principles of microeconomics - production decision

8/3/2019 Principles of Microeconomics - Production Decision

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A Firm¶s Production

Dr. Katherine Sauer

Principles of Microeconomics

ECO 2020



Overview:

I. Deciding Whether or Not to ProduceII. Deciding How Much to Produce

III. The Firm¶s Supply Curve

IV. Deciding to Exit an Industry



At the most basic level, an existing firm has the followingdecisions 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 afirm 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, itwill

- 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 theaverage 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 firm¶s 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 firm¶s total cost is $7000, then

calculate this firm¶s profits.


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 firm¶s profit or loss. If you were an

economic advisor to this firm, what advice would you give them?


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



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 costis $7. Calculate this firm¶s profit or loss. If you were an economic

advisor to this firm, what advice would you give them?


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 areearning 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 + 25 = AFC

If AFC = 5, then TFC =

AFC = TFC / Q

5 = TFC / 10005000 = 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 additionalcosts of increasing output.

If the marginal revenue of producing an additional unit of

output exceeds the marginal cost of producing it, then thefirm could increase profits by increasing production.

If MR > MC then increase production.

MR = change in TR MC = change in TC

change in Q change in Q



If at a given level of output the marginal revenue is less

than the marginal cost, reduce production in order toincrease 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 marginalrevenue and marginal costs are equal.



Quantity Total Total Marginal Marginal

Revenue Cost Revenue Cost

0 0 8

1 14 11

2 26 16

3 36 26

4 44 39

5 50 57

----

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

----

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



Quantity Total Total Marginal Marginal Profit

Cost Revenue Revenue Cost

0 0 0 --- ---

1 14 8 14 3

2 26 16 12 5

3 36 26 10 10

4 44 39 8 13

5 50 57 6 18

0 ± 8 = -8

14 ± 11 = 3

26 ± 16 = 10

36 ± 26 = 10

44 ± 39 = 5

50 ± 57 = -7

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 can¶t

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 > MCat 2000 units, MR < MC

MR = MC at some amount between 1500 and 2000

units.

But, the firm can¶t produce that exact amount.

The firm would choose to produce 1500 units.



If a firm can¶t produce exactly where MR = MC, then it

should produce at the last output level where MR > MC.



III. The Firm¶s 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 firm¶s

supply curve.



Marginal

Cost

Price,

MarginalRevenue

quantity

Average

Variable Cost

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 AVCis called the

³shutdown price´.

Shutdown

Price

p1

Q1=0

p2

Q2=0

p3

Q3=0



Marginal

Cost

Price,

MarginalRevenue

quantity

Average

Variable Cost

At the shutdown price,

P=AVC so the firm

will choose to produce.

The profit

maximization rule says

the firm will producethe level of output

where MR = MC.

Suppose that MR isequal to the shutdown

price, the firm will

produce Q4.

Shutdown

Price

p1

Q1=0

p2

Q2=0

p3

Q3=0

Q4



Marginal

Cost

Price,

MarginalRevenue

quantity

Average

Variable Cost

For any level of marginal revenue that

is greater than or

equal to the shutdown

price, the profitmaximizing quantity

is found where MR

intersects the MC

curve.

Shutdown

Price

p1

Q1=0

p2

Q2=0

p3

Q3=0

Q4 Q5

MR5



Marginal

Cost

Price,

MarginalRevenue

quantity

Average

Variable Cost

We can now trace out

the firm¶s supply

curve.

An individual firm¶s

supply curve starts at

the minimum of AVC

and follows up itsMC curve.

Shutdown

Price

p1

Q1=0

p2

Q2=0

p3

Q3=0

Q4 Q5

MR5

Supply

Curve



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 productioncosts.



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 wouldearn 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 theindustry.

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.



Marginal

Cost

Price,

MarginalRevenue

quantity

Average

Variable Cost

When P = ATC,

profits are zero and a

firm is ³breakingeven´.

We call this price, the

breakeven price.

Shutdown

Price

Average Total

CostBreakevenPrice



Marginal

Cost

Price,

MarginalRevenue

quantity

Average

Variable Cost

Because in the

long run, firms

will exit the

industry if they areearning losses, the

long run supply

curve starts at the

minimum of ATC,not at the

minimum of AVC.

Shutdown

Price

Average Total

CostBreakevenPrice

Long

Run

Supply



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 firm¶s short run supply curve starts at the minimum

of AVC and follows up the MC curve.

A firm¶s 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.

principles of microeconomics - production decision

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