econ 1021 midterm 1 Flashcards
midterm 1
1
Q
Scarcity
A
the inability to get everything we want. This is universa
2
Q
Incentive
A
A reward that encourages an action or a penalty that discourages one
3
Q
Economics
A
A social science that studies the choices government, firms, and societies have to make as they cope with scarcity and the incentives that influence and reconcile those choices.
4
Q
Economics divides in to main parts
A
Microeconomics, Macroeconomics
5
Q
Microeconomics
A
The study of small-scale economic events that impact individuals and firms in society.
6
Q
microeconomics example question
A
Why are people buying more e-books and fewer hard copy books?
7
Q
Macroeconomics
A
The study of large economic phenomenon like national economies and global economic stability.
8
Q
macroeconomics example question
A
Why does the unemployment rate in Canada fluctuate?
9
Q
(What, How, and For Whom?)
Goods and services
A
Objects that people value and produce to satisfy human wants
10
Q
Two BIG questions in economics
A
How do choices end up determining what, how, and for whom goods are produced?
When do choices made in self-interest also promote social interest?
11
Q
(How)Factors of Production
A
the resources businesses use to produce goods and services
12
Q
Factors of production are grouped into four categories
A
Land – earns rent
Labour – earns wages
Capital – earns interest
Entrepreneurship – earns profit
13
Q
Self-interest
A
People make choices in support of their own interests with the goal of advancing their own agendas.
14
Q
Social Interest
A
An outcome is in the social interest if it benefits society as a whole
15
Q
Social interest has two dimensions
A
Efficiency
Equity
16
Q
Efficient
A
An everyday situation that cannot be improved upon.
17
Q
Equity
A
is fairness, but economists have a variety of views about what is fair.
18
Q
Tradeoff
A
an exchange, giving up something to gain something else.
19
Q
Globalization
A
expansion of foreign trade, borrowing and lending, and investment
20
Q
Four topics that generate discussion and that illustrate tension between self-interest and social interest are
A
Globalization
Information-age monopolies
Global warming
Economic instability
21
Q
Information-Age Monopolies
A
The Information Revolution, spanning the past four decades, brought technological advancements like smartphones, laptops, applications, and the Internet. While benefiting individual self-interest, it raises questions about its impact on the broader social interest.
22
Q
Centrally planned socialism
A
Government controls the means of production and determines the direction of the economy.
Karl Marx and other theorists supported these ideas
The modern-day Occupy Wall Street movement advocates to ideas similar to these (redistribution of wealth, greater corporate regulations, etc.)
The MIXED ECONOMY combines these two ideas and is most prevalent in the economies of developed countries, including Canada.
23
Q
Market Capitalism
A
The market is free for individuals to buy and sell goods and services.
Adam Smith said that an INVISIBLE HAND existed that promoted social interest by corporations competing against each other in their self-interests
24
Q
Six economic ways of thinking
A
Choice is a tradeoff
People make rational choices by comparing benefits and costs
Benefit is what you gain from something
Cost is what you must give up for something
Most choices are how much choices made at the margin
Choices respond to incentives
25
Economists distinguish between two types of statement
Positive statements—what is
Normative statements—what ought to be
26
A positive statement can be tested by checking it against facts.
A normative statement expresses an opinion and cannot be tested.
27
ECONOMIC MODELS
are used to explain the economic world.
28
economists also use
Natural experiments
Statistical investigations
Economic experiments
29
OPPORTUNITY COST
is the cost of the highest valued alternative to a decision.
All tradeoffs involve an opportunity cost
30
Marginal Benefit
The benefit that arises from an increase in an activity.
31
Marginal Cost
The opportunity cost of an increase in an activity.
32
Production Possibilities Frontier
The boundary between those combinations of goods and services that can be produced and those that cannot. The PPF looks at a MODEL ECONOMY where only TWO GOODS CHANGE and all others do not.
33
PPF illustrates
scarcity because all points inside of the curve are ATTAINABLE and all points outside of the curve are UNATTAINABLE.
34
Production efficiency
Occurs when we produce the greatest amount of goods for the lowest cost. This occurs at all the points ALONG the PPF.
