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Firm
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An institution that hires factors of production and organizes them to produce and sell goods and services
A firms goal is to maximize profit.
If the firm fails to maximize its profit, the firm is either eliminated or taken over by another firm
A firms goal is to maximize profit.
If the firm fails to maximize its profit, the firm is either eliminated or taken over by another firm
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Accounting profit
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Accountants measure a firms profit to ensure that the firm pays the correct amount of tax and to show investors how their funds are being used.
Profit = total revenue - total cost
Accounts use Revenue Canada rules
Profit = total revenue - total cost
Accounts use Revenue Canada rules
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Economic accounting
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Economists measure a firms profit to enable them to predict the firms decisions, and the goal of these decisions is to maximize economic profit.
Economic profit = total revenue - total cost (measured as the opportunity cost of production)
Economic profit = total revenue - total cost (measured as the opportunity cost of production)
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Firms opportunity cost of production
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The value of the best alternative use of the resources that a firm uses in production.
Sum of the cost of using resources
Bought in the market
Owned by the firm
Supplied by the firms owner
Sum of the cost of using resources
Bought in the market
Owned by the firm
Supplied by the firms owner
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Resources bought in the market
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The amount spent by a firm on resources bought in the market is an opportunity cost of production because the firm could have bought different resources to produce some other good or service
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Resources owned by the firm
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If the firm owns capital and uses it to produce its output, then the firm incurs an opportunity cost. This is because it could have sold the capital and rented capital from another firm. The firm implicitly rents the capital from itself.
The firms opportunity cost of using the capital it owns is called the implicit rental rate of capital
The firms opportunity cost of using the capital it owns is called the implicit rental rate of capital
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implicit rate of capital
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The implicit rate of capital is made up of
1) Economic depreciation
2) Interest forgone
1) Economic depreciation
2) Interest forgone
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economic depreciation
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the change in the market value of capital over a given period
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interest forgone
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the return of the funds used to acquire the capital
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Resources Supplied by the Firm's Owner
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entrepreneurship and labor
the return to entrepreneurship is profit
the return to entrepreneurship is profit
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Normal profit
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the profit that an entrepreneur earns on average
normal profit is the cost of entrepreneurship and is an opportunity cost of production
normal profit is the cost of entrepreneurship and is an opportunity cost of production
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owners labour services
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the owner may supply labour but not take a wage.
The opportunity cost of the owners labour is the wage income forgone by not taking the best alternative job.
The opportunity cost of the owners labour is the wage income forgone by not taking the best alternative job.
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Total opportunity cost of production
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Cost of resources bought in market
Includes: Materials, wages, leases, bank interest
Cost of resources owned by firm
Includes: Economic depreciation, forgone interest
Cost of resources supplied by owner
Includes: normal profit, forgone wages
Includes: Materials, wages, leases, bank interest
Cost of resources owned by firm
Includes: Economic depreciation, forgone interest
Cost of resources supplied by owner
Includes: normal profit, forgone wages
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Economic profit
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Revenue - total opportunity cost of production (above)
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Decisions to achieve maximum economic profit
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1. What to produce and in what quantities
2. How to produce
3. How to organize and compensate its managers and workers
4. How to market and price its products
5. What to produce itself and buy from others
Firms main objective is profit maximization
2. How to produce
3. How to organize and compensate its managers and workers
4. How to market and price its products
5. What to produce itself and buy from others
Firms main objective is profit maximization
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Decision time frames
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Some decisions are crucial to the survival of the firm
Some decisions are irreversible (or very costly to reverse)
Other decisions are easily reversed and are less critical to the survival of the firm, but still influence profit.
Time frames
The short run
The long run
Some decisions are irreversible (or very costly to reverse)
Other decisions are easily reversed and are less critical to the survival of the firm, but still influence profit.
