Production theory Flashcards
Why do firms incur costs?
A firm uses factor inputs in production that have to be paid for
Define opportunity cost
Everything that must be forgone to acquire an item
Define explicit cost
Input costs that acquire an outlay of money by the firm (have to forgo something and give money)
Define implicit cost
Input costs that do not require an outlay of money by the firm
Why do economists include implicit costs when calculating the total cost?
Because they could influence the decisions made about the business
Define short run in an economical sense
The period of time in which some factors of production that cannot be changed
Define long run in an economical sense
The period of time in which all factors of production can be altered
Give an example of a short run factor of production
The number of workers
Give an example of a long run factor of production
The size of the factory
What is the production function?
Q=f(K, L)
What is Q in the production function?
Output
What is K in the production function?
Input capital
What is L in the production function?
Labour
Define marginal product
The increase in output that arises from an additional unit of input
What is the marginal product function?
MPf= change in total product/ change in quantity of the factor
What does the total cost curve show the relationship of?
Quantity of output produced and the total cost of production
What happens to the marginal product when the amount of workers is increased but everything else stays the same?
It dimininshes
Define diminishing marginal product
The property whereby the marginal product of an input declines as the quantity of the input increases
Why does the marginal product diminish when the number of workers is increased but everything else stays the same?
As the number of workers increases, more people have to share the equipment, reducing efficiency which means that as more people are hired, each additional worker contributes less to the production of the pizzas.
What happens to the production function graph as the marginal product declines?
It becomes flatter
What is on the x and y axis of the total cost curve?
X axis- quantity produced
Y axis- total cost
What is the equation for the total cost of production?
C(Q)=Pl x L(Q) + Pk x K(Q)
What is Pl?
Price of labour per hour
What is L(Q)?
Labour hours
What is Pk?
Price of hiring capital
What is K(Q)?
Capital
What is C(Q)?
Total cost of production
What happens to the total cost curve as the amount produced rises?
It gets steeper as the amount produced increases
What happens to the production function as the amount produced rises?
It gets flatter as the amount produced increases
Why is the total cost curve relatively steep when the quantity produced is large?
Producing additional product requires extra labour, therefore it is more costly.
What does a steep total cost curve reflect?
Diminishing marginal product
Define fixed cost
Costs that are not determined by the quantity of total output produced
Define variable cost
Costs that are dependent on the quantity of output produced
Give two examples of fixed costs
Rent
Labour
Give two examples of variable costs
Ingredients/ components
Overtime work
What is a firm’s total cost the sum of?
Fixed cost plus variable cost
What is the equation for the firm’s total cost?
TC(Q)=VC(Q) + FC
What is a key factor in working out how much of a product to produce?
How the costs will vary as the level of production changes.
How can you find the cost of a typical unit produced?
Divide total cost by the quantity of output produced
What is the name of the cost of a typical unit produced?
Average total cost
How can you find the average fixed cost?
Divide fixed costs by the quantity of output
How do you find the average variable cost?
Divide variable costs by the quantity of output
Define marginal cost
The increase in the total cost that arises from an extra unit of production
What is the marginal cost calculation?
delta TC / delta Q
What can various average costs measures and marginal costs be derived from?
The total cost function
What is the total cost function?
TC= f(Q)
e.g TC= 7Q + 5Q + 1500
(Fixed costs are 1500 here)
What do the x and y axis show on a cost curve?
X axis = quantity produced
Y axis = marginal and average costs
What property does a cost curve with a rising marginal cost show?
Diminishing marginal product
When a small quantity is produced, the marginal product of an extra worker is large and the marginal cost of one extra unit is small, however this switches with higher quantities produced.
What happens to the average fixed cost as the output rises?
It declines because the fixed cost does not change as the output rises and therefore gets split across a larger amount of units.
Why does average variable cost increase as the output rises?
Because of diminishing marginal product
Why is the average total cost often U shaped on a cost curve?
Because as output rises, average fixed costs decline whilst average variable costs increase
What does the bottom line of the U shaped average total cost curve on a cost curve show?
The quantity that minimises average total cost (sometimes known as efficient scale)
Define efficient scale?
The quantity of output that minimises average total cost
What does it mean when the marginal cost is less than the average total cost?
Average total cost is falling
What does it mean when the marginal cost is greater than the average total cost?
Average total cost is rising
On a cost curve, where does the marginal cost curve cross the average total cost curve?
The marginal cost curve crosses the average total cost curve at its minimum
What happens to the average cost at the point at which the marginal cost curve intersects the average total cost curve?
The cost of the additional unit is the same as the average total cost, so the average total cost does not change
What can make the average variable cost U shaped?
If the marginal product increases before diminishing
What are the 3 main features of cost curves?
