Chapter 6 & 7 - Vocabualary, Summary, Review, Practice Questions and More

If SCOPE is less than 0

then it is actually cheaper to produce Q1 and Q2 separately.

total cost

the sum of a firm's fixed and variable cost TC= FC+VC

average product

total quantity of output divided by the number of units of input used to produce it APL= Q/L

If the scope is greater than 0

the total cost of producing Goods 1 and 2 jointly is less than making the goods separately,

Marginal product of labor

= change in quality/change in labor

returns to scale

A change in the amount of output in response to a proportional increase in all the inputs.

Jim's Consulting is owned by James Smith. For the past year, Jim's Consulting had the following revenues and costs Revenues $600,000 Supplies $20,000 Electricity and water $10,000 Employee salaries $300,000 Jim's salary $250,000 James has the option of shutting down and renting out the building he owns for $60,000 per year. Additionally, James could go work for a larger consulting house for $275,000 per year. 1. What is Jim's Consulting's accounting cost? 2. What is Jim's Consulting's economic cost? 3. What is Jim's Consulting's economic profit?

1. Accounting cost : = 20,000 + 10,000 + 300,000 + 250,000 = 580,000 2.Economic cost = Accounting costs, + Building + larger consulting house = 580,000 + 60,000 + 25,000 580,000 + 60,000 + 25,000 = 665,000 You can not include both 250 and 275 or you are double counting 3. Economic profit = Revenues - accounting cost - economic cost = 600,000 - 580,000 + 65,000 600,000 - 665,000 = -$65,000

The ability to adjust capital inputs, which firms enjoy in the long run, has two important implications.

1. The firm can alleviate diminishing marginal products of labor by increasing the amount of capital it uses at the same time. 2. It has an ability to substitute between capital and labor. [Section 6.3]

A. Simplifying Assumptions about Firms' Production Behavior

1. The firm produces a single good. 2. The firm has already chosen which product to produce. 3. The firm's goal is to minimize the cost of producing whatever quantity it chooses to make. 4. The firm uses only two inputs, capital and labor, in making its product. 5. In the short run, a firm can choose to employ as much or as little labor as it wants, but it cannot rapidly change how much capital it uses. In the long run, the firm can freely choose the amounts of both labor and of capital it employs. 6. The more inputs the firm uses, the more output it makes. 7. A firm's production exhibits diminishing marginal returns to labor and capital. 8. The firm can buy as many capital or labor inputs as it wants at fixed prices. 9. If there is a well-functioning capital market (e.g., banks and investors), the firm does not have a budget constraint.

Suppose that the wage rate is $10 per hour and the rental rate of capital is $25 per hour. Draw a graph (with labor on the horizontal axis and capital on the vertical axis) showing the isocost line for . Indicate the horizontal and vertical intercepts along with the slope.

800 = 10L+25k 800/$10 = 80 800/25= 32 We can plot these points on the graph below and then draw a line connecting them. This is the isocost line labeled C1. Slope is 32/80= -.04

total cost curve

A curve that shows a firm's cost of producing particular quantities.

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

A firm capital is fixed in the short run but variable in the long run.

What is the sunk cost fallacy?

A firm that lets its sunk costs affect its operating decisions has committed the sunk cost fallacy. In the forward-looking perspective, firms--and people--shouldn't allow costs that have already been paid and cannot be recovered to affect their decisions in the present.

Why is a fixed cost curve horizontal? Why does a variable cost curve have a positive slope?

A firm's fixed costs are constant no matter what its output level is, resulting in a horizontal fixed cost curve. The variable cost curve is positively sloped--as production increases, the associated variable costs increase.

cost minimization

A firm's goal of producing a specific quantity of output at minimum cost.

Describe the relationship between fixed, variable, and total costs.

A firm's total cost is equal to the sum of its fixed and variable costs.

accounting profit

A firm's total revenue minus its accounting cost.

economic profit

A firm's total revenue minus its economic cost.

production function

A mathematical relationship that describes how much output can be made from different combinations of inputs.

