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The Supply Side of the Market in Three Parts

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The Supply Side of the Market in Three Parts Econ Dept, UMR Presents TheThe SupplySupply SideSide ofof thethe MarketMarket inin ThreeThree Parts:Parts: I.I. AnAn IntroductionIntroduction toto SupplySupply andand ProducerProducer SurplusSurplus II.II. TheThe ProductionProduction FunctionFunction III.III. CostCost FunctionsFunctions StarringStarring uSupplySupply vProductionProduction vCostCost uProducerProducer surplussurplus FeaturingFeaturing uThe Law of Diminishing Marginal Product uThe MP/P Rule uEconomic Cost vs. Accounting Cost uEconomic Profit vs. Accounting Profit uThe Unimportance of Sunk Cost PartPart III:III: CostCost FunctionsFunctions LinkingLinking ProductionProduction toto CostsCosts u Each production relationship has a cost counterpart v TP:variable input -- variable cost v AP:variable input -- average variable cost v MP:variable input -- marginal cost v Fixed inputs -- fixed (or sunk) cost v MP/P rule -- equal MC rule u The production function and the MP/P rule tells us the minimum cost of producing any level of output, q: cost = input price times inputs required = P*R Short Run Costs First by definition we have Fixed Costs that do not vary with output FC = iK ; where i is the price of the fixed input, capital (K) FC q/t q0 q1 q2 q3 Often fixed costs are also sunk costs. Sunk costs are costs already incurred and are beyond recovery. TC Second, we have Short variable cost. Run TVC + FC = TC Adding TVC and FC Costs gives Total Costs TVC Fixed Costs TVC = wL where w is the price of the variable input, labor (L) FC q/t q0 q1 q2 q3 Notice the vertical distance between TC and TVC is Fixed Cost Short TC Run TVC Costs Notice the curvature of TC and TVC is the Fixed Costs same. The slope of both at any output is marginal cost At q3, slope of TC = slope of TVC = MC FC MC = (ÎTC/ Îq) q/t = (ÎTVC/ Îq) q0 q1 q2 q3 The rise over the run is the change in cost, total or variable, divided by the change in output Short TC Run TVC Costs Tangency’s to show minimum AVC and ATC •q1 min AVC •q2 min ATC Note, q2 > q1 as long as fixed costs are present. That is the FC output at which AVC is minimized is q/t less than the output q q q q 0 1 2 3 at which ATC is (TVC/q) = AVC; (TC/q) = ATC minimized as long as FC > 0 Short TC Run TVC Costs Inflection Points •q0 min MC At q0, the law of diminishing marginal returns sets in FC q/t q0 q1 q2 q3 At the Inflection Point, TC and TVC stop increasing at a decreasing rate and start increasing at an increasing rate. MC falls up to q0 then starts to increase. Short TC EverythingEverything TogetherTogether Run TVC Costs Tangency’s to show Fixed Costs minimum AVC and Inflection Points ATC •q0 min MC •q1 min AVC FC •q2 min ATC •q slope of TC q/t 3 q0 q1 q2 q3 = slope of TVC = MC at q3 TVC + TFC = TC = wL + iK PerPer UnitUnit ShortShort RunRun CostsCosts u Let’s look now at costs on a per unit basis v Average fixed cost, AFC = FC/q v Average variable cost, AVC = TVC/q v Average total cost, ATC = TC/q v Marginal cost, MC = ÎTC/Îq = ÎTVC/Îq AFC = FC/q Short Run Per Unit Costs First, Average Fixed Costs declines throughout the range of output. This is because you are dividing a constant, FC, with an ever increasing quantity. AFC q/t q0 q1 q2 Short Run In the short run, the average curves take on a “U” shape Per Unit driven by the law of diminishing Costs marginal returns ATC AVC Notice the vertical distance between ATC and AVC is AFC AFC q q q q/t AFC = FC/q 0 1 2 AVC = TVC/q Also note, q2 > q1 as long as fixed costs are present ATC = AFC + AVC = TC/q AFC is not very important, so Short Run it is often not drawn with the Per Unit other per unit curves Costs ATC AVC Notice the minimum AVC at q1, occurs when the average product of the variable input is maximized q/t q0 q1 q2 AVC = TVC/q ATC = AFC + AVC = TC/q Notice MC is “U” shaped too with its Short Run Short Run minimum point, at q0, coinciding with Per Unit the output where the marginal Costs product of the variable input is maximized MC ATC AVC q/t q0 q1 q2 MC = ÎTC/Îq = ÎTVC/Îq Short Run EverythingEverything Per Unit TogetherTogether Costs MC ATC AVC AFC q/t q0 q1 q2 AFC = TFC/q MC = ÎTC/Îq AVC = TVC/q = ÎTVC/Îq ATC = AFC + AVC = TC/q BeforeBefore GoingGoing toto thethe LongLong RunRun u Review what we mean by “costs” v Costs are opportunity costs v Or, costs are benefits foregone-the benefits of the next best alternative given up v Market prices are often good measures of opportunity costs OpportunityOpportunity CostCost u In economics, costs are always the value of the benefits given up--opportunity cost u Sometimes these opportunity costs are monetary, e.g., Wages paid labor u Sometimes these opportunity costs are nonmonetary, e.g., Value of time used EconomicEconomic CostsCosts u Total cost (TC) - the total