Econ 301 Exam 3

short-run vs long-run expansion path

the short-run expansion path is horizontal at the fixed level of capital, the firm increases output by increasing the amount of labor it uses; the long-run expansion path is upward sloping because a firm increases output by using more of both inputs

opportunity cost (economic cost)

the value of the best alternative use of any input the firm employs

isocost line equation

C = wL + rK

slope of a Cobb-Douglas isoquant

MRTS = (-a/b)(K/L)

long-run average cost curve shape

U-shaped; increasing returns to scale, constant returns to scale, decreasing returns to scale

short-run average cost curve shape

U-shaped; initially downward sloping because the average fixed cost curve is downward sloping (spreading the fixed cost over more units of output lowers the average fixed cost per unit); the upward slope at higher levels of output is due to diminishing marginal returns

does a change in factor prices affect the slopes of the isoquant or isocost lines?

a change in input prices does not affect the isoquant, which depends only on technology (the production function); a change in the cost of one of the inputs affects the mix of inputs that a firm uses and the changes the slope of the isocost line

price taker

a firm that cannot significantly affect the market price for its output or the prices at which it buys inputs

competitive market structure

a market in which many firms produce identical products and firms can easily enter and exit the market

short run entry and exit

a new firm cannot enter a market in the short run because it cannot quickly build a new plant or make other large capital expenditures; a firm cannot fully exit in the short run, it can choose not to produce, but it is stuck with some fixed inputs

constant returns to scale

the average cost of production remains constant as output increases

isocost line

all the combinations of inputs that require the same total expenditure; straight line whose slope depends on relative prices of inputs; intersect the axes at C/r and C/w; slope equals -w/r

short-run output decision for a competitive firm

because a competitive firm's marginal revenue equals the market price, a profit-maximizing competitive firm produces the amount of output at which its marginal cost equals the market price (MC = MR = p)

isocost vs budget line

both are straight lines whose slopes depend on relative prices; the consumer has one budget constraint whereas a firm faces many isocost lines depending on level of production at which it chooses to operate

learning curve

the relationship between average costs and cumulative output

a firm chooses the lowest-cost (economically efficient) way to produce a given level of output by

combining cost information contained in the isocost lines with information about efficient production summarized by an isoquant

a market is competitive if

each firm in the market is a price taker

residual demand curve

faced by an individual firm; the market demand that is not met by other sellers at any given price; the residual demand at any given price is the horizontal difference between the market demand and the supply curve of the other firms

output decision

if a firm produces, what output level, q*, maximizes its profit or minimizes its loss?

long-run average cost curve shape and smoothness

in its long-run planning a firm chooses its plant size and investment in capital based on the desired level of output; if a firm has limited plant sizes to choose from, the long-run average cost curve is scalloped; if a firm may choose any plant size it wants, it is smooth and U-shaped; the short-run cost is at least as high as long-run cost and is higher if the wrong level of capital is used in the short run

a firm's average cost may fall over time for 3 reasons

increasing returns to scale; technological progress; learning by doing

shutdown decision

is it more profitable to produce q* or to shut down and produce no output?

short-run competitive firm supply curve

its marginal cost curve above its minimum average variable cost (the profit-maximizing output at each market price is determined by the intersection of the market price and the firm's marginal cost curve, but if the market price falls below its minimum average variable cost it shuts down)

if isoquant is not smooth, the lowest-cost method of production can only be determined using the

lowest isocost rule

a firm's three equivalent approaches to pick the lowest cost combination of inputs to produce a given level of output when isoquants are smooth

lowest isocost rule; tangency rule; last dollar rule

tangency rule

pick the bundle of inputs where the isoquant is tangent to the isocost line; set MRTS equal to -w/r

last dollar rule

pick the bundle of inputs where the last dollar spent on one input gives as much extra output as the last dollar spent on any other input; MPL/w = MPK/r

lowest isocost rule

pick the bundle of inputs where the lowest isocost line touches the isoquant; show that other practical combinations of input produce less than q-bar units or produce q-bar units at greater cost

general Cobb-Douglas production function

q = AL^aK^b

economic profit

revenue minus opportunity cost; business profit minus opportunity cost; if economic profit is zero, then a firm is earning the same return on its investment as it would from putting the money in its next best alternative

cost-minimizing combination of inputs is determined by

tangency between the q equals q-bar isoquant curve and the lowest isocost line; -MRTS = -w/r; the rate at which the firm can trade capital for labor in the input markets equals the rate at which it can substitute capital for labor in the production process

economies of scale

the average cost of production falls as output increases

diseconomies of scale

the average cost of production increases as output increases

marginal profit

the change in profit a firm gets from selling one more unit of output; the derivative of the profit function with respect to quantity; the slope of the profit curve; dpi/dq; MR - MC

marginal revenue

the change in revenue a firm gets from selling one more unit of output; dTR/dq

long-run expansion path

the cost-minimizing combination of inputs for each output level; a line through the points of tangency between isocost and isoquant lines; shows the same relationship between long-run cost and output as the long-run cost curve

firms must take market price

the firm can sell as much as it wants at that price so it has no incentive to lower price, and it cannot increase the price at which it sells its product because it demand is perfectly elastic

if market price is between average total cost and average variable cost

the firm makes a loss, but it reduces its loss by operating rather than shutting down because its revenue exceeds its variable cost

if market price is above average cost

the firm makes a profit

factor price changes

the firm minimizes its new cost by substituting away from the now relatively more expensive input toward the now relatively less expensive input

3 equivalent rules to choose how much output to produce

the firm sets its output where its profit is maximized; the firm sets its output where its marginal profit is zero; the firm sets its output where its marginal revenue equals its marginal cost

shutdown rule

the firm shuts down only if it can reduce its loss by doing so; the firm shuts down only if its revenue is less than its avoidable cost (the sunk fixed cost is irrelevant to the shut-down decision)

if market price is less than the average variable cost

the firm will shut down in the short run because its revenue is less than its variable cost, so it makes a greater loss by operating than by shutting down because it loses money on each unit sold in additions to its fixed cost

long-run average cost curve as the envelope of short-run average cost curves

the long-run average cost curve is tangent at one point to each possible short-run average cost curve

five characteristcs of perfectly competitive markets that force firms to be price takers

the market consists of many buyers and sellers; all firms produce identical products; all market participants have full information about price and product characteristics; transaction costs are negligible; firms can easily enter and exit the market

in the short run a competitive firm shuts down if

the market price is less than its short-run average variable cost at the profit-maximizing quantity

market structure

the number of firms in the market, the ease with which firms can enter and leave the market, and the ability of firms to differentiate their products from those of their rivals

learning by doing

the productive skills and knowledge that workers and managers gain from experience; in the short-run extra production reduces a firm's average cost because of economies of scale, but in the long run, extra production reduces average cost because of learning by doing

marginal rate of technical substitution (MRTS)

the rate at which a firm can substitute capital for labor in the production process