A Firms Production

Dr. Katherine Sauer Principles of Microeconomics ECO 2020

Overview: I. II. III. IV. Deciding Whether or Not to Produce Deciding How Much to Produce The Firms Supply Curve Deciding to Exit an Industry

At the most basic level, an existing firm has the following decisions to make: - whether to produce or not (short run) - how much to produce - what price to charge - whether to exit the industry or not (long run)

(The price to charge depends on what kind of competition a firm faces we will learn about this later.)

In certain circumstances, a firm will decide to shut down and produce zero output. There is a difference between a temporary shutdown of a firm and an exit from the market. A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to a long-run decision to leave the market.

One important difference is that, when a firm shuts down temporarily, it still must pay fixed costs. If a firm exits the industry in the long run, it has no costs.

I. The Decision to Shut Down or Produce If a firm shuts down and produces a quantity of zero, it will - earn no revenue - have no variable costs - still have to pay fixed costs Therefore, a firm will shut down if the revenue that it would get from producing is less than its variable costs of production: Shut down if TR < TVC

Remember that TR = P x Q

and TVC = AVC x Q.

We can re-write the shutdown rule as: TR < TVC P x Q < AVC x Q P < AVC

So, when the market price is less than the average variable cost, a firm will choose to shut down temporarily. This firm will be earning a loss equal to its total fixed cost. profits = - total fixed cost

If the market price is greater than or equal to the average variable cost, then the firm will choose to produce. Produce if P > AVC

This firm will be earning profits of: profits = TR TC profits = P x Q ATC x Q profits = (P ATC)Q

Ex: Suppose a firm produces 300 units of output. If the market price is $2 and the average total cost is $1.50, then calculate this firms profits. profit = TR TC = (P ATC)Q profit = (2 1.50)(300) profit = (0.50)(300) profit = $150

Ex: Suppose a firm produces 1000 units of output. If the market price is $5 and the firms total cost is $7000, then calculate this firms profits. profit = TR TC = (P ATC)Q 2 approaches: 1) since we are given TC information, calculate TR 2) calculate ATC from TC profit = TR TC TR = P x Q = (5)(1000) = 5000 profit = 5000 7000 profit = - $2000 profit = (P ATC)Q ATC = TC / Q = 7000/1000 = $7 profit = (5 7)(1000) profit = (-2)(1000) profit = - $2000

Ex. Suppose that a firm is producing 100 units of output. The market price is $2, the average variable cost is $5 and the average total cost is $7. Calculate this firms profit or loss. If you were an economic advisor to this firm, what advice would you give them? profit = TR TC = (P ATC)Q profit = (2 7)100 profit = (-5)100 profit = $-500 Since the price is less than the average variable cost, we would advise that this firm temporarily shut down. It would then earn a loss equal to its total fixed costs. To calculate the TFC, we could first find the AFC. ATC = AFC + AVC 7 = AFC + 5 2 = AFC

If AFC = 2, then TFC = AFC = TFC / Q 2 = TFC / 100 200 = TFC This firm would earn a loss of $200 if it shut down. It would be better to shut down and lose $200 than to keep producing and lose $500.

Ex. Suppose a firm is producing 1000 units of output. The market price is $5, the average variable cost is $2 and the average total cost is $7. Calculate this firms profit or loss. If you were an economic advisor to this firm, what advice would you give them? profit = TR TC = (P ATC)Q profit = (5 7)1000 profit = (-2)1000 profit = $-2000 Since the price is greater than the average variable cost, we would advise that this firm to keep producing even though they are earning a loss. Over the long run, if they continue to earn losses, we would suggest they exit the industry.

Suppose you were not the only consultant this firm contacted. The advice they got from another advisor is to temporarily shut down. Explain to the firm why this advisor is incorrect. If the firm shuts down, it will earn a loss equal to its fixed costs. To calculate the TFC, we could first find the AFC. ATC = AFC + AVC 7 = AFC + 2 5 = AFC If AFC = 5, then TFC = AFC = TFC / Q 5 = TFC / 1000 5000 = TFC

This firm would earn a loss of $5000 if it shut down. If it keeps producing it would earn a loss of $2000. Since the price exceeds the average variable cost, it is better for this firm to keep operating than to temporarily shut down. In the long run, it may decide to exit the industry.

II. How much to produce? The firm will weigh the additional benefits and additional costs of increasing output. If the marginal revenue of producing an additional unit of output exceeds the marginal cost of producing it, then the firm could increase profits by increasing production. If MR > MC then increase production.

MR = change in TR change in Q

MC = change in TC change in Q

If at a given level of output the marginal revenue is less than the marginal cost, reduce production in order to increase profits. If MR < MC then decrease production.

When marginal revenue and marginal cost are equal, this is the profit maximizing level of output for a firm. If MR = MC then the level of output will result in the maximum level of profits.

This is known as the profit maximization rule. Produce the level of output where marginal revenue and marginal costs are equal.

