wrapping up supply
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Wrapping up supply
Today: More on profit maximization, determinants
of supply, and surplus
Today… We make this
graph make intuitive sense
We will see that: Profits are positive
at price P1
Profits are negative at prices P2 and P3
Firms will shut down when price is P3
Profit maximization
Remember that this is our goal For the most part, we will
implement MB/MC analysis again Exception: Shutdown condition
If a firm can lose less by closing than opening, it will close
Costs
Cost to hire an employee is $100/day
Assume $1000 in fixed costs for a phone manufacturer per day Note average fixed cost (AFC)
decreases as the number of phones increases
Our output example for today
# of employees hired per day
Number of phones produced
0 0
1 20
2 45
3 55
4 63
5 67
Increasing returns? Notice that the marginal productivity
for the 1st worker is 20; 2nd worker, 25 Why?
Specialization Assembly line can help increase
marginal productivity up to a certain point
Marginal productivity eventually decreases
Cost table# of
empl./day
Phones per day
Fixed cost
($/day)
Var. cost ($/day)
Total cost
($/day)
MC ($/phone
)
0 0 1000 0 1000
1 20 1000 100 1100
2 45 1000 200 1200
3 55 1000 300 1300
4 63 1000 400 1400
5 67 1000 500 1500
How to calculate MC
Marginal cost (MC) is how much additional cost is necessary to produce an additional phone
For example, each additional phone from the 1st worker is cost to hire worker / # of phones
produced ($100/day) / (20 phones/day) =
$5/phone
Cost table# of
empl./day
Phones per day
Fixed cost
($/day)
Var. cost ($/day)
Total cost
($/day)
MC ($/phone
)
0 0 1000 0 1000
5.00
1 20 1000 100 1100
4.00
2 45 1000 200 1200
10.00
3 55 1000 300 1300
12.50
4 63 1000 400 1400
25.00
5 67 1000 500 1500
Suppose that phones sell for $18 each
How many people should be hired? Hire the next worker if the MB of
the next phone produced is at least as much as the MC
This is the same as finding the number of workers that maximizes profits
Marginal analysis: Hire 4 employees/day
# of empl./day
Phones per day
MB ($/phone) MC ($/phone)
0 0
18.00 5.00
1 20
18.00 4.00
2 45
18.00 10.00
3 55
18.00 12.50
4 63
18.00 25.00
5 67
How much profit? –$266# of
empl./dayPhones per day
Total rev. ($/day)
Total cost ($/day)
Profit ($/day)
0 0 0 1000 –1000
1 20 360 1100 –740
2 45 810 1200 –390
3 55 990 1300 –310
4 63 1134 1400 –266
5 67 1206 1500 –294
Shutdown condition Finally, we must check to see if the firm
is better off shutting down when profits are negative
If total revenue is less than total variable cost for all levels of output (Q), then the firm should shut down
This is equivalent to the firm making worse profits for all Q > 0 than for Q = 0
Shutdown condition check Profits are better
when 4 employees are hired (–$266) than when the firm shuts down (–$1000)
This firm stays in business
# of empl./da
y
Total cost
($/day)
Profit ($/day)
0 1000 –1000
1 1100 –740
2 1200 –390
3 1300 –310
4 1400 –266
5 1500 –294
Back to our graph We have finished a
discrete example Now, we will see
how we get the marginal cost (MC), average total cost (ATC), and average variable cost (AVC) curves
Marginal cost MC starts by
decreasing, then increases sharply
# of empl./day
MC ($/phone)
0
5.00
1
4.00
2
10.00
3
12.50
4
25.00
5
Average total cost ATC falls
initially, then eventually increases
# of empl./da
y
Phones per day
Total cost ($/day)
ATC ($/phone)
0 0 1000 N/A
1 20 1100 55
2 45 1200 26.67
3 55 1300 23.64
4 63 1400 22.22
5 67 1500 22.39
Average variable cost AVC falls
initially, then eventually increases
# of empl./da
y
Phones per day
VC ($/day)
AVC ($/phone)
0 0 0 N/A
1 20 100 5.00
2 45 200 4.44
3 55 300 5.45
4 63 400 6.35
5 67 500 7.46
ATC and AVC costs converge Note ATC = AVC + AFC Since AFC is decreasing
as Q increases, the difference between ATC and AVC gets smaller as Q increases
Thus, ATC and AVC curves get closer as Q increases
MC curve Remember: Marginal
means for an additional unit produced
If marginal is below average, this brings the average down
If marginal is above average, this brings the average up
MC curve
Marginal cost curve tells us how average cost curves (ATC and AVC) move
MC curve is below average cost curve when average cost curve is decreasing
MC curve is above average cost curve when average cost curve is increasing
Back to the graph All curves
decrease initially, but eventually increase
MC curve tells us which direction ATC and AVC curves are going
Back to the graph
At P1 positive profits, since TR > TC (P Q > ATC Q)
At P2 negative profits
At P3 firm shuts down (TR is less than VC for all Q)
Warning! Look at red circle This is a point
where P3 and MC curves intersect
Ignore these points on the MC curve that are downward-sloping, since profit is minimized here
Determinants of supply
Technology Input prices The number of suppliers Expectations of future prices Changes in the price of other
relevant products
Some examples If technology improves or input prices
decrease, production becomes less costly
If the number of suppliers increases, we can horizontally add the additional supply to the market
If the price of calculators increases, some phone suppliers may devote more of its capital to producing calculators
Producer surplus
Producer surplus is similar conceptually to consumer surplus
For a unit or service sold, producer surplus is the difference between the price paid and the minimum payment the seller is willing to accept for it
Example of producer surplus When P = 25 per
unit, shaded area is approximate producer surplus
Area is a triangle, one-half times length times height: 0.5 10 25 = 125
Why are CS and PS important?
Consumer surplus (CS) and producer surplus (PS) are important since these measures give us a crude measure of the total benefits to society
Next week, we will see situations in which total surplus can be reduced
This concludes supply Important things to remember with
supply Individual and market supply Steps to profit maximization
Useful to know individual firm supply, production function, FC, VC, TC, MC, AFC, AVC, ATC, shutdown condition
Determinants of supply Producer surplus
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