ECN 112 Chapter 12 Lecture Notes

12.1 Economic Cost and Profit
A. The Firm’s Goal
The firm’s goal is to maximize its profit
1. The firm’s profit is calculated as total revenue – total cost.
B. Accounting Cost and Profit
1. Accountants measure cost and profit to ensure firms follow rules imposed by the Internal Revenue Service. Accountants do not consider opportunity costs.
C. Opportunity Cost
Economists emphasize the fact that resources used to make one good are prevented from being used to make another good.
1. Firms employ factors of production.
2. A firm’s opportunity cost of production is the cost of employing its factors of production.
3. Explicit Costs and Implicit Costs
Opportunity costs are divided into implicit and explicit costs.
a. An explicit cost is a cost paid in money.
b. An implicit cost is an opportunity cost incurred by a firm when it uses a factor of production for which it does not make a direct money payment.
c. Economic depreciation is an opportunity cost of a firm using capital that it owns—measured as the change in the market value of capital over a given time period. Economic depreciation is an implicit cost.
d. A normal profit is the return to entrepreneurship. Normal profit is part of a firm’s opportunity cost because it is the cost of not running another firm.
D. Economic Profit
Economic profit is a firm’s total revenue minus total cost. The total cost is the total opportunity cost.
12.2 Short-Run Production
A firm’s production costs depend on the time frame over which the firm plans to produce output. There are two decision time frames facing firms:
A. The Short Run: Fixed Plant
The short run is a time frame in which the quantities of some resources are fixed. In the short run, a firm can usually change the quantity of labor it uses but not its technology and the quantity of capital.
a. The resources that cannot be changed are called fixed factors of production. Fixed factors of production are the firm’s technology, capital, and management and are called the firm’s plant.
b. The factors that can be changed are called variable factors of production. Variable factors of production include labor.
c. To change output in the short run, firms must change the quantity of variable factors it uses.
B. The Long Run: Variable Plant
The long run is the time frame in which the quantities of all resources can be varied.
a. A long-run decision is not easily reversed. The difference between the cost of a plant and its resale value is a sunk cost. A sunk costs is irrelevant to a firm’s decisions.
C. Total Product
Total product is the total quantity of a good produced in a given time period. The total product curve, graphed with the quantity of labor on the x-axis and total product on the y-axis, is upward sloping until it reaches its maximum, after which it becomes downward sloping.
D. Marginal Product
Marginal product (MP) is the change in total product that results from a one-unit increase in the quantity of labor employed. The marginalproductcurve is upward sloping, reaches a maximum, and then declines.
1. Increasing Marginal Returns
Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker. Most production processes experience increasing marginal returns initially.
2. Decreasing marginal returns occur when the marginal product of an additional worker is less than the marginal product of the previous worker..
a. The law of decreasing returns states that as a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually decreases.
E. Average Product
The average product (AP) is the total product divided by the quantity of an input. The average product of labor is total product divided by the quantity of labor employed. The averageproductcurve is upward sloping, reaches a maximum, and then declines. The marginal product curve intersects the average product curve at the AP curve’s maximum point.
1. Marginal Grade and Grade Point Average
The relationship between the marginal grade and grade point average is the same a the relationship between marginal product and average product:
a. When the marginal product is greater than the average product, the average product is increasing.
b. When the marginal product is less than the average product, the average product is decreasing.
I2.3 Short-Run Cost
A. Total Cost
There are three total cost concepts:
1. Total cost (TC) is the cost of all the factors of production used by a firm. Total cost divides into two parts: total fixed cost and total variable cost.
2. Total fixed cost (TFC) is the cost of the fixed factors of production used by a firm—the cost of land, capital, and entrepreneurship.
3. Total variable cost (TVC) is the cost of the variable factor of production used by a firm—the cost of labor.
4. Total cost = total fixed cost + total variable cost.
B. Marginal Cost
Marginal cost (MC) is the change in total cost that results from a one-unit increase in output.
C. Average Cost
There are three average cost concepts:
1. Average fixed cost (AFC) is total fixed cost per unit of output. AFC = TFC ¸ Q. The AFC curve is downward sloping.
2. Average variable cost (AVC) is total variable cost per unit of output. AVC = TVC ¸ Q. The AVC curve is U-shaped.
3. Average total cost (ATC) is total cost per unit of output, which equals average fixed cost plus average variable cost. The ATC curve is U-shaped and lies above the AVC curve. The vertical distance between the ATC and AVC curves is average fixed cost.
4. The MC curve intersects the ATC curve and the AVC curve at their minimum points.
D. Why the Average Total Cost Curve is U-Shaped
The ATC curve is U-shaped because ATC is the sum of AFC and AVC. The U-shape reflects the factors that determine the shapes of those two curves:
1. The AFC curve is downward sloping because as output increases, the firm spreads its fixed costs over larger and larger amounts of output.
2. The AVC curve is U-shaped because of decreasing marginal returns.
E. Cost Curves and Product Curves
The cost curves and product curves are linked.
1. In the range of employment and output over which the AP curve is upward sloping, the AVC curve is downward sloping, and in the range over which the AP curve is downward sloping, the AVC curve is upward sloping.
2. In the range of employment and output over which the MP curve is upward sloping, the MC curve is downward sloping, and in the range over which the MP curve is downward sloping, the MC curve is upward sloping.
F. Shifts in the Cost Curves
Cost curves shift in response to changes in two factors:
1. Technology.
A technological change that increases productivity shifts the product curves upward and the cost curves downward. If a technological change results in the firm using more capital, the average fixed cost curve shifts upward and at low levels of output, the average total cost curve may shift upward. At large output levels, average total cost decreases.
2. Prices of factors of production.
An increase in the price of a factor of production increases costs and shifts the cost curves upward. An increase in fixed cost does not affect the variable cost or marginal cost curves (TVC, AVC, and MC curves). An increase in variable cost does not affect the fixed cost curves (TFC and AFC). The total cost curves (TC and ATC curves) are affected by a price change for any factor of production.
I2.4 Long-Run Cost
In the long run, the firm can vary both the quantity of labor and the quantity of capital.
A. Plant Size and Cost
When a firm changes its plant size, the firm’s scale changes and its cost of producing a given output changes. When a firm changes the size of its plant, it might experience:
1. Economies of Scale
Economies of scale is a condition in which, when a firm increases its plant size and labor employed by the same percentage, its output increases by a larger percentage and its average total cost decreases.
a. Economies of scale result from the specialization of labor and capital.
2. Diseconomies of Scale
Diseconomies of scale is a condition in which, when a firm increases its plant size and labor employed by the same percentage, its output increases by a smaller percentage and its average total cost increases.
3. Constant Returns to Scale
Constant returns to scale is a condition in which, when a firm increases its plant size and labor employed by the same percentage, its output increases by the same percentage and its average total cost remains constant.
B. The Long-Run Average Cost Curve
The long-run average cost curve (LRAC) is a curve that shows the lowest average cost at which it is possible to produce each output when the firm has had sufficient time to change both its plant size and labor employed.
1. Economies and Diseconomies of Scale
The LRAC is divided into segments reflecting the three types of scale:
a. The downward-sloping portion of the LRAC reflects economies of scale.
b. The flat portion of the LRAC reflects constant returns to scale.
c. The upward-sloping portion of the LRAC reflects diseconomies of scale.