Midterm 1 Review (Ch 14, 15, 24, 25, 29)
Chapter 14: The Costs of Production
Costs of Production: The total value of all resources, both monetary and non-monetary, used to produce goods and services. Understanding these costs is crucial for firms to make informed decisions about pricing, production levels, and resource allocation.
Explicit Costs: Direct monetary payments made to others for resources, goods, or services. These are easily quantifiable and recorded in accounting books.
Examples: Wages paid to employees, rent for factory space, raw material purchases, utility bills, interest payments on loans.
Implicit Costs: The opportunity costs of resources owned and used by the firm in production. These represent the value of the best alternative use of those resources and are not typically recorded as out-of-pocket expenses.
Examples: The forgone salary an owner could earn working elsewhere, the interest income lost by using owner's capital in the business instead of investing it, the rental income lost by using an owner's building for the business.
Profits: Measures of a firm's financial performance.
Economic Profit: Calculated by subtracting both explicit and implicit costs from total revenue (Economic\, Profit = TR - Explicit\, Costs - Implicit\, Costs). This provides a more comprehensive view of profitability, considering all opportunity costs.
Accounting Profit: Calculated by subtracting only explicit costs from total revenue (Accounting\, Profit = TR - Explicit\, Costs). This is typically what appears on a company's financial statements.
Key Formulas: Essential for cost analysis and profit calculation.
Total Revenue (TR) = P \times Q (Price per unit multiplied by Quantity sold)
Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)
Profit (\pi) = TR - TC
Cost Types: Categorization of costs based on their variability with output.
Fixed Costs (FC): Costs that do not vary with the quantity of output produced in the short run. They are incurred even if no output is produced.
Examples: Rent, insurance premiums, property taxes, salaries of administrative staff (often considered fixed).
Variable Costs (VC): Costs that change directly with the quantity of output produced. As production increases, variable costs increase.
Examples: Raw materials, production wages, electricity used in production, shipping costs.
Total Cost (TC) = FC + VC. Represents the sum of all costs incurred in producing a certain quantity of output.
Average Costs: Costs per unit of output.
Average Fixed Cost (AFC) = FC/Q (Fixed cost per unit; declines as quantity increases due to the spreading effect)
Average Variable Cost (AVC) = VC/Q (Variable cost per unit; typically falls initially then rises due to diminishing returns)
Average Total Cost (ATC) = TC/Q = AFC + AVC (Total cost per unit; often U-shaped)
Marginal Cost (MC): The change in total cost resulting from producing one additional unit of output. It is crucial for firms to decide whether to produce more or less.
MC = \frac{\Delta TC}{\Delta Q}. The marginal cost curve typically slopes upward due to diminishing marginal product.
Production Function: A mathematical relationship that shows the maximum quantity of output a firm can produce from any given combination of inputs (e.g., labor, capital). It illustrates the efficiency of production and often exhibits diminishing marginal returns in the short run.
Short-Run vs. Long-Run: Economic time frames for production decisions.
Short Run: A period during which at least one input (typically capital, like factory size) is fixed, while other inputs (like labor) are variable. Firms can adjust output by changing variable inputs only.
Long Run: A period during which all inputs are variable. Firms can adjust the scale of their operations (e.g., build new factories, exit industries). This flexibility allows for:
Economies of Scale: When long-run average total cost falls as the quantity of output increases (e.g., specialization, bulk purchasing).
Diseconomies of Scale: When long-run average total cost rises as the quantity of output increases (e.g., coordination problems, bureaucratic inefficiencies).
Constant Returns to Scale: When long-run average total cost remains unchanged as the quantity of output changes.
Chapter 15: Firms in Competitive Markets
Characteristics of Perfect Competition: An idealized market structure with several key features:
Many buyers and sellers: No single buyer or seller has significant market power to influence prices.
Identical products (homogenous): All firms sell exactly the same product, making it impossible for consumers to prefer one seller over another based on the product itself.
