Sellers and Incentives in Economics

Here are my notes and thoughts on sellers and incentives in economics.

In much the same way that consumers choose the optimal bundle of goods and services to maximize their net benefits, sellers choose what to produce and how much to produce to maximize their net benefits: profits.

The seller’s problem has three parts:

1. Production
2. Costs
3. Revenues

An optimizing seller makes decisions at the margin. The supply curve reflects a willingness to sell a good or service at various price levels. Producer surplus is the difference between the market price and the marginal cost curve. Sellers enter and exit markets based on profit opportunities.  

Three conditions characterize perfectly competitive markets are:

1. No buyer or seller is big enough to influence the market price
2. Sellers in the market produce identical goods
3. Their is free entry and exit in the market

Just as a consumer can buy as much as he wants at the market price, sellers are price-takers in that they can sell as much as they want at the market price. The rationale behind this assumption is that an individual seller tends to only sell a tiny fraction of the total amount of a good produced. Because the seller’s output is small relative to that of the market, the individual choice of how much to produce isn’t going to be important for market outcomes. But the combined effect of many seller’s decisions will affect the market price. 

The three elements of the seller’s problem are:

1. Making the goods
2. Cost of doing business
3. Rewards of doing business

A firm is a business entity that produces and sells goods or services. Every firm faces the decision of how to combine inputs to create outputs. Production is the process by which the transformation of inputs (such as labor and machines), to outputs (such as goods and services) occurs. The relationship between the quantity of inputs used and the quantity of outputs produced is called the production function. 

Physical capital is any good, including machines and buildings, used for production. 

Economists refer to the short run as a period of time when only some of a firm’s inputs can be varied. Alternatively, the long run is defined as a period of time wherein a firm can change any input. This means that physical capital is a fixed factor of production or an input that cannot change in the short run. That labor is a variable factor of production or an input that can change in the short run. Marginal product is the additional amount of output obtained from adding one more unit of input, such as a worker. The marginal product increases with the addition of the first few workers. This happens because workers specialize in a particular portion of their jobs. In specialization, workers develop specific skill sets to increase total productivity. 

The marginal product eventually decreases with successive additions of workers. This is the same as diminishing returns of additional workers. Adding too many workers can decrease overall production. It will depend on the environment and place. 

The cost of production is what the firm must pay for its inputs. 

\[ \text{total cost} = \text{variable cost} + \text{fixed cost} \]

Total cost is the sum of variable and fixed costs. Variable costs are those costs associated with variable factors of production. A fixed cost is a cost associated with a fixed factor of production, such as equipment. It does not change with production in the short run. 

The average total cost is total cost divided by total output. 

The average variable cost is the total variable cost divided by total output. 

Average fixed cost is the total fixed cost divided by the total output.

Marginal cost is the change in total cost associated with producing one more unit of output. 

\[ \text{marginal cost} = \frac{ \text{change in total cost}}{ \text{change in output}} \]

A firm makes money from selling goods. The revenue of a firm is the amount of money it brings in from the sale of its outputs. Revenue is determined by the price of its goods sold times the number of units sold.

\[ \text{total revenue} = \text{price} * \text{quantity sold} \]

Recall that in perfectly competitive markets, sellers can sell all they want at the market price. This means they are price-takers. The price of a unit sold comes from the intersection of the market demand curve and the market supply curve. So, the intersection of market supply and market demand gives the equilibrium price. 

Marginal revenue is the change in total revenue associated with producing one more unit of output. In a perfectly competitive market, marginal revenue is equal to the market price. Therefore, the marginal revenue curve is equivalent to the demand curve  facing sellers. 

The profits of a firm are the difference between total revenues and total costs.

\[ \text{profits} = \text{total revenues} - \text{total costs} \]

If a firm can produce another unit of output at a marginal cost that is less than the market price, it should do so, because it can make a profit on producing that unit. 

