background to supply Flashcards
what is the goal of a firm?
maximise profits
what is profit?
total revenue-total cost
what is total revenue?
the amount a firm receives for the sale of its output (P*Q)
what is total cost?
the market value of the inputs used for producing the output
what is the opportunity cost?
the cost of something is what you give up to receive it?
the opportunity cost of an item refers to all things that must be foregone to acquire that item. opportunity cost includes both explicit costs and implicit costs
what does cost of production include?
both explicit and implicit costs
what are explicit costs?
are input costs that require a payment of money by the firm; e.g. wage of an employee
what are implicit costs?
are input costs that do not require a payment of money by the firm e.g. income that the firm owner could have earned by doing something else
how do economists measure profit?
economists are interested in how firms make production and pricing decisions. These decisions are based on explicit and implicit costs.
- economists include both explicit and implicit costs when measuring a firm’s costs.
how do accountants account profit?
they have to keep track of the money that flows into and out of firms
- accountants only measure explicit costs and ignore implicit costs
what is economic profit?
total revenue - explicit costs - implicit costs
what is accounting profit?
total revenue-explicit costs
what are production costs in the short-run and long-run?
firms incur costs when they buy inputs to produce the goods and services they plan to sell.
in the short run some factors of production cannot be changes
short run: period of time in which some factors of production cannot be changed
long run: the period of time in which all factors of production can be altered
what is the production function?
this relationship between the quantity of inputs used to produce a good and the quantity of output of that good.
q = (K, L) where Q=output K=capital and L=labour
what does a short-term production function?
in the short run, labour is variable and capital fixed. Short term production function states how total output changes with labour (L) for a given level of capital (K).
what is total physical product of labour?
total output that is produced by the units of labour, for a given capital
what is the average product of an input?
in the production process, it is the units of output produced per unit of input (while keeping other inputs constant)
- average product is a global concept (total output divided by total input)
- the higher the average product, the more productive an input is and vice versa.
what is the equation of average product of labour?
output/labour
what is the equation of average product of capital?
output/capital
what is the marginal product?
the marginal product of an input in the production process is the increase in output that arises from an additional unit of that input.
what is the equation for marginal product?
change in total product/change in quantity of the factor
what is the equation of marginal product of labour?
change in output/change in labour
what is the equation of marginal product of capital?
change in output/change in capital
what is diminishing marginal product?
the property whereby the marginal product of an input declines as the quantity of the input increases. e.g. as more and more workers are hired at a firm, each additional worker contributes less and less to production, because equipment is limited.
what are costs of production divided into?
fixed and variable costs
what are fixed costs?
costs that do not vary with the quantity of output produced (e.g. cost for tractors)
what are variable costs?
costs that do vary with the quantity of output produced (e.g. costs of workers)
what is the equation for total cost?
Total costs = total fixed costs + total variable costs
what is average cost?
average cost is the cost of a typical unit of output i.e., average cost per unit of output
- calculated by dividing the firm’s total costs by the quantity of output produced
what is the equation of average total costs?
ATC = TC/Q
= (TVC+TFC)/Q
= TVC/Q + TFC/Q
= AVC+AFC
what is marginal cost?
this measures the increase in total cost that arises from an extra unit of production i.e. cost of producing one more unit of output
ratio of the change in total production and the change in total ouput
what is the equation for marginal cost?
MC= change in total cost/change in quantity
= ∆TC/∆Q
= TC(Q+1) - TC(Q)
how is marginal costs curve shown?
MC eventually rises with the quantity of output (it can decline with output in the beginning)
what are the properties of the cost curves?
average total cost is U-shaped
- bottom of the ATC curve occurs at the quantity that minimises average total cost
- this quantity is called the efficient scale of the firm (at this point producing a typical unit is cheapest)
the marginal cost curve crosses the average total cost curve and the average variable cost curve at their lowest point
what is the relationship marginal cost?
- whenever marginal cost is lower than average total cost (MC < ATC), average total is falling
- whenever marginal cost is higher than average total cost (MC > ATC), average total cost is rising
- the marginal cost curve crosses the average total cost curve (MC=ATC) at the efficient scale (minimum of ATC)
what is the relationship between marginal cost and average variable cost?
- whenever marginal cost is lower than average variable cost (MC < AVC), average variable cost is falling
- whenever marginal cost is higher than average variable cost (MC > AVC), average variable cost is rising
- the marginal cost curve crosses the average variable cost curve (MC=AVC) in the minimum of AVC
what are the costs in the short run and long run?
the division of total costs between fixed and variable costs depends on the time horizon being considered.
- the short run: the period of time in which some factors of production cannot be changed
- the long run: the period of time in which all factors of production can be altered.
e.g. rent is fixed cost in short run - how to pay regardless of how much produced. in the long-run you have to pay rent but it is variable
why does a long-term cost curve differ from its short-run cost curve?
many costs are fixed in the short run but variable in the long run
what is economies of scale?
increasing returns to scale: long-run average total cost falls as the quantity of output increases (cost of typical unit decreases as you produce more)
what is diseconomies of scale?
decreasing returns to scale: long-run average total cost rises as the quantity of output increase (cost of typical unit increases as you produce more)
what are constant returns to scale?
long-run average total cost stays the same as the quantity of output increases
what are the benefits of economies of scale?
