Unit 3 Economics Review

Module 54

The Production Function

Accounting Profit

The accounting profit of a business is its total revenue minus its explicit cost and depreciation. The accounting profit is the number that someone has to report on her income tax forms and that she would be obliged to report to anyone thinking of investing in her business. (Krugman 531)

Economic Profit

The total revenue she receives minus her opportunity cost, which includes implicit as well as explicit costs. In general, when economists use the simple term profit, they are referring to economic profit. (We adopt this simplification in this book.)

Concentration Ratios

They measure the percentage of industry sales accounted for by the "X" largest firms.

Total Cost Equation

Total Cost = Fixed Cost + Variable Cost or TC = FC + VC

Module 55

Firm Costs:

Minimum-Cost Output

(Diagram pg. 587)

Oligopolist

A producer in such an industry.

Module 52

Defining Profit

Module 59

Graphing Perfect Competition:

Explicit Cost

It is the form of actual cash outlays.

Normal Profit

Most of us would generally think earning zero profit was a bad thing. After all, a firm's goal is to maximize profit—profit is what firms are after! However, an economic profit equal to zero is not bad at all. An economic profit of zero means that the firm could not do any better using its resources in any alternative activity. Another name for an economic profit of zero is a normal profit.

Break-Even Price

Of a price-taking firm it is the market price at which it earns zero profits.

Marginal Revenue

The marginal benefit of that unit is the additional revenue generated by selling it; this measure has a name—it is called the marginal revenue of that output. The general formula for marginal revenue is: Marginal Revenue = Change in Total Revenue Generated by One Addition Unit of Output = Change in Total Revenue/Change in Quantity of Output or MR = ∆TR/∆Q

Diminishing Returns to an Input

when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input.

P < minimum ATC

Firm unprofitable. Exit from industry in the long run. Profitability condition (minimum ATC = break-even price)

Production Function

It is the relationship between the quantity of inputs a firm uses and the quantity of output it produces.

Monopoly

An industry controlled by a monopolist.

Optimal Output Rule Part One

Find the profit-maximizing quantity by calculating the total profit at each quantity for comparison. Then we will use marginal analysis to determine the optimal output rule, which turns out to be simple: as our discussion of marginal analysis in Module 1 suggested, a producer should produce up until marginal benefit equals marginal cost.

P = minimum ATC

Firm breaks even. No entry into or exit from industry in the long run. Profitability condition (minimum ATC = break-even price)

P = minimum AVC

Firm indifferent between producing in the short run or not. Just covers variable cost. Production Condition (minimum AVC = shut-down price)

P > minimum AVC

Firm produces in the short run. If P < minimum ATC, firm covers variable cost and some but not all of fixed cost. If P > minimum ATC, firm covers all variable cost and fixed cost. Production Condition (minimum AVC = shut-down price)

P > minimum ATC

Firm profitable. Entry into industry in the long run. Profitability condition (minimum ATC = break-even price)

P < minimum AVC

Firm shuts down in the short run. Does not cover variable cost. Production Condition (minimum AVC = shut-down price)

Shut-Down Price

A firm will cease production in the short run if the market price falls below the shut-down price, which is equal to minimum average variable cost.

In other words, in this industry supply is perfectly elastic in the long run

Given time to enter or exit, firms will supply any quantity that consumers demand. An example is beach front resort hotels, which must compete for a limited quantity of prime beachfront property. Industries that behave like this are said to have increasing costs across the industry. A downward-sloping industry supply curve indicates decreasing costs across the industry.

Profitability Rules

If the firm produces a quantity at which TR > TC, the firm is profitable. If the firm produces a quantity at which TR = TC, the firm breaks even. If the firm produces a quantity at which TR < TC, the firm incurs a loss.

Module 57

Introduction to Market Structure:

Module 58

Introduction to Perfect Competition:

Implicit Cost

It does not involve an outlay of money; instead, it is measured by the value, in dollar terms, of the benefits that are foregone. For example, the implicit cost of a year spent in college includes the income you would have earned if you had taken a job instead. (Krugman 530)

Natural Monopoly

It exists when economies of scale provide a large cost advantage to a single firm that produces all of an industry's output.

U-Shaped Average Total Cost Curve

It falls at low levels of output and then rises at higher levels. The average total cost curve has a distinctive U shape that corresponds to how average total cost first falls and then rises as output increases. Economists believe that such U-Shaped Average Total Cost Curves are the norm for firms in many industries.

