LEARNING OBJECTIVES:

You should understand:

KEY POINTS:
  1. The goal of firms is to maximize profit, which equals total revenue minus total cost.
  2. When analyzing a firm’s behavior, it is important to include all the opportunity costs of production. Some of the opportunity costs, such as the wages a firm pays its workers, are explicit. Other opportunity costs, such as the wages the firm owner gives up by working in the firm rather than taking another job, are implicit.
  3. A firm’s total costs can be divided between fixed costs and variable costs. Fixed costs are costs that do not change when the firm alters the quantity of output produced. Variable costs are costs that do change when the firm alters the quantity of output produced.
  4. From a firm’s total cost, two related measures of cost are derived. Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost would rise if output were increased by one unit.
  5. When analyzing firm behavior, it is often useful to graph average total cost and marginal cost. For a typical firm, marginal cost rises with the quantity of output. Average total cost first falls as output increases and then rises as output increases further. The marginal-cost curve always crosses the average-total-cost curve at the minimum of average total cost.
  6. A firm’s costs often depend on the time horizon being considered. In particular, many costs are fixed in the short run but variable in the long run. As a result, when the firm changes its level of production, average total cost may rise more in the short run than in the long run.

I. What Are Costs?

A. Total Revenue, Total Cost, and Profit

1. Goal of a firm: to maximize profit.

2. Definition of Total Revenue: the amount a firm receives for the sale of its output.

3. Definition of Total Cost: the market value of the inputs a firm uses in production.

4. Definition of Profit: total revenue minus total cost.

B. Costs as Opportunity Costs

1. Principle #2: The cost of something is what you give up to get it.

2. The costs of producing an item must include all of the opportunity costs of inputs used in production.

3. Total opportunity costs include both implicit and explicit costs.

II. The Total-Cost Curve

1. We can draw a graph of the firm’s total cost curve by plotting the level of output (x-axis) against the total cost of producing that output (y-axis). Again, this is the basic graph.

a. The total cost curve gets steeper and steeper as output rises.

b. This increase in the slope of the total cost curve is also due to diminishing marginal product: As Helen increases the production of cookies, she needs more labor and her kitchen becomes overcrowded.

III. The Various Measures of Cost

A. Fixed and Variable Costs

1. Definition of Fixed Costs: costs that do not vary with the quantity of output produced.

2. Definition of Variable Costs: costs that do vary with the quantity of output produced.

B. Average and Marginal Cost

1. Definition of Average Total Cost: total cost divided by the quantity of output.

2. Definition of Average Fixed Cost: fixed costs divided by the quantity of output.

3. Definition of Average Variable Cost: variable costs divided by the quantity of output.

4. Definition of Marginal Cost: the increase in total cost that arises from an extra unit of production.

5. Rising Marginal Cost

a. This occurs because of diminishing marginal product.

b. At a low level of output, there are few workers and a lot of idle equipment. But as output increases, the lemonade stand (or factory) gets crowded and the cost of producing another unit of output becomes high.

6. U-Shaped Average Total Cost

a. Average total cost is the sum of average fixed cost and average variable cost.

b. AFC declines as output expands and AVC increases as output expands. AFC is high when output levels are low. As output expands, AFC declines pulling ATC down. As fixed costs get spread over a large number of units, the effect of AFC on ATC falls and ATC begins to rise because of diminishing marginal product.

a. Marginal cost eventually rises with output.

b. The average total cost curve is U-shaped.

c. Marginal cost crosses average total cost at the minimum of the average total cost.

 

FIRMS IN COMPETITIVE MARKETS

 

LEARNING OBJECTIVES:

You should understand:

 

 

KEY POINTS:
  1. Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm’s average revenue and its marginal revenue.
  2. To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost. Thus, the firm’s marginal cost curve is its supply curve.
  3. In the short run, when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run, when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost.
  4. In a market with free entry and exit, profits are driven to zero in the long run. In this long-run equilibrium, all firms produce at the efficient scale, price equals minimum average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price.
  5. Changes in demand have different effects over different time horizons. In the short run, an increase in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to losses. But if firms can freely enter and exit the market, then in the long run the number of firms adjusts to drive the market back to the zero-profit equilibrium.

I. What Is a Competitive Market?

A. The Meaning of Competition

B. The Revenue of a Competitive Firm

1. Total revenue from the sale of output is equal to price times quantity.

 

 

  1.  
    1. Definition of Marginal Revenue: the change in total revenue from an additional unit sold.

3. The profit-maximizing quantity can also be found by comparing marginal revenue and marginal cost.

a. As long as marginal revenue exceeds marginal cost, increasing output will raise profit.

  1. Profit Max level of Output
    1. If marginal revenue is less than marginal cost, the firm can increase profit by decreasing output.
    2. Profit-maximization occurs where marginal revenue is equal to marginal cost.

a. If marginal revenue is greater than the marginal cost, the firm can increase its profit by increasing output.

b. If marginal cost is greater than marginal revenue, the firm can increase its profit by decreasing output.

c. At the profit-maximizing level of output, marginal revenue is equal to marginal cost.

 

1. In some circumstances, a firm will decide to shut down and produce zero output.

2. There is a difference between a temporary shutdown of a firm and an exit from the market.

a. A shutdown refers to the short-run decision not to produce anything during a specified period of time because of current market conditions.

b. Exit refers to a long-run decision to leave the market.

c. One important difference is that, when a firm shuts down temporarily, it still must pay fixed costs.

