Chapter 8 Flashcards
When does technical efficiency occur?
- In making its profit-maximizing choice, the firm tries to be technically efficient.
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Technical efficiency occurs when a given number of inputs are combined in such a way to maximize the level of output.
- Technical efficiency is not enough for profits to be maximized.
- To maximize profit, the firm chooses among the many technically efficient options.
- The firm uses the technically efficient option that has the lowest cost
- To maximie profit, the firm chooses the lowest cost combination of labour and capital.
How does a firm maximize profit?
The firm chooses the lowest cost combination of labour and captial that is technically efficient..
What is cost minimization?
An implication of profit maximization that firms choose the production method that produces any given level of output at the lowest possible cost.
If it is possible to substitute one factor for another to keep output constant while reducing total cost, the firm is currently not minimizing its costs.
What is the necessary condition for cost minimization?
- Whenever the ratio of the marginal product of each factor to its price is not equal for all factors, there are possibilities for factor substitutions that will reduce costs (for a given level of output).
- Profit-maximizing firms react to changes in factor prices by changing their methods of production.
Describe the principle of substitution.
- Methods of production change when the relative prices of factors change.
- Relatively more of the cheaper factor and relatively less of the more expensive factor will be used.
- The principle of substitution is the principle that methods of production will change if relative prices of inputs change, with relatively more of the cheaper input and relatively less of the more expensive input being used.
Describe a long-run average cost (LRAC) curve.
- When all factors of production can be varied, there exists a least-cost method of producing any given level of output.
- If this cost is expressed in terms of dollars per unit of output, we obtain the long-run average cost of producing each level of output.
- The long-run average cost (LRAC) curve is the curve showing the lowest possible cost of producing each level of output when all inputs can be varied.
- The LRAC is the boundary between cost levels that are attainable, with known technology and given factor prices, and those that are unattainable.
- Since all costs are variable in the long run, we do not need to distinguish between AVC, AFC, and ATC, as we did in the short-run.
- In the long run, there is only one LRAC for any given set of input prices.
When is a firm said to have economies of scale or diseconomies of scale?
- Over the range of output from zero to QM long-run average cost is falling, and the firm is enjoying increasing returns.
- Increasing returns is a situation in which output increases more than in proportion to inputs as production increases.
- At QM the firm is at its minimum efficient scale and the firm experiences constant returns.
- The minimum efficient scale is the smallest output at which LRAC reaches its minimum
- Economies of scale have been realized
- Over the range of output greater than QM the firm is experiencing decreasing returns.
- Decreasing returns is a situation in which output increases less than in proportion to inputs as production increases.
- Decreasing returns imply that the firm suffers some diseconomies of scale.
When is a firm suffering diseconomies of scale?
Over the range of output greater than QM the firm is experiencing decreasing returns, a situation in which output increases less than in proportion to inputs as production increases.
Decreasing returns imply that the firm suffers some diseconomies of scale.
Describe the relationship between LRAC and SRATC curves. [4]
- The LRAC curve shows the lowest cost of producing any output when all factors are variable
- Each SRATC curve shows the lowest cost of producing any output when one or more factors are fixed.
- No short-run cost curve can fall below the long-run cost curve because the LRAC curve represents the lowest attainable cost for each possible output.
- Each SRATC curve is tangent to the LRAC curve at the level of output for which the quantity of the fixed factor is optimal, and lies above it for all other levels of output.
What is technological change? How is it measured? What are its three aspects?
- Technological change is any change in the available techniques of production.
- To measure the extent of technological change, economists use the notion of productivity.
- Productivity is the output produced per unit of some input.
- Two widely used measures of productivity are output per work and output per hour of work.
- Technological change is endogenous to the economic system rather than something that occurs for unknown reasons.
- There are three aspects of technological change:
- New techniques
- Improved inputs
- New products
What is the signficance of productivity growth?
- ‘Dismal science’
- Predictions of Thomas Malthus
- Proven wrong for two reasons:
- Populations did not expand as quickly as predicted
- Technological advancements have increased output
Describe efficiency. [4]
- SR = firm can vary only one input quantity | LR = firm can vary all inputs quantities
- Technical efficiency = minimizing the quantity (Qinput) of all inputs to produce a given output
- Economic (productive) efficiency = minimizing the cost (Pinput * Qinput) of all inputs to produce a given output
- Given factor prices, firms seek to minimize cost of all inputs.
Describe profit maximization (cost minimization) in the long run.
- Q of all inputs vary; P of inuts is constant. The goal is to hire Q of inuts that minimizes costs.
Describe application of the principle of substitution.
Principle of substitution = as the relative P of inputs change, firm will substitute the cheaper, for themore expensive input.
Application:
- This principle directs the ‘allocation of resources’.
- e.g., Banks use instant tellers rather than tellers
- e.g., China is N intensive, Canada is K intensive
Describe the three sections of the LRAC curve.
Note on confusing terminology:
- SR diminishing returns - always occur because fixed input.
- LR decreasing returns to scale - may not happen because all inputs may be increased infinitely.
- Specialization of labour = SR, where different worker does different job.
- Division of labour = LR, where different workers do different parts of job.
Compare increasing and decreasing returns to scale.
- Increasing returns to scale = double inputs, more than double outputs.
- Decreasing returns to scale = double inputs, less than double outputs.
What are the reasons for increasing returns to scale? [5]
- Indivisibility/lumpiness of Factors of production
- advantages of large firms
- cannot divide a machine, building, manager
- as scale increases, firm can use more complex machines
- Division of labour
- firm can have single worker doing part of the job
- Internal economies
- marketing, financing, legal, management, research spread over larger output
- External economies
- less pollution, less strain on infrastructure, higher factor prices
- Supply of factors of production is elastic
- if firm needs more factors, the price of factors rises slowly
What are the reasons for decreasing returns to scale?
- Middle management mush
- Alienation of workforce
What is MES and capacity?
- MES = Minimum efficient scale = minimum output (scale) at which plant is at LRAC minimum (efficient)
- Capacity output = output at which firm is at SRAC minimum, the ‘capacity’ of the firm
Describe left of tangency, at tangency, and right of tangency. (re: relation between SRAC and LRAC)
- LRAC is ‘envelope’ of family of SRAC curves
- Each point on LRAC has associated with it an SRAC, the point of tangency being the optimal level of the fixed factor
- Left of tangency = too much K (capital), SRAC > LRAC
- At tangency = right amount of K, SRAC = LRAC
- Right of tangency = too little K, SRAC > LRAC
How does technology impact the LRAC?
Lowers the entire diagram
How may a firm move away from expensive input? [2]
- LR: substitute away - move to or down LRAC
- VLR: innovate away - shift LRAC down
What is isoquant analysis?
Analogous to indifference curve analysis with three decision variables:
- Total cost and price of factors (isocost)
- Output (isoquant)
- Isocost line = all possible combinations of factors available, with a given total outlay and P of factors
- Slope = -PK/PN
- Shifts: PK*QK + PN*QN = TC (changes in TC or P’s)
What is an isoquant line?
All possible combinations of the factors that yield a given level of output.
What is the condition for profit maximization? (cost minimization)
Isocost tangent to isoquant.
MPK/PK = MPN/PN<br></br>K - capital | N - labour
Compare maximizing total utility and minimizing total costs.
- Maximizing utility: start with straight budget line, and try to get on the highest indifference curve
- Minimizing cost: start with the curved isoquant line, and try to get on the lowest straight isocost line
What is the profit maximization point?
Isocost tangent to isoquant
Same thing as saying:
Marginal products per dollar are equal
