Econ Chapt 7- Producers in the Short Run – Flashcards

7.1 *What are firms?* - Identify the various forms of business organization and discuss the different ways that firms can be financed. 7.2 *Production, Costs, and Profits* - Distinguish between accounting profits and economic profits. 7.3 *Production in the Short Run* - Understand the relationships among total product, average product, and marginal product; and the law of diminishing marginal returns. 7.4 *Costs in the Short Run* - Explain the difference between fixed and variable costs, and the relationships among total costs, average costs, and marginal costs.

- Go behind the scenes of the supply curve to understand how it is determined by the behaviour of firms. - Begin comparing the firms that we see in the real world with those that appear in economic theory. - Introduce the concepts of costs, revenues, and profits, and outline the key role that profits play in determining the allocation of a nation's resources. - To determine the most profitable quantity for a firm to produce supply to the market, we need to see how its costs vary with its output. - When examining the relationship between output and cost, *time* plays an important role. - In this chapter, we focus on the short run, where a firm can change only *some* of its inputs, and output is governed by the famous *law of diminishing returns.*

A firm can be organized in 6 different ways: 1. *single proprietorship* - A firm that has one owner who is personally responsible for the firm's actions and debts. 2. *ordinary partnership* - A firm that has two or more joint owners, each of whom is personally responsible for the firm's actions and debts. 3. *limited partnership* - A firm that has two classes of owners: *general partners*, who take part in managing the firm and are personally liable for the firm's actions and debts, and *limited partners*, who take no part in the management of the firm and risk only the money that they have invested. - less common than an ordinary partnership 4. *corporation* - A firm that has a legal existence separate from that of the owners. - The shares of a *private* corporation are not traded on any stock exchange, whereas the shares of a *public* corporation are. 5. *state-owned enterprise* - A firm that is owned by the government. In Canada, these are called *Crown corporations" 6. *Non-profit organizations* - Firms that provide goods and services with the objective of just covering their costs. These are often called NGOs, for non-governmental organizations. - Ex. YMCA

Firms that have operations in more than one country. - Unusual for single and ordinary proprietorships, but common for limited partnerships (ex. large law and accounting firms) and very common for large corporations. - The number and importance of MNEs have increased greatly over the last few decades. A large amount of international trade represents business transactions of MNEs - between diff corporations, as well as between diff regional operations of the same corporation. -Play an increasing role in the ongoing process of globalization. -Not all production in the economy takes place within firms. Many gov agencies provide goods and services. ex defence, education etc. In most of these cases, goods and services are provided to citizens without charging directly for their use; const are financed through the gov general tax revenues.

The money a firm raises for carrying on its business is sometimes called its financial capital, as distinct from its real capital (which is the firm's physical assets). The use of the term capital can refer to both an amount of money and a quantity of goods. The basic types of financial capital used by the firms are equity and debt.

*The funds provided by the owners of the firm.* - Individual proprietorships and partnerships, one or more owners providing much of the required funds. A corporations acquires funds from its owners in return for stocks, shares, or equities. Money goes to company and shareholders become owners of the firm, risking the loss of their money and gaining the right to share in the firm's profits. *Dividends* - Profits paid out to shareholders of a corporation. -An easy way for an established firm to raise money is to retain current profits rather than paying them out to shareholders. Financing investment from such *retained earnings* adds to the value of the firm and hence raises the market value to existing shares.

*The funds borrowed from creditors (individuals or institutions) outside the firm.* - Firms creditors are *not* owners; they have lent money in return for some form of loan agreement, or IOU. Firms often borrow from commercial banks or other financial institutions, and can also choose to borrow money directly from non-bank lenders, whom there are many possible types of loan agreements, called *debt instruments* or *bonds* *Bond* - A debt instrument carrying a specified amount, a schedule of interest payments, and (usually) a date for redemption of its face value. -Two characteristics are common to all loan agreements: 1. *The principal of the loan* - They carry an obligation to repay the amount borrowed. 2. *Interest* - They carry an obligation to make some form of payment to the lender. The *redemption date* of the debt - The time at which the principal is to be repaid. *Term* - The amount of time between the issue of the debt and its redemption date.

