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4.4.2MAXIMIZING PROFITS OVER THE SHORT RUN

We know that the short run is distinguished by the existence of a fixed factor, or factors, of production. In the short run, a firm has fixed and variable costs whereas in the long run all factors of production are variable, and hence long-run total costs are variable also. Figure 4.12 includes the cost information for examining the short-run profit-maximizing decisions for a firm.

Short-run average total costs are equal to short-run average variable costs plus short-run average fixed cost.

SATC = SAVC + SAFC

The marginal cost curve SMC drawn is relative to the average total cost curve SATC. The decision about what output level to produce in the short run is based on the same logic as for the long-run decision i.e. where

SMC = MR.

One important distinction, however, between shortand long-run output must be noted. The firm in Figure 4.12 chooses its profit-maximizing output in the short run, Q , from the SMC = MR decision rule. The firm also sets its price from the corresponding point on the demand curve, P . If you compare P to the average cost of producing this level of output, you see that AC lies above the price while AVC lies below. This means that the price is sufficient to cover average variable costs but not to cover total costs. Should this firm remain in business? What is in the firm’s best economic interest?

	Cost/
	revenue/
	price	SATC
	AC*
	P*	SAVC
	AVC*
	SMC	SAFC
	Q*	Output
		MR

F I G U R E 4 . 1 2 P R O F I T M A X I M I Z A T I O N I N T H E S H O R T R U N

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If the firm decides to produce and sell its output at the price P , it makes an economic loss because its average costs are not covered. However, all average variable costs can be paid and some of its average fixed costs. If the firm did not produce in the short run, its fixed costs would still have to be paid. The firm has to choose between:

•producing zero output and paying for its fixed costs; or

•producing Q at a short-run loss.

As long as a firm can generate at least enough revenue to cover its short-run average variable costs of production, it should stay in business in the short run.

The firm needs to cut its costs somehow (or earn a higher price) to ensure the price covers average total costs in the long run or else the firm faces closure. The firm might be able to negotiate new prices with its suppliers, or lower rent from its landlord, or use its equipment more efficiently, for example, so that it can reduce its costs and its short-run cost curves would move down over time.

A firm that cannot cover its average variable costs in the short run should stop production. Its losses are lower at no output than if its variable costs cannot be covered by the price it earns on output.

Economic analysis

To follow the economic analysis of profit maximization conducted above, economists use demand, cost and revenue curves. The general patterns of the demand, cost and revenue curves have emerged from economists’ analysis of how firms operate and are analytical tools that help the economist to think about and examine the decisions facing firms. Many firms would probably not be able to draw exact or even inexact diagrams of these curves, however, in their knowledge of how their businesses operate day-to-day and over the longer term, they learn and understand how much they should produce to make profits, when they should cut back on production as their costs rise faster than revenue, and how their customers react to changes in prices. Such information allows firms to change their output in order to improve their profit position. Hence, the analytical tools of the economist are grounded in the reality facing firms and contribute to our understanding of how firms behave.

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4 . 5 S U P P LY, P R O D U C E R S

A N D P R O D U C E R S U R P L U S

The supply curve shows us the amount of output suppliers wish to supply at different prices and the upward slope of the curve indicates that the higher the price, the more suppliers are willing to supply, which is related to the increasing marginal costs of production. The benefit or utility that producers generate can be analysed using the concept of producer surplus.

Producer surplus – the benefit to producers due to the difference between the price suppliers are willing to receive for their output and what they actually receive.

To calculate producer surplus we need to examine the supply curve in equilibrium, as shown in Figure 4.13.

In equilibrium, the quantity of output bought and sold and the price charged are shown as Q and P . If price were P0 producers would supply no output in this market because there is no economic incentive – supply costs would not be covered.

At a price above P0, for example, P1, Q1 would be produced as only those producers who have sufficiently low costs would be willing to supply to the market. In equilibrium, however, the price is higher at P so more suppliers produce for this market. While price is P , this means that all the suppliers who would have willingly supplied at a lower price can earn P for their output, thus they benefit from receiving a higher price than they require as an incentive to supply the market. The shaded area in the figure above the supply curve and below P represents the sum total of the benefit to all such suppliers a measure of producer welfare.

