Short run and long run cost curves , firms introduction in economy
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Oct 17, 2024
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About This Presentation
Lecture notes on microeconomics
Slide Content
Intermediate
Microeconomics
Cost curves: Continued
Sisir Debnath
Microeconomics
Cost curves: Continued
Sisir Debnath
Short-Run and Long-Run Marginal Cost Curves
•For any output levely > 0,the long-run marginal cost is the marginal cost for
the short-run chosen by the firm.
•This is always true, no matter how many and which short-run circumstances
exist for the firm.
Sisir Debnath: Microeconomics9/30/2024
•For any output levely > 0,the long-run marginal cost is the marginal cost for
the short-run chosen by the firm.
•This is always true, no matter how many and which short-run circumstances
exist for the firm.
Sisir Debnath: Microeconomics9/30/2024
Determinants of the Shape of the Long-Run Cost Curve
•The law of diminishing marginal productivity does not apply in the long run
•All inputs are variable in the long run
•The shape of the long-run cost curve is due to the existence of economies and
diseconomies of scale
9/30/2024 Sisir Debnath: Microeconomics
•The law of diminishing marginal productivity does not apply in the long run
•All inputs are variable in the long run
•The shape of the long-run cost curve is due to the existence of economies and
diseconomies of scale
9/30/2024 Sisir Debnath: Microeconomics
Economies of Scale
•Production exhibits economies of scale when long-run average total costs
decrease as output increases
•These are shown by the downward sloping portion of the long-run average
total cost curve
•An indivisible setup cost is the cost of an indivisible input for which a certain
minimum amount of production must be undertaken before the input becomes
economically feasible to use
•The cost of a blast furnace or an oil refinery is an example of an indivisible
setup cost
•Indivisible setup costs create many real-world economies of scale
9/30/2024 Sisir Debnath: Microeconomics
•Production exhibits economies of scale when long-run average total costs
decrease as output increases
•These are shown by the downward sloping portion of the long-run average
total cost curve
•An indivisible setup cost is the cost of an indivisible input for which a certain
minimum amount of production must be undertaken before the input becomes
economically feasible to use
•The cost of a blast furnace or an oil refinery is an example of an indivisible
setup cost
•Indivisible setup costs create many real-world economies of scale
9/30/2024 Sisir Debnath: Microeconomics
Economies of Scale
•Because of the importance of economies of scale, business people often talk
about the minimum efficient level of production
•The minimum efficient level of production is the amount of production that
spreads setup costs out sufficiently for firms to undertake production profitably
•The minimum efficient level of production is reached once the size of the
market expands to a size large enough for firms to take advantage of all
economies of scale
9/30/2024 Sisir Debnath: Microeconomics
•Because of the importance of economies of scale, business people often talk
about the minimum efficient level of production
•The minimum efficient level of production is the amount of production that
spreads setup costs out sufficiently for firms to undertake production profitably
•The minimum efficient level of production is reached once the size of the
market expands to a size large enough for firms to take advantage of all
economies of scale
9/30/2024 Sisir Debnath: Microeconomics
Diseconomies of Scale
•Production exhibits diseconomies of scale when long-run average total costs
increase as output increases
•These are shown by the upward sloping portion of the long-run average total
cost curve
•Diseconomies of scale usually, but not always, start occurring as firms get
large
9/30/2024 Sisir Debnath: Microeconomics
•Production exhibits diseconomies of scale when long-run average total costs
increase as output increases
•These are shown by the upward sloping portion of the long-run average total
cost curve
•Diseconomies of scale usually, but not always, start occurring as firms get
large
9/30/2024 Sisir Debnath: Microeconomics
Diseconomies of Scale
•Two reasons for diseconomies of scale are:
1.Increased monitoring costs (the costs incurred by the organizer of
production in seeing to it that the employees do what they’re supposed to
do)
2.Loss of team spirit (the feelings of friendship and being part of a team that
bring out people’s best efforts)
9/30/2024 Sisir Debnath: Microeconomics
