D. Changing output levels and input prices
    1. How input choices relate to long-run costs

See worksheet: The relationship between isoquants and average total cost curves      A firm's output expansion path (OEP) traces out the cost-minimizing input combinations for all output levels, holding relative input prices constant     It's analogous to an ICC for consumer theory

Each point on an OEP = a point on the firm's LRATC     A firm can never do better in SR than LR. LRATC is an envelope of all possible SRATCs.

    2. Long-run costs depend on scale economies

    Important for optimal firm size

    We've already seen SR
    --recall in particular that DMR results in the eventual upward slope of MC, AVC and ATC

    LR:  DMR is not relevant.
    So what can we say about shape of long run cost curves?
    There exists much variety.

    Unit costs: For all output levels...
    --LRATC is calculated with the same formula (TC/Q) as SRATC except all inputs are varied to achieve the lowest possible LRTC.
    --LRMC tells us the extra cost of another unit with all costs variable.
    These are true minimum values since the firm will adjust all inputs to satisfy the LCC.

As Q rises:
Range 1:    Falling LRATC =>    economies of scale	Range 2:    Minimum LRATC =>    optimal firm size(s)	Range 3:    Rising LRATC =>    diseconomies of scale
Division of labor	Replication	Management constraints(?)

    Minimum efficient scale (Q*) = the lowest Q where LRATC is minimized

    Note1: Economies of scale do not constrain firms to use a constant factor intensity. Recall in general: up Q => up K-intensive techniques

    Note2: except at point of tangency, LRATC < SRATC <-- greater flexibility in LR.
    Tangency => same slope for LRATC and SRATC
    (Economist Jacob Viner tried to make LRATC pass through the bottom of each SRATC--can't do it.)

    Note3: Most common empirically--we see ranges 1&2, but not range 3.

    Main exception:
    Falling LRATC --> natural monopoly
    Example: public utilities

    3. Input prices and input combinations

Consider what happens as relative input prices change     PL PK PL/PK Advice TCa $20 $20 1 --- +PL $40 $20 2 -L,+K -PK $20 $10 2 -L,+K TCb     2

    ? What happens to optimal input combination for producing Qo?

    To produce a given output (Qo) when prices change, only an input substitution effect occurs

   So you know for sure what happens to optimal input combinations when prices change.

    IV. The perfectly competitive (PC) market

    Recall: firm must do 2 things to max profit:
    1. Minimize cost of whatever amount is produced
        --we've just finished looking at this
    2. Decide how much to produce
        --we turn to that now

    Deciding how much to produce brings consumers and producers together in the market
        Consumers: part II: the demand side of the market
        Producers: part III: the supply side of the market

    We consider this interaction now in the context of a perfectly competitive market

Learning objectives: State the assumptions of perfect competition (PC). Determine and diagram a PC firm's profit-maximizing output level and profits in the short run and the long run.

    Assumptions

    (1) identical (homogeneous) products for all producers:
restricts all competition to a single dimension--price

    (2) many "small" sellers--each one too small to influence price of output  (zero measure)
    => firms are "price takers"
    regardless of industry demand, firm's D is horiz.

    (3) easy entry and exit
    => LR profits = 0

     (4) perfect information
    rules out miscalculations

    Relevance of PC--why study such an extreme case?

    (1) about 1/2 of economy is PC

    (2) provides a benchmark, a standard of comparison when looking at what goes wrong with markets

    (3) helps us understand firm behavior
    --competitive pressures
    --collusion
    --rent-seeking, etc.

    A. Equilibrium in the short run

    1. Choosing output

    Using marginal analysis to maximize profit

    Recall goal: max TR-TC.
    Note: selling extra output raises profits if and only if TR rises by more than TC:
    DTR > DTC => Dp > 0
    MR > MC =>  Dp > 0 => produce more

    Stop when MR<=MC.
    That will maximize your profits, with one possible exception:
    If p<0, check shutdown condition.

    Overall: 2-step process to choosing profit-maximizing output (Q*):
    Step 1: Expand production as long as MR > MC (the upward-sloping portion of MC).
    Step 2: If profits are < 0, check to be sure that TR > TVC (=> P > AVC). If not, shut down.

    The shutdown option:
    Q=0 => TR = 0, TC = TFC, p = -TFC

    => better to operate at Q* if
    p > -TFC =>
    TR - TC  > -TFC =>
    TR > TC - TFC =>
    TR > TVC =>
    TR/Q* > TVC/Q* =>
    P > AVC at Q*

    2. Calculating and illustrating profits

        p = TR - TC
            = P^.Q* - ATC^.Q*
            = (P - ATC)Q*

            = a rectangle:
            base = Q*
            height=P-ATC at Q*

Complete review worksheets