Firms and Production 6.1 The Ownership and Management of Firms ...
Chapter 6: Firms and Production 6.1 The Ownership and Management of Firms Private, Public and Nonprofit firms - Private sector: Owned by individuals or other non-governmental entities and whose owners try to earn a profit - Public sector: Firms and organizations that are owned by governments or government agencies - Non-for-profit sector: Organizations that are neither government-owned nor intended to earn profit o Pursue social or public interest objectives The Ownership for For-Profit Firms - Sole proprietorship: Firms owned by a single individual who is personally liable for the firm’s debts - General Partnership: Businesses jointly owned and controlled by two or more people who are personally liable for the firm’s debts - Corporations: Owned by shareholders in proportion to the number of shares of stock they hold o Limited liability: the personal assets of corporate owners cannot be taken to pa a corporation’s debts even if it goes into bankruptcy What Owners Want - To maximize profit -
=R–C : Profit; R: Revenue; C: Cost R = pq p: Price; q: Quantity
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Efficient production: if the firm cannot produce its current level with less inputs
6.2 Production - Capital service (K): Use of long-lived inputs such as land, buildings, and equipment - Labor service (L): Hours ofwork provided by managers, skilled workers, and lessskilled workers - Materials (M): Natural resources and raw goods and processed products
Production Functions - The relationship between the quantities of inputs used and the maximum quantity of output that can be produced, given current knowledge of technology and organization - q = f (L,K) o Where q units are produced using L units of labor services and K units of capital o Function only shows the maximum amount of output that can be produced from given levels of labor and capital Time and the Variability of Inputs - Short run: The period of time so brief that at least one factor of production cannot be varied practically - Fixed input: A factors that a firm cannot vary practically in the short run - Variable input: Factor of production whose quantity the firm can change readily during the relevant time period - Long run: Long enough period of time that all inputs can be varied o No fixed inputs – all factors of production are variable inputs 6.3 Short-Run Production: One Variable and One Fixed Input - In the short run, we assume capital is a fixed input and that labor is a variable input o Increasing output by altering only labor - Production Function
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o q = f (L,K) o q: Output; L: Workers;K: Fixed number of unites of capital o It is the amount of output that a given amount of labor can produce holding the quantity of other inputs fixed Marginal Product of Labor o MPL =
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o The exact relationship between output and labor Average Product of Labor o APL = o The ratio of output to the number of workers used to produce that output
6.4 Long-Run Production: Two Variable Inputs - Both capital and labor are variable - The firm can substitute one input for another while continuing to produce the same level of output, in much the same way a consumer can maintain a given level of utility -
Cobb-Douglas Production Function o q = LaKb o L: Labor (workers) per day; K: Capital services per day
Isoquants - Curve that shows the efficient combinations of labor and capital that can produce a single (iso) level of output (quantity) - If the production function is q = f(L,K) then the equation for an isoquant where output is held constant at q is -
o q = f(L,K) Isoquants show a firm’s flexibility in producing a given level of output o Smooth curves because the firm can use fractional units of each input Properties of Isoquants: o Same properties as indifference curves except that isoquants holds quantity constant whereas indifference curves hold utility constant o The farther an isoquant is from the origin, the greater the level of output o Isoquants do not cross
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o Isoquants slope downward o Isoquants must be thin Shape of isoquants o The curvature of an isoquant shows how readily a firm can substitute one input for another o Extreme cases: Inputs are perfect substitutes
If perfect substitutes, each isoquant is a straight line Linear production: q = x+y Inputs cannot be substituted for each other
Inputs must be in fixed proportions
Fixed proportion production function: q = min(g,b) o Where the min function means “the minimum number of g or b”
Isoquants would be in right angles Imperfect substitution between inputs
Isoquants are convex Along a curved isoquant, the ability to substitute one input for another varies
The marginal rate of technical substitution falls as labor increases n a convex isoquant
Substituting Inputs - The slope of an isoquant shows the ability of a firm to replace one input with another while holding output constant - Slope of an isoquant is called the Marginal Rate of Technical Substitution o MRTS = o Tells us how many nits of capital the firm can replace with an extra unit of labor while holding output constant o Because isoquants slope downwards, MRTS is negative Diminishing Marginal Rates of Technical Substitution - The curvature of the isoquant away from the origin - As we move down and to the right along the isoquant, the slope becomes flatter – the slope gets closer to zero – because the ratio K/L grows closer to zero
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The more labor the firm ha, the harder it is to replace the remaining capital with labor, so MRTS falls as the isoquant becomes flatter
The Elasticity of Substitution - The percentage change in the capital-labor ratio divided by the percentage change in the MRTS
