Chapter 8: The Firm, Profit, and the Costs of Production

The firm

An organization that employs factors of production to produce a good or service that it hopes to profitably sell

Accounting profit 

The difference between total revenue and total explicit costs

Economic profit

The difference between total revenue and total explicit and implicit costs

Explicit costs

Direct, purchased, out-of-pocket costs paid to resource suppliers outside the firm. Also referred to as *accounting costs*

Implicit costs

Indirect, non-purchased, or opportunity costs of resources provided by the entrepreneur. Also called *economic costs*

Short run

A period of time too short to change the size of the plant, but many other, more variable resources can be adjusted to meet demand

Long run

A period of time long enough to alter the plant size. New firms can enter the industry and existing firms can liquidate and exit

Production function

The mechanism for combining production resources, with existing technology, into finished goods and services. Inputs are turned into outputs

Fixed inputs

Production inputs that cannot be changed in the short run. Usually this is the plant size or capital

Variable inputs

Production inputs that the firm can adjust in the short run to meet changes in demand for their output. Often this is labor and/or raw materials

Total Product of Labor (TPL)

The total quantity, or total output, of a good produced at each quantity of labor employed

Marginal Product of Labor (MPL)

The change in total product resulting from a change in the labor input. MPL = DTPL/DL, or the slope of total product

Average Product of Labor (APL)

Total product divided by labor employed: APL = TPL/L

Law of diminishing marginal returns

As successive units of a variable resource are added to a fixed resource, beyond some point the marginal product declines

Total fixed costs (TFC)

Costs that do not vary with changes in short-run output. They must be paid even when output is zero

Total variable costs (TVC)

Costs that change with the level of output. If output is zero, so are total variable costs

Total cost (TC)

The sum of total fixed and total variable costs at each level of output: TC = TVC + TFC

Marginal cost (MC)

The additional cost of producing one more unit of output. MC = DTC/D*Q* = DTVC/D*Q* or the slope of total cost and total variable cost

Average fixed cost (AFC)

Total fixed cost divided by output: AFC = TFC/*Q*

Average variable cost (AVC)

Total variable cost divided by output: AVC = TVC/*Q*

Average total cost (ATC)

Total cost divided by output. ATC = TC/*Q* = AFC + AVC

Relationship between MPL and MC

If labor is the variable input being paid a fixed wage (*w*), MC and MPL are inverses of each other. MC = *w/*(D*Q/*DL) = *w*/MPL

Relationship between APL and AVC

In the simplified case where labor is the variable input being paid a fixed wage (*w*), AVC and APL are inverses of each other. AVC = *w/*(*Q*/L) = *w*/APL

Economies of scale

The downward part of the LRAC curve where LRAC falls as plant size increases. This is the result of specialization, lower cost of inputs, or other efficiencies from larger scale

Minimum efficient scale

The plant size at which the LRAC first reaches its minimum point

Constant returns to scale

Occurs when LRAC is constant over a variety of plant sizes

Diseconomies of scale

The upward part of the LRAC curve where LRAC rises as plant size increases. This is usually the result of the increased difficulty of managing larger firms, which results in lost efficiency and rising per-unit costs

Increasing returns to scale in production

The long-run outcome when output more than doubles from a doubling of all inputs

Constant returns to scale in production

 The long-run outcome when output exactly doubles from a doubling of all inputs

Decreasing returns to scale in production

The long-run outcome when output less than doubles from a doubling of all inputs