Production is INEFFICIENT when resources are unused or misallocated or both
Resources are unused when they could be working
They are misallocated when they are assigned to tasks for which they are not the best match (example: assigning pizza chefs to work in a cola factory)
35
Tradeoff Along the PPF
Every choice along the PPF involves a tradeoff
36
Opportunity cost:
Highest valued alternative forgone. Since there are only two goods on the PPF, the opportunity cost directly correlates to changes in the production rates of both products.
37
Marginal cost:
The opportunity cost of producing one more unit.
38
Marginal benefit:
The benefit from consuming one more unit of a good or service.
The most you are willing to pay for something
Cannot be derived from the PPF
39
Principle of decreasing marginal benefit
The more we have of a good or service the lower the marginal benefit and thus the lower the price we are willing to pay.
40
Preferences
are a description of a person’s likes and dislikes.
To describe preferences, economists use the concepts of marginal benefit and the marginal benefit curve.
41
Allocative efficiency
When goods and services are produced at the lowest possible cost for the greatest possible benefit. This can be found by superimposing both the MC and MB curves on one plane and finding where they reach equilibrium.
42
marginal benefit curve
shows the relationship between the marginal benefit of a good and the quantity of that good consumed.
43
Specialization
Producing only one or few goods.
44
A COMPARATIVE ADVANTAGE
occurs if an individual can produce a product at a lower opportunity cost than anyone else.
45
Economic growth
Expansion of production possibilities.
Increases standard of living
Does not overcome scarcity or avoid opportunity cost
46
An ABSOLUTE ADVANTAGE
occurs when an individual is more productive than others.
47
Two key factors of economic growth
Technological change
Capital accumulation
48
Technological change
is the development of new goods and of better ways of producing goods and services.
49
Capital accumulation
Growth of capital resources, including human capital.
In the context of economic growth, we must give up producing an abundance of one resource to gain new capital.
The more of an existing resource a firm gives up to accumulate more capital, the greater their PPF will expand outwards
50
Two types of economic coordination systems
Central Planning, Decentralized (market) coordination
51
Central planning
Does not work because individuals are tasked with planning the economy’s future without knowing people’s production possibilities and preferences. Thus, production ends up INSIDE the PPF (wrong things are produced)
52
Decentralized (market) coordination
Works best, but requires four complementary social institutions
53
Decentralized (market) coordination
Firms – Unit that hires factors of production and organizes them to produce and sell goods and services (ex. Loblaws)
Markets – Any arrangement that enables buyers and sellers to get information and do business with each other (ex. World Oil Market)
Property rights – Social arrangements that govern the ownership, use, and disposal of anything that people value are called property rights
Money – Any commodity or token that is generally acceptable as a means of payment
54
firm
is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services.
55
market
is any arrangement that enables buyers and sellers to get information and do business with each other.
56
Property rights
are the social arrangements that govern ownership, use, and disposal of resources, goods, or services
57
Substitution Effect
When the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded of the good or service decreases.
58
Income Effect
When the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded of the good or service decreases.
59
Competitive Market
A market that has many buyers and sellers so that no single buyer or seller can influence the entire market
60
Money Price
The price of an object in the number of dollars that must be given up in exchange for it.
61
Relative Price
Ratio between one price and another. This is an example of OPPORTUNITY COST. When we consider demand and supply we consider it as a RELATIVE PRICE and not a money price.
62
If you demand something
You want it
Can afford it
Plan to buy it
DEMAND reflects a decision about which wants to satisfy
63
Quantity Demanded
A good or service that consumers plan to buy during a given time period at a particular price.
64
Law of Demand
Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of the good, the greater is the quantity demanded.
65
Demand
Refers to the entire relationship between the price of a good and the quantity demanded of the good.
66
Demand curve
shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same.
67
The willingness and ability to pay for a good (Demand Curve)
The smaller the quantity available, the higher is the price that someone is willing to pay for another unit.
Willingness to pay measures marginal benefit.
68
CHANGES IN DEMAND
occur when any factor influencing demand occurs, other than price
When demand increases, the demand curve shifts rightward.
When demand decreases, the demand curve shifts leftward.