- higher production levels allow specialisation and increase the possibility that technology can be used. This permits workers to become better at their tasks
- firms operating at larger scale can gain advantages by being in a position to negotiate more favourable borrowing rates or lower supply costs (bulk buying)
why does diseconomies of scale occur?
because of coordination and communication problems that are inherent to any large organisation
what are perfectly competitive markets?
buyers and sellers are so numerous that no single buyer or seller can influence the market price (i.e. they are small compared to the size of the market). they are “price takers”
what is the behaviour of competitive firms?
- no control over the price of the good => each firm is a price taker
- each firm can sell any quantity at the market price
- each firm observes the market price and decides how much output to produce and whether to shut down/exit a market
what is normal profit?
the firm’s total revenue is equal to its total costs, economic profit = 0
supernormal profit is the firm’s total revenue is greater than total costs, economic cost > 0
what is average revenue?
the amount that the firm earns per unit of output sold
AR = TR/Q
what is marginal revenue?
extra revenue of selling one more unit of output
MR=∆TR/∆Q
what is average revenue equal to in competitive and non-competitive markets?
competitive:
average revenue=marginal revenue= price of the good
AR=MR=P
non-competitive:
P = AR ≠ MR
how do firms maximise profit?
production should be increased as long as marginal revenue > marginal cost
production should stop at the point where marginal revenue = marginal cost
how do firms decide how much to produce?
if MR > MC => increase production
- when an extra unit is produced, the amount TR increases by is MR and the amount TC increases by is MC
if MR>MC, then producing an extra unit increases TR more than TC
if MR<MC => decrease production
if marginal revenue=marginal cost => production level is optimal and profit is maximised
when is profit is maximised?
MR=MC
in perfect competition, profit is maximised when MR=P(=AR)
so a firm in perfect competition maximises profits when it produces a quantity such that the marginal cost for that quantity equals the ongoing market price: P=MC
what is the marginal revenue curve the same as?
the demand curve that the firm faces
the demand curve for a competitive firm is perfectly elastic because the good sold by the firm has many perfect substitutes
in competitive markets what is the marginal cost curve?
the firm’s supply curve (but only the part situated above the AVC curve)
the firms marginal cost curve determines the quantity the firm is willing to supply at each price
how are shut down and exit decisions made?
shut down refers to a short-run decision not to produce anything during a specific period because of current market conditions
exit refers to a long-run decision to leave a market
what costs do shut down and exits involve?
a firm that shuts down temporarily still pays the fixed cost, but not the variable costs of producing.
A firm that exits saves both its fixed and variable costs.
exits can only be done in the long run.
what are sunk costs?
costs that have already been committed and cannot be recovered
sunk costs should be ignored when making decisions given that the decision outcome doesn’t impact the sunk cost
fixed costs are sunk costs in the short term e.g. rent for a factory
when should you shut down?
if profit without taking FC into account < 0
if TR - (TC - FC) < 0
if TR - VC < 0
if TR < VC
if TR/Q < VC/Q
if P*Q/Q < VC/Q
if P < AVC
the firm shuts down if the revenue it gets from producing is less than the variable cost of production (TR<VC) or when the market price is less than AVC
the portion of the marginal cost curve that lies above AVC is the competitive firm’s short-run supply curve
when would a firm exit the market?
they exit it would get form producing is less than its total cost
exit if TR < TC
TR/Q < TC/Q
P < ATC
when would a firm enter the market?
if the revenue it would get from producing is higher than its total cost
enter if TR > TC
TR/Q > TC/Q
P > ATC
the competitive firm’s long-run supply curve is the portion of its marginal cost curve that lies above average total cost
what is a supply curve in a competitive market?
short-run supply curve: the portion of its marginal cost curve that lies above average variable cost
long-run supply curve: the portion of its marginal cost curve that lies above average total cost
what is the equation of profit maximisation?
profit = TR - TC
= PQ - TC
= (PQ/Q-TC/Q)Q
=(P - ATC)Q
what are the key differences in between the short and long run?
- there are no sunk fixed costs in the long run (i.e. all costs are variable)
- the number of firms in the market is not fixed in the long run, firms can enter or leave the market freely
if firms already in the market are profitable what happens to new firms?
new firms will enter the market, quantity supplied will increase and price will decrease and profits will decline
if firms in the market are making losses what happens to existing firms?
some existing firms will exit, the quantity supplied will decrease, the price will rise and profits will increase
after entry and exit, firms that remain in the market must be making what profit?
zero profit
Profit = (P-ATC)*Q = 0 only if P=ATC
entry and exit ends only when price and average total cost are driven to equality so P=MC=ATC in the long run
what must the long run equilibrium of a competitive market with free entry and exit have firms operating at?
their efficient scale
why do competitive firms stay in business if they make zero profit?
profit = TR - TC
