Theory of Production and the Firm Flashcards
the study of how firms’ decisions about prices and quantities depend on market conditions
Industrial Organization
The goal of a firm
Maximize profit
total revenue (formula)
P x Q
Profit (formula)
TR - TC
require an outlay of money by the firm
Explicit Costs
do not require an outlay of money by the firm
Implicit Costs (ex: rent)
relationship between the quantity of inputs and quantity of outputs
production function
the increase in output that arises from an additional unit of input
marginal product
marginal product declines as the quantity of input increases
diminishing marginal product or law of diminishing returns
Does not depend on the quantity of output produced
fixed costs
A cost that changes as the firm alters the quantity of output produced
variable costs
total cost (formula)
FC + VC
Average total cost (formula)
TC / Q
an increase in total cost that arises from an extra unit of production
marginal cost
Three common features of cost curves
- MC rises with quantity output
- ATC is U-shaped
- MC crosses ATC at the minimum of average total cost
The efficient scale of the firm
the quantity that minimizes average total cost
When MC < ATC
ATC is falling (a good thing)
When MC > ATC
ATC is rising (bad)
When long-run ATC declines as output increases,
there are economies of scale
When long-run ATC rises as output increases
there are diseconomies of scale
the economies stock of equipment and structures
capital
inputs used to produce goods and services
factors of production
demand for a factor of production
derived demand
increase in output produced by an increase in labor
marginal product of labor
Price times Marginal Product of Labor
Value of the Marginal Product
extra revenue from adding labor (VMP - Wage)
Marginal Revenue Product
The goal of Profit Maximizing Firms (equation)
wage and prices
VMP = Wage
P > ATC
What causes labor demand curve to shift?
- Output Price (increase in price)
- Technological Change
- Supply of other factors
The process by which inputs are combined, transformed, and turned into outputs.
Production
An organization that comes into being when a person or a group of people decides to produce a good or service to meet a perceived demand.
firm
Basic decisions of firms
- How much output to supply
- Which production technology to use
- How much of each input to demand
The total of (1) out-of-pocket costs or explicit cost, (2) normal rate of return on capital, and (3) opportunity cost of each factor of production or implicit cost.
Total cost or total economic cost
Annual flow of income generated by an investment.
Rate of return of capital that is just sufficient to keep owners/investors satisfied
Normal Rate of Return
The firm is operating under a fixed scale (fixed factor) of production, and firms can neither enter nor exit an industry
short run
Firms can increase or decrease the scale of operation, and new firms can enter and existing firms can exit the industry
long run
The production method that minimizes cost.
Optimal Method of Production
The quantitative relationship between inputs and outputs.
Production Technology
Technology that relies heavily on human labor instead of capital.
labor-intensive technology
Technology that
relies heavily on capital instead of human labor
capital-intensive technology
When additional units of a variable input are added to fixed inputs after a certain point, the marginal product of the variable input declines.
law of diminishing returns
The average amount produced
by each unit of a variable factor of production
average product
Two things determine the cost of production
(1) technologies that are available and (2) input prices
A graph that shows all the combinations of capital and labor that can be used to produce a given amount of output.
Isoquant
A graph that shows all the combinations of capital and labor available for a given total cost.
Isocost Line
To calculate costs, a firm must know two things:
- Quantity and combination of inputs it needs to produce its product;
- how much those inputs cost
Another term for fixed costs
sunk costs
TVC depends on (2)
1) Techniques of production that are available
2) The prices of the inputs required by each technology
_____ also intersects the average variable cost curve at its minimum point.
Marginal Cost
Out of pocket costs or explicit costs
Accounting costs
Includes the full opportunity costs of all inputs // implicit costs
Economic costs
The profit-maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to
short-run marginal cost
when the revenue received from the sale cannot even cover the variable costs
firm will shutdown production
shutdown occurs when
marginal revenue is below average variable cost
2 rules to maximize profits
- MR = MC
2. firm should shutdown rather than operate if it can reduce losses by doing so.
shutdown rule
“in the short run a firm should continue to operate if price exceeds average variable costs.”
three short-run
production alternatives facing a firm
- shutdown production if the price is less than average variable cost
- profit maximization
- loss minimization
