Background to

Supply: Firms in
6
Competitive Markets
Copyright©2014 Cengage
 The Cost of Production
A firm’s costs are a key determinant of its
production and pricing decisions.
Costs as Opportunity Costs

A firm’s cost of production includes all the

opportunity costs of making its output of
goods and services.
Explicit and Implicit Costs
• A firm’s cost of production include explicit costs
and implicit costs.
o Explicit costs are input costs that require a direct
outlay of money by the firm.
o Implicit costs are input costs that do not require an
outlay of money by the firm.
 Figure 6 Economic versus Accountants

How an Economist How an Accountant

Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

Copyright©2014 Cengage
The Production Function

The production function shows the relationship

between quantity of inputs used to make a
good and the quantity of output of that good.
Marginal Product
• The marginal product of any input in the
production process is the increase in output
that arises from an additional unit of that input.
Table 1 A Production Function and Total Cost:
Paolo’s Pizza Factory

Copyright©2014 Cengage
 The Production Function
Diminishing Marginal Product
• Diminishing marginal product is the property
whereby the marginal product of an input
declines as the quantity of the input increases.
o Example: As more and more workers are hired at a
firm, each additional worker contributes less and
less to production because the firm has a limited
amount of equipment.
Figure 1a. Paolo’s Production Function

Quantity of
Output
(pizzas
per hour)
150 Production function
140
130
120
110
100
90
80
70
60
50
40
30
20
10

0 1 2 3 4 5 Number of Workers Hired

Copyright©2014 Cengage
The Production Function

Diminishing Marginal Product

• The slope of the production function measures
the marginal product of an input, such as a
worker.
• When the marginal product declines, the
production function becomes flatter.
From the Production Function to the Total
Cost Curve
The relationship between the quantity a
firm can produce and its costs is illustrated
by the total cost curve
Table 1 A Production Function and Total Cost:
Paolo’s Pizza Factory

Copyright©2014 Cengage
Figure 1b. Paolo’s Total Cost Curve

Total
Cost

€ 80 Total-cost
curve

70

60

50

40

30

20

10

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity

of Output
(pizzas per hour)
Copyright©2014 Cengage
 THE VARIOUS MEASURES OF
COST
Costs of production may be divided into
fixed costs and variable costs.
 Fixed and Variable Costs

Fixed costs are those costs that do not vary

with the quantity of output produced.
Variable costs are those costs that do vary
with the quantity of output produced.
Time Periods
• For many firms, the division of total costs
between fixed and variable costs depends on
the time horizon being considered.
o In the short run, some costs are fixed.
o In the long run, fixed costs become variable costs.
Fixed and Variable Costs

Total Costs
• Total Fixed Costs (TFC)
• Total Variable Costs (TVC)
• Total Costs (TC)
• TC = TFC + TVC
Fixed and Variable Costs

Average Costs
• Average costs can be determined by dividing the
firm’s costs by the quantity of output it produces.
• The average cost is the cost of each typical unit of
product.
Types of Average Cost
• Average Fixed Costs (AFC)
• Average Variable Costs (AVC)
• Average Total Costs (ATC)
• ATC = AFC + AVC
Types of Average Costs

F
i
xed
costF
C
A
F=
C =
Qu
an
ti
tyQ

V
a
r
ia
bl
ecotV
s C
A
V
C= =
Qu
a
nty Q
i
t

T
ot
alc
ost T
C
A
T=
C =
Qu
ant
iyQ
t
Fixed and Variable Costs

Marginal Cost
• Marginal cost (MC) measures the increase in
total cost that arises from an extra unit of
production.
• Marginal cost helps answer the following
question:
o How much does it cost to produce an additional unit
of output?
(
c
ha
ng
ei
nt
ot
a
lco
s)
t T
C
=
M
C =
(
ch
an
g
ei
nqu
an
ti
t
y)Q
 Marginal Cost
Luciano’s Lemonade Stand

Q
uan
tity T
ota
l M
arginal Q
uan
tity T
ota
l M
arginal
Co
st C o
s t Co
st C o
s t
0 €
3.0
0 —
1 3.3
0 €
0.3
0 6 €
7.8
0 €
1.3
0
2 3.8
0 0.5
0 7 9.3
0 1.5
0
3 4.5
0 0.7
0 8 1
1.0
0 1.7
0
4 5.4
0 0.9
0 9 1
2.9
0 1.9
0
5 6.5
0 1.1
0 1
0 1
5.0
0 2.1
0
Cost Curves and Their Shapes

