Review Topics for the Final Examination Chapter 6 Cost and Production Gains from Specialization Specialization of resources Reason of its occurrence Mutual self interest of the individuals in the economy Result Modern economics are characterized by a high degree of specialized labor and other resources Three reasons for the devision of labor 1 Specialization increases the dexterity or skill through repetition 2 Time is saved by not passing from one task to another 3 Specialization facilitates the invention of machines to take over the routine tasks performed by labor Adam Smith The Wealth of Nations 1776 Comparative Advantage Sources of Rent When both cooperate in production each specialization in the task for which he has a comparative advantage the production possibilities curve becomes bowed outward This allows each to consume a greater amount of goods than either could when acting alone Because of rising marginal costs the relatively efficient resources such as especially fertile land are paid amounts in excess of the minimum necessary to call forth production This excess is called rent These are gains to suppliers in the same way that the difference between a consumer s initial marginal value of some good and the price paid for the good in the market represents a consumer s surplus By maximizing rents owners direct those resources to those who can use them most efficiently that is to generate the greatest net increase in value This increased value is derived from the usefulness of these resources in satisfying consumers demand for goods Economic Efficiency Pareto Efficient is an economy in which 1 The gains from trade are exhausted In such a situation it is not possible to make one person better off without making some other person worse of according to each person s own preferences 2 All consumers purchase goods at the same price and where the price of any good is equal to the marginal cost of production of that good p MC Sales taxes and other laws or regulations that cause consumers marginal value to differ from the marginal cost of production results in inefficiencies that is lost mutual benefits from trade Chapter 7 The law of Diminishing Returns Production Functions Production Function is the quantitative or mathematical relationship between inputs used in production and the level of output forthcoming Q F K L It measures the maximum amount of output that can be produced by a given combination of inputs Inputs and Output Input Something used in the production process factors of production Output The new good resulting from the combined actions of inputs goods and services which are more useful that is more highly valued to consumers than the total of the input values in their raw state Marginal Product The increase in output that occurs when an additional input is added to a fixed amount of other factors To calculate the change in total product that results from a one unit increase in the quantity of labor employed Law of Diminishing Marginal Product As one input of production is added to a fixed amount of other inputs after some points the marginal product of the variable input continually diminishes InputsOutputs Examples labor land machinery capital end products food clothing intermediate goods tractors Diminishing Returns at the Intensive versus Extensive Margin Extensive Margin The margin for decision making at the level of the industry that is the margin external to individual firms Intensive Margin The relevant margin for decision making at the level of the firm that is the margin internal to individual firms Diminishing Returns at the extensive margin The phenomenon that when industries expand eventually the ability to replicate the productive process decreases as firms must use inputs that are less and less efficient increasing marginal costs Diminishing Returns at the intensive margin When more of identical units of a productive input are added to a fixed amount of other factors of production the amount by which the input increases output becomes smaller and smaller diminishing marginal product Distinction Caused by the inability to replicate efficient resources as output increases The ability to expand output is constrained both by diminishing marginal product within the firm diminishing returns on the intensive margin and incomplete replicability of specific factors of production diminishing returns on the extensive margin Connection Between Diminishing Returns and Rent Diminishing Returns An imprecise term in economics meaning one of the two following alternatives Rents Payment to some resource over and above the minimum needed to call forth production Rents occur at the extensive margin because of the difference in efficiencies in production between some input and the least efficient input of its type that is used Relationship Between Production and Cost Functions A cost function measures the minimum total cost of producing Q units of output C Q WL L WK K Profit Maximization and Factor Demand Value of the Marginal Product Input Price The value of the marginal product of a factor of production is called its marginal value product It is the number of physical units the firms produces times the per unit price p MP w A firm engaging in profit or rent maximization employs factors of production as long as the value of the marginal product of each factor is greater than or equal to the additional cost to the firm of that factor When the value of the marginal product falls to the wage of that factor the firm ceases to hire that input Construction of Tables like 7 1 and 7 2 Table 7 1 Marginal Product Total Product Number of Laborers Average Product Total Product Number of Laborers 1 Number of Laborers 2 Total Product 3 Marginal Product 4 Average Product1333 002854 0031575 0042165 2552655 2063045 0073334 7183524 3893614 00103603 601135 13 18 Table 7 2 output price 10 wage of labor 40 Total Labor Cost wage Number of laborers Rents Value of Total Product Total Labor Cost Definitions Value of Total Product The amount that consumers pay for the total output MVP p MP Value of Marginal Product Marginal Value Product The value of the marginal product of a factor MVP number of physical units the firm produces the per unit price Property Rights and Resource Allocation private and common Common property results in overuse of the unowned resource Under a system of privately owned resources and competitive markets the resulting allocation of resources is Pareto efficient