CH.7 TERMS

the difference between revenue and the total cost to a firm of producing the goods and services it offers for sale

profit

A firm earns an economic profit when

profits are greater than zero after implicit costs are considered

University of Tennessee Neyland Football Stadium Fixed costs

property and equipment - (usually physical capital but some level of labor can be fixed) *costs stadium faces no matter how many people come to the game* -maintenance costs -lighting and sound -referees

normal rate of return

return just sufficient to keep investors satisfied; it therefore represents the opportunity cost of capital.

Variable costs

rise as the level of output increases

Marginal product

the change in output resulting from a one-unit increase in labor (ΔQ/ΔL)

Technology alters the shape of the

long-run ATC curve

long run

a period sufficient for a firm to adjust all factors of production, including plant capacity *Firms can enter or exit the industry

Partnership Advantages

-Ability to share work -Ability to share risks

Sole Proprietorship Advantages

-Control by owner -No layers of management

Corporation Disadvantages

-Costly to organize -Possible double taxation of income

ROLE OF TECHNOLOGY

-Enhances production techniques -Improves global communications -Provides computing power for easier expansion and economies of scale

Corporation Advantages

-Limited personal liability -Greater ability to raise funds

PARTNERSHIPS

-More than one owner -Can divide tasks among partners -Division of labor -Personal assets of all owners subject to unlimited liability -Includes negligence by partners

SOLE PROPRIETORSHIP

-One owner -Easy to start -Limited access to financial capital -Owner's personal assets subject to unlimited liability

CORPORATIONS

-Owners called stockholders -Have legal rights (much like an individual) -Can raise money by issuing stocks and bonds -Owners protected by limited liability -Losses limited to value of stock

Partnership Disadvantages

-Unlimited personal liability -Limited ability to raise funds

Sole Proprietorship Disadvantages

-Unlimited personal liability -Limited ability to raise funds

DISECONOMIES OF SCALE can be due to:

-increased bureaucracy in management -increased cost of a scarce resource used in production -increasingly difficult terrain or rising operational costs

Economies of scale result from

-specialization of labor and management -better use of capital -complementary production techniques

3 types of implicit costs

1) foregone wages/salary 2) foregone interest 3) economic depreciation

WHAT COST IS GENERALLY ASSUMED TO BE FIXED?

A LEASE ON A BUILDING

Average cost

A measure of productivity (in terms of cost efficiency)

Why should sunk costs be ignored for decision making?

A sunk cost is a cost that has already been paid and cannot be recovered. Because no money can be returned, sunk costs should not influence future decisions.

ATC=

AFC + AVC

SUNK COSTS

ALREADY INCURRED; CANNOT BE RECOVERED. RATIONAL DECISIONS ABOUT PRODUCTION IGNORE SUNK COSTS

DIMINISHING RETURNS TO LABOR OCCUR

AS MORE WORKERS ARE USED

List some of the reasons why the long-run average total cost curve has sort of a flat bowl shape. It declines early on, then is rather flat over a portion, and finally slopes upward.

As a firm expands its output, economies of scale are encountered due to specialization of labor and management. Eventually, a flat region is reached, reflecting the fact that the firm can duplicate its operations at virtually the same cost. Finally, the firm gets so big that it begins to lose control, and costs begin to rise.

Why is the average fixed cost curve not U-shaped? Why does it not turn up as the average variable cost and average total cost curves do?

Because fixed costs are fixed, total fixed costs do not vary, thus as more output is produced, average fixed costs continue to fall as the Q in FC/Q gets larger

COST STRUCTURE

DEPENDS ON THE NATURE OF THE PRODUCTION PROCESS

Role of entrepreneurs

Despite accounting for only about 13 % of the population, immigrants now start more than 1/4 of new businesses in this country. Fast-growing ones, too--more than 20% of the 2014 Inc. 500 CEOs are immigrants.

EXPLICIT COSTS

EXPENSES PAID DIRECTLY TO SOME ENTITY (WAGES, LEASE PAYMENTS, RAW MATERIALS, TAXES, ETC.)

What is the difference between explicit and implicit costs? What is the difference between economic and accounting profits? Are these four concepts related? How?

Explicit costs are those out-of-pocket expenses paid to others, while implicit costs are opportunity costs. Economic profits are profits after both explicit and implicit costs are deducted, while accounting profits typically do not have implicit costs deducted. The four concepts are related in how they are defined, with implicit costs playing an important role.

TC=

FC + VC

AFC = average fixed cost

FC/Q

Average fixed cost

FC/Q Fixed cost divided by the quantity of output produced

LONG RUN PRODUCTION COSTS firms/plants

Firms choose the plant size appropriate for their market; plant size can be adjusted as output levels change Each plant size is associated with a unique long-run cost structure

If marginal cost is less than average total cost, are average total costs rising or falling? Alternatively, if marginal cost is more than average total cost, are average total costs rising or falling? Explain how this example might apply to a basketball player attempting to achieve a high average points per game.

If marginal cost is less than average total cost, then average total cost is falling and vice versa. A baseball player hitting .333 (gets a hit one-third of the time on average) will see his average rise when he gets a hit and fall when he does not. If the average income of your class is $15,000 (some people work), and Tom Cruise decides to take a refresher course in economics and joins your class, the average income rises, and vice versa if someone with no income joins the class. A basketball player's average points per game (ppg) is calculated based on all games played to date in a season. Suppose a player's average is 10 ppg. If the player scores 15 points in the next game, her marginal score (15) is greater than her average (10), which means that her average will rise. Alternatively, if she scores only 5 points in the next game, her marginal score (5) is less than her average (10), which means her average will fall.