Free entry and exit: Firms can easily enter or leave the market without significant barriers, ensuring that long-run economic profits are zero.
Perfect information: Buyers and sellers have complete knowledge about prices, products, and market conditions.
As a result of these characteristics, individual firms in a perfectly competitive market are price takers.
Revenue for Competitive Firm: How a perfectly competitive firm generates income.
Total Revenue (TR) = P \times Q (Price of the good multiplied by Quantity sold).
Average Revenue (AR) = TR/Q = P (Revenue per unit sold; in perfect competition, AR always equals the market price).
Marginal Revenue (MR) = \frac{\Delta TR}{\Delta Q} = P (The additional revenue from selling one more unit; in perfect competition, MR also always equals the market price because the firm is a price taker).
Profit Maximization: The primary goal of a firm, achieved at the output level where Marginal Revenue (MR) equals Marginal Cost (MC). This rule applies to all types of firms.
Specifically, firms produce where MR = MC, and it's essential that the MC curve is rising at this intersection point to ensure profit maximization (or loss minimization).
Short-Run Shutdown Decision: A firm's decision to temporarily cease production in the short run if it cannot cover its variable costs, even if it might continue to incur fixed costs.
A firm will shut down if its revenue is less than its variable costs, which translates to P < AVC (Price falls below average variable cost). By shutting down, the firm minimizes its losses to its fixed costs.
Chapter 24: Measuring a Nation’s Income
GDP Definition: Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country's borders in a specific time period (typically a year or a quarter). It is the most common measure of a nation's total economic output and income.
GDP Components: The four major expenditure categories that comprise GDP:
GDP = C + I + G + NX
C (Consumption): Spending by households on goods and services, excluding new housing.
I (Investment): Spending on capital equipment, inventories, and structures, including household purchases of new housing.
G (Government Purchases): Spending by local, state, and federal governments on goods and services (e.g., infrastructure, military salaries). It excludes transfer payments.
NX (Net Exports): Exports minus imports. (Exports are goods and services produced domestically and sold abroad; imports are goods and services produced abroad and sold domestically).
Exclusions from GDP: Activities not counted in GDP calculation and the reasons why:
Used goods: Their sale represents a transfer of an asset, not new production.
Financial assets: Such as stocks and bonds, represent claims on future production, not actual production themselves.
Transfer payments: Government payments to individuals (e.g., social security, unemployment benefits) for which no good or service is received in return; considered income redistribution, not production.
Household production: Goods and services produced by individuals for their own consumption within the household (e.g., cooking, cleaning, childcare) are not exchanged in markets and thus not easily measured.
Intermediate goods: Goods used as inputs in the production of other goods (e.g., raw materials, components) are excluded to avoid double-counting; only the final good is counted.
GDP Calculation: Can be approached in two primary ways:
Income Approach: Sums all incomes earned by households and firms in the economy (wages, rent, interest, profits).
Expenditure Approach: Sums all spending on final goods and services in the economy (C + I + G + NX).
Fundamentally, aggregate income (what is earned) must equal aggregate expenditure (what is spent) because every transaction involves both a buyer and a seller.
Nominal vs. Real GDP: Distinguished by how prices are accounted for.
Nominal GDP: The sum of current year prices and quantities. It reflects both changes in quantities produced and changes in prices. Thus, an increase in nominal GDP could be due to more output or higher prices.
Real GDP: Uses base year prices to calculate the value of current output. This removes the effect of inflation, allowing for a more accurate comparison of economic output over time by reflecting only changes in the quantity of goods and services produced.
Chapter 25: Measuring the Cost of Living
Price Index: A measure of the average price level of a basket of goods and services in an economy over time. The Consumer Price Index (CPI) is the most common price index, designed to measure changes in the cost of living for a typical urban consumer.
Consumer Price Index (CPI) calculation: A weighted average of prices of a fixed basket of goods and services purchased by typical urban consumers.