If one isoquant is farther from the origin than another, does it represent a higher or lower level of output? Why can't two isoquants cross?

A producer's isoquants share many of the same characteristics as a consumer's indifference curves. Isoquants farther from the origin are associated with higher output levels. Isoquants cannot cross because if two isoquants did, it would imply that the same quantities of inputs yield two different quantities of output.

decreasing returns to scale

A production function for which adjusting all inputs by the same multiple changes output by less than that multiple.

increasing returns to scale

A production function for which changing all inputs by the same proportion changes output more than proportionately.

constant returns to scale

A production function for which changing the amount of capital and labor by some multiple changes the quantity of output by exactly the same multiple.

What does a production function tell us?

A production function shows the relationship between a firm's inputs (capital and labor) and its output quantity.

average fixed cost (AFC)

AFC= FC/Q

average product of capital

APK = Q/K

average variable cost (AVC)

AVC= VC/Q

What is the difference between a firm's accounting and economic costs? How do these costs relate to a firm's accounting and economic profits?

Accounting costs include the direct costs of operating a business, while a firm's economic costs are its accounting costs plus its opportunity costs. A firm can calculate its profits in one of two ways: as accounting profits equal to its total revenue minus its accounting costs, or as economic profits equal to its total revenue minus its economic costs.

total factor productivity growth (technological change)

An improvement in technology that changes the firm's production function such that it gets more output from the same amount of inputs.

Fixed Cost (FC)

An input cost that does not vary with the amount of output, even if it is zero.

fixed cost

An input cost that does not vary with the amount of output, even if output is zero.

Name the three measures that examine a firm's per-unit cost at a given level of output.

Average fixed, average variable, and average total cost curves calculate a firm's fixed, variable, and total costs as costs per nit.

Cost curves relate a firm's cost to its output quantity.

Because fixed cost doesn't change as output changes, fixed cost curves are horizontal, and total cost curves are parallel to variable cost curves (separated by the amount of fixed cost). [Section 7.3]

accounting cost

The direct costs of operating a business, including costs for raw materials, wages paid to workers, rent paid for office or retail space, and the like.

isocost line

C = wL + rK

Suppose that the wage rate is $10 per hour and the rental rate of capital is $25 per hour. Write an equation for the isocost line for a firm.

C= 10L+25K

specific capital

Capital that cannot be used outside of its original application.

This relationship, whereby production increases proportionally with inputs, is called.... •Double inputs à Output ___________ •Quadruple inputs à Output ________________

Constant Returns to Scale.

Describe the conditions under which a firm has economies of scale, diseconomies of scale, and constant economies of scale.

Economies of scale look at the way a firm's costs increase with output. A firm with economies of scale has costs that increase at a slower rate than the increase in output. With diseconomies of scale, the firm's costs increase at a faster rate than the increase in output. Constant economies of scale indicate that the firm's costs increase at the same rate as the increase in output.

When does a producer face economies of scope? When does a producer face diseconomies of scope?

Economies of scope look at how a firm's costs change when it produces more than one product. Economies of scope exist when a firm can produce more than one product simultaneously at a lower cost that producing the products separately. Diseconomies of scope indicate than a firm produces more than one product simultaneously at a higher cost than producing the products separately.

Fixed cost versus Sunk costs are...

Fixed cost does not change when the firm's output does and must be paid even if output is zero. It can only be avoided by the firm completely shutting down and disposing of the inputs (an action that can be undertaken only in the long run). Sunk costs are fixed costs that can never be recovered even if the firm shuts down completely. Costs that are already sunk should not affect decisions going forward, because they have already been paid regardless of what choice is made in the present. [Section 7.2]

What is the difference between fixed costs and variable costs?

Fixed costs are always the same and variable costs change.

Provide some examples of unavoidable fixed costs. How are these related to sunk costs? Describe why a firm should not consider sunk costs when making decisions.

