Microeconomics Ch. 6-10

Roy opens up a latte stand for two hours during the most common break between final exams at his college. He spends $10 for ingredients and sells $60 worth of lattes. In the same two hours, he could have washed his neighbor's cars for $40. Roy has an accounting profit of ______ and an economic profit of______.

$50; $10 Revenue - explicit = accounting profit 60 - 10 = 50 Revenue - explicit - implicit= economic profit 60 - 10 - 40 = 10

accounting profit

- A cash concept. - Means: total revenue - explicit costs - The difference between dollars brought in and dollars paid out. - This is the amount reported for taxes purposes and on financial statements.

TR TC Quantity

- At any given quantity, total revenue minus total cost will equal profit. - One way to determine the most profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the largest amount.

Private firms

- Employ more than 500 workers - These small scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses

Market structure is a multidimensional concept that involves how competitive the industry is and is defined by questions such as these:

- How much market power does each firm in the industry possess? - How similar is each firm's product to the products of other firms in the industry? - How difficult is it for new firms to enter the industry? - Do firms compete on the basis of price, advertising, or other product differences?

Determining the Highest Profit by Comparing Total Revenue and Total Cost

- If you increase the number of units sold at a given price, then total revenue will increase. - If the price of the product increases for every unit sold, then total revenue also increases.

Economic Loss

- Occurs when total revenue is less than economic costs. - When a firm experiences an economic loss they may choose to stay in business or go out of business, depending upon the nature of their costs

What are the different market (aka industry) structures?

- Perfect Competition - Monopoly - Monopolistic Competition - Oligopoly.

What other forms do fixed costs can take?

- The cost of machinery or equipment to produce the product, research and development costs to develop new products, even an expense like advertising to popularize a brand name. - The level of fixed costs varies according to the specific line of business - e.g.) manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed.

How to read a Total revenue and total costs graph

- The horizontal axis shows the quantity of frozen raspberries produced in packs; - the vertical axis shows both total revenue and total costs, measured in dollars. - The total cost curve intersects with the vertical axis at a value that shows the level of fixed costs, and then slopes upward

Long Run

- The period of time when all costs are variable. - Depends on the specifics of the firm in question - it is not a precise period of time. e.g.) If you have a one-year lease on your factory, then the long run is any period longer than a year, since after a year you are no longer bound by the lease. No costs are fixed in the long run. A firm can build new factories and purchase new machinery, or it can close existing facilities

WHY ARE TOTAL COST AND AVERAGE COST NOT ON THE SAME GRAPH?

- Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output being produced. - These costs are measured in dollars. - If they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis. - If you graphed both total and average cost on the same axes, the average cost would hardly show.

Production involves a number of important decisions that define the behavior of firms. These decisions include, but are not limited to:

- What product or products should the firm produce? - How should the products be produced (i.e., what production process should be used)? - How much output should the firm produce? - What price should the firm charge for its products? -How much labor should the firm employ? * The answers to these questions depend on the production and cost conditions facing each firm. The answers also depend on the structure of the market (aka industry) for the product(s) in question.

Normal profit (zero economic profit)

- When a firm's total revenue is equal to its economic costs - The break even point for the firm

Marginal revenue curve

- additional revenue gained from selling one more unit. - a perfectly elastic demand curve for its product—that is, the firm's demand curve is a horizontal line drawn at the market price level. - This also means that the firm's marginal revenue curve is the same as the firm's demand curve which is the market price: Every time a consumer demands one more unit, the firm sells one more unit and revenue goes up by exactly the same amount equal to the market price.

Long run

- all resources are variable - firms will react to profits by increasing the size of their production capabilities by adding on to or building new factories, etc. - They will respond to losses by reducing production or exiting the market.

HOW CAN CITIES BE VIEWED AS EXAMPLES OF ECONOMIES OF SCALE?

- cities provide a large group of nearby customers, so that businesses can produce at an efficient economy of scale. - They provide a large group of workers and suppliers, so that business can hire easily and purchase whatever specialized inputs they need. - Cities are big enough to offer a wide variety of products - they are related to growth in the overall size of population and market in an area

HOW DO ECONOMIES OF SCALE COMPARE TO DIMINISHING MARGINAL RETURNS?

