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Econ After Midtern 2.docx

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School
University of Waterloo
Department
Economics
Course
ECON 202
Professor
Barry Mc Clinchey
Semester
Spring

Description
CHAPTER 11: OUTPUT AND COSTS The biggest decision that an entrepreneur makes is what industry to establish a firm. Their background knowledge and interests drive their decision. Decision also depends on the expectation that total revenue will exceed total cost. Firm makes many decisions to achieve its main objective: profit maximization To study the relationship between a firm’s output decision and its cost, we distinguish between two decision time frames: • The short run: time frame in which the quantity of at least one factor of production is fixed. For most firms, capital, land, and entrepreneurship are fixed factors of production and labour is the variable factor of production. Fixed factors of production are called the firm’s plant: in the short run, a firm’s plant is fixed. Short run decisions are easily reversed. • The long run: time frame in which the quantities of all factors of production can be varied. That is the long run is a period in which the firm can change its plant. Long-run decisions are not easily reversed. - Sunk cost: cost incurred by the firm and cannot be changed. They are irrelevant to firm’s current decisions. To increase output in the short run, a firm must increase the quantity of labour employed. We describe the relationship between output and the quantity of labour employed by using three related concepts: • Total product: the maximum output that a given quantity of labour can produce. • Marginal product: the increase in total product that results from a one-unit increase in the quantity of labour employed, other inputs remaining the same. • Average product: is equal to the total product divided by the quantity of labour employed. Product Curves: graphs of the relationships between employment and the three product concepts you’ve just studied. They show how total product, marginal product, and average product change as employment changes. 1 Total Product Curve: similar to PPF. It separates attainable output levels from those that are unattainable. Only the points on the total product curve are technologically efficient. Marginal Product Curve: The height of a bar measures marginal product. Marginal product is also measured by the slope of the total product curve. The total product and marginal product curves differ across firms and types of goods. But the shapes of the product curves are similar because almost every production process has two features: • Increasing Marginal Returns initially: increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker. Arises from increased specialization and division of labour. • Diminishing marginal returns eventually: occur when the marginal product of an additional worker is less than the marginal product of the previous worker. Arise from the fact that more and more workers are using the same capital and working in the same space. As more workers are added, there is less and less for the additional workers to do that is productive. The law of diminishing returns: As a firm uses more of a variable factor of production, with a given quantity of a fixed factor of production, the marginal product of the variable factor eventually diminishes. Average Product Curve: average product is largest marginal product and average product are equal on the graph (they cut each other). For the number of workers at which marginal product exceeds average product, average product is increasing. For the number of workers at which marginal product is less than average product, average product is decreasing. 2 To produce more output in the short run, a firm must employ more labour, which means that it must increase its costs. We describe the relationship between output and cost by using three cost concepts: • Total Cost: (TC) is the cost of all the factors of production it uses. We separate total cost into total fixed cost and total variable cost. - Total Fixed Cost (TFC): is the cost of the firm’s fixed factors. Fixed costs do not change with output - Total Variable Cost (TVC): is the cost of the firm’s variable factors. Total variable cost changes as output changes. - Total cost is the sum of total fixed cost and total variable cost. That is, → TC = TFC + TVC • Marginal Cost: (MC) increase in total cost that result from a one-unit increase in total product. - we calculate MC as the increase in TC divided by the increase in output (Total product) - over the output range with increasing marginal returns, marginal costs falls as output increases - over the output range with diminishing marginal returns, marginal cost rises as output increases • Average Cost: average cost measures can be derived from each of the total cost measures: - Average Fixed Cost (AFC): total fixed cost per unit of output - Average Variable Cost (AVC): total variable cost per unit of output - Average Total Cost (ATC): total cost per unit of output → ATC = AFC + AVC (to get this, divide each term by quantity produced Q) Why the Average Total Cost (ATC) is curve U-Shaped: • Initially marginal product exceeds average product, which brings rising average product and falling AVC 3 • Eventually marginal product falls below average product, which brings falling average product and rising AVC • The ATC curve is U-Shaped for the same reasons The shapes of a firm’s cost curves are determined by the technology it uses: • MC is at its minimum at the same output level at which marginal product is at its maximum • When marginal product is rising, marginal cost is falling • AVC is at its minimum at the same output level at which average product is at its maximum • When average product is rising, average variable cost is falling Shifts in Cost curve • The position of a firm’s short-run cost curves depends on two factors: - Technology: - Technological change influences both the productivity curves and the cost curves. - An increase in productivity