•Two reasons for diseconomies of scale are:
1.Increased monitoring costs (the costs incurred by the organizer of
production in seeing to it that the employees do what they’re supposed to
do)
2.Loss of team spirit (the feelings of friendship and being part of a team that
bring out people’s best efforts)
9/30/2024 Sisir Debnath: Microeconomics
Constant Returns to Scale
•Production exhibits constant economies of scale when average total costs do
not change as output increases
•Constant returns to scale are shown by the flat portion of the long-run
average total cost curve
•Constant returns to scale occur when production techniques can be replicated
again and again to increase output
• This occurs before monitoring costs rise and team spirit is lost
9/30/2024 Sisir Debnath: Microeconomics
•Production exhibits constant economies of scale when average total costs do
not change as output increases
•Constant returns to scale are shown by the flat portion of the long-run
average total cost curve
•Constant returns to scale occur when production techniques can be replicated
again and again to increase output
• This occurs before monitoring costs rise and team spirit is lost
9/30/2024 Sisir Debnath: Microeconomics
The Importance of Economies and Diseconomies of Scale
•The long-run and short-run average cost curves have the same U-shape, but
the underlying causes of this shape differ
•Economies and diseconomies of scale account for the shape of the long-run
average cost curve
•Initially increasing and eventually diminishing marginal productivity accounts
for the shape of the short-run average cost curves
•Economies and diseconomies of scale play important roles in real-world
production decisions
9/30/2024 Sisir Debnath: Microeconomics
•The long-run and short-run average cost curves have the same U-shape, but
the underlying causes of this shape differ
•Economies and diseconomies of scale account for the shape of the long-run
average cost curve
•Initially increasing and eventually diminishing marginal productivity accounts
for the shape of the short-run average cost curves
•Economies and diseconomies of scale play important roles in real-world
production decisions
9/30/2024 Sisir Debnath: Microeconomics
A Typical Long-Run Average Total Cost Curve
??????
Costs per
unit
Long-run
average total
cost (�????????????????????????)
ATC falls because of
economies of scale
ATC is constant because
of constant returns to
scale
ATC rises because of
diseconomies of scale
Minimum
efficient level
of
production
9/30/2024 Sisir Debnath: Microeconomics
??????
Costs per
unit
Long-run
average total
cost (�????????????????????????)
ATC falls because of
economies of scale
ATC is constant because
of constant returns to
scale
ATC rises because of
diseconomies of scale
Minimum
efficient level
of
production
9/30/2024 Sisir Debnath: Microeconomics
The Envelope Relationship
•Long-run costs are always less than or equal to short-run costs because:
•In the long run, all inputs are flexible
•In the short run, some inputs are fixed
•There is an envelope relationship between long-run and short-run average
total costs. Each short-run cost curve touches the long-run cost curve at only
one point.
•In the short run all expansion must proceed by increasing only the variable
input
•This constraint increases cost
9/30/2024 Sisir Debnath: Microeconomics
•Long-run costs are always less than or equal to short-run costs because:
•In the long run, all inputs are flexible
•In the short run, some inputs are fixed
•There is an envelope relationship between long-run and short-run average
total costs. Each short-run cost curve touches the long-run cost curve at only
one point.
•In the short run all expansion must proceed by increasing only the variable
input
•This constraint increases cost
9/30/2024 Sisir Debnath: Microeconomics
The Envelope of Short-Run Average Total Cost Curves
SRMC
3
SRATC
3
SRMC
4
SRATC
4
SRMC
1
SRATC
1
SRMC
2
SRATC
2
�????????????????????????
y
Costs per unit
9/30/2024 Sisir Debnath: Microeconomics
SRMC
3
SRATC
3
SRMC
4
SRATC
4
SRMC
1
SRATC
1
SRMC
2
SRATC
2
�????????????????????????
y
Costs per unit
9/30/2024 Sisir Debnath: Microeconomics
Intermediate
Microeconomics
Firm supply
Sisir Debnath
Microeconomics
Firm supply
Sisir Debnath
Firm Supply
•How does a firm decide how much product to supply? This depends upon the
firm’s
• technology
• market environment
• goals
• competitors’ behaviors
Sisir Debnath: Microeconomics9/30/2024
•How does a firm decide how much product to supply? This depends upon the
firm’s
• technology
• market environment
• goals
• competitors’ behaviors
Sisir Debnath: Microeconomics9/30/2024
Market Environments
•Are there many other firms, or just a few?
