = $2

13

$40

10/8 = $1.25

19

$50

10/6 = $1.6

23

$60

10/4 = $2.5

25

$70

10/2 = $5

26

$80

10/1 = $10

23

Costs (dollars)

Aver
m

RelationshipMP
between Production and Cost
Quantity of labor
Why is the ATC curve UMC
shaped?
ATC
Quantity of output

When the marginal cost is below

the average, it pulls the average
down.
When the marginal cost is above
the average, it pulls the average
up.

The MC curve intersects the ATC curve at its lowest point.

Example:
The average income in the room is $50,000.
An additional (marginal) person enters the room: Bill Gates.
If the marginal is greater than the average it pulls it up.
Notice that MC can increase but still pull down the average.

24

Shifting Cost
Curves

25

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
100
100
100
100
100
100
100
100

TC
100
110
116
121
126
130
136
146

MC
10
6
5
3
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9

What if Fixed
Costs increase to
$200

26

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
100
100
100
100
100
100
100
100

TC
100
110
116
121
126
130
136
146

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
27

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
200
200
200
200
200
200
200
200

TC
100
110
116
121
126
130
136
146

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
28

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
200
200
200
200
200
200
200
200

TC
200
210
216
221
226
230
236
246

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9

Which Per Unit Cost Curves Change?

29

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
200
200
200
200
200
200
200
200

TC
200
210
216
221
226
230
236
246

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9

ONLY AFC and ATC Increase!

30

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
200
200
200
200
200
200
200
200

TC
200
210
216
221
226
230
236
246

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
200
110
8
100
58
7
66.6 30.3
6.5
50
31.5
6
40
26
6
33.3 22.67
6.6
28.6 20.9

ONLY AFC and ATC Increase!

31

Shifting Costs Curves

If fixed costs change ONLY AFC and ATC Change!

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
200
200
200
200
200
200
200
200

TC
200
210
216
221
226
230
236
246

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
200 210
8
100 108
7
66.6 73.6
6.5
50
56.5
6
40
46
6
33.3 39.3
6.6
28.6 35.2

MC and AVC DONT change!

32

Shift from an increase in a Fixed Cost

MC

Costs (dollars)

ATC1
ATC
AVC

AFC1
AFC
Quantity

33

Shift from an increase in a Fixed Cost

MC

Costs (dollars)

ATC1
AVC

AFC1
Quantity

34

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
100
100
100
100
100
100
100
100

TC
100
110
116
121
126
130
136
146

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9

What if the cost for

variable resources
increase

35

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
10
16
21
26
30
36
46

FC
100
100
100
100
100
100
100
100

TC
100
110
116
121
126
130
136
146

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
36

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
11
18
24
30
35
43
55

FC
100
100
100
100
100
100
100
100

TC
100
110
116
121
126
130
136
146

MC
10
6
5
5
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9
37

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
11
18
24
30
35
43
55

FC
100
100
100
100
100
100
100
100

TC
100
111
118
124
130
135
143
155

MC
10
6
5
3
4
6
10

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9

Which Per Unit Cost Curves Change?

38

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
11
18
24
30
35
43
55

FC
100
100
100
100
100
100
100
100

TC
100
111
118
124
130
135
143
155

MC
11
7
6
6
5
8
12

AVC AFC ATC

10
100
110
8
50
58
7
33.3 30.3
6.5
25
31.5
6
20
26
6
16.67 22.67
6.6
14.3 20.9

MC, AVC, and ATC Change!

39

Shifting Costs Curves

TP
0
1
2
3
4
5
6
7

VC
0
11
18
24
30
35
43
55

FC
100
100
100
100
100
100
100
100

TC
100
111
118
124
130
135
143
155

MC
11
7
6
6
5
8
12

AVC AFC ATC

11
100
110
9
50
58
8
33.3 30.3
7.5
25
31.5
7
20
26
7.16 16.67 22.67
7.8
14.3 20.9

MC, AVC, and ATC Change!

