Chapter 7: Production, Cost, and the Perfect Competition Model

7.1 The Production Function

Allocative efficiency: when marginal cost = marginal value

  • Also known as efficiency in output
  • Marginal cost: cost of producing one more unit
  • Marginal value: value of one more unit

Technical efficiency: reached when economy’s factors of supply are used to maximize production

  • Also known as efficiency in production

Marginal product: additional output produced per period when one more unit of an input is added

Law of diminishing marginal returns: as one amount of an input increases, marginal returns will eventually decrease

Average product:

Total product curve: shows relationship between total amount of output produced vs. number of units of an input used

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  • Fixed costs: do not change when more output is produced
  • Variable costs: do change when more output is produced
  • Total Costs = Total Fixed Costs + Total Variable Costs
    • TC = TFC + TVC

7.2 Short- and Long-Run Production Costs

Short run: time frame where at least one factor of production is constant

  • Firms cannot enter/exist market
  • Long-run: all factors of production are variable, no fixed costs

Economies of scale: exist over range of output where long-run average cost curve slopes down

  • Cost per unit decreases

7.3 Types of Profit

  • Profit: value remaining after paying all costs and financial obligations of a company
    • Profit = TR - TC
  • Gross profit: total sales - total cost of goods/services
  • Operating profit: gross profit - operating expenses
  • Net profit: amount left after deducting all other expenses
    • Ex) After taxes, loan interests

7.4 Profit Maximization

  • Profit: total revenue - total cost
  • Break-even points: points on graph where total revenue = total cost
  • Profit maximization: loss minimization

7.5 Perfect Competition

When is there perfect competition?

  • Many sellers
  • Products are standardized
  • Firms accept market price → “price takers”
  • Firms can enter/exit market freely

Economic profits: total revenue - total cost

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