Ch4 Supply.docx

Module 4 - Supply 4.1 Introduction All suppliers of goods (firms, govt or individuals) face the same three basic problems How much output for each time period What price to charge What’s the most efficient way to produce the output To derive a market supply curve, we must study productivity and costs from that, derive a firms supply curve by summing all firms supply curves in a market we get the market supply curve 4.2 Productivity Most supply curves look like this: 206756050165Production Frontier 00Production Frontier 478790-444500Output 100076034290A 00A 4572005778500 145796097155B 00B 4787909588500 Variable factor input e.g. labor This productivity curve shows the maximum that can be produced (cet par) given that the firm is acting in an engineering efficient manner, i.e.: all goods and services are being produced using the least possible amount of resources all resources are being fully employed The supply curve is drawn with Output on one axis and one of the variable factors that influence output on the other, cet. par. Output increases as you increase the input – partly due to specialization (or division) of labor Their comes a point that an increase in the input variable produces proportionally less of an increase in the output until the output flattens Point A is outside the production frontier and so is unachievable, whereas B is inside and is achievable but represents an output that is not economically efficient (a point on the production curve would be economically efficient) The production curve can only shift if one or more of the other variable inputs that we assumed to be cet. par. also shift e.g. a new fixed asset is purchased The Average Product of the variable factor (in the above case labor) is: APL = TP/L Note 1: TP = total physical product = quantity rather than $ Note: is it was a different variable factor then instead of Q/L (e.g. raw material) it would be Q/RM The APL is calculated for a different values of L, giving a curve The average product usually increases at first and then starts to reduce at a certain output The Marginal Product of the variable factor input (in this case labor) is: MPL = TP/L Marginal product measures the benefit in terms of extra output of adding an additional unit of the variable factor - e.g. what benefit do you gain by adding an extra worker. Again, we use the term marginal ‘product’, because we are dealing with physical quantities rather than monetary amounts – the Y axis below is ‘Output’ and that is measured in physical units (kgs or just units) rather than dollars 206756050165Total Product (TP) 00Total Product (TP) 478790-444500Output 4572005778500 113093566675MP 00MP 235077050800AP 00AP 5226056794500 522605254000 4787909588500 Variable factor input e.g. labor There are five important relationships between these curves: When TP=0, AP=0 When AP is at its maximum, MP=AP If MP>AP, AP is increasing If MP ATC = AVC + AFC 241681078105Output Output 00Output Output 82740547752000115379556451500 3265170546100026555703302000 4551045128905Total Product 00Total Product 3287395508000 42894251587500870585-571500167576513335ATC 00ATC 228663545720AVC 00AVC 484378099695Variable Input 00Variable Input 3284855520700097980566675Avg Cost 00Avg Cost 628650889000 324358010223500 374396018415MPL 00MPL 451675560325Max APL 00Max APL 4908550997585Variable Input 00Variable Input 3243580-381000 4897755120015APL 00APL 324358013335000 330644552070004343400-78168500 The AVC curve is inversely proportional to the APL curve – when costs are at their lowest, average product is at its highest. this is because: AVC = VC/Q and APL = TP/L The VC increase as L increases but as L increases APL decreases, hence AVC is inversely related to APL Marginal Cost is the cost of producing one additional unit of output i.e. MC = TC 8597909588500124079096520MC 00MC 2003425-3175Output 00Output 28517851193800022421859779000 413766047625Total Product 00Total Product 37236401085850039179513081000 117538528575001873250110490 00 65278010795Min MC 00Min MC 287147011684000566420131445Marginal Cost 00Marginal Cost 2152657366000 443039518415Variable Input 00Variable Input 28301952095500 333057583185MPL 00MPL 4103370125095Max MPL 00Max MPL 3733800946150028301956096000 2874010-212090000 448437038735APL 00APL 4495165186055Variable Input 00Variable Input 289306011684000 MC is inversely proportional to MP – this is because MC = TC and MPL = TP/L but TC = FC + VC and VC is directly proportional to L hence an increase in L will produce an increase in MC and a decrease in MPL Just like productivity, costs have the following relationship: When TP = 0, TVC = 0 and TC = FC When ATC is min, ATC=MVC When AVC is min, AVC = MC When MC >ATC (AVC), ATC (AVC) is increasing When MC< ATC (AVC), ATC (AVC) is decreasing 4.4 Firm Supply in the Short run To simplify the analysis in both the short and long run we make 4 assumptions the firm only produces one good the firm can sell as much as it can produce at the going market price and it has no control over market price – the presence of the firm in the market has no influence on the market price the cost of factors of production is outside the control of any one firm the firms goal is profit maximization. Profit () is maximized when total revenue (TR) minus total cost (TC) is maximized the firm is producing in an engineering efficient manner The profit maximizing level is when the difference between TR and TC is maximized = TR-TC, so /Q = TR/Q – TC/Q = AR – ATC so profit per unit output is maximized when the difference between the AR curve and the ATC curve is at its maximum. But maximizing profit per unit does not necessarily maximize total profit. To find the profit maximizing output level, use marginal analysis i.e. when is MR = MC? At that point the output at that point is the output that will maximize total profit MC is made up of the change in the variable cost and the change in fixed cost as output increases, but since in the short term fixed costs do not change, then MC is really made up of the change in variable costs, e.g. adding more labor to cope with increased output If, at any given output MRMC, then each additional unit is making them more money then it is costing them, hence profit is maximized when MR=MC What quantities would the firm be willing to produce at each and every price? 