Foundations of Microeconomics - Production and Cost Flashcards

Economic Cost and Profit

• The Firm’s Goal: The primary objective of any firm is to maximize profit.

• Accounting vs. Economic Perspective:

  • Accountants: Measure cost and profit to ensure correct income tax payments and to demonstrate to lenders (banks) how loans are utilized.

  • Economists: Aim to predict the decisions a firm makes to maximize profit. These decisions are driven by opportunity cost and economic profit.

• Opportunity Cost: The highest-valued alternative forgone is the opportunity cost of production. It represents the amount the firm must pay the owners of factors of production (labor, capital, land, and entrepreneurship) to attract them away from their next best use.

• Explicit vs. Implicit Costs:

  • Explicit Cost (EC): A cost that is paid directly in money (e.g., wages, rent, materials).

  • Implicit Cost (IC): An opportunity cost incurred when a firm uses a factor of production for which it makes no direct money payment. The two primary implicit costs are:

    • Economic Depreciation: The change in the market value of capital over a specific period. It is the opportunity cost of using capital the firm already owns.

    • Cost of Owner's Resources: This includes forgone wages (what the owner could have earned working elsewhere) and forgone interest (what the owner could have earned on the funds invested in the firm).

• Normal Profit: This is the return to entrepreneurship. It is considered a part of a firm’s opportunity cost because it represents the cost of the entrepreneur not running another firm.

• Economic Profit Calculation:

  • Economic Profit = Total Revenue − Total Cost

  • Total Cost = Explicit Costs + Implicit Costs (including Normal Profit)

  • Formula for Total Revenue: $\text{Total Revenue} = \text{Price} \times \text{Quantity sold}$

  • Relational outcomes:

    • If a firm makes an economic profit, the entrepreneur earns more than normal profit.

    • If a firm incurs an economic loss, the entrepreneur receives less than normal profit.

• Example Cost Structure (Sam’s Smoothies):

  • Total Revenue: $150,000$

  • Explicit Costs: Cost of goods ($20,000$) + Wages ($22,000$) + Interest ($3,000$) = $45,000$

  • Implicit Costs: Forgone wages ($34,000$) + Forgone interest ($1,000$) + Economic depreciation ($4,000$) + Normal profit ($16,000$) = $55,000$

  • Opportunity Cost ($45,000 + 55,000$) = $100,000$

  • Economic Profit ($150,000 - 100,000$) = $50,000$

  • Accounting Profit calculation differs as it ignores implicit costs: $\text{Accounting Profit} = \text{Total Revenue} - \text{Explicit Costs} - \text{Accounting Depreciation}$

Short Run and Long Run

• The Short Run (Fixed Plant): A time frame where the quantities of some resources are fixed. Usually, capital remains fixed while labor can be varied.

• The Long Run (Variable Plant): A time frame where the quantities of all resources can be changed. There are no fixed inputs in the long run.

• Sunk Cost: A past expenditure on a plant with no resale value. Sunk costs are irrelevant to a firm's current and future decisions.

Short-Run Production

• To increase output in the short run, a firm must increase variable inputs (labor) applied to fixed capital.

• Total Product (TP): The total quantity of a good produced in a given period. TP increases as labor ($L$) increases: $L \uparrow \rightarrow TP \uparrow$.

• Marginal Product (MP): The change in total product resulting from a one-unit increase in labor.

  • Formula: $MP = \frac{\Delta TP}{\Delta L}$

  • MP measures the contribution of the last worker added.

• Average Product (AP): Total product per worker employed; also known as productivity.

  • Formula: $AP = \frac{TP}{L}$

• Marginal Returns Patterns:

  • Increasing Marginal Returns: Occur initially due to increased specialization and division of labor (MP of new worker > MP of previous worker).

  • Decreasing Marginal Returns: Occur as more workers use the same equipment and workspace ($MP$ of new worker < $MP$ of previous worker).

  • Negative Marginal Returns: Output actually falls as more labor is added.

