Producers in the Short Run

Chapter 7: Producers in the Short Run

7.1 What Are Firms?

  • Definitions of Firms

    • A firm is defined as an organization that produces goods or services for sale.

  • Types of Business Organizations:

    1. Single Proprietorships: Owned and run by one individual.

    2. Ordinary Partnerships: Owned by two or more individuals who share profits and losses.

    3. Limited Partnerships: Comprise general partners who manage the business and limited partners who invest but do not manage.

    4. Corporations: Entities that are legally distinct from their owners, with private and public corporations existing based on ownership structures.

    5. State-Owned Enterprises: Also known as Crown corporations; these are owned by government entities.

    6. Non-Profit Organizations: Organizations that operate for a collective, public, or social benefit instead of profit.

  • Multinational Enterprises (MNEs):

    • Defined as firms that operate in more than one country.

    • Commonly observed in limited partnerships and larger corporations, while rare in single proprietorships and ordinary partnerships.

    • The prevalence and influence of MNEs have significantly increased in recent decades.

7.2 Financing of Firms

  • Financial Capital:

    • Refers to the money a firm raises to conduct its business activities.

    • Distinction from Physical Capital, which includes assets such as factories, machinery, and vehicles.

  • Types of Financial Capital:

    • Equity:

    • In sole proprietorships and partnerships, funds are often provided by the owners themselves.

    • Corporations acquire funds through owners in exchange for shares (equities), which represent ownership.

    • Profits distributed to shareholders are termed dividends.

    • Debt:

    • Creditors provide loans and are not considered owners of the firm.

    • Firms incur obligations to repay the principal and interest on loans, documented by debt instruments or bonds.

Goals of Firms

  • Economists generally make two key assumptions regarding the behavior of firms:

    1. Firms are presumed to maximize profits.

    2. Each firm is viewed as a single, cohesive decision-making unit.

  • These assumptions enable economists to predict the behavior of firms in various scenarios.

Applying Economic Concepts 7-1: Is it Socially Responsible to Maximize Profits?

  • Competing Views:

    1. Unadorned capitalism and the goal of profit maximization may not align with the broader public interest.

    2. Profit maximization can be argued to benefit customers and employees, promote innovation, and enhance living standards.

  • Considerations:

    • Environmental implications of profit maximization.

    • The role of government regulation.

    • Potential motivations for firms to alter their behaviors to be more socially responsible.

7.2 Production, Costs, and Profits

  • Types of Inputs for Production:

    1. Intermediate Products: Inputs that are outputs from other firms.

    2. Natural Inputs: Resources provided by nature.

    3. Labor Services: Inputs derived from human effort.

    4. Physical Capital Services: Services rendered by physical assets like machinery.

  • Production Function:

    • Represents the maximum output achievable from a specific combination of inputs.

    • It articulates the technological relationship between inputs and outputs.

    • Notationally expressed as: Q=f(L,K)Q = f(L, K), where $Q$ is output, $L$ is labor input, and $K$ is capital input.

    • Emphasizes that production is a flow concept.

Costs and Profits

  • Explicit Costs:

    • Defined as direct payments made by firms for goods and services.

    • Examples include:

    • Hiring wages

    • Equipment rentals

    • Interest payments on debts

    • Purchase of intermediate inputs

    • Depreciation costs associated with physical capital wear over time.

    • Formula for Accounting Profit:
      Accounting Profit=Revenues−Explicit Costs\text{Accounting Profit} = \text{Revenues} - \text{Explicit Costs}

  • Economic Profit:

    • Calculated by subtracting both explicit and implicit costs from total revenues.

    • Implicit Costs: Represent opportunity costs without market transactions, such as:

    • The owner's time.

    • The owner's capital investment opportunity costs.

    • Formula for Economic Profit:
      Economic Profit=Revenues−(Explicit Costs+Implicit Costs)\text{Economic Profit} = \text{Revenues} - (\text{Explicit Costs} + \text{Implicit Costs})

    • Alternatively expressed:
      Economic Profit=Accounting Profit−Implicit Costs\text{Economic Profit} = \text{Accounting Profit} - \text{Implicit Costs}

    • Negative economic profits are referred to as economic losses.