•Do other firms’ decisions affect our firm’s payoffs?
•Is trading anonymous in a market? Or are trades arranged with separate
buyers by middlemen?
Sisir Debnath: Microeconomics9/30/2024
•Are there many other firms, or just a few?
•Do other firms’ decisions affect our firm’s payoffs?
•Is trading anonymous in a market? Or are trades arranged with separate
buyers by middlemen?
Sisir Debnath: Microeconomics9/30/2024
Market Environments
•Monopoly: Just one seller that determines the quantity supplied and the
market-clearing price.
•Oligopoly: A few firms, the decisions of each influencing the payoffs of the
others.
Sisir Debnath: Microeconomics9/30/2024
•Monopoly: Just one seller that determines the quantity supplied and the
market-clearing price.
•Oligopoly: A few firms, the decisions of each influencing the payoffs of the
others.
Sisir Debnath: Microeconomics9/30/2024
Market Environments
•Dominant Firm: Many firms, but one much larger than the rest. The large
firm’s decisions affect the payoffs of each small firm. Decisions by any one small
firm do not noticeably affect the payoffs of any other firm.
•Monopolistic Competition: Many firms each making a slightly different
product. Each firm’s output level is small relative to the total.
•Pure Competition: Many firms, all making the same product. Each firm’s
output level is small relative to the total.
Sisir Debnath: Microeconomics9/30/2024
•Dominant Firm: Many firms, but one much larger than the rest. The large
firm’s decisions affect the payoffs of each small firm. Decisions by any one small
firm do not noticeably affect the payoffs of any other firm.
•Monopolistic Competition: Many firms each making a slightly different
product. Each firm’s output level is small relative to the total.
•Pure Competition: Many firms, all making the same product. Each firm’s
output level is small relative to the total.
Sisir Debnath: Microeconomics9/30/2024
Market Environments
•Later topics will examine monopoly, oligopoly, and the dominant firm.
•Today we will explore only pure competition.
Sisir Debnath: Microeconomics9/30/2024
•Later topics will examine monopoly, oligopoly, and the dominant firm.
•Today we will explore only pure competition.
Sisir Debnath: Microeconomics9/30/2024
Pure Competition
•A firm in a perfectly competitive market knows it has no influence over the
market price for its product. The firm is a market price-taker.
•If the firm sets its own price above the market price, then the quantity
demanded from the firm is zero.
•If the firm sets its own price below the market price, then the quantity
demanded from the firm is the entire market quantity demanded.
•So, what is the demand curve faced by the individual firm?
Sisir Debnath: Microeconomics9/30/2024
•A firm in a perfectly competitive market knows it has no influence over the
market price for its product. The firm is a market price-taker.
•If the firm sets its own price above the market price, then the quantity
demanded from the firm is zero.
•If the firm sets its own price below the market price, then the quantity
demanded from the firm is the entire market quantity demanded.
•So, what is the demand curve faced by the individual firm?
Sisir Debnath: Microeconomics9/30/2024
Market demand
Pure Competition
•The equilibrium price in
the market is ??????
�
•At a price of ??????
′′
the firm
faces the entire market
demand.
•At a price of ??????
′
the
demand faced by the firm
is ⋯?
•The demand curve
faced by the firm is ⋯
Sisir Debnath: Microeconomics9/30/2024
y
??????
Market supply
??????
�
??????
′′
??????
′
Pure Competition
•The equilibrium price in
the market is ??????
�
•At a price of ??????
′′
the firm
faces the entire market
demand.
•At a price of ??????
′
the
demand faced by the firm
is ⋯?
•The demand curve
faced by the firm is ⋯
Sisir Debnath: Microeconomics9/30/2024
y
??????
Market supply
??????
�
??????
′′
??????
′
Market demand
Pure Competition
•The equilibrium price in
the market is ??????