3702056096000 7620004572000Price 3308350107950AR6=MR6 00AR6=MR6 2328545-87630ATC 00ATC 9582159588500185039030480MC 00MC 20681956032500335153098425AR5=MR5 00AR5=MR5 369570647700078359063500P6 19589751212850034925010350500230695550165AVC 00AVC P5 3329940180975AR3=MR3 00AR3=MR3 337375546355AR4=MR4 00AR4=MR4 176657035560003924303810000P4 370840222250015671802032000326390020320 AR2=MR2 00 AR2=MR2 P3 8928101352550012623802667000339471048260AR1=MR1 00AR1=MR1 361315137795003708402857500P2 P1 3702052857500 Output Q1 Q2 Q3 Q4 Q5 Q6 Because we assume that the price is fixed at all outputs, P = AR= MR At price P1, AR1AVC. It would not produce Q2 because at that output MR>MC and so profit would not be maximized At P4, the firm breaks even (AR=ATC) At P5 and P6 the firm should produce Q5 and Q6 This then produces the firms short run supply curve (the portion of MC that the firm will produce at): 13061951250950063119078740002609852095500 6311901968500 2832103365500 Q2 Q6 As price increases, the firms MC curve (and therefore its supply curve) becomes vertical – i.e. MC costs keep rising with no gain in units produced Given a fixed capital input and no technological advances, only a change in the variable cost factor can produce a shift in the firm’s supply curve e.g. an increase in the labor rate will cause the supply curve to shift upwards Each supply curve starts when MC=AVC (Q2 above) 4.5. Market Supply 4.5.1 Market supply in the short run The market supply is the aggregate of the amounts that all firms in a given market would be willing to supply at each price We assume that the market consists of a large number of firms so that no one firm can influence the price of the good in question 4.5.2 Shifting Supply Curve If a change in the cost of variable factors (e.g. recession) occurs, supply curve shifts In the recession example, the cost of labor would reduce which would shift the AVC down. It would also shift the MC curve to the right because at the same price as before more labor can produce more output The market supply curve would then shift to the left and slightly down (as the AVC=MC point would be slightly lower) 4.5.3 Equilibrium of Firm In the short term (when some inputs & costs are fixed), a firm is in equilibrium at a particular output level when MC=MR In the long run MC and MR are constantly changing due to things like technical advances and changes consumer tastes - hence a firm may never reach long term equilibrium The total cost of producing a good is its fixed and variable costs plus the profit that could have been earned in producing the best alternative (opportunity cost) We will include this opportunity cost in the firms fixed cost figure Thus when a firm is breaking even (TC=TR) it will earning a sufficient return to prevent the resources from leaving the industry – the firm is earning ‘normal profit’ If excess profits are being made (TR>TC), then new resources will enter the industry 4.5.4 The Long run In the long run, no factors of production are fixed For long term profit maximization, marginal revenue must equal long run marginal cost 3702056096000 7620004572000Price 1719580-6350LMC 00LMC 226314055245LAC 00LAC 82740510858500 337375589535P=AR=MR 00P=AR=MR 176657035560003924303810000P 3702052857500 Output Q Same as short term, profit maximization for price P is at quantity Q The Long term average cost (LAC) is the line that traces the lowest average cost for each and every level of output when no resources are fixed. Hence at Q it shows you what combination of input resources yield profit maximization If a capital purchase is made, then the firm is back in the short run (a fixed cost has been incurred). If a price change then occurs, the firm can only adjust variable factor inputs so that MC=MR and so then MR no longer = LMC A firm will only be in equilibrium for both long and short term if the price of the good, the state of technology and all factor input prices remain unaltered If the price ever falls below the minimum point on the LAC, then the firm would stop producing as its opportunity costs would no longer be covered 4.5.5 Market Supply in the Long run Assuming that there are n firms in the short run with exactly the same cost curves, the SHORT term supply curve is made up of n times the MC curve (for MC>AVC) If a high price is being commanded and therefore abnormal returns being gained by firms in the short term, then in the long term resources will be diverted to the industry If the factor prices do not increase as more firms move in, then the ATC (including their opportunity cost) will remain constant and so the long term supply curve will be horizontal at a price which intersects the minimum of the ATC curve This is because : at a price < min ATC no firm will produce any output at price = min ATC, firms will make a normal profit at price>min ATC, new firms will enter the market until the price is forced back to min ATC If the factor prices increase as new firms then each firms MC curve moves to the left (less ouput for the same price) and their ATC curves move up, giving a MC=MR price point higher than before Then the long term supply curve will be a upward curve similar to the short term supply curve but at less of an angle 4.6 Real World Applications It is difficult to estimate production frontiers – when is a factory operating at engineering efficiency? Figures can be calculated for the total annual output of the economy divided by the labor input The Marginal product of labor is related to the wage rate in a competitive market – those whose marginal products are low (e.g. the unskilled) have low wage rates Individuals whose marginal product is considered to be zero are the unemployed The relationship between changes in output and changes in the variable factor is not linear, but can be either: increasing, constant or diminishing Returns to factor input imply changing only one factor input, cet. par. – this is a short term thing Returns to scale refer to changing output due to a change in all factor inputs (long term) Supply elasticity is a measure of the change in quantity of output due to a change in price – we use the short run supply curve for the short run and the long for the long Q/Q P/P Additional Notes: Economic Efficiency is being achieved when all of the following are in place: all goods and services are being produced using the least possible amount of resources (engineering efficiency) all resources are being fully employed the production of that set of goods satifies society’s wants as fully as possible 2) Diminishing returns means that as a firm uses more of a variable factor with a given amount of fixed factors, the marginal productivity of the variable factor diminishes Review Questions B D D D B D D D A B B C D C D C – less output at same price D A C D d b b b