P
	S
P*
P1
P0	D
Q1	Q
	Q*

F I G U R E 4 . 1 3 S U P P L Y A N D P R O D U C E R S U R P L U S

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4 . 6 P R O D U C E R S ’ R E S P O N S E T O P R I C E C H A N G E S

From the shape of the supply curve we know that at different prices producers wish to supply different quantities of output. The extent to which they wish to supply more or less of their output if price changes is measured by the price elasticity of supply.

Price elasticity of supply (PES) is the responsiveness of quantity supplied to changes in price. It may be elastic, inelastic or unit elastic.

It is computed as the proportional change in quantity supplied divided by the

proportional change in price: % QS/% P
Arc PES is computed as	QS		×		1/2[P 1		+ P 2]
		P		1	/	2[QS1	+ QS2]

If price increases we would expect producers to supply more and for a price fall, we would expect producers to cut back on their output. Thus, price elasticity of supply is usually a positive number. For a PES of 1.5, for every 10% rise in price, quantity supplied would rise by 15%. For values of PES greater than 1, quantity supplied is elastic or relatively responsive to changes in prices. Where PES is less than 1 PES is inelastic – a price change of 10% would lead to a quantity change of less than 10%. Where PES is 1, a small change in price has the same proportional effect on quantity supplied.

The extent to which suppliers are able to change their output in response to a price change depends on the business and time frame being considered.

A ship-builder cannot expand its capacity as quickly as a car manufacturer and the same is true for a car manufacturer relative to an ice-cream van.

	In the case of all businesses, however, price elasticity of supply will be lower
in	the short run than in the long run because in the short run firms will
be	unable to respond as completely to the change in price as in the

long run.

The supply curve is flatter in the long run than in the short run. In the long run, firms can fully adjust to the price change.

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The long-run/short-run consideration also has implications in terms of the availability of factors of production. The elasticity of supply of factors of production is relevant in determining the elasticity of supply of the products for which they are inputs. If suppliers cannot source inputs required to expand their production when the price of their product rises, they simply cannot expand output. A factory producing cars that cannot source extra steel required to produce additional cars (or that can only source extra steel at relatively high prices) will have little ability or incentive to respond to expected price increases in cars.

The quantity firms are willing to supply to a market may not always respond to changes in the price. If the price of potatoes doubled overnight, growers would be unable to adjust their supplies quickly to the new price. Over a short time period, supply would be perfectly inelastic (vertical) where quantity is ‘stuck’ at the output growers selected before the price change. Rational producers would react over time and where possible expand their output. Some new entrants would switch from growing other crops and still others might establish new businesses in the industry.

If the price of cinema tickets doubles, the short-run capacity of a cinema is fixed and supply cannot respond immediately.

In other markets supply may be perfectly elastic (horizontal) implying that quantity supplied is unlimited at one price only.

Information on price elasticity of supply can be useful for those interested in the future supply of products.

Within the EU estimates of supply elasticities are useful in the context of agricultural prices. The EU has an overproduction of many agricultural products – milk, butter, beef, mutton, etc. – due to its practices of supporting the prices of the products via floor prices. Since the EU wants to reduce the output of these products it has decided to cut the prices gradually over time.

To examine the effect of cutting prices, it would be useful to carry out research on the price elasticities of supply of the products to provide information on the expected supply effects of price changes.

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P R I C E C E I L I N G S , U S O I L , I N C E N T I V E S A N D P R I C E E L A S T I C I T Y O F S U P P LY

In the United States prior to 1978/9 a price ceiling was in place on domestically produced oil. The country was heavily dependent on imported oil, the price of which was determined by demand and supply. Limits on supplies by the Organization of Petroleum Exporting Countries (OPEC) kept the price high.

Although the objective of the US oil-price policy was to keep oil prices low for consumers and businesses, the low price was reducing incentives for firms in the industry to engage in more exploration and drilling. A debate followed that focused on the effect of removing the price ceiling in terms of domestic producers’ responses. How much extra would suppliers supply at higher prices? Estimates of the price elasticity of oil put it at just under 1, meaning that to increase quantity supplied by 10%, the price would need to rise by just over 10%.

