Economic Profit

Profit per unit equals revenue per unit (or price) minus cost per unit (or average total cost).
($25 - $14) = 11

Total economic profit equals: (price average cost) x quantity produced

($25 - $14) x 9 = $99

2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e OSullivan & Sheffrin

Shut-down Decision

The firm should continue to operate if the benefit of operating (total revenue) exceeds the cost of operating, or total variable cost.
TR = (P x Q) must be greater than STVC = SAVC x Q, therefore,
If P > SAVC, the firm should continue to operate If P < SAVC, the firm should shut down

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

The Shut-down Decision

The firm suffers a loss, but since price is greater than average variable cost, the firm continues to operate.
Economics: Principles and Tools, 2/e

When price drops to $9, the firm adjusts output down to 6 rakes per minute to maintain P=SMC. The average variable cost of producing 6 rakes per minute is $6.

2001 Prentice Hall Business Publishing

OSullivan & Sheffrin

The Shut-down Decision

The firms shutdown price is the price at which the firm is indifferent between operating and shutting down.

At $5, P = SAVC. Above this price, the firm is better off continuing to produce at a loss. Below this price, the firm is better off shutting down because it could not recover its operating cost.
Economics: Principles and Tools, 2/e OSullivan & Sheffrin

2001 Prentice Hall Business Publishing

Short-run Supply Curve

The firms short-run supply curve shows the relationship between the market price and the quantity supplied by the firm over a period of time during which one inputthe production facility cannot be changed.

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

The Market Supply Curve

The short-run market supply curve shows the relationship between the market price and the quantity supplied by all firms in the short run.

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

A Market in Long-run Equilibrium

A market reaches a long-run equilibrium when three conditions hold:
1. The quantity of the product supplied equals the

quantity demanded
2. Each firm in the market maximizes its profit, given

the market price

3. Each firm in the market earns zero economic profit,

so there is no incentive for other firms to enter the market

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

Short-run Supply Curve

For any price above the shut-down price, the firm adjusts output along its marginal cost curve as the price level changes. Below the shut-down price, quantity supplied equals zero.

The short-run supply curve is the firms SMC curve rising above the minimum point on the SAVC curve.
Economics: Principles and Tools, 2/e

2001 Prentice Hall Business Publishing

OSullivan & Sheffrin

A Market in Long-run Equilibrium

In short-run equilibrium, quantity supplied equals quantity demanded and each firm in the market maximizes profit. In addition to the conditions above, in long-run equilibrium the typical firm earns zero economic profit so there is no further incentive for firms to enter the market.
Economics: Principles and Tools, 2/e OSullivan & Sheffrin

2001 Prentice Hall Business Publishing

A Market in Long-run Equilibrium

In long-run equilibrium, price equals marginal cost (the profit-maximizing rule), and price equals shortrun average total cost (zero economic profit).

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

The Long-run Supply Curve for an Increasing-cost Industry

An increasing-cost industry is an industry in which the average cost of production increases as the total output of the industry increases. The average cost increases as the industry grows for two reasons:

Increasing input prices Less productive inputs

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

Industry Output and Average Production Cost

Number of Firms Industry Output Rakes per Firm

50 100 150

350 700 1,050

7 7 7

Typical Cost for Typical Firm $70 84 96

Average Cost per Rake

$10 12 14

The rake industry is an increasing-cost industry because the average cost of production increases as the total output of the industry increases.
Economics: Principles and Tools, 2/e OSullivan & Sheffrin

2001 Prentice Hall Business Publishing

Drawing the Long-run Market Supply Curve

Each point on the long-run supply curve shows the quantity of rakes supplied at a particular price (i.e., at a price of $12, 100 firms produce 700 rakes). The long-run industry supply curve is positivelysloped for an increasing cost OSullivan & Sheffrin

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

An Increase in Demand and the Incentive to Enter

An increase in market demand puts upward pressure on price. As price increases, there is an opportunity to earn profit in the short run, and the industry attracts new firms.

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

The Long-run Effects of an Increase in Demand

In the short-run, firms respond to the increase in demand by adjusting output in their existing production facilities, and the price adjusts from $12 to $17.

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

The Long-run Effects of an Increase in Demand

In the long run, after new firms enter, equilibrium settles at $14. The new price is a higher price than the price before the increase in demand (increasing cost industry).

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

Long-run Supply Curve for an Constant-cost Industry

In a constant-cost industry, firms continue to buy inputs at the same prices.

The long-run supply curve is horizontal at the constant average cost of production. After the industry expands, the industry settles at the same long-run equilibrium price as before.

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

Long-run Supply Curve for the Ice Industry

An increase in the demand for ice increases the price of ice to $5 per bag.
In the long-run, the price of ice returns to its original level.

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin