![]() Producer Surplus is the amount we have before paying our fixed costs. This should clear up the relationship between FC, PS, and Profits. In this case, after paying VC, The Clip Joint has $105 left over to pay off a portion of its fixed costs. In fact, firms will produce in the short-run even when P 0, then the firm has enough money to pay for all of its variable costs, plus some money left over to pay for its fixed costs. In the long run, this will not be sustainable. In the last example, The Clip Joint made healthy profits of $210 per day because P > ATC. This is no surprise – producer surplus is just our earnings before we subtract the fixed costs! When There’s Losses What is the difference between profits and producer surplus? Calculating $360 – $210, we find our fixed cost value of $150. Note that our AVC and ATC are always calculated from the quantity where MC = P, as this is the profit maximizing quantity. Figure 7.2dĬalculating producer surplus, with PS = (P – AVC) × Q, we find Π = (7.5 – 4.23) x 110 = $360. Using marginal analysis, we will produce until MC = P, or where our price line intersects our marginal cost. Consider a market where The Clip Joint faces a price of $7.5. Let’s bring this understanding to our graph. ![]() Since fixed costs do not change, the ∆PS = ∆Π and the analysis of ∆ Π >∆VC will be identical. Our marginal analysis tells us to increase production if ∆PS >∆VC (MB>MC). Even though profits and producer surplus are not the same, the act of maximizing PS maximizes profits as well. The only difference between PS and profit is fixed cost. Marginal analysis certainly maximizes producer surplus, but what about profits? Recall that producer surplus does not subtract fixed cost. This means that P = MR = MB. Knowing that a firm maximizes producer surplus when MC = MB, we can now see that for a competitive firm, this occurs when P = MC. If price is $7, then every Q will earn the firm $7 of revenue. In this case, our price is our marginal benefit, since the price the firm receives is equal to the marginal revenue from an action. If MB > MC, they will increase Q, and stop when MB = MC. In Topic 1, we learned that economic agents use marginal analysis to make decisions about whether to increase a behaviour. A market price will dictate where they produce. If The Clip Joint is operating in a city with many other identical barber shops, they will lose their ability to set prices. While we will use producer theory for non-competitive markets, for now, we are looking at price-taking firms. Remember that fixed cost is always equal to $150 regardless of quantity, but AFC is always decreasing, as this $150 gets spread out across more goods. Now, without knowing fixed cost, we can work backwards from our diagram to calculate total fixed cost at any Q.Ĭalculating FC at any other point, we will find that it is always equal to $150. Remember that we derived ATC using fixed costs. Calculating fixed cost, we see it equals $150, as stated in Topic 7.1. Figure 7.2aĪt Q = 50, our ATC = $7 and AVC = $4. Since FC = (AFC x Q), on our graph, we can find what total fixed costs are by simply multiplying the difference in AVC and ATC by the quantity at that level. ![]() In Topic 7.1, we showed that ATC = AVC + AFC. First, let’s see the different variables we can calculate from our graph. Now that we have built our model for Producer Theory, we want to use it as a tool to understand how individual firms behave when faced with different prices. Be able to identify break-even and shut-down points.Identify when firms will exit in the short-run.Calculate fixed costs, producer theory, and profits.Let's continue with our orange juice producing example In this situation I want to think about what a rational quantity of orange juice might be what would be a rational quantity of orange juice to produce given a market price So let's say that the market price right now is 50 cents a gallon and I'm going to assume that there are many producers here so we're going to have to be price takers and obviously we want to charge as much as we can per gallon but if we charge even a penny over 50 cents a gallon then people are going to buy all of their orange juice from other people so this is the price that we can charge 50 cents per gallon So, if we think about it in terms of marginal revenue per incremental gallon well that first incremental gallon we're going to get 50 cents the next incremental gallon we're going to get 50 cents for that one and the next one we're going to get 50 cents as well.By the end of this section, you will be able to:
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