Chapter 10Production

Profit Definitions

What is a firm?

• A firm is a business organization that brings together and coordinates the factors of production for the purpose of supplying goods and services.

Goal of the firm – Maximize profits

Given it’s Technology

Define Technological Change

Opportunity Cost and Economic Profit

• Recall that a firm’s opportunity cost of production is its best foregone alternative.

In the firm’s production decision, they face 2 types of costs:

1) Explicit costs – “outlay costs” “accounting costs” – Money used topay for the use of the factors of production

2) Implicit Costs – opportunities foregone but not paid for directly

Where do firms face implicit costs?

Implicit Costs• Where do firms face implicit costs?

1) Capitala. Economic depreciation ( accounting depreciation)

- Change in the market price of capital over a given period

b. Interest

2) Owner’s resources- Normal Profit

Normal Profit• A measure of the implicit costs of owner-supplied

resources in a firm over a given period of time (Portion of the firms cost that is not included in the accounting cost)

Thus we must note the distinction between “Accounting Profit” and “Economic Profit”

Accounting Profit = Total Revenue – explicit costs(uses conventional depreciation approach)

Economic Profit = Total Revenue – opportunity costs(uses economic depreciation approach)

Production and Costs

Production

Short-Run Costs

Short-Run vs. Long-Run

• Technically, time does not determine the difference between “short-run” and “long-run”

The Short Run is defined by the presence of a factor of productionthat is fixed in quantity –typically, this is capital (K). In the short-run,firms can only change the amount of non-capital inputs (e.g. Labor)

The Long Run is defined by the ability for firms to vary thequantities of all factors of production. The time in which this takesa firm to do so may depend upon the firm as well as the industry.

SHORT-RUN PRODUCTION

Total Product (TP) (Q): describes how output varies inthe SR as more of any variable input is used with the fixed input, under current technology

Marginal Product (MP): the increase in output from one more unit of an input when the quantity of all other inputs are unchanged

Average Product (AP): the total output produced dividedby the number of units of the input used

Marginal/Average Product• Formulas for MP and AP • Since Kapital is fixed in quantity, we are

concerned with Marginal and Average products of labor

MPL: TP/ L

APL: TP/L

What do the TP, MPL and APL curves look like?

What is the relationship between MPL and APL?

Law of Diminishing Marginal Produce

• As a firm uses more a variable input, with a given quantity of fixed inputs, the MP of a variable input eventually diminishes.

Short Run Costs

• Short-run costs can be separated according to the nature of the input:

Fixed Costs (Total Fixed Costs) (TFC): total cost to all the fixedinputs (Overhead costs) - must be incurred in the short-run even if don't produce anything

Total Variable Cost (TVC): total cost to the variable inputs

Total Cost (TC): sum of all the costs of all inputs in the production process

SO, TC=TFC+TVC

Marginal Costs• However, when firms are choosing to

maximize profit, they are more concerned with Marginal Costs – the cost of producing 1 more unit of output.

MC = TC/Q

What do we know about the relationship between MC and MP?

Average Costs• Firms are also concerned with Average

Costs. In the short-run, there are 3 average costs:

Average Fixed Costs: AFC= TFC/Q

Average Variable Costs: AVC=TVC/Q

Average Costs: AC=TC/Q

Thus, AC=AVC + AFC What do these curves look like?

Why are these curves important?

GRAPHICAL ANALYSIS OF SR COST

Graph 1: TC, TVC, TFC

1) Why is TVC upward sloping ? 2) Why does TC slope upward ?

Graph 2: MC, ATC, AFC, AVC

1) Why is AFC downward sloping ? 2) Why is AVC "U-shaped" ? 3) Why is ATC "U-shaped" ? 4) Why does MC curve slope upward ? 5 ) Where does the MC curve intersect AVC ? ATC ?

Key Terms• Technology• Technological Change• Short Run vs Long Run• Marginal Product of

Labor• Average Product of

Labor• Law of Diminishing

Returns• Economic Profit vs

Accounting Profit

• Explicit Cost• Implicit Cost• Fixed Cost• Variable Cost• Total Cost• Marginal Cost• Average Fixed Cost• Average Variable Cost• Average Total Cost