Marginal cost eventually rises with the quantity of output
The average total cost curve is U shaped
The marginal cost curve crosses the average total cost curve at the minimum of average total cost
Why can long-run cost curves differ from short-run ones?
Many decisions are fixed in the short-run but variable in the long-run
Which type of average cost curve is flatter: short-run or long-run?
Long-run
Where do the short-run average cost curves lie in relation to the long-run average cost curve?
On or above the long-run average cost curve
Why is the long run average cost curve lower than the short run ones?
This is because firms have more flexibility in the long run. Essentially, in the long run it can choose which short term cost curve it wants to use (e.g the cost curve for two factories) but in the short run it doesn’t have a choice
Why is the long-run average cost curve often U shaped?
At low levels of production, the benefits of increased size are yet to be realised, but at high levels of production, the benefits have already been realised (its at its capacity) and therefore the long- run average total cost rises at high levels of production.
What are 3 outcomes that can occur when a firm increases its scale of production?
Economies of scale
Constant returns to scale
Diseconomies of scale
Define constant returns to scale
The property whereby long-run average total cost stays the same as the quantity of output changes
Define economies of scale
The property whereby long-run average total cost falls as the quantity of output increases.
Define diseconomies of scale
The property whereby the long-run average total cost increases as the quantity of output increases.
When do constant returns to scale occur?
When long-run average total cost does not vary with output
When do economies of scale occur?
When the proportionate increase in output is greater than the proportionate increase in total cost
When do diseconomies of scale occur?
When the long-run average total cost rises as output increases
What is the formula for returns of scale?
Returns of scale = % change in quantity of output/ % change in quantity of all factor inputs
Why do economies of scale often arise?
Higher production levels allow specialisation among workers and increase the possibility that technology can be used, helping the worker to become better at their task
What are two advantages for firms operating at a large scale?
They can negotiate more favourable borrowing rates and can get discounts from suppliers which will reduce variable costs.
Why might diseconomies of scale arise?
Because of coordination and communication problems present in large organisations
What are two possible pricing decisions that a business with economies of scale could face?
Keep the price the same and enjoy larger profit margins.
Keep the same profit margin by reducing the price which would increase competitiveness
What can a firm that has a dominant position in a market do?
Increase its price and still sell all of its products.
What is the equation for revenue?
P x Q
P is price
Q is quantity
Give an example of a competitive market
Milk
In a competitive market, what determines the price?
The market conditions, not the firm
What is total revenue proportionate to?
The amount of output
Why is the total revenue proportionate to the amount of output?
If the output is doubled, but the price stays the same then the total revenue also doubles
Define average revenue
Total revenue divided by quantity sold
What does the average revenue tell an economist?
How much revenue a firm receives for the typical unit sold
What is the rule about average revenue?
For ALL firms, average revenue equals the price of the good
Define marginal revenue
The change in total revenue from an additional unit sold
What is the rule for competitive firms about marginal revenue?
For competitive firms ONLY marginal revenue equals the price of the good.
Why does the marginal revenue equal the price of the good for competitive firms?
The price is fixed for a competitive firm
What do economists assume is the main goal of a firm?
To maximise profit
What is the written equation for profit?
Profit = total revenue - total cost
Define economic profit
Total revenue minus total cost, including both implicit and explicit costs
Define accounting profit
Total revenue minus total explicit cost
How can the profit-maximising quantity be found?
By comparing the marginal revenue and marginal cost from each unit produced
What happens so long as marginal revenue exceeds marginal cost?
Increasing the quantity produced adds to profit so long as the marginal revenue exceeds marginal cost
If marginal revenue is less than marginal cost, what should be done to production?
It should decrease because the change in profit will decrease
At what output is the profit-maximising quantity found?
At the output where MR =MC
Define normal profit
The minimum amount required to keep factors of production in their current use
Define abnormal profit
The profit over and above normal profit
What is the economic profit at the zero-profit equilibrium?
Zero
In what time scale is abnormal profit seen?
In the short-run
What is there incentive for if firms are making an abnormal profit?
There is an incentive for other firms to enter the market to take advantage of the profits that exist, this creates a dynamic that moves the market to equilibrium
What does a flat horizontal price line show?
It shows that the firm is a price taker
What is meant by a price taker?
The price is the same, no matter the output
What is the general rule for profit maximisation?
At the profit-maximising level of output, marginal revenue and marginal cost are exactly equal
What does the marginal revenue equal for a competitive firm and why?
Marginal revenue is equal to market price because the firm is a price taker
How can the profit-maximising quantity be found on a marginal cost curve?
It can be found at the point at which the price intersects the marginal cost curve
How can a competitive firm’s supply curve be found?
It is the firms marginal cost curve
Why is the firms marginal cost curve also its supply curve?
Because the marginal cost curve determines the quantity of the good the firm is willing to supply at any price
Define shut down
A short-run decision to not produce anything during a specific time period because of current market conditions. It therefore still has to pay fixed costs.