o Tells us how the input factor ratio changes as the slope of the isoquant changes o If the elasticity is large – a small change in the slope results in a big increase in the factor ratio – the isoquant is relatively flat o As the elasticity falls, the isoquant becomes more curved o As we move along the isoquant, both K/L and the absolute value of the MRTS change in the same direction, so the elasticity is positive 6.5 Returns to Scale - How much output changes if a firm increases all its inputs proportionately? Constant, Increasing, and Decreasing Returns to Scale - Increasing Returns to Scale o If output rises more than in proportion to an equal percentage increase in all inputs o Occurs when the firm is small with small amounts of output Returns to specialization (workers and equipment) - Constant Return to Scale o When all inputs are increased by a certain percentage, output increases by that same percentage
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o Occurs when moderate amounts of output is produced – no returns to specialization and returns to scale are eventually exhausted Decreasing Returns to Scale o If output rises less than in proportion to an equal percentage increase in all inputs o Occurs if the firm continues to grow and managing staff becomes more difficult so the firm suffers
6.6 Productivity and Technical Change Relative Productivity - Measure this by expressing the firm’s actual output, q, as a percentage of the output that the most productive firm in the industry could have produced, q*, from the same amount of inputs: 100q/q* Chapter 7: Costs - Explicit Cost: The wages and bills the sole proprietor must pay to conduct business - Implicit Cost: The opportunity cost s of resources owned by the firm – do not involve contractual payments 7.1 Measuring Costs Opportunity Costs - The value of the best alternative use of that resource 7.2 Short-Run Costs Short-Run Cost Measures - Fixed Cost, Variable Cost, and Total Cost o Fixed Cost: A cost that does not vary with the level of output
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o Variable Cost: The production expense that changes with the quantity of output produced o Total Cost: The sum of a firm’s variable and fixed costs C = VC + F Marginal Cost o The amount by which a firm’s cost changes if it produces one more unit of output o MC =
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Average Cost o Average Fixed Cost (AFC): The fixed cost divided by the units of output produced AFC = F/q AFC rises because fixed cost is spread over more units o Average Variable Cost (AVC): The variable cost divided by the units of output produced AVC = VC/q
AVC may either increase or decrease as output rises because the variable cost increases with output o Average Cost (AC): The total cost divided by the units of output produced AC = C/q or AVC + AFC Production Functions and the Shape of Cost Curves - If a firm produces output using capital and labor and capital is fixed in the short run, the firm’s variable cost is its cost of labor o VC = Lw o L: Number of hours of Labor, w: Wage per hour -
If the firm increases its labor enough, it reaches a point of diminishing marginal returns to labor, where each extra worker increases output by a smaller amount
7.3 Long-Run Costs Input Choice - Isoquant Line o The firm’s total cost is the sum of its labor and capital costs C = wL + rK wL: wage per hour x labor; rK: K hours of machine services at a rental rate of r per hour
o Isocost Line: The combination of labor and capital that cost the same amount Where the isocost lines hit the capital and labor azes depend on the firm’s cost and the input prices Isocosts that are farther from the origin have higher costs than those closer to the origin The slope of each isocost line is the same
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Minimizing Costs o Three approaches to minimize cost:
Lowest Isocost rule – pick the bundle with the lowest isocost line touches the isoquant
Tangency rule – pick the nuble where the isoquant is tangent to the isocost
Last-Dollar Rule – pick the bundle of inputs where the last dollar spent on one input gives as much extra output as the last dollar spent on any other input o Firm chooses its inputs so that the MRTS equals the negative of the relative input prices
Shows the rate at which the firm can substitute capital for labor holding total cost constant o The firm minimizes the cost of production by selecting inputs such that MPL/w=MPK/r How Long-Run Cost Varies with Output - Expansion Path o The curve through the tangency points o The cost-minimizing combination of labor and capital for each output level
- Long-Run Cost Function o Shows the relationship between the cost of production and output o C(q) = wL + rK Chapter 8: Competitive Firms and Markets 8.1 Perfect Competition Price Taking - Market is perfectly competitive if each firm in the market is a price taker that cannot significantly affect the market price for its output or the prices at which it buys inputs
- A competitive firm would be a price taker if it faces a demand curve that is horizontal at the market price Why A Firm’s Demand Curve Is Horizontal - Firms are likely to be price takers in markets that have some or all of the following properties: o The market contains a large number of firms o Firms sell identical products o Buyers and sellers have full information about the prices charged by all firms
o Transaction costs – the expenses of finding a trading partner and completing the trade beyond the price paid for the good or service are low o Firms can freely enter and exit the market Deviation of a Competitive Firm’s Demand Curve - Residual Demand Curve: the market demand that is not met by other sellers at any given price o Dr(p) o Shows the quantity demanded from the firm at price, p
- Q = D(p) : The quantity the market demands - S(p) : The supply curve of the other firms - Thus, the residual demand function:
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o Dr(p) = D(p) - S(p) o When S(p) > D(p), the residual quantity demanded is 0 The firm only sells to people who have not bought the same product from another seller In equilibrium, D(p) = S(p) Slope of the residual demand curve: o
8.2 Profit Maximization Profit -