With this marginal decision making in mind, its straightforward to see how a firm maximizes its profits. It should expand production until:

\[ \text{marginal revenue} = \text{marginal cost} \]

This is the same as producing where price equals marginal cost, because marginal revenue equals price in a perfectly competitive market. 

We can compute total profits by taking the difference between price and average total cost at the point of production and multiplying that difference by the total quantity produced. 

Accounting profits are equal to revenues minus explicit costs. Explicit costs are the sorts of line item expenditures that accountants carefully tally and report, like wages or equipment costs. Economic profits are equal to total revenues minus both explicit and implicit costs.  

The mr=mc rule is powerful because we can determine in the short run how a competitive firm changes its output when the market price changes. 

When considering how responsive the firm is to price changes, we can use elasticity measures. For sellers, the most important measure that economists use is called the price elasticity of supply. This is the measure of how responsive the quantity supplied is to price changes.

Price elasticity of supply = percentage change in quantity supplied / percentage change in price

The price elasticity of supply will tend to be positive, because as price increases, firms tend to increase their quantity supplied.

An elastic supply means that quantity supplied is quite responsive to price changes. Any given percentage change in price leads to a larger percentage change in quantity supplied. In a perfectly elastic supply curve, a very small change in price leads to an infinite change in quantity supplied.  

Alternatively. An inelastic supply means that any given percentage change in price causes a smaller percentage change in quantity supplied. In this case, at every different price, the same quantity is supplied. 

Much like demand elasticities, the size of supply elasticities is determined by several factors. Key determinants include whether the firm has excess inventories. Likewise, how long the firm has to respond to price changes is important, the longer the time to respond, is the more elastic the supply will be. Finally, if workers are readily available, then supply will be more elastic because the firm can respond to price increases by quickly hiring workers. 

A shutdown is a short run decision to not produce anything during a specific time period. Sunk costs are a special type of cost that, once they have been committed, can never be recovered. One of the important things to remember about sunk costs is that once they are committed, they shouldn’t affect current or future production decisions. They can’t affect the relative costs and benefits of current and future production decisions. 

The short run supply curve is the portion of its marginal cost curve that lies above average variable cost. If the market price lies at a point on its marginal cost curve that lies below the minimum of the average variable cost curve, then the firm should shut down. Otherwise, it should produce. 

Producer surplus is computed by taking the difference between the market price and the marginal cost curve. Graphically, producer surplus is the area above the marginal cost curve and below the equilibrium price line. In this way, it is distinct from economic profits. 

A consumer’s surplus arises from being willing to pay above the market price, a producer’s surplus arises from selling units at a price that is above the marginal cost. Similar to consumer surplus, we can add up the seller’s producer surplus to obtain the total producer surplus in the market. We do this by measuring the area above the marginal cost curve that is below the equilibrium price line to compute producer surplus for the entire market. 

There are several ways in which producer surplus can increase or decrease. For example, if a shift in the market demand curve causes a higher equilibrium market price, then producer surplus increases, because the area above the supply curve and below the equilibrium price line gets larger. 

Firms often think about more than just each day’s production. Many businesses issue quarterly reports that discuss the firm’s long term outlook. 

The long run is defined as a period of time in which all factors of production are variable. In the long run, there are no fixed factors of production, because even machines and buildings can be retrofitted, purchased, expanded, or sold. Because of this fact, there are important differences between a firm’s short and long run supply curves. 

In the short run, if it wants to change production, it can only do so by hiring or laying off workers. This is because only labor is variable in the short run. In the long run, the firm searches for the optimal combination of workers and building size. Also in the long run, the firm is able to combine workers and physical capital to achieve the minimal average total cost for each output level. This difference causes the short run cost curves to be above the long run cost curve. 

Economies of scale occur over the daily output range and such an effect might occur because as the scale of the plant gets bigger, workers have more opportunities to specialize. When average total cost does not change with the level of output, the plant experiences constant returns to scale. Diseconomies of scale occur when average total cost increases as output rises and this might happen because management teams begin to get spread too thin or duplication of tasks occurs.

