Notesale: Turn your study into money

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Production, Cost and Perfect Competition Profits
Any firm’s main goal is to maximize profits
...
Total revenue is the selling price multiplied
by the quantity sold and total costs are the sum of the cost of all factors of production
used in producing the quantity sold
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However all firms face similar decisions on how to produce
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how to produce will directly affect costs and thus profits
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There are two time-frame of production, the short run in which
the quantity of at least one factor of production is fixed, and the long run in which the
quantities of all factors of production
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In the short run, firms cannot change certain factors of
production and thus much employ the variable factors on fixed factors to increase output
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Short Run (SR) Production
We assume that there are only two factors of production for simplicity, which are labor
(L) and capital (K)
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Total product (TP)
Total Product (TP) is the maximum amount of output a certain quantity of labor can
produce on the fixed capital
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If we assume that there is one capital (a machine), and one worker is hired, then this will
worker can produce a certain output
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Marginal product (MP)
The first worker increased output with a certain amount, then the second worker
increased output with some different amount
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Marginal product is the change in total product due
to changing labor by one unit (hour or worker)
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The increase in output of the second worker will
be higher then the first because of specialization and division of labor, but only at the
beginning
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If we hire a third worker the output will increase but the increase in
output from the third will be less than from the second
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This means at the beginning the
marginal product increases because of specialization and division of labor, then reaches a
maximum and then marginal product starts decreasing
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Total Cost (TC)
To produce, the firm hires factors of production that it must pay its costs
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In the short run, the firm has some
fixed and some variable factors of production
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Total Fixed Costs (TFC)
The firm must employ all factors of production, if the quantities of some factors doesn’t
change with the quantity of output then the cost of those factors of production will be
fixed
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Total cost is the sum of total fixed cost and total variable cost
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In calculation, it is the change in total cost divided by the change in
total product
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Each additional
worker receives the same wage rate but increases output with a different amount, this
means that when marginal product is increasing the marginal cost is decreasing
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Finally,
when marginal product decreases then the marginal cost will be increasing
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Perfect Competition
Firms in perfect competition are price takers which means that when a single firm’s
output decision cannot affect the market price
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Total Revenue (TR)
Total revenue is equal to the price multiplied by the quantity sold
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Marginal Revenue (MR)
Marginal revenue is the change in total revenue that results from a one unit increase in
quantity sold
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Economic Profit or Loss
The goal of the competitive firm is to maximize economic profits, given the constraints it
faces
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how to produce at minimum cost
2
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whether to enter or exit the market
At low levels of production, the total revenue will be low and will not cover the total cost
of production and the firm will incur loss
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Profits will reach a maximum and
then starts to decrease and any further increase in production will incur more cost than
revenue and the profits will turn into losses (because of diminishing marginal
productivity and increasing marginal cost)
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Economic Profit
At the profit maximization quantity where marginal revenue equals marginal cost (MR =
MC), if the price per unit sold is greater then the cost per unit, then there is positive
economic profits for each unit sold
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When the price falls, the MR will decrease and the
market will reach the long run equilibrium when the economic profits reach zero
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If there are zero economic profits then there is no incentive for
firms to enter or exit the market, and the market is at the long run equilibrium
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If a firm is facing economic loss it must compare its production loss
with its shut down loss (Total fixed cost), and takes the decision that minimizes its loss
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When the price rises, the MR will
increase for the remaining firms and the market will reach the long run equilibrium when
the economic profits reach zero
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If the revenue received from

production will cover the variable costs and part of the fixed cost then the firm should not
shut down because this means that if it shuts down it will lose more than when it
produces
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Summary:
Production
In SR there is a fixed FP which is K and variable FP which is L
↑ L → ↑ TP : change in TP because of change in L is called MP
MP increases because of specialization and division of labor, then reaches a max and
starts to decrease because of fixed K
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MR is the same as price and in the perfect
competition it doesn’t change with TP
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the firm has one machine
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the cost per worker is
$25
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1
...

2
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Calculate the ATC and AVC at the profit maximization output
4
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in case of loss, using calculations, is the firm going to shut down?
6
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K L TP
1 0 0
1 1 4
1 2 10
1 3 13
1 4 15
1 5 16

MP TR
0
4
36
6
90
3
117
2
135
1
144

MR TFC
25
9
25
9
25
9
25
9
25
9
25

TVC
0
25
50
75
100
125

TC
25
50
75
100
125
150

MC
6
...
17
8
...
5
25

2
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33 and at TP = 14 (between 13 and 15) MC= 12
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then the profit maximization output is 13
units
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ATC = TC / TP, TP= 13 and TC = 100 the ATC = 100/13 = $7
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8
4
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7) x 13]= $ 16
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no loss, no shut down
6
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When the price falls, the MR will decrease and the market will reach the long run
equilibrium when the economic profits reach zero
...
the firm has one machine
...
the cost per worker is
$25
...

1
...

2
...
Calculate the ATC and AVC at the profit maximization output
4
...
in case of loss, using calculations, is the firm going to shut down?
6
...

K L TP
1 0 0
1 1 4
1 2 10
1 3 13
1 4 15
1 5 16

MP TR
0
4
36
6
90
3
117
2
135
1
144

MR TFC
55
9
55
9
55
9
55
9
55
9
55

TVC
0
25
50
75
100
125

TC
55
80
105
130
155
180

MC
6
...
17
8
...
5
25

2
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33 and at TP = 14 (between 13 and 15) MC= 12
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then the profit maximization output is 13
units
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ATC = TC / TP, TP= 13 and TC = 100 the ATC = 130/13 = $10
AVC = TVC / TP, TP= 13 and TVC = 75 the ATC = 75/13 = $5
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Economic profit or loss= [(Price – ATC ) x Q ]= [(9 - 10) x 13]= $ -13 (economic loss)
5
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8 – 9) x 13] = 55 + (-3
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6
= $13
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4, then the firm will not shut down and
will produce 13 units
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because of the economic loss then some firms will exit the market, this will shift the
market supply to the left and the equilibrium price will rise
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