AP Microeconomics Review #3 (part 1) Rixie April 20, 2017

Production & Cost Explicit & implicit costs; Accounting & economic profit; Product measures; Cost measures

Explicit v. Implicit Costs Explicit costs: direct, purchased, out-of-pocket costs Money is actually being exchanged Ex: cost of raw materials, wages, rent, licenses/permits Implicit costs: indirect, non-purchased costs Next-best alternatives that have been forgone Implicit costs ARE opportunity costs!

Accounting v. Economic Profit Accounting profit = Total revenue – Explicit costs Economic profit = Total revenue – Explicit costs – Implicit costs (economic costs include both explicit & implicit costs)

Short-run v. Long-run Fixed inputs: resources that go into the production process that cannot be changed in the short run Variable inputs: resources that can be adjusted in the short run to meet changes in demand (labor is variable) ALL inputs are variable in the long-run! Plant Size (Capital) Fixed Costs Variable Costs Entry/Exit of Firms Short Run Fixed Some No Long Run Variable None All Yes

Short-run Production Measures Total Product (TP) - the total quantity/output of a good produced at each quantity of a resource employed (usually labor) Marginal Product (MP) - The change in total product resulting from a change in the input (addition of a worker) MP = (Change in TP) / (Change in # of Inputs) ***If labor is changing one unit at a time, then: MP = Change in TP Average Product (AP) - Total product divided by the number of inputs employed (# of workers) AP = TP / # of inputs ***Much less likely to use this one

Law of Diminishing Marginal Returns As successive units of a variable resource are added to a fixed resource, the additional output will eventually decrease It is not always more efficient to add more inputs To determine when diminishing returns set in, you must calculate marginal product (if it’s not given) and look for the unit at which MP begins to decrease (NOT when it becomes negative)

Short-run Cost Measures Total cost = Total fixed cost + total variable cost Total fixed cost = Total cost – total variable cost TFC is constant Total variable cost = Total cost – total fixed cost Marginal cost = (Change in total cost)/(change in Q of output) Usually the change in Q of output is just equal to one, so you can disregard the denominator

Short-run Cost Measures (continued) Average Total Cost (ATC) = TC / (Q of Output) or ATC = AFC + AVC Average Variable Cost (AVC) = TVC / (Q of Output) or AVC = ATC – AFC Average Fixed Cost (AFC) = TFC / (Q of Output) or AFC = ATC - AVC

Relationship between Marginal Product & Marginal Cost These measures are inversely related: Marginal cost & marginal product Average variable cost & average product Ex: as long as MP increases, MC is decreasing, and vice versa

Know what these cost curves will typically look like (for all market structures!) Marginal cost (MC) looks like the Nike swoosh! ATC will always be above AVC ATC and AVC will always intersect MC at their minimums Since TFC is constant, AFC will always decrease

Long-run Average Costs

Long-run Average Costs If a firm is operating on the downward sloping portion of LRAC, it is experiencing economies of scale. Long-run average costs are decreasing as plant size increases If plant size doubles, output more than doubles If a firm is operating on the flat portion of LRAC, it is experiencing constant returns to scale. Long-run average costs remain constant as plant size increases If plant size doubles, output also doubles If a firm is operating on the upward sloping portion of LRAC, it is experiencing diseconomies of scale. Long-run average costs are increasing as plant size increases If plant size doubles, output less than doubles

Types of Efficiency (Really important to know these!!!) Productive efficiency Occurs when a firm is being as efficient with its resources as possible Found on a graph where Price = Minimum Average Total Cost Allocative efficiency Occurs when the socially optimal amount of something is being produced Found on a graph where Price = Marginal Cost

Perfect Competition Graphical Analysis; Profit-maximization; Efficiency

Perfect Competition – first of four market structures As much of this information is already typed out in the Unit 3 Key Concepts Outline (PDF), most of this section will consist of graphs/visuals

Golden Rule for Profit-Maximization in the Product Market Golden Rule for Profit-Maximization in the Product Market (all market structures) Regardless of the type of market structure, profit-maximizing firms will always produce the quantity where: Marginal Revenue (MR) = Marginal Cost (MC) This is easily identifiable on a graph – it’s where the MR and MC curves intersect. When given data in a table instead, choose the quantity where MR = MC, or the quantity where they come as close as possible as long as MR > MC Never produce a quantity with MC > MR

Identifying Profit Rectangles on Graphs (for any market structure) Find the price at the profit-maximizing quantity, then go down or up to ATC, and over to the y-axis If you had to go up to ATC, the firm is taking a loss because P < ATC If you had to go down to ATC, the firm is making a profit because P > ATC If P = ATC, there is no profit rectangle and the firm is earning zero economic profit (breaking even)

Side-by-side graph of a P.C. market & firm *Profit rectangle is outlined in red

Side-by-side graph of a P.C. market & firm *Loss rectangle is outlined in red

Side-by-side graph of a P.C. market & firm *There is no profit rectangle because this firm will shut down, & its loss will be equal to TFC

What happens in the long-run? Short-run profits attract firms to the industry (cause entry of firms in the long-run) Short-run losses cause firms to leave the industry in the long- run Entry & exit of firms causes the industry supply curve to shift (right for entry, left for exit), which affects the market price Since P.C. firms are price takers, the firm’s MR = D = AR = P will shift up or down with the market price Ultimately, in the long-run, perfectly competitive firms break even & experience both productive & allocative efficiency

Example: short-run profits attract firms to this industry in the long-run: