ECO101H1 Chap.4 Firms, Competition and Labor
Firms, Competition and Labor
Cost Includes the Next Best Use
Economic cost includes the value of resources in their next best available use. Paying oneself a low salary does not make one's time cheap if other work is available at a higher return. Likewise, using owned equipment can sacrifice rental income. The relevant cost depends on the decision and horizon.
A payment already committed may remain unavoidable after shutting down today, while a future lease renewal can be avoided by leaving the industry.
Fixed, Variable and Average Costs
Fixed cost does not change with current output over the horizon being analysed. Variable cost changes when the firm produces more or less. Their sum is total cost, and dividing each by output produces the corresponding average measure.
Average total cost therefore includes both average variable cost and average fixed cost. Spreading a fixed payment over more units lowers its average contribution, but that accounting effect does not imply that every additional unit is inexpensive to produce.
Marginal Cost and Productivity
Marginal cost concerns the change in total cost caused by more output.
A derivative gives the local rate of change in a continuous model; a difference between adjacent output levels gives the cost of a discrete increase. State which convention applies. When labor is the only variable input and the hourly wage is fixed, the cost of extra production depends on how much additional output the next labor input creates.
Diminishing marginal product can make marginal cost rise.
The Competitive Firm
A price-taking firm treats the market price as beyond its own control. Its marginal revenue equals that price, so an interior output decision compares price with marginal cost. On a rising marginal-cost segment, equality identifies the candidate output. The firm must then check whether producing is preferable to shutting down.
A horizontal demand curve for an individual small firm should not be confused with the downward-sloping demand curve for the entire market.
Profit After the Quantity Decision
Once output has been chosen, calculate total revenue and subtract total economic cost. An equivalent calculation multiplies output by the difference between price and average total cost.
Producer surplus subtracts variable cost from revenue and can therefore remain positive when economic profit is negative.
Zero economic profit means the firm covers all opportunity costs included in its cost schedule; it does not mean the owner receives no compensation or that the business has no sales.
Shutdown, Exit and Entry
The short-run operating comparison asks whether revenue covers avoidable variable costs and contributes toward unavoidable fixed cost.
A firm may rationally operate at a loss when shutdown would lose even more. Long-run exit allows additional commitments to be avoided. In a competitive constant-cost industry with identical firms and free entry, positive economic profit attracts entrants and expands market supply. Losses encourage exit.
These adjustments explain why the long-run price can differ from the price a current firm takes as given.
Derived Labor Demand
Workers are hired because their output generates revenue. With a competitive product market, multiply marginal physical product by the output price to find the value of marginal product. Compare that contribution with the cost of hiring the next worker.
Higher demand for the product can raise its price and increase labor demand even when physical productivity stays unchanged. A wage change instead produces a movement along an unchanged labor-demand schedule when other conditions are held fixed.
Wage Floors and Employment
A binding minimum wage in the standard competitive labor market sets pay above equilibrium.
Firms choose their quantity demanded at that wage, while workers choose the quantity they wish to supply. The gap is excess labor supply. It differs from the reduction in employment, which compares hiring before and after the intervention. A more elastic labor-demand schedule implies a larger proportional employment response to a given proportional wage rise.
Specify the competitive assumptions before extending this result to another labor-market structure.
What this chapter covers
- 01
Opportunity Costs of Production
- 02
Fixed and Variable Costs
- 03
Marginal Product and Cost
- 04
Competitive Output
- 05
Profit and Producer Surplus
- 06
Shutdown and Entry
- 07
Derived Labor Demand
- 08
Minimum Wage Effects
Worked example · free
Choose output while making a short-run loss
- 2Differentiate total cost to obtain MC=4+4q, then solve 20=4+4q for q=4.
- 3Calculate revenue 20×4=80, variable cost 4×4+2×4²=48 and total cost 98.
- 2Compare operating profit −18 with shutdown profit −50; operating improves the result by 32.
Key terms
- Fixed Cost
- Fixed cost is a cost that remains unchanged as current output varies within the stated decision horizon. Whether it is avoidable depends on the available action and time period.
- Variable Cost
- Variable cost is the portion of total cost that changes with production. In the simple shutdown model, it is the cost avoided by producing nothing.
- Marginal Cost
- Marginal cost is the additional cost associated with more output, measured as a local derivative or a discrete change according to the model.
- Average Total Cost
- Average total cost is total economic cost divided by output. It includes fixed and variable contributions and is defined only at positive output.
- Economic Profit
- Economic profit is revenue minus all economic costs, including relevant implicit opportunity costs. It can differ from profit measured using only explicit payments.
- Marginal Product
- Marginal product is the extra physical output attributable to an additional input while other inputs are held fixed. It is not the output price or the wage.
- Derived Demand
- Derived demand is demand for an input that arises from the value of the output it helps produce. Labor demand therefore responds to product-market conditions.
Firms, Competition and Labor FAQ
How can a business keep running when economic profit is negative?
Continuing may cover variable expenses and part of a fixed commitment that must be paid either way. The right immediate comparison is the operating result against the shutdown result, not against an imagined option with no remaining cost.
Does a fixed-cost increase change today’s best output?
If the cost is truly unchanged across all current production choices, it does not change the marginal-cost schedule. The selected interior output can remain the same, even though profitability and later decisions about entry or exit change.
Why can the discrete next-unit cost differ from a derivative?
A derivative measures the rate at a point, while a whole additional unit moves across an interval. If the rate rises during that interval, the complete cost increase exceeds the rate evaluated at its starting point.
Must higher physical productivity always lower break-even price?
Improved productivity can reduce variable costs, but acquiring the technology may add fixed costs. Since break-even price depends on minimum average total cost, both effects must be considered before predicting the final direction.
What separates employment loss from excess labor supply?
Employment loss compares the number hired before a wage floor with the number hired after it. Excess labor supply compares desired work and desired hiring at the new wage; additional people seeking work can make this gap larger.
Exam move
Start with a small cost table and reconstruct total, variable, average and marginal costs without copying a completed diagram. Then solve for competitive output at a specified price and calculate profit using both revenue minus total cost and the price-minus-average-cost rectangle. Check shutdown separately.
For labor practice, create a sequence of marginal products, value each at the product price and compare the result with the wage. Change only product price, then only wage, and explain why the two changes move labor demand in different ways.
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