Production Function
Total Product (TP)
Marginal Product (MP)
Average Product (AP)
TP: Total output or quantity produced
MP: Additional Output generated by additional inputs (workers)
AP: The output per unit of input
Define the following terms and give an example for each?
Fixed Costs
Variable Costs
Fixed costs are production costs that cannot change in the short run. An example would be the sq ft of a factory.
Variable Costs are production costs that can change in the short run and vary with levels of output. An example would be electricity, inputs, or workers in a firm.
What is the difference between short-run and long-run costs?
In the short run at least one factor of production is fixed. In the long-run all inputs of production are variable.
What is normal profit?
Explicit Costs + Implicit Cost = Total Revenue.
The minimum level of profit a business needs to earn to remain in business.
List three key components of a Perfectly Competitive market.
Does a pure, perfectly competitive market exist in the real world?
1. Large number of buyers and sellers (no single buyer or seller can influence price)
2. Identical Products: No differentiation b/w competitors
3. Free Entry and Exit: No barriers to enter or exit the industry
Explain how the law of diminishing returns affects production.
As variable resources are added to fixed resources, that additional output produced from each worker will eventually fall. "Too many cooks in the kitchen."
How do short run costs behave as production increases? (AFC, AVC, ATC, MC)
Fixed costs do not change so AFC decrease as production increases.
Variable Costs increase as production increases. At low levels of input AVC decreases, when MC intersects AVC, AVC begins to rise.
Total Costs increase as production increases. ATC initially falls, reaches a minimum, when it intersects MC, then rises again.
MC, initially falls due to increasing returns to scale, and then rises when diminishing marginal returns kick in.
Define the different types of economies of scale.
1. Increasing Returns to scale/Economies of Scale
2. Constant Returns to Scale
3. Decreasing Returns to Scale/Diseconomies of scale
1. As input doubles, outputs more than double. ΔCost / ΔOutput < 1
2. As input doubles, output doubles.
ΔCost / ΔOutput = 1
3. As input doubles, output increases by less than double.
ΔCost / ΔOutput > 1
Define the following terms:
a. Accounting Profit
b. Economic Profit
a. Accounting profit = TR - Explicit Costs
b. Economic profit = TR - (Explicit Costs + Implicit Costs)
Define the following terms as they relate to perfect competition.
a. Price Takers, b. Perfect Information, c. Mobility of labor and capital
a. no single firm can influence price, so all firms accept the industry price.
b. Buyers and sellers have perfect knowledge of market/industry conditions like price
c. All factors of production could be feely switched to other industries.
Describe the three stages of production:
1. Increasing Marginal Returns
2. Decreasing Marginal Returns
3. Negative Marginal Returns
2. Decreasing marginal returns. MP is falling. TP is increasing at a decreasing rate. Each worker adds less and less due to fixed resources.
3. MP is negative, TP is decreasing. Workers are getting in each others way.
Which of the following is considered a fixed cost in the short-run?
a. rent for factory, paid monthly
b. Salaries of permanent staff
c. Equipment maintenance costs
d. Insurance premiums that increase with production
e. all the above
a and b. They will not change with an increase in production.
c. changes based on machine usage
d. changes based on production increases.
Define Minimum Efficient Scale (MES) and draw a graph on the board showing a firms MES.
MES is the lowest output level at which a firm can produce its goods or services at the lowest possible average cost per unit.
The most profitable level of output for any firm operating in the short run is the level of output at which
a. MR > MC at the highest amount b. MR= MC
c. P >ATC by the highest amount d. P = ATC
e. P = MC
b. MR = MC
What are the two main conditions for long run equilibrium in Perfectly Competitive Markets?
1. All firms will earn zero economic profit. 2. The industry is stable with no firms entering or exiting. MR = MC point
A firm's production function shows the relationship between which two variables?
a. Output and labor
b. Labor and Capital
c. Output and Costs
d. All the above
b. True: these are inputs of the production function.
c. Irr. costs do not factor into the production function.
d. A & C are incorrect
In the short run, which of the following is true of a firm's average total cost of production?
a. It is equal to marginal cost plus average variable cost.
b. It is equal to marginal cost plus average fixed cost.
c. It is equal to average fixed cost plus average variable cost.
d. It always increases when a firm increases production.
e. It is zero if the firms shuts down.
a. False, MC isn't a part of ATC
b. False, MC isn't a part of ATC
c. Correct: ATC = AFC + AVC
d. False, ATC is "U" Shaped.
e. False, Fixed costs must still be paid if a firm shuts down.