69
Six main factors that change demand are
The prices of related goods
Expected future prices
Income
Expected future income and credit
Population
Preferences
70
Prices of Related Goods
When the price of a substitute for an energy bar rises or when the price of a complement of an energy bar falls, the demand for energy bars increases.
71
Expected Future Prices
If the price of a good is expected to rise in the future, current demand for the good increases and the demand curve shifts rightward.
72
Income
When income increases, consumers buy more of most goods and the demand curve shifts rightward.
73
Normal good
is one for which demand increases as income increases.
74
Inferior good
is a good for which demand decreases as income increases.
75
Expected Future Income and Credit
When income is expected to increase in the future or when credit is easy to obtain, the demand might increase now.
76
Population
The larger the population, the greater is the demand for all goods.
77
Preferences
People with the same income have different demands if they have different preferences.
An increase in income increases the demand for energy bars and shifts the demand curve rightward.
78
Movement Along the Demand Curve
When the price of the good changes and other things remain the same, the quantity demanded changes and there is a movement along the demand curve.
79
A Shift of the Demand Curve
If the price remains the same but one of the other influences on buyers’ plans changes, demand changes and the demand curve shifts.
80
If a firm supplies a good or service, then the firm
Has the resources and the technology to produce it,
Can profit from producing it, and
Has made a definite plan to produce and sell it
81
Resources and technology
determine what it is possible to produce. Supply reflects a decision about which technologically feasible items to produce
82
The law of supply states
States that, all else being equal, an increase in the price of a good leads to a greater quantity supplied, while a decrease in price results in a smaller quantity supplied.
Originates from the general tendency for the marginal cost of production to rise as the quantity produced increases.
83
Supply
refers to the entire relationship between the quantity supplied and the price of a good.
84
Minimum Supply Price
A supply curve is also a minimum-supply-price curve.
As the quantity produced increases, marginal cost increases.
The lowest price at which someone is willing to sell an additional unit rises.
This lowest price is marginal cost.
85
Supply curve
shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same.
86
A Change in Supply
Occur when factors other than the price of a good influence selling plans.
This leads to a new supply curve, reflecting the quantity producers plan to sell at each price.
An increase in supply shifts the curve rightward, while a decrease shifts it leftward.
87
The six main factors that change supply of a good are
The prices of factors of production
The prices of related goods produced
Expected future prices
The number of suppliers
Technology
State of nature
88
Prices of Factors of Production
If the price of a production factor rises, the minimum price for each quantity of the good also rises.
Effect: Decreases supply, shifting the supply curve leftward.
89
Prices of Related Goods Produced
Substitute: Another good produced with the same resources; its price decrease increases the supply of the original.
Complement: Goods produced together; an increase in the complement's price increases the supply of the original.
90
91
Expected Future Prices
If the price of a good is expected to rise in the future, supply of the good today decreases and the supply curve shifts leftward
92
The Number of Suppliers
The larger the number of suppliers of a good, the greater is the supply of the good. An increase in the number of suppliers shifts the supply curve rightward.
93
Technology
Advances in technology create new products and lower the cost of producing existing products.
So advances in technology increase supply and shift the supply curve rightward
94
The State of Nature
The state of nature includes all the natural forces that influence production—for example, the weather.
A natural disaster decreases supply and shifts the supply curve leftward.
95
Movement Along the Supply Curve
If the price of the good changes while other factors remain constant, the quantity supplied changes, leading to a movement along the supply curve.
96
A Shift of the Supply Curve
If the price remains the same but some other influence on sellers’ plans changes, supply changes and the supply curve shifts.
97
Equilibrium in a market occurs
when the price balances the plans of buyers and sellers
98
Equilibrium price
is the price at which the quantity demanded equals the quantity supplied.
99
Equilibrium quantity
is the quantity bought and sold at the equilibrium price.
Price regulates buying and selling plans.
Price adjusts when plans don’t match.
100
Price Adjustments
Above: Surplus lowers price.
Below: Shortage raises price.
At equilibrium: Buyer and seller plans align; price remains until demand or supply changes.
101
Both Demand and Supply Change in the Same Direction
Changes in Equilibrium:
Increase in demand and supply raise equilibrium quantity.