Table 7-1: Accounting Versus Economic Profit for Ruthie’s Gourmet Soup Company
Summary of Financial Performance

Category

Amount ($)

Total Revenues

Blank

Explicit Costs

Blank

Wages and Salaries

500

Intermediate Inputs

400

Rent

80

Interest on Loan

100

Depreciation

80

Total Explicit Costs

1160

Accounting Profit

840

Implicit Costs

Blank

Opportunity Cost of Owner’s Time

160

Opportunity Cost of Owner’s Capital (risk-free return of 4%)

60

(b) risk premium of 3%

45

Total Implicit Costs

265

Economic Profit

575

  • Profit Maximization Output:

    • Economic profit ($\pi$) signifies the difference between total revenue ($TR$) and total costs ($TC$) associated with product output:
      π=TR−TC\pi = TR - TC.

Time Horizons for Decision Making

  • Short Run:

    • Defined as a period during which the quantity of some inputs is fixed, referred to as fixed factors (e.g. capital, land).

    • Inputs that can be altered in the short run are known as variable factors.

  • Long Run:

    • The time duration over which all factors of production can be modified, though the technology remains constant.

  • Very Long Run:

    • Involves the time frame where both all factors of production and technology can be altered.

7.3 Production in the Short Run

  • Total, Average, and Marginal Products:

    • Total Product (TP): Total output produced in a defined time period.

    • Average Product (AP): Computed by dividing total product by the number of units of variable factors used:
      AP=TPLAP = \frac{TP}{L}

    • Marginal Product (MP): Change in total output that comes from adding one more unit of the variable factor:
      MP=ΔTPΔLMP = \frac{\Delta TP}{\Delta L}

Diminishing Marginal Product

  • As output increases in the short run, more of the variable factor combines with a fixed factor leading to diminishing returns:

    • Definition: Each additional unit of a variable factor results in increasingly lesser contributions to total output.

The Average-Marginal Relationship

  • Conditions:

    • When an additional worker's output raises average product (AP), it indicates that MP > AP.

    • Conversely, when an additional worker's output decreases average product, MP < AP.

    • The intersection of MP and AP occurs at AP's maximum point.

Applying Economic Concepts 7-2: Three Examples of Diminishing Returns

  1. Workouts in the Gym: Each additional set of exercise contributes less to fitness than the previous set.

  2. Pollution Control: Each new filter on a smokestack decreases pollution more insignificantly than the prior filter.

  3. Portfolio Diversification: Adding each new stock lowers portfolio risk less than previously added stocks.

7.4 Costs in the Short Run

Defining Short-Run Costs

  • Components of Costs:

    • Total Cost (TC):

    • Comprises both Total Fixed Cost (TFC) and Total Variable Cost (TVC):
      TC=TFC+TVCTC = TFC + TVC

    • Average Total Cost (ATC), Average Fixed Cost (AFC), and Average Variable Cost (AVC):
      ATC=AFC+AVCATC = AFC + AVC

  • Marginal Cost (MC):

    • Change in total cost triggered by increasing output slightly, expressed as:
      MC=ΔTCΔQMC = \frac{\Delta TC}{\Delta Q}

    • Notably, marginal costs equate to marginal variable costs since fixed costs remain constant with output variations.

Short-Run Cost Curves

  • Graph Characteristics:

    • Total fixed costs do not shift with output changes (top graph).

    • Marginal cost intersects average total cost (ATC) and average variable cost (AVC) at their lowest points (bottom graph).

    • Average total cost generally follows a U-shape, initially decreasing with rising output, reaching a minimum before ultimately increasing.

Why U-Shaped MC and AVC Curves?

  • This phenomenon occurs due to:

    • Each added worker results in a different output addition, ultimately leading to diminishing average product (AVC).

    • Key Points:

    • AVC reaches its lowest at maximum AP.

    • MC reaches its minimum at the maximum marginal product (MP).

Capacity

  • Defined as the output level aligned with minimum short-run average total cost, thus not incurring rising average costs.

  • Firms producing below this capacity are in a state of excess capacity.

Shifts in Short-Run Cost Curves

  • Changes in variable factor prices lead to a rise in both ATC and MC.

  • Conversely, increases in fixed factor prices will elevate TFC with no alteration to variable costs, leading to ATC rises but unchanged MC.

Applying Economic Concepts 7-3: The Digital World

  • Digital products exhibit substantial initial costs with minimal marginal costs, indicating that the law of diminishing returns does not apply.

  • In this context, marginal cost remains low across all units produced, leading to:
    AVC=MCAVC = MC and declining Average Total Cost (ATC) due to the distribution of fixed costs over increased output.