opportunity cost of all resources used in production v TC = monetary costs + Nonmonetary costs EconomicEconomic vs.vs. AccountingAccounting ConceptsConcepts ofof CostsCosts andand ProfitsProfits u In economics costs are opportunity costs u In accounting costs are defined according to accepted accounting rules designed for tax and public disclosure purposes u Since the definitions of cost differ so do the definitions of profits v Economic profit = total revenue - opportunity costs v Accounting profit = total revenue - accounting costs IllustrationIllustration ofof AccountingAccounting ProfitProfit vs.vs. EconomicEconomic ProfitProfit Assume: Monetary costs (explicit costs) for a month =$15,000 Non-monetary costs for a month = $ 4,000 Total costs =$19,000 Economic profit = total revenue (TR) - total costs (TC) If total revenue for this month is equal to $19,000 then: there is no economic profit, but there would be a $4,000 accounting profit. Accounting profit does not count non-monetary costs as a cost thus profit would be reported as $4,000 Suppose:Suppose: u Monthly costs include: v Owner’s time and expertise $2,000 v Land already owned but could $3,000 be rented v Payroll expenses $9,000 v Utility bills $1,000 u Total economic costs $15,000 u Total accounting costs $10,000 The difference between accounting and economic costs are non-monetary costs are not included in the accounting costs EconomicEconomic ProfitProfit OverviewOverview u TR = TC the opportunity costs are covered and there is no economic profit u TR > TC revenue exceeds opportunity costs and there is an economic profit u TR < TC opportunity costs exceed revenues and there is economic loss ConsiderConsider HooeyHooey andand Dewie,Dewie, WhoWho OpenedOpened aa BusinessBusiness SellingSelling TurquoiseTurquoise BeltsBelts inin thethe DenverDenver Airport.Airport. u Display Cart Costs $10,000 and Is Paid by Withdrawing Hooey and Dewie’s Savings That Was Earning 5% Per Year. The Cart Will Last One Year and Has No Salvage Value. u Belts Cost $20.00 Each From the Supplier. u Sales Are Estimated to Be 1,000 Belts Per Year. u The Price of the Belts Is $60.00. u The Cart Clerk Is Paid $14,000. u Hooey and Dewie Will Put in 2000 Hours of Labor During the Year. QUESTION: Is This Business Going to Make a Profit, or Should Hooey and Dewie Move Back in With Uncle Donald? HooeyHooey andand DewieDewie HaveHave aa TotalTotal RevenueRevenue ofof $60,000$60,000 forfor thethe YearYear u Total revenues.............................$60,000 v P*q = $60*1,000 HooeyHooey andand DewieDewie HaveHave AccountingAccounting CostsCosts ofof $44,000$44,000 forfor thethe YearYear Total Revenues. .$60,000 Total Accounting Costs (Monetary Cost) Belts From Supplier. .$20,000 Clerk Cost . 14,000 Cart Cost. 10,000 $44,000 Acct’ing Profit = Total Revenue – Acct’ing Costs = 60,000 - 44,000 = $16,000 (And We Are Ignoring Taxes) ButBut HooeyHooey andand DewieDewie HaveHave nonmonetarynonmonetary CostsCosts TooToo Total Revenues $60,000 Total Accounting Costs (Monetary Cost) Belts From Supplier $20,000 Clerk Cost 14,000 Cart Cost 10,000 $44,000 Total Nonmonetary Cost Interest Foregone on $10,000 $ 500 Opportunity Cost of 2000 Hours X Economic Costs $44,500 + X Economic Profits = Total Revenue - Economic Costs = 60,000 - 44,500 - X = $15,500 - X HooeyHooey andand DewieDewie’’ss AdventureAdventure u Did they make a profit? u It depends on the value they place on their time, the 2000 hours v They cleared $16,000 according to the accountant and would be asked to pay taxes on this amount (after figuring loopholes) v But the opportunity cost of their savings and time were not taken into account u $500 for foregone interest lowers profit by $500 u If they value their time less than $7.50 per hour (= $15,500/2000) they made a profit otherwise, they didn’t and should move back in with uncle Donald BeforeBefore MovingMoving toto thethe LongLong Run,Run, LetLet’’ss ReviewReview u Total cost concepts u Per unit cost concepts u The shape of cost curves v Due to the law of diminishing marginal returns u The relationship between marginal and average u Efficiency in getting what we want TotalTotal CostCost ConceptsConcepts u Total fixed cost (FC) - costs which do not vary with output v The costs of fixed inputs, e.g., Capital u Total variable costs (TVC) - any cost that varies with the quantity of output produced v The costs of variable inputs, e.g., Labor u Total cost (TC) - sum of all costs of production v TC = fixed costs + total variable costs PerPer UnitUnit CostCost ConceptsConcepts u Marginal cost (MC) - the additional cost of producing one more unit of output v MC = DTC / Dq u Average variable cost (AVC) = TVC/q u Average fixed cost (AFC) = FC/q u Average total cost (ATC) = TC/q ShapeShape ofof CostCost CurvesCurves u Total cost and total variable cost v Eventually steeper
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