6: The theory of the firm I: production, costs, revenues and profit. Flashcards
Differentiate between the short run and the long run in the context of production:
The short run is a time period during which at least one input is fixed and cannot be changed by the firm. For example, if a firm wants to increase output, even if it can hire more labour and increase equipment, if it cannot quickly change the size of its buildings or factories, it is in the short run. The long run is a time period when all inputs can be changed, they are all variable.
What is the total product (TP)?
The total quantity of output produced by a firm.
What is the marginal product (MP)? How is it calculated?
The extra or additional output resulting from one additional unit of the variable input, or labour.
MP = ∆TP / ∆units of labour
What is the average product (AP)? How is it calculated?
The total quantity of output per unit of variable input, or labour. This tells us how much each unit of labour (each worker) produces on average. AP = TP/units of labour.
Describe the total product curve, marginal product curve and average product curve:
Units of variable input (labour) on the x axis.
Units of output on the y axis.
The TP curve is increasing as there is an incresaing marginal output, until it curves the other way and marginal output is decreasing (kind of like an s). Eventually it curves over, and there is a negative marginal output.
The MP curve increases until the MP starts to be negative and then it just keeps being negative. It hits 0 when the TP curve starts to go down. When the TP curve goes downward, MP is negative so MP curve crosses the x axis.
AP curve is simply increasing and then decreasing in the middle.
What is the relationship between the average and marginal product curves? What does this mean?
When the marginal product curve lies above the average product curve (MP>AP), average product is increasing. When the marginal product curve lies above the AP curve (AP>MP) the average product curve is decreasing. This means the marginal product curve always intersects the average product curve when it is at its maximum.
What is the law of diminishing returns?
The law of diminishing returns/marginal product states that as more and more units of a variable input (such as labour) are added to one or more fixed inputs, the marginal product of the variable input at first increases, but there comes a point where it begins to decrease.
What are costs of production?
Cost of productions are money payments to buy resources, which include land, labour, capital and entrepreneurship.
What are explicit costs?
Payments made by a firm to outsiders to acquire resources for use in production.
What are implicit costs?
The sacrificed income arising from the use of self owned resources by a firm.
What are economic costs?
The sum of explicit and implicit costs, or total opportunity costs incurred by a firm for its use of resources, whether purchased or self owned.
What are fixed costs? Examples?
What are variable costs? Example?
Fixed costs are costs that do not change as output changes. For example, rental payment. Even if there is zero output, these payments still have to be made in the short run.
Variable costs are costs that vary as output increases or decreases. An example is the wage cost of labour
Why are there no fixed costs in the long run?
Because in the long run there are no fixed inputs.
What is total cost?
The sum of fixed costs and variable costs.
How do you calculate average fixed cost (AFC)?
TFC/Q (Units of output)
How do you calculate average variable cost (AVC)?
TVC/Q (Units of output)
How do you calculate average total cost (ATC)?
TC/Q (Units of output)
TC = TFC + TVC
How do you calculate ATC?
ATC = AFC + AVC
What is marginal cost?
How is it calculated?
It is the extra or additional cost of producing one more unit of output. MC = TC / ∆Q = ∆TVC / Q because fixed cost is fixed and does not change.
Draw a diagram illustrating the total cost curves in the short run:
The TFC curve is a horizontal line as it is a fixed amount that does not change as output changes.
The TVC increases as output increases but at a varying rate due to the law of diminishing returns.
The TC curve is the vertical sum of TFC and TVC, so the vertical difference between TC and TVC is TFC. TC and TVC are parallel.
Draw a diagram illustrating the relationship between marginal cost and average costs and explain the connection with production in the short run (p148):
The AFC curve indicates that AFC falls continuously as output increases, because it represents the amount of fixed costs (TFC) divided by an ever growing quantity of output.
ATC, AVC and MC all fall originally, reach a minimum and then rise.
The ATC curve is the vertical sum of AFC and AVC, so the vertical difference between the ATC and AVC curves is equal to AFC. ATC is above AVC. The distance between them starts off large and then gets smaller as AFC gets much smaller.
The MC intersects the AVC and ATC curves at their minimum points.
AFC starts very high and then decreases exponentially until it is very small, with an asymptote at 0.
Why does MC intersect the AVC and ATC curves at their minimum points?
Because when the marginal cost is lower than the average cost, the average cost falls. When it is greater than the average cost, the average cost rises.
What is the relationship between MP/AP curves and MC/AVC curves?
They are mirror imagines of each other. Where MP and AP increase, MC and AVC decrease and visa versa.
Explain the relationship between MP/AP curves and MC/AVC curves:
When output is lower, an increase in labour increases the marginal product, and this decreases marginal cost as productivity increases. Decreasing product means that additional output of each unit of labour is falling so the additional cost of each unit of labour (marginal cost) must be increasing. Thus, it is due to the law of diminishing returns.
What qre constant returns to scale?
Constant returns to scale means that output increases at the same proportion as all inputs, they change by the same percentage.
What are increasing returns to scale?
Increasing returns to sale means that output increases more than in proportion to the increase of all inputs.