Marginal cost rises with the amount of

output produced (increasing MC).
• This reflects the property of diminishing
marginal product.
Figure 3b. Luciano’s Average-Cost and Marginal-Cost
Curves

Costs
€ 3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright©2010 Cengage
Table 2 The Various Measures of Cost:
Luciano’s Lemonade Stand

Copyright©2014 Cengage
Cost Curves and Their Shapes

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

At very low levels of output average total
cost is high because fixed cost is spread
over only a few units.
Average total cost declines as output
increases.
Average total cost starts rising because
average variable cost rises substantially.
Cost Curves and Their Shapes

Relationship between Marginal Cost and

Average Total Cost
• Whenever marginal cost is less than average
total cost, average total cost is falling.
• Whenever marginal cost is greater than
average total cost, average total cost is rising.
Cost Curves and Their Shapes

Relationship Between Marginal Cost and

Average Total Cost
• The marginal cost curve crosses the average
total cost curve at the quantity that minimizes
average total cost.
Figure 3d. Luciano’s Average Cost and Marginal Cost
Curves

Costs
€ 3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright©2014 Cengage
Figure 3a. Luciano’s Average Cost and Marginal Cost
Curves

Costs
€ 3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright©2014 Cengage
Cost Curves and Their Shapes

Relationship Between Marginal Cost and

Average Total Cost
• The marginal cost curve crosses the average
total cost curve at the quantity that minimizes
average total cost
o This quantity is called the efficient scale of the firm
o Efficient scale is the quantity that minimizes average
total cost.
Cost Curves and Their Shapes

If the average total cost decreases as the

quantity produced increases, there are
economies of scale
If the average total cost is constant as the
quantity produced increases, there are constant
returns to scale
If the average total cost increases as the quantity
produced increases, there are diseconomies of
scale
 REVENUES
The revenues of a firm depend on the
market structure in which the firm operates
(perfect competition, monopoly,
monopolistic competition, etc.)
 WHAT IS A COMPETITIVE
MARKET?
A perfectly competitive market has the
following characteristics:
• There are many buyers and sellers in the
market.
• The goods offered by the various sellers are
largely the same (homogenous).
• Firms can freely enter or exit the market.
 WHAT IS A COMPETITIVE
MARKET?
As a result of its characteristics, the
perfectly competitive market has the
following outcomes:
• The actions of any single buyer or seller in the
market have a negligible impact on the market
price.
• Buyers and sellers must accept the price
determined by the market.
• Firms and buyers are price takers.
The Revenue of a Competitive Firm

Total revenue for a firm is the selling price

times the quantity sold.
TR = (P  Q)

Total revenue is proportional to the amount of

output.
The Revenue of a Competitive Firm
Marginal revenue is the change in total
revenue from an additional unit sold.
MR =TR/ Q

In perfect competition:

𝜕𝑇𝑅 𝑄 𝜕(𝑃∗𝑄)
MR = = =𝑃
𝜕𝑄 𝜕𝑄

Firms are price-takers→ MR equals the

price of the good.
The Revenue of a Competitive Firm

Average revenue tells us

how much revenue a firm
receives for the typical Total revenue
AverageRevenue=
unit sold. Quantity
Average revenue is total
PriceQuantity
revenue divided by the =
Quantity
quantity sold.
In perfect competition: =Price
Firms are price-takers→
average revenue equals
the price of the good.
Table 4 Total, Average, and Marginal Revenue for
a Competitive Firm

Copyright©2014 Cengage
Economic Profit versus Accounting Profit

Economists measure a firm’s economic

profit as total revenue minus total cost,
including both explicit and implicit costs.
Accountants measure the accounting profit
as the firm’s total revenue minus only the
firm’s explicit costs.
Economic Profit versus Accounting Profit

When total revenue exceeds both explicit

and implicit costs, the firm earns economic
profit.
• Economic profit is smaller than accounting
profit.
 Figure 6 Economic versus Accountants

How an Economist How an Accountant

Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

Copyright©2014 Cengage
PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
The goal of a competitive firm is to
maximize profit.
This means that the firm will want to
produce the quantity that maximizes the
difference between total revenue and total
cost.
41 Profit maximization

Profits
(Q)=TR(Q)−TC(Q)
Profit maximization:

𝜕(Q) 𝜕𝑇𝑅 𝑄 𝜕𝑇𝐶 𝑄

= − = 𝑀𝑅 − 𝑀𝐶
𝜕𝑄 𝜕𝑄 𝜕𝑄

𝜕(Q)
Hence > 𝟎 if and only if MR > 𝑴𝑪 𝑸
𝜕𝑄

If MR > MC , the profit will increase if the firm increases the quantity
produced
If MR < MC , the profit will decrease if the firm increases the quantity
produced
Profit maximization
Profit maximization occurs at the
quantity where marginal revenue equals
marginal cost.
• When MR > MC the firm should increase Q to
increase profit
• When MR < MC the firm should decrease Q to
increase profit
• When MR = MC profit is maximized.
Perfect competition: MR=P
• Hence profit max if and only if P=MC
The Marginal-Cost Curve and the Firm’s Supply Decision

Profit maximising level of output.