• The Law of Decreasing Returns: As a firm uses more of a variable input (labor) with a given quantity of fixed inputs (capital), the marginal product of the variable input eventually decreases.

• Product Curve Relationships:

  • When MP > AP, $AP$ is increasing.

  • When MP < AP, $AP$ is decreasing.

  • When $MP = AP$, $AP$ is at its maximum.

Short-Run Cost

• Total Cost (TC): The cost of all factors of production.

  • $\text{TC} = \text{TFC} + \text{TVC}$

  • Total Fixed Cost (TFC): Costs that do not change with output (cost of land, capital, entrepreneurship).

  • Total Variable Cost (TVC): Costs that vary with output (cost of labor).

• Marginal Cost (MC): The change in total cost resulting from a one-unit increase in output.

  • Formula: $MC = \frac{\Delta TC}{\Delta Q}$ or $MC = \frac{\Delta TVC}{\Delta Q}$

• Average Costs:

  1. Average Fixed Cost (AFC): $\frac{TFC}{Q}$. AFC always decreases as output increases (referred to as "spreading overhead").

  2. Average Variable Cost (AVC): $\frac{TVC}{Q}$. AVC is typically U-shaped.

  3. Average Total Cost (ATC): $\frac{TC}{Q}$ or $ATC = AFC + AVC$. ATC is also U-shaped.

• Characteristics of Cost Curves:

  • The vertical distance between TC and TVC is TFC.

  • The vertical distance between ATC and AVC is AFC.

  • The MC curve intersects the AVC and ATC curves at their minimum points.

  • The U-shape of the ATC curve is driven by two competing forces: the falling AFC (as cost is spread over more units) and the eventually rising AVC (due to decreasing marginal returns).

Cost and Product Curve Links

• A firm’s cost curves are the mirror image of its product curves.

• MC and MP relationship:

  • When $MP$ rises, $MC$ falls.

  • When $MP$ is at its maximum, $MC$ is at its minimum.

  • Link: $MC = \frac{W}{MP}$ (where $W$ is the wage rate).

• AVC and AP relationship:

  • When $AP$ rises, $AVC$ falls.

  • When $AP$ is at its maximum, $AVC$ is at its minimum.

  • Link: $AVC = \frac{W}{AP}$.

Shifts in Cost Curves

• Technology: Advancements in technology increase productivity, shifting TP, MP, and AP curves upward. This shift lowers the average and marginal costs, moving short-run cost curves downward.

• Factor Prices:

  • Increase in Fixed Cost (e.g., Rent): TFC, TC, and AFC shift upward. TVC, AVC, and MC remain unchanged.

  • Increase in Variable Cost (e.g., Wage Rate): TVC, TC, AVC, and MC shift upward. TFC and AFC remain unchanged.

Long-Run Cost

• Returns to Scale:

  1. Economies of Scale: Exist if a firm increases all inputs by a certain percentage and output increases by a larger percentage. ATC decreases as output increases. Sources include increased specialization of labor and capital.

  2. Diseconomies of Scale: Exist if a firm increases all inputs by a certain percentage and output increases by a smaller percentage. ATC increases. This is usually caused by coordination and control difficulties in large organizations.

  3. Constant Returns to Scale: Exist if a firm increases inputs and output by the same percentage. ATC remains constant.

• Long-Run Average Cost Curve (LRAC): Shows the lowest average cost of producing each output when the firm can change both plant size and labor. It is formed by the "lower boundary" of all possible short-run ATC curves.

Case Study: Walmart vs. 7-Eleven

• Data:

  • Walmart Supercenter: Approximately $99,000$ square feet; serves $30,000$ customers/week.

  • 7-Eleven: Approximately $2,000$ square feet; serves $5,000$ customers/week.

• Cost Comparison:

  • The lower-cost store depends on the scale of operation ($Q$).

  • At lower customer volumes (below a crossover quantity $Q$), the small store (7-Eleven) has a lower ATC because its fixed costs are small.

  • At higher customer volumes (above $Q$), the large store (Walmart) has a lower ATC because it can exploit economies of scale that are unavailable to small stores.