Economists generally make two key assumptions about firm behaviour: 1. Firms are assumed to be profit maximizers. 2. Each firm is assumed to be a single, consistent decision-making unit.

In order to produce the goods or services that it sells, each firm needs inputs. Hundreds of inputs enter into the production of any specific output. *These inputs can be grouped into four broad categories:* *1*. Inputs that are outputs from some other firm. - ex. spark plugs, electricity, steel. - *Intermediate products* - All outputs that are used as inputs by other producers in a further stage of production. *2*. Inputs that are provided directly by nature. - ex. land owned or rented by the firm. *3*. Inputs that are services of labour - provided by workers and managers employed by the firm. *4*. Inputs that are services of physical capital - ex. the facilities and machines used by the firm. - All production can be accounted for by the services of the other three kinds of input, which are called *factors of production* - Land, Labour, Capital.

- *Production Function*: A functional relation showing the *maximum* output that can be produced/obtained by any given combination of inputs. - Describes the technological relationship between the inputs that a firm uses and the output it producers. (ignore the role of land). *Q=f(K,L)* Q = the flow of output K = the flow of capital services L = the flow of labour services f = the production function itself - Changes in the firm's technology, which alter the relationship between inputs and output, are reflected by the changes in the function f.

- Controversy over the need of firms to behave in a socially responsible manner. - Advocates of this view start from the position that unadorned capitalism, and the goal of profit maximization does not serve in the broader public interest. In this view, corporate social responsibility must involve more than simply maximizing profits. - Others argue that firms should focus on maximizing profits, and by doing so they are providing significant benefits to their customers and their employees, not just their shareholders. It is the pursuit of profits that leads firms to develop new products and production methods- improving overall living standards. - Gov sets rules in the public interest and then leave firms free to max profits within the constraints set by those rules. - Corporations do change their behaviour over time - in response to: 1. changes in laws and regulations, and 2. in response to changes in consumer attitudes. -If governments can be relied upon to establish and enforce rules and regulations in the public interest, and consumers continue to actively express their preferences through their decisions in the marketplace, then firms may be able to be socially responsible and profit seeking at the same time.

Firms arrive at what they call *Profits* by: *Profits = Revenue - Cost* - Revenues (they obtain by selling their output) - Costs (all costs associated with their inputs) - Profits (the return to the owners' financial investment in the firm)

Compared with accountants, economists use somewhat different concepts of cost and profits. *Accounting profits = Revenues - Explicit costs* - When accountants measure profits, they begin w the firm's revenues and then subtract all of the explicit costs incurred by the firm. *Explicit costs* - the costs that actually involve a purchase of goods or services by the firm. ex. hiring workers, renting equipment, interest payments on debt, etc. *Economic profits = Revenues - (Explicit costs + Implicit costs) = Accounting profits - Implicit costs* - Economic profit is also known as *pure profit* - Also subtract some *implicit costs* - items for which there is no market transaction but for which there is still an opportunity cost for the firm that should be included in the complete measure of costs. - *The 2 most important implicit costs are:* 1. The opportunity cost of the owner's time 2. The opportunity cost of the owner's capital *Economic Profit* - The difference between the revenues received from the sale of output and the opportunity cost of the inputs used to make the output. Negative economic profits are called *economic losses*. *Economists include both implicit and explicit costs in their measurement of profits, whereas accountants include only explicit costs. Economic profits are therefore less than accounting profits.* - Firms are interested in the financial return to their owners, which is what they call *profits*. They must also conform w tax laws, which define profits in the same way. In contrast, economists are interested in how profits affect *resource allocation* - Economic Profits show more of an accurate representation, includes the OC of owners time and capital.

