Unit 3: Production, Cost, and the Perfect Competition Model

production function

the way a firm combines inputs to produce an output

short run

inputs are fixed, can’t alter plant capacity

long run

all inputs are variable, plant capacity can be changed

variable inputs

can be changed in the short run

fixed inputs

can’t be changed in the short run

total product

total quantity of output produced by one more unit of variable input

marginal product

additional output produced by one more unit of variable output

average product

average quantity of output produced by one unit of variable output (labor)

law of diminishing returns

as you produce another unit your returns continue to decrease

MP increases

TP increases

MP is positive but decreases

TP is increasing at a decreasing rate

MP is zero

TP is at a maximum

MP is negative

TP is increasing

fixed cost

cost that must be paid even when output is zero

fixed cost formula

tfc = q x afc

variable cost

cost that changes as output changes

variable cost formula

tvc = q x avc

total cost

sum of fixed and variable costs

total cost formula

tc = tvc + tfc

marginal cost

additional cost of producing one more unit of output

marginal cost _______ intially

decreases (specialization)

marginal cost eventually _____

rises (diminishing returns)

marginal cost formula

mc = Δtc/Δq

average fixed cost formula

afc = fc/q

average variable cost formula

avc = vc/q

average total cost formula

atc = avc + atc

increasing returns to scale

output is increasing at a faster rate than all inputs

decreasing returns to scale

output is increasing at a slower rate than all inputs

constant returns to scale

output is increasing at the same rate as all inputs

profit formula

profit = revenue - cost

explicit costs

out of pocket expenses

implicit costs

money value of your opportunity cost

total revenue formula for accounting profit

tr = p x q

total cost formula for accounting profit

tc = fc + vc

accounting profit formula

accounting profit = revenue - explicit costs

total revenue formula for economic profit

tr = p x q

total cost formula for accounting profit

tc = explicit + implicit

economic profit formula

economic profit = tp - (explicit cost + implicit cost)

normal profit/zero economic profit

covers implicit and explicit costs

marginal analysis

cost benefit analysis

marginal revenue = marginal cost

ideal point at which you stop producing

marginal revenue formula

MR=ΔTR/ΔQ

marginal cost formula

MC=ΔTC/ΔQ

profit maximization rule

MR=MC

when TR>TC

firm earns an economic profit

when TR=TC

firm breaks even, makes a normal profit

when TR<TC

firm earns an economic loss

if TR>TC or TC=TR

firms will stay open

if VC<TR<TC

firms will stay open

if TR<VC<TC

firms will shut down temporarily because of seasonal businesses

shutting down rule

total revenue must cover the variable costs to continue

when MR=MC≥ATC

profit or break even

when MR=MC between ATC and AVC

loss but still open

when MR=MC≤AVC

shut down temporarily

barriers to entry

obstacles that prevent new competitors from entering a market

examples of barriers to entry

patents, copyrights, brand identity, start-up costs, government restrictions, etc

in the long run there are no

fixed costs

firm earns a loss in the long run

firm will exit the market or industry

firms are earning a positive economic profit in the long run

other firms will enter (because there are profit making oppurtunities)

characteristics of perfect competition

1. price taking firm (accept the market price)

2. lots of competitors

3. identical products

4. free entry and exit in the market (no patents, restrictions, licenses, etc.)

5. zero economic profit in the long run

perfect competition model

horizontal demand curve (MR=D=AR=P)

changes in supply and demand for the whole market will change

the price the firm must accept

for perfect competition firms, price changes will

lead to change in quantity and profits/losses

profit formula

profit= price-ATC