=R–C o : Profit; R: Revenue, C: Cost
Two Steps to Maximizing Profit - Output decision: If the firm produces what output level, q*, maximizes its profit or
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minimizes its loss? o Firm sets its output where its profit is maximized o Firm sets its output where its marginal profit is zero o Firm sets its output where its marginal revenue equals its marginal cost Shutdown decision: Is it more profitable to produce q* or to shut down and produce no output? o The firm shuts down only if it can reduce its loss by doing so o The firm shuts down only if its revenue is less than its avoidable cost
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If a firm chooses to continue operating at a loss, the following is true: o Average Cost ≥ p ≥ Average Variable Cost o Marginal Revenue = Marginal Cost o p = Marginal Cost o If its revenue can pay a portion of its fixed costs
8.3 Competition in the Short-Run Short-Run Competitive Profit Maximization - Short-run output decision o Marginal Revenue, -
Short-Run Shutdown Decision o The firm can gain from shutting down only if its revenue is less than its shortrun variable cost: Pq < VC(q) (by dividing both sides by q, the equation can be written like:
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= Market Price, p
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A competitive firm shuts down if the market price is less than the minimum of its short-run AVC curve
Short-Run Market Supply Curve o The maximum number of firms in the market, n, is fixed o If all the firms in a competitive market are identical, Market supply = n x supply on an individual firm, q The more identical firms producing a at a given price, the platter the short-run market supply curve at that price o When firms have different shutdown prices, the market supply reflect a different number of firms at various prices even in the short run Short-run Competitive Equilibrium o If a firm is currently in a short-run equilibrium earning a profit and a lumpslum tax is impose, the firm will not change output but earn a lower profit o If a firm is currently in a short-run equilibrium earning a profit and an increase in variable prices occurs, the firm will decrease output and earn a lower profit
8.4 Competition in the Long Run Long-Run Competitive Profit Maximization
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Long-run output decision o The company will pick the quantity that maximizes long-run profit Revenue – Long-run cost o Operate where long-run marginal profit is 0 and where marginal revenue = long-run marginal cost Long-run shutdown decision o Firm shuts down if it would suffer an economic loss by continuing to operate Long-Run Market Supply Curve o The more firms in the market, the flatter the market supply curve o Entry and Exit
The number of firms in a market in the long run is determined by the entry and exit of firms
A firm enters the market if it can make a long-run profit, > 0 A firm exits in the market to avoid a long run loss, < 0 If firms in the market are making zero long-run profit, they are indifferent between staying in the market and exiting The decision to exit the industry is a long-run decision and in the longrun, all costs are variable A firm shuts down if it would make an economic loss by operating; if
price < average total cost If the market price is initially at minimum long-run average cost, an increase in demand will raise the price in the short-run Firms will have short-run profits, which stimulates entry Entry shifts the supply curve to the right, causing the equilibrium price to fall toward the minimum average cost o Long-Run Market Supply with Identical Firms and Free Entry The long-run market supply curve is flat at the minimum long-run average cost if firms can freely enter and exit the market, an unlimited number of firms have identical costs, and input prices are constant o Long-Run Market Supply When Entry Is Limited If the number of firms in a market is limited in the long-run, the market supply curve slopes upward Entry becomes limited because:
The government restricts the number Firms need a scarce resource Entry is costly
o Market Supply when firms differ Long-run market supply curve slopes upward since firms with relatively low minimum long-run average costs are willing to enter the market at lower prices than others o Long-Run Market Supply When Input Prices Vary with Output In markets where factor prices rise or fall when output increase, the long-run supply curve slopes even if firms have identical costs and can freely enter and exit If a relatively small share of the total quantity of a factor of production is used in a specific market, as the market’s output expands, the price
of the factor is unlikely to be affected In contrast, if a very large share of a factor is used in one market, the price of that input is more likely to vary with that market’s output To produce more goods, firms must use more inputs Increasing cost market: When input prices rise and thus, the price of the final goods rice
Long-Run supply curve is upward sloping Constant cost market: Where input prices remain constant as output prices increase
Long-Run supply curve is flat Decreasing cost market: As market output rises, at least some factor prices fall
Long-Run supply curve is downward sloping o Long-Run Market Supply Curve with Trade The world equilibrium price and quantity for a good are determined by the intersection of the world supply curve (the horizontal sum of the supply curves of each producing country) and the world demand curve (the horizontal sum of the demand curves of each consuming
country) Residual Supply Curve: the quantity that the market supplies that is not consumed by other demanders at any given price
Residual Supply Function: Sr(p) = S(p) - D(p) S(p): part of the world supply; D(p): part not consumed by any other demander elsewhere in the world Long-Run Competitive Equilibrium
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The intersection of the long-run market supply and demand curves determines the long-run competitive equilibrium