- Especially in small and relatively new firms, owners spend a lot of time developing their business, and often pay themselves far less than they could earn if they were instead to offer their labour services to other firms. - Ex. An entrepreneur who opens a restaurant may pay herself $1000 per month while building the business, even though she could earn $4000 per month in her next best alternative job. In this case, there is an *implicit* cost to her firm of $3000 per month that would be missed by the accountant who measure only the explicit cost of her wage at $1000 per month.

What is the OC of financial capital that owners have invested in a firm? 1. Ask what would be earned by lending this amount to someone else in a riskless load, The owners could have purchase a government bond, which has no significant risk of default. Suppose the return on this is 3% per year. This amount is the risk-free rate of return on capital. It is an opportunity cost since the firm could close down operations, lend out its money, and earn a 3% return. 2. Ask what the firm could earn in addition to this amount by lending its money to another firm where risk of default was equal to the firm's own risk of loss. Suppose this is an additional 4%. This is the risk premium, and is also a cost. If the firm does not expect to earn this much in its own operations, it could close down and lend its money out to some equally risky firm and earn 7% (3% pure return plus 4% risk premium)

*Economic profits and losses play a crucial signalling role in the workings of a free-market system* - Economic *profits* in an industry are the signal that resources can profitably be moved into that industry. - *Losses* are the signal that resources can profitably be moved elsewhere. - Only if there are *zero* economic profits (revenues exactly cover OC) there is no incentive for resources to move into or out of an industry.

Firm's output = Economic profit (where all explicit and implicit costs are considered) (The lowercase Greek letter pi) ?- the level of output that max a firm's economic profit. This is the difference between: The total revenue (TR) each firm derives from the sale of its output, and The total cost (TC) of producing that output. ? = TR - TC By determining the profit-maximizing level of output for any given firm, we be closer to understanding the firm's supply curve, which helps us better understand the origin of market supply curves.

Economists classify the decisions that firms make into 3 types: 1. *The short run* - How best to use existing plant and equipment. 2. *The long run* - What new plant and equipment and production process to select, given known technical possibilities. 3. *The very long run* - How to encourage, or adapt to, the development of new technologies.

A period of time in which the quantity of some inputs (fixed factors) cannot be changed. - The length of time over which some of the firm's factors of production are fixed - Inputs that are not fixed but instead can be varied in the short run re called variable factors. - Short run does not correspond to a specific length of time - *Fixed factor*: An input whose quantity cannot be changed in the short run. - Usually an element of capital (ex plant and equipment), or land, services of management, or even the supply of skilled labour. - *Variable factor*: An input whose quantity can be changed over the time period under consideration.

A period of time in which all inputs (factors of production) may be varied, but the existing technology of production cannot be changed (technology is fixed). - does not correspond to a specific length of time. - The firm's *planning decisions* are long-run decisions because they are made from given technological possibilities but with freedom to choose from a variety of production processes that will factor inputs and different proportions. (firm is faced with decisions of whether to expand the scale of its operations, to branch out into new products or new areas, or to change its method of production)

A period of time that is long enough for the technological possibilities available to a firm to change. - Modern industrial societies are characterized by continually changing technologies that lead to new and improved products and production methods.

- Want to know - with a fixed amount of capital - how output changes as the firm increases or decreases its amounts of labour.