Quantity 0 1 2 3 4 5

Total Revenue 0 14 26 36 44 50

Total Cost 8 11 16 26 39 57

Marginal Revenue ---14-0 / 1-0 = 14 26-14 / 2-1=12 36-26 / 3-2=10 44-36 / 4-3=8 50-44 / 5-4=6

Marginal Cost ---11-8 / 1-0 =3 16-11 / 2-1 =5 26-16 / 3-2 =10 39-26 / 4-3 =13 57-39 / 5-4 = 18

Quantity Total Total Cost Revenue 0 1 2 3 4 5 0 14 26 36 44 50 0 8 16 26 39 57

Marginal Marginal Revenue Cost --14 12 10 8 6

Profit 0 8 = -8 14 11 = 3 26 16 = 10 36 26 = 10 44 39 = 5 50 57 = -7

> > = < <

--3 5 10 13 18

The profit maximizing rule tells us that profits will be at their maximum when the firm produces the level of output where marginal revenue and marginal cost are equal.

Sometimes due to the logistics of production, a firm cant change its output by only one unit. ex: must produce in 500 unit batches In this case, it may not be possible to produce the level of output that equalizes marginal revenue and marginal cost. ex: at 1500 units, MR > MC at 2000 units, MR < MC MR = MC at some amount between 1500 and 2000 units. But, the firm cant produce that exact amount. The firm would choose to produce 1500 units.

If a firm cant produce exactly where MR = MC, then it should produce at the last output level where MR > MC.

III. The Firms Supply Curve We have determined that a firm will choose to produce if: P > AVC We have determined that a firm will produce the level of output where: MR = MC We can combine this information to derive the firms supply curve.

When the market price is less than the average variable cost, the firm will temporarily shut down and produce a quantity of zero. The price corresponding to the minimum of the AVC is called the shutdown price.

Price, Marginal Revenue Marginal Cost

Shutdown Price p3 p2 p1 Q1=0 Q2=0 Q3=0

Average Variable Cost

quantity

At the shutdown price, P=AVC so the firm will choose to produce.

Price, Marginal Revenue Marginal Cost

The profit maximization rule says the firm will produce the level of output Shutdown Price where MR = MC.
p3

Average Variable Cost

Suppose that MR is equal to the shutdown price, the firm will produce Q4.

p2 p1 Q1=0 Q2=0 Q3=0 Q4

quantity

For any level of marginal revenue that is greater than or equal to the shutdown price, the profit maximizing quantity is found where MR intersects the MC curve.

Price, Marginal Revenue Marginal Cost

MR5

Shutdown Price p3 p2 p1 Q1=0 Q2=0 Q3=0 Q4 Q5

Average Variable Cost

quantity

We can now trace out the firms supply curve. An individual firms supply curve starts at the minimum of AVC and follows up its MC curve.

Price, Marginal Revenue

Supply Curve MR5

Marginal Cost

Shutdown Price p3 p2 p1 Q1=0 Q2=0 Q3=0 Q4 Q5

Average Variable Cost

quantity

Adding up individual firms supply curve will yield the market supply curve. Recall: When learning about the supply curve previously, we said it depends on production costs. We have now derived exactly how it relies on production costs.

IV. The Decision to Exit an Industry If a firm exits the market, it will earn no revenue, but it will have no costs either. Therefore, a firm will exit if the revenue that it would earn from producing is less than its total costs: exit if TR < TC Recall we can re-write this as: P x Q < ATC x Q P < ATC

Recall the profit formula: profit = TR TC profit = P x Q ATC x Q profit = (P ATC) Q When P < ATC, profits are negative. Over the long run, we would expect a firm with consistent losses to exit the industry. When P = ATC, profits are zero (normal profits). When P > ATC, profits are positive. Over the long run, we would expect firms to enter an industry with positive profits.

Price, Marginal Revenue

When P = ATC, profits are zero and a firm is breaking even. We call this price, the breakeven price.

Marginal Cost
Breakeven Price Shutdown Price

Average Total Cost Average Variable Cost

quantity

Price, Marginal Revenue

Because in the long run, firms will exit the industry if they are earning losses, the long run supply curve starts at the minimum of ATC, not at the minimum of AVC.

Long Run Supply Breakeven Price Shutdown Price

Marginal Cost Average Total Cost

Average Variable Cost

quantity

Summary: A firm will choose to produce if P > AVC. This firm will produce the amount of output that maximizes profit. MR = MC determines the of output. This firm may be earning a profit or loss. If P > ATC, profit. If P = ATC, break even. If P < ATC, loss. A firm will temporarily shut down if P < AVC. This firm will produce a quantity of zero. This firm will earn a loss equal to fixed costs.

A firm will exit the industry if it consistently earns losses. If P < ATC, profits are negative, exit the industry in the long run. This firm will earn no revenue and incur no costs. A firm will stay in the industry as long as P > ATC. When an industry consistently has positive profits, new firms will want to enter that market.

A firms short run supply curve starts at the minimum of AVC and follows up the MC curve.

A firms long run supply curve starts at the minimum of ATC and follows up the MC curve. The market supply curve is found by adding up all of the individual firms supply curves.