An exit is a long run decision to leave the market. Exit if price is less than average total cost or if total revenue is less than total cost. 

The long run supply curve is the portion of its marginal cost curve that lies above the average total cost. 

Total profit in the long run is computed exactly like its short run profit. Total revenue minus total cost. Profit equals the difference between price and average total cost multiplies by the quantity sold. Accordingly, when computing producer surplus in the long run, we take the difference between market price and the seller’s long run marginal cost curve. 

Much like the short and long run analyses for the individual firm, at the industry level there are critical distinctions between the short run and the long run. The primary difference is that even though the number of firms in the industry is fixed in the short run, in the long run, firms can enter or exit the industry in response to changes in profitability. This is because in the long run, they have the ability to change both labor and physical capital.

If there is free entry into the industry, which means entry is unfettered by any special legal or technical barriers, the entry process continues until the last entrant drives the market price down to the minimum average total cost. 

The market supply curve is the summation of individual firms’ supply curves, adding new firms causes the industry to provide higher quality at any given price. 

We know that the market price in a perfectly competitive industry is determined by the intersection of the market demand and market supply curves. A shift to the right of the market supply supply curve lowers the market price. Atr this point, the market reaches an equilibrium, because no more firms will enter. Firms will keep entering the market as long as the new price remains above the minimum average total cost. A new entry into the market will further shift the market supply to the right and lower the market price even more. They will keep doing this until it is no longer profitable to enter the market. 

Free exit from the market means their exit is unfettered by any special legal or technical barrier. The firms that exit first will be the ones with the highest cost. 

Notice that regardless of initial demand or supply shifts and accompanying price changes in the market, entry or exit causes the market to reach the minimum of the long run average total cost curve. That is, the equilibrium quantity in the market might change due to market demand and supply shifts., but the equilibrium price always returns to the minimum of the long run average total cost. 

Even though the industry’s short run supply curve is upward sloping, the industry’s long run supply curve is horizontal at the long run minimum average total cost level. Price always returns to the minimum average total cost, and because average total cost does not change, price always remains the same in the long run. This is because variations in long run industry output are absorbed by firm entry and exit, causing long run quantity to change while equilibrium price remains the same. 

The second long run outcome achieved with free entry and exit is that firms in a perfectly competitive market earn zero economic profits in equilibrium. Economic profits serve as an important signal as to whether firms are better off in this industry or in some other industry. If economic profits are positive, then entry occurs until economic profits fall to zero. If economic profits are negative, exit occurs until these profits rise to zero. Free entry and exit forces price to the minimum average total cost, and therefore economic profits are zero in the long run equilibrium. 

However, economic profits are not the same as accounting profits. As a business owner, when economic profits are zero, it simply means that you cannot earn more money if you take your talents to a different industry. You are being paid at least your opportunity cost of time. 

Sellers optimize by solving the seller’s problem, which dictates that decisions are made on the margin. Expand production until marginal cost equals marginal revenue.

Short and long run supply curves provide an indication of seller’s willingness to sell at various price levels. 

The difference between price and the marginal cost curve is producer surplus.

Free entry and exit cause long run economic profits to equal zero in a perfectly competitive market. 

With an understanding of decision making rules from the seller’s problem and the forces of free entry and exit, we can not only better understand hot ro run our own business but also better predict how sellers will respond to incentives.

 In a perfectly competitive market, a seller:

1. Cannot choose to raise the price of its goods since all sellers in the market produce identical goods, so raising the price would result in losing all its customers.

All firms in a perfectly competitive market are said to be:

1. Price takers

The marginal cost curve intersects the average total cost curve at its minimum point. Graphically, the marginal cost curve should start below the average total cost curve, intersect it at the average total cost’s lowest point, and then remain above the average total cost.

When the average total cost curve is decreasing, we know that the marginal cost curve is below the average total cost curve, and when the average total cost curve is increasing, we know that marginal cost is above the average total cost curve. 