Define exit
A long-run decision to leave the market, it no longer has to pay either variable or fixed costs
Why do short-run and long-run decisions differ?
Because most firms cannot avoid their fixed costs in the short-run but they can in the long-run
What happens to the revenue of a firm if it shuts down?
It loses all of its revenue from the sale of its product
Why would a firm shutdown?
If the revenue that it would get from producing is less than its variable costs of production
What are the 3 equations for shutdown?
Shut down if TR < VC
Shut down if TR/Q < VC/Q
Shut down if P < AVC (P is price)
What two factors are part of a competitive firm’s short-run profit-maximising strategy?
Quantity produced is at the price at which marginal cost equals the price of the good
If the price is less than the average variable cost at that quantity then it is better to shut down.
How can a firm’s short-run supply curve be found?
It is the portion of its marginal cost curve that is above the average variable cost.
Define sunk cost
A cost that has already been committed and cannot be recovered
What is a sunk cost the opposite of? Explain why
It is the opposite of opportunity cost, this is because opportunity costs are what you have to give up if you choose to do one thing instead of another, but a sunk cost cannot be avoided
When can sunk costs be avoided and why?
When making decisions about life such as business strategy, this is because they cannot be avoided
When can a firm ignore sunk costs?
When a firm’s costs are sunk in the short-run they can be ignored when deciding how much to produce
When can fixed costs be ignored?
When deciding the quantity to supply
What happens to the revenue if the firm exits the market?
It will lose all of its revenue from sales
What will a firm save if it exits the market?
Both its fixed and variable costs
Why would a firm exit the market?
If its revenue is less than its total cost
What are the 3 equations for exit?
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC
When would an entrepreneur enter the market?
If the price of the good exceeds the average total cost of production
Enter if P > ATC
What is the criterion for entry the opposite of?
The criterion for exit
What are the two factors of the competitive firm’s long-run profit-maximising strategy?
It produces the quantity at which the marginal cost is equal to the price of the good.
If the price is less than the average total cost at that quantity, the firm chooses to exit (or not enter) the market.
What is the competitive firm’s long run supply curve?
The proportion of the marginal cost curve that lies above the average total cost.
What is the equation for finding profit on a graph?
Profit = (P - ATC) x Q
How do you calculate profit on a graph for a firm?
Find the area of the rectangle: (P - ATC) x Q
What is assumed about the number of firms in a market in the short-run?
There is a fixed number of firms
What is assumed about the number of firms in a market in the long-run?
The number of firms can change as a result of changing market conditions
How can you find the market supply curve in a competitive market with a fixed number of firms? (short-run)
Add the quantity supplied by each firm in the market. so long as price is above average variable cost, each firm’s marginal cost curve is its supply curve.
How can you find the market supply curve in a competitive market with entry and exit? (long-run)
It is assumed that all firms and potential firms have the same cost curves. Entry and exit occurs meaning that firms that remain in the market must be making zero economic profit or normal profit. The long-run equilibrium of a competitive market must have firms operating at their efficient scale. There is only one price consistent with zero profit, meaning that the long-run supply curve is a horizontal line.
Why is it assumed in the long-run that all firms and potential firms have the same cost curves?
It is assumed that all firms have access to the same technology for producing goods and access to the same markets to buy the inputs for production
Why does entry and exit occur in the long run?
Firms make abnormal profit which acts as an incentive for firms to join the market, this causes prices and therefore profits to decline. If then firms start to not make a profit, they will leave, driving prices back up.
Why does the long-run equilibrium of a competitive market have to have firms operating at their efficient scale?
Price is equal to both marginal cost and average total cost, so there two costs must be equal and this occurs when a firm is operating at the minimum of the total average cost.
What implication is there when all firms are operating at their efficient scale, but there are more firms? (competitive market)
The quantity sold is greater
What are two reasons why the long-run supply curve might slope upwards?
Some resources used in production may only be available in limited quantities
Firms may have different costs
What happens if some of the resources used in production are limited?
The price is driven upwards, increasing costs. An increase in demand cannot lead to an increase in supply without driving up costs, leading to a rise in price
Why might firms have different costs?
Some people have more time than others, work faster than others or use different equipment or materials.
What two things might encourage a firm to enter a market?
Having lower costs
Higher market prices to make entry profitable for higher cost firms
Why is it possible for firms with lower costs to make a profit in the long-run in a competitive market?
Their costs are lower but the price is the same with all firms, no matter their costs. Firms have different costs.
If firms have different costs, what does the price in the competitive market in the long-run reflect?
It reflects the average total costs of the marginal firm which is the firm that would exit the market if the market if the price were any lower and earns zero profit.
Why is the long-run supply curve more elastic than the short-run supply curve?
Firms can enter and exit more easily in the long-run.
