Production, Cost and the Perfect Competition Model

Question 1

Why do firms face costs and what are these costs called?

Answer 1

Firms face costs because the resources they need, have alternative uses that other firms compete for. Therefore, the economic cost is the payment that must be made to obtain or retain a resource

Question 2

What is an opportunity cost?

Answer 2

The cost of the foregone, next-best alternative

Question 3

What do all resources have associated with them?

Answer 3

All resources have an opportunity cost.

Ex. An oak tree can be sold as lumber or can be bought as raw material to be made into a table

Question 4

What is the difference between explicit and implicit costs?

Answer 4

1. Explicit - a firm’s monetary payment for a resource it doesn’t have

Ex. Purchasing new assets, hiring workers, purchasing raw materials

2. Implicit - the opportunity cost for using resources that it already has

Ex. Giving workers a day off

Question 5

How is accounting profit found and what are its disadvantages?

Answer 5

Accounting profit = Total Cost- Revenue

Accounting profit does not account for implicit costs and therefore is an idealized summary

Question 6

What is normal profit

Answer 6

1. Normal profit takes into account both explicit and implicit costs
2. Normal profit is a condition that exists when a company or industry’s economic profit is equal to zero.

Question 7

How is economic profit different from accounting profit?

Answer 7

Economic profit factors in implicit costs and directs how resources are allocated in the economy

Economic profit = Revenue - Explicit - Implicit

Question 8

What can a firm conclude if it breaks even?

Answer 8

Allows entreprenuers to conclude that they are doing exactly as well as they could expect to in an alternative business venture

Question 9

How do resources flow when positive economic profits are achieved?

Answer 9

Resources will move toward producing with higher net benefits

Question 10

What is plant capacity?

Answer 10

1. The size of the factory building, the amount of machinery and equipment, and other capital resources
2. The bigger the organization, the harder it becomes to change plant capacity

Question 11

What is the difference between short (fixed plant) and long run (variable plant)

Answer 11

Short run - period too brief for a firm to alter its plant capacity, yet long enough to permit a change in the degree to which the plant’s capacity is used

Long run - period long enough for a firm to adjust the quantities of all resources that it employs, including plant capacity

Question 12

What is total product (TP)?

Answer 12

The total quantity, or total output, of a particular good or service produced

Question 13

What is marginal product (MP)?

Answer 13

The extra output or added product associate with adding a unit of a variable resource to the production process

MP = change in TP/change in labor input

Question 14

What is average product (AP)?

Answer 14

Alternatively called “labor productivity”, AP is output per unit of labor input

AP = TP/units of labor

Question 15

What is the law of diminishing returns?

Answer 15

1. Law that assumes that technology is fixed and thus techniques of prodction do not change
2. As sucessive units of a variable resource (labor) are added to a fixed resource (capital or land), beyond some point the benefit will increase at a decreasing rate

Ex. A farm or a shirt factory

Question 16

What does a total production curve look like?

Answer 16

1. Rises initially at an increasing rate
2. Increases but at a diminishing rate
3. After reaching a maximum point it declines

Question 17

What does a marginal product curve look like

Answer 17

1. MP is the slope of the total product curve because it measures the change in total producted with each succeeding unit of labor

Question 18

What is the relationship between an MP and TP curve?

Answer 18

1. When TP is increasing at an increasing rate, MP is rising
2. When TP is increasing at a decreasing rate, MP is positive but falling
3. When TP is at maximum, MP is at 0
4. When TP declines, MP becomes negative

Question 19

What is the relationship between an MP and AP curve?

Answer 19

1. When MP exceeds AP, AP rises
2. When MP is less than AP, AP declines
3. MP intersects AP where AP is at its maximum

Question 20

What are fixed costs?

Answer 20

1. Costs that do not vary with changes in output
2. Fixed costs are beyond a business manager’s current control; they are incurred in the short run and must be paid regardless of output level

Ex. rental payments, interest on firm’s debts, insurance premiums

Question 21

What are variable costs?

Answer 21

1. Costs that change with the level of output however it increases by increasing amounts due to the law of diminishing returns
2. Variable costs can be controlled or altered in the short run by changing production levels

Ex. payments for materials, fuel, power, transportation services, and labor

Question 22

What is total cost (TC)?

Answer 22

The sum of fixed cost and variable costs at each level of output which is measured vertically on a graph

TC = TFC + TVC

Question 23

What is average fixed cost (AFC)?

Answer 23

1. Because TFC is the same regardless of oupute, AFC must declien as output increases.
2. As output rises, the TFC is spread over a larger and larger output AKA “spreading the overhead”
3. AFC is a continually declining curve as total ouput increases

AFC = TFC/Q

Question 24

What is average variable cost (AVC)?

Answer 24

1. Due to increasing and then diminishing returns, AVC declines initially, reaches a minimum, and then increases again.
2. AVC is a U-shaped curve because production is relativel tin

AVC = TVC/Q

Question 25

What are the characteristics of a perfectly competitive market?

Answer 25

1. Many buyers and sellers in the market
2. The goods offered are about the same
3. Firms can freely enter or exit the market (if they feel they can make or lose a profit)

Question 26

What is an example of a perfectly competitive market?

Answer 26

Agriculture before social programs of the New Deal

Question 27

What are the outcomes of a perfectly competitive market?

Answer 27

1. Individual firm produces a small portion of the total market output
2. The firm cannot have influence over the price it charges (the customer will either leave or cause the customer to go bankrupt)

Question 28

In a perfectly competitive market, what is the individual firm considered?

Answer 28

Price taker who takes the price determined by the market as the price that it will receive for its output