• If marginal revenue is greater than the marginal cost,
the firm can increase its profit by increasing output.
• If marginal cost is greater than marginal revenue,
the firm can increase its profit by decreasing output
• At the profit-maximizing level of output, marginal
revenue is equal to marginal cost.
Table 5 Profit Maximization: A Numerical Example

Copyright©2014 Cengage
 Figure 7 Profit Maximization for a Competitive Firm

Costs
and The firm maximizes
Revenue profit by producing
the quantity at which
marginal cost equals MC
marginal revenue.
MC2

ATC
P = MR1 = MR2 P = AR = MR
AVC

MC1

0 Q1 QMAX Q2 Quantity

Copyright©2014 Cengage
Measuring profit

Profit = TR - TC.
Because TR = P x Q and TC = ATC x Q,
we can rewrite profit as:
Profit = (P – ATC) x Q.
Figure 11a. Profit as the Area between Price and Average
Total Cost

(a) A Firm with Profits

Price

MC ATC
Profit

ATC P = AR = MR

0 Q Quantity
(profit-maximizing quantity)
Copyright©2014 Cengage
Figure 11b. Profit as the Area between Price and Average
Total Cost

(b) A Firm with Losses

Price

MC ATC

ATC

P P = AR = MR

Loss

0 Q Quantity
(loss-minimizing quantity)
Copyright©2014 Cengage
The Firm’s Short-Run Decision to Shut Down

The firm will not shut down (short run) if and

only if:
(Q) > (0)
Hence if and only if…
PQ – TVC(Q) – FC > -FC 

PQ – TVC(Q) > 0 

P > AVC(Q)
The Firm’s Short-Run Decision to Shut Down

The firm shuts down if the revenue it gets

from producing is less than the variable
cost of production.
• Shut down if TR < TVC
• Shut down if TR/Q < TVC/Q
• Shut down if P < AVC
The portion of the marginal cost curve that lies
above average variable cost is the competitive
firm’s short-run supply curve.
The Firm’s Short-Run Decision to Shut Down

A shutdown refers to a short-run decision

not to produce anything during a specific
period of time because of current market
conditions.
Exit refers to a long-run decision to leave
the market.
Figure 9 The Competitive Firm’s Short Run Supply Curve

Costs
Firm’s short-run
If P > ATC, the supply curve MC
firm will continue
to produce at a
profit.
ATC

If P > AVC, firm will

continue to AVC
produce in the
short run.

Firm
shuts
down if
P < AVC
0 Quantity

Copyright©2014 Cengage
Spilt Milk and Sunk Costs

The firm considers its sunk costs when

deciding to exit, but ignores them when
deciding whether to shut down.
• Sunk costs are costs that have already been
committed and cannot be recovered.
The Firm’s Long-Run Decision to Exit or
Enter a Market
In the long run, the firm exits if the revenue
it would get from producing is less than its
total cost.
• Exit if TR < TC
• Exit if TR/Q < TC/Q
• Exit if P < ATC
The Firm’s Long-Run Decision to Exit or
Enter a Market
A firm will enter the industry if such an
action would be profitable.
• Enter if TR > TC
• Enter if TR/Q > TC/Q
• Enter if P > ATC
 THE SUPPLY CURVE IN A
COMPETITIVE MARKET
The competitive firm’s long-run supply
curve is the portion of its marginal cost
curve that lies above average total cost.
Figure 10 The Competitive Firm’s Long-Run Supply Curve

Costs
Firm’s long-run
supply curve MC = long-run S

Firm
enters if
P > ATC ATC

Firm
exits if
P < ATC

0 Quantity

Copyright©2014 Cengage
 THE SUPPLY CURVE IN A
COMPETITIVE MARKET
Short-Run Supply Curve
• The portion of its marginal cost curve that lies
above average variable cost.
Long-Run Supply Curve
• The marginal cost curve above the minimum
point of its average total cost curve.
 THE SUPPLY CURVE IN A
COMPETITIVE MARKET
Market supply equals the sum of the
quantities supplied by the individual firms in
the market.
The Short Run: Market Supply with a Fixed
Number of Firms
For any given price, each firm supplies a
quantity of output so that its marginal cost
equals price.
The market supply curve reflects the
individual firms’ marginal cost curves.
 Figure 12 Market Supply with a Fixed Number of Firms

