Chapter 7

The LRAC Curve and the Size and Number of Firms

For graph (a): • Low-cost firms will produce at output level R. • When the LRAC curve has a clear minimum point, then any firm producing a different quantity will have higher costs. • In this case, a firm producing at a quantity of 10,000 will produce at a lower average cost than a firm producing 5,000 or 20,000 units.

The LRAC Curve and the Size and Number of Firms, Continued

For graph (b): • Low-cost firms will produce between output levels R and S. • When the LRAC curve has a flat bottom, then firms producing at any quantity along this flat bottom can compete. • In this case, any firm producing a quantity between 5,000 and 20,000 can compete effectively, • Firms producing less than 5,000 or more than 20,000 would face higher average costs and be unabie to compete.

General Case of Total Product and Marginal Product Curves.

General case of total product curve. General case of marginal product curve.

7.2 Production in the Short Run

Production • Categories of factors of production (inputs) - resources that firms use to produce their products,: • Natural Resources (Land and Raw Materials) • Labor · Capital • Technology Entrepreneurship • Production function - mathematical equation that tells how much output (Q) a firm can produce with given amounts of the inputs. Q=f[NR,L, K.t, E]

7.1 Explicit and Implicit Costs, and Accounting and Economic Profit

Profit = Total Revenue - Total Cost • Revenue - the income a firm generates from selling its products. Total Revenue - Price x Quantity Sold • Explicit costs - out-of-pocket costs; actual payments. • Wages, rent, etc. • Implicit costs - the opportunity cost of using resources that the firm already owns. · Depreciation goods, materials, and equipment

Economies of Scale

• A small factory like S produces 1,000 alarm clocks at an average cost of $12 per clock. • A medium factory like M produces 2,000 alarm clocks at a cost of $8 per clock. • A large factory like L produces 5,000 alarm clocks at a cost of $4 per clock. • Economies of scale exist because the larger scale of production leads to lower average costs.

Types of Profit

• Accounting profit - the difference between dollars brought in and dollars paid out. Accounting Profit = Total Revenue - Explicit Costs • Economic profit - includes both explicit and implicit costs. -Economic Profit =Total Revenue - Total -Costs Total Costs = Explicit Costs + Implicit Costs

How Output Affects Total Costs

• At zero production, the fixed costs of $160 are still present. • As production increases, variable costs are added to fixed costs, and the total cost is the sum of the two.

Average Profit

• Average Profit or profit margin = price - average cost • If the market price > average cost, then average profit will be positive. • If price is < average cost, then profits will be negative.

Cost Curves

• Average total cost (ATC) • Typically U-shaped • Average variable cost (AVC) Lies below the average total cost curve and Typically U-shaped or upward-sloping. • Marginal cost (MC) Generally upward- sloping

Costs

• Average total cost (ATC) - total cost divided by the quantity of output produced. • Marginal cost (MC) - the additional cost of producing one more unit of output. • Average variable cost - variable cost divided by quantity of output.

Ranges on the Long-run Average Cost Curve

• Constant returns to scale - when expanding all inputs proportionately does not change the average cost of production. • 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 or run efficiently.

7.3 Costs in the Short Run

• Factor payments - what the firm pays for the use of the factors of production (aka costs, from the firm's perspective). • Raw materials prices • Rent Wages and salaries • Interest and dividends • Profit • Variable costs - costs of the variable inputs, like labor. • Fixed costs - costs of the fixed inputs, like rent. Expenditure that a firm must make before production starts •Do not change in the short run • Do not change regardless of the level of production. • Total cost - the sum of fixed and variable costs of production

Theory of the Firm

• Firm (or producer or business) - an organization that combines inputs of labor, capital, land, and raw or finished component materials to produce outputs. • Private enterprise - the ownership of businesses by private individuals • Production - the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs.

The Spectrum of Competition

• Firms face different competitive situations. • At one extreme-perfect competition-many firms are all trying to sell identical products. • At the other extreme-monopoly-only one firm is selling the product, and this firm faces no competition. • Monopolistic competition is a situation with many firms selling similar, but not identical products. • Oligopoly is a situation with few firms that sell identical or similar products.

Inputs

• Fixed inputs (K) - factors of production that can't be easily increased or decreased in a short period of time • Variable inputs (L) - factors of production that a firm can easily increase or decrease in a short period of time • Short-hand form for the production function: Q=f[L, K]

7.4 Production in the Long Run

• In the long run, all factors (including capital) are variable. • Production function is Q = f[L, K] • Because all factors are variable, the long run production function shows the most efficient way of producing any level of output.

Shapes of Long-Run Average Cost Curves

• Long-run average cost (LRAC) 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. • Short-run average cost (SRAC) curves - the average total cost curve in the short term; shows the total of the average fixed costs and the average variable costs.

Marginal Product

• Marginal product (MP) - the additional output of one more worker. • Law of Diminishing Marginal Productivity - general rule that as a firm employs more labor, eventually the amount of additional output produced declines.

Short and Long Run Production

• Short run - period of time during which at least some factors of production are fixed. • Long run - period of time during which all factors are variable.

From Short-Run Average Cost Curves to Lc Run Average Cost Curves

• The five different short-run average cost (SRAC) curves each represents a different level of fixed costs, from the low level of fixed costs at SRAC, to the high level of fixed costs at SRAC, • Other SRAC curves, not in the diagram, lie between the ones that are here. • The long-run average cost (LRAC) curve shows the lowest cost for producing each quantity of output when fixed costs can vary, and so it is formed by the bottom edge of the family of SRAC curves. • If a firm wished to produce quantity Q, it would choose the fixed costs associated with SRAC

7.5 Costs in the Long Run

• The long run is the period of time when all costs are variable. • Production technologies - alternative methods of combining inputs to produce output • Economies of scale - the situation where, as the quantity of output goes up, the cost per unit goes down.

The Size and Number of Firms in an Industry

• The shape of the long-run average cost curve has implications for: • how many firms will compete in an industry • whether the firms in an industry have many different sizes • or if they will tend to be the same size.

Short Run Production Function for Trees

• The top graph shows the short run total product for trees. • As the number of lumberjacks increase, the output also increases, until 5 lumberjacks are reached. • The bottom graph shows that as workers are added, the MP increases at first, but sooner or later additional workers will have decreasing marginal product.