Test 2: Chapters 7 & 9 (Economic Costs and Utility in Microeconomics)

Economic cost

Defined as the payment that must be made to obtain and retain the services of a resource. It is the income that a firm must provide to resource suppliers to attract resources away from alternative uses.

Explicit costs

Monetary payments the firm makes to those from whom it must purchase resources that it does not own. Example: wage payment the firm must make to its workers.

Implicit costs

The opportunity costs of using the resources that the firm already owns to make the firm's own product rather than selling those resources to outsiders for cash. Example: forgone rent from the building owned and used by Amazon.

Economic costs formula

= Explicit costs + Implicit costs

Accounting profit

= Total sales revenue - Total explicit costs

Economic profit

= Accounting profit - Total implicit costs

Normal profit

Refers to the level of accounting profit at which a firm generates an economic profit of zero after paying for entrepreneurial ability.

Short run

A period of time that is too brief for a firm to alter its plant capacity, but during which the firm can change output somewhat by increasing or decreasing its variable inputs.

Long run

A period of time that is long enough for the firm to adjust the plant size as well as enter or leave the industry. All inputs are variable in this

Total product (TP)

The total quantity that is produced.

Marginal product (MP)

The amount that total product changes when labor changes by one unit. It reflects the change in output when one more unit of labor is hired.

Average product (AP)

The output that is produced per unit of labor.

Marginal product formula

= change in total product / change in labor input

Average product formula

= total product / units of labor

Law of diminishing returns

The principle that as successive increments of a variable resource, like labor, are added to a fixed resource, like land or capital, beyond some point the marginal or the extra product of the variable resource, will eventually decrease.

Impact of excess labor

When a firm hires so many workers but keeps the office size the same, it impedes the worker's ability to produce. Thus, the additional output of the additional workers starts to decline, diminishing return.

Relationship between TP, MP, & AP

Involves that when TP is increasing at the initial phase of production, MP is also increasing. When TP is increasing at a decreasing rate, MP starts to decrease. When TP is at a maximum, MP is zero.

Increasing Marginal Returns

When TP is rising at an increasing rate, leading to a larger MP.

Diminishing Marginal Returns

When TP continues to increase but by smaller amounts, causing MP to decrease.

Fixed Costs

Costs that do not change in total when the firm changes its output, such as rental payments and insurance premiums.

Variable Costs

Costs that increase with output and decrease when output is reduced, such as payments for materials and labor.

Total Cost (TC)

= Calculated as Total Fixed Cost (TFC) + Total Variable Cost (TVC)

Average Fixed Cost (AFC)

Calculated as Total Fixed Cost (TFC) divided by Quantity.

Average Variable Cost (AVC)

Calculated as Total Variable Cost (TVC) divided by Quantity.

Average Total Cost (ATC)

Calculated as Average Fixed Cost (AFC) + Average Variable Cost (AVC) or Total Cost (TC) divided by Quantity.

Marginal Cost (MC)

Calculated as the Change in Total Cost (TC) divided by the Change in Quantity.

Total Fixed Cost (TFC)

The total of all fixed costs incurred by a firm.

Total Variable Cost (TVC)

The total of all variable costs incurred by a firm.

Graph of Total Cost (TC) and Total Variable Cost (TVC)

TC is the sum of fixed and variable costs; TVC changes with output.

Graph of Average Total Cost (ATC), Average Variable Cost (AVC), and Average Fixed Cost (AFC)

AFC falls as fixed costs are spread over larger output; AVC initially falls then rises.

Relationship of MC, ATC, and AVC on a Graph

MC cuts through ATC and AVC at their minimum points; MC's position relative to ATC and AVC determines their rise or fall.

Relationship between MP and MC

When MP is rising, MC is falling, and when MP is falling, MC is rising.

Relationship between AP and AVC

When AP is rising, AVC is falling, and when AP is falling, AVC is rising.

Graphical effect of wage rate increase on cost curves

The AVC, ATC, and MC would shift up.

Graphical effect of wage rate decrease on cost curves

The AVC, ATC, and MC would shift down.

Technological improvement effect on cost curves

Lead to a fall (shift down) in all cost curves.

Change in fixed costs (increase) effect on cost curves

The AFC and ATC curves will shift upwards, but the position of the AVC and MC curves would not be altered.

Long-run cost curves behavior

All resources are variable, and thus all costs are variable.

Long-run average-total-cost curve

Made up of segments of the short-run cost curves (ATC-1, ATC-2, etc.) of various-size plants.

U-shaped long-run average-total-cost curve

Economies of scale followed by diseconomies of scale cause the curve to be U-shaped.

Economies of scale

Firms experience when the long run ATC curve is declining.

Diseconomies of scale

Firms experience when the long run ATC curve is increasing.

Constant returns to scale

Present when long run ATC is flat.

Example of economies of scale

If a firm increases all its inputs by 5 percent and its output increases by 10 percent

Example of constant returns to scale

If output increases by 5 percent when inputs increase by 5 percent

Example of decreasing returns to scale

If output increases by less than 5 percent when inputs increase by 5 percent

Minimum Efficient Scale (MES)

The lowest level of output at which a firm can minimize long-run average total cost.

Sources of economies of scale

Achieved because of labor specialization, managerial specialization, efficient capital, and learning by doing.

Reasons for diseconomies of scale

Achieved due to difficulty in efficiently controlling and coordinating a firm's operations as it becomes a large-scale producer.

Utility

A subjective notion in economics, referring to the amount of satisfaction or pleasure a person gets from consumption of a good or service.

Total Utility

The total amount of satisfaction one gets from the consumption of a single product or a combination of products.

Marginal Utility

The extra utility a consumer gets from one additional unit of a specific product; it refers to the change in total utility.

Law of Diminishing Marginal Utility

The fact that added satisfaction declines as a consumer acquires additional units of a given product.

Behavior of Total Utility

As more of a product is consumed, total utility increases at a diminishing rate, reaches a maximum, and then declines.

Marginal Utility and Total Utility Relationship

Marginal utility reflects the changes in total utility, diminishing with increased consumption, becoming zero when total utility is at a maximum, and negative when total utility declines.

Utility-Maximizing Rule

Indicates that a consumer should allocate money income so that the last dollar spent on each product yields the same amount of extra (marginal) utility.

Marginal Utility-to-Price Ratio

A consumer will maximize utility when each good is purchased in amounts such that the marginal utility per dollar spent is the same for all goods.

Algebraic Generalization of Utility Maximization

MUa/Pa = MUb/Pb, where MUa is the marginal utility of product A, Pa is the price of product A, MUb is the marginal utility of product B, and Pb is the price of product B.

Utility Maximization Equation Not Fulfilled

If MUa/Pa > MUb/Pb, the consumer should purchase more of A and less of B.

Income Effect

The impact that a price change has on a consumer's real income and, consequently, on the quantity demanded of the good.

Substitution Effect

The impact that a change in a product's price has on its relative expensiveness and on the quantity demanded.

Demand Curve Explanation

The downward sloping demand curve is explained by the income effect, substitution effect, and diminishing marginal utility.

Equilibrium Attainment

A decline in price expands the consumer's real income, allowing for the purchase of more products until equilibrium is attained.

Price Decrease Impact

It decreases its relative expensiveness, leading consumers to substitute more of this good for others.

Price Increase Impact

The substitution effect will tend to make the quantity decrease.

Commonality of Income Effect, Substitution Effect, and Diminishing Marginal Utility

They all explain the slope of the demand curve.