The Many Types of Cost: A Summary

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Reserved. May not be copied, scanned, or
duplicated, in whole or in part, except for
use as permitted in a license distributed
with a certain product or service or

Calculating Costs
Q

VC

FC

TC

AVC

AFC

ATC

MC

50

n/a

n/a

n/a

n/a

10

10

60

10

30

80

20

16.67

36.67

30

100

150

12.5

37.5

150

30

210

260

35

8.33

43.33

60

Input Response over the Long and Short Run

8-3

Long-run and Short-run Average Cost Curves

8-4

10.9
Average and Marginal Cost Curves for the Cubic Cost Curve Case

Costs
SMC (k0) SAC (k0)

SAC (k1)

q0

MC

SMC (k2) SAC (k2)

AC

SMC (k1)

q1

q2

Output
per period

This set of curves is derived from the total cost curves shown in Figure 10.8. The
AC and MC curves have the usual U-shapes, as do the short-run curves. At q1,
long-run average costs are minimized. The configuration of curves at this
minimum point is important.
5

Short-run vs. Long-run Costs

In the long run a firm can vary all inputs
Will choose least-cost input combination for each output
level

In the short run a firm has at least one fixed input

Produce some level of output at least-cost input
combination
Can vary output from that in short run but will have
higher costs than could achieve if all inputs were
variable

Long-run average variable cost curve is the lower

envelope of the short-run average cost curves
One short-run curve for each possible level of output

8-6

Characteristics of Perfect Competition

1.
1. Many
Many buyers
buyers and
and many
many sellers.
sellers.
2.
2. The
The goods
goods offered
offered for
for sale
sale are
are largely
largely the
the

same.
same.

3.
3. Firms
Firms can
can freely
freely enter
enter or
or exit
exit the
the market.
market.

Because of 1 & 2, each buyer and seller

is a price taker takes the price as
given.

The Revenue of a Competitive Firm

Total revenue (TR)
Average revenue
(AR)
Marginal revenue
(MR):
The change in TR
from
selling one more
unit.

TR = P x Q
TR
=P
AR =
Q
TR
MR =
Q

ACTIVE LEARNING

Calculating TR, AR, MR

Fill in the empty spaces of the

table.
P

TR

AR

$10

n/a

$10

$10

$10

$10

$10

$40

$10

$50

2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

MR

$10

MR = P for a Competitive
Firm
A competitive firm can keep
increasing its output without
affecting the market price.
So, each one-unit increase in Q
= P is to
only
true
causes MR
revenue
rise
byfor
P, i.e., MR
firms in competitive
= P.
markets.

Profit Maximization
At any Q
with MR >
MC,
increasing
Q raises
At
any Q
profit.
with MR <
MC,
reducing Q
raises
profit.

TR

TC Profit MR MC

$0

$5

$5

10

20

15

30

23

40

33

50

45

$1 $4
0
10 6
10

Profit
= MR
MC
$6
4
2

10 10

10 12

A Firms Short-run Decision to Shut Down

Cost of shutting down: revenue loss

= TR
Benefit of shutting down: cost
savings = VC
(firm must still pay FC)
So, shut down if TR < VC
Shut down if P < AVC
Divide both
sides by Q:
TR/Q <
VC/Q

A Competitive Firms SR Supply Curve

The firms SR
Costs
supply curve
is the portion
of
If Pcurve
> AVC,
its MC
then
firm
above
AVC.
produces Q
where P = MC.
If P < AVC,
then firm shuts
down
(produces Q =
0).

MC
ATC
AVC

A Firms Long-Run Decision to Exit

Cost of exiting the market: revenue
loss = TR
Benefit of exiting the market: cost
savings = TC
(avoidable FC are zero when you exit)
So, firm exits if TR < TC
Divide both sides
Exit by
if PQ< to
ATCwrite the
firms decision rule as:

The Competitive Firms Supply Curve

The firms
LR supply
curve is the
portion of
its MC curve
above LRATC.

Costs
MC
LRATC

ACTIVE LEARNING

Identifying a firms profit

Determine
this firms
total profit.
Identify the
area on the
graph that
represents
the firms
profit.

A competitive firm
Costs, P
MC
MR
ATC

P=
$10
$6

50
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING

Answers
A competitive firm
Costs, P
Profit per
unit
= P ATC
= $10 6
= $4

MC
P=
$10
$6

MR
ATC

profi
t

Total profit
= (P ATC) x
Q = $4 x 50
= $200
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

50

ACTIVE LEARNING

Identifying a firms loss

Determine
this firms
total loss,
assuming
AVC < $3.
Identify the
area on the
graph that
represents
the firms
loss.

