2. Law of Diminishing Returns In
Review 1. Production Function Short-Run: Variable Factor (labour) Fixed Factor (capital) 2. Law of Diminishing Returns In short run, marginal product (MP) of variable factor eventually declines 3. MP and MC MP increases => MC decreases MP decreases (eventually) => MC increases (eventually) Diagram #2
MC intersects ATC at minimum of ATC Short run (there is a fixed factor of production) : ATC is U - shaped Long run (no fixed factor) : ATC is not necessarily U - Shaped Firm's Long run ATC Schedule 1. In short run, GM must hire more workers to increase output ("LAw of Diminishing Returns" applies) 2. In long run, GM can build more assembly plants as well as hire more workers 2.1 "Law of Diminishing Returns" does not apply
2.2 MP does not necessarily fall after some point -> MC does not necessarily rise 3.Suppose firm doubles all inputs (a) Output doubles (constant returns to scale) -> ATC unchanged (b) Output less than doubles (diseconomies of scale) -> ATC increases (c) Output more than doubles (economies of scale) -> ATC falls 4. Assumes that costs of inputs - such as wages for workers - do not change when firm doubles all inputs (firm is a "price take") Long - Run Average Total Cost Curve
Economies of Scale: Diseconomies of Scale:
Specialization (for example) Organization and Co-ordination Costs
2011 Exam #45 A firm produces its output with one variable factor (labour) and one fixed factor (capital). If a firm's total fixed cost is $200, and its total costs is $400 to produce one unit and $620 to produce two units, the firm is a) already facing diminishing returns b) not yet facing diminishing returns c) facing constant returns (concept long run) d) already facing increasing returns (concept long run since variable factor) e) none of the above MC of first unit: 200 (TC - TFC = 400 - 200 = MC) MC of second unit: 220 (620 - 400) Answer: a) already facing diminishing returns Note: c) and d) are immediately wrong, since both pertain to long run when there is no fixed factor Should Firm Stay in Business? Is firm earning a profit? Economics vs. Accounting profits Economic Profit: Total Revenue Minus Opportunity Cost Opportunity Cost: Explicit: Wage paid to employees, cost of raw materials, etc Implicit: Opportunity Cost of owner's invested capital (normal rate of profit)
Opportunity Cost of owner's time Explicit Costs: Costs that require an outlay of money by the firm Implicit Costs: Costs that do not require an outlay of money by the firm Accounting Profit: Total Revenue Minus Total Explicit costs Economic Profit: Total Revenue Minus Total (Explicit + Implicit) costs Insight: Accounting profit "tracks" money inflows and outflows Economic profit also requires that implicit opportunity costs be identified and estimated Purpose of economic profit is to determine: 1. whether firm should exit (leave) industry 2. whether other firms have an incentive to enter industry An individual buys a business for $400,000. She invests $200,000 and borrows $200,000. Total Revenue: Opportunity Costs:
$100,000
Explicit: Wages Raw Materials Bank Interest (10%)
$40,000 $25,000 $20,000
Implicit: Opportunity Cost Of own Funds (15%) Economic Profit (Loss)
$30,000
($15,000)
Economic Profit: negative => firm should exit in long run Accounting Profit: $15,000 does not provide signal regarding entry/exit 1. Accounting Profit $15,000 2. Owner asks Accountant Should I stay in business? 3. Accountant responds You earned $15,000 on your investment of $200,000 or 7.5% If you can earn more than 7.5% elsewhere, you should get out of the business.
(Economist: If opportunity cost of your invested funds is more than 7.5%, economic profit is negative and you should leave the industry) You are producing 40 flat TVs. Your ATC schedule: Output
ATC ($)
40
40
41
41
A buyer offers you $75 to produce another TV. Should you? Answer: NO Additional (marginal) cost of producing 41st TV exceeds $75 TC to produce 40 TVs : 40 * $40 = $1,600 41 TVs: 41 * $41 = $1,691 MC = $1,691 - $1,600 = $81
MC intersects ATC at minimum of ATC Short run (there is a fixed factor of production) : ATC is U - shaped Long run (no fixed factor) : ATC is not necessarily U - Shaped Firm's Long run ATC Schedule 1. In short run, GM must hire more workers to increase output ("LAw of Diminishing Returns" applies) 2. In long run, GM can build more assembly plants as well as hire more workers 2.1 "Law of Diminishing Returns" does not apply
2.2 MP does not necessarily fall after some point -> MC does not necessarily rise 3.Suppose firm doubles all inputs (a) Output doubles (constant returns to scale) -> ATC unchanged (b) Output less than doubles (diseconomies of scale) -> ATC increases (c) Output more than doubles (economies of scale) -> ATC falls 4. Assumes that costs of inputs - such as wages for workers - do not change when firm doubles all inputs (firm is a "price take") Long - Run Average Total Cost Curve
Economies of Scale: Diseconomies of Scale:
Specialization (for example) Organization and Co-ordination Costs
2011 Exam #45 A firm produces its output with one variable factor (labour) and one fixed factor (capital). If a firm's total fixed cost is $200, and its total costs is $400 to produce one unit and $620 to produce two units, the firm is a) already facing diminishing returns b) not yet facing diminishing returns c) facing constant returns (concept long run) d) already facing increasing returns (concept long run since variable factor) e) none of the above MC of first unit: 200 (TC - TFC = 400 - 200 = MC) MC of second unit: 220 (620 - 400) Answer: a) already facing diminishing returns Note: c) and d) are immediately wrong, since both pertain to long run when there is no fixed factor Should Firm Stay in Business? Is firm earning a profit? Economics vs. Accounting profits Economic Profit: Total Revenue Minus Opportunity Cost Opportunity Cost: Explicit: Wage paid to employees, cost of raw materials, etc Implicit: Opportunity Cost of owner's invested capital (normal rate of profit)
Opportunity Cost of owner's time Explicit Costs: Costs that require an outlay of money by the firm Implicit Costs: Costs that do not require an outlay of money by the firm Accounting Profit: Total Revenue Minus Total Explicit costs Economic Profit: Total Revenue Minus Total (Explicit + Implicit) costs Insight: Accounting profit "tracks" money inflows and outflows Economic profit also requires that implicit opportunity costs be identified and estimated Purpose of economic profit is to determine: 1. whether firm should exit (leave) industry 2. whether other firms have an incentive to enter industry An individual buys a business for $400,000. She invests $200,000 and borrows $200,000. Total Revenue: Opportunity Costs:
$100,000
Explicit: Wages Raw Materials Bank Interest (10%)
$40,000 $25,000 $20,000
Implicit: Opportunity Cost Of own Funds (15%) Economic Profit (Loss)
$30,000
($15,000)
Economic Profit: negative => firm should exit in long run Accounting Profit: $15,000 does not provide signal regarding entry/exit 1. Accounting Profit $15,000 2. Owner asks Accountant Should I stay in business? 3. Accountant responds You earned $15,000 on your investment of $200,000 or 7.5% If you can earn more than 7.5% elsewhere, you should get out of the business.
(Economist: If opportunity cost of your invested funds is more than 7.5%, economic profit is negative and you should leave the industry) You are producing 40 flat TVs. Your ATC schedule: Output
ATC ($)
40
40
41
41
A buyer offers you $75 to produce another TV. Should you? Answer: NO Additional (marginal) cost of producing 41st TV exceeds $75 TC to produce 40 TVs : 40 * $40 = $1,600 41 TVs: 41 * $41 = $1,691 MC = $1,691 - $1,600 = $81