Fixed costs include expenditures on overhead such as the cost of the building or plant and utility bills. Once paid, these types of expenditures become sunk costs, but a firm can avoid them by closing up shop and shutting down. Once they are sunk costs, however, the firm shouldn't take them into consideration when making production decisions. That would be committing the sunk cost fallacy.

For our pourposes, the long run is defined as a period of time during which all inputs into production are?

Fully adjustable

Suppose that the wage rate is $10 per hour and the rental rate of capital is $25 per hour. Suppose the price of capital falls to $20 per hour. Show what happens to the c=$800 isovost line including any changes in tercepts

If R falls to $20, the horizontal intercept is unaffected. If the firm is only using labor, a change in the price of capital will have no impact. However, the vertical intercept rises to $800 /R = $800/20 = 40 and the isocost line becomes steeper (C2). The new slope is= -W/R= -0.5.

Short run

In production economics, the period of time during which one or more inputs into production cannot be changed.

How will a firm react to an increase in the price of one input relative to another?

In reaction to an increase in the price of one input (say, labor), the firm will substitute away from units of that input to another (in this case, capital) in the long run. In the short run, capital is considered to be fixed.

Why is a firm's short-run total cost greater than its long-run total cost? Explain why this is also true for a firm's short-run and long-run average costs.

In the short run, a firm has fixed costs on capital, while in the long run, the firm can vary both its capital and labor inputs. As a result, the short-run total cost may be greater than long-run total cost. Since average cost is calculated as the total cost per unit of output, the same relationship holds true for a firm's short-run and long-run average costs.

What are the differences between a firm's production in the short run and the long run?

In the short run, a firm's capital is fixed, while in the long run, a firm can change its quantities of both labor and capital.

variable inputs

Inputs that can be changed in the short run.

fixed inputs

Inputs that cannot be changed in the short run.

_____ shows how quantities of inputs are related to output produced.

Isoquant maps

The relationship is reffered to as the _____: The rate at which the firm can trade input X for input Y holding output constant (_____)

Marginal rate of technical substition ' MRTSxy

a.Cost minimization occurs when

Mpk/r=mpl/w

Define opportunity cost. How does a firm's opportunity cost relate to its economic cost?

Opportunity cost is the value of what a producer gives up by using an input. A firm's opportunity costs are what differentiate the calculation of its accounting costs from that of its economic costs. Specifically, opportunity costs are included in economic costs but not in accounting cost.

Cost minimization refers to the firm's goal of producing a specific quantity of ____ at minimum _____. Which is an example of _____.

Output at a minimum cost. Constrained optimization

What happens if the amount of capital and labor used both double?

Output doubles!

Factors of Production or Inputs:

Productive resources, such as labor, land, raw materials, and capital equipment that firms use to manufacture goods and services are called factors of production.

When is a production function said to have constant returns to scale, increasing returns to scale, or decreasing returns to scale?

Returns to scale refer to the change in the amount of output in response to a proportional change in all the inputs. Constant returns to scale indicate that a proportional change in all inputs changes the quantity of output by that same proportion. Increasing returns to scale mean that a proportional change in all inputs changes the quantity of output more than proportionately. Finally, decreasing returns to scale imply that a proportional change in all inputs changes the quantity of output less than proportionately.

Why does a firm's fixed cost not affect its marginal cost of producing an additional unit of a product?

Since a firm's fixed cost does not vary with the level of output, fixed cost does not affect its marginal cost of producing an additional unit of output. That marginal cost is dependent only on the firm's variable cost, and is equal to marginal variable cost.

How does technological change affect a firm's output?

Technological change, A, enters the production function as a scale factor: Q = A•f(K,L). This type of technological change implies that after an improvement in technology, the firm produces extra output using the same level of productive inputs as prior to the change.

Production in the Short Run

The "short run" refers to the case in which the level of capital is fixed. Q = f (K, L)

marginal product

The additional output that a firm can produce by using an additional unit of an input (holding use of the other input constant).

Output:

The amount of goods and services produces by the firm is the firm's.

operating cost

The cost a firm incurs in producing its output.