Chapter 9: Properties and Applications of the Competitive Model 9.1 Zero Profit for Competitive Firms in the Long Run - Competitive firms earn zero profit in the long run whether or not entry is completely free - As a consequence, competitive firms must maximize profit 9.2 Producer Welfare - Producer surplus: The difference between the amount for which a good sells and the minimum amount necessary for the seller to be willing to produce the good Measuring Producer Surplus Using a Supply Curve - We use the supply curve – the marginal cost curve above its minimum average variable cost - PS = Area of Triangle created from price and quantity produced Using Producer Surplus - To study the effects of any shock that does not affect the fixed cost of firms - Used to measure the effect of a chock on all the firms in a market without having to measure the profit of each firm separately - Calculating Market Producer Surplus: o The area above the supply curve and below the market price line at p* up to the quantity sold, Q* o It is the horizontal sum of the marginal cost curves of each of the firms 9.3 How Competition Maximizes Welfare - Measuring welfare of society: o W = CS + PS o W: Welfare, CS: Consumer Surplus; PS: Producer Surplus o Change in surplus = ending welfare – initial welfare
Lowering Welfare - Deadweight loss: The net reduction in welfare from a loss of surplus by one group that is not offset by a gain to another group o Also, it is the opportunity cost of giving up some of this good to buy more of another good - The deadweight loss results because consumers value extra output by more than the marginal cost of producing it - Producing less than the competitive output lowers welfare o DWL is the area above the supply curve and below the demand curve from the constrained (market failure) equilibrium quantity up to the competitive -
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equilibrium quantity Producing more than the competitive output lowers welfare o The cost of producing this extra output exceeds the value consumers place on it o The DWL is the area under the supply curve and above the demand curve form the competitive equilibrium quantity to the constrained (market failure) equilibrium quantity The reason that competition maximizes welfare is that price equals marginal cost at the competitive equilibrium o At the competitive equilibrium, demand equals supply, which ensures that price equals marginal cost Market Failure: Inefficient production or consumption, often because a price exceeds marginal cost
9.4 Policies That Shift Supply Curves Restricting the Number of firms - A limit of the number of firms causes the supply curve to shift to the left - As a result, the equilibrium price rises and the equilibrium quantity falls -
o Consumers do not buy as much as they would at lower prices Those who are in the market when the policy is imposed gain from more profits
Raising Entry and Exit Costs - Instead of restricting the number of entries, governments may raise the cost of entering, indirectly restricting that number - Raising the cost of exiting a market discourages some firms from entering - Entry Barriers
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o If its cost will be greater than that of firms already in the market, a potential firm might not enter a market even if existing firms are making a profit o A long-run barrier to entry is an explicit restriction or a cost that applies only to potential new firms – existing are not subject to the restriction or do not bear the cost Exist Barriers o Short-run: exist barriers keep numbers high o Long-run: exit barriers limit the number of firms in the market
9.5 Policies That Create a Wedge Between Supply and Demand Curves Welfare Effects of a Sales Tax - Sales tax causes the price that consumers pay to rise resulting in a loss of consumer surplus, and the price that firms receive to fall, resulting in a drop in producer surplus - However, this tax provides government revenue
Welfare Effects of a Price Floor - In some markets, the government sets a minimum price, which is the lowest price a -
consumer can legally pay for the good Must be above equilibrium price
Welfare Effects of a Price Ceiling - It is the highest price that a firm can legally charge
Chapter 10: General Equilibrium and Economic Welfare 10.1 General Equilibrium - Partial Equilibrium Analysis: an examination of equilibrium and changes in equilibrium in one market isolation o Holding prices and quantities of other goods fixed o Ignore markets affect other markets’ equilibrium prices and quantities - General Equilibrium: the study of how equilibrium is determined in all markets simultaneously Minimum Wages with Incomplete Coverage - Minimum wage causes the quantity of labor demanded to be less than the quantity of labor supplied - Residual Supply Curve: the quantity the market supplies that is not met by demanders in other sectors at any given wage - Residual Supply function for the uncovered sector: o Su(w) = S(w) – Dc(w) o S(w): Total Supply; w: Wage; Dc(w): Amount of labor used in the covered sector -
Causes: o Employment drop in covered sectors o Employment rise in uncovered sectors o Wage in uncovered sectors falls below original competitive level
10.2 General-Equilibrium Exchange Economy: Trading Between Two People Endowments - Initial allocation of goods Mutually Beneficial Trades - 4 assumptions about ones taste behavior: o Utility Maximization o Usual-shaped indifference curves o Nonsatiation – each person has positive marginal utility for each good o No interdependence – neither person’s utility depends on the other’s consumption
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Contract Curve: Contains all the Pareto-efficient allocations (where the indifference curves are tangent)