What is the difference between accounting profit and economic profit?

1. Economic profit subtracts both explicit and implicit costs from total revenue. While accounting profit only subtracts explicit costs.

Is it possible for accounting profit to be positive and economic profit to be negative?

1. Yes, this could occur if explicit costs were modest and implicit costs were high

Under which of the following examples is it likely that the accounting profit is positive and the economic profit is negative?

1. If you open an amusement park in the middle of new york city

Fixing up old houses requires plumbing and carpentry. Jack can fix up three houses in a year if he does all of the carpentry and plumbing himself. His wage is 100,000 per year. Average total cost is the total cost divided by the total output. Jack’s average total cost of fixing up three old houses is:

1. (100000/3) = 33,333

George is an excellent plumber and Harriet is an excellent carpenter. George can do all of the plumbing and Harriet can do all of the carpentry to fix up eight houses per year. Each earns a wage of 100000 per year. If george and Harriet work together and fix up eight old houses each year, their average cost is:

1. (200000/8) = 25000

This problem tells us that one of the sources of economies of scale is:

1. Specialization. Economies of scale occur when average total cost falls as the quantity produced increases.

Which of the following equations calculates the profits of a firm?

1. Total revenues - total costs

When comparing the accounting profit with economic profit, it must be true that the accounting profit is:

1. Greater than or equal to economic profit

The graph to the right shows the average total cost, average variable cost, marginal cost, and marginal revenue curves for a firm in a perfectly competitive market. In order to maximize profits, this firm should produce approximately:

1. 11 units of output

Calculate the price of elasticity of supply in the following examples, then determine if supply is relatively elastic or inelastic, or perfectly elastic or inelastic. 

When the price of a pen increased from 3 to 4, the quantity supplied by a firm increased from 100 to 150 pens. The price elasticity of supply is:

1. (q2-q1) / (q2+q1)/2 all over (p2-p1) / (p2+p1)/2 = (150-100) / (150 + 100)/2 all over (4.00 - 3.00) / (4.00 + 3.00)/2 = 50 / 125 all over (1.00) / (3.50) = .4 / .29 = 1.38

In this case, the price elasticity of supply is:

1. Relatively elastic

When the price of bottled water increased from 2.00 to 2.25, the quantity supplied by a firm increased from 200 to 216 bottles. The price elasticity of supply is:

1. .65

In this case, the price elasticity of supply is:

1. Relatively inelastic

Even though the price of an acre of land increased from 6000 to 10000, the quantity supplied did not change. The price elasticity of supply is:

1. 0

In this case, the price elasticity of supply is:

1. Perfectly inelastic

The ISS is a habitable satellite launched by NASA. In 2009, NASA was considering shutting down the ISS within the next 5-6 years. Among those who were opposed to this idea of de-orbiting the ISS was senator Bill Nelson who was quoted as saying, if we’ve spent a hundred billion dollars, i don’t think we should shut it down in 2015. 

The hundred billion dollars is known as a:

1. Sunk cost

Given this information, the senator’s comment is:

1. Flawed

Since these types of costs:

1. Should not affect current and future decisions

You are planning to build an apartment building. Your market research department estimates that your revenues will be 800000. Your engineering department estimates the cost will be 600000. You started construction and spent 200000 to build the foundation when the recession began. This causes the market research department to revise its revenue estimates downward to 399950. Should you complete the apartment building?

1. No, the remaining cost to build is 400000 and you only expect to earn 399950. You will ignore the 200000 since it is a sunk cost

Producer surplus is the difference between the:

1. Price consumers pay and the supply curve

The graph on the right shows the long run average total cost curve for a  perfectly competitive firm. Refer to points a,b, and c and identify where the firm would experience economies of scale, constant returns to scale, and diseconomies of scale.

1. Point a = economies of scale since the average total cost curve is decreasing as the quantity produced is rising.
2. B = constant returns to scale since the slope is constant
3. C = Diseconomies of scale since since the average total cost curve is increasing as the quantity produced is rising

A firm is experiencing economies of scale when its:

1. Average total cost declines as more output is produced

The table below shows the long run total costs of three different firms.

