1. REVIEW
COSTS OF
PRODUCTION,
THEORY OF THE
FIRM

2. ECONOMIC COSTS
Profits to an Profits to an
Economist Accountant
T
Economic (opportunity) Costs
Economic O
Profit T
A Accounting
L Profit
Implicit costs
(including a
R
normal profit)
E
V
Explicit Accounting
E
Costs
N costs (explicit
U costs only)
E

3. SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product, TP
Total Product
Increasing
Marginal
Average Product, AP, and
Quantity of Labor
Marginal Product, MP
Returns
Average
Product
Marginal
Quantity of Labor Product

4. SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product, TP
Total Product
Diminishing
Marginal
Average Product, AP, and
Quantity of Labor Returns
Marginal Product, MP
Average
Product
Marginal
Quantity of Labor Product

5. SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product, TP
Total Product
Negative
Marginal
Average Product, AP, and
Quantity of Labor
Marginal Product, MP
Returns
Average
Product
Marginal
Quantity of Labor Product

6. PRODUCTIVITY AND COST CURVES
Average product and
marginal product
AP
MP
Quantity of labor
MC
Costs (dollars)
AVC
Quantity of output

7. LONG-RUN PRODUCTION COSTS
Unit Costs
Output

8. LONG-RUN PRODUCTION COSTS
Unit Costs
Output

9. LONG-RUN PRODUCTION COSTS
The long-run ATC just “envelopes”
all of the short-run ATC curves.
Unit Costs
Output

10. LONG-RUN PRODUCTION COSTS
Unit Costs
long-run ATC
Output

11. ECONOMIES AND
DISECONOMIES OF SCALE
•Labor Specialization
•Managerial
Specialization
•Efficient Capital
• Other Factors
Diseconomies of Scale
Constant Returns to Scale
graphically presented...

12. ECONOMIES AND
DISECONOMIES OF SCALE
Economies
of scale
Unit Costs
long-run ATC
Output

13. ATC decreases as ATC is constant as
Output increases Output increases
Economies Constant returns
of scale to scale
Unit Costs
long-run ATC
Output

14. ATC decreases as ATC is constant as ATC increases as
Output increases Output increases Output increases
Economies Constant returns Diseconomies
of scale to scale of scale
Unit Costs
long-run ATC
Output

15. MARGINAL REVENUE-MARGINAL COST APPROACH
Profit Maximization Position
$200
Economic Profit MC
150
Cost and Revenue
$131.00 MR
ATC
100 AVC
$97.78
50
0
1 2 3 4 5 6 7 8 9 10

16. MARGINAL REVENUE-MARGINAL COST APPROACH
Profit Maximization Position
$200
Economic Profit MC
150
Cost and Revenue
$131.00 MR
MR = MC ATC
100 AVC
Optimum
$97.78
Solution
50
0
1 2 3 4 5 6 7 8 9 10

17. MARGINAL REVENUE-MARGINAL COST APPROACH
Short-Run Shut Down Point
$200
MC
150
Cost and Revenue
ATC
100 AVC
$71.00 MR
50 Minimum AVC
is the Shut-Down
Point
0
1 2 3 4 5 6 7 8 9 10

18. SHORT-RUN COMPETITIVE EQUILIBRIUM
The Competitive Firm “Takes” its
Price from the Industry Equilibrium
S= MCs
P P
Economic
ATC Profit S=MC
$111 D $111
AVC
D
8 Q 8000 Q
Firm Industry
(price taker)

19. SHORT-RUN COMPETITIVE EQUILIBRIUM
The Competitive Firm “Takes” its
Price from the Industry Equilibrium
S= MCs
P P
Economic
ATC Profit S=MC
$111
How about the
D $111
long-run?
AVC
D
8 Q 8000 Q
Firm Industry
(price taker)

20. PROFIT MAXIMIZATION IN THE LONG RUN
Temporary profits and the reestablishment
of long-run equilibrium
S1
P P
MC
ATC
$60 $60
50 50
40 MR 40
D1
100 Q 100,000 Q
Firm Industry
(price taker)

21. PROFIT MAXIMIZATION IN THE LONG RUN
An increase in demand increases profits…
Economic S1
P Profits P
MC
ATC
$60 $60
50 50
40 MR 40
D2
D1
100 Q 100,000 Q
Firm Industry
(price taker)

22. PROFIT MAXIMIZATION IN THE LONG RUN
New competitors increase supply, and lower
prices decrease economic profits.
Zero Economic S1
P P S2
Profits MC
ATC
$60 $60
50 50
40 MR 40
D2
D1
100 Q 100,000 Q
Firm Industry
(price taker)

23. PROFIT MAXIMIZATION IN THE LONG RUN
Decreases in demand, losses, and the
reestablishment of long-run equilibrium
S1
P P
MC
ATC
$60 MR $60
50 50
40 40
D1
100 Q 100,000 Q
Firm Industry
(price taker)

24. PROFIT MAXIMIZATION IN THE LONG RUN
A decrease in demand creates losses…
Economic S1
P Losses P
MC
ATC
$60 MR $60
50 50
40 40
D1
D2
100 Q 100,000 Q
Firm Industry
(price taker)

25. PROFIT MAXIMIZATION IN THE LONG RUN
Competitors with losses decrease supply, and
prices return to zero economic profits.S3
Return to Zero S1
P Economic Profits P
MC
ATC
$60 MR $60
50 50
40 40
D1
D2
100 Q 100,000 Q
Firm Industry
(price taker)