CPI = \frac{Cost \, of \, Market \, Basket \, in \, given \, year}{Cost \, of \, Market \, Basket \, in \, base \, year} \times 100
Producer Price Index (PPI): Measures the average change over time in the selling prices received by domestic producers for their output. It is often considered an early indicator of future inflation in consumer prices, as changes in producer costs can eventually be passed on to consumers.
CPI vs. GDPPI: Two key measures of inflation with different scopes.
CPI: Focuses on the prices of a fixed basket of goods and services typically purchased by households, including imported goods and services. It reflects the cost of living for consumers.
GDP Deflator (GDPPI): Measures the price level of all new, domestically produced final goods and services. It reflects the prices of all goods and services produced within a country's borders, excluding imports.
Sources of Inflation: The underlying causes of a sustained increase in the general price level.
Demand-pull inflation: Occurs when aggregate demand in an economy outpaces aggregate supply, pulling prices upward (e.g., rapid money supply growth, strong consumer confidence).
Cost-push inflation: Occurs when increases in the cost of production (e.g., rising wages, higher raw material prices, supply shocks) push up prices.
Effects of Unanticipated Inflation: Unexpected changes in the price level can have significant consequences:
Redistribution of wealth: Debtors gain (they repay loans with money worth less), and creditors lose (they are repaid with money worth less).
Menu costs: The costs associated with changing prices (e.g., printing new menus, updating catalogs).
Relative price issues and resource misallocation: Inflation distorts relative prices, leading to inefficient resource allocation as firms and consumers struggle to distinguish between changes in real prices and changes due to overall inflation.
Uncertainty: Makes long-term planning difficult for businesses and individuals.
Limitations of CPI: Factors that can lead to an overstatement of the true cost of living increase:
Substitution bias: The CPI uses a fixed basket of goods, but consumers often substitute away from goods whose prices have risen toward relatively cheaper goods. The CPI doesn't immediately reflect this substitution.
Quality bias: Over time, goods and services improve in quality. A price increase might reflect improved quality rather than a true increase in the cost of living (e.g., a computer today is more expensive but also far more powerful).
New goods bias: New products are often not included in the CPI basket until they become widely adopted, which can delay the reflection of their (often falling) prices and the increased purchasing power they offer.
Chapter 29: Unemployment
Labor Force Definition: Consists of all individuals aged 16 and older who are either employed (working for pay) or unemployed (actively seeking work). This definition excludes people not in the labor force, such as full-time students, retirees, homemakers, and those institutionalized.
Labor Force Participation Rate (LFPR): The percentage of the adult population that is in the labor force.
LFPR = \frac{Labor \, Force}{Adult \, Population} \times 100
A higher LFPR generally indicates a larger supply of labor available for production.
Unemployment Rate Calculation: The percentage of the labor force that is unemployed.
Unemployment \, Rate = \frac{Unemployed}{Labor \, Force} \times 100
This rate can understate true joblessness by excluding discouraged workers (who have stopped looking for work) and overstate it by including those who are not seriously looking.
Natural Rate of Unemployment: The normal rate of unemployment around which the actual unemployment rate fluctuates. It represents the lowest sustainable unemployment rate achievable in an economy where the labor market is in equilibrium.
It is the sum of frictional and structural unemployment.
Frictional unemployment: Short-term unemployment that arises from the process of matching workers with jobs (e.g., individuals changing jobs, new entrants to the labor force).
Structural unemployment: Long-term unemployment that results from a mismatch between the skills workers possess and the skills demanded by employers, or from persistent joblessness in specific industries/regions due to technological change or globalization.
The natural rate indicates
full employment, but not zero unemployment, as frictional and structural unemployment are always present.Cyclical unemployment: Unemployment that rises and falls with the business cycle. It's the deviation of the actual unemployment rate from the natural rate. It is zero when the economy is at its natural rate of unemployment.