Unit 3 Test Outline: Cost Curves, Profit, and Perfect Competition (Modules 52-60)
I. Costs, Profit, and Profit Maximization –3.5 Modules 52 and 53 (18% of test bank)
Definition of Profit: Profit = Total Revenue (TR) – Total Cost (TC)
Economists include both explicit costs (money payments) and implicit costs (opportunities given up) when determining total cost
Positive economic profit occurs when total revenue exceeds both explicit and implicit costs
A normal profit occurs when total revenue = total costs; thus economic profit = 0
It is normal to tradeoff an opportunity when an alternative choice provides the same amount of benefit. This is a normal decision that achieves a normal profit. Anything more than normal is positive economic profit.
Profit maximization (or loss minimization) occurs when the marginal revenue received when producing the last unit of production = the marginal cost of producing that unit or MR = MC
II. Productivity, Cost Curves, and Economies of Scale – Module 54-55 (37% of test bank)
Total Product (TP), Average Product (AP), and Marginal Product (MP) Curves – not shown in Krugman text!! (You will not need to draw these curves, but it really helps to understand their relationship to each other and to their reflection in cost curves.)
Productivity curves represent how much can be produced with a given amount of capital as more labor is added
Total costs = Fixed costs + Variable Costs
Fixed costs for a firm are costs that are not associated with how much is being produced. Regardless of how much is produced, the firm must pay the same amount each month for things like rent or mortgage, installment loans on capital equipment, and, to a certain extent, utilities.
Variable costs are costs that are dependent on how much input is hired or purchased to produce more output. Variable costs include input costs such as natural resources and labor. Firms have some control over how much they buy/hire of “land” and labor and how much they pay for it.
Total fixed and total variable costs are important for firms, but more important for making decisions about how much to produce and at what price to sell are marginal cost and average cost.
The marginal cost curve mirrors (reflects) the marginal product curve. Initially it decreases due to increasing returns to an input given a specific amount of capital available. In other words, the initial cost of producing more units will be more productive and less costly per unit because you are fully using the available capital resources (machinery, factories, retail stores, vehicles, and other tools of production).
Marginal cost eventually increases due to diminishing returns to an input (capital) -- a decrease in the rate of productivity growth as more units are produced. In other words, as capital resources are more fully used, it becomes increasingly more costly per unit to produce more output. Thus the “Nike swoosh” shape of the MC curve – initially decreasing but ultimately increasing marginal costs.
Average total cost (ATC) = Total cost/Quantity ATC mirrors the average product curve
The ATC curve initially decreases because the firm’s fixed costs are spread out over more output (the spreading effect) -- AFC continuously decreases as more quantity is produced -- but eventually increases as the more variable inputs are needed to product more output (the diminishing returns effect) -- AVC initially decreases but eventually increases and becomes more significant in affecting ATC as more quantity is produced.
P = Minimum ATC = productive efficiency for an individual firm because it represents the least costly output given the amount of land, labor, and capital that a firm has available.
P = MC = allocative efficiency for society because it represents the greatest amount of total welfare (consumer and producer surplus), thus signalling the preferred allocation of land, labor and capital in the production of a good or service relative to other possible uses of those same resources.
MC crosses ATC at its minimum. At points below ATC, MC is less than ATC – initially decreasing and then increasing but still having the effect of pulling ATC down. (Like a lower test grade would pull down your previous test grade average). Once MC crosses ATC after the least-cost output (min. ATC), MC pulls ATC up. This creates diseconomies of scale (higher average costs with more production). If this situation persists, firms should acquire more capital (open new stores, build more assembly lines, increase fleet of delivery trucks, etc.) in order to meet the growing need for more labor and other variable inputs.
III. Long-run ATC and Economies of Scale – Module 56 (8% of test bank)
Long-run ATC takes into account the need to take on more fixed costs to keep ATC at its minimum as more and more output is produced. If capital is not being fully utilized, the ATC curve is decreasing as more output is produced which is called economies of scale created by producing where there are increasing returns to scale. In the long-run, all resources are variable including capital.