10.3 Competitive Exchange - Competitive market has two desirable properties: o The competitive equilibrium is efficient Pareto efficient allocation – no one can be better off without making someone worse off o Any efficient allocations can be achieved by competition Efficient allocations can be obtained by competitive exchange Competitive Equilibrium - Price line: All the combinations of goods that one can get from trading, given their endowment The Efficiency of Competition - In a competitive equilibrium, the indifference curves of both types of consumers are tangent at the same bundle on the price line - MRS of each indifference curve = the slope of the line o MRS =
10.4 Production and Trading Comparative Advantage - Marginal Rate of Transformation
=R–C : Profit; R: Revenue; C: Cost R = pq p: Price; q: Quantity
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Efficient production: if the firm cannot produce its current level with less inputs
6.2 Production - Capital service (K): Use of long-lived inputs such as land, buildings, and equipment - Labor service (L): Hours ofwork provided by managers, skilled workers, and lessskilled workers - Materials (M): Natural resources and raw goods and processed products
Production Functions - The relationship between the quantities of inputs used and the maximum quantity of output that can be produced, given current knowledge of technology and organization - q = f (L,K) o Where q units are produced using L units of labor services and K units of capital o Function only shows the maximum amount of output that can be produced from given levels of labor and capital Time and the Variability of Inputs - Short run: The period of time so brief that at least one factor of production cannot be varied practically - Fixed input: A factors that a firm cannot vary practically in the short run - Variable input: Factor of production whose quantity the firm can change readily during the relevant time period - Long run: Long enough period of time that all inputs can be varied o No fixed inputs – all factors of production are variable inputs 6.3 Short-Run Production: One Variable and One Fixed Input - In the short run, we assume capital is a fixed input and that labor is a variable input o Increasing output by altering only labor - Production Function
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o q = f (L,K) o q: Output; L: Workers;K: Fixed number of unites of capital o It is the amount of output that a given amount of labor can produce holding the quantity of other inputs fixed Marginal Product of Labor o MPL =
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o The exact relationship between output and labor Average Product of Labor o APL = o The ratio of output to the number of workers used to produce that output
6.4 Long-Run Production: Two Variable Inputs - Both capital and labor are variable - The firm can substitute one input for another while continuing to produce the same level of output, in much the same way a consumer can maintain a given level of utility -
Cobb-Douglas Production Function o q = LaKb o L: Labor (workers) per day; K: Capital services per day
Isoquants - Curve that shows the efficient combinations of labor and capital that can produce a single (iso) level of output (quantity) - If the production function is q = f(L,K) then the equation for an isoquant where output is held constant at q is -
o q = f(L,K) Isoquants show a firm’s flexibility in producing a given level of output o Smooth curves because the firm can use fractional units of each input Properties of Isoquants: o Same properties as indifference curves except that isoquants holds quantity constant whereas indifference curves hold utility constant o The farther an isoquant is from the origin, the greater the level of output o Isoquants do not cross
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o Isoquants slope downward o Isoquants must be thin Shape of isoquants o The curvature of an isoquant shows how readily a firm can substitute one input for another o Extreme cases: Inputs are perfect substitutes
If perfect substitutes, each isoquant is a straight line Linear production: q = x+y Inputs cannot be substituted for each other
Inputs must be in fixed proportions
Fixed proportion production function: q = min(g,b) o Where the min function means “the minimum number of g or b”
Isoquants would be in right angles Imperfect substitution between inputs
Isoquants are convex Along a curved isoquant, the ability to substitute one input for another varies
The marginal rate of technical substitution falls as labor increases n a convex isoquant
Substituting Inputs - The slope of an isoquant shows the ability of a firm to replace one input with another while holding output constant - Slope of an isoquant is called the Marginal Rate of Technical Substitution o MRTS = o Tells us how many nits of capital the firm can replace with an extra unit of labor while holding output constant o Because isoquants slope downwards, MRTS is negative Diminishing Marginal Rates of Technical Substitution - The curvature of the isoquant away from the origin - As we move down and to the right along the isoquant, the slope becomes flatter – the slope gets closer to zero – because the ratio K/L grows closer to zero
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The more labor the firm ha, the harder it is to replace the remaining capital with labor, so MRTS falls as the isoquant becomes flatter
The Elasticity of Substitution - The percentage change in the capital-labor ratio divided by the percentage change in the MRTS
o Tells us how the input factor ratio changes as the slope of the isoquant changes o If the elasticity is large – a small change in the slope results in a big increase in the factor ratio – the isoquant is relatively flat o As the elasticity falls, the isoquant becomes more curved o As we move along the isoquant, both K/L and the absolute value of the MRTS change in the same direction, so the elasticity is positive 6.5 Returns to Scale - How much output changes if a firm increases all its inputs proportionately? Constant, Increasing, and Decreasing Returns to Scale - Increasing Returns to Scale o If output rises more than in proportion to an equal percentage increase in all inputs o Occurs when the firm is small with small amounts of output Returns to specialization (workers and equipment) - Constant Return to Scale o When all inputs are increased by a certain percentage, output increases by that same percentage
