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 yf(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 gt AP, then AP is increasing. If MPlt 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 AVCoutput
VC 4020 800
15
Another Example
AVC 20 AFC 5 output 10 Find TC AC
20 5 25 TC 2510 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 PxX 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
Px1X1 Px2X2 Px3X3 . .. 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 doesnt 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 firms goal is assumed to be
maximizing profit. Remember that profit
is Firm Profit PyY - 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 gt0
Profit gt 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 lt 0i
Profit lt 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 PyY, 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 Firms Supply Curve
AC
MC

AVC
ps
shutdown point
40
The firms supply curve, cont.
The firms 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).
51
When demand decreases
In the short run, firms will go from an
equilibrium of zero profits to economic losses.
In the longer run, some firms will leave the
industry. Long run response is lower total
output, fewer firms, a return to zero economic
profits, and a lower price (unless long-run
supply is perfectly elastic, e.g. the constant
cost industry).
52
Long Run Equilibrium
If entry and exit is completely open in an
industry, firms that are operating at a loss will
eventually close down.. As firms exit, supply
contracts (shifts to the left) and price rises.
Hence, in the long-run price cannot remain
below the minimum AC of the firms in an industry
53
Long Run Equilibrium
Similarly, if profits are too high in
a particular industry, new firms will
eventually be attracted into the market, causing
supply to shift to the right (increase) and price
to fall.
54
Special Cases
In a constant cost industry, output can be
doubled by doubling costs. In this case, the
long-run supply curve is horizontal (perfectly
elastic). Changes in demand will have no impact
on price in the long-run.
55
Long Run for Constant Cost Case
P
D
D
S
Q
56
Increasing Costs
If some factors of production are in
limited supply (e.g. prime agricultural land
for producing grapes), the industry will have
increasing costs. To double output will
require more than doubling of costs. In this
case, long run supply will still slope upwards.
57
Fixed Supply
Some items are completely fixed in quantity,
regardless of price. Specific artistic
creations and prime real estate locations are of
this type. In this case an increase in demand
will cause price to rise but cannot change
quantity.
58
Fixed Supply Graph
P
S
D
D
Q