Do firms 1 and 2 experience economies of scale or diseconomies of scale?

1. Firm 1 is experiencing economies of scale and firm 2 is experiencing diseconomies of scale.

Minimum efficient scale is the lowest level of output where long run average total cost is minimized. Firm 3’s minimum efficient scale occurs when the output is:

1. 3 units

You are one of 5 identical firms that sell widgets. Each day, you have a fixed cost of $9 to operate. The marginal cost of your first widget is $1, second is $2, third $3, fourth $7, and for the fifth it is $8. You have a capacity constraint of 5 and you can only produce a whole number of widgets. The average variable cost for a firm that produces 2 widgets is:

1. (2+1)/2 = 1.50

The market level quantity supplied given the market price of a widget is 2.50 is:

1. Each firm will supply two widgets as the marginal cost of the third widget will be greater than the market price. Since there are 5 firms, the total market level quantity supplied is 2*5 = 10 widgets

Suppose the market level demand is fixed at 18. In other words, there is perfectly inelastic demand. In the short run, the equilibrium price will be:

1. For the market supply to be 18, each firm must be willing to supply either 3 or 4 widgets. At a market price of $7, firms will be willing to supply 4 widgets as the marginal cost will be equal to the price.

If firms are perfectly competitive, the equilibrium price in the long run will be

1. In the long run, price will be driven to the minimum average total cost. At q=2, average total cost is $6, at Q=4. average total cost is $5.50. Therefore, in the long run, the equilibrium price will be $5.

Click on the table icon that shows fixed costs, variable costs, and total costs for different output levels. Then use this data to help fill in missing information

0 - - -

1 16 5 21

2 8 8 16

3 5.33 10.33 15.66

Using the same table, what is the marginal cost of the third unit produces?

1. 15

The graph on the right shows the cost curves for a random firm competing in a perfectly competitive market. Given the shape of the curves label each curve:

1. Marginal cost, average total cost, average variable cost

Which of the following statements regarding producer surplus are not true?

1. It is not possible to calculate the total producer surplus in the market
2. It is the area below the marginal cost curve
3. It is the difference between total cost and total revenue

When the market price(p) is 3.50, the total producer surplus equals:

1. 375

If the equilibrium market price(p) changes to 3.00, the total producer surplus would:

1. Decrease

Assume that the market for chocolates is perfectly competitive. Which of the following statements would be true in this case?

1. Jill starts to produce chocolates today but the addition of her supply into the market does not decrease the market price

Consider a market where there are many firms with different cost structures. When determining which firms enter the market first, we look at:

1. Average total cost

The last firm to enter earns:

1. Zero economic profits

If demand shifts to the left(decreases), the last firm that entered:

1. Earns negative economic profits and so exits the market

The graph on the right shows the long run average cost curve and marginal cost curve for a firm in a perfectly competitive market. Based on the graph to the right, the long run supply curve is:

1. Segment bc, since at prices below B the firm would shut down in the long run

The graph on the right shows the short run cost curves and three possible marginal revenue curves for a perfectly competitive firm.

If the firm were facing mr1, then we know that this firm should:

1. Keep producing, since it is making a profit at the profit maximizing output

If the firm were facing mr2, then we know that his firm should:

1. Keep producing, even though it is incurring a loss it is less than the fixed costs that must be paid if it shuts down

If the firm were facing mr3, then we know that his firm should:

1. Shut down, since it is incurring a loss that is greater than the fixed costs that must be paid if it shuts down

Assume that a perfectly competitive market in a long run equilibrium with firms earning zero profit experiences a sudden increase in demand for its good.

1. As a result, in the long run, the rise in marginal revenue will cause firms to enter the market. 

How does a change in the number of firms in the market impact the market equilibrium?

1. Put a point above the current equilibrium point
2. Draw a curve shifted to the right