Week 5 - Producer Theory

Question 1

Profit

Answer 1

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.

Question 2

Profit formula

Answer 2

Profit (π) = Total Revenue (TR) - Total Cost (TC)

Question 3

Explicit cost

Answer 3

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.

Question 4

Implicit cost

Answer 4

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.

Question 5

Profit-maximizing firm

Answer 5

A firm whose primary goal is to maximize the difference between its total revenues and total costs.

Question 6

Price taker

Answer 6

A firm that has no influence over the price at which it sells its product.

Question 7

Production function

Answer 7

q = f(K, L)
Output: quantity (q)
Inputs: Capital (K), Labour (L)

Question 8

Assumption of the production function

Answer 8

The more inputs a firm uses, the more output it makes.

Question 9

Inputs in the short run

Answer 9

In the short run capital is a fixed input and labour is a variable input.

Question 10

Marginal product of labour (MPL)

Answer 10

The additional output the firm can produce by using an additional unit of labour (keeping capital fixed).

Question 11

Marginal product of labour formula

Answer 11

ΔQ / ΔL
or partial derivative of production function with respect to labour

Question 12

Diminishing marginal product of labour

Answer 12

As a firm hires additional units of labour, while keeping capital fixed, the marginal product of labour falls.

Question 13

Inputs in the long run

Answer 13

In the long run, both capital and labour are variable inputs.

Question 14

What defines the long run

Answer 14

It does not have a specific time length but is simply the time it takes for all inputs to become variable.

Question 15

Do firms have more flexibility in the short or long run

Answer 15

The long run because they can change both capital and labour
They can decide trade-offs between labour and capital while keeping output fixed.

Question 16

Isoquant

Answer 16

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.

Question 17

Marginal rate of technical substitution (MRTS)

Answer 17

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.

Question 18

Marginal rate of technical substitution formula

Answer 18

MRTS = MPL / MPK

Question 19

Cobb-Douglass production function

Answer 19

A model to show the relation between the output (q) and inputs (K, L) of production.

Question 20

Cobb-Douglass production function formula

Answer 20

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.

Question 21

What happens when capital and labour are perfect complements

Answer 21

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.

Question 22

What happens when capital and labour are perfect substitutes

Answer 22

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.

Question 23

Returns to scale

Answer 23

A change in level of output in response to a proportional increase of inputs

Question 24

Constant returns to scale

Answer 24

Output changes by the same amount as the increase in inputs.

Question 25

Increasing returns to scale

Answer 25

Output changes by a greater proportion than the increase in inputs.

Question 26

Decreasing returns to scale

Answer 26

Output changes by a smaller proportion than the increase in inputs.

Question 27

Technology change (Total factor productivity growth)

Answer 27

An improvement in technology that changes the firms production function so that there is more output from the same inputs.

Question 28

Fixed Cost (FC)

Answer 28

A cost that does not change with output.
Comes from a fixed input.

Question 29

Variable Cost (VC)

Answer 29

A cost that changes with output.
Comes from a variable input.

Question 30

Total Cost (TC)

Answer 30

Fixed cost + variable cost

Question 31

Short run fixed cost

Answer 31

Per unit price of capital (r)
Can be thought of as rental rate of machines/ rent for a factory/office space.

Question 32

Short run variable cost

Answer 32

Variable Cost: per unit price of labour (w)
Can be thought of as the wage rate

Question 33

Average Cost (AC)

Answer 33

Total Cost (TC) / Output (q)

Question 34

Marginal Cost (MC)

Answer 34

The cost of producing 1 more unit of output.

Question 35

Marginal Cost formula

Answer 35

dTC / dq
Derivative of total cost with respect to q

Question 36

Where does marginal cost and average cost intersect

Answer 36

At the minimum of average cost.
This is where a firm can maximise its profits.

Question 37

Average Variable Cost (AVC)

Answer 37

Variable cost / output (q)

Question 38

Where does marginal cost and average variable cost intersect

Answer 38

At the minimum of average variable cost

Question 39

Cost minimisation

Answer 39

The most economically efficient combination of labour and capital for a given output

Question 40

Isocost line

Answer 40

A graph showing the combinations of capital and labour that result in a given total cost.

Question 41

How does changes in labour and capital change the isocost line

Answer 41

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.

Question 42

Cost formula

Answer 42

TC = rK + wL
r: per unit cost of capital (K)
w: per unit cost of labour (L)

Question 43

Cost minimisation

Answer 43

Finding the combination of labour and capital that has the lowest cost for a given output.

Question 44

Finding when cost is minimised

Answer 44

Cost is minimised when the isocost line is a tangent to an isoquant curve - when MRTS = w/r

Question 45

Economies of scale

Answer 45

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

Question 46

Diseconomies of scale

Answer 46

A firm has diseconomies of scale if doubling output causes cost to more than double.
Can happen because of: managerial diseconomies / bureaucracy; geographical diseconomies.

Question 47

Constant economies of scale

Answer 47

A firm has constant economies of scale if doubling output causes costs to double.

Question 48

Long run cost curves

Answer 48

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.