Economies of scope

Firms produce more than one output.

Products may be related or unrelated.

Product transformation curve Number of

Variety is more important than specialization. tractors

Negative slope represents that the firm must give

up one output to have more of the other output.
O2
O1
Straight line represent that there is no difference if a
single firm produce the products or two firms.
Number of
cars
Profit Maximization and
perfect competition
Perfectly competitive markets
Free entry and exit: highly fragmented
Large number of sellers and buyers.
There is no special cost that make it difficult for a firm to enter of exit an industry.
Buyers can easily switch from one supplier to another.

Product homogeneity:
Products of all firms in a market are perfectly substitutable.
No firm can raise the price of its products.

Price taking: Price awareness

Market is competitive- each firm face a large number of direct competition.
Each firm produces a small proportion of total market output.
A single firm cannot influence the market price.
Profit maximization by individual firm
Profit: Difference between total
revenue and total cost. Cost, revenue,
C(q)
profit (rupees
per year) A
(q) = R(q) C(q) R(q)

B
Marginal revenue: Change in revenue
resulting from 1-unit increase in
output.
Outputs (units
per year)
MR (q) = R / q q0 q* q1

MC (q) = C / q (q)

MR (q) = MC (q)
Demand curve for a competitive firm
Price (in rupees)

Individual firm is price taker.

Output is fixed.
The demand curve of a competitive firm 1,000
D =AR=MR=P
is given by a horizontal line.
MR (q) = TR / q = pq / q = p
MR = P = AR
1 2 3 4 5 6 7 8 9 10
Demand curve of an individual firm is perfectly Output (units)
elastic.
Increasing quantity by a firm would not affect
the price.
Short run- Choosing output
In short run
Capital is fixed 100 Cost (per unit)
Number of firms is fixed. rupees MC

The choice decision is- labour, material etc 75

ATC
A
Profit is maximized at q* level of output. 50
Profit AR=MR=P
AVC
At q1, MR > MC, profit could be increased. 25

At q2, MC > MR, cost can be saved.

0
q0 q*
Why do we choose q* instead of q0 for q1 q2

production? Output (units per year)

Production is done at the point where MR=MC

and marginal cost is rising.
Short run- Choosing output with high
fixed cost
No change in MC and AVC. 100 Cost (rupees
per unit) MC
B ATC
ATC is higher position. 75
Loss
A
At q*, price is less than ATC. 50
AR=MR=P
Loss is minimized. AVC
25

The firm although makes loss in the short 0

run, but continue to operate till it q*

recovers AVC. Output (units per year)

Expect the prices to rise in the long run. What if the price is below AVC?
Cost of production may fall in long run. Losing money on every unit
Competitive firms short-run supply curve
Price (rupees
per unit)
Output decision- price is equal to marginal
cost. MC
p2
Price decision- The firm shuts down when
price is below the average variable cost. ATC
A
p1

Supply curve- It is that portion of the marginal AVC

cost curve for which MC > AVC. P = AVC

At p1, the quantity supplied is q1 and at p2, 0

the quantity supplied is q2. q1 q2

Output
Supply is zero when price is lower than AVC.
Firms response to change in input prices
Price (rupees MC 2
per unit)

With increase in price of inputs, marginal MC 1

cost curve shifts up.
The profit maximizing output is now q2
and MC2 = P. P = MR
Higher input prices would lead to
reduction in output of the firm.
0
When the quantity reduces to q2, there is a q2 q1

saving equal to area of triangle. Output

 Short-run market supply curve
The supply curve of every firm is different due to different production functions.
Short-run market supply curve: It shows the amount of output that the industry will
produce in short run for every possible price.
It is an addition of the supply curves of every single firm.
MC1 MC2 MC3 S

p3
Market supply:
Price (rupees
per unit) p1= production by
firm 3
p2 = 2+5+8=15
p2
p3 = 4+7+10 =21
p1

2 4 5 7 8 10 15 21 Quantity
How Much Copper at Which Price?

