Firm ’ s decisions

1. Firm’s decisions Lecture 26 – academic year 2014/15 Introduction to Economics Fabio Landini

2. What do we do today: A firm and its costs Total, fixed and variable costs Average and marginal revenue How firm set optimal Q

3. Firm behaviour We want to study firm behaviour in in presence of different market structures (in this case mainly perfect competition).

4. Firm’s aim The main objective of a firm is to maximize profit Profit:Total revenue (TR) minus Total cost (TC)

5. Profit: revenue - costs Revenue: amount that a firm earns through sales Costs: Amount that a firm spends for factors of production

6. Opportunity costs Production costs include both explicit costs and implicit costs: Explicit costs: monetary costs that are necessary to hire factors of production. Implicit costs: costs that do not require any direct cash outlay. Taken together we have opportunity costs

7. Economists: look at opportunity costs Accountants: look at explicit costs, but often neglect implicit costs When the revenue is higher than both explicit costs and implicit costs the firm makes economic profit Opportunity costs

8. Example: Is University enrolment a good investment in Italy? • Average taxes paid by undergraduate students during the first 4 years (data 2003-04): 2.178 euro. • Other direct expenses to follow classes and write exams: 3.273 . • Foregone income (comparison with non-Univ. students): 65.838. • Total expenses: 71.739. • Income differential for university degree (wit respect to non-Univ. students, computed during the first 40 years of activity): 134.000. • Value of university degree neat of its cost: (134.000-71.739) = 62.408 • Average annual return of university degree: 9,9 %. Source: Moro-Bisin, La laurea: un ottimo investimento, www.LaVoce.info, 24/10/2005.

9. Production function

10. Production function It shows the relationship between the quantity of production factors “efficiently employed” and the quantity produced. Important: it does not describe all possible combinations between the quantity of production factors and final product. But only. those without useless “waste”. Example: if I can produce 10 unitsof a good with 5 workersor only 2 workers, the only point in the production function is (10, 2) (product=10, work=2), and not (10, 5). (10, 5) is inefficient with respect to (10, 2).

11. Production function Marginal product (of labour) Q obtained through L of one unit Previous table: L=0 -> L=1 produces Q = 50 L=1 -> L=2 produces Q = 40 L=2 -> L=3 produces Q=30 And so on….

12. Marginal product From the table you can see that the marginal product is always positive, but decreasing That is: if L increases: The level of production always increases(positive marginal product), However such an increase is smaller at the margin (decreasing marginal product) Why? Presence of fixed factors (e.g. congestion effects in using a machine)

13. From production to costs

14. Curve of total cost

15. Total and marginal cost Marginal cost Total cost that derive from Q of one unit Q -> total cost (i.e. marginal cost is positive) Moreover: the Total cost is greater at the margin (marginal cost is increasing) Explanation: it depends on the structure of the production function (fixed factors)

16. Relationship between MP and MC

17. Average cost and marginal cost Average cost: FC, VC, TC over Q Average fixed cost (AVFC) Average variable cost (AVVC) Average total cost (AVC) Marginal cost Increase in TC if ΔQ=1 Equal to: ΔCT/ΔQ The firm consider both AVC and MC to take her production decision

18. The U-shaped AVC AVC Cost (in euro) Q* Quantity

19. Costs (pp. 220)

20. Costs (pp. 220)

21. Shape of AVC Why is AVC U-shaped? Because it is the sum of AVFC and AVVC AVFC is decreasing with respect to Q AVVC is increasing with respect to Q AVC Costo (in euro) AVVC AVFC Quantità

22. Production in perfect competition Given this cost structure, how does a firm decide the quantity to be produced? Let’s study this problem in a perfectly competitive market Characteristics:  Many sellers and buyers  Product are perfect substitute  Free entry Consequences:  firms are price taker

23. Price and revenue

24. Firm’s revenue in perfect competition In a perfectly competitive market: MR = price NB: This is not true in other market structures

25. Profit maximization Firm’s objective = max profit  i.e.: set Q such that the difference between TR and TC is max This happens when the firm set Q such that MR = MC If MR > MC, an increase in Q increases profit If MR < MC, an increase in Q reduces profit If MR = MC, profit is max

26. Firm production decision Price MC AVC 0 Quantity

27. Firm production decision Price MC AVC P P = AVR = MR 0 Quantity

28. Firm production decision Price MC AVC P P = AVR = MR Profit max Q 0 Q Quantity

29. Firm production decision Price MC AVC P P = AVR = MR AVC Profit max Q 0 Q Quantity

30. Firm production decision Price MC AVC Profit P P = AVR = MR AVC Profit max Q 0 Q Quantity

31. What happens in with free entry? Price MC AVC P P = AVR = MR 0 Q Quantity

32. The existence of a positive profit will lead more firm to enter -> in supply -> price Price MC AVC P P = AVR = MR 0 Q Quantity

33. The existence of a positive profit will lead more firm to enter -> in supply -> price Price MC AVC P P = AVR = MR P’ P’ = AVR’ = MR’ 0 Q Quantity Q’

34. The existence of a positive profit will lead more firm to enter -> in supply -> price Price MC AVC P P = AVR = MR P’ P’ = AVR’ = MR’ P’’ P’’ = AVR’’ = MR’’ 0 Q Quantity Q’ Q’’

35. As soon as profit=0 no firm will enter any more… Price MC AVC P P = AVR = MR P’ P’ = AVR’ = MR’ P’’ P’’ = AVR’’ = MR’’ 0 Q Quantity Q’ Q’’

36. Conclusion We studied tools that firms use to take decision Firms set profit set Q so that MR=MC, i.e. max profit If there is free entry in the market profit tends to zero in the long period