Producer Choice-Mod 3

The firm optimization problem

A firm chooses the output quantity that maximizes profit. Profit = total revenue - total economic cost.

Short run vs. long run

In the short run, at least one factor of production is fixed. In the long run, all factors of production are variable.

Production function

The production function shows the maximum output produced from inputs: Y = f(K, L), where K is capital and L is labor.

Total, marginal, and average product

Total product (TP) is total output. Marginal product of labor MPL = change in TP / change in labor. Average product of labor APL = TP / labor.

Relationship between MPL and TP

When MPL is positive, TP rises; when MPL is positive but falling, TP rises at a decreasing rate; when MPL = 0, TP is maximized; when MPL is negative, TP falls.

Relationship between MPL and APL

When MPL > APL, APL rises. When MPL < APL, APL falls. When MPL = APL, APL is at its maximum.

Diminishing marginal returns

Adding more units of a variable input such as labor to a fixed input such as capital eventually causes marginal product to fall. This is a short-run concept.

Returns to scale

Returns to scale is a long-run concept. Output changes by the same percentage as all inputs under constant returns, by a greater percentage under increasing returns, and by a smaller percentage under decreasing returns.

Fixed costs vs. variable costs

Fixed costs do not vary with output and must be paid even when output is zero. Variable costs change with output.

Core cost formulas

TC = FC + VC; AFC = FC/Q; AVC = VC/Q; ATC = TC/Q = AFC + AVC; MC = change in TC / change in Q.

Average and marginal cost relationships

AFC falls as output rises. When MC is below an average cost, it pulls that average down; when MC is above it, it pushes that average up. MC crosses AVC and ATC at their minimum points.

Cost curve shifters

Higher variable-input costs shift VC, TC, AVC, ATC, and MC upward. Higher fixed costs shift FC, TC, AFC, and ATC upward. Better technology shifts cost curves downward except total fixed cost.

Accounting cost vs. economic cost

Accounting cost includes explicit operating expenses. Economic cost also includes opportunity cost, so economic profit accounts for both explicit and implicit costs.

Marginal decision rule for firms

If MR > MC, produce more. If MR < MC, produce less. Profit is maximized at the output where MR = MC.

Price taker rule

A price-taking firm cannot control market price, so marginal revenue equals price: MR = P. Its profit-maximizing output satisfies P = MR = MC.