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Economics 2005 (Microecon) Chapter 7

by: Tim Reynolds

Economics 2005 (Microecon) Chapter 7 ECON 2005

Tim Reynolds
Virginia Tech
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Chapter 7 will be covered on the next exam 3/30/16. These notes cover the basics and the bulk of what you will need to know.
Principles of Economics
Steve Trost
Class Notes
Economics, firms, costs, Marginal, Average Cost, short run, Long Run, return




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This 10 page Class Notes was uploaded by Tim Reynolds on Monday March 14, 2016. The Class Notes belongs to ECON 2005 at Virginia Polytechnic Institute and State University taught by Steve Trost in Spring 2016. Since its upload, it has received 18 views. For similar materials see Principles of Economics in Economcs at Virginia Polytechnic Institute and State University.


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Date Created: 03/14/16
Economics 2005 (Microeconomics) – Chapter 7 Things to Think About. What makes people happy? - High income improves evaluation of life, but not emotional well-being. In US, after exceeding an income of 75k/year, more money doesn’t appear to have a positive correlation with happiness. Excess money can improve one’s view of their life, but that does not necessarily mean more money will make them emotionally more content. Let’s make logical decisions like a firm would make… What is a firm? – A firm is viewed as a bundle of contracts. Inputs go into a firm and outputs come out. Contracts with owners are what allows this transformation of inputs to outputs. Book Definition of a firm - Economic units formed by profit-seeking entrepreneurs who employ resources to produce goods and services for sale --> This does not include non-profit firms (But we will focus on profit-raising entities for this course). Question #1. Which is not a firm? a) Lemonade Stand b) Landscaping Company c) US Department of Agriculture d) General Motors *View End of Notes for Answer What do firms do? 1. Produce goods and services 2. Maximize Profits (Primary Objective) a. Profits= total revenue-total costs or P = TR - TC Accountants vs. Economists- quick overview - They both use this same equation, but both measure costs differently. - Accountants consider only EXPLICIT costs (money changes hands, money trail, any money value directly involved in a process) - Economists consider EXPLICIT and IMPLICIT costs (money doesn’t change hands, opportunity costs (other opportunities a firm is forgoing when making decisions)) Costs - In general, for most inputs, the opportunity cost is the dollar value of the input (explicit cost is the total cost). o Example- If someone offers you $10,000,000 for your farmland and you say no, the cost to maintain that land has now become $10,000,000 because you forwent that option. The Behavior of Profit-maximizing Firms Total Cost (total economic cost) = the total of:  Out-of-pocket (explicit) costs  Normal rate of return on capital (or forgone interest)  Opportunity Cost of each factor of production (implicit) *Keep in mind when we use the term “profit,” we are referring to “economic profit” (as described when comparing accountant and economic methods). - Normal Rate of Return on capital is basically the minimum amount you have to pay back your investors to convince them to keep investing in your firm. - Normal Profit (aka zero economic profit) - The accounting profit earned when all resources earn their opportunity cost. This occurs when TR=Total economic cost. *Any accounting profit in excess of “normal profit” is considered positive “economic profit.” ALL firms must make three basic decisions to achieve what we assume to be their primary objective- maximizing profits. 1. How much output to supply. 2. Which production technology to use. 3. How much of each input to demand. a. Determining 1 and 2 will help a firm determine 3. Again, the firm’s decision is based on 3 things: 1. The market price of output. 2. The techniques of production. 3. Prices of inputs. *Output price determines potential revenue. - Optimal Method of Production- Firms decide how to approach the decisions described above by choosing the production that minimizes cost. As we know, the following are the potential economic inputs:  Land  Labor  Capital  Entrepreneurial skill *You can review these again in more depth at: - s=wpd&c=dsp&k=production+inputs Technology  Production Technology- Relationship between inputs and outputs. (How inputs turn into outputs)  Labor-intensive technology- Technology that relies heavily on human labor instead of capital.  Capital-intensive technology- Technology that relies heavily on capital instead of labor. Which method should firms choose? - Their decision is based off of analyzing the cost vs. quality of each method, given the situation. *HOWEVER, Assume firms are always going to go with the cheaper method. This may not always be realistic, but it makes our lives as economists a whole lot easier. *Answer for multiple choice question #1: C – US Department of Agriculture is not a firm because it does not make the transformation of any sort of inputs to outputs. Economics 2005 Chapter 7 Cont’d Complementary Inputs vs Substitute Inputs Examples:  Complementary- labor  Substitutes- If you are making a desk, metal and wood are substitutes. Back to Firms- How do they make their decisions? The Production Process  Production function or total production function: The relationship between the amount of resources (inputs) employed and a firm’s total product (outputs).  Marginal product: The additional output that can be produced by adding one more unit of a specific input, ceteris paribus. o Marginal product of labor = change in total product/change in total units of labor. o Marginal product of capital = change in total product/change in total capital.  