Principles of Microeconomics Chapter 13 We assume that firms primary goal is to maximize profit Total revenue the amount a firm receives for the sale of its output Total cost the amount a firm pays to buy inputs Profit total revenue total costs Costs Explicit costs input costs that require an outlay of money by the firm e g wages for workers land machines Implicit costs input costs that do not require an outlay of money by the firm e g opportunity cost of working at firm A instead of wages paid if you worked at firm B Total cost is the sum of explicit and implicit costs An important implicit cost is the opportunity cost of the financial capital that has been invested in the business Example Caroline uses 300 000 of her savings to buy a factory If she had left it in the bank she would be making 15 000 a year To own the factory she gave up 15 000 a year in interest Profits Economic profit total revenue minus total cost including both implicit and explicit costs Accounting profit total revenue minus total explicit cost Economic profit is what motivates the firms that supply goods and services A firm making positive economic profit with stay in business It is covering all its opportunity costs and has some revenue left over to reward the firm owners Production and Costs assuming the short run Production function the relationship between quantity of inputs used to make a good and the quantity of output of that good Marginal product the increase in output that arises from an additional unit of input e g when the number of workers increases from 1 to 2 cookie production increases from 50 to 90 the marginal product of the second worker is 40 Diminishing marginal product As the number of inputs or workers increases the marginal product decreases This is explained by the idea that as there are more workers they must share more space and equipment slowing them down Total cost curve relationship between quantity produced and total cost it becomes steeper as q produced increases reflecting diminishing marginal product Fixed costs costs that do not vary with the quantity of output produced incurred even if the firm produces nothing e g rent Variable costs costs that vary with the quantity of output produced e g cost of coffee beans milk sugar etc As you produce more you will need to buy more of these things a firm s total cost is equal to fixed cost plus variable cost Average total cost total cost divided by the quantity of output sum of AFC and AVC This tells us the cost of a typical unit Average fixed cost fixed cost divided by the quantity of output Average variable cost variable cost divided by the quantity of output Marginal cost the increase in total cost that arises from an extra unit of production Marginal cost change in total cost change in quantity Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced Marginal cost tells us the increase in total cost that arises from producing an additional unit of output Marginal cost rises with the quantity of output produced This reflects diminishing marginal product when the quantity produced is already high the marginal product of adding another worker is low and the marginal cost of an extra unit is large ATC curves are U shaped because it is the sum of AVC and AFC AFC always declines as output rises because the fixed cost is spread over a larger number of units AVC typically rises as output increases because of diminishing marginal product Efficient scale the quantity of output that minimizes average total cost found at the bottom of the U shape Whenever marginal cost is less than average total cost average total cost is falling Whenever marginal cost is greater than average total cost average total cost is rising Marginal cost curve crosses the ATC curve at the ATC s minimum ATC is rising at low levels of output marginal cost is below ATC meaning ATC is falling When output is higher marginal cost is above ATC meaning Marginal cost eventually rises with the quantity of output The marginal cost curve crosses the ATC curve at the ATC curve is U shaped minimum of ATC Many decisions are fixed in the short run but variable in the long run A firm s long run cost curves are different from short run curves because firms have greater flexibility in the long run Economies of scale the property whereby long run average total cost falls as the quantity of output increases Diseconomies of scale the property whereby long run average total cost rises as the quantity of output increases Constant returns to scale the property whereby long run average total cost stays the same as the quantity of output changes Economies of scale often arise because higher levels of production allow specialization among workers making them better at a specific task Diseconomies of scale can arise because of coordination problems Long run ATC is also U shaped
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