- diminishing marginal returns refers only to the short-run average cost curve, where one variable input (like labor) is increasing, but other inputs (like capital) are fixed. - Economies of scale refers to the long-run average cost curve where all inputs are being allowed to increase together. * it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change, and at the same time has increasing or constant economies of scale when all inputs change together to produce a larger-scale operation.

Production

- goes beyond manufacturing - it includes any process or service that creates value, including transportation, distribution, wholesale and retail sales

price taker (perfectly competitive firm)

- hypothetical extreme - a starting point for analyzing the other industry structures, and producers in a number of industries do face many competitor firms selling highly similar goods, in which case they must often act as price takers. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. - The market price is determined solely by supply and demand in the entire market and not the individual farmer. -Also, a perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market. - In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or, if profits are not possible, where losses are lowest. It can't choose the price it changes

variable costs

- incurred in the act of producing—the more you produce, the greater the variable cost. -Labor is treated as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. - Also include raw materials.

implicit costs

- more subtle but just as important - They represent the opportunity cost of using resources already owned by the firm. - Often for small businesses, they are resources contributed by the owners; (for example, starting and working in the business means giving up a formal salary, or using funds in a savings account to start the business means giving up the interest payments that would have been earned on these funds.)

Amazon demonstrates the significant advantages economies of scale

- no retail locations - sells online and delivers by mail. - offers almost any book in print, convenient purchasing, and prompt delivery by mail. -holds its inventories in huge warehouses in low-rent locations around the world. -The warehouses are highly computerized using robots and relatively low-skilled workers, making for low average costs per sale

How has Amazon changed the book selling industry and managed to crush its competition?

- production model and cost structure: it enabled Amazon to undercut the prices of its competitors even when factoring in the cost of shipping

marginal cost

- the additional cost of producing one more unit of output. - So it is not the cost per unit of all units being produced, but only the next one (or next few). - It can be calculated by taking the change in total cost and dividing it by the change in quantity.

The questions to help determine market structure characteristics are the following:

1. How many firms participate in the industry? One? A few? Many? 2. Is the product standardized or differentiated? In other words, can you tell the product produced by one firm from another? 3. How difficult is it to enter the industry? Are there barriers to entry? 4. Are individual firms price makers or price takers? 5. What are the forms of competition? For example, is there advertising, differentiation by location, accompanying services, etc.?

If the quantity demanded in the market is only slightly higher than the quantity at the minimum of the LRAC ...

A few firms will compete

Ogliopoly

A handful of firms in a market

High Price v. Low Price in TR

A higher price would mean that total revenue would be higher for every quantity sold. A lower price would mean that total revenue would be lower for every quantity sold

Profit margin

Average profit = price - average cost * This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive; if price is below average cost, then profits will be negative.

The marginal cost line intersects the average cost line exactly at the ______ of the average cost curve

Bottom * The reason why the intersection occurs at this point is built into the economic meaning of marginal and average costs.

variable costs can be _______, so they convey information about the firm's ability to cut costs in the present and the extent to which costs will increase if production rises.

Changed

Firm (business)

Combines input of entrepreneurial ability, labor, capital, land, and raw or finished component materials to produce goods and services. If it's successful, the outputs are more valuable than the inputs

As an input becomes more expensive (in this case, the labor input), firms will attempt to _____ on using that input and will instead shift to other inputs that are relatively less expensive.

Conserve

Marginal costs from the increase in production are greater than marginal revenues, and so profits would _______.

Decline

You will notice that what occurs on the production side is exemplified on the cost side. This is referred to as what?

Duality

Calculating Explicit & Implicit costs

Ex: Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he gets established. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. A law clerk could be hired for $35,000 per year. If these figures are accurate, would Fred's legal practice be profitable? 1. calculate the costs. You can take what you know about explicit costs and total them: Office ental: $50k Law clerk's salary: + $35k Total: $85k 2. Subtract the explicit costs from the revenue Revenue: $200k Explicit costs: - $85k Accounting profit: $115k 3. You need to subtract both the explicit and implicit costs to determine the true economic profit: Total revenues - explicit costs - implicit costs $200k - $85k- $125k = -$10k/ year * Fred would be losing $10,000 per year. That does not mean he would not want to open his own business, but it does mean he would be earning $10,000 less than if he worked for the corporate firm. Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm.

Theory of the Firm

Explains that firms behave in much the same way as consumers behave

The leviathan effect

Hits firms that become too large to run efficiently, across the entirety of the enterprise. Firms that shrink their operations are often responding to finding itself in the diseconomies region, thus moving back to a lower average cost at a lower output level.