shifts the average and marginal product curves upward and the average and marginal cost curves downward. - If a technological advance brings more capital and less labour into use, fixed costs increase and variable costs decrease - Prices of Factors of Production: - An increase in the price of factors of production increases costs and shifts the cost curves. - An increase in a fixed cost shifts the total cost (TC) and average total cost (ATC) curves upward but does not shift the marginal cost (MC) curve. - An increase in a variable cost shifts the total cost (TC), average total cost (ATC), and marginal cost (MC) curves upward. Long-Run Costs 4 In the long run, all inputs are variable and all costs are variable. • The Production Function: - The behaviour of long-run costs depends upon the firm’s production function. - The firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labour. • Diminishing Returns: occur with each of the four plant sizes as the quantity of labour increases. As the firm increases the quantity of labour employed, the marginal product of labour (eventually) diminishes. • Diminishing Marginal Product of Capital: - Diminishing returns also occur with each quantity of labour as the quantity of capital increases. - The marginal product of capital is the increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labour employed - A firm’s production function exhibits diminishing marginal returns to labour (for a given plant) as well as diminishing marginal returns to capital (for a quantity of labour) - For each plant, diminishing marginal product of labour creates a set of short run, U-Shaped cost curves for MC, AVC, and ATC. • Short-Run Cost and Long-Run Cost - The average cost of producing a given output varies and depends on the firm’s plant - The larger the plant, the greater is the output at which ATC is at a minimum. - The firm has 4 different plants: 1, 2, 3 , or 4 knitting machines. - Each plant has a short-run ATC curve - The firm can compare the ATC for each output at different plants. - Long run average cost curve (LRAC): the relationship between the lowest attainable average total cost and output when the firm can change both the plant it uses and quantity of labour it employs. Consists of 4 short-run ATC curves 5 • Economies and Diseconomies of Scale - Economies of Scale: are features of a firm’s technology that lead to falling long- run average cost as output increases - Diseconomies of Scale: are features of a firm’s technology that lead to a rising long-run average cost as output increases - Constant returns to Scale: are features of a firm’s technology that lead to constant long-run average cost as output increases. • Minimum Efficient Scale: - Defined as the smallest output at which long-run average cost reaches its lowest level. - If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale output level. - A firm experiences economies of scale up to some output level - Beyond that output level, it moves into constant returns to scale or diseconomies of scale. CHAPTER 12: PERFECT COMPETITION Perfect Competition: is a market in which • Many firms sell identical products to buyers • There are no restriction on entry into the market • Established firms have no advantage over new ones • Sellers and buyers are well informed about prices Perfect competition arises: • When firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the industry • And when each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from Price Takers: 6 • In perfect competition, each firm is a price taker • A price taker is a firm that cannot influence the price of a good or service because its production is an insignificant part of the total market. • No single firm can influence the price—it must “take” the equilibrium market price. • Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic. Economic Profit and Revenue: • The firm’s goal is to maximize economic profit, which equals total revenue minus total cost. • A firms total revenue equals price, P, multiplied by quantity sold, Q, or P x Q. • A firm`s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. • The demand for a firm`s product is perfectly elastic because one firm`s sweater is a perfect substitute for another firm`s sweater • The market demand is not perfectly elastic because a sweater is not a perfect substitute for other goods. • The goal of the competitive firm is to maximize economic profit, given constraints it faces. To achieve its goal, a firm must decide: 1. How to produce at minimum cost 2. What quantity to produce 3. Whether to enter or exit a market The Firm`s Output Decision—Marginal Analysis and Supply Decision: • The firm can use marginal analysis to determine the profit-maximizing output • Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC. 7 Temporary Shutdown Decision: • If the firm makes an economic loss it must decide to exit the market or to stay in the market • If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily • The decision will be the one that minimizes the firm’s loss Loss Comparison: • The firm’s loss equals Total Fixed Cost (TFC) plus Total Variable Cost (TVC) minus Total Revenue (TR). - Economic loss = TFC + TVC – TR - = TFC + (AVC – P) x Q • If the firm shuts down, Q is zero and the firm still has to pay its TFC • So the firm incurs an economic loss equal to TFC • This economic loss is the largest that the firm must bear Shutdown Point: • A firm’s shutdown point is the price and quantity at which it is indifferent between producing and shutting down • This point is where AVC is at its minimum • It is also the point at which the MC curve crosses the AVC curve 8 • At the shutdown point, the firm is indifferent between producing and shutting down temporarily • The firm incurs a loss equal to TFC from either action The Firm’s Supply Curve: • A perfectly competitive firm’s supply curve shoes how the firm’s profit maximizing output varies as the market price varies, other things remaining the same. • Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve • But at a price below the shutdown point, the firm produces nothing. Output, Price, and Profit in the Short Run—Market Supply in the Short Run: • The short run market supply curve shows the quantity supplied by all the firms in the market at each price when each firm’s plant and the number of firms remain the same. The quantity supplied by the market at a given price is the sum of the quantities supplied by all the firms in the market • Short-run Equilibrium: market demand and short-run market supply determine the market price and market output. 