Economics

ECO 2301, Principles of Microeconomics 1

Course Learning Outcomes for Unit V Upon completion of this unit, students should be able to:

5. Recall the theories of economic regulation. 5.1 Identify the relationship between total cost and marginal cost. 5.2 Identify the profit maximizing amount of output to produce when given short-run total and

marginal cost. 5.3 Identify the point at which the firm should shut down in the short run.

Course/Unit Learning Outcomes

Learning Activity

5.1

Unit Lesson Chapter 7, pp. 109–119 Article: “Relating Product Prices to Long-Run Marginal Cost: Evidence From

Solar Photovoltaic Modules” Unit V Assignment

5.2

Unit Lesson Chapter 7, pp. 109–119 Article: “Relating Product Prices to Long-Run Marginal Cost: Evidence From

Solar Photovoltaic Modules” Unit V Assignment

5.3 Unit Lesson Chapter 7, pp. 109–119 Unit V Assignment

Required Unit Resources Chapter 7: Production and Cost in the Firm, pp. 109–119 In order to access the following resource, click the link below. Reichelstein, S., & Sahoo, A. (2018, September). Relating product prices to long-run marginal cost: Evidence

from solar photovoltaic modules. Contemporary Accounting Research, 35(3). https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=131948842&site=ehost-live&scope=site

Unit Lesson Why are firms in business? Some firms are in operation to fulfill a dream of the owner. Some businesses are in operation to improve society. Regardless of the motivation, business operations can be summarized as consisting of people, products, and profits (Iacocca, 1984). Without profits, even the most relevant business cannot be sustainable. Profits of a firm are relatively easy to define. Profits represent the amount of sales revenues that are greater than resource costs (McEachern, 2019). This means profits are determined by subtracting a firm’s costs from its revenues. The output level that produces the highest profits is the optimal output level for the firm. However, there are many facets associated with analyzing a firm’s revenue and costs that are important to understand. In this unit, we will explore how economists analyze revenue and costs and help firms make decisions.

UNIT V STUDY GUIDE

Costs in the Firm

ECO 2301, Principles of Microeconomics 2

UNIT x STUDY GUIDE

Title

Costs in the Short Run In the short run, there are two different types of costs: fixed and variable. Fixed costs (FC) represent any production expense that is not related to the firm’s rate of output (McEachern, 2019). In other words, the firm will have to pay these costs regardless of whether they produce any product or not. For example, a firm that makes chairs will have a building and machinery/equipment that may be rented or purchased. The firm will have to pay insurance for that building and machinery/equipment. These expenses will be paid by the firm if the firm makes one million chairs per month or no chairs at all. Variable cost (VC) is the cost of variable resources. Variable cost increases or decreases as the rate of output changes (McEachern, 2019). For example, the firm that makes chairs will have to purchase supplies (wood, screws, labor, and so on) to make the chairs. If no chairs are produced, there will be no need for these supplies. This means that the variable cost would equal zero if no chairs were produced. As the number of chairs that are produced increases, more supplies will be required. This suggests that variable cost will increase as the number of chairs produced each month increases. Variable cost is determined by the price per unit of the variable resource(s) multiplied by the total number of the variable resource(s) used in production.

Unit Price of Total Number of Variable Cost (VC) = Variable x Variable Resources

Resources The total cost (TC) of production associated with production is determined by adding the fixed costs and variable cost. The total cost of production will never equal zero because fixed costs will never equal zero. As output (q) increases, total cost will increase because more variable resources are being used.

Total Cost (TC) = Fixed Costs + Variable Costs Total Cost Will Never Equal 0 (TC ≠ 0)

Calculating Profits Using Total Cost and Revenue

Using the example from Unit IV, assume that the only variable resource for the firm producing chairs is labor. The firm can employ between zero and 10 workers per day. Each worker earns $100 per day. The table below demonstrates various output levels (chairs produced), number of workers, price of labor, variable cost, fixed cost, and total cost associated with producing chairs in a day.

ECO 2301, Principles of Microeconomics 3

UNIT x STUDY GUIDE

Title

(a) (b) (c) (d) (e) (f)

(b x c) (d + e)

Chairs Produced per

Day (Output, q)

Number of Workers per

Day

Price per Worker per Day

Variable Cost (VC)

Fixed Cost (FC)

Total Cost (TC)

0 0 $100 $0 $75 $75 10 1 $100 $100 $75 $175 30 2 $100 $200 $75 $275 70 3 $100 $300 $75 $375

100 4 $100 $400 $75 $475 120 5 $100 $500 $75 $575 130 6 $100 $600 $75 $675 135 7 $100 $700 $75 $775 137 8 $100 $800 $75 $875 137 9 $100 $900 $75 $975 135 10 $100 $1,000 $75 $1,075

The only other requirement needed to calculate profitability is revenue that would be generated at each output level. To calculate revenue, simply multiply the price per unit of the output and the total output at each level. For this example, assume the price per chair is $50. Given this information, three more columns—price per unit of output (price per chair), total revenue, and profit—can be added to the table.

