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ECONOMICS TEXTBOOK NOTES Chapter 7 – Producers in the Short Run 7.2 – Production, Costs, and Profits  intermediate products – all outputs that are used as inputs by other producers in a further stage of production  production function – a functional relation showing the maximum output that can be produced by any given combination of inputs o Q = f(L,K)  Q = flow of output  K = flow of capital services  L = flow of labour services  f = the production function itself  accounting profits = revenues – explicit costs  economic profits = revenues – explicit costs – implicit costs o economic profits – the difference between the revenues received from the sale of output and the opportunity cost of the inputs used to make the output o economic profits in an industry are a signal that resources can profitably be moved into the industry  π = TR [total revenue] – TC [total cost]  short run – the length of time over which some of the factors of production of the firm are fixed  long run – the length of time over which all of the firm’s factors of production are variable, but technology is fixed  very long run – the length of time over which all factors of production and technology can be varied 7.3 – Production in the Short Run  total product (TP) – total amount produced by a firm during in a certain period of time  average product (AP) – total product divided by the number of units of the variable factor used in production o AP = o point of diminishing average productivity is when AP reaches a maximum  marginal product (MP) – the change in total output that results from using one more unit of a variable factor o MP = o point of diminishing marginal productivity where MP reaches a maximum  law of diminishing returns – increasing quantities of a variable factor will eventually lead to a decrease in the marginal product of the variable factor  AP curve slopes upward as long as the MP curve is above it, regardless of the slope of the MP curve o in order for average product to rise, marginal product must exceed the average product o to increase the average, the marginal must be greater than the average 7.4 – Costs in the Short Run  total cost (TC) – sum of all costs of producing any given level of output  total fixed cost (TFC) – all costs of production that do not vary with the level of output  total variable cost (TVC) – total costs of production that vary directly with the level of output o TC = TFV + TVC  average total cost (ATC) - total cost divided by number of units of output, or the sum of average fixed cost and average variable cost  average fixed cost (AFC) – total costs divided by the number of units of output  average variable cost (AVC) – total variable costs divided by the number of units of output o ATC = = AFC + AVC  marginal cost (MC) – increase in total cost resulting from increasing output by one unit o MC =  the AFC, AVC and ATC curves o average fixed cost (AFC) curve decreases as output rises because of a phenomenon called spreading overhead o average variable cost (AVC) curve declines as output rises, reaches a minimum, and then begins to rise o average total cost (ATC) derived by vertically adding the AFC and AVC curves o the gap between ATC and AVC starts off large but gets smaller as output increases  the MC curve o plotted on the midpoint of the output interval o declines steadily as output initially increases, reaches a minimum, then rises as outputs increase farther  Why are the cost curves U-shaped? o product curves are hill-shaped o cost curves are U-shaped because the relationship between labour input and output is closely related to the relationship between output and cost  as labour increases, output increases, but begins to decrease at a certain point – output declines then rises; therefore costs decline and rise  eventually diminishing average product of the variable factor implies eventually increasing average variable cost  eventually diminishing marginal product of the variable factor implies eventually increasing marginal costs  capacity is the largest output that can be produced without encountering rising average costs per unit – where ATC = MC, at the lowest point of ATC  excess capacity – when a firm is producing at an output less than the point of minimum average total cost  shifts in short-run cost curves o changes in factor prices – as wage increases, variables cost increase, and total costs also increase – upward shift in ATC and MC curves o changes in the amount of the fixed factor – if you get a larger factory, total fixed costs increase, and other factors such as Chapter 8 – Producers in the Long Run 8.1 – The Long Run: No Fixed Factors  technically efficient – combining a given number of inputs in such a way as to maximize the level of output Long Run Cost Minimization  cost minimization – implication of profit maximization that firms choose the production method that produces any given level of output at the lowest possible cost o = , or =  law of diminishing marginal returns says that with other inputs held constant, an increase in the amount of one factor used will decrease that factor’s marginal product  if both sides are the same, the firm cannot make any substitutions between labour and capital to reduce costs with output held constant  profit-maximizing firms adjust the quantities of factors they use to the prices of the factors given by the market The Principle of Substitution  principle of substitution – the principle that methods of production will change if relative prices of inputs change, with relatively more of the cheaper input and relatively less of the more expensive input being used  if the price of labour decreases, then the company will begin to use more labour and less capital  individual firms tend to use less of factors that are scarce to the economy and more of factors that are plentiful o ex. Banks used to use a lot of people as tellers, but now more people use ATMs, internet banking, and automated telephone banking; for this reason, banks made a substitution of capital for labour Long Run Cost Curves  long run average cost (LRAC) curve – the curve showing the lowest possible cost of producing each level of output when all inputs can be varied o determined by firm’s current technology and by prices of the factors of production o can be considered a boundary – points below it are unattainable o to move from one point to another on the LRAC curve requires an adjustment in all factor inputs (ex. building a larger factory) o there is only one LRAC for any given set of inputs – no need to distinguish between AVC, AFC and ATC The Shape of the Long-Run Average Cost Curve  “saucer-shaped”  economies of scale – when long run average costs decline as output rises; shown in the change of output from 0 to  increasing returns (to scale) – a situation in which output increases more than in proportion to inputs as the scale of a firm’s production increases; a firm in this situation is a decreasing-cost firm o larger plants use greater specialization, because specialized equipment is only useful when the volume of output is very large  minimum efficient scale (MES) – the smallest output at which LRAC reaches its minimum; all available economies of scale have been realized at this point o LRAC curve is flat – the firm encounters constant costs over the relevant range of outputs – the firm’s long run average costs do not change as its output changes o constant returns (to scale) – when output increases in proportion to inputs as the scale of production is i
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