Patent

It gives an inventor a temporary monopoly in the use or sale of an invention.

Copyright

It gives the creator of a literary or artistic work the sole right to profit from that work.

Economic Profit

It incorporates all of the opportunity cost of resources owned by the firm and used in the production of output, while accounting profit does not.

Price-Taking Consumer

It is a consumer whose actions have no effect on the market price of the good or service he or she buys.

Variable Cost (VC)

It is a cost that depends on the quantity of output produced. It is the cost of the variable input.

Fixed Cost

It is a cost that does not depend on the amount of output produced and can be altered only in the long run.

Fixed Cost (FC)

It is a cost that does not depend on the quantity of output produced. It is the cost of the fixed input. In business, a fixed cost is often referred to as an "overhead cost."

Sunk Cost

It is a cost that has already been incurred and is nonrecoverable. A sunk cost should be ignored in a decision about future actions.

Explicit Cost

It is a cost that requires an outlay of money. For example, the explicit cost of a year of college includes tuition. (Krugman 530)

Price-Taking Firm

It is a firm whose actions have no effect on the market price of the good or service it sells.

Standardized Product (Commodity)

It is a good that when consumers regard the products of different firms as the same good.

Perfectly Competitive Market

It is a market in which all market participants are price-takers.

Monopolistic Competition

It is a market structure in which there are many competing firms in an industry, each firm sells a differentiated product, and there is free entry into and exit from the industry in the long run.

Maximizing Economic Profit

It is a measure based on the opportunity cost of resources used by the firm.

Perfectly Competitive Industry

It is an industry in which firms are price-takers.

Oligopoly

It is an industry with only a small number of firms.

Fixed Input

It is an input whose quantity is fixed for a period of time and cannot be varied.

Variable Input

It is an input whose quantity the firm can vary at any time.

Zero Economic Profit

It is know as a normal profit.

Accounting Profit

It is profit calculated using only the explicit costs incurred by the firm.

Barrier to Entry

It is something that prevents other firms from entering the industry and to earn economic profits, a monopolist must be protected by it.

Marginal Cost

It is the added cost of doing something one more time. In the context of production, marginal cost is the change in total cost generated by producing one more unit of output. (550)

Implicit Cost

It is the benefits forgone in the next best use of the firm's resources.

Average Fixed Cost (AFC)

It is the fixed cost per unit of output. It is fixed cost divided by the quantity of output, also known as the fixed cost per unit of output. For example, if Selena's Gourmet Salsas produces 4 cases of salsa, average fixed cost is $108/4 = $27 per case. AFC = (Fixed Cost)/(Quantity of Output) = FC/Q

Market Share

It is the fraction of the total industry output accounted for by that firm's output.

Monopolist

It is the only producer of a good that has no close substitutes.

Implicit Cost of Capital

It is the opportunity cost of the capital used by a business; it reflects the income that could have been earned if the capital had been used in its next best alternative way. It is just as much a true cost as if someone had rented her equipment instead of owning it.

Minimum-Cost Output

It is the quantity of output at which average total cost is lowest—it corresponds to the bottom of the U-shaped average total cost curve.

Herfindahl-Hirschman Index (HHI)

It is the square of each firm's share of market sales summed over the industry. It gives a picture of the industry market structure.

Long Run

It is the time period in which all inputs can be varied.

Average Variable Cost (AVC)

It is the variable cost per unit of output. It is variable cost divided by the quantity of output, also known as variable cost per unit of output. At an output of 4 cases, average variable cost is $192/4 = $48 per case. AVC = (Variable Cost)/(Quantity of Output) = VC/Q

Average Total Cost or Average Cost

It is total cost divided by quantity of output produced.The average total cost is total cost divided by the quantity of output produced; that is, it is equal to total cost per unit of output. If we let ATC denote average total cost, the equation looks like this: ATC = (Total Cost)/(Quantity of Output) = (TC)/(Q)

Economies of Scale

It is when long-run average total cost declines as output increases.

Diseconomies of Scale

It is when long-run average total cost increases as output increases.

Free Entry and Exit

It is when new firms can easily enter into the industry and existing firms can easily leave the industry.

Decreasing Returns to Scale

It is when output increases less than in proportion to an increase in all inputs.

Increasing Returns to Scale

It is when output increases more than in proportion to an increase in all inputs. For example, with increasing returns to scale, doubling all inputs would cause output to more than double.

