Chapter 3--The Costs of Production and Profit Maximization Flashcards
What are the two types of Costs of Production? What do they sum to?
- Fixed costs (FC), which do not vary based upon the quantity produced (so, they are present when production is 0) and
- Variable costs (VC), which do vary with different quantities produced
Fixed cost plus Variable Cost = Total Cost
What is a Sunk Cost (SC)?
A cost that has already been committed and cannot be recovered (e.g.: a proprietary piece of equipment that is not useful to anyone but the company)
What is the “short run?”
A time horizon in which there are some fixed costs
What is the “long run?”
A situation where previously fixed costs (in the short run) become variable
What is Average Fixed Cost (AFC)?
Fixed Cost / Quantity Produced
Tells us what each item costs in terms of fixed cost
What is Average Variable Cost (AVC)?
Variable Cost / Quantity Produced
Tells us what each item costs in terms of variable cost
What is Average Total Cost (ATC)?
Total Cost / Quantity Produced
or
Average Variable Cost + Average Fixed Cost
What is Marginal Cost (MC)?
The change in the total cost that arises per extra unit of production
(New total cost - old total cost) / (New quantity produced - old quantity produced)
What happens when marginal cost is higher than average variable cost or average total cost?
The cost of the AVC or ATC (respectively) must increase with increase quantity produced
What are the three characteristics of a perfectly competitive industry? What is the implication?
1) There are many buyers and sellers
2) The good is homogeneous, and
3) Businesses are free to enter and exit the industry at their choosing
The implication is that no businesses operating in the industry may influence the price of the product it sells
What is a Price Taker?
A business operating in a perfectly competitive industry
What sets market price in a perfectly competitive industry?
The interaction of market demand and market supply
What is Total Revenue (TR)?
The price of a good sold X the quantity of a good sold
What is Marginal Revenue (MR)?
The change in the total revenue generated by an additional unit sold
(New total revenue - old total revenue) / (new quantity sold - old quantity sold)
What is Marginal Revenue in a perfectly competitive industry?
The market price of the product
When attempting to maximize profits in a perfectly competitive industry, what two things constrain business owners?
1) The cost of producing output is based on some factors out of his control (i.e.: competency of employees, and market prices for inputs into the production process), and
2) The price that can be charged is determined by the market, not the business owner
Taking constraints into consideration, what are the two decisions a business owner must make in a perfectly competitive industry to maximize profits?
1) Determine the quantity to produce that is profit-maximizing, and
2a) In the short run, determine whether to produce, or shut down the company for a short period of time; or
2b) In the long run, determine whether to produce, or exit the industry forever
What is the Profit Maximizing Rule?
A business maximizes profits when it produces where the Marginal Revenue from selling another unit equals the Marginal Cost of producing another unit to sell
Shut-Down Rule: When should a company shut down in the short run?
When the losses from operating are greater than fixed costs
or
When production at the Profit Maximizing Quantity generates total revenues that are less than variable costs
When does the Long-Run Exit Decision come into consideration? What are is the Rule?
When prices remain low for very long periods of time.
A business should exit the industry if production at the profit maximizing quantity generates total revenue less than total costs (since there are no fixed costs in the long run)
What three characteristics define a monopolistic industry?
1) There are many buyers and only one seller;
2) The good is heterogeneous; and
3) Barriers to entering the market exist
What is a Price Setter?
A business operating in a monopolistic industry, since the lack of competition allows the seller to set the market price
When attempting to maximize profits in a monopolistic industry, what two things constrain business owners?
1) Its expenses and costs
2) Market demand
Taking constraints into consideration, what are the three decisions a business owner must make in a monopolistic industry to maximize profits?
1) Determine the quantity to produce that is profit-maximizing (done in the same way as under competitive circumstances);
2) Decide what price to charge; and
3) Decide whether to produce or shut down the business for a short period of time (done in the same way as under competitive circumstances)
What price is charged in a monopolistic industry?
The price that people will pay at the profit-maximizing quantity (according to the demand schedule)
What is an Economy of Scale?
A product that has a large fixed cost and a relatively low marginal cost (e.g.: high R&D to develop a product, but inexpensive to produce once developed).
Thus, as production of these products increase, average total cost decreases.
So, if market demand is large, this company should produce as much of its product as possible to reduce average cost.
What is a Diseconomy of Scale?
A production quantity range within which production of products causes an increase in average total cost.
What is a Constant Economy of Scale?
An economy with a constant average total cost as production increases
What is Economy of Scope?
A situation where a company can produce several products together at less cost than a group of single-purpose companies operating independently
What is a Joint Cost? What are the implications of significant Joint Costs?
A cost that does not change with the scope of production
When joint costs are considerable, it makes sense for companies to consolidate and share them, operating under economies of scope