What does the curvature of an isoquant imply about the two inputs, capital and labor?

The curvature of the isoquant demonstrates the degree of substitutability between capital and labor. A nearly straight isoquant implies that the MRTS is nearly constant along the isoquant, implying that the two inputs are close substitutes. A more curved isoquant indicates that capital and labor are poor substitutes.

What is an expansion path and how does it relate to a firm's total cost curve?

The expansion path plots the optimal input combinations for each output quantity. The total cost curve plots the output quantities from the expansion path against the total cost of the productive inputs.

What is the marginal rate of technical substitution? What does it imply about an isoquant's shape?

The marginal rate of technical substitution is the rate a which the firm can trade one input (X, usually labor) for another (Y, usually capital) holding output constant, and is equal to the marginal product of input X over the marginal product of input Y. For the standard case, the MRTS implies a curved isoquant because as you move down and to the right along the isoquant, the marginal product of labor becomes low relative to the marginal product of capital.

cost curve

The mathematical relationship between a firm's production costs and its output.

short-run total cost curve

The mathematical representation of a firm's total cost of producing different quantities of output at a fixed level of capital.

sunk cost fallacy

The mistake of letting sunk costs affect forward-looking decisions.

operating revenue

The money a firm earns from selling its output.

Examining firm-level production data over time reveals increasing output, even when input levels are held constants

The only way to explain this is by assuming some change to the production function

learning by doing

The process by which a firm becomes more efficient at production as it produces more output.

marginal rate of technical substitution (MRTSXY)

The rate at which the firm can trade input X for input Y, holding output constant.

diminishing marginal product

The reduction in the incremental output obtained from adding more and more labor.

Relationship AVC and AP

The shape of the AVC curve is also due to the law of diminishing marginal returns.

Relationship MC and MP

The shape of the MC curve is attributable to the law of diminishing marginal returns.

In the short run, the firm's capital inputs are held constant along its expansion path, and all changes in output come from changing labor inputs. What does this mean?

This means that, for all quantities except that quantity at which the fixed capital level is cost-minimizing, short-run total and average total costs must be higher than their long-run values. Every fixed capital level has its own short-run cost curves. The long-run average total cost curve is an "envelope" of all the short-run average total cost curves. Long-run marginal cost equals the short-run marginal costs at the quantities at which the fixed capital level is cost-minimizing. [Section 7.5]

diseconomies of scale

Total cost rises at a faster rate than output rises.

economies of scale

Total cost rises at a slower rate than output rises.

constant economies of scale

Total cost rises at the same rate as output rises.

The marginal product of capital / Rate of return = Marginal product of labor / by the wage

True

variable cost

a cost that rises or falls depending on how much is produced

Marginal cost

a firms cost of producing one more unit of output change in total cost divided by change in quanity MC= Change in TC / Change in Q

This allow construction of the total cost curve which shows

a firms cost of producing particular quantities

Final good

a good that is bought by a consumer

intermediate goods

a good that is used to produce another good

When there is technological change,

a production function changes over time so that a fixed amount of inputs can produce more output. This is reflected by a shift of a production function's isoquants toward the origin. [Section 6.6]

The marginal product of an input is the change in output that results from

a small change in an input holding the levels of all other inputs constant.

Economic cost includes

accounting cost plus the opportunity cost of inputs. Opportunity cost is the value of the input's next-best use. Decisions should be made taking opportunity costs into account — that is, on the basis of economic cost, not accounting cost. [Section 7.1]

An isocost line connects ....

all the combinations of capital and labor that the firm can purchase for a given total expenditure on inputs. The relative costs of capital and labor determine the slope of the isocost line. [Section 6.4]

Total factor growth

an improvement in technolgry that changes the firm production function such that the more output is obtained from the same amount of inputs.

A firm's total cost

can be split into fixed and variable components. Variable costs are costs that change with the output level. [Section 7.3]

We can use the cost minimization approach to describe how

capital and labor change as output increases.