�
•At a price of ??????
′′
the firm
faces the entire market
demand.
•At a price of ??????
′
the
demand faced by the firm
is ⋯?
•The demand curve
faced by the firm is ⋯
Sisir Debnath: Microeconomics9/30/2024
y
??????
Market supply
??????
�
??????
′′
??????
′
Firm demand
Pure Competition
•The equilibrium price in
the market is ??????
�
•At a price of ??????
′′
the firm
faces the entire market
demand.
•At a price of ??????
′
the
demand faced by the firm
is ⋯?
•The demand curve
faced by the firm is ⋯
Sisir Debnath: Microeconomics9/30/2024
y
??????
Market supply
??????
�
??????
′′
??????
′
Firm demand
Smallness
•What does it mean to say that an individual firm is “small relative to the
industry”?
Sisir Debnath: Microeconomics9/30/2024
•What does it mean to say that an individual firm is “small relative to the
industry”?
Sisir Debnath: Microeconomics9/30/2024
Firm demand
Smallness
•The individual firm’s
technology makes it
always to supply only a
tiny part of the total
quantity demanded in
the market
•We will consider only
the horizontal portion of
the demand
Sisir Debnath: Microeconomics9/30/2024
y
??????
??????
�
??????
′′
??????
′
Firm’s MC
Smallness
•The individual firm’s
technology makes it
always to supply only a
tiny part of the total
quantity demanded in
the market
•We will consider only
the horizontal portion of
the demand
Sisir Debnath: Microeconomics9/30/2024
y
??????
??????
�
??????
′′
??????
′
Firm’s MC
Demand Curves for the Firm and the Industry
Sisir Debnath: Microeconomics
??????
Y
Market demand is
downward sloping
Market
Supply
Firm demand is perfectly
elastic (horizontal)
P0
Market
Demand
??????
y
P0
Firm
Demand
P = D = MR
y
1y
2y
3
9/30/2024
Sisir Debnath: Microeconomics
??????
Y
Market demand is
downward sloping
Market
Supply
Firm demand is perfectly
elastic (horizontal)
P0
Market
Demand
??????
y
P0
Firm
Demand
P = D = MR
y
1y
2y
3
9/30/2024
The Firm’s Short-Run Supply Decision
•Each firm is a profit maximizer and in a short run.
•How does each firm choose its output level?
➢By solving:
max
??????≥0
????????????=????????????−??????(??????)
Sisir Debnath: Microeconomics9/30/2024
•Each firm is a profit maximizer and in a short run.
•How does each firm choose its output level?
➢By solving:
max
??????≥0
????????????=????????????−??????(??????)
Sisir Debnath: Microeconomics9/30/2024
The Firm’s Short-Run Supply Decision
max
??????≥0
????????????=????????????−??????(??????)
•What can a solution look like?
• ??????
∗
>0 Known as an interior solution.
• ??????
∗
=0 If the maximum profit is obtained by not producing at all.
Sisir Debnath: Microeconomics9/30/2024
max
??????≥0
????????????=????????????−??????(??????)
•What can a solution look like?
• ??????
∗
>0 Known as an interior solution.
• ??????
∗
=0 If the maximum profit is obtained by not producing at all.
Sisir Debnath: Microeconomics9/30/2024
The Firm’s Short-Run Supply Decision
•For the interior case of ??????
∗
>0, the first-order condition is
�??????
�??????
=??????−�??????(??????)≡0.
•Or similarly, ??????=�??????(??????).
•In other words, to maximize profits, firms should choose the level of output,
??????
∗
, where market price equals the marginal cost.
Sisir Debnath: Microeconomics9/30/2024
•For the interior case of ??????
∗
>0, the first-order condition is
�??????
�??????
=??????−�??????(??????)≡0.
•Or similarly, ??????=�??????(??????).
•In other words, to maximize profits, firms should choose the level of output,
??????
∗
, where market price equals the marginal cost.
Sisir Debnath: Microeconomics9/30/2024
The Firm’s Short-Run Supply Decision
Sisir Debnath: Microeconomics9/30/2024
MC
??????