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o Occurs when moderate amounts of output is produced – no returns to specialization and returns to scale are eventually exhausted Decreasing Returns to Scale o If output rises less than in proportion to an equal percentage increase in all inputs o Occurs if the firm continues to grow and managing staff becomes more difficult so the firm suffers
6.6 Productivity and Technical Change Relative Productivity - Measure this by expressing the firm’s actual output, q, as a percentage of the output that the most productive firm in the industry could have produced, q*, from the same amount of inputs: 100q/q* Chapter 7: Costs - Explicit Cost: The wages and bills the sole proprietor must pay to conduct business - Implicit Cost: The opportunity cost s of resources owned by the firm – do not involve contractual payments 7.1 Measuring Costs Opportunity Costs - The value of the best alternative use of that resource 7.2 Short-Run Costs Short-Run Cost Measures - Fixed Cost, Variable Cost, and Total Cost o Fixed Cost: A cost that does not vary with the level of output
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o Variable Cost: The production expense that changes with the quantity of output produced o Total Cost: The sum of a firm’s variable and fixed costs C = VC + F Marginal Cost o The amount by which a firm’s cost changes if it produces one more unit of output o MC =
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Average Cost o Average Fixed Cost (AFC): The fixed cost divided by the units of output produced AFC = F/q AFC rises because fixed cost is spread over more units o Average Variable Cost (AVC): The variable cost divided by the units of output produced AVC = VC/q
AVC may either increase or decrease as output rises because the variable cost increases with output o Average Cost (AC): The total cost divided by the units of output produced AC = C/q or AVC + AFC Production Functions and the Shape of Cost Curves - If a firm produces output using capital and labor and capital is fixed in the short run, the firm’s variable cost is its cost of labor o VC = Lw o L: Number of hours of Labor, w: Wage per hour -
If the firm increases its labor enough, it reaches a point of diminishing marginal returns to labor, where each extra worker increases output by a smaller amount
7.3 Long-Run Costs Input Choice - Isoquant Line o The firm’s total cost is the sum of its labor and capital costs C = wL + rK wL: wage per hour x labor; rK: K hours of machine services at a rental rate of r per hour
o Isocost Line: The combination of labor and capital that cost the same amount Where the isocost lines hit the capital and labor azes depend on the firm’s cost and the input prices Isocosts that are farther from the origin have higher costs than those closer to the origin The slope of each isocost line is the same
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Minimizing Costs o Three approaches to minimize cost:
Lowest Isocost rule – pick the bundle with the lowest isocost line touches the isoquant
Tangency rule – pick the nuble where the isoquant is tangent to the isocost
Last-Dollar Rule – pick the bundle of inputs where the last dollar spent on one input gives as much extra output as the last dollar spent on any other input o Firm chooses its inputs so that the MRTS equals the negative of the relative input prices
Shows the rate at which the firm can substitute capital for labor holding total cost constant o The firm minimizes the cost of production by selecting inputs such that MPL/w=MPK/r How Long-Run Cost Varies with Output - Expansion Path o The curve through the tangency points o The cost-minimizing combination of labor and capital for each output level
- Long-Run Cost Function o Shows the relationship between the cost of production and output o C(q) = wL + rK Chapter 8: Competitive Firms and Markets 8.1 Perfect Competition Price Taking - Market is perfectly competitive if each firm in the market is a price taker that cannot significantly affect the market price for its output or the prices at which it buys inputs
- A competitive firm would be a price taker if it faces a demand curve that is horizontal at the market price Why A Firm’s Demand Curve Is Horizontal - Firms are likely to be price takers in markets that have some or all of the following properties: o The market contains a large number of firms o Firms sell identical products o Buyers and sellers have full information about the prices charged by all firms
o Transaction costs – the expenses of finding a trading partner and completing the trade beyond the price paid for the good or service are low o Firms can freely enter and exit the market Deviation of a Competitive Firm’s Demand Curve - Residual Demand Curve: the market demand that is not met by other sellers at any given price o Dr(p) o Shows the quantity demanded from the firm at price, p
- Q = D(p) : The quantity the market demands - S(p) : The supply curve of the other firms - Thus, the residual demand function:
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o Dr(p) = D(p) - S(p) o When S(p) > D(p), the residual quantity demanded is 0 The firm only sells to people who have not bought the same product from another seller In equilibrium, D(p) = S(p) Slope of the residual demand curve: o
8.2 Profit Maximization Profit -
=R–C o : Profit; R: Revenue, C: Cost
Two Steps to Maximizing Profit - Output decision: If the firm produces what output level, q*, maximizes its profit or
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minimizes its loss? o Firm sets its output where its profit is maximized o Firm sets its output where its marginal profit is zero o Firm sets its output where its marginal revenue equals its marginal cost Shutdown decision: Is it more profitable to produce q* or to shut down and produce no output? o The firm shuts down only if it can reduce its loss by doing so o The firm shuts down only if its revenue is less than its avoidable cost