The MRTSLK(L,K) can be

derived from the condition that, along an isoquant, quanity of output produced is held constant.

•Firms ________ subject to a given amount of production by adjusting the ratio of capital to labor. •Graphically, cost minimization requires ________ between the isoquant for a level of production & the lowest cost isocost line.

minimize costs tangency

In the short run, a firm's level of capital ....

fixed. Differences in output must be achieved by adjusting labor inputs alone. We looked at properties of the production function including an input's marginal and average product (we focused on labor in this case, because capital is fixed). We saw examples of diminishing marginal products for labor, where the incremental output obtained from using another unit of labor in production decreases. [Section 6.2]

The slope of an isquant describes how

inputs may be substituted to produce a level of output

An isoquant curve shows all combinations ...

of inputs that allow a firm to make a particular quantity of output. The curvature and slope of the isoquant represent the substitutability of the inputs in the production of the good. In particular, the negative slope of the isoquant is equal to the marginal rate of technical substitution of labor for capital. [Section 6.4]

Q=f(K,L)

production function

Start with a production function

• Similar to a utility function for consumers, except more tangible • Mathematical relationship between amount of output and various combinations of inputs

Simplifying Assumptions about Firms' Production Behavior

1. the firms produces a single good 2. the firm has already chosen which product to produce 3. For whatever quantity it makes, the firm's goal is to minimize the cost of producing it. 4. The firm uses only two inputs to make its product: capital and labor. 5. In the short run, a firm can choose to employ as much or as little labor as it wants, but it cannot rapidly change how much capital it uses. In the long run, the firm can freely choose the amounts of both labor and the capital it employs. 6. The more inputs the firm uses, the more output it makes. 7. A firm's production exhibits diminishing marginal returns to labor and capital. 8. The firm can buy as many capital or labor inputs as it wants at fixed market prices. 9. If there is a well-functioning capital market (e.g., banks and investors), the firm does not have a budget constraint.

Scope

= [TC(Q1,0)+TC(0,Q2)]-TC(Q1,Q2)/ TC(Q1,Q1)

Slope of line

= wage / rate of return

Average total cost

=TC/Q

sunk cost

A cost that, once paid, cannot be recovered.

isoquant

A curve representing all the combinations of inputs that allow a firm to make a particular quantity of output.

Application : CHAPTER 6 Complete the following table and use that information to answer the questions that follow. # K L Q MPL APL APK 1 3 0 0 2 3 5 20 3 3 10 70 4 3 15 140 5 3 20 200 6 3 25 250 7 3 30 290 8 3 35 315 9 3 40 320 10 3 45 320 11 3 50 310 BE ABLE TO SOLVE FOR MPL APL APK a. Identify the fixed and variable inputs. b. Over what range of the variable input usage do increasing marginal returns exist? c. Over what range of the variable input usage do decreasing marginal returns exist? d. Over what range of input usage do negative marginal returns exist?

A. Capital is fixed and labor and quantity are variable B. 1 - 4 C. 5-10 D. 11

What is an isocost line? What does its slope tell us about the relative cost of labor and capital?

An isocost line is the curve that shows all the input combinations that yield the same cost. Since the slope of the isocost line is the negative ratio of wages to the capital rental rate, -W/R, we can use the slope to determine the cost tradeoff of substituting labor for capital (or vice versa).

Two additional important cost concepts are average and marginal costs. Describe the difference

Average cost at a given output quantity equals the ratio of cost to output. Average fixed cost falls continuously as output increases. Average variable cost and average total cost tend to be U-shaped, falling initially, but then rising as output increases. Marginal cost is the additional cost of making one more unit of output. [Section 7.4]

economies of scope

The simultaneous production of multiple products comes at a lower cost than if a firm made each product separately and then added up the costs.

economic cost

The sum of a producer's accounting and opportunity costs.

opportunity cost

The value of what a producer gives up by using an input.