??????
P = D = MR
??????
??????
∗
??????
′
•At y= ??????
??????
∗
,??????=�?????? and the
�?????? is rising, therefore ??????
??????
∗
is a
profit maximizing output
•So, a profit maximizing supply
level can only lie on the upward
sloping part of the firm’s MC
curve
Sisir Debnath: Microeconomics9/30/2024
MC
??????
??????
P = D = MR
??????
??????
∗
??????
′
•At y= ??????
??????
∗
,??????=�?????? and the
�?????? is rising, therefore ??????
??????
∗
is a
profit maximizing output
•So, a profit maximizing supply
level can only lie on the upward
sloping part of the firm’s MC
curve
A Competitive Firm
•Find output where MC = MR,
this is the profit maximizing
output (??????
??????
∗
)
•Find profit per unit at ??????
??????
∗
•Since P > ATC at ??????
??????
∗
, this firm is
earning profits
Sisir Debnath: Microeconomics
AVC
MC
??????
??????
ATC
P = D = MR
MC = MR
??????
??????
∗
ATC at ??????
??????
∗
P
ATC
Profits
9/30/2024
•Find output where MC = MR,
this is the profit maximizing
output (??????
??????
∗
)
•Find profit per unit at ??????
??????
∗
•Since P > ATC at ??????
??????
∗
, this firm is
earning profits
Sisir Debnath: Microeconomics
AVC
MC
??????
??????
ATC
P = D = MR
MC = MR
??????
??????
∗
ATC at ??????
??????
∗
P
ATC
Profits
9/30/2024
A Competitive Firm
Sisir Debnath: Microeconomics
AVC
MC
ATC
MC = MR
ATC at ??????
??????
∗
??????
=ATC
P = D = MR
??????
??????
??????
??????
∗
•Find output where MC = MR,
this is the profit maximizing
output (??????
??????
∗
)
•Find profit per unit at ??????
??????
∗
•Since ?????? = ATC at ??????
??????
∗
, this firm is
earning normal profits (i.e., zero
profits)
9/30/2024
Sisir Debnath: Microeconomics
AVC
MC
ATC
MC = MR
ATC at ??????
??????
∗
??????
=ATC
P = D = MR
??????
??????
??????
??????
∗
•Find output where MC = MR,
this is the profit maximizing
output (??????
??????
∗
)
•Find profit per unit at ??????
??????
∗
•Since ?????? = ATC at ??????
??????
∗
, this firm is
earning normal profits (i.e., zero
profits)
9/30/2024
A Competitive Firm
Sisir Debnath: Microeconomics
AVC
MC
ATC
MC = MR
ATC at ??????
??????
∗
P
ATC
P = D = MR
Losses
??????
??????
??????
??????
∗
•Find output where MC = MR,
this is the profit maximizing
output (??????
??????
∗
)
•Find profit per unit at ??????
??????
∗
•Since ?????? < ATC at ??????
??????
∗
, this firm is
making losses
9/30/2024
Sisir Debnath: Microeconomics
AVC
MC
ATC
MC = MR
ATC at ??????
??????
∗
P
ATC
P = D = MR
Losses
??????
??????
??????
??????
∗
•Find output where MC = MR,
this is the profit maximizing
output (??????
??????
∗
)
•Find profit per unit at ??????
??????
∗
•Since ?????? < ATC at ??????
??????
∗
, this firm is
making losses
9/30/2024
The Firm’s Short-Run Supply Decision
•But not every point on the upward-sloping part of the firm’s MC curve
represents a profit maximum.
•The firm’s profit function is
????????????=????????????−????????????=????????????−??????−??????
????????????.
•If the firm chooses ?????? = 0 then its profit is
????????????=0−??????−??????
??????0=−??????.
Sisir Debnath: Microeconomics9/30/2024
•But not every point on the upward-sloping part of the firm’s MC curve
represents a profit maximum.
•The firm’s profit function is
????????????=????????????−????????????=????????????−??????−??????
????????????.
•If the firm chooses ?????? = 0 then its profit is
????????????=0−??????−??????
??????0=−??????.