(a) (b) (c) (d) (e) (f) (g) (h) (i)

(b x c) (d + e) (a x g) (h - f)

Chairs Produced per Day

(Output, q)

Numbe r of

Worker s per Day

Price per

Worker per Day

Variable Cost (VC)

Fixe d

Cost (FC)

Total Cost (TC)

Price per

Chair

Total Revenu

e (TR)

Profit

0 0 $100 $0 $75 $75 $50 $0 - $75 10 1 $100 $100 $75 $175 $50 $500 $325 30 2 $100 $200 $75 $275 $50 $1,500 $1,225 70 3 $100 $300 $75 $375 $50 $3,000 $2,625

100 4 $100 $400 $75 $475 $50 $5,000 $4,525 120 5 $100 $500 $75 $575 $50 $6,000 $5,425 130 6 $100 $600 $75 $675 $50 $6,500 $5,825

135 7 $100 $700 $75 $775 $50 $6,750 $5,975 137 8 $100 $800 $75 $875 $50 $6,850 $5,975

137 9 $100 $900 $75 $975 $50 $6,850 $5,875 135 10 $100 $1,000 $75 $1,075 $50 $6,750 $5,675

Notice that when no chairs are produced in a day, profits are equal to -$75. This is because the firm still has to pay fixed costs regardless of whether production occurs or not. As output levels begin to increase, profits begin to increase as well. Profits reach their maximum point when 135 or 137 chairs are produced per day. Both of these levels of output result in a total profit of $5,975. Producing more or less than the optimal level of chairs per day would result in lower profits.

Determining Optimal Output Using Marginal Revenue and Marginal Cost As you already know, economists analyze data in many different ways. Economists are interested in calculating the average variable cost, average fixed cost, average total cost, marginal cost, and marginal

ECO 2301, Principles of Microeconomics 4

UNIT x STUDY GUIDE

Title

revenue. Performing these calculations can tell us the profit maximizing level of output, but they can also reveal some other interesting aspects regarding the production and price levels that result in the firm breaking even and when it would be best for the firm to shut down in the short run. Below are the equations to use when calculating average variable cost, average fixed cost, average total cost, marginal cost, and marginal revenue:

• Average Variable Cost (AVC) = Variable Cost ÷ Output

• Average Fixed Cost (AFC) = Fixed Cost ÷ Output

• Average Total Cost (ATC) = Total Cost ÷ Output

• Marginal Cost (MC) = Change in Total Cost ÷ Change in Output

• Marginal Revenue (MR) = Change in Total Revenue ÷ Change in Output

Marginal Cost and Marginal Revenue in More Detail The first three formulas above (AVC, AFC, and ATC) are relatively straightforward. Simply divide the identified cost by the output level. Calculating marginal cost and marginal revenue can take a couple of steps, but they are not difficult. For example, we know the following about calculating marginal cost:

Marginal Cost (MC) = Change in Total Cost

Change in Output When we calculate marginal cost, we are calculating the difference in total cost from one output level to another and dividing that by the change in output from one level to another. For example, in the table above, when zero units of output (chairs per day) were produced, total cost equaled $75. When 10 chairs were produced per day, total cost equaled $175. These numbers are plugged into the formula for marginal cost below, and the calculations give us a marginal cost of $10:

Marginal Cost (MC) = $175 – $75

10 – 0

Marginal Cost (MC) = $100

10

Marginal Cost (MC) = $10 Next, the total cost for producing 30 chairs per day equaled $275. We also know that the total cost for producing 10 chairs equals $175. We can now calculate the marginal cost associated with increasing the level of production from 10 to 30 chairs, which turns out to be $5:

Marginal Cost (MC) = $275 – $175

30 – 10

Marginal Cost (MC) = $100

20

Marginal Cost (MC) = $5 You can continue to calculate the marginal cost for each level of output in the same way. Marginal revenue is calculated in the same manner as marginal cost, except you are using total revenue instead of total cost. For example, we know the following for marginal revenue:

ECO 2301, Principles of Microeconomics 5

UNIT x STUDY GUIDE

Title

Marginal Revenue (MR) = Change in Total Revenue

Change in Output When we calculate marginal cost, we are calculating the difference in total revenue from one output level to another and dividing that by the change in output from one level to another. For example, in the table above, when zero units of output (chairs per day) were produced, total revenue equaled $0. When 10 chairs were produced per day, total revenue equaled $500. When these numbers are plugged into the formula for marginal cost below, we find that the marginal revenue in this situation is $50:

Marginal Revenue (MR) = $500 – $0

10 – 0

Marginal Revenue (MR) = $500

10

Marginal Revenue (MR) = $50 Next, looking back at the table again, the total revenue for producing 30 chairs per day equaled $1,500. We also know that the total revenue for producing 10 chairs equals $500. We can now calculate the marginal revenue associated with increasing the level of production from 10 to 30 chairs. Our calculations tell us that the marginal revenue for this situation equals $50:

Marginal Revenue (MR) = $1,500 – $500

30 – 10

Marginal Revenue (MR) = $1,000

20

Marginal Revenue (MR) = $50 You can continue to calculate the marginal cost for each level of output in the same way. However, notice that marginal revenue never changes from one output level to another. Also, notice that the calculated marginal revenue is equal to the price level of the output. Instead of spending time making all these calculations for marginal revenue, we can simply record the price of the output for marginal revenue, which is $50.

Shortcut Hint: Marginal revenue is equal to the price of the output under perfect competition.

Now, we have all the information needed to expand the table even more. Below is our original table, but columns have been added to include data for average variable cost, average fixed cost, average total cost, marginal cost, and marginal revenue. A larger version of the full table is available.

ECO 2301, Principles of Microeconomics 6

UNIT x STUDY GUIDE

Title

From previous units, we know that marginal analysis can be used to find the optimal level of output to produce. When trying to determine the optimal level of output to produce, the decision rule is to find that level of output where marginal revenues equal marginal costs. For example, in the table above, the calculated marginal revenue equals $50. Marginal costs equal $50 when 137 chairs are produced using eight workers per day. At this level of output, $5,975 in profits will be made. Notice that the same maximum profit of $5,975 will also be made when seven workers are used and 135 chairs are produced. However, this level of profit is not optimal because the labor resources are not being used efficiently. We can tell where the variable resource, such as labor in this example, is being used efficiently when marginal revenues are equal to marginal costs.

Other Things Marginal Cost Tells Us It is certain that firms will produce output at a level where profits are maximized. Marginal cost tells us more than just what the optimal level of output is that will produce the highest profits. For example, let’s examine the cost curves below.

• The average fixed cost curve (AFC) begins by decreasing at a rapid rate. Slowly, the average fixed cost curve flattens out, but it continues to decrease.

• The average variable cost curve (AVC) starts by decreasing, reaches a minimum point, and then starts increasing.

• The average total cost curve (ATC) starts by decreasing at a rapid rate, reaches a minimum, and then starts to increase.

• The marginal cost curve (MC) begins by decreasing, reaches a minimum point, and then begins to increase. The marginal cost curve intersects the average variable cost curve (AVC) at the lowest point for the average variable cost (point B). The marginal cost curve also intersects the average total cost curve at the lowest point for the average total cost (point A).

ECO 2301, Principles of Microeconomics 7

UNIT x STUDY GUIDE

Title

Now, we know that the level of output to produce is determined by the point where the marginal revenue (MR) intersects the marginal cost (MC). If the marginal revenue intersects the marginal cost at point A, the optimal level of output will be Q*. However, notice that point A is also where marginal cost equals average total cost. When marginal revenue intersects marginal cost at this point, the firm is breaking even. Break-even is defined as the point where total revenues are exactly equal to total costs (McEachern, 2019).

If marginal revenue (MR) intersects marginal cost (MC) above point A, firms will be earning a profit. The level of profit will be the difference between the marginal revenue and a horizontal line drawn through point A. This profit level is shown in the graph below:

Now, not all firms will be able to earn enough revenue to cover all their costs. When firms first begin operation, sales may not be enough to cover all the fixed and variable costs of production (for example, buying machinery, renting a building, and paying for variable resources). However, these firms still remain in operation. This is because these firms can slowly pay for the fixed costs in the short run. However, if firms cannot pay for the variable costs in the short run, then they would be better off shutting down. For example, let’s refer back to the firm that produces chairs. If the firm was going to lose $100 by producing five chairs, the firm would be better off shutting down in the short run because they would only lose $75 (their fixed cost) if they produced no chairs at all. When we look at the curves below, point B becomes

ECO 2301, Principles of Microeconomics 8

UNIT x STUDY GUIDE

Title

very important. If marginal revenue (MR) intersects marginal cost (MC) at point B, we also know it is equal to average variable cost (AVC). Firms will not produce at a level where marginal revenue is below point B.

One last important note about these curves: Notice how the firm will operate as long as marginal revenue (MR) is above the minimum point of average variable cost (AVC) when it intersects marginal cost (MC). At every level above point B on the marginal cost curve, the firm will produce. That means that the marginal cost curve, above the minimum average variable cost (AVC) curve, is the supply curve for the firm.

References Iacocca, L. A. (with Novak, W.). (1984). Iacocca: An autobiography. Bantam Books. McEachern, W. A. (2019). Micro ECON6: Principles of microeconomics. Cengage Learning.

https://online.vitalsource.com/#/books/9781337671828