3. If a firm shuts down, it will earn no revenue and will have only fixed costs (no variable costs).

4. 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 < VC. (Not covering Variable Costs)

Shut down if P < AVC. (The Shutdown Point)

D. The Firm’s Long-Run Decision to Exit or Enter a Market

1. If a firm exits the market, it will earn no revenue, but it will have no costs as well.

2. Therefore, a firm will exit if the revenue that it would earn from producing is less than its total costs:

Exit if TR < TC. (They have a loss)

Exit if P < ATC. (Below the )-profit point)

4. A firm will enter an industry when there is profit potential, so this must mean that a firm will enter if revenues will exceed costs:

Enter if P > ATC. (There is a profit in the market)

National Income and GDP

  1. Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.
  2. Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. More precisely, GDP is the market value of all final goods and services produced within a country in a given period of time.
  3. GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports. Consumption includes spending on goods and services by households, with the exception of purchases of new housing. Investment includes spending on new equipment and structures, including households’ purchases of new housing. Government purchases include spending on goods and services by local, state, and federal governments. Net exports equal the value of goods and services produced domestically and sold abroad (exports) minus the value of goods and services produced abroad and sold domestically (imports).
  4. Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP uses constant base-year prices to value the economy’s production of goods and services.
  5. GDP is a good measure of economic well-being because people prefer higher incomes to lower incomes. But it is not a perfect measure of well-being. For example, GDP excludes the value of leisure and the value of a clean environment.

The Economy’s Income and Expenditure

A. To judge whether or not an economy is doing well, it is useful to look at Gross Domestic Product (GDP).

1. GDP measures the total income of everyone in the economy.

2. GDP measures total expenditure on an economy’s output of goods and services.

 The Measurement of Gross Domestic Product

A. Definition of Gross Domestic Product (GDP): the market value of all final goods and services produced within a country in a given period of time.

B. "GDP is the Market Value..."

1. To add together different items, market values are used.

2. Market values are calculated by using market prices.

C. "...of All..."

1. GDP includes all items produced and sold legally in the economy.

2. The value of housing services is somewhat difficult to measure.

a. If housing is rented, the value of the rent is used to measure the value of the housing services.

b. For housing that is owned (or mortgaged), the government estimates the rental value and uses this figure to value the housing services.

3. GDP does not include illegal goods or services or items that are not sold in markets.

a. When you hire someone to mow your lawn, that production is included in GDP.

b. If you mow your own lawn, that production is not included in GDP.

D. "...Final..."

1. Intermediate goods are not included in GDP.

2. The value of intermediate goods is already included as part of the value of the final good.

3. Goods that are placed into inventory are considered to be "final" and included in GDP as a firm’s inventory investment.

a. Goods that are sold out of inventory are counted as a decrease in inventory investment.

b. The goal is to count the production when the good is finished, which is not necessarily the same time that the product is sold.

E. "...Goods and Services..."

1. GDP includes both tangible goods and intangible services.

F. "...Produced..."

1. As mentioned above, current production is counted.

2. Used goods sold do not count as part of GDP.

G. "...Within a Country..."

1. GDP measures the production that takes place within the geographical boundaries of a particular country.

2. If a Canadian citizen works temporarily in the United States, the value of his output is included in GDP for the United States. If an American owns a firm in Haiti, the value of the production of that firm is not included in U.S. GDP.

H. "...in a Given Period of Time."

1. The usual interval of time used to measure GDP is a quarter (three months).

2. When the government reports GDP, the data is generally reported on an annual basis.

3. In addition, data are generally adjusted for regular seasonal changes (such as Christmas).

GDP (Y) can be divided into four components: consumption (C), investment (I), government purchases (G), and net exports (NX).

Definition of Consumption: spending by households on goods and services, with the exception of purchases of new housing.

 Definition of Investment: spending on capital equipment, inventories, and structures, including household purchases of new housing.

Definition of Government Purchases: spending on goods and services by local, state, and federal governments.

1. Salaries of government workers are counted as part of the government purchases component of GDP.

2. Transfer payments are not included as part of the government purchases component of GDP.

Definition of Net Exports: spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports).

Real Versus Nominal GDP

A. There are two possible reasons for total spending to rise from one year to the next.

1. The economy may be producing a larger output of goods and services.

2. Goods and services could be selling at higher prices.

B. When studying GDP over time, economists would like to know if output has changed (not prices).

C. Thus, economists measure real GDP by valuing output using a fixed set of prices.

MEASURING THE COST OF LIVING

Definition of Consumer Price Index (CPI): a measure of the overall cost of the goods and services bought by a typical consumer.

How the Consumer Price Index is Calculated

1. Fix the basket.

a. The Bureau of Labor Statistics uses surveys to determine a representative bundle of goods and services purchased by a typical consumer.

2. Find the prices.

3. Compute the basket’s cost.

By keeping the basket the same, only prices are being allowed change. This allows us to isolate the effects of price changes over time.

Problems in Measuring the Cost of Living

1. Substitution Bias

a. When the price of one good changes, consumers often respond by substituting another good in its place.

b. The CPI does not allow for this substitution; it is calculated using a fixed basket of goods and services.

c. This implies that the CPI overstates the increase in the cost of living over time.

2. Introduction of New Goods

a. When a new good is introduced, consumers have a wider variety of goods and services to choose from.

b. This makes every dollar more valuable, which means that there is an increase in the purchasing power of the dollar.

c. Because the market basket is not revised often enough, these new goods are left out of the bundle of goods and services included in the basket.

3. Unmeasured Quality Change

a. If the quality of a good falls from one year to the next, the value of a dollar falls; if quality rises, the value of the dollar rises.

b. Attempts are made to correct prices for changes in quality, but it is often difficult to do so because quality is hard to measure.

4. The size of these problems is also difficult to measure.

5. The issue is important because many government transfer programs (such as Social Security) are tied to increases in the CPI.

6. Most studies indicate that the CPI overstates the rate of inflation by approximately 1 percentage point per year.

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