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When economists examine firms over time they must define the Short Run and Long Run Short Run –Only some inputs (e.g. labor) can be adjusted –Not enough time to adjust all inputs (such as capital) Long Run –long enough time to adjust all inputs (capital as well as labor)

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Simple Illustration: Fixed and Variable Costs

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Costs at a Typical Firm (T8.1)

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Marginal Cost and the Marginal Product of Labor Note that marginal cost first declines and then increases for the example firm The explanation is that the marginal product of labor first increases before it decreases –in other words, diminishing returns to labor do not set for a while A graph of the production function illustrates this very well

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The production function and variable costs (T8.2)

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Average Cost Average Total Cost –equals Total Cost/Quantity produced (TC/Q) –also called cost per unit Average variable cost (VC/Q) Average fixed cost (FC/Q)

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Sketching cost curves MC curve should cut ATC and AVC curves at their lowest points ATC curve and AVC curve should get closer to each other as quantity increases for a flourish, add a little dip at the start of your marginal cost curve

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Finding Total Costs, Total Revenue, and Profits Find profit maximizing level of production Find total costs: TC = ATC times Q –because ATC = TC/Q –ATC times Q is the area of a rectangle Find total revenue = P times Q –P times Q is also the area of a rectangle Profits (or loss) is the difference between in the two rectangles

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The Breakeven Point

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Shutdown Point

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The Long Run Now the firm can adjust its capital What happens to the ATC curve?

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The Long Run Average Total Cost Curve Sketch a different ATC curve for each level of capital The long run ATC curve is the lowest ATC curve for each quantity produced

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Economies and Diseconomies of Scale

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Warning: Diminishing Returns to Labor and Increasing Returns to Scale can Occur at the Same Firm Returns to labor –the other factors ( e.g. capital) are unchanged More teachers in one classroom Returns to scale –all factors change –analogy with Gulliver Teachers and classrooms both increase

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Part 5 The Theory of Production and Cost

Part 5 The Theory of Production and Cost

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