Lecture Economics for investment decision makers: Chapter 3 - CFA In stitute

Chapter 3 - Demand and supply analysis: The firm. This chapter focuses on decision making by the suppliers/producers of goods and services, whereas Chapter 2 examined the role of individuals in shaping the demand for goods and services.

1 Introduction

2 Objectives of the Firm

Normal profit and Economic profit

Normal profit is the accounting profit such that both explicit and implicit costs

are covered:

Normal profit = Accounting profit – Economic profit

- Also known as abnormal profit or supernormal profit.

Accounting profit = Economic profit + Normal profit

Example:

Total explicit costs €500Opportunity cost €400Accounting profit €1,000 – 500 = €500

Economic profit €1,000 – 500 – 400 = €100

Economic rent

Economic rent is the high profit attributed to a fixed, limited supply.

Q1

Demand2Demand1

P2

Supply

P1

3 Analysis of revenue, costs,

and profits

Calculating TR, AR, and MR

The production function

• The factors of production are inputs to the production of goods or services,

including land, labor, capital, and materials

• The production function is the relationship between the quantity produced

and the factors of production: capital (K) and labor (L)

Q = f(K,L)

Costs of production

• Total cost (TC) is the sum of all costs of producing goods or services.

• Total fixed cost (TFC) is the sum of all costs that do not change with the level

of production

- A quasi-fixed cost is a cost that is fixed for a specific range of production

but that changes at different levels of production

• Total variable cost (TVC) is the sum of all costs that change with the level of

• Average total cost (ATC) is the total cost divided by the quantity produced.

• Marginal cost (MC) is the change in total cost for one more unit produced.

Suppose that the fixed costs of

production are $50 and that the

variable cost per unit begins at $24 per

unit, declines to $12, and then

increases to $15

• The average fixed cost declines

throughout

• The average variable cost declines

and then increases

• The average total cost declines and

then increases

• The marginal cost declines and then

increases

Breakeven and shutdown

• The breakeven point is the quantity produced at which all costs are covered.

- Under perfect competition, the breakeven point is the quantity of production

at which the price, average revenue, and marginal revenue are equal to

average total cost

- Quantity at which TR = TC.

• The shutdown point is the quantity produced at which the average revenue is

less than the average variable cost

- Quantity at which AR < AVC.

- At shutdown, the firm must pay fixed costs but stops production because it cannot cover variable costs

Economies and Diseconomies of Scale

• The short-run average total cost curve (SRATC) is determined by the firm’s

fixed-input constraint

• The long-run average total cost curve (LRATC) is composed of the

minimums of the possible short-run average total cost curves

• Economies of scale (also known as increasing returns to scale) are the

lowered cost structures available when a firm grows in size

- They may arise from many sources, including the division of labor, capital intensity, use of by-products, and buying power

- There may be a point where more output increases costs, which would

represent diseconomies of scale.

• Operating at the least cost (the minimum efficient scale, or MES) is important

for the long-term survival of a firm

Profit-maximizing output

• Profit is maximized when the difference between total revenue and total cost is maximized, which is also the point at which marginal revenue is equal to

marginal cost

• Determining profit-maximizing output requires

1. forecasting the revenues and costs in order to estimate the production level

at which the difference is maximized

2. computing the change in total revenue per unit and the change in total cost per unit and produce to the point at which they are equal

3. comparing the estimated cost per unit of input with the contribution margin per unit

Profit maximization: Short and long run

• In the short run, without economies of scale, the firm earns a normal profit

• In the long run, although the firm is able to exploit economies of scale, the firm earns an economic profit

- If the market is imperfectly competitive, the firm is able to earn an economic profit as long as competitors do not enter the market

- If the market is perfectly competitive, competitors will enter and the economic profit is driven to zero

Long-run industry supply

• The long-run supply curve for an industry is the relationship between

quantities supplied and prices under perfect competition

• An increasing-cost industry is one in which the prices and costs increase for

increased output

- Long-run supply curve is upward sloping

• A decreasing-cost industry is one in which the prices and costs decrease for

increased output

- Long-run supply curve is downward sloping

• A constant-cost industry is one in which the prices and costs remain the

same for increased levels of output

- Long-run supply curve is flat

Productivity

Example: Productivity of labor

Diminishing marginal returns

• The marginal product (MP) is the change in the total product from a one-unit

change in the input

• Increasing marginal returns exist when the marginal product of an input

increases when using more of the input

• Diminishing marginal returns exist when the marginal product of an input

decreases when using more of the input

- The law of diminishing returns is the law that adding another unit of input

will result in less marginal product than the previous unit of input

• The marginal revenue product (MRP) is the change in total revenue from a

one-unit change in the input

Profit-maximizING levels of output

Example: Optimal level of inputs

Marginal Revenue Product

MRP/

Price of Input

Units of

Total Product

Marginal Product

Marginal Revenue Product

Suppose that the cost per unit of Input 1 is €16 and the cost per unit of Input 2

is €10 If the cost of the product is €2.50 and the total products are as below, what are the optimal levels of Input 1 and Input 2?

• The profit of concern in the theory of the firm is economic profit, which

considers not only explicit costs but also implicit costs

• If a firm is able to maintain a comparative advantage (such as economies of scale), it can earn economic profit In a market with perfect competition,

however, economic profits are zero; firms can earn a normal profit, which is a profit in which revenues just cover both implicit and explicit costs

• Profit maximization occurs at the level of production at which the difference between total revenue and total costs is the greatest or, equivalently, where marginal revenue equals marginal cost

• In the long run, all inputs to the firm are variable, which expands profit potential and the number of cost structures available to the firm

• Under perfect competition, long-run profit maximization occurs at the minimum point of the firm’s long-run average total cost curve

• Increases in productivity reduce business costs and enhance profitability.

• An industry supply curve that is positively sloped will increase production costs

to the firm in the long run An industry supply curve that is negatively sloped will decrease production costs to the firm in the long run

• In the short run, assuming constant resource prices, increasing marginal

returns reduce the marginal costs of production and decreasing marginal

returns increase the marginal costs of production