The movie industry earns a substantial portion of its total revenues through Internet streaming and downloads. Although producing a movie can cost tens of millions of dollars, the marginal cost of producing another copy or download is practically nothing. For this industry, would short-run ATC and MC still be U-shaped? If not, what would these curves look like?

In industries that have very high fixed costs and virtually no marginal costs, the short-run ATC and MC curves would not have the typical U-shape of more traditional industries. Instead, when MC = $0, the curve is nearly horizontal. This means that the average total cost curve would continuously fall as more quantity is produced, and would resemble an average fixed cost curve.

How does the short run differ from the long run? Is the long run the same for all industries? Why or why not?

In the short run, one factor of production is fixed, but in the long run all factors can vary, and firms can enter or leave the industry. The long run differs for industries and firms because the time required to expand plant capacity differs among industries. Some industries (chemical and nuclear power plants) are heavily regulated, while others (restaurants and retail establishments) are not, and these regulations take more or less time to fulfill.

ECONOMIC COSTS

Include both explicit and implicit costs

What is the difference between marginal cost and average total cost?

Marginal cost is the additional cost of producing one more unit, while average total cost is the average cost per unit of all units produced. Marginal cost is used by businesses to determine whether to expand or restrict production, while average total cost provides an overall indicator of performance that will determine if a business remains in the industry over the long run.

IF TOO MANY WORKERS ARE USED

NEGATIVE RETURNS TO LABOR CAN RESULT

IMPLICIT COSTS

OPPORTUNITY COSTS OF USING RESOURCES (DEPRECIATION, ASSET DEPLETION, FORGONE WAGES)

REVENUE =

PRICE PER UNIT × QUANTITY

ECONOMIES OF SCOPE

PRODUCING INTERDEPENDENT PRODUCTS (AS DOES PROCTER & GAMBLE) HELPS TO REDUCE PRODUCTION AND MARKETING COSTS

TYPES OF FIRMS

SOLE PROPRIETORSHIP PARTNERSHIPS CORPORATIONS

ATC= average total cost

TC/Q

Average total cost

TC/Q

PRODUCTION

THE PROCESS OF TURNING INPUTS INTO OUTPUTS

THE GOAL OF BUSINESSES IS

TO MAXIMIZE PROFITS

ECONOMIC PROFIT

TOTAL REVENUE − EXPLICIT COSTS − IMPLICIT COSTS

ACCOUNTING PROFIT

TOTAL REVENUE − EXPLICIT COSTS

PROFITS =

TOTAL REVENUE − TOTAL COST

Marginal cost

The change in total cost from the production of one more unit of output. MC = ΔTC/ΔQ

PRODUCTION COSTS IN THE SHORT RUN Marginal cost

The change in total cost from the production of one more unit of output. MC = ΔTC/ΔQ

In order to take this class, you had to pay tuition, buy the textbook, and buy a new laptop. Which of these items (if any) would be considered a sunk cost? Explain your reasoning.

The tuition you paid is most likely a sunk cost if the university does not provide any refunds if you drop the course. A textbook is not a sunk cost, because you may be able to sell the book to the bookstore at the end of the term for a small amount of money. A laptop is not a sunk cost, because a used laptop can be sold at any time.

If you work hard building your business and end up earning zero economic profit for the year, would this be considered a failed business to an economist? Why or why not?

To an economist, earning zero economic profit is not a bad outcome at all. Zero economic profit means that a business is earning normal profits, a level of profits that would be earned under the next best alternative use of resources. In other words, economic profit takes into account all opportunity costs, including the value of the time and money given up to pursue the business.

AVC= average variable cost

VC/Q

Average variable cost

VC/Q Variable cost divided by the quantity of output produced

Why should a firm never hire a worker when negative marginal returns set in?

When marginal returns are negative, hiring an additional worker causes total production to fall. Therefore, a firm would be better off not hiring that worker.

In the long run, firms build plants that

achieve the lowest possible average cost based on the output level

PRODUCTIONS COSTS IN THE LONG RUN

all inputs can be adjusted; therefore, there are no fixed costs in the long run

A normal profit equals

an economic profit of zero

AVC and ATC curves

are U-shaped

MP crosses the AP

at its maximum

average total cost is the sum of

average fixed cost plus average variable cost

increase in the marginal product

can result from the division of labor and from specialization

University of Tennessee Neyland Football Stadium In the short-run

capacity of the stadium is fixed

what earns the Majority of Revenue and Profits

corporations

marginal cost curve

crosses the minimum points of the ATC and AVC curves

SHORT RUN COST CURVES At relatively low levels of output

curves slope downward, reflecting increasing returns as average costs fall

average fixed cost curve always

decreases as production increases

MARGINAL PRODUCT falls as (short run)

diminishing returns set in

SHORT RUN COST CURVES As production rises

diminishing returns set in, and average costs rise

As firms continue to grow, they eventually encounter

diseconomies of scale as average total costs rise

Fixed costs (overhead)

do not vary with the quantity produced

If a firm's rate of return on capital falls below the normal rate of return

investors will put their funds to use elsewhere

short run

is a period when at least one factor of production is fixed and cannot be altered *Plant capacity is fixed

As a firm's output increases

its long-run average total costs tend to fall

MARGINAL PRODUCT rises as (short run)

more workers are hired

Average long-run costs change with

output as economies of scale wear out

Total costs

sum of fixed and variable costs

University of Tennessee Neyland Football Stadium Variable costs

technology, labor, materials *costs that vary depending on attendance* -number of police officers -number of workers to sell -concessions -amount of concessions available

University of Tennessee Neyland Football Stadium If UT expects more people to attend on average

they can expand capacity in the long run

Average product

total output divided by the amount of labor input (Q/L)

when the marginal product of labor is increasing

total output increases at an increasing rate

when the marginal product of labor is decreasing, but still positive

total output increases, but at a decreasing rate