Econ Midterm 2

What is the difference between short run and long run?

In the short run at least one factor of production is fixed and in the long run all factors of production are variable.

What is the economic interpretation of zero profits?

The concept of zero profit implies that the firm makes enough revenue to cover all the costs incurred including the enterpreneur's labor cost.

Explain the concept of diminishing technical rate of substitution

The technical rate of substitution measures the trade-off between the two inputs while keeping output constant. The diminishing technical rate of substitution implies that as the amount of one input is increased while adjusting the other input, the TRS declines. In other words, as we continue to trade one input for the other, initially in order to get 1 extra unit of input 1 we have to give up a small amount of input 2, but as the tradeoff continues, in order to get 1 more unit of input 1 we must give up a much larger amount of input 2 as compared to the initial amount.

What are the two assumptions we make about the technology of a production function?

The technology of a production function must be: - monotonic - if increase among of one of inputs, should be able to produce as much output as you were producing originally - convex - if there are 2 ways of producing y amounts of output using (x1, x2) and (z1, z2), the weighted average will produce at least y units of output

What are the assumptions required to have a perfectly competitive market?

There must be many sellers, homogeneous good and they must display price taking behaviour.

The average cost function _______ in the case of decreasing returns to scale.

increases

What are factors of production?

inputs to production

When average variable cost is decreasing, MC ________ the AVC.

less than

What is sunk cost, explain with an example.

A cost that the firm has already incurred and cannot be recovered. Ex. Paint

What is the difference between a fixed factor and a variable factor of production?

A fixed factor of production is an input which is used in a fixed amount to produce the output. A variable factor of production is an input whose amount can be changed when it is being used to produce the output.

What are the three constraints that a profit-maximizing firm faces?

A profit maximizing firm faces the following three constraints: Technological constraints- represented by the production function Economic constraint-represented by the cost function Market costraint- the firm can sell only as much output as the consumers are willing to buy.

What are quasi-fixed factors of production? Explain with an example.

A quasi-fixed factor of production is an input which is used in a fixed amount to produce the output but it will be used only when a positive amount of the output is produced. Example: Electricity, a business will need to pay the electricity bill if and only if they produce a positive amount of output and thereby use electricity as an input to produce the output. If no output is produced, the machines are not used, electricity is not used.

f(x1, x2) = Ax1^ax2^b What is the economic interpretation of A, a and b.

A: The technology parameter, amount of output produced when we use one unit of each input. a: how the amount of output responds to changes in input 1 b: how the amount of output responds to changes in input 2 Alternatively, a, b can be interpreted as the proportions of the two inputs used.

If a firm makes negative profits in the short run, under what condition will the firm it continue to stay in business?

AC > P ≥ AVC

What are barriers to entry? Explain with an example.

Barriers to entry are conditions that restrict new firms from entering the market. Example: patent rights, if firm A holds the patent rights to a certain technology that is required to produce the output, other firms cannot enter the market, since they do not have the technology required to produce the good.

Explain the different kinds of factors of production with an example for each type.

Factors of production can be divided into three categories: Capital goods, that is inputs that are produced goods such as computers, printers, desk and chairs etc. Land, the physical property on which either the factory or plant is set up or incase of farming the land itself is used as an input. Labor, the workers employed to work for the company or business.

Why do firms make zero profit in the long run under perfect competition?

In perfect competition there is free entry and exit of firms. This implies that if the existing firms in the market make a positive profit, this will act as an incentive to enter for other firms. New firms will enter the market and this will increase the market supply and thus decrease the market price, driving the profits down to zero. If the existing firms in the marketmake negative profits, this will force some firms to leave the market, thereby decreasing themarket supply and driving up the market price till the firms earn zero profit. Hence due to the condition of free entry and exit, in the long run the firms make zero profit.

Why can the long run cost never exceed the short run cost?

In the short run the firm has at least one fixed factor of production and must minimize his costs subject to the constraint of the fixed factor of production. However in the long run, the firm can choose all his factors of production, that is all the inputs are variable. The firm will take advantage of this and choose that amount of the fixed factor that minimizes his cost. Thus the long run cost must be less than or equal to the short run constant but never exceed it.

Define increasing returns to scale.

Increasing returns to scale is a type of technology wherein doubling the inputs produces more than double the ouput.

What are the features of perfect or pure competition?

Many sellers Homogeneous good Price taking behaviour Free entry and exit

Under what condition should the firm shut down in the long run?

P < AC

In a world with two inputs x1 and x2 and one output y, we have the marginal product of input 1 as MP1= ∆y/∆x1 = 7 What is the economic interpretation of the above equation?

The above equation implies that, if we increase input 1 by 1 unit, output will increase by 7 units.

Why does the average cost curve have a U shape?

The average fixed cost (AFC) decreases as output increases while the average variable cost (AVC) eventually increases as output increases. The average cost (AC) is the summation of the average fixed and the average variable cost, hence initially the fall in AFC is more than the increase in the AVC and the AC curve falls; as output is increased, eventually the rise in AVC is more than the fall in AFC and the AC curve increases, thus giving it a u shape.

What is diminishing marginal product?

The concept of diminishing marginal product states that as we employ more of one input while keeping the other fixed, the additional output produced by each additional unit of input employed will decrease.

Define producers' surplus.

The difference between the price the producer is willing to sell the good at and the price the producer actually sells the good at.

What are the three conditions that must be fulfilled to derive the supply curve of a competitive firm?

The firm must be producing where P = MC. The supply curve must lie along the upward sloping part of the marginal cost curve. P ≥ AVC

What is the difference between fixed and quasi-fixed cost?

The fixed cost is the cost associated with the fixed factor of production (that is, the input that is used in a fixed amount in the short run) and the quasi-fixed cost is the cost associated with the quasi-fixed factor of production (that is the input that is used in a fixed amount only when a positive amount of output is produced).

What is opportunity cost?

The loss incurred from the next best alternative when a choice is made.

The area beneath the marginal cost curve up to y gives us the variable cost of producing y units of output. Explain the logic behind this statement.

The marginal cost curve measures the cost of producing each additional unit of output. Adding the cost of producing each unit of output gives us the total cost of production sans the fixed cost. Hence if y is the amount of output produced, then the area beneath the MC curve is equivalent to adding the variable cost of producing each unit output.

What is the difference between market demand curve and demand curve in the case of perfect competition?

The market demand curve measures the relationship between the market price and the total amount of the product being sold (total output produced by all the firms in the market) while the demand curve facing the firm measures the relationship between the market price and the output sold by a single firm.

What is a production function?

The production function gives you the maximum possible output that you can get from a given amount of inputs.

What is a production set?

The set of all all combinations of inputs and output that are produced in a techno-logically feasible way is called a production set.

What is the difference between long run and short run cost function?

The short run cost is the cost associated with the variable and fixed factor of production while the long run cost is associated only with the variable factors of production (given that all factors of production are variable in the long run).

What is the shut down condition?

The shutdown condition is the point at which the firm should leave the market. In the short-run if the firm's average variable cost lies above the market price, that is the firm is unable to cover its variable cost, it should shut down in the short run.

The average cost function ________ in the case of increasing returns to scale.

decreases

When average variable cost is at its minimum, MC _________ the AVC.

equal to

When average variable cost is increasing, MC ___________ the AVC.

more than

The average cost function _________ in the case of constant returns to scale.

remains constant