40

Shifting Costs Curves

If variable costs change MC, AVC, and ATC Change!

TP
0
1
2
3
4
5
6
7

VC
0
11
18
24
30
35
43
55

FC
100
100
100
100
100
100
100
100

TC
100
111
118
124
130
135
143
155

MC
11
7
6
6
5
8
12

AVC AFC ATC

11
100
111
9
50
59
8
33.3 41.3
7.5
25
32.5
7
20
27
7.16 16.67 23.83
7.8
14.3 22.1
41

Shift from an increase in a Variable Costs

MC1

Costs (dollars)

MC
ATC1
AVC1
ATC
AVC

AFC
Quantity

42

Shift from an increase in a Variable Costs

MC1

Costs (dollars)

ATC1
AVC1

AFC
Quantity

43

44

4 Market
Structures
Candy Markets Simulation

45

FOUR MARKET STRUCTURES

Perfect
Competition

Monopolistic
Competition

Oligopoly

Pure
Monopoly

Every product is sold in a market that can be

considered one of the above market
structures.
For example:
1. Market for restaurants in Lancaster area
2. Market for American Cars
3. Market for oil in 1900
4. Market for Strawberries
5. Market for Cereal
46

Perfect
Competition
47

FOUR MARKET STRUCTURES

Perfect
Competition

Monopolistic
Competition

Oligopoly

Pure
Monopoly

Imperfect Competition

Characteristics of Perfect Competition:

Examples of Perfect Competition: Avocado farmers,
sunglass huts, and hammocks in Mexico

Many small firms

Identical products (perfect substitutes)
No Control over Price (Price Takers)
Easy for firms to enter and exit the industry
Symmetric (same) information
Firms in ANY market structure will choose to
profit maximize

48

Law of One Price

In an efficient, perfectly competitive market, all
identical goods must have only one price.
Result: Each firm is a price taker. Firms have no
control of the price
Traffic Analogy
When there is heavy traffic,
why do all lanes seem to go the
same speed?
Cars leave slower lanes and
enter faster lanes.
Similarly, what happens in
perfectly competitive markets
if firms earn excessive profit? 49

50

Perfectly Competitive Firms

Example:
Say you go to Mexico to buy a hammock.
After visiting at few different shops you find that
the buyers and sellers always agree on $15.
This is the market price (where demand and
supply meet)
1. Is it likely that any shop can sell hammocks for $20?
2. Is it likely that any shop will sell hammocks for $10?
3. What happens if a shop prices hammocks too high?
4. Do you think that these firms make a large profit off
of hammocks? Why?
These firms are price takers because the sell their
products at a price set by the market.
51

Demand for Perfectly Competitive

Firms
Why are they Price Takers?
If a firm charges above the market price, NO
ONE will buy. They will go to other firms
There is no reason to price low because
consumers will buy just as much at the market
price.
Since the price is the same at all quantities
demanded, the demand curve for each firm is

Perfectly Elastic Demand

(A Horizontal straight line)
52

The Competitive Firm is a Price Taker

Price is set by the Industry
P

$15

Demand

$15

D
5000

Industry

Firm
(price taker)

Q
53

The Competitive Firm is a Price Taker

Price is set by the Industry
What is the additional
revenue for selling an P
additional unit?
1st unit earns $15
2nd unit earns $15
Marginal revenue is $15
constant at $15
Notice:
Total revenue increases
at a constant rate
MR equal Average
Revenue

Demand
MR=D=AR=P

Firm
(price taker)

Q
54

The Competitive Firm is a Price Taker

Price is set by the Industry
What is the additional
revenue for selling an P
additional unit?
For
Perfect
Competition:
1st unit
earns
$15
2nd unit earns $15
MR
=
D
=
AR
=
P
Demand
Marginal revenue is $15
constant at $15
MR=D=AR=P
Notice:
Total revenue increases
at a constant rate
MR equal Average
Revenue

Firm
(price taker)

