7.0) Exam I Statistics and Week 8 Agenda�7.1) Firms, Profits, and Economic Costs�7.2) Production in the Short Run�7.3) Cost of Production in the Short Run and the Long Run�Appendix) Consumer and Producer Optimization

Ch7. Production and Costs

ECO 1002. Principles of Microeconomics

Week 8

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Dr. Christopher Paik

7.1) Firms and Profits

Firms and entrepreneurs employ resources and produce goods and services with the goal of making a profit.

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• Firms: an economic institution that transforms inputs into outputs or products.

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• Entrepreneurs
• Sole proprietors (one owner)
• Partnerships (two or more owners)
• Corporation (many shareholders)

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• To achieve profit, revenues and costs must be considered.

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• Profit (economic approach) = Total revenue (TR) – Total cost (TC)
• TR = P x Q
• TC = Economic costs = Explicit costs + Implicit costs

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• When it comes to economic profit, we consider the opportunity cost.

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7.1) Economic Profit

Accounting Profit vs. Economic Profit

• Accounting Profit = Total Revenue – Explicit Costs

= TR – Explicit Costs

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• Total Revenue = P x Q
• P = price per unit
• Q = quantity sold

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• Explicit Costs
• The sum of out-of-pocket costs

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7.1) Economic Profit

Accounting Profit vs. Economic Profit

• Economic Profit = Total Revenue – Total Cost

= TR – TC

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• Total Revenue = P x Q
• P = price per unit
• Q = quantity sold

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• Total Cost
• Explicit Cost + Implicit Cost
• Implicit Cost = Opportunity Cost

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7.1) Economic Profit

Accounting Profit vs. Economic Profit

7.2) Production in the Short Run

Short Run vs. Long Run

• Short run
• The time period in which at least one resource is fixed
• E.g.,) Restaurant business lease 1 year vs. 3 years
• TC = FC + VC

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• Long run
• The time period in which all resources are changeable
• E.g.,) Downsized restaurant business
• TC = VC

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• Then, let’s see a case where firms can vary their output in the short run by altering labor only

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7.2) Production in the Short Run

Firms can vary their output in the short run by altering labor only.

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• Increasing marginal returns
• Q grows faster as additional labor is hired (specialization)
• Diminishing marginal returns
• Each additional worker adds to Q but at a diminishing rate

• MP > AP = Hiring an additional worker increases average productivity
• The law of diminishing returns

7.3) Cost of Production in the Short Run

Short-run costs vs. Long-run costs

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• In the short run, as least one factor is fixed, whereas in the long run, all factors are variable.
• Fixed costs (FC)
• Variable costs (VC)

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• TC = FC + VC

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• Sunk costs
• Firms should not consider them (e.g., tuition)
• Most sunk costs are fixed costs

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• Q. How do total costs change when the level of output changes?

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7.3) Cost of Production in the Short Run

ATC = AFC + AVC

7.3) Cost of Production in the Short Run

• If AVC = VC/Q, then VC = AVC x Q
• VC = $400 x 2 = $800

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• All units of FC are the same in the short run.
• FC = $1,000

Q. How do we find VC given AVC?

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Q. How do we determine FC in the short run?

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7.4) Cost of Production in the Long Run

Short run costs vs. Long run costs

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• In the long run, all inputs (such as labor and capital) are variable.
• FC do not exist in the long run
• Firms can expand or close their plants
• Enter or exit the industry

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• Production in the long run
• Increasing returns to scale Input x 2, output more double
• Constant returns to scale Input x 2, output double
• Decreasing returns to scale Input x 2, output less double

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• Production costs in the long run
• TC between small firm vs. large firm
• ATC between small firm vs. large firm
• In the long run, average costs fall when more output is produced

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• Economies of scale
• Constant returns to scale
• Diseconomies of scale

Jacob Clifford images

Appendix) Consumer Preferences – Indifference Curve

Below indifference curve is not straight line, why?

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• Slope changes as you move between different combination of goods
• The slope of indifference curve is called MRS (marginal rate of substitution)
• MRS measures the rate at which you are willing to give up one good in order to obtain more of another good, while you are maintaining your utility

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• This person is willing to forego 2 burritos to consume 1 latte

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Appendix) Consumers’ Income and the Budget Constraint

Understand how consumers maximize their utility by choosing a bundle of goods to consume

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• To incorporate prices and the consumer's income into our model of consumer behavior, we use budget constraint
• a curve that describes the entire set of consumption bundles a consumer can purchase by spending all income

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• Suppose you have an income of $50 to spend on burritos which cost $10 each and lattes $5 each. Below figure shows the budget constraint corresponding to this example:

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Appendix) Consumers’ Income and the Budget Constraint

Understand how consumers maximize their utility by choosing a bundle of goods to consume

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Appendix) Consumer’s Utility Maximization Problem

Solving the consumer's optimization problem

Appendix) Possible Input Combinations – Isoquants

The Slope of Isoquants = Marginal Rate of Technical Substitution (MRTS)

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The negative of the slope of the isoquant is called the MRTS, and it is the rate at which the firm can trade input X for input Y, holding output constant

Appendix) Firms’ Input Cost - Isocost Lines

Appendix) Firm's Cost-Minimization Problem

Solving the firm's optimization problem – a graphical approach