Time frames
The short run
The long run
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The short run
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-a time frame in which the quantity of one or more resources used in production is fixed
-for most firms, the capital, called the firms plant, is fixed in the short run
-other resources used by the firm (labour, raw materials, and energy) can be changed in the short run
-short run decisions are easily reversed
-for most firms, the capital, called the firms plant, is fixed in the short run
-other resources used by the firm (labour, raw materials, and energy) can be changed in the short run
-short run decisions are easily reversed
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The long run
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-a time frame in which the quantities of all resources including plant size can be varies
-long run decisions are not easily reversed
-long run decisions are not easily reversed
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sunk cost
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a cost incurred by the firm and cannot be reversed
if a firms plant has no resale value, the amount paid for it is a sunk cost
sunk costs are irrelevant to a firms current decisions
if a firms plant has no resale value, the amount paid for it is a sunk cost
sunk costs are irrelevant to a firms current decisions
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relationship between output and the quantity of labour employed
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to increase output in the short run, a firm must increase the amount of labour employed
Three concepts describe the relationship between output and the quantity of labour employed:
1. total product
2. marginal product
3. average product
Can be illustrated by product curves or product schedules
Three concepts describe the relationship between output and the quantity of labour employed:
1. total product
2. marginal product
3. average product
Can be illustrated by product curves or product schedules
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Product schedules
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Total product- the total output produced in a given period
marginal product of labour- the change in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same
average product of labour- equal to total product divided by the quantity of labour employed
marginal product of labour- the change in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same
average product of labour- equal to total product divided by the quantity of labour employed
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quantity of labour employed increased
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Total product increases
Marginal product increases initially-but eventually decreases
average product decreased
Marginal product increases initially-but eventually decreases
average product decreased
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product curves
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product curves show how the firms total product, marginal product, and average product change as the firm varies the quantity of labour employed (see reference graph in booklet)
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total product curve
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similar to the ppf; separates attainable output levels from unattainable output levels in the short run
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Marginal product curve
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Shows how many extra outputs are created with each additional input
almost all production processes have:
increasing marginal returns initially
diminishing marginal returns eventually
see reference graph in booklet
almost all production processes have:
increasing marginal returns initially
diminishing marginal returns eventually
see reference graph in booklet
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increasing marginal returns
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initially, the marginal product of a worker exceeds the marginal product of the previous worker
the firm experiences increasing marginal returns
arise from increased specialization and division of labour
the firm experiences increasing marginal returns
arise from increased specialization and division of labour
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diminishing marginal returns
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eventually, the marginal product of a worker is less than the marginal product of the pervious worker
the firm experiences diminishing marginal returns
arises because each individual worker has less access to capital and less space in which to work
the firm experiences diminishing marginal returns
arises because each individual worker has less access to capital and less space in which to work
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law of diminishing returns
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as a firm uses more of a variable input with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes
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average product curve
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-when marginal product exceeds average product, average product increases
-when marginal product is below average product, average product decreases
-when marginal product equals average product, average product is at its maximum
(see booklet for reference graph)
-when marginal product is below average product, average product decreases
-when marginal product equals average product, average product is at its maximum
(see booklet for reference graph)
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short run cost
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To produce more output in the short run, the firm must employ more labor, which means that it must increase its costs
three cost concepts and three types of cost curves are:
total cost
marginal cost
average cost
three cost concepts and three types of cost curves are:
total cost
marginal cost
average cost
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total cost
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total cost (TC)- the cost of all resources (factors of production) used.
- increases as output increases
separated into:
Total fixed cost (TFC)- the cost of the firms fixed inputs. Fixed costs do not change with output (includes normal profit)
- same at each output level
Total variable cost (TVC)- the cost of the firms variable inputs. variable costs do not change with output.
- increases as output increases
TC = TFC + TVC
See reference graph in booklet
- increases as output increases
separated into:
Total fixed cost (TFC)- the cost of the firms fixed inputs. Fixed costs do not change with output (includes normal profit)
- same at each output level
Total variable cost (TVC)- the cost of the firms variable inputs. variable costs do not change with output.
- increases as output increases
TC = TFC + TVC
See reference graph in booklet
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marginal cost
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the cost of producing one more unit of a good.