The impact on equilibrium price is uncertain; increased demand raises it, while increased supply lowers it.Decrease in both demand and supply lowers equilibrium quantity.
The impact on equilibrium price is uncertain; decreased demand lowers it, while decreased supply raises it.
102
Price Elasticity of Demand
A units-free measure of the responsiveness of the quantity demanded to a change in the price.
103
Calculating Price Elasticity of Demand
Percentage change in the quantity demanded/Percentage change in the price
FORMULA
|( % change in QD / % change in price )|
Delta Q/Average Q
Delta P/Average P
In this specific case, regardless of whether or not the elasticity equation yields a negative result, you ALWAYS take the absolute value.
104
Average Price and Quantity
By using the average price and average quantity, we get the same elasticity value regardless of whether the price rises or falls.
105
Percentages and Proportions
The ratio of two proportionate changes is the same as the ratio of two percentage changes.
% ΔQ / %ΔP = ΔQ / ΔP
106
A Units-Free Measure
Elasticity is a ratio of percentages, so a change in the units of measurement of price or quantity leaves the elasticity value the same.
107
Minus Sign and Elasticity
Formula result is negative (price and quantity move oppositely).
Magnitude (absolute value) indicates the responsiveness of quantity to a price change.
108
Perfectly inelastic demand.
If the quantity demanded doesn’t change when the price changes, the price elasticity of demand is zero and the good
109
UNIT ELASTIC demand curve.
If the percent change in quantity demanded equals the percent change in price, then the price elasticity of demand is ONE which yields
110
INELASTIC
If the percentage change in quantity demanded is less than the percentage change in price then the demand curve is INELASTIC
111
PERFECTLY ELASTIC DEMAND
If the quantity demanded changes by an infinitely large percentage in response to a tiny price change, then the price elasticity of demand is infinity and the good is said to have a PERFECTLY ELASTIC DEMAND.
Example: Two vending machines side-by-side that offer the same goods
Horizontal Line
112
ELASTIC (PED>1)
If the percentage change in quantity demanded exceeds the percentage change in price, then the demand curve is ELASTIC (PED>1).
Example: Automobiles and furniture
113
Factors that Influence the Elasticity of Demand
Closeness of substitutes
The closer substitutes for a good, the more elastic the demand curve because people are able to easily change the good they purchase based on the price
The proportion of income spent on the good
The greater proportion of income spent on a good, the more elastic (or less inelastic
The time elapsed since the price change
The longer the time has elapsed since a price change, the more elastic is the demand
Elasticity of demand is NOT the same as slope.
Total Revenue 🡪 Price of a good x Amount of good sold
114
Total Revenue and Elasticity
If the demand curve is elastic, cuts to the price will generally yield far greater demand and result in a revenue increase
If the demand curve is inelastic, cuts to the price will result in a decrease in revenue
If the demand curve is unit elastic, then the total revenue does not change
115
Total Revenue Test
A method of testing for the elasticity of demand by seeing how the total revenue changes as a result of increases and decreases to the price.
If a price cut increases total revenue, demand is elastic.
If a price cut decreases total revenue, demand is inelastic.
If a price cut leaves total revenue unchanged, demand is unit elastic.
116
Income Elasticity of Demand
The measure of the responsiveness of the demand for a good or service to changes in income.
Calculated 🡪 ( % change in QD / % change in income )
Percentage Change in Quantity Demanded/Percentage change income
117
Income elasticities of demand fall into three categories
Positive and greater than 1 (normal good, and income ELASTIC)
Positive and less than 1 (normal good, and income INELASTIC)
Negative (INFERIOR good)
118
Inferior good
The quantity demanded decreases when the income increases.
119
Cross Elasticity of Demand
Of measure of the responsiveness of the demand for a good to the change in the price of a substitute or complement.
Calculation 🡪 ( % change in QD / % change in the P of a sub. or complement )
Percentage Change in Quantity Demanded/Percentage change in price of substitute or complement
120
Cross Elasticity of Demand
If the cross elasticity of demand is POSITIVE then the demand and price of the other good change in the same direction, making them SUBSTITUTES.
If the cross elasticity of demand is NEGATIVE then demand and price of the other good changes in the opposite direction, so the two goods are COMPLIMENTS.
