MGEA02H3 Chapter Notes - Chapter 7: Average Variable Cost, Diminishing Returns, Marginal Product
DepartmentEconomics for Management Studies
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Chapter 7: Producers in the Short Run
7.1 – WHAT ARE FIRMS
Financing of Firms
The money a firm raises for carrying on its business is sometimes called its financial
The basic types of financial capital used by firms are equity and debt.
Equity is the funds provided by the owners of the firm.
Debt is the funds borrowed from creditors outside the firm.
Goals of Firms
All firms are assumed to be profit-maximizers, seeking to make as much profit for their
owners as possible.
Each firm is assumed to be a single, consistent decision-making unit.
The desire to maximize profits is assumed to motivate all decisions made within a firm,
and such decisions are assumed to be unaffected by the peculiarities of the persons
making the decisions and by the organizational structure in which they work.
7.2 – PRODUCTION, COSTS, AND PROFITS
Factors of production: land, labour and capital.
The production function describes the technological relationship between inputs that a
firm uses and the output that it produces.
Costs and Profits
Economic Versus Accounting Profits
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Accounting profits = Revenues – Explicit costs
By explicit costs, we mean the costs that actually involve a purchase of goods or services
by the firm.
oExamples: the hiring of workers, the rental of equipment, interest payments on
debt, and the purchase of intermediate inputs.
Economic profits (pure profit) = Revenues – (Explicit costs + Implicit costs)
Implicit costs are items for which there is no market transaction but for which there is
still an opportunity cost for the firm that should be included in the complete measure of
oExamples: opportunity cost of owner’s time and opportunity cost of owner’s
Implicit costs are just as important as explicit costs. Economists include both implicit
and explicit costs in their measurement of profits, whereas accounting profits include
only explicit costs. Economic profits are therefore less than accounting profits.
Profits and Resource Allocation
Economic profits and losses play a crucial signaling role in the workings of a free-market
Economic profits/losses in an industry are the signal that resources can profitable be
moved elsewhere into the industry.
Zero economic profits have no incentive for resources to move into or out of industry.
Pi (profit) = TR – TC
We can best focus on essentials by dealing with only two inputs – labour and capital. (Q =
Time Horizons for Decision Making
Economists classify the decisions that firm make into three types
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