Sisir Debnath: Microeconomics9/30/2024
The Firm’s Short-Run Supply Decision
•So the firm will choose an output level ?????? > 0 only if
????????????=????????????−??????−??????
????????????≥−??????
•or only if
????????????−??????
????????????≥0.
•Or equivalently, only if
??????≥
??????
????????????
??????
=??????????????????(??????).
Sisir Debnath: Microeconomics9/30/2024
•So the firm will choose an output level ?????? > 0 only if
????????????=????????????−??????−??????
????????????≥−??????
•or only if
????????????−??????
????????????≥0.
•Or equivalently, only if
??????≥
??????
????????????
??????
=??????????????????(??????).
Sisir Debnath: Microeconomics9/30/2024
??????
??????
The Shutdown Decision
•The shutdown point is the point
below which the firm will be
better off if it shuts down than it
will if it stays in business
•If ?????? > min of AVC, then the firm
will still produce, but earn a loss
•If ?????? < min of AVC, the firm will
shut down
•If a firm shuts down, it still has to
pay its fixed costs
Sisir Debnath: Microeconomics
AVC
MC
ATC
??????
Shutdown P = D = MR
??????
??????
∗
9/30/2024
??????
The Shutdown Decision
•The shutdown point is the point
below which the firm will be
better off if it shuts down than it
will if it stays in business
•If ?????? > min of AVC, then the firm
will still produce, but earn a loss
•If ?????? < min of AVC, the firm will
shut down
•If a firm shuts down, it still has to
pay its fixed costs
Sisir Debnath: Microeconomics
AVC
MC
ATC
??????
Shutdown P = D = MR
??????
??????
∗
9/30/2024
??????
??????
The Supply Curve of a Firm in a Competitive Market
•Above the minimum AVC the MC
is always rising
•For ??????>??????????????????, the firm’s short run
supply curve is given by the MC
curve above the AVC; and For ??????≤
?????????????????? the firm’s supply is zero.
Sisir Debnath: Microeconomics
AVC
MC
ATC
??????
Shutdown
??????
??????
∗
??????
??????
∗
9/30/2024
??????
The Supply Curve of a Firm in a Competitive Market
•Above the minimum AVC the MC
is always rising
•For ??????>??????????????????, the firm’s short run
supply curve is given by the MC
curve above the AVC; and For ??????≤
?????????????????? the firm’s supply is zero.
Sisir Debnath: Microeconomics
AVC
MC
ATC
??????
Shutdown
??????
??????
∗
??????
??????
∗
9/30/2024
The Firm’s Short-Run Supply Decision
•Shutdown is not the same as exit.
•Shutting down means producing no output (but the firm is still in the industry
and suffers its fixed cost).
•Exiting means leaving the industry, which the firm can do only in the long run.
Sisir Debnath: Microeconomics9/30/2024
•Shutdown is not the same as exit.
•Shutting down means producing no output (but the firm is still in the industry
and suffers its fixed cost).
•Exiting means leaving the industry, which the firm can do only in the long run.
Sisir Debnath: Microeconomics9/30/2024
The Firm’s Long-Run Supply Decision
•The long run is the circumstance in which the firm can choose among all of its
short-run circumstances.
•How does the firm’s long-run supply decision compare to its short-run supply
decisions?
•The long-run cost ??????(??????) of producing ?????? units of output consists only of
variable costs since all inputs are variable in the long run.
Sisir Debnath: Microeconomics9/30/2024
•The long run is the circumstance in which the firm can choose among all of its
short-run circumstances.
•How does the firm’s long-run supply decision compare to its short-run supply
decisions?
•The long-run cost ??????(??????) of producing ?????? units of output consists only of
variable costs since all inputs are variable in the long run.
Sisir Debnath: Microeconomics9/30/2024
The Firm’s Long-Run Supply Decision
Sisir Debnath: Microeconomics9/30/2024
Sisir Debnath: Microeconomics9/30/2024
The Firm’s Long-Run Supply Decision
Sisir Debnath: Microeconomics9/30/2024
Sisir Debnath: Microeconomics9/30/2024
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