Reference pg. 96 and 97 in the textbook if clarification is needed
121
Elasticity of Supply
Measures the responsiveness of quantity supplied to a change in the price of a good.
Calculation 🡪 ( % change in QS / % change in price )
Percentage change in quantity supplied/Percentage change in price
122
Elasticity of Supply
If the elasticity of supply is >1 then the supply is ELASTIC.
If the elasticity of supply is <1 then the supply is INELASTIC.
123
Factors that influence the Elasticity of Supply
Resource substitution possibilities, Time frame for the supply decision
124
Resource substitution possibilities
Whether or not goods can be produced by using rare or common resources will reflect its responsiveness to a price change. Commodities that require very rare materials can be almost perfectly inelastic, while items that can be manufactured using common materials are generally more elastic
124
Time frame for the supply decision – We can distinguish three time frames of supply
Momentary supply, Short-run supply, Long-run supply
124
Momentary supply
When the price changes, the momentary supply is the immediate response to a change in supply of that good (Ex. some fruits and vegetables have a perfectly inelastic momentary supply because immediate changes in price cannot change their predetermined outputs)
125
Short-run supply
The response of the quantity supplied to a price change when only some of the possible adjustments to production can be made. This is generally inelastic because most firms cannot make drastic changes to their production capabilities
125
Long-run supply
The response of the quantity supplied to a price change after all technologically possible ways of adjusting supply have been exploited. For most goods, long-run supply is either elastic or perfectly elastic
126
The budget line
describes the limits to the household’s consumption choices
if two goods are X and Y, and the available income is I, write the budget equation:
PY + PX = I
Y = I/Py - (Px/Py)X
The budget line represents a constraint on an individual’s choices – what is affordable and what is unaffordable.
127
A Change in Income
An change in money income brings a parallel shift of the budget line.
The slope of the budget line doesn’t change because the relative price doesn’t change.
128
An indifference curve
is a line that shows combinations of goods among which a consumer is indifferent.
129
Marginal Rate of Substitution
The marginal rate of substitution, (MRS) measures the rate at which a person is willing to give up good y to get an additional unit of good x while at the same time remain indifferent (remain on the same indifference curve).
The magnitude of the slope of the indifference curve measures the marginal rate of substitution
130
Preferences and Indifference Curves
If the indifference curve is relatively steep, the MRS is high.
In this case, the person is willing to give up a large quantity of y to get a bit more x.
If the indifference curve is relatively flat, the MRS is low.
In this case, the person is willing to give up a small quantity of y to get more x.
131
diminishing marginal rate of substitution
is a general tendency for a person to be willing to give up less of good y to get one more unit of good x, while at the same time remaining indifferent as the quantity of good x increases.
132
is a general tendency for a person to be willing to give up less of good y to get one more unit of good x, while at the same time remaining indifferent as the quantity of good x increases.
The shape of the indifference curves reveals the degree of substitutability between two goods.
133
Best Affordable Choice
The consumer’s best affordable choice is
On the budget line
On the highest attainable indifference curve
Has a marginal rate of substitution between the two goods equal to the relative price of the two goods
134
price effect.
The effect of a change in the price of a good on the quantity of the good consumed
135
The effect of a change in the price of a good on the quantity of the good consumed
The effect of a change in income on the quantity of a good consumed
136
Indivisible goods
Cannot be divided into smaller parts.
136
Divisible goods
Can be bought in any quantity desired.
Examples: Gasoline and electricity
Makes up the budget line
137
Real income
The quantity of goods that the household can afford to buy.
138
Relative price
: Price of one good divided by the price of another good
139
When prices change, so does the budget line
The lower the price of a good on the x-axis, the flatter the budget line
The higher the price of a good measured on the x-axis, the steeper is the budget line
A change in money income shifts the budget line but the slope remains the same. Therefore, it changes the real income but does not change the relative price
140
Indifference curve
Shows combinations of goods among which a consumer is indifferent.
141
Preference map
A series of indifference curves that resemble the contour lines on a map.
142
Indifference curve steep
Marginal rate of substitution is high – a person is willing to give up a large quantity of good y to get an additional unit of good x while remaining indifferent.
