Chapter 7: Production, Costs, and Industry Structure - Notes

Chapter 7: Production, Costs, and Industry Structure

7.1: Explicit and Implicit Costs, and Accounting and Economic Profit

• Firm (or producer or business): An organization that combines inputs of labor, capital, land, and raw or finished component materials to produce outputs.
• Private enterprise: The ownership of businesses by private individuals.
• Production: The process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs.
• Profit:
  • $\text{Profit} = \text{Total Revenue} - \text{Total Cost}$
• Revenue: The income a firm generates from selling its products.
  • $\text{Total Revenue} = \text{Price} \times \text{Quantity Sold}$
• Explicit costs: Out-of-pocket costs; actual payments (e.g., wages, rent).
• Implicit costs: The opportunity cost of using resources that the firm already owns (e.g., depreciation of goods, materials, and equipment).
• Accounting profit: The difference between dollars brought in and dollars paid out.
  • $\text{Accounting Profit} = \text{Total Revenue} - \text{Explicit Costs}$
• Economic profit: Includes both explicit and implicit costs.
  • $\text{Economic Profit} = \text{Total Revenue} - \text{Total Costs}$
  • $\text{Total Costs} = \text{Explicit Costs} + \text{Implicit Costs}$

7.2: Production in the Short Run

• Factors of production (inputs): Resources that firms use to produce their products.
  • Natural Resources (Land and Raw Materials)
  • Labor
  • Capital
  • Technology
  • Entrepreneurship
• Production function: Mathematical equation that tells how much output (Q) a firm can produce with given amounts of the inputs.
  • $Q = f [NR, L, K, t, E]$
• Fixed inputs (K): Factors of production that can’t be easily increased or decreased in a short period of time.
• Variable inputs (L): Factors of production that a firm can easily increase or decrease in a short period of time.
• Short-hand form for the production function:
  • $Q = f [L, K]$
• Short run: Period of time during which at least some factors of production are fixed.
• Long run: Period of time during which all factors are variable.
• Output (Q) is also called Total Product (TP).
  • $Q = TP = f [L]$
• Marginal product (MP): The additional output of one more worker.
  • $MP = \frac{\Delta TP}{\Delta L}$
• Law of Diminishing Marginal Productivity: General rule that as a firm employs more labor, eventually the amount of additional output produced declines.

7.3: Costs in the Short Run

• Factor payments: What the firm pays for the use of the factors of production (aka costs, from the firm’s perspective).
  • Raw materials prices
  • Rent
  • Wages and salaries
  • Interest and dividends
  • Profit
• Variable costs: Costs of the variable inputs, like labor.
• Fixed costs: Costs of the fixed inputs, like rent.
  • Expenditure that a firm must make before production starts
  • Do not change in the short run
  • Do not change regardless of the level of production.
• Total cost: The sum of fixed and variable costs of production.
• Average total cost (ATC): Total cost divided by the quantity of output produced.
  • $ATC = \frac{TC}{Q}$
• Marginal cost (MC): The additional cost of producing one more unit of output.
  • $MC = \frac{\Delta TC}{\Delta Q}$
• Average variable cost: Variable cost divided by quantity of output.
• Average Profit or profit margin: price – average cost
  • If the market price > average cost, then average profit will be positive.
  • If price is < average cost, then profits will be negative.

7.4: Production in the Long Run

• In the long run, all factors (including capital) are variable.
  • Production function is $Q = f [L, K]$
• Because all factors are variable, the long run production function shows the most efficient way of producing any level of output.

7.5: Costs in the Long Run

• The long run is the period of time when all costs are variable.
• Production technologies: Alternative methods of combining inputs to produce output
• Economies of scale: The situation where, as the quantity of output goes up, the cost per unit goes down.
• Long-run average cost (LRAC) curve: Shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology.
• Short-run average cost (SRAC) curves: The average total cost curve in the short term; shows the total of the average fixed costs and the average variable costs.
• Constant returns to scale: When expanding all inputs proportionately does not change the average cost of production.
• Diseconomies of scale: The long-run average cost of producing each individual unit increases as total output increases.
  • A firm or a factory can grow so large that it becomes very difficult to manage or run efficiently.
• The shape of the long-run average cost curve has implications for:
  • how many firms will compete in an industry
  • whether the firms in an industry have many different sizes
  • or if they will tend to be the same size.
• When the LRAC curve has a clear minimum point, then any firm producing a different quantity will have higher costs.
• When the LRAC curve has a flat bottom, then firms producing at any quantity along this flat bottom can compete.