Total Product (TP) - Total amount produced by a firm during some time period. - For any given amount of the fixed factor, total product will change as more or less of the variable factor is used. Average Product (AP) - Total product divided by the number of units of the variable factor used in its production. AP = TP/L (Labour being our VF) Marginal Product (MP) - The change in the total output that results from using one more unit of the variable factor. Greek letter ? (delta) - means "the change in" marginal product. MP= ?TP/?L - the *change* in output caused by the *change* in quantity of the variable factor. - ex. The increase in labour from 3 to 4 units (?L=1) increases output from 13 to 22 (?TP=9), therefore MP=9, and is recorded between 3 and 4 units of labour. The level of labour input at which marginal product reaches a maximum is called the *point of diminishing marginal productivity*. - Each are aspects of the same single relationship described by the production function. (related to one another)

*Law of Diminishing Returns* - The hypothesis that if increasing quantities of a variable factor are applied to a given quantity of fixed factors (holding the level of technology constant), the marginal product of the variable factor will eventually decrease. - If additional workers allow more efficient divisions of labour, marginal product will rise. According to the law of diminishing returns, when there is only an unchanging amount of physical capital the scope for such increases must eventually disappear, and sooner or later the marginal products of additional workers must decline. Eventually, as moe and more workers are employed marginal product may reach zero and even become negative. Its not hard to see why if you consider the extreme case, in which there would be so many workers in a limited space that additional workers would simply get in the way, reducing the total output (negative marginal product)

If increasing quantities of a variable factor are applied to a given quantity of fixed factors, the average product of the variable factors will eventually decrease. - The average product curve slopes upward as long as the marginal product curve is *above it*; whether the marginal product curve is itself sloping upward or downward is irrelevant. -In order for the average product to rise when a new worker is added, the marginal product (the output of the worker) must exceed the average product. -If the marginal is greater than the average, the average must be rising; if the marginal is less than the average, the average must be falling. Ex. if you had a 3.6 GPA last semester and this (marginal) semester you only get a 3.0 GPA, your GPA will fall. To increase your GPA, you must score better in this (marginal) semester than you have on average in the past - that is, to increase the average, the marginal must be greater than the average.

- The majority of firms cannot influence the prices of the inputs that they use; instead, they must pay the ongoing market price for their inputs. - Given these prices and the physical returns summarized by the product curves, the costs of producing different levels of output can be calculated.

*Total Cost (TC)* - The total cost of producing any given level of output. Total cost is divided into two parts: (1) total fixed cost (2) total variable cost *TC = TFC + TVC*

*Total Fixed Cost (TFC)* - All cost of production that do not vary with the level of output. - Also referred to as *overhead cost*

*Total Variable Cost (TVC)* -Total costs of production that vary directly with the level of output. - cost of the variable factors, which varies directly w the level of output. (it rises when output rises and it falls when output falls) ex. The cost of labour and intermediate inputs that are used to produce output. As the level of output increases or decreases, the amount of labour and intermediate inputs required for production changes in the same direction.

Total cost of producing any given number of units of output divided by that number of units tells us the average total cost per unit of output. - It can also be calculated as the sum of average fixed costs and average variable costs. - Also called unit cost or average cost. *ATC = TC/Q* *ATC = AFC + AVC* *Q* = the total units of output (earlier referred to as the total product, TP)

Total fixed cost divided by the number of units of output - declines continuously as output increases because the amount of the fixed cost attributed to each unit of output falls. - This is known as *spreading overhead* *AFC = TFC/Q*

Total variable cost divided by the number of units of output - tells us the variable cost per unit of output. - AVC first declines as output rises, reaches a minimum, and then increases as output continues to rise. *AVC = TVC/Q*

The increase in total cost resulting from increasing output by *one unit.* - Marginal costs are always marginal *variable* costs because fixed costs do not change as output varies. *MC = ?TC/?Q* - Marginal cost is calculated by the change in total cost divided by the change in output that brought about it.

In part (ii) of Figure 7-2 (graph in notebook), *The average fixed cost (AFC) curve* steadily declines as output rises. Since there is a given amount of capital with a total fixed cost of $100, increases in the level of output lead to a steadily declining fixed cost per unit of output. This is the phenomenon of *spreading overhead* *The average variable cost (AVC) curve* shows the variable cost per unit of output. It declines as output rises, reaching a minimum at approximately 100 units of output. As output increases about this level, AVC rises. Since *average total cost (ATC)* is simply the sum of AFC and AVC, it follows that the ATC curve is derived geometrically by vertically adding the AFC and AVC curves. The result is an ATC curve that declines initially as output increases, reaches a minimum, and then rises as output increases further. Referred as a "U-shaped" ATC curve.