Which of the following is a result of increasing returns to scale?
a. Upward-sloping short-run marginal cost curve.
b. Downward-sloping marginal physical product of labor curve.
c. Downward-Sloping long-run average total cost curve.
d. Diseconomies of scale.
e. Diminishing returns
a. Opp. Describes Diminishing Returns
b. MPL describes how adding one more unit of labor changes output, when it is downward sloping that is diminishing returns.
c. True: When ATC is diminishing there are increasing returns to scale.
d. Opp.
e. Diminishing returns makes returns to scale go down not up.
Kieran owns and operates his own bike shop. In the past week a competitor offered to buy Kieran's bike shop for $100,000 and hire Kieran for $50,000 per year. Assume the annual interest rate is 6 percent, and Kieran's accounting profit from his bike shop is $60,000. Kieran's economic profit is:
a. -$96,000 b. -$90,000
c. 4,000 d.$10,000
e. $60,000
c. $4,000. Economic Profit = (TR: Accounting Profit: $60,000) - (Explicit Costs: $50,000 + $6,000)
The allocatively efficient level of output is produced in any market structure when
a. firms are experiencing economics of scale
b. marginal revenue is equal to zero
c. long-run economic profits is equal to zero
d. price is equal to marginal cost
e. average variable cost is at a minimum
d. price is equal to marginal cost
# of bakers / Total Production per hour
1 3
2 7
3 12
4 16
5 19
6 21
7 22
8 20
a. After which barber do diminishing marginal returns begin for Bob's Barber Shop?
b. Assume Bob's Barber Shop sells haircuts in a P.C. market at a unit price of $9. Calculate the marginal revenue product of the 6th barber.
c. Assume there is an increase in the demand for haircut services in the market. What will happen to the price of a haircut and the amount of barber shops in the short-run?
a. They begin after the 3rd worker b/c the MP of the 4th worker (4) is less than the MP of the 3rd worker (5)
b. MRP = P x MP = $9 x 2 = $18
c. Price will increase and # of barber shops will increase.
FRQ Done on the Board:
Assume that a firm uses capital as a fixed factor of production and uses labor as a variable factor. The marginal production of labor at first increases then decreases with the amount of labor.
a. Using a correctly labeled graph, draw and identify the firm's ATC, AVC, and MC curve
b. i. Why is the MC shaped like it is?
ii. What does the difference b/w AVC and ATC represent?
MC is U-shaped b/c there are increased returns to labor followed by decreasing returns to labor or b/c diminishing marginal returns.
A firm’s long-run production technology is represented by a production function for capital K and labor L. Suppose that for small output levels the firm experiences increasing returns to scale, then a range of constant returns to scale, and eventually decreasing returns to scale beyond some high output.
(a) Draw a graph of the firm’s Long-Run Average Total Cost (LRATC) curve and label the regions corresponding to economies of scale (increasing returns to scale), constant returns to scale, and diseconomies of scale (decreasing returns to scale). Mark the minimum efficient scale on the graph.
(b) Suppose the firm currently produces an output Q1, which lies in the region of increasing returns to scale, below the minimum efficient scale. The firm considers doubling all inputs. Explain qualitatively how output and average cost would change under:
increasing returns to scale
constant returns to scale
decreasing returns to scale
a. Graph of the firm's LRATC and labeled regions correspond with: increasing returns to scale, constant returns to scale, and decreasing returns to scale. Mark the minimum efficient scale on the graph.
b. Increasing returns to Scale: output more than doubles.
Constant Returns to Scale: output exactly doubles.
Decreasing returns to Scale: output less than doubles.
Assume that a firm is maximizing short-run profits and that price is greater than average variable cost. Which of the following must be true at the firm's level of output?
a. MR = ATC b. MR > TVC
c. MR = P & P > ATC d. MR = MC
e. P = ATC
Assume that a firm producing a good in a constant-cost perfectly competitive industry is in long-run equilibrium.
The firm adopts a new supply chain management technology that reduces its production costs, while other firms have not yet adopted it.
How will the firm’s profit-maximizing output change in the short run and the long run?
Short Run Long Run
a. Increase Return to original
b. Decrease Decrease
c. Increase Increase
d. Return to original Return to original
e. Decrease Return to original
a. Short Run: Increase, the innovations saves costs
b. The savings in cost create a profit and new firms will enter looking for the profit, so driving MR back down to the original level.