CHAPTER 3

DEMAND AND SUPPLY ANALYSIS: THE

FIRM
Presenters name
Presenters title
dd Month yyyy

1. INTRODUCTION

Theory of
Demand for goods
the
by individuals
Consumer
Theory of
the Firm

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Supply of goods and

services by firms

2. OBJECTIVES OF THE FIRM

Profit () in general terms is total revenue (TR) less total cost (TC):
Accounting profit is the net income, as determined using accounting
principles:
The costs in this case are only explicit costs.
Economic profit is
Economic profit = Total revenue Total economic cost,
where total economic costs include the implicit opportunity costs.

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NORMAL PROFIT AND ECONOMIC PROFIT

Normal profit is the accounting profit such that both explicit and implicit costs
are covered:
Normal profit = Accounting profit Economic profit
- Also known as abnormal profit or supernormal profit.
Accounting profit = Economic profit + Normal profit
Example:

Revenues

1,000

Total explicit costs

500

Opportunity cost

400

Accounting profit

1,000 500 = 500

Economic profit

1,000 500 400 = 100

Normal profit

500 100 = 400

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ECONOMIC RENT
Economic rent is the high profit attributed to a fixed, limited supply.
Supply

P2
P1

Demand2
Demand1
Q1

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3. ANALYSIS OF REVENUE, COSTS,

AND PROFITS
Total revenue (TR) is the total of receipts from the sale of a good or service.
Total revenue = Price Quantity
Average revenue (AR) is the mathematical average of revenue per unit sold.
Average revenue =
Marginal revenue (MR) is the revenue on the next unit sold.
Marginal revenue =

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CALCULATING TR, AR, AND MR

Q

TR

AR

MR

100 $1.25

$125

$1.25

$1.30

200 $1.30

$260

$1.30

$1.33

300 $1.33

$399

$1.33

$1.35

400 $1.35

$540

$1.35

$1.37

500 $1.37

$685

$1.37

$1.37*
Average revenue
Marginal revenue

* Assuming $1.37 for

quantities beyond 500

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THE PRODUCTION FUNCTION

The factors of production are inputs to the production of goods or services,
including land, labor, capital, and materials.
The production function is the relationship between the quantity produced
and the factors of production: capital (K) and labor (L)
Q = f(K,L)

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COSTS OF PRODUCTION
Total cost (TC) is the sum of all costs of producing goods or services.
Total fixed cost (TFC) is the sum of all costs that do not change with the level
of production.
- A quasi-fixed cost is a cost that is fixed for a specific range of production
but that changes at different levels of production.
Total variable cost (TVC) is the sum of all costs that change with the level of
production.
Average fixed cost (AFC) is the total fixed cost divided by the quantity
produced.
Average variable cost (AVC) is the total variable cost divided by the quantity
produced.
Average total cost (ATC) is the total cost divided by the quantity produced.
Marginal cost (MC) is the change in total cost for one more unit produced.

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EXAMPLE
Suppose that the fixed costs of
production are $50 and that the
variable cost per unit begins at $24
per unit, declines to $12, and then
increases to $15.

Average fixed cost

Average variable cost
Average total cost
Marginal cost

The average fixed cost declines

throughout.
The average variable cost declines
and then increases.
The average total cost declines and
then increases.
The marginal cost declines and then
increases.

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BREAKEVEN AND SHUTDOWN

The breakeven point is the quantity produced at which all costs are covered.
- Under perfect competition, the breakeven point is the quantity of production
at which the price, average revenue, and marginal revenue are equal to
average total cost.
- Quantity at which TR = TC.
The shutdown point is the quantity produced at which the average revenue is
less than the average variable cost.
- Quantity at which AR < AVC.
- At shutdown, the firm must pay fixed costs but stops production because it
cannot cover variable costs.

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ECONOMIES AND DISECONOMIES OF SCALE

The short-run average total cost curve (SRATC) is determined by the firms
fixed-input constraint.
The long-run average total cost curve (LRATC) is composed of the
minimums of the possible short-run average total cost curves.
Economies of scale (also known as increasing returns to scale) are the
lowered cost structures available when a firm grows in size.
- They may arise from many sources, including the division of labor, capital
intensity, use of by-products, and buying power.
- There may be a point where more output increases costs, which would
represent diseconomies of scale.
Operating at the least cost (the minimum efficient scale, or MES) is important
for the long-term survival of a firm.

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PROFIT-MAXIMIZING OUTPUT
Profit is maximized when the difference between total revenue and total cost is
maximized, which is also the point at which marginal revenue is equal to
marginal cost.
Determining profit-maximizing output requires
1. forecasting the revenues and costs in order to estimate the production level
at which the difference is maximized.
2. computing the change in total revenue per unit and the change in total cost
per unit and produce to the point at which they are equal.
3. comparing the estimated cost per unit of input with the contribution margin
per unit.

