AP MICRO Unit 3: Production, Cost, & the Perfect Competition Model

Production Function

The mathematical expression of the relationship between costs and benefits for a business; the input costs for given output

Theory of the Firm

The idea that the goal and purpose of a business is to make decisions that maximize profits

Total Product

The total output for a given quantity of input

Average product

The total product divided by the number of units of a given input

Marginal Product

The additional number of units of output that results from another unit of input, which can be a negative number

Law of Diminishing Marginal Returns

The principle that as more and more of an input is used in short-run production, the marginal product eventually declines

Short Run

A period of time in which any production input, such as rent or property taxes, cannot be changed

Fixed Input

A factor of production that cannot be changed in the short term

Variable Input

Any input that can be increased in immediate response to demand for output

Fixed Cost

Input costs that do not change based on the amount produced or in the period of time under consideration

Variable Costs

Any production cost of a business that depends on the quantity produced

Specialization

The designation of resources and workers to specific tasks to produce in a more efficient and effective way

Division of Labor

Dedicating workers to separate stages in the production process, often dramatically increasing overall productivity

Long-Run Average Total Cost Curve/LRATC

Illustrates lowest cost per unit at each level of output when all factors of production are variable

Economies of Scale

The range of production quantities in which increased input quantities produce proportionately increasing output quantities, loweing average total cost - range of decreasing LRATC

Efficient Scale

The range of production quantities in which increased input quantities produce proportionately equal output quantities, not changing average total cost; also known as constant returns to scale -  range where LRATC is constant and at its minimum

Diseconomies of Scale

The range of production quantities in which increased input quantities produce proportionately lesser output quantities, increasing average total cost - range of increasing LRATC

Productivity

The rate of output generated per a unit of input

Minimum Efficient Scale (MES)

The point where a firm produces a good at its lowest possible opportunity cost

Market Concentration

The extent to which the supply of a particular good or service is distributed among its producers, measured in various ways; generally if one or a few firms produce the vast majority of a good, its market is highly concentrated

Normal Profit

When a company is earning zero economic profit

Profit

The difference between total revenue and total cost

Operate

Produce one or more units of a given good or service

Shut Down

Stopping economic production or reducing production to zero units

Shutdown Rule

A firm will stop production in the short run when the price is lower than the firm’s average variable cost

Produce with Profit

• MR = MC = P > ATC

• Short Run: firms continue to produce

• Long Run: firms enter market & push the market price down

Break Even

• MR = MC = P = ATC

• Short Run: businesses will continue to operate

• Long Run: will stay in the market

Produce at a Loss

• MR = MC = P < ATC

• Short Run: businesses will continue to operate

• Long Run: will leave the market

Shut Down

• MR = MC = P < AVC

• Short Run (& Long Run): businesses will have no incentive to operate and will shut down immediately

TR - TC

= Economic Profit

Perfect Competition

A market structure with many firms selling identical products with no market power - it is productively and allocatively efficient

No Allocative Waste

When…

• No producers supply a surplus that cannot be sold or must be sold at a loss

• All consumers who are willing and able to pay the market price for the good have the good available to purchase

Characteristics of Perfectly Competitive Markets

1. Many Firms

2. Price-Taking

3. No Barriers

4. Identical Products

5. Perfect Knowledge

Competitive Markets: MR. DARP

Marginal Revenue = Demand = Average Revenue = Price

In Competitive Markets: ATC minimum point is BELOW the profit maximizing point

• Short run: economic profit

• Long run: economic profit won’t last long as more markets enter (shifting supply curve to the right and lowering the market equilbrium price). This eliminates economic profit, shifting MR. DARP down, leading to the firm to break even

In Competitive Markets: ATC minimum point is ABOVE the profit maximizing point

• Short run: economic losses

• Long run: firms experiencing losses will leave the market (shifting supply curve to the left, increasing the market price, and lowering the market equilibrium quantity). This eliminates economic losses, shifting MR. DARM up, leading the firm to break even

Break Even Point

Where the minimum point of ATC is equal to the profit maximization point (MC = MR)

Productive Efficiency

Price = Minimum ATC

• When the optimal combination of inputs is being applied to produce the maximum amoutn possible

Allocative Efficiency

Price = MC

• Producing and exchanging where the marignal benefit to the consumers equals the marginal beenfit to producers

The 3 Industry-Specific Costs

Every good and services exists in an…

• Increasing-cost industry

• Decreasing-cost industry

• Constant-cost industry

Constant Cost Industry

• Production costs will not be affected as firms enter and leave the market

• If demand is above or below the intersection of MC and ATC, only MR. DARP and the dashed lines will move as the market adjusts equilbrium to eliminate the temporary economic profits or losses

• LRS: horizontal (flat)

Increasing-Cost Industry

• Any industry that depends on factors of production that will become more expensive as quantity demanded increases, shifting ATC and MC upwards

• New increased short-run market price provides firms in the market with temporary economic profits

• Long-run equilibrium price ends up higher than original price

• LRS: upward-sloping

Decreasing-Cost Industry

• As industry grows larger and more firms enter, cost of prodution falls

• MC and ATC curves go down when firms enter and go up when firms exit

• Long-run equilibrium price ends up lower than original price

• LRS: downward-sloping

Long Run Supply (LRS)

Indicates the relationship between market price and total quantity supplied in a perfectly competitive market (after all firms entered/exited/adjusted/etc)

LRS vs. LRATC

LRS: for the whole industry

LRATC: for an individual firm