- Points on the curve are plotted at the *midpoint* of the output interval shown in the table. - The MC curve declines steadily as output initially increases, reaches a minimum somewhere near 70 units of output, and then rises as output increases further.

- Recall that the MP and AP curves in Figure 7-1 are both "hill shaped" (an inverted U) whereas the AVC and MC curves are both U-Shaped. - Since labour input adds directly to cost, the relationship between labour input and output-the AP and MP curves-is closely linked to the relationship between output and cost-the AVC and MC curves. - Eventually diminishing average product (AP) of the variable factor implies eventually increasing (AVC) - Eventually diminishing marginal product of the variable factor implies eventually increasing marginal costs. - Since ATC=AFC+AVC, the ATC curve gets its shape from both the AFC and the AVC curves. The AFC curve is steadily declining as a given amount of overhead (fixed factor) is spread over an increasing number of units of output. - The AVC curve is U-shaped for the reasons we have just seen regarding the relationship between AP and AVC. - The ATC curve begins to rise (after reaching its min) only when the effect of the increasing AVC dominates the effect of the declining AFC. - We therefore see the ATC curve reaching its min at a level of output above where the AVC reaches its min.

- The level of output that corresponds to the minimum short-run average total cost is often called the *capacity* of the firm. - When used in this sense, the capacity is the largest output that can be produced without encountering rising average costs per unit. - In part (ii) of Figure 7-2, capacity output is about 107 units, but higher outputs can be achieved, provided that the firm is willing to accept the higher per-unit costs that accompany any level of output that is "above capacity" - A firm that is producing at an output less than the point of minimum average total cost is said to have *excess capacity*. - The technical definition gives the word *capacity* a meaning that is different from the one used in everyday speech, in which it often means an upper limit that cannot be exceeded. - The existence of a fixed factor, such as a factory with a given amount of machinery or equipment, usually leads to clear cases of diminishing marginal returns and thus to the U-shaped cost curves.

Drawn holding 2 things constant: 1) the amount of the fixed factor used by the firm (existence of a fixed factor ensures we are in the short run) 2) Factor prices - the price per unit of labour and price per unit of capital - are held constant.

- Changes in factor prices affect firms' costs. - Consider a change in the wage, the price of a unit of labour services - increase in wage increases variable costs, leaves fixed costs unaffected, and therefore increases the firm's total costs. Since marginal costs are always marginal *variable* costs, such a change will also increase the firm's marginal costs. Increase in the price of the variable factor will cause an upward shift in the firm's ATC and MC curves. - An increase in the price of a unit of the fixed factor will cause the firm's total *fixed* costs to rise, but its variable costs will be unaffected. The ATC curve will shift up but the MC curve will not move. - A change in the price of a variable factor shifts the average total cost curve and marginal cost curve.

- In the short run, firms have a fixed amount of some factor of production, Physical capital is usually thought of as the fixed factor in the short run. - There are 2 effects to the firm's production costs if it increases the size of its factory: 1. Firm's total fixed costs have increased. 2. The increase in the size of the factory means that labour and other variable factors now have more (or better) physical capital with which to work, and this generally increases their average and marginal product, and reduces marginal and average costs. - The overall effect on the ATC curve is difficult to predict without more info about the firm's technology. It depends on how much the firm's output rises when it increases its use of *all* factors. We need to have more detailed info about the firm's production fnc before we know how a change in the firm's plant size will affect its ATC curve. - Changing from one plant size to another is considered to be a long-run decision by the firm.

- Many digital products have constant and near-zero marginal costs and so are a good example of settings where diminishing marginal returns are not present.