143
Indifference curve is flat
Marginal rate of substitution is low – a person is willing to give up a small amount of good y to get an additional unit of good x while remaining indifferent.
144
Income effect
The effect of a change in income on buying plans
145
Substitution effect
The effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original situation and the new one.
The direction of the substitution effect never varies, it always goes to the right
146
Inferior good
Demand increases when income decreases.
For an inferior good the income effect is negative, which means that a lower price does not inevitably lead to an increase in the quantity demanded
The substitution effect of a fall in the price increases the quantity demanded, but the negative income effect works in the opposite direction and offsets the substitution effect to some degree
If negative income effect = positive substitution effect, a fall in price leaves the quantity bought the same
This makes demand perfectly inelastic
If the negative income effect is smaller than the positive substitution effect, a fall in price increases the quantity bought and the demand curve still slopes downward like that for a normal good
The demand curve for this inferior good might be less elastic than that of a normal good though
If the negative income effect exceeds the positive substitution effect, a fall in the price decreases the quantity bought and the demand curve slopes upward
This does not occur in the real world because demand does not slope upward
147
A firm
is an institution that hires factors of production and organizes them to produce and sell goods and services.
148
The Firm’s Goal
A firm’s goal is to maximize profit.
If the firm fails to maximize its profit, the firm is either eliminated or taken over by another firm that seeks to maximize profit.
149
Accounting Profit
Accountants measure a firm’s profit to ensure that the firm pays the correct amount of tax and to show it investors how their funds are being used.
Profit equals total revenue minus total cost.
Accountants use Revenue Canada rules based on standards established by the accounting profession
150
Economic Accounting
Economists measure a firm’s profit to enable them to predict the firm’s decisions, and the goal of these decisions is to maximize economic profit.
151
Economic profit
is equal to total revenue minus total cost, with total cost measured as the opportunity cost of production.
152
A Firm’s Opportunity Cost of Production
A firm's opportunity cost of production includes the value of the resources it uses, comprising costs from resources bought in the market, resources owned by the firm, and resources supplied by the firm's owner.
153
Resources Bought in the Market
Resources Bought in the Market
154
The implicit rental rate of capital is made up of
Economic depreciation
Interest forgone
155
Resources Owned by the Firm
When a firm utilizes its owned capital for production, it faces an opportunity cost as it could have alternatively sold or rented out the capital. This implicit cost is termed the implicit rental rate of capital, reflecting the foregone rental income the firm could have earned from its capital assets.
156
Resources Supplied by the Firm’s Owner
The owner's contribution can involve both entrepreneurship and labor. Entrepreneurship yields profit, with normal profit representing the average profit an entrepreneur anticipates. This normal profit serves as the cost of entrepreneurship, constituting an opportunity cost of production.
157
Economic depreciation
is the change in the market value of capital over a given period.
Interest forgone is the return on the funds used to acquire the capital.
158
normal profit
The profit that an entrepreneur can expect to receive on average is called
159
The Short Run
In the short run, a firm operates with fixed quantities of certain resources, like its capital or plant, while other resources, such as labor, raw materials, and energy, can be adjusted. Short-run decisions are typically reversible and focus on managing variable inputs to optimize operations.
160
Economic Accounting: A Summary
Economic profit equals a firm’s total revenue minus its total opportunity cost of production.
161
Decision Time Frames
The firm aims to maximize profit and makes various decisions toward this goal. Some decisions are vital for the firm's survival or entail significant irreversible costs. Others are easily reversible but still impact profit. These decisions are categorized into the short run and the long run time frames.
162
Short-Run Technology Constraint
To increase output in the short run, a firm must increase the amount of labour employed.
Three concepts describe the relationship between output and the quantity of labour employed:
Total product
Marginal product
Average product
162
The Long Run
In the long run, a firm can adjust all of its resources, including the size of its plant or capital. Decisions made in the long run are typically more permanent and irreversible compared to those made in the short run. Sunk costs, which are incurred and cannot be recovered, are irrelevant to a firm's current decisions because they cannot be changed or recovered.
163
Product Schedules
Total product= is the total output produced in a given period.
The marginal product= of labour is the change in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same.
The average product =of labour is equal to total product divided by the quantity of labour employed.