26. MARGINAL REVENUE-MARGINAL COST APPROACH
Loss Minimization Position
$200
Economic Loss MC
150
Cost and Revenue
ATC
100 AVC
$91.67
$81.00 MR
50
0
1 2 3 4 5 6 7 8 9 10

27. MONOPOLY REVENUES & COSTS
Elastic
$200
150
Dollars
200
50 MR D
Q
T
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
$750
Dollars
500
TR
250
Q
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

28. MONOPOLY REVENUES & COSTS
Elastic Inelastic
$200
150 Inelastic
Dollars Portion
200 MR is Negative
A Monopolist will 50 MR D
always operate on Q
the Elastic Portion 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
of the Demand
$750
Curve
Dollars
500
TR
250
Q
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

29. OUTPUT AND PRICE DETERMINATION
Profit Maximization Under Monopoly
Remember the MR=MC Rule?
200
175 Profit
Per Unit
Price, costs, and revenue
150
MC
$122 125
$94 100
Profit ATC
75
D
50
25 MR = MC
MR
Q
0 1 2 3 4 5 6 7 8 9 10

30. OUTPUT AND PRICE DETERMINATION
Profit Maximization Under Monopoly
200
175 Profit
Per Unit
Price, costs, and revenue
150
MC
$122 125
$94 100
Profit ATC
75
D
50
25 MR = MC
MR
Q
0 1 2 3 4 5 6 7 8 9 10

31. OUTPUT AND PRICE DETERMINATION
Loss Minimization Under Monopoly
200 Loss
Since Pm exceeds AVC, Per Unit
175
the firm will produce
Price, costs, and revenue
150 MC
A ATC
125 Loss
Pm AVC
100
V
75
D
50
25 MR = MC
MR
Q
0 1 2 3 4 5 6 7 8 9 10
Qm

32. OUTPUT AND PRICE DETERMINATION
Loss Minimization Under Monopoly
200 Loss
Per Unit
What are the
175
Price, costs, and revenue
150 MC
Economic Effects AVC
A
Pm125 Loss
ATC
of Monopoly?
V
100
75
D
50
25 MR = MC
MR
Q
0 1 2 3 4 5 6 7 8 9 10
Qm

33. INEFFICIENCY OF PURE MONOPOLY
P An industry in pure competition S = MC
sells where supply and
demand are equal
At MR=MC
A monopolist
will sell less
units at a
Pm higher price
than in
Pc competition
D
MR
Q
Qm Qc

34. INEFFICIENCY OF PURE MONOPOLY
P S = MC
At MR=MC
A monopolist
will sell less
units at a
Pm higher price
than in
Pc competition
Monopoly pricing effectively
creates an income transfer from
buyers to the seller! D
MR
Q
Qm Qc

35. REGULATED MONOPOLY
P Dilemma of Regulation
MR = MC Which Price?
Fair-Return Price
Price and Costs
Pm
Socially-Optimum
Price
Pf ATC
Pr MC
D
MR
Qm Qf Qr Q

36. MONOPOLISTIC COMPETITION
AND EFFICIENCY
Long-Run Equilibrium MC
Price is Not
= Minimum ATC
ATC
P3
= A3
Price and Costs
Price  MC
D
MR
Q3
Quantity

37. MONOPOLISTIC COMPETITION
AND EFFICIENCY
• Not Productively Efficient
 Minimum ATC
• Not Allocatively Efficient
Price  MC
• Excess Capacity
Graphically…

38. OLIGOPOLY BEHAVIOR
A Game-Theory Overview
RareAir’s Price Strategy
High Low
A $12 B $15
High
Uptown’s Price Strategy
$12 $6
C $6 D $8
Low
$15 $8

39. OLIGOPOLY BEHAVIOR
A Game-Theory Overview
RareAir’s Price Strategy
High Low
A $12 B $15 Greatest
Combined
High Profit
Uptown’s Price Strategy
$12 $6
C $6 D $8
Low
$15 $8

40. OLIGOPOLY BEHAVIOR
A Game-Theory Overview
RareAir’s Price Strategy
High Low
A $12 B $15 Independent
Actions
High Stimulate
Uptown’s Price Strategy
$12 $6 Response
C $6 D $8
Low
$15 $8

41. OLIGOPOLY BEHAVIOR
A Game-Theory Overview
RareAir’s Price Strategy
High Low
A $12 B $15 Independent
Actions
High Stimulate
Uptown’s Price Strategy
$12 $6 Response
Gravitating
C $6 D $8 to the
Low Worst Case
$15 $8

42. OLIGOPOLY BEHAVIOR
A Game-Theory Overview
RareAir’s Price Strategy
High Low
Collusion
A $12 B $15 Invites a
Different
High Solution.
Uptown’s Price Strategy
$12 $6
C $6 D $8
Low
$15 $8

43. OLIGOPOLY BEHAVIOR
A Game-Theory Overview
RareAir’s Price Strategy
High Low
Collusion
A $12 B $15 Invites a
Different
High Solution.
Uptown’s Price Strategy
$12 $6
C $6 D $8
Low
$15 $8

44. OLIGOPOLY BEHAVIOR
A Game-Theory Overview
RareAir’s Price Strategy
High Low
Collusion
A $12 B $15 Invites a
Different
High Solution.
Uptown’s Price Strategy
$12 $6
But, the
incentive
to cheat
C $6 D $8 is very real.
Low
$15 $8