The numerical calculations behind average cost, average variable cost, and marginal cost will change from firm to firm.

However, the general patterns of these curves, and the relationships and economic intuition behind them, will not change.

perfect competition

It happens when the following conditions occur: 1) there are many firms and many buyers in the market 2) each firm produces a standardized product - there is no way to differentiate one firm's product from another firm's product 3) firms can enter and leave the market without any restrictions—in other words, there is free entry and exit into and out of the market 4) firms within the market are price takers 5) sellers and buyers have all relevant information to make rational decisions about the product being bought and sold, therefore no advertising, etc. is needed.

formula for marginal cost

MC=change in TC/change in Q * marginal cost changes as the firm produces a greater quantity The firm's profit-maximizing choice of output will occur where MR = MC (or at a choice close to that point)

profit-maximizing quantity of production (Q) for a perfectly competitive firm will occur where marginal revenue is equal to marginal cost—that is, where...

MR = MC

A profit-seeking firm should keep expanding production as long as

MR > MC

formula for marginal revenue

Marginal revenue = 🔺in total revenue/ 🔺in quantity

explicit costs

Out-of-pocket costs that are made with dollars either via cash, check, or electronically wiring funds. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs.

the profit-maximizing rule for a perfectly competitive firm can also be written as a recommendation to produce at the quantity where _____.

P = MC.

A perfectly competitive firm is known as a _____ because the pressure of competing firms forces them to accept the prevailing equilibrium price in the market.

Price taker

Profit Equation

Profit = Total Revenue - Total Cost

A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. To understand why this is so, consider a different way of writing out the basic definition of profit:

Profit = Total revenue - Total Cost = (price)(quantity produced) - (Average Cost)(Quantity - the perfectly competitive firm can sell any number of units at exactly the same price. - It implies that the firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price. - When the perfectly competitive firm chooses what quantity to produce, then this quantity—along with the prices prevailing in the market for output and inputs—will determine the firm's total revenue, total costs, and ultimately, level of profits.

Expanding production into the zone where MR < MC will only _____ economic profits.

Reduce

If the marginal cost of production is below the average cost for producing previous units, then producing one more additional unit will ______ average costs overall

Reduce

Economies of scale

Refers to the situation where, as the quantity of output goes up, the cost per unit goes down. This is the idea behind "warehouse stores" like Costco or Walmart. In everyday language: a larger factory can produce at a lower average cost than a smaller factory.

New developments in production technology can ______ the long-run average cost curve in ways that can alter the size distribution of firms in an industry.

Shift

Fixed costs are often _____ that cannot be recouped. In thinking about what to do next, ____ should typically be ignored, since this spending has already been made and cannot be changed.

Sunk costs

Average total and variable costs measure _______ of producing some quantity of output.

The average costs

Economic costs

The sum of explicit costs and implicit costs

If the quantity demanded in the market far exceeds the quantity at the minimum of the LRAC...

Then many firms will compete

What do chemical engineers who design these plants have long used?

They call it the "six-tenths rule" A rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only six-tenths as much.

law of diminishing returns

When additional units of a variable input are added to fixed inputs after a certain point, the marginal product of the variable input declines. e.g.) adding more barbers will have less impact than the second one did. This is the pattern of diminishing marginal returns. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other's way. In this case, the addition of still more barbers would actually cause output to decrease. *The total costs of production will begin to rise more rapidly as output increases. Each additional input contributes less and less to overall production

long run equilibrium

Will be attained when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero.

If the quantity demanded in the market is less than the quantity at the minimum of the LRAC ...

a single-producer monopoly is a likely outcome

short run

a situation in which firms are producing with at least one fixed resource (such as the size of a factory) and incur fixed costs of production

Production technologies

alternative methods of combining inputs to produce output

In order to determine ______________ , the firm's total costs must be divided by the quantity of its output.

average cost

average profit

average profit = profit / Q produced = total revenue - total cost / Q produced = TR/QP - TC/QP = Average revenue - average cost

______________ occur when the marginal gain in output diminishes as each additional unit of input is added.

diminishing marginal returns

If a perfectly competitive market involves many firms selling identical products, then, in the face of such competition,

each of these firms must act as a price-taker.

