Microeconomics - Chapter 6: The Costs of Production
Law of Supply
According to this law, a firm is willing to produce and sell a greater quantity of a good when the price of the good increases.
The supply curve has an upward slope
Firms
Firm's objective
The goal of a firm is to maximize profit
Profit = Total Revenue (TR) - Total Cost (TC)
Revenue: sale of its output. Cost: market value of the inputs used in production
Firm's cost of production includes all the opportunity costs of making its output
include both explicit & implicit cost
Explicit Cost
Implicit Cost
Input costs that require a direct outlay of money, like worker wag
Input costs that do not require a direct outlay of money, like rental value of a property
Economic Profit
Measured by economics as firm's total revenue minus total cost, including both explicit & implicit cost
EP = TR - TC(IC + EC)
Accounting profit
Measured by accountants, is the firm's TR minus only explicit cost
AP = TR - TC (only EC)
When TR > IC + EC, firm earns economic profit
Economic profit is smaller than accounting profit
Production Function
The relationship b/w quantity of inputs and the quantity of output in production process
q = f(L, K, etc.)
Cost Function
Relationship b/w the quantity of output, q, & cost of producing that output using combination of the input
C = C(q)
Contribution of each input to production of output.
Marginal Product
In the production process is the increase in output that arises from an additional unit of that input
MPx = delta q / delta X
Diminishing Marginal Product
The property where the MP of an input declines as the Q of the input increases
The slope measures marginal product of an input
When the MP declines, the curve flattens
Production Costs
C = wL + rK + etc
The optimal combination is the 1 with the smallest cost to produce q. Known as:
Cost-minimizing cmobination of inputs
If the cost-minimizing combination it is known as:
Determines pricing decisions of the firm under different market structure.
This function is also known as Total Cost
Cost of Production (TC)
Fixed Cost (FC)
Variable Cost (VC)
Those cost that do not vary with the quantity of output produced
Those costs do vary with the quantity of output produced
TC = FC + VC
Average Cost
Can be determined by dividing the firm's costs by the quantity of output it produces
ATC = TC / q
AFC = FC/q +
AVC = VC/q
Marginal Cost (MC)
Measures increase in TC that arises from extra unit of production
MC = delta TC / delta q
Cost Curves
MC rises with the quantity produced (reflect the property DMP)
The average TC curve is U-shaped
Bottom of the U-shaped ATC curve shows the quantity (q) that minimizes the average TC. This quantity is known as:
Efficient Scale
Relationship b/w MC & AC
When MC < ATC, ATC is falling
When MC > ATC, ATC is rising
Quantity that minimizes average TC
3 Important properties of Cost Curve
- MC eventually rises as the quantity of output increases
- ATC is U-Shaped
- The MC curve crosses the ATC curve at the minimum of ATC
Costs in Short & Long run
In short run, many inputs are fixed, thus, most costs are fixed. hence why in short run many if firm's decision are limited
In longrun, most inputs can be changed & are variable, thus most fixed cost can become variable. A firm's long run cost-curve differ from its short-run cost curves. In long run, a firm has more flexibility and should make better or at least as good as choices in short run
Thus, the long-run cost is always lower than the short-run cost
Economies of scale
Property whereby long-run ATC falls as the quantity of output increases.
Diseconomies of scale
Property whereby the ATC rises as the quantity of ouptut increases
Constant return to scale
Property whereby long-run ATC stays the same as the quantity of output increases
Profit Maximization
Profit = TR - TC
Produce the quantity that maximizes the above difference
To maximize the profit
When MR > MC
Increase q to increase profit, thus profit is not maximized
When MR < MC
When MR = MC
Decrease q to increase profit, thus profit is not maximized
Changes in q cannot improve profit, this profit is maximized
Generla condition to profit maximization by firm