Average Product: The average amount produced by each unit of a variable factor of production (input). o Average product of labor = total product/total units of labor o Average product of capital = total product/total capital Law of diminishing marginal returns: When additional units of a variable input are added to fixed inputs, after a certain point the marginal product of the variable input declines. *Let’s remember fixed inputs are resources that you cannot easily change, i.e. size of your office/shop. In the short run, every firm will face diminishing returns. This means that every firm finds it progressively more difficult to increase its output as it approached capacity production. Short vs. Long run So far everything we’ve talked about has been in the “short run.”  Short run: The period of time for which two conditions hold: The firm is operating under a fixed scale (fixed factor) of production, and firms can neither enter nor exit an industry.  Long run: That period of time for which there are no fixed factors of production: Firms can increase or decrease scale of operation, and new firms can enter and existing firms can exit the industry. *The definition of how long is SR and LR varies and is firm specific.  i.e. For GM, it might take 2 years to change the firm’s capacity (build a new factory), but a lemonade stand can be shut down overnight or double in size after a shopping trip (replenishing resources). COSTS  What firms really care about are the costs associated with production. There are 4 important “types” of cost: 1. Fixed Costs a. Average fixed costs 2. Variable costs a. Average variable costs 3. Total costs a. Average total costs 4. Marginal costs a. Average marginal costs Costs in the short run  Fixed cost: Any cost that does not depend on the firm’s level of output (Q). These costs are incurred even if the firm is producing nothing.  i.e. - Rent on a store, property taxes. *FC’s are called “overhead costs”  Sun costs: Another name for fixed costs n the short run because firms have no choice but to pay them.  Total fixed costs: The total of all costs that do not change with output, even if output is zero.  Average fixed cost: Total fixed cost divided by the number of units of output; a per-unit measure of fixed costs. AFC=TFC/q If you are not a fixed cost, you are a variable cost:  Variable Cost: A cost that depends on the level of production chosen (Q).  i.e.- Labor, lemons (for the lemonade stand)  Total variable cost: The total of all costs that vary with output in the short run *Remember, we always assume that for each potential level of output, a firm will choose the production method and input mix that will minimize its variable cost.  Total Costs: Fixed costs plus variable costs (TC=FC+VC)  Average total cost: Total cost divided by the number of units of output. ATC=TC/q *It is only in the short run that we make the FC/VC distinction. In the long run there are no fixed costs, just variable costs.  Marginal cost: The increase in total cost that results from producing one more unit of output. Marginal costs reflect changes in variable costs only since fixed costs do not change.  MC=change in total cost/change in total product In the short run, every firm is constrained by some fixed input: 1. Leads to diminishing returns to variable inputs 2. Limits its capacity to produce. **As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output. Marginal costs ultimately increase with output in the short run. So the law of diminishing marginal returns is the same as the law of increasing marginal costs. Econ 2005 Chapter 7 Extended/Recap In the short run, every firm is constrained by some fixed input that:  Leads to diminishing returns to variable inputs  Limits its capacity to produce  * As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels output. Marginal costs ultimately increase with output in the short run. So, the law of diminishing marginal returns is the same as the law of increasing marginal costs. Recall: Product Curves MP= change in total product/change in units of labor = slope (TP) *The shape of the short-run marginal cost curve is fundamentally attributed to limited fixed costs. Costs in the short run: *Marginal cost intersects average variable cost at the lowest, or minimum point of AVC.  To get TOTAL COSTS, we just add fixed costs and variable costs.  The relationship between average total cost and mc is exactly the same as the relationship between average variable cost and marginal cost. Costs are Societal  Marginal cost represents the cost to society of making one more unit of the good in question. Long Run Costs *In the long run all costs are variable and the firm can change anything it wants.  Long-run average cost curve (LRAC) - A curve that indicates the lowest average cost of production at each rate of output when the size or “scale” of the firm is allowed to vary.  Every possible short-run AC curve is tangent to the LRAC, those tangency points represent the lowest-cost way to produce each level of output. LRAC answers the question: “Given a level of output, what is the lowest long run cots at which I can produce?” Long-run Costs: Economies and Diseconomies of Scale  Increasing returns to scale, or economies of scale- An increase in a firm’s scale of production leads to lower costs per unit produced.  Constant returns to scale- An increase in a firm’s scale of production has no effect on costs per unit produced.  Decreasing returns to scale, or diseconomies of scale- An increase in a firm’s scale of production leads to higher costs per unit produced. LRAC Graph  IF slope is increasing, there is a diseconomies of scale.  IF slope is decreasing, there is an economies of scale.  IF the slope is constant, there is a constant returns to scale. Looking Ahead: What the costs tell us.  Average variable cost gives the “shutdown pint,” which is the boundary for whether a particular firm should stop production or continue production in the short run.  Average total cost gives us information about the level of profits (or losses) a firm will receive for a given amount of output.  Marginal cost gives the profit maximizing level of output. We will see soon that firms will want to produce where MR=MC in order to maximize profit (where MR= Margnal Revenue).


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