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PROFIT MAXIMIZATION: SHORT AND LONG RUN

In the short run, without economies of scale, the firm earns a normal profit.
In the long run, although the firm is able to exploit economies of scale, the firm
earns an economic profit.
- If the market is imperfectly competitive, the firm is able to earn an economic
profit as long as competitors do not enter the market.
- If the market is perfectly competitive, competitors will enter and the economic
profit is driven to zero.

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LONG-RUN INDUSTRY SUPPLY

The long-run supply curve for an industry is the relationship between
quantities supplied and prices under perfect competition.
An increasing-cost industry is one in which the prices and costs increase for
increased output.
- Long-run supply curve is upward sloping.
A decreasing-cost industry is one in which the prices and costs decrease for
increased output.
- Long-run supply curve is downward sloping
A constant-cost industry is one in which the prices and costs remain the
same for increased levels of output.
- Long-run supply curve is flat.

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PRODUCTIVITY
Productivity is the average output per unit of input.
- Labor productivity is used as a measure of productivity because it is easily
identified and measured.
- Unit of input for labor = L
Increasing productivity increases profitability.
- In the case of labor, increased rewards to workers may further increase
productivity.
Measures:
- Total product (TP), or output, is the sum of production in number of units
produced; also represented as Q.
- Average product (AP) is the total product divided by the number of units of
input, .
- Marginal product (MP) is the productivity of the next unit produced, or the
change in total product if one more unit of input is added:
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EXAMPLE: PRODUCTIVITY OF LABOR

Labor

Total Product

10

10 0 =

10

10/1 =

10.0

19

19 10 =

19/2 =

9.5

27

27 19 =

27/3 =

9.0

34

34 27 =

34/4 =

8.5

40

40 34 =

40/5 =

8.0

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Marginal Product

Average Product

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DIMINISHING MARGINAL RETURNS

The marginal product (MP) is the change in the total product from a one-unit
change in the input.
Increasing marginal returns exist when the marginal product of an input
increases when using more of the input.
Diminishing marginal returns exist when the marginal product of an input
decreases when using more of the input.
- The law of diminishing returns is the law that adding another unit of input
will result in less marginal product than the previous unit of input.
The marginal revenue product (MRP) is the change in total revenue from a
one-unit change in the input.

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PROFIT-MAXIMIZING LEVELS OF OUTPUT

If there is a single input, the profit-maximizing level of output is the point at
which
Marginal revenue product = Price of the input
If there is more than one input, the profit-maximizing level of inputs is the point
at which the marginal products of the inputs, relative to their respective prices,
are the same:
==
The optimal level of each input is the point at which the ratio of the marginal
product to its own price is equal to 1.

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EXAMPLE: OPTIMAL LEVEL OF INPUTS

Suppose that the cost per unit of Input 1 is 16 and the cost per unit of Input 2 is
10. If the cost of the product is 2.50 and the total products are as below, what
are the optimal levels of Input 1 and Input 2?
Input 1
Marginal
Total Marginal Revenue
MRP/
Units Product Product Product Price of Input
0

10

10

25

19

27

4
5

Input 2
Marginal
Units Total Marginal Revenue
MRP/
of Product Product Product Price of Input
0

1.56

20

20

50.00

5.00

23

1.41

35

15

37.50

3.75

20

1.25

40

12.50

1.25

34

18

1.09

43

7.50

0.75

40

15

0.94

44

2.50

0.25

The optimal levels are four units of Input 1 and three units of Input 2.
Profit = 2.5 (34 + 40) (4 16) (3 10) = 185 64 30 = 91
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SUMMARY
The profit of concern in the theory of the firm is economic profit, which
considers not only explicit costs but also implicit costs.
If a firm is able to maintain a comparative advantage (such as economies of
scale), it can earn economic profit. In a market with perfect competition,
however, economic profits are zero; firms can earn a normal profit, which is a
profit in which revenues just cover both implicit and explicit costs.
Profit maximization occurs at the level of production at which the difference
between total revenue and total costs is the greatest or, equivalently, where
marginal revenue equals marginal cost.
In the long run, all inputs to the firm are variable, which expands profit potential
and the number of cost structures available to the firm.
Under perfect competition, long-run profit maximization occurs at the minimum
point of the firms long-run average total cost curve.

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SUMMARY
A firm shuts down in the short run if total revenue does not cover variable cost
in full.
A firms production function defines the relationship between total product and
inputs, whereas average product and marginal product are key measures of a
firms productivity.
Increases in productivity reduce business costs and enhance profitability.
An industry supply curve that is positively sloped will increase production costs
to the firm in the long run. An industry supply curve that is negatively sloped will
decrease production costs to the firm in the long run.
In the short run, assuming constant resource prices, increasing marginal
returns reduce the marginal costs of production and decreasing marginal
returns increase the marginal costs of production.

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