Eventually a firm will reach its absolute long-run minimum ATC after expanding its output by adding more of all resources. This minimum ATC may remain
IV. Product Market Structures and Perfect Competition – Module 57-59 (21% of test bank)
Characteristics of perfect competition: 1) many, many producers; 2) identical product; 3) easy to enter or exit; and 4) no control over price – firms are price takers
Firms in perfect competition have a perfectly elastic demand curve. They can produce and sell as much of the product as they want as long as they sell it for the market price. Therefore, the market demand is also equal to the marginal revenue, average revenue, and price for the firm.
PC firms produce the profit-maximizing quantity at the point where their marginal cost curve (Nike swoosh) crosses the elastic demand curve (MR DARP)
In the short-run, a PC firm may be able to earn an economic profit where the profit-maximizing quantity is above ATC for the firm. It may also suffer economic profit if ATC is above the profit-maximizing (or loss-minimizing) quantity.
A PC firm suffering economic loss will continue to operate as long as its loss-minimizing output is above AVC. In this case, a firm will be able to cover all of its variable costs and some of its fixed costs. If it were to shut down in this situation, it would still have to pay all of its fixed costs, so it is better to remain open and at least pay for some of these costs.
If a PC firm is receiving a price for its product that is below AVC, then it should shut down. It will still have fixed costs to pay, but it can start looking for alternative economic uses for its fixed expenses – it’s time to literally, “sell the farm.”
V. Long-run equilibrium in Perfect Competition – Module 60 (16% of test bank)
In the long-run, the best that a PC firm can achieve is normal profit (zero economic profit). This is because if PC firms are earning economic profit, then many more firms will enter the market which would shift supply to the right and lower the price. In the long-run, MR DARP will intersect with minimum ATC and MC for the firm.
If firms are suffering economic loss in the short-run, some firms that are not covering the AVC will shut down. As a result, the supply curve will shift to the left for the entire market which will cause MR DARP to increase for the firms that are still in the market. In the long-run, MR DARP will intersect with minimum ATC and MC for the firm.
PC firms in long-run equilibrium are both allocatively efficient (P = MC) and productively efficient (P = minimum ATC)
I. Costs, Profit, and Profit Maximization
Profit = Total Revenue (TR)
Total Cost (TC); includes both explicit (money payments) and implicit costs (opportunities given up).
Positive economic profit occurs when TR > explicit + implicit costs.
Normal profit (zero economic profit) occurs when TR = TC.
Profit maximization (or loss minimization) occurs when marginal revenue (MR) = marginal cost (MC).
II. Productivity, Cost Curves, and Economies of Scale
Productivity curves (Total, Average, Marginal Product) reflect cost curves.
Total Costs = Fixed Costs (not associated with output) + Variable Costs (dependent on output).
Marginal Cost (MC) initially decreases (increasing returns) then increases (diminishing returns), forming a "Nike swoosh" shape.
Average Total Cost (ATC) = Total Cost/Quantity. It initially decreases (spreading fixed costs) but eventually increases (diminishing returns effect of variable inputs).
MC aATC at its ATC minimum.
Productive efficiency: Price (P) = Minimum ATC for a firm.
Allocative efficiency: P = MC for society.
III. Long-run ATC and Economies of Scale
In the long-run, all resources, including capital, are variable.
Long-run ATC considers adding more fixed costs to maintain minimum ATC as output expands.
Economies of scale occur when ATC decreases as output increases due to increasing returns to scale.
IV. Product Market Structures and Perfect Competition
Characteristics of perfect competition (PC): many producers, identical product, easy entry/exit, firms are price takers.
PC firms have a perfectly elastic demand curve, where P = Marginal Revenue (MR) = Average Revenue (AR).
PC firms maximize profit where MC crosses the elastic demand curve (MR DARP).
In the short-run, PC firms may earn economic profit or loss.
A PC firm will continue to operate in the short-run if P is above Average Variable Cost (AVC) to cover variable costs and some fixed costs.
A PC firm should shut down if P is below AVC.
V. Long-run equilibrium in Perfect Competition
In the long-run, PC firms achieve only normal profit (zero economic profit) due to firm entry/exit adjusting market supply and price.
Long-run equilibrium for PC firms: MR DARP intersects with minimum ATC and MC.
PC firms in long-run equilibrium are both allocatively efficient (P = MC) and productively efficient (P = minimum ATC).