At 70 cents per pound- Bingham

Canyon mine would operate at full
capacity.

The U.S. supply curve is the horizontal

sum of the supply curves of all 17 U.S.
copper mines.

The world supply curve is the

horizontal sum of the supply curves of all
70 copper mines worldwide.
Elasticity of market supply
Price elasticity of market supply measures the sensitivity of industry
output to market price.
Elasticity of supply is the percentage change in quantity supplied Q in
response to a one percent change in price.
Es = (Q/Q) / (P/P)
If marginal cost increases rapidly with quantity then what would be the
elasticity?
Perfectly inelastic supply: When the industrys plant and equipment are
fully utilized- short run
more output is possible only if new plants are built- long run
Perfectly elastic supply: When marginal cost is constant.
Producer surplus of a firm in the short run
Price (rupees
per unit)

MC
Producer surplus: Sum of unit surpluses
p2
over all units given by differences Producer
surplus
between the market price of a good and A P=MR
p1
the marginal cost of production.
AVC
P = AVC

0
q1 q2

Output
Producer surplus for market in the short
run
Price (rupees
Producer surplus for market: The area per unit)
below the market price and above the S

market supply curve.

Producer surplus versus profit P*

Producer surplus = PS = R-VC

Profit = R- VC- FC
Producer
D
A firm having lower cost have high producer surplus
0
surplus as compared to the firms with very Q*

high cost. Output

Long-run profit maximization
What is the property of long-run?
In short run, the MC and AC curves are well Rupees per
unit of output
below the price = MR line.
There is positive profit given by ABCD.
SMC
In the long run LMC
LAC
There is economies of scale. SAC
D A E P=MR
40
Economies of scale upto LMC=LAC, C
thereafter diseconomies of scale. G B
F
30
The output level can be increased up to
LMC=P.
0
Profit level can be further increased to DEFG. q1 q2 q3 Output
Long-run competitive equilibrium
Economic profit of a firm is = Revenue-wL-rK

Zero economic profit: A firm earning a normal return on its investment i.e. it is
doing as well by investing its money in capital as it could by investing elsewhere.

When a firm is earning positive profit then there are high returns on financial
investment.

As a result, all firms would want to enter the market.

Production would increase, causing the prices to fall.
 Long-run competitive equilibrium
What is the price of output A long-run competitive equilibrium have 3 conditions:
in the long-run? All firms maximize profit.
In short run, supply of the No firm has an incentive to either enter or exit.
firm would be q1. Price is such that the quantity supplied is equal to demand.
More firms enter the
market. Individual firm Market
Rupees per Rupees per
Supply would increase. unit of output unit of output
S1
Market equilibrium would
be attained where LAC = LMC
LAC
S2
LMC.
40 P1
P1

30 P2
P2

0 0 D
q2 q1 q1 q2
 Long-run supply curve of Industry
Shape of long run supply curve depends on price of inputs.
Individual firm Market
Constant cost industry Rupees per Rupees per
unit of output unit of output
Inputs can be purchased
without increase in per S1
LMC
unit price. LAC
S2

40 P2
Long run supply curve is P2

horizontal line = long run 30 P1

minimum average cost. P1

0 0 D1 D2
q1 q2 q1 q2
 Long-run supply curve of Industry
Shape of long run supply curve depends on price of inputs.
Individual firm Market
Increasing cost industry Rupees per Rupees per
LAC2 unit of output
Price of inputs increases as unit of output LMC 2 S1
the demand for input LMC 1 S2
grows. P2
LAC 1 SL
P2 P2
P3 P3
P3
Diseconomies of scale
P1 P1
P1
Long run supply curve is
upward sloping. 0 0 D1 D2
q1 q2 q1 q2 q3
Long-run supply curve of Industry
Shape of long run supply curve depends on price of inputs.

Decreasing cost industry

Price of inputs decreases as the demand for input grows.
Economies of scale
Average cost curve shifts downward.
Fall in market price.
Higher output at lower price.
Long run supply curve is downward sloping.