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If a firm chooses to continue operating at a loss, the following is true: o Average Cost ≥ p ≥ Average Variable Cost o Marginal Revenue = Marginal Cost o p = Marginal Cost o If its revenue can pay a portion of its fixed costs
8.3 Competition in the Short-Run Short-Run Competitive Profit Maximization - Short-run output decision o Marginal Revenue, -
Short-Run Shutdown Decision o The firm can gain from shutting down only if its revenue is less than its shortrun variable cost: Pq < VC(q) (by dividing both sides by q, the equation can be written like:
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= Market Price, p
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A competitive firm shuts down if the market price is less than the minimum of its short-run AVC curve
Short-Run Market Supply Curve o The maximum number of firms in the market, n, is fixed o If all the firms in a competitive market are identical, Market supply = n x supply on an individual firm, q The more identical firms producing a at a given price, the platter the short-run market supply curve at that price o When firms have different shutdown prices, the market supply reflect a different number of firms at various prices even in the short run Short-run Competitive Equilibrium o If a firm is currently in a short-run equilibrium earning a profit and a lumpslum tax is impose, the firm will not change output but earn a lower profit o If a firm is currently in a short-run equilibrium earning a profit and an increase in variable prices occurs, the firm will decrease output and earn a lower profit
8.4 Competition in the Long Run Long-Run Competitive Profit Maximization
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Long-run output decision o The company will pick the quantity that maximizes long-run profit Revenue – Long-run cost o Operate where long-run marginal profit is 0 and where marginal revenue = long-run marginal cost Long-run shutdown decision o Firm shuts down if it would suffer an economic loss by continuing to operate Long-Run Market Supply Curve o The more firms in the market, the flatter the market supply curve o Entry and Exit
The number of firms in a market in the long run is determined by the entry and exit of firms
A firm enters the market if it can make a long-run profit, > 0 A firm exits in the market to avoid a long run loss, < 0 If firms in the market are making zero long-run profit, they are indifferent between staying in the market and exiting The decision to exit the industry is a long-run decision and in the longrun, all costs are variable A firm shuts down if it would make an economic loss by operating; if
price < average total cost If the market price is initially at minimum long-run average cost, an increase in demand will raise the price in the short-run Firms will have short-run profits, which stimulates entry Entry shifts the supply curve to the right, causing the equilibrium price to fall toward the minimum average cost o Long-Run Market Supply with Identical Firms and Free Entry The long-run market supply curve is flat at the minimum long-run average cost if firms can freely enter and exit the market, an unlimited number of firms have identical costs, and input prices are constant o Long-Run Market Supply When Entry Is Limited If the number of firms in a market is limited in the long-run, the market supply curve slopes upward Entry becomes limited because:
The government restricts the number Firms need a scarce resource Entry is costly
o Market Supply when firms differ Long-run market supply curve slopes upward since firms with relatively low minimum long-run average costs are willing to enter the market at lower prices than others o Long-Run Market Supply When Input Prices Vary with Output In markets where factor prices rise or fall when output increase, the long-run supply curve slopes even if firms have identical costs and can freely enter and exit If a relatively small share of the total quantity of a factor of production is used in a specific market, as the market’s output expands, the price
of the factor is unlikely to be affected In contrast, if a very large share of a factor is used in one market, the price of that input is more likely to vary with that market’s output To produce more goods, firms must use more inputs Increasing cost market: When input prices rise and thus, the price of the final goods rice
Long-Run supply curve is upward sloping Constant cost market: Where input prices remain constant as output prices increase
Long-Run supply curve is flat Decreasing cost market: As market output rises, at least some factor prices fall
Long-Run supply curve is downward sloping o Long-Run Market Supply Curve with Trade The world equilibrium price and quantity for a good are determined by the intersection of the world supply curve (the horizontal sum of the supply curves of each producing country) and the world demand curve (the horizontal sum of the demand curves of each consuming
country) Residual Supply Curve: the quantity that the market supplies that is not consumed by other demanders at any given price
Residual Supply Function: Sr(p) = S(p) - D(p) S(p): part of the world supply; D(p): part not consumed by any other demander elsewhere in the world Long-Run Competitive Equilibrium
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The intersection of the long-run market supply and demand curves determines the long-run competitive equilibrium
