Ch. 7

 

Perfect competition

Monopoly

Price takers/setters

profit (p)

factors of production

materials, capital

intermediate goods

Costs – total, fixed, variable

         Average, marginal

Short and long run

 

We now turn from looking at consumers to firms.

 

Economists assume that there are different types of firms – price takers and price setters.
The former market is described as perfect competition.

The latter as one where firms have monopoly power.

 

Economists assume that firms are interested in maximizing profit.

 

They define profit (p) as TR-TC.

We already have a definition of TR = p*q

If a firm is a price taker (MR=p), what can they control?

Q and their costs.

 

So minimizing costs may be seen as a way of maximizing profit.

 

How do firms incur costs?

They buy inputs (factors of production) that are used to produce the good.

These include, labor, materials (raw and intermediate goods) capital, etc.

 

Labor is generally seen as a variable cost, eg as something that you can change in the short run.  
But some things are seen as fixed – if you are a farmer and own a piece of land. If you make cars and already have built a factory with an assembly line in it, this is a fixed cost.

When thinking about fixed costs, opportunity costs again become relevant.

Even if a farmer owns her land, she could rent it, or sell it, so there is an opportunity cost of farming the land.

Fixed costs are seen to be the same, no matter how much you produce. In other words FIXED COSTS DO NOT VARY AS YOU VARY Q.

Variable costs vary with production (Q).

If you decide not to farm your land, you still have the land, but you can let go of all your workers.
If you decide to farm your land, you may hire 50-100 workers, so labor is variable.

You need to figure out the optimal number of workers to hire.

 

TC = FC + VC

Can graph these as well, with $ (costs) on Y axis and .output on X

If FC don’t vary with Q, then what will the fixed cost curve look like?

If VC do vary with Q, what will that line look like?
And how about TC?

                                                              

 

We can also calculate marginal cost.
What is marginal cost – additional cost, per unit output.

What will the marginal cost of FC be?

There is no marginal cost, since FC don’t vary.

But you can calculate a marginal cost of TC or VC. (How will these differ?)

 

DTC/ DQ = DVC/ DQ = MC

(Doesn’t matter if you use TC or VC)

 

Can also look at average cost, per unit of output.

ATC = TC/Q

AVC = VC/Q

AFC = FC/Q

 

What will these lines look like in general?  Can graph TC, FC and VC with Q ($ on Y, Q on X). Can also graph ATC, AVC, AFC and MC on one graph with $ on Y and Q on X.

What is the relationship between these different costs.  The second set is derived from the first.
Also note that MC intersects AC at the bottom (minimum).

Intuitively you can think of this as:

 

What happens if your costs change?

 

Suppose for instance that your fixed costs double?

How will that change the curves?

 

How about if the variable costs increase?

 

Do in-class exercise!

 

Notice that concepts introduced early in the course are being reintroduced here –

When economists talk about costs they include opportunity costs, and they consider fixed costs to be sunk costs in the short run!

By definition, FC are those that cannot be changed in the short run – a lease, the purchase of a machine, etc.

They matter to the firm more in making long run decisions.

 

Opportunity costs also matter – if you own a business, you need to think about alternative uses for your time.

If you could be working for a firm and earning $50,000 a year, then that is the opportunity cost of your time.

These costs are relevant, because they help us distinguish btw short and long run and economic and accounting profits (which we will talk about next time).

 

In the short run, you have fixed and variable costs. In other words, some costs are sunk, or unavoidable.

In the long run, all costs are variable.

 

In the short run, your plant size (of the number of plants), for instance if fixed. It may make more sense to have a bigger factory, or more factories, but in the short run you have to make due with what you have. In the long run, you have to choose the optimal plant size or number of plants.