(a) Individual Firm Supply (b) Market Supply

Price Price

MC Supply

€ 2.00 € 2.00

1.00 1.00

0 100 200 Quantity (firm) 0 100,000 200,000 Quantity (market)

Copyright©2014 Cengage
The Long Run: Market Supply with Entry and
Exit
Firms will enter or exit the market until
profit is driven to zero.
In the long run, price equals the minimum
of average total cost.
The long-run market supply curve is
horizontal at this price.
 Figure 13 Market Supply with Entry and Exit

(a) Firm’s Zero-Profit Condition (b) Market Supply

Price Price

MC

ATC

P = minimum Supply
ATC

0 Quantity (firm) 0 Quantity (market)

Copyright©2014 Cengage
Normal and abnormal profit

 Profit is equal to total revenue minus total cost.

• To an economist, total cost includes all of the
opportunity costs of the firm.
• When a firm is earning zero profit, this must mean that
the firm's revenues are compensating the firm's
owners for the time and money that they have
expended to keep their businesses going.
 Definition of abnormal profit: the profit over and
above normal profit
A Shift in Demand in the Short Run and
Long Run
An increase in demand raises price and
quantity in the short run.
Firms earn profits because price now
exceeds average total cost.
 Figure 14a. An Increase in Demand in the Short Run and
Long Run

(a) Initial Condition

Firm Market
Price Price

MC ATC Short-run supply,

S1
A
P1 P1 Long-run
supply

Demand, D1

0 Quantity (firm) 0 Q1 Quantity (market)

Copyright©2014 Cengage
 Figure 14b. An Increase in Demand in the Short Run and
Long Run

(b) Short-Run Response

Firm Market
Price Price

Profit MC ATC S1
B
P2 P2
A
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Quantity (market)

Copyright©2014 Cengage
 Figure 14c. An Increase in Demand in the Short Run and
Long Run

(c) Long-Run Response

Firm Market
Price Price

MC S1
ATC B S2
P2
A C
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Q3 Quantity (market)

Copyright©2014 Cengage
The Long Run: Market Supply with Entry and
Exit
At the end of the process of entry and exit,
firms that remain must be making zero
economic profit.
The process of entry and exit ends only
when price and average total cost are
driven to equality.
Long-run equilibrium must have firms
operating at their efficient scale.
Why Do Competitive Firms Stay in Business
If They Make Zero Profit?
Profit equals total revenue minus total cost.
Total cost includes all the opportunity costs
of the firm.
In the zero-profit equilibrium, the firm’s
revenue compensates the owners for the
time and money they expend to keep the
business going.
Why the Long-Run Supply Curve Might Slope
Upward
Some resources used in production may be
available only in limited quantities.
Firms may have different costs.
 Higher cost firms enter in the market only if the price
rises.
MATHEMATICAL APPENDIX
73 Average cost and marginal cost
𝑇𝐶(𝑄) 𝜕𝑇𝐶 𝑄
𝐴𝑇𝐶 𝑄 = ; MC Q =
Q 𝜕𝑄
𝜕𝐴𝐶 𝑄
𝐴𝑇𝐶 𝑄 will decrease with Q whenever <0
𝜕𝑄
𝜕𝐴𝑻𝐶 𝑄
Le’t compute :
𝜕𝑄
𝑇𝐶 𝑄 𝜕𝑇𝐶 𝑄 𝜕𝑄
𝜕𝐴𝑇𝐶 𝑄 𝜕 𝑄− 𝑇𝐶(𝑄)
𝑄 𝜕𝑄 𝜕𝑄
= =
𝜕𝑄 𝜕𝑄 𝑄2
𝜕𝑇𝐶 𝑄
𝑄 − 𝑇𝐶(𝑄) 1 𝜕𝑇𝐶 𝑄 𝑇𝐶(𝑄)
𝜕𝑄
= 2
= −
𝑄 𝑄 𝜕𝑄 𝑄
1
= 𝑀𝐶(𝑄) − 𝐴𝑇𝐶(𝑄)
𝑄

𝝏𝑨𝑻𝑪 𝑸
Hence < 𝟎 if and only if 𝑴𝑪 𝑸 < 𝑨𝑻𝑪(𝑸)
𝝏𝑸