Economies of scope describe

how a firm's total cost changes with its product specialization. If producing two outputs jointly is cheaper than producing the same amount of the two outputs separately, then there are economies of scope. There are diseconomies of scope if it is instead more expensive. [Section 7.6]

Returns to scale is a property of production functions that describes

how the level of output changes when all inputs are simultaneously changed by the same amount. Production functions can have returns to scale that are constant (if all inputs increase by a factor, output changes by the same factor); increasing (if all inputs increase by a factor, output changes by more than that factor); or decreasing (if all inputs increase by a factor, output changes by less than that factor). [Section 6.5]

An isoquant is a curve representing combination of

inputs that allow a firm to make a particular quality of output

Definition: Diminishing marginal product

is a feature of the production function; as the firm uses additional units of a given input, the marginal product of that input falls 1. This is a short-run phenomenon caused by the presence of a fixed input. 2. Diminishing marginal returns do not have to occur all of the time; a production function may have increasing returns initially, but then the marginal product will eventually fall as the variable input is increased.

A final Good

is a good bought by a consumer

an intermediate good

is a good that is used to produce another good.

A product function

is a mathematical relationship that describes how much output can be made from different combinations of inputs.

The total product...

is the total output of the firm in a given period of time

An _______ shows all of the input combinations that yield the same _____. •Similar to the budget constraint facing consumers, equation given by

isocost line where TC is total cost, R is the "rental rate" of capital, and W is the wage rate. •Rearranging yields capital as a function of the rental rate, wage rate, and labor.

The cost minimization model requirees two concepts

isoquants and isocost lines.

Firm always ____ the cost of production

minimize

An expansion path is a curve, that illustrates how the optimal mix

of inputs varies with total output

The average product of an input is equal to the total output that is to be

produced divided by the quantity of the input that is used in its production:

The feasible but inefficient points below the production function make up the firm's...

production sets

Return to Scale

refers to the change in output when all inputs are increased in the same proportion.

Economies of scale describe the

relative rate at which a firm's cost changes when its output changes. When cost increases at a slower rate than output, the firm has economies of scale. Average cost is falling and the long-run average total cost curve is downward-sloping when there are economies of scale. If cost increases at a faster rate than output, diseconomies of scale occur. Average total cost is rising and the long-run average total cost curve is upward-sloping in this case. If cost increases at the same rate as output, there are neither scale economies nor diseconomies, and long-run average total cost is constant. [Section 7.6]

The firm will minimize cost subject to a

specific amount of output that much be produced.

A firm is technologically efficient

t if it is attaining the maximum possible output from its inputs (using whatever technology is appropriate).

A production function relates the quantities of inputs

that a producer uses to the quantity of output it obtains from them. Production functions typically have a mathematical representation in the form Q = f(K, L). A commonly used production function is the Cobb-Douglas production function, which has the form Q = KαLβ, where α and β are constants. [Section 6.1]

If Scope = 0

the costs are equivalent, and economies of scope are zero.

Variable costs

the costs of inputs that chage as the firm changes it quanity of output

A firm aims to minimize its costs at any given level of output. The firm's cost-minimizing output occurs where

the isocost line is tangent to the isoquant, or where the marginal rate of technical substitution is equal to the relative price of labor to capital. [Section 6.4]

production

the process by which a person, company, government, or non-profit agency uses inputs to create a good or service for which others are willing to pay

In looking at a firm's production practices,

we made several simplifying assumptions. Most important, we assume that cost minimization — minimizing the total cost of producing the firm's desired output quantity — is a key objective of any producer. [Section 6.1]

A firm's cost curves are derived from its expansion path,

which uses isoquants and isocost curves to show how its input choices change with output. The total cost curve relates the costs tied to the isocost lines and the quantities tied to the isoquants that intersect the expansion path. [Section 6.7]

QUESTION: Are there any examples of true decreasing returns?

•Regulatory burden: As firms grow larger, they are often subject to more regulations.

Generally, firms should not experience decreasing returns to scale.

•When this phenomenon is observed in data, it often results from not accounting for all inputs (or attributes).