Review

1. Review Exam 3

2. Exam 3 Covers • Chapter 6 • Chapter 7 (with appendix) • Chapter 8

3. Chapter 6 Concepts • Production function • Diminishing Returns • Average Product • Marginal Product • Various terms and definitions

4. The Production Function The production function relates inputs to output in physical terms. It can be represented by an equation of the form y=f(x), by a graph or by a table.

5. Total Product Total product is another way of saying “output.”

6. Average Product To find average product, divide total product (or output) by the input level.

7. Marginal Product Marginal product tells you how much extra output you get from each extra unit of input. To calculate marginal product, take the change in total product (or output) and divide by the change in input.

8. MP and AP If MP > AP, then AP is increasing. If MP< AP, then AP is falling.

9. Example

10. Three Stages of Production • Stage 1, AP is rising. (TP rising and MP positive) • In Stage 2, AP is falling and MP is positive. (TP still positive) • In Stage 3, MP is negative. (TP is falling)

11. Another Type of Problem If AP = 14 and input is 10, find TP. AP = Output/input 14 = Output/10 Output = 140

12. Returns to Scale If output increases proportionately more than inputs, we have increasing returns to scale. If output increases in the same proportion as inputs, we have constant returns to scale. If output increases proportionately less than input, we have decreasing returns to scale.

13. Chapter 7: Costs • Total Cost (TC) = Variable Costs (VC) + Fixed Costs (FC) • AC (ATC) = TC divided by output or AC= AVC + AFC • AVC = VC divided by output • AFC = FC divided by output

14. Working with Costs You can use the information to derive different things. Example: AC = 50 AFC = 10 output =20 Find VC AVC = AC – AFC (AC = AVC + AFC) AVC = 50 – 10 = 40 VC = AVC*output VC = 40*20 = 800

15. Another Example AVC = 20 AFC = 5 output = 10 Find TC AC = 20 + 5 = 25 TC = 25*10 = 250

16. Chapter 8 Review of Some Key Concepts

17. Variable Cost Variable cost is what is spent on variable inputs. If there is only one variable input, VC = Px*X Where Px is the input price and X is the amount used. Some books use “TVC” for “VC” where T stands for “total.”

18. More on Variable Cost If there are two or more variable inputs: VC = Px1*X1 + Px2*X2 + Px3*X3 . .. Where Px1 is the input price for one of the variable inputs and X1 is the amount of that input used, Px2 is the input price for the next variable input and X2 is the amount of the second input used, and so on.

19. Average Variable Cost AVC = Variable Cost divided by output. In stage 1 of production, AVC decreases. In stage 2 (or 3) AVC increases.

20. Fixed Cost Fixed cost doesn’t change as output changes, in the short run. .

21. Average Fixed Cost AFC = FC/output. Some books used “TFC” for FC AFC falls as output increases.

22. Marginal Cost Marginal cost is the change in VC divided by the change in output. It can also be calculated using the change in TC divided by the change in output.

23. Profit-Maximizing Decision Rule In perfect competition, the rule is: MC = output price Look for this point and check to be sure it is in stage 2 of production!

24. Perfect Competition: Illustration of firm-level demand P P S d D q Q Entire Market One firm

25. Marginal Revenue Marginal revenue is the extra amount a firm will earn from selling one more unit of its output. Under perfect competition, the marginal revenue will therefore by equal to ___________. product price Formal definition: Marginal revenue is the change in total revenue resulting from a one unit increase in output.

26. Goal of Profit Maximizing The firm’s goal is assumed to be maximizing profit. Remember that profit is: Firm Profit = Py*Y - TC Where Y is firm output.

27. On the graph We find the point where Marginal Revenue or price (as shown by the flat demand curve, d), hits MC. The profit-maximizing output is found at this point. Profit, or loss, per unit is the vertical distance between MR and AC at that point. On the following graph, the unit profit is shown by the solid orange line.

28. Graphically Profit >0 Profit > 0 MC AC d p q

29. Graphically Profit = 0 MC Profit = 0 AC p d q

30. Zero-profit point The zero-profit point occurs at the minimum point of the AC curve. This point is also called the “break-even” point.

31. Graphically Profit < 0i Profit < 0 MC AC p d q

32. Producing at a Loss Would a rational, profit-maximizing producer ever produce at a loss? Remember that TC is the sum of fixed costs, which do not change in the short run even if nothing is produced, and VC.

33. Producing at a loss, continued In the short run, firms will produce at a loss so long as that loss is less than total fixed costs. In other words, they compare the loss they would get from not producing (the total fixed costs) with the loss they would get if they produce.

34. At the point where price = MC for • a perfectly competitive firm, Total • Revenue = $2000, VC = $2100 and • FC = $100. What should this firm do? • Shut down • Produce and make a profit • Produce because the loss is less than • Fixed costs • d) Change its output level

35. Covering Variable Costs In the short run, producers will produce so long as the TR is greater than the total variable costs. The shutdown point comes where revenues just equal variable costs, or losses from production are equal to the fixed costs.

36. AVC and Price If TR = VC (total variable costs), then Price = AVC. Why? TR= Py*Y, so divide both sides by Y to get this equivalency.

37. Shutdown Rule When the price falls below the minimum AVC, the firm will shut down. On a table, find the shutdown point by looking at the AVC entries and finding the smallest one. The shutdown price is equal to the lowest AVC. The output level is found by reading across the table to find the output level.

38. Graphically AC MC AVC ps shutdown point

39. The Firm’s Supply Curve AC MC AVC ps shutdown point

40. The firm’s supply curve, cont. The firm’s supply curve is the portion of its marginal cost curve beyond the shutdown point. (Shown in purple on the preceding graph.)

41. From Firm to Industry The market supply curve for a good is the horizontal sum of all the individual firms’ supply curves.

42. short run and long run In the short run, demand shifts produce greater price adjustments and smaller quantity adjustments than in the long run.

43. Factor Adjustments In the short run, supply can only be adjusted using variable factors. The fixed factors (such as equipment and factory buildings) cannot change. In the longer run, the fixed factors can also be adjusted, and firms can enter or exit the industry. Hence, supply tends to be more elastic in the long run than in the short run.

44. Short run and long run situations P P Ss Sl Q Q short run long run

45. What happens when demand increases? In the short run: There will be an increase in price and output per firm will rise. The increased price will bring higher profits for each firm in the industry.

46. Short run price change in market P Ss Q short run

47. Short run response to increased demand at the firm level MC The firm now has economic profits. AC p d’ d q’ q

48. When firms earn economic profits New firms will enter the industry in the longer run. The long run supply curve is more elastic than the short run. The increased number of firms will bring more output to the industry. In most cases, the new entrants will also bid up the price of inputs, so that the AC curves will rise.

49. Long Run situation AC’ AC d’ d’’ d

50. When Demand Increases In the long run, total output will increase, firm numbers will increase, economic profits will return to zero, and price will increase unless long-run supply is perfectly elastic (as would be the case in a constant cost industry only).