Long-Run Market Equilibrium

It is when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur.

Short-Run Market Equilibrium

It is when the quantity supplied equals the quantity demanded, taking the number of producers as given.

Profit and Loss Determination

It is whether the market price is more or less than the farm's minimum average total cost.

The Principle of Marginal Analysis

It provides a clear message about when to stop doing anything: proceed until marginal benefit equals marginal cost. To apply this principle, consider the effect on a producer's profit of increasing output by one unit. (Krugman 537)

Price-Taking Firm's Optimal Output Rule

It says that a price-taking firm's profit is maximized by producing the quantity of output at which the market price is equal to the marginal cost of the last unit produced.

Short-Run Individual Supply Curve

It shows how an individual firm's profit-maximizing level of output depends on the market price, taking fixed cost as given.

Marginal Revenue Curve

It shows how marginal revenue varies as output varies.

Marginal Cost Curve

It shows how the cost of producing one more unit depends on the quantity that has already been produced.

Total Product Curve

It shows how the quantity of output depends on the quantity of the variable input, for a given quantity of the fixed input. The physical quantity of output, bushels of wheat, is measured on the vertical axis; the quantity of the variable input, labor (that is, the number of workers employed), is measured on the horizontal axis. The total product curve here slopes upward, reflecting the fact that more bushels of wheat are produced as more workers are employed.

Short-Run Industry Supply Curve

It shows how the quantity supplied by an industry depends on the market price, given a fixed number of firms.

Long-Run Industry Supply Curve

It shows how the quantity supplied responds to the price once producers have had time to enter or exit the industry.

Total Cost Curve

It shows how total cost depends on the quantity of output.

Long-Run Average Total Cost Curve

It shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output.

Industry Supply Curve

It shows the relationship between the price of a good and the total output of the industry as a whole. But here we take some extra care to distinguish between the individual supply curve of a single firm and the supply curve of the industry as a whole.

Module 56

Long-Run Costs and Economies of Scale:

Module 60

Long-Run Outcomes in Perfect Competition:

Marginal Product

Of an input is the additional quantity of output produced by using one more unit of that input.

Total Cost (TC)

Of producing a given quantity of output is the sum of the fixed cost and the variable cost of producing that quantity of output.

Three Conditions of Monopolistic Competition

One a large number of competing firms two differentiated products, and three free entry into and exit from the industry in the long run.

The system of market structure is based on two dimensions

One the number of firms in the market (one, few, or many) and two whether the goods offered are identical or differentiated.

Profit=(P−ATC)×Q (Because

P is equal to TR/Q and ATC is equal to TC/Q)

In general, a firm's profit equals its total revenue—which is equal to the price of the output times the quantity sold, or P × Q—minus the cost of all the inputs used to produce its output, its total cost. That is

Profit = Total Revenue − Total Cost (how economists define and calculate profit.) (Krugman 530)

Module 53

Profit Maximization

Profit Per Unit of Output

Profit/Q=TR/Q−TC/Q

Profit Equation

Profit=TR−TC

Optimal Output Rule Part Two

The application of the principle of marginal analysis to the producer's decision of how much to produce is called the optimal output rule, which states that profit is maximized by producing the quantity at which the marginal revenue of the last unit produced is equal to its marginal cost. As this rule suggests, we will see that people maximize their profit by equating marginal revenue and marginal cost.

Concentration Ratio Example

The four-firm concentration ratio or the eight-firm concentration ratio.

The Diminishing Returns Effect

The larger the output, the greater the amount of variable input required to produce additional units, leading to higher average variable cost.

The Spreading Effect

The larger the output, the greater the quantity of output over which fixed cost is spread, leading to lower average fixed cost.

The first column shows the quantity of output in bushels, and the second column shows Jennifer and Jason's total revenue from their output

The market value of their output. Total revenue, TR, is equal to the market price multiplied by the quantity of output: TR=P×Q

Imperfect Competition

When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized as this.

Constant Returns to Scale

When output increases directly in proportion to an increase in all inputs.

The Optimal Production Decision in the Short Run

When the market price is below the minimum average variable cost. When the market price is greater than or equal to the minimum average variable cost.

The market price of the good to the firm's break-even price, its minimum average total cost

Whenever the market price exceeds the minimum average total cost, the producer is profitable. Whenever the market price equals the minimum average total cost, the producer breaks even. Whenever the market price is less than the minimum average total cost, the producer is unprofitable.