Chapter 9: Properties and Applications of the Competitive Model 9.1 Zero Profit for Competitive Firms in the Long Run - Competitive firms earn zero profit in the long run whether or not entry is completely free - As a consequence, competitive firms must maximize profit 9.2 Producer Welfare - Producer surplus: The difference between the amount for which a good sells and the minimum amount necessary for the seller to be willing to produce the good Measuring Producer Surplus Using a Supply Curve - We use the supply curve – the marginal cost curve above its minimum average variable cost - PS = Area of Triangle created from price and quantity produced Using Producer Surplus - To study the effects of any shock that does not affect the fixed cost of firms - Used to measure the effect of a chock on all the firms in a market without having to measure the profit of each firm separately - Calculating Market Producer Surplus: o The area above the supply curve and below the market price line at p* up to the quantity sold, Q* o It is the horizontal sum of the marginal cost curves of each of the firms 9.3 How Competition Maximizes Welfare - Measuring welfare of society: o W = CS + PS o W: Welfare, CS: Consumer Surplus; PS: Producer Surplus o Change in surplus = ending welfare – initial welfare
Lowering Welfare - Deadweight loss: The net reduction in welfare from a loss of surplus by one group that is not offset by a gain to another group o Also, it is the opportunity cost of giving up some of this good to buy more of another good - The deadweight loss results because consumers value extra output by more than the marginal cost of producing it - Producing less than the competitive output lowers welfare o DWL is the area above the supply curve and below the demand curve from the constrained (market failure) equilibrium quantity up to the competitive -
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equilibrium quantity Producing more than the competitive output lowers welfare o The cost of producing this extra output exceeds the value consumers place on it o The DWL is the area under the supply curve and above the demand curve form the competitive equilibrium quantity to the constrained (market failure) equilibrium quantity The reason that competition maximizes welfare is that price equals marginal cost at the competitive equilibrium o At the competitive equilibrium, demand equals supply, which ensures that price equals marginal cost Market Failure: Inefficient production or consumption, often because a price exceeds marginal cost
9.4 Policies That Shift Supply Curves Restricting the Number of firms - A limit of the number of firms causes the supply curve to shift to the left - As a result, the equilibrium price rises and the equilibrium quantity falls -
o Consumers do not buy as much as they would at lower prices Those who are in the market when the policy is imposed gain from more profits
Raising Entry and Exit Costs - Instead of restricting the number of entries, governments may raise the cost of entering, indirectly restricting that number - Raising the cost of exiting a market discourages some firms from entering - Entry Barriers
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o If its cost will be greater than that of firms already in the market, a potential firm might not enter a market even if existing firms are making a profit o A long-run barrier to entry is an explicit restriction or a cost that applies only to potential new firms – existing are not subject to the restriction or do not bear the cost Exist Barriers o Short-run: exist barriers keep numbers high o Long-run: exit barriers limit the number of firms in the market
9.5 Policies That Create a Wedge Between Supply and Demand Curves Welfare Effects of a Sales Tax - Sales tax causes the price that consumers pay to rise resulting in a loss of consumer surplus, and the price that firms receive to fall, resulting in a drop in producer surplus - However, this tax provides government revenue
Welfare Effects of a Price Floor - In some markets, the government sets a minimum price, which is the lowest price a -
consumer can legally pay for the good Must be above equilibrium price
Welfare Effects of a Price Ceiling - It is the highest price that a firm can legally charge
Chapter 10: General Equilibrium and Economic Welfare 10.1 General Equilibrium - Partial Equilibrium Analysis: an examination of equilibrium and changes in equilibrium in one market isolation o Holding prices and quantities of other goods fixed o Ignore markets affect other markets’ equilibrium prices and quantities - General Equilibrium: the study of how equilibrium is determined in all markets simultaneously Minimum Wages with Incomplete Coverage - Minimum wage causes the quantity of labor demanded to be less than the quantity of labor supplied - Residual Supply Curve: the quantity the market supplies that is not met by demanders in other sectors at any given wage - Residual Supply function for the uncovered sector: o Su(w) = S(w) – Dc(w) o S(w): Total Supply; w: Wage; Dc(w): Amount of labor used in the covered sector -
Causes: o Employment drop in covered sectors o Employment rise in uncovered sectors o Wage in uncovered sectors falls below original competitive level
10.2 General-Equilibrium Exchange Economy: Trading Between Two People Endowments - Initial allocation of goods Mutually Beneficial Trades - 4 assumptions about ones taste behavior: o Utility Maximization o Usual-shaped indifference curves o Nonsatiation – each person has positive marginal utility for each good o No interdependence – neither person’s utility depends on the other’s consumption
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Contract Curve: Contains all the Pareto-efficient allocations (where the indifference curves are tangent)
10.3 Competitive Exchange - Competitive market has two desirable properties: o The competitive equilibrium is efficient Pareto efficient allocation – no one can be better off without making someone worse off o Any efficient allocations can be achieved by competition Efficient allocations can be obtained by competitive exchange Competitive Equilibrium - Price line: All the combinations of goods that one can get from trading, given their endowment The Efficiency of Competition - In a competitive equilibrium, the indifference curves of both types of consumers are tangent at the same bundle on the price line - MRS of each indifference curve = the slope of the line o MRS =
10.4 Production and Trading Comparative Advantage - Marginal Rate of Transformation
