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Chapter 11 Full Notes

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ECON 1131
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Chapter 11 The Firm’s How Problem and The Total Cost of Production The Total Cost of Production  Long-run total cost curve: the OTE relationship between output and total cost in the long run  Short-run total cost curve: the OTE relationship between output and total cost in the short run  Marginal cost is the change or increase in total cost from producing one more unit of output o Marginal cost is the slop of the total cost curve at each level of output The Shape of the Total Cost Curves  Total cost continually increases as output increases and continually decreases at output decreases  Total cost does not increase proportionally with output Total Cost in the Long Run and in the Short Run  The LRTC curve begins at the origin o B/c all long run factors are variable-should the firm decide not to produce at all, it will hire no factors of production and incur no costs  The SRTC curve intersects the total cost axis well above the origin o In the short run at least one of the factors of production is fixed, so there will always be some costs even if the firm produces no output  Short run is divided into two components: o SRTC= FC + SRVC  Fixed cost: the cost associated with the fixed factors of production in the short run  Variable cost: the cost associated with the variable factors of production  The vertical distance between SRTC and VC at any level of output is the amount of the firm’s variable cost at that output  In the long run, there is no distinction between LRTC and LRVC Additional Characteristics of the Total Cost Curves  The time dimension- output on the horizontal axis is measured as a rate of production over a specified length of time, so total cost is also flow variable measured over the same length of time as the output  Other things equal- the TC curve is an OTE relationship between total cost and level of output o If output is on the horizontal axis, the effect on total cost of changes in any one of the other variables must be represented as a shift up or down of the entire TC curve o Cost saving innovations in production technology shift the total cost curve down at every level of output  Economic (opportunity) cost versus accounting cost- a TC curve depicts the total economic cost of production at every output. In a production context, opportunity cost is the value that a firm’s inputs would have in their next best use o The total economic or opportunity costs includes the annual operating expenses plus the opportunity cost of the capital and labor  Operating expenses: accounting costs incurred by the firm by producing and selling its output- includes explicit monetary costs and certain nonmonetary costs  Explicit monetary (operating) costs: the firms out of pocket payments for its factors of production plus the general sales and excise taxed paid by the firm on the sale of its products  Nonmonetary operating costs: costs of production that do not involve out of pocket payments for factors of production, the most important is the depreciation estimate of the firm’s capital  The opportunity cost of capital: the return that the owners of the firm could earn if the value of the capital they own were invested in their next best investment alternatives o Cost of owner supplied funds is not an operating expense  Dividends: the portion of after-tax profits that the managers of the firm pay to the stockholders  Retained earnings: the funds of the firm remaining from total revenues after paying all operating expenses, income taxes, and dividends. Used to finance future investments.  The opportunity cost of labor: the wage or salary available to the employees of a firm in their next best employment alternatives  The total cost curve and economic efficiency: the points on a total cost curve depict the best possible relationship between output and total cost at every level of output o TC is 1he minimum cost of producing output at q 1 o OR: q is1the maximum output attainable for a cost of TC 1  The total cost curve is an efficiency frontier for the firm Least Cost Production The Structure of the How Problem  Points on the curve describe the maximum output obtainable for the given amount of total cost  The firm’s How problem: o Objective is to produce the most output it can, o Subject to the constraint that it spends a given amount of money on factors of production o Alternatives are the different combination of factors of production that the given amount of money can buy  Afirm needs two pieces of information to solve its How problem: o 1) The total cost of purchasing any combination of factors of production o 2) The maximum output attainable from any combination of the factors  Total Cost o The cost of any one factor is the product of its price times the quantity of the factor hired o TC= P * L + P * M M P * K K  The Production Function o Knowing the maximum output attainable from any combination of factors is difficult o Production function: the relationship between a firm’s outputs and its inputs that indicates the maximum output attainable from all possible combinations of inputs that the firm might use o The production fn indicates the maximum output attainable from all possible combinations of inputs, not just the factors of production that the firm is currently using Maximum Output/Least-Cost Production The Least Cost Production Rule  MP iL the additional output from adding one unit of labor P , Lhe wage is the addition to total cost from adding 1 unit of labor  MP /LP =Lq /ΔTC  With ratios unequal for two different types of labor, the firm must be operating in the inefficient region above and to the left of its total cost curve- it is increasing output but not total cost  So long as MP /L1 > L1 / P L2 L2 ,he firm can always obtain additional output at not additional cost by substituting equal dollar amounts of L1 for L2  Once ratios have equalized, the ability to obtain additional output costlessly ends.  Ratios tend to equalize because of the Law of Diminishing Returns (says that the marginal product of a variable factor tends to decline as the firm uses more of the factor)  Firms should substitute towards the factor with the higher output per dollar on the margin so they obtain additional output at no additional cost  In summary: the least cost production rule: o 1) Equalize MP /P FcrFss all factors of production o 2) If the MP /F rFtios are unequal between two factors, substitute towards the factor with the higher ratio The Shape of the Total Cost Curve OnceAgain  Economies of scale (in terms of LRTC): the region of the long-run total cost curve along which
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