Week 5 - Producer Theory Flashcards
Profit
The total revenue a firm receives minus all costs (explicit and implicit) from producing it.
Assuming that the firm produces a single good and that the firm has already chosen which good to produce.
Profit formula
Profit (π) = Total Revenue (TR) - Total Cost (TC)
Explicit cost
Out-of-pocket monetary payments a business has to make to produce a good/service.
E.g., wage payments, rental payments for machines/ office space etc.
Implicit cost
A specific type of opportunity cost of using resources that the firm already owns, instead of using them for something else.
E.g., owners time, company property or personal savings invested etc.
Profit-maximizing firm
A firm whose primary goal is to maximize the difference between its total revenues and total costs.
Price taker
A firm that has no influence over the price at which it sells its product.
Production function
q = f(K, L)
Output: quantity (q)
Inputs: Capital (K), Labour (L)
Assumption of the production function
The more inputs a firm uses, the more output it makes.
Inputs in the short run
In the short run capital is a fixed input and labour is a variable input.
Marginal product of labour (MPL)
The additional output the firm can produce by using an additional unit of labour (keeping capital fixed).
Marginal product of labour formula
ΔQ / ΔL
or partial derivative of production function with respect to labour
Diminishing marginal product of labour
As a firm hires additional units of labour, while keeping capital fixed, the marginal product of labour falls.
Inputs in the long run
In the long run, both capital and labour are variable inputs.
What defines the long run
It does not have a specific time length but is simply the time it takes for all inputs to become variable.
Do firms have more flexibility in the short or long run
The long run because they can change both capital and labour
They can decide trade-offs between labour and capital while keeping output fixed.
Isoquant
A curve representing all combinations of labour and capital that result in the same level of output.
They are downward sloping, convex, and cannot intersect one another.
Marginal rate of technical substitution (MRTS)
The rate at which the firm can trade capital for one more unit of labour, holding the output constant.
MRTS is the absolute value of the gradient of an isoquant.
Marginal rate of technical substitution formula
MRTS = MPL / MPK
Cobb-Douglass production function
A model to show the relation between the output (q) and inputs (K, L) of production.
Cobb-Douglass production function formula
q = KᵅLᵝ
α and β are output elasticities of capital and labour respectively, which measure the responsiveness of output to a change in each input.
What happens when capital and labour are perfect complements
The isoquant will be 2 perpendicular lines intersecting where K = L
To increase output, you have to increase both capital and labour, increasing just L or just K will not change output.
E.g., a company has 1 developer and 1 computer. To increase output they need more developers and more computers.
What happens when capital and labour are perfect substitutes
The isoquant will be a downward sloping straight line with a gradient of -1 (or MRTS of 1).
1 worker can be replaced by 1 worker or vice versa and output will remain the same.
Returns to scale
A change in level of output in response to a proportional increase of inputs
Constant returns to scale
Output changes by the same amount as the increase in inputs.
Increasing returns to scale
Output changes by a greater proportion than the increase in inputs.
Decreasing returns to scale
Output changes by a smaller proportion than the increase in inputs.
Technology change (Total factor productivity growth)
An improvement in technology that changes the firms production function so that there is more output from the same inputs.
Fixed Cost (FC)
A cost that does not change with output.
Comes from a fixed input.
Variable Cost (VC)
A cost that changes with output.
Comes from a variable input.
Total Cost (TC)
Fixed cost + variable cost
Short run fixed cost
Per unit price of capital (r)
Can be thought of as rental rate of machines/ rent for a factory/office space.
Short run variable cost
Variable Cost: per unit price of labour (w)
Can be thought of as the wage rate
Average Cost (AC)
Total Cost (TC) / Output (q)
Marginal Cost (MC)
The cost of producing 1 more unit of output.
Marginal Cost formula
dTC / dq
Derivative of total cost with respect to q
Where does marginal cost and average cost intersect
At the minimum of average cost.
This is where a firm can maximise its profits.
Average Variable Cost (AVC)
Variable cost / output (q)
Where does marginal cost and average variable cost intersect
At the minimum of average variable cost
Cost minimisation
The most economically efficient combination of labour and capital for a given output
Isocost line
A graph showing the combinations of capital and labour that result in a given total cost.
How does changes in labour and capital change the isocost line
An increase in the cost of labour (wages), pivots the isocost line and makes it steeper.
An increase in the cost of capital (interest rates), pivots the isocost line and makes it flatter.
Cost formula
TC = rK + wL
r: per unit cost of capital (K)
w: per unit cost of labour (L)
Cost minimisation
Finding the combination of labour and capital that has the lowest cost for a given output.
Finding when cost is minimised
Cost is minimised when the isocost line is a tangent to an isoquant curve - when MRTS = w/r
Economies of scale
A firm has economies of scale if doubling output causes cost to less than double.
Can happen because of: fixed costs; specialisation; quality of machinery
Diseconomies of scale
A firm has diseconomies of scale if doubling output causes cost to more than double.
Can happen because of: managerial diseconomies / bureaucracy; geographical diseconomies.
Constant economies of scale
A firm has constant economies of scale if doubling output causes costs to double.
Long run cost curves
Firms can vary both capital and labour in the long run meaning they can shift between different short run supply curves.
Long run average costs initially fall due to economies of scale then may eventually rise due to diseconomies of scale.