When the price ceiling was removed the price increased and quantity supplied rose also. Rational consumers and businesses reacted by using oil somewhat more conservatively. Rational suppliers reacted to the higher prices by engaging in further exploration.

4 . 7 F I R M S ’ I N V E S T M E N T B E H A V I O U R

A key function of firms in the economic system is to maintain and upgrade the productive capacity of their companies; firms engage in investment.

Investment leads to the creation of capital assets.

Firms invest in fixed capital – which is plant, machinery and equipment – and in working capital, which is stocks of finished goods (inventories) waiting to be sold. In the national accounts, investment also includes the construction of business premises and residential construction. Investment by firms is also called private investment. If a firm wishes to produce a set level of output into the future it must invest sufficiently to cover the depreciation of its fixed capital.

Depreciation is the decline in value of an asset over time attributable to deterioration due to use and obsolescence.

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If a firm wishes to increase its output in the future it needs to invest sufficiently in its capital to cover more than just depreciation. An increase in investment by most firms increases an economy’s productive capacity pushing out its production possibility frontier and leading to economic growth, assuming of course that consumers buy the additional output produced with the new capital (this is expanded on in Chapter 9).

Net investment is the term used to describe only that investment which creates new capital assets, whereas gross investment includes the value of capital depreciation plus new capital investment.

Expectations about the future play a central role in a firm’s investment decisions and firms make their best guesses today on what future demand for their products will be and attempt to make the most appropriate investment decisions on that basis. Firms’ expectations about the future vary over time and the investment component of aggregate demand is actually the most changeable or volatile portion of aggregate demand in the national accounts. Much of the volatility derives from firms’ behaviour regarding their inventories. Firms’ inventory levels fluctuate widely depending on their expectations about business conditions. While holding a lot of inventories might not make sense due to storage costs or perishability, it makes sense for firms to have some stocks as their predictions about demand are not perfect and having inventories allows them a buffer to deal with unexpected demand so shortages are minimized.

In analysing the investment behaviour of firms using the definition of economic activity as planned consumption plus planned investment, planned government expenditures plus net exports, economists usually begin with the assumption that planned investment demand (denoted I ) is autonomous, i.e. independent of the level of national income. This assumption is not far removed from reality because the level of national income today is not a crucial decision variable for a firm thinking about investing; rather the focus for firms is on their expectations of the future and demand for their output in the future. Graphically, this can be represented by the investment function as in Figure 4.14.

The investment function describes the macroeconomic or aggregate investment behaviour in an economy.

In Figure 4.14, the level of autonomous investment I is constant, whatever the level of national income, Y . Since much of firms’ investments are financed by loans, investment decisions are sensitive to changing interest rates, and hence investment

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Investment

Investment

function

I*

Y

F I G U R E 4 . 1 4 T H E I N V E S T M E N T F U N C T I O N

can be influenced by policies and activity in the financial sector of an economy that cause rates to change (these are discussed further in Chapter 7).

4 . 8 G O V E R N M E N T I N F L U E N C E O N S U P P LY A N D P R O D U C T I O N

As the EU agriculture and US oil examples indicate, governments sometimes wish to influence production. In the case of oil the objective was to increase domestic supply whereas the EU agricultural policies focus on reducing production. For governments trying to increase the output of certain industries, targeted industrial policies may be used. Subsidies are one instrument used by governments to try to support domestic industries.

Subsidy: a payment or a tax concession from the government that reduces producers’ average production costs.

A government might wish to use subsidies for an industry that is not competitive and facing a declining market share. Or a strong lobby group with its own particular interests might be successful in negotiating subsidies to stave off competition in the future.

In the car industry in the 1970s and 1980s both European and US producers faced stiff competition from Japanese car manufacturers that were using new ways of organizing their factories – ‘lean production’ – which facilitated the Japanese firms’ reduction of their average production costs. In attempts to support domestic car producers, policies were used to try to support domestic output and producers at the expense of foreign output and producers. This meant reducing imports of cars allowing domestic (and higher-cost) producers to serve their home market.