164
Product Curves
Product curves show how the firm’s total product, marginal product, and average product change as the firm varies the quantity of labour employed
165
Diminishing returns
Increasing marginal returns stem from heightened specialization and the division of labor. Conversely, diminishing marginal returns occur due to reduced access to capital and workspace for each additional worker. The law of diminishing returns, considered almost universal, asserts that as a firm increases its utilization of a variable input alongside fixed inputs, the marginal product of the variable input will eventually decline.
166
Total Cost
A firm’s total cost (TC) is the cost of all resources used.
Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output.
Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output.
Total cost equals total fixed cost plus total variable cost. That is:
TC = TFC + TVC
166
Marginal Cost
Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product.
Over the output range with increasing marginal returns, marginal cost falls as output increases.
Over the output range with diminishing marginal returns, marginal cost rises as output increases.
166
Average Product Curve
When marginal product exceeds average product, average product increases.
When marginal product is below average product, average product decreases.
When marginal product equals average product, average product is at its maximum.
167
Short-Run Cost
To produce more output in the short run, the firm must employ more labour, which means that it must increase its costs.
Three cost concepts and three types of cost curves are
Total cost
Marginal cost
Average cost
168
Average Cost
Average cost measures can be derived from each of the total cost measures:
Average fixed cost (AFC) is total fixed cost per unit of output.
Average variable cost (AVC) is total variable cost per unit of output.
Average total cost (ATC) is total cost per unit of output.
ATC = AFC + AVC.
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Why the Average Total Cost Curve Is U-Shaped
The U-shape of the ATC curve comes from two factors: spreading fixed costs over more output (AFC decreases as output increases), and diminishing returns (AVC increases faster than AFC decreases).
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Average and Marginal Product and Cost
A firm's cost curves are influenced by its technology:
MC is lowest where MP is highest.
When MP rises, MC falls.
AVC is lowest where AP is highest.
When AP rises, AVC falls.
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Shifts in the Cost Curves
The position of a firm’s cost curves depend on two factors:
Technology
Prices of factors of production
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Technology
Technological advancements impact both product and cost curves:
Increased productivity raises product curves and lowers cost curves.
Shifting towards more capital and less labor increases fixed costs but decreases variable costs.
Consequently, average total cost rises at low output levels but falls at high output levels.
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Prices of Factors of Production
A rise in factor prices escalates costs and alters cost curves:
Increased fixed costs shift the TC and ATC curves upward but leave the MC curve unchanged.
Elevated variable costs shift all curves—TC, ATC, and MC—upward.
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The Production Function
The behavior of long-run cost depends upon the firm’s production function.
The firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labour.
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Diminishing Marginal Product of Capital
Diminishing marginal returns affect both labor and capital inputs in production:
The marginal product of capital reflects the additional output gained from increasing capital while keeping labor constant.
Diminishing marginal returns to both labor and capital lead to U-shaped cost curves for MC, AVC, and ATC in the short run for each plant.
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Short-Run Cost and Long-Run Cost
The firm's average total cost (ATC) depends on its plant size:
Larger plants typically achieve lower ATC, reaching a minimum at higher output levels.
The firm operates four plants, each with its own short-run ATC curve.
By comparing the ATC for each output across different plants, the firm can assess cost efficiency.
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Long-Run Average Cost Curve
The long-run average cost (LRAC) curve shows the lowest average total cost possible across various output levels when the firm can adjust both its plant and labor. It helps firms plan by indicating the most cost-efficient plant size for different output ranges. Once a plant is chosen, costs align with the average total cost (ATC) curve linked to that plant. Figure 10.9 illustrates this LRAC concept.
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Economies and Diseconomies of Scale
Economies of scale cause long-run average costs to decrease as output increases, while diseconomies of scale result in rising long-run average costs with increased output. Constant returns to scale maintain a consistent long-run average cost as output changes.
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Minimum Efficient Scale
A firm typically encounters economies of scale until reaching a certain output level. Beyond this point, it may face constant returns to scale or even diseconomies of scale. The minimum efficient scale represents the lowest output level at which long-run average costs are minimized. In a U-shaped long-run average cost curve, this point identifies the minimum efficient scale output level.
