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Theory of the firm
Explanation of how a firm makes cost-minimizing production decisions and how its resulting cost varies with its output.
Production Decisions of a Firm
o Production Technology – describing how inputs (labor, capital, and raw materials) can be transformed into outputs
o Cost Constraints – describes how firms take into account the prices of labor, capital, and other inputs, concerned about its cost of production
o Input Choices – describes how the firm must choose how much of each input to use in producing its output
Factors of production
Inputs into the production process (e.g. labor, capital, and materials) Materials include steel, plastics, electricity, water, and any other goods that the firm buys and transforms into final products. Capital includes land, buildings, machinery, and other equipment, as well as inventories.
A compact description of how inputs are turned into output, represents the firm’s production technology. Function showing the highest output that a firm can produce for every specified combination of inputs.
o q = F(K,L) output q capital K labor L
Period of time in which quantities of one or more production factors cannot be changed.
Amount of time needed to make all production inputs variable.
Output per unit of a particular input.
Average product of labor (APL)
The output per unit of labor input. Measures the productivity of the firm’s workforce in terms of how much output each worker produces on average.
o Output/labor input = q/L
Additional output produced as an input is increased by one unit.
Marginal product of labor (MPL)
The additional output produced as the labor input is increased by one unit.
o Change in output/change in labor input = Δq/ΔL
Law of diminishing marginal returns
Principle that as the use of an input increases with other inputs fixed, the resulting additions to output will eventually decrease. When there are too many workers, some workers become ineffective and the marginal product of labor falls. Applies to the short run when at least one input is fixed. Results from limitations on the use of fixed inputs like machinery. Describes a declining marginal product but not necessarily a negative one.
Average product of labor for an entire industry or for the economy as a whole. Determines the real standard of living
Stock of capital
Total amount of capital available for use in production. Because an increase in capital means more and better machinery, each worker can produce more output for each hour worked.
Development of new technologies allowing factors of production to be used more effectively by producing new and higher-quality goods
Curve showing all possible combinations of inputs that yield the same output
Graph combining a number of isoquants, used to describe a production function. Each isoquant corresponds to a different level of output and the level of output increases as we move up and to the right in the figure.
Marginal rate of technical substitution (MRTS) of labor for capital
Amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant. Slope of isoquant without negative sign, always a positive quantity. Graphs are downward sloping and convex
o MRTS = -Change in capital input/change in labor input
o –ΔK/ΔL (for a fixed level of q)
o MRTS is diminishing, falls as you move along an isoquant
o –(ΔK/ΔL) = (MPL)/(MPK) = MRTS
Fixed-proportions production function
Production function with L-shaped isoquants, so that only one combination of labor and capital can be used to produce each level of output. Each level of output requires a specific combination of labor and capital: Additional output cannot be obtained unless more capital and labor are added in specific proportions.
Returns to scale
Rate at which output increases as inputs are increased proportionally
o Increasing returns to scale – Situation in which output more than doubles when all inputs are doubled
o Constant returns to scale – Situation in which output doubles when all inputs are doubled
o Decreasing returns to scale – Situation in which output less than doubles when all inputs are doubled
Actual expenses plus depreciation charges for capital equipment. Accountants are usually concerned with keeping track of assets and liabilities and reporting past performance for external use, as in annual reports.
Cost to a firm of utilizing economic resources in production. All costs relevant to production
Cost associated with opportunities forgone when a firm’s resources are not put to their best alternative use
o Economic cost = Opportunity cost
Expenditure that has been made and cannot be recovered. It should not influence a firm’s financial decisions. Because it has no alternative use, its opportunity cost is zero.
o Prospective sunk cost – An investment. A firm must decide if this decision is economical, whether it will lead to a flow of revenues large enough to justify its cost. Can affect a firm’s decisions
Total cost (TC or C)
Total economics cost of production, consisting of fixed and variable costs
Fixed cost (FC)
Cost that does not vary with the level of output and that can be eliminated only by shutting down.
Variable cost (VC)
Cost that varies as output varies.
Most costs are fixed in the very short term while nearly all are variable in the very long term
Policy of treating a one-time expenditure as an annual cost spread out over some number of years, treating them as ongoing fixed costs
Marginal cost (MC)
Increase in cost resulting from the production of one extra unit of output. Equal to the increase in variable cost or total cost resulting from an extra unit of output
Average total cost (ATC)
Firm’s total cost divided by its level of output
Average fixed cost (AFC)
Fixed cost divided by the level of output
Average variable cost (AVC)
Variable cost divided by the level of output
User cost of capital
Annual cost of owning and using a capital asset, equal to the economic depreciation plus forgone interest.
o Forgone interest is the interest the firm could have earned if they did not buy the asset, opportunity cost.
o User cost of capital – Economic depreciation + (Interest Rate)(Value of Capital)
o Can also be expressed as a rate per dollar of capital: r = depreciation rate + interest rate
Cost per year of renting one unit of capital, should be equal to the user cost r
Graph showing all possible combinations of labor and capital that can be purchased for a given total cost. The point of tangency of the isoquant and the isocost line gives the cost-minimizing choice of inputs
Curve passing through points of tangency between a firm’s isocost lines and isoquants
Long-run average cost curve (LAC)
Curve relating average cost of production to output when all inputs, including capital, are variable.
Short-run average cost curve (SAC)
Curve relating average cost of production to output when level of capital is fixed.
Long-run marginal cost curve (LMC)
Curve showing the change in long-run total cost as output is increased incrementally by one unit.
Economies of scale
Situation in which output can be doubled for less than a doubling of cost.
o Measured in terms of cost-output elasticity EC – the percentage change in the cost of production resulting from a one percent increase in output
o Economies of scale when Ec is less than one and diseconomies when Ec is greater than one
Diseconomies of scale
Situation in which doubling of output requires more than a doubling of cost.
Product transformation curve
Curve showing the various combinations of two different outputs (products) that can be produced with a given set of inputs. A firm is likely to enjoy production or cost advantages when it produces two or more products.
o This curve is bowed outward (concave) because joint production usually has advantages
Economies of scope
Situation in which joint output of a single firm is greater than output that could be achieved by two different firms when each produces a single product.
Diseconomies of scope
Situation in which joint output of a single firm is less than what could be achieved by separate firms when each produces a single product.
Degree of economies of scope (SC)
Percentage of cost savings resulting when two or more products are produced jointly rather than individually
Graph relating amount of inputs needed by a firm to produce each unit of output to its cumulative output. Convex, shows that firms learn over time and become more effective
Function relating cost of production to level of output and other variables that the firm can control.
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