9 • Changes in demand bring changes in short-run market equilibrium. If demand increases and the demand curve shifts rightward (D3), the market price rises. If the demand decreases and the demand curve shift leftward (D1), the price falls. If the demand curve shifts farther than (D1), the market price remains at the same price as (D1) because market supply curve is horizontal at that price. Profits and Losses in the Short-Run: • Economic profit (or loss) per sweater is price, P, minus average total cost, ATC. So economic profit (or loss) is (P – ATC) x Q. If price equals average total cost, a firm breaks even – the entrepreneur makes normal profit. If price exceeds average total cost the firm makes an economic profit. If the price is less than average total cost, the firm incurs an economic loss. Three Short-run outcomes for the firm 10 Break-even Point ATC Economic loss Entry and Exit: • New firms enter a market in which existing firms are making an economic profit • As new firms enter a market, the market price falls and the economic profit of each firm decreases • Entry occurs in a market when new firms come into the market and the number of firms increases • Exit occurs when existing firms leave a market (normally when they are having an economic loss) and the number of firms decreases • As firms leave a market, the market price rises and the economic loss incurred by the remaining firms decreases • Entry and exit stop when firms make zero economic profit • Entry results in an increase in the market output, but each firm’s output decreases. Because the price falls, each firm moves down its supply curve and produces less. Because the number of firms increases, the market produces more. 11 • Exit results in a decrease in market output, but each firm’s output increases. Because the price rises, each firm moves up its supply curve and produces more. Because the number of firms decreases, the market produces less. • Check page 284 for example on the graphs work! • When economic profit and economic loss have been eliminated and entry and exit stopped, a competitive market is in long-term equilibrium. (this rarely happens) Changing Taste and Advancing Technology • Changes in technology are constantly lowering the costs of production • The demand for and supply of some items increases and the demand for and supply of others decreases • The market for recorded music illustrates changes in demand that arise from changing tastes and changes in supply that arise from advances in technology Permanent Change in Demand: • A decrease in demand shifts the market demand curve leftwards. • These graphs illustrates the effects of a permanent decrease in demand when the market is in long-run equilibrium External Economies and Diseconomies: • External Economies are factors beyond the control of an individual firm that lower the firm’s costs as the market output increases. 12 • External Diseconomies are factors outside the control of a firm that raise the firm’s costs as the market output increases. • Long-run market supply curve shows how the quantity supplied in a market varies as the market price varies after all the possible adjustments have been made, including changes in each firm’s plant and the number of firms in the market. Technological Change • New technologies are constantly discovered that lower cost techniques of production • New technology enables firms to produce at lower average cost and lower marginal cost —firms’ cost curves shifts downward • Firms that adopt the new technology make an economic profit (cost curves shift downward) • With lower costs, firms are willing to supply a given quantity at a lower price or, equivalently, they are willing to supply a larger quantity at a given price. (market supply increases and market supply curve shifts rightward. Efficient Use of Resources: • Resources are used efficiently when we produce the goods and services that people value most highly. If someone can be better off without anyone else be worse off, resources are not being used efficiently. - (Ex. suppose we produce a computer that no one wants and no one will ever use, and, at the same time, some people are clamouring for more video games. If we produce fewer computes and reallocate the unused resources to produce more video games, some people will be better off and no one will be worse off) • This situation arises when marginal social benefit equals marginal social cost • When market for a good or service is in equilibrium, the gains from trade are maximized CHAPTER 13: MONOPOLY Monopoly is a market: • That produces a good or service for which no close substitute exists • In which there is one supplier that is protected from competition by a barrier preventing the entry of new firms selling that good or service How monopoly arises: Monopoly has two key features: 13 • No close substitutes - if a good has a close substitute, that firm effectively faces competition from the producers of the substitute - a monopoly sells a good that has no close substitute • Barrier to entry - A constraint that protects a firm from potential competitors is called a barrier to entry - Three types of barriers are: 1. Natural 2. Ownership 3. Legal Natural Barrier to Entry: • They create a natural monopoly - Natural monopoly is an industry in which economies of scale enable one firm to supply the entire market at the lowest possible cost. (Ex. Firms that deliver gas, water, electricity to our homes) Ownership Barriers: • An ownership barriers to entry occurs if one
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