A competitive firm
Costs, P
MC
ATC

$5
MR

P = $3
30

2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING

Answers
A competitive firm
Costs, P
MC

Total loss
= (ATC P) x
Q = $2 x 30
= $60

ATC

$5
P = $3

loss

loss per unit =

MR
$2

30
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market demand curve

Horizontal summation of individual demand curves

Suppose Juan demand curve is given as: Qj=10-4P at prices < 2.5 0 at P>2.5, and
Emilys demand curve is Qe=6-2P at P<3 and 0 at >3.
The market demand curve is:
Qd = 0 for P>3
=6-2P for 2.5<P<3
=16-6P for P< or =3

Market Supply curve

Horizontal summation of individual supply curves

Suppose Anitras supply function is given as: Qa=8P-8 at prices >1 and 0 at P<1, and
Roberts supply function is Qr=3P-1.5 at P>0.5 and 0 atP<0.5.
The market demand curve is:
Qs= 11P-9.5 for P>=1
=3P-1.5 for 0.5<=P<1
=0 for P< 0.5

Demand and Supply: Long run

Long-run supply curve is found by summing supply curves of all
potential suppliers
Free entry in a market implies that anyone who wishes to start a
firm has access to the same technology and entry is unrestricted
With free entry, the number of potential firms in a market is
unlimited
Long-run market supply curve is a horizontal line at ACmin

Why is long run supply curve horizontal?

In short run, new equilibrium is achieved through movement
along the short-run supply curve: Price rises
In long run, firms enter the market: New equilibrium brings

Price ($/bench)

return to initial price but at a higher quantity

S10

B
P* = ACmin
= 100

S
^
D

D
2000

4000

Garden Benches per Month

14-23

Finding the long run and short run

equilibrium

Qd= 32900-600P; VC = 5Q+Q2/80, FC=845, MC=5+Q/40

(1) Suppose there is free entry and exit and fixed costs are avoidable.
What is the long run equilibrium? How many firms are there?
Ans: Efficient scale of production is where ACmin=MC. This gives us
Q=260 units per day at a price of P=MC=11.50.
At a price of 11.50, market demand =32900-600*11.5=26000 units.
Hence number of firms= DemandSupply = 100.
(2) Suppose demand doubles to 65800-1200P. If in the short run, fixed
costs are sunk, what is the new short run competitive equilibrium?
Since P=MC we find the supply curve as Qs= 40P-200 if P>=5 and 0
otherwise. Market supply curve is 100*Qs = 4000-20000P if P>=5.
In short run equilibrium, equating demand and supply, we get
P=16.50. At this price, total Q produced and sold is 46000 and each
firm sells 460 units. Since the price is > 11.5, each firm makes a profit.

Producer Surplus
A firms producer surplus equals its
revenue less its avoidable costs
= producer surplus sunk cost
Represented by the area between firms price
level and the supply curve

Common application: investigate welfare

implications of various policies
Can focus on producer surplus instead of profit
because the policies cant have any effects on
sunk costs

9-25

Producer Surplus

9-26

Aggregate Surplus
Can use market supply and demand curves to measure
aggregate surplus
Consumers total willingness to pay is area under market
demand curve up to the quantity consumed
Producers total avoidable cost is the area under the market
supply curve up to the quantity produced
In a competitive market without any intervention, aggregate
surplus is maximized
No deadweight loss: reduction in aggregate surplus
below its maximum possible value
14-27

Consumer and Producer Surplus

Consumer surplus is the sum of consumers total

willingness to pay less their total expenditure
Sum of individual consumers surpluses
Also called aggregate consumer surplus
Producer surplus is the sum of firms revenues less
avoidable costs
Sum of individual firms producer surpluses
Also called aggregate producer surplus

Aggregate surplus = Consumer surplus + Producer Surplus

14-28

Aggregate, Consumer, and Producer

Surplus

14-29

Aggregate Surplus and

Economic Efficiency
Perfectly competitive market produces an outcome that is
economically efficient
Net benefits indicate that consumers benefit from the goods
exceed the costs of producing them
Aggregate surplus equals consumers total willingness to pay for a
good less firms total avoidable cost of production
Total benefits from consumption equal to willingness to pay
Area under consumers demand curve up to that quantity
Total avoidable costs of production include all of a firms costs other
than sunk costs
Area under its supply curve up to its production level
14-30

Maximizing Aggregate Surplus

No way to increase aggregate surplus in perfectly competitive
markets by changing:
Who consumes the good: Suppose in the initial equilibrium, Juan consumed 4
cones and Emily consumed 3. Is there any other way that the cones can be
divided so that aggregate surplus increases? Ans: No. Juans WTP > Emilys WTP
for the additional cone.
Who produces the good: can we reassign sales in a way to lower the avoidable
costs of production and increase aggregate surplus?
Ans: No. If we reassign sale of an additional cone from Anita to Robert, costs would
increase because Roberts MC> Anitas MC.
How much of the good is produced and consumed: Can an additional cone be
produced and sold at its MC? No. The WTP for the additional cone < MC of
producing it.

Competitive markets maximize aggregate surplus

14-31