micro E conomics Unit 7 Slide 1 Created: Jan 2007 by Jim Luke. Division of labour is the great cause of its increased power, as may be better understood from a particular example, such as pin-making..The effect is similar in all trade and also in the division of employments. -- Adam Smith

micro E conomics Unit 7 Slide 2 Created: Jan 2007 by Jim Luke. The Firm’s Problem Objective: maximize profits Revenue – Costs = Profit (P * Q) – VC – FC = Profit Constraints:  Costs  Demand  Market Price

micro E conomics Unit 7 Slide 3 Created: Jan 2007 by Jim Luke. The Firm’s Decision Process Long-Run Decision   What product? Technology? Scale? Fixed cost commitment? Short-Run   How much to produce (Q)? What price? Calculate Profit ?

micro E conomics Unit 7 Slide 4 Created: Jan 2007 by Jim Luke. Opportunity Costs Explicit Costs requires actual spending of money – easily measurable Implicit Costs opportunity cost & value foregone, no actual money changes hands -- estimated in dollar terms

micro E conomics Unit 7 Slide 5 Created: Jan 2007 by Jim Luke. What Is Profit? Profit = Revenues – Costs Accounting Profit =  Revenues – Explicit Costs Economic Profit =  Revenues – (Explicit costs + Implicit costs)

micro E conomics Unit 7 Slide 6 Created: Jan 2007 by Jim Luke. Sunk Costs & Rational Decisions “Sunk” Costs:  costs already spent and not recoverable  do not affect marginal decision-making

micro E conomics Unit 7 Slide 7 Created: Jan 2007 by Jim Luke. Production (Q) and Costs Fixed Costs:  Costs which do not change as Q increases Variable Costs  Costs which increase as Q increases Total Costs  = Fixed Costs + Variable Costs

micro E conomics Unit 7 Slide 8 Created: Jan 2007 by Jim Luke. Comparing Costs to Quantity Total Cost:  Total of all costs paid to produce all units from 1 through Q) Average Cost:  Cost of each of the Q units  = Total Cost / Q Marginal Cost  Cost of producing one more unit  “increase in total costs when Q is increased 1 unit”

micro E conomics Unit 7 Slide 9 Created: Jan 2007 by Jim Luke. Production & Costs: Short Run Production with One Variable Input in the Short Run From Marginal Physical Product to Marginal Costs More than One Variable Input A Set of Short-Run Cost Curves Some Geometric Relationships

micro E conomics Unit 7 Slide 10 Created: Jan 2007 by Jim Luke. Short-Run Cost Curves

micro E conomics Unit 7 Slide 11 Created: Jan 2007 by Jim Luke. Short-Run Cost Curves Formulas:  Total Cost: TC= TFC + TVC  Marginal Cost: MC= ∆TC/∆Q  Average Variable Cost: AVC= TVC/Q  Average Fixed Cost: AFC= TFC/Q  Average Total Cost: ATC= TC/Q

micro E conomics Unit 7 Slide 12 Created: Jan 2007 by Jim Luke. Why Do Cost Curves Increase? production function relationship between the quantity of inputs a firm uses and the quantity of output it produces. fixed input quantity is fixed and cannot be varied. variable input quantity can vary more variable input  more output

micro E conomics Unit 7 Slide 13 Created: Jan 2007 by Jim Luke. Diminishing Returns to an Input Suppose: 2 resources combine to produce 1 product then more resource  more output BUT what if only 1 resource can be increased? diminishing returns to an input   an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input.

micro E conomics Unit 7 Slide 14 Created: Jan 2007 by Jim Luke. The Long-Run Decision: Economies of Scale & LRAC LRAC: All Inputs Variable  Economies of Scale  Constant Economies of Scale  Diseconomies of Scale NOT Series of Short-Runs