The term ______________ describes a situation where the quantity of output rises, but the average cost of production falls.

economies of scale

constant returns to scale

expanding all inputs proportionately does not change the average cost of production

fixed costs

expenditures that do not change regardless of the level of production, at least not in the short term. Whether you produce a lot or a little, the fixed costs are the same. E.g.) when you sign a lease, the rent stays the same regardless of how much you produce, at least until the lease runs out

The analysis of costs begins by distinguish between two types of cost for the firm:

explicit and implicit.

When a firm looks at its total costs of production in the short run, a useful starting point is to divide total costs into two categories:

fixed costs (cannot be changed in the short run) and variable costs (can be changed)

A firm's ______________ consist of expenditures that must be made before production starts that typically, over the short run, ______________ regardless of the level of production.

fixed costs; do not change

agglomeration economies

help to explain why every economy, as it develops, has an increasing proportion of its population living in urban areas.

At the level of output where MR = MC, the firm should recognize that it has achieved the _________.

highest possible level of economic profits.

The economies of scale curve is a...

long-run average cost curve, because it allows all factors of production to change.

The term ______________ is used to describe the additional cost of producing one more unit.

marginal cost

to maximizing profits means looking at how changes in production affect ______ and ______.

marginal revenue; marginal cost

One of the unique circumstances for perfectly competitive firms is that _______.

price = AR = MR = Demand curve for the firm

low marginal costs of production first ______ average costs and then higher marginal costs _______.

pull down average costs; pull them up. * think of it as in terms of your own grades. If the score on the most recent quiz you take is lower than your average score on previous quizzes, then the marginal quiz pulls down your average. If your score on the most recent quiz is higher than the average on previous quizzes, the marginal quiz pulls up your average.

In order to determine the average variable cost, the firm's variable costs are divided by ______________.

quantity of output

Different choices about capital investment in the present will cause it to end up with different___________ in the future.

short-run average cost curves

long-run average cost curve

shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology

As labor becomes relatively more expensive, profit-seeking firms will seek to _____ the use of other inputs

substitute *e.g.) if there is a high wage economy aka Japan, U.S., Canada or Western Europe it is likely to use production technologies that conserve on the number of workers and focuses more on machines. in a lower-wage country like Mexico, China, or South Africa, it is likely to use production technologies with more workers and less machinery

What happens if the price drops low enough so that the total revenue line is completely below the total cost curve; that is, at every level of output, total costs are higher than total revenues?

suffer losses. But a profit-maximizing firm will prefer the quantity of output where total revenues come closest to total costs and thus where the losses are smallest.

short run average cost curve

the average total cost curve in the short term; shows the total of the average fixed costs and the average variable costs

If the firm is producing at a quantity of output where marginal revenue exceeds marginal cost, then,

the firm should keep expanding production.

If the price(=MR=AR=Demand curve) that a firm charges is lower than its average cost of production, ______.

the firm will suffer losses

total revenue

the income brought into the firm from selling its products. It is calculated by multiplying the price of the product times the quantity of output sold: Total Revenue=Price × Quantity

once production starts, total costs and variable costs rise. While variable costs may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This is caused by __________

the law of diminishing marginal returns

diseconomies of scale

the long-run average cost of producing each individual unit increases as total output increases * A firm or a factory can grow so large that it becomes very difficult to manage, resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other, and as failures to communicate lead to disruptions in the flow of work and materials. Not many overly large factories exist in the real world, because with their very high production costs, they are unable to compete for long against plants with lower average costs of production. some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses.

Private enterprise

the ownership of businesses by private individuals, is a hallmark of the U.S. economy.

if the LRAC curve has a flat-bottomed segment of constant returns to scale ...

then firms in the market may be a variety of different sizes.

If the LRAC curve has a single point at the bottom ...

then the firms in the market will be about the same size

average total cost

total cost divided by the quantity of output *sometimes referred to as average cost Average cost curves are typically U-shaped

______________ is calculated by taking the quantity of everything that is sold and multiplying it by the sale price.

total revenue

economic profit

total revenue minus total cost, including both explicit and implicit costs

average variable cost

variable cost divided by the quantity of output * Note that at any level of output, the average variable cost curve will always lie below the curve for average total cost. The reason is that average total cost includes average variable cost and average fixed cost

______________ include all of the costs of production that increase with the quantity produced.

variable costs