Q
55

Maximizing
PROFIT!
56

Short-Run Profit Maximization

What is the goal of every business?
To Maximize Profit!!!!!!
To maximum profit, firms must make the
right output
Firms should continue to produce until the
additional revenue from each new output
equals the additional cost.
Example (Assume the price is $10)
Should you produce
if the additional cost of another unit is $5
if the additional cost of another unit is $9
if the additional cost of another unit is $11

57

Short-Run Profit Maximization

What is the goal of every business?
To Maximize Profit!!!!!!
To maximum profit firms must make the right
output
Firms should continue to produce until the
additional revenue from each new output
equals the additional cost.
Example (Assume the price is $10)
Should you produce
if the additional cost of another unit is $5
if the additional cost of another unit is $9
if the additional cost of another unit is $11

Profit Maximizing Rule

MR=MC

58

Lets put costs and revenue together

on a graph to calculate profit.

59

How much output should be produced?

How much is Total Revenue? How much is Total Cost?
Is there profit or loss? How much?
P
$9
MC
8
7
6
5
4
3
2
1

Profit = $18

Total Cost=$45
Total Revenue =$63

MR=D=AR=P
ATC
AVC
Dont forget
that averages
show PER UNIT
COSTS

1 2 3 4 5 6 7 8 9 10 Q

60

Suppose the market demand falls. What

would happen if the price is lowered from
$7 to $5?
The MR=MC rule still applies but now the
firm will make an economic loss.

The profit maximizing rule is also the

loss minimizing rule!!!

61

Cost and Revenue

How much output should be produced?

How much is Total Revenue? How much is Total Cost?
Is there profit or loss? How much?
MC

$9
8
ATC
7
6
AVC
Loss
=$7
5
MR=D=AR=P
4
3
2 Total Cost = $42
Total Revenue=$35
1
1 2 3 4 5 6 7 8 9 10 Q

62

Assume the market demand falls even

more. If the price is lowered from $5 to $4
the firm should stop producing.

Shut Down Rule:

A firm should continue to produce as long

as the price is above the AVC
When the price falls below AVC then the
firm should minimize its losses by shutting
down
Why? If the price is below AVC the firm is
losing more money by producing than they
would have to pay to shut down.
63

Cost and Revenue

SHUT DOWN! Produce Zero

$9
8
7
6
5
4
3
2
1

MC
ATC
AVC
Minimum AVC
is shut down
point
1 2 3 4 5 6 7 8 9 10 Q

64

P<AVC. They should shut down

Cost and Revenue

Producing nothing is cheaper than staying open.

$9
8
7
6
5
4
3
2
1

MC
ATC
Fixed Costs=$10

TC=$35

AVC
MR=D=AR=P

TR=$20
1 2 3 4 5 6 7 8 9 10 Q

65

Profit Maximizing Rule

MR = MC

Three Characteristics of MR=MC Rule:

1. Rule applies to ALL markets

structures (PC, Monopolies, etc.)
2. The rule applies only if price is
above AVC
3. Rule can be restated P = MC for
perfectly competitive firms (because
MR = P)

66

Practice
67

#1

Should the firm produce? Yes

What output should the firm produce? 10
What is TR at that output? What is TC? TR=$140
TC=$100
How much profit or loss? Profit=$40

$20
Cost and Revenue

MC
15
14

MR=D=AR= P
ATC
AVC

10
6
5
0

6 7

10

68

#2

What output should the firm produce? Zero Shutdown

(Price below AVC)
What is TR at MR=MC point?$45
What is TC at MR=MC point?$55
How much profit or loss? Loss=Only Fixed Cost $5

Cost and Revenue

$20

MC
ATC
AVC

15
11
10
9

MR=D=AR=P

5
0

69

What output should the firm produce? 6

What is TR at that output? $90
What is TC? $120
How much profit or loss? Loss= $30

#3
$40
Cost and Revenue

MC
30

ATC
20
19
15
10
0

AVC
MR=D=AR=P

70