-over the output range with increasing marginal returns, marginal cost falls as output increases
-over the output range with diminishing marginal returns, marginal cost rises as output decreases
-over the output range with increasing marginal returns, marginal cost falls as output increases
-over the output range with diminishing marginal returns, marginal cost rises as output decreases
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average cost
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average cost measures can be derived from each of the total cost measures:
Average fixed cost (AFC)- total fixed cost per unit of output
Average variable cost (AVC)- total variable cost per unit of output
Average total cost (ATC)- total cost per unit of output
ATC = AFC + AVC
Average fixed cost (AFC)- total fixed cost per unit of output
Average variable cost (AVC)- total variable cost per unit of output
Average total cost (ATC)- total cost per unit of output
ATC = AFC + AVC
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Calculating total cost and average cost
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TC = TFC + TVC
Divide all by Q (quantity produced) to get:
ATC = AFC + AVC
Divide all by Q (quantity produced) to get:
ATC = AFC + AVC
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average and marginal product and cost
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The shape of a firms cost curves are determined by the technology it uses
- MC is at its maximum at the same output level at which MP is at its minimum
- when MP is rising, MC is falling
- AVC is at its minimum at the same output level at which AP is at its maximum
- when AP is rising, AVC is falling.
See booklet for reference graph
- MC is at its maximum at the same output level at which MP is at its minimum
- when MP is rising, MC is falling
- AVC is at its minimum at the same output level at which AP is at its maximum
- when AP is rising, AVC is falling.
See booklet for reference graph
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shifts in the cost curves
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position of a firms cost curves depend on two factors
- technology
- prices of factors of production
- technology
- prices of factors of production
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technology
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an increase in productivity shifts the product curves upward and the cost curves downward
if a technological advance results in the firm using more capital and less labour, fixed costs increase and variable costs decrease
if a technological advance results in the firm using more capital and less labour, fixed costs increase and variable costs decrease
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prices of factors of production
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an increase in the price of a factor of production increases costs and shifts the cost curves
- an increase in a fixed cost shifts the total cost (TC) and average total cost (ATC) curves upward but does not shift the marginal cost (MC) curve.
- an increase in a variable cost shifts the total cost (TC), average total cost (AT), and marginal cost (MC) curves upward.
- an increase in a fixed cost shifts the total cost (TC) and average total cost (ATC) curves upward but does not shift the marginal cost (MC) curve.
- an increase in a variable cost shifts the total cost (TC), average total cost (AT), and marginal cost (MC) curves upward.
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long run cost
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in the long run, all inputs are variable, and all costs are variables (you can increase hiring (labour) and capital)
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the production function
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the relationship between the maximum output attainable and the quantities of both capital and labour.
-as the size of the plant increases, the output that a given quantity of labour can produce increases
-as the quantity of labour increases, diminishing returns occur
reference graph in booklet
-as the size of the plant increases, the output that a given quantity of labour can produce increases
-as the quantity of labour increases, diminishing returns occur
reference graph in booklet
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diminishing marginal product of capital
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the increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labour employed
for each plant, diminishing marginal product of labour creates a set of short run, U-shaped costs curves for MC, AVC and ATC
for each plant, diminishing marginal product of labour creates a set of short run, U-shaped costs curves for MC, AVC and ATC
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Average total cost curve
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the lowest ATC curve for each output level is the best curve.
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lowest run average cost curve
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the relationship between the lowest attainable average total cost and output when both the plant and labour are varies.
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economies of scale
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features of a firm's technology that make average total cost fall as output increases (increasing output while cost going down)
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diseconomies of scale
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features of a firms technology that lead to rising long-run average cost as output increases
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constant returns to scale
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features of a firm's technology that lead to constant long-run average cost as output increases
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minimum efficient scale
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the smallest quantity of output at which the long run average cost reaches its lowest level
if the long run average cost curve is u shaped, the minimum point identifies the minimum efficient scale output level
if the long run average cost curve is u shaped, the minimum point identifies the minimum efficient scale output level
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