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Chapter 7:

Producers in the
Short Run

Copyright © 2017 Pearson Canada Inc.


Chapter Outline/Learning Objectives

Section Learning Objectives


After studying this chapter, you will be able to

7.1 What Are Firms? 1. identify the various forms of business organization and
discuss the different ways that firms can be financed.

7.2 Production, Costs, 2. distinguish between accounting profits and economic


and Profits profits.

7.3 Production in 3. understand the relationships among total product,


the Short Run average product, and marginal product; and the law of
diminishing marginal returns.

7.4 Costs in 4. explain the difference between fixed and variable costs,
the Long Run and the relationships among total costs, average costs,
and marginal costs.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 2


7.1 What Are Firms?

Organizations of Firms
A firm can be organized in any one of six different ways:

1. A single proprietorship
2. An ordinary partnership
3. The limited partnership
4. A corporation
5. A state-owned enterprise
6. Non-profit organizations

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 3


7.1 What Are Firms?

Organizations of Firms
Firms that have operations in more than one country are called
multinational enterprises (MNEs).

This is unusual for single proprietorships and ordinary partnerships,


but common for limited partnerships and very common for larger
corporations.

The number and importance of MNEs have increased greatly over


the last few decades.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 4


Financing of Firms

The money a firm raises for carrying on its business is called financial
capital.

Financial capital is distinct from physical capital, which is the firm’s


assets, such as factories, machinery, offices, and fleets of vehicles.

The basic types of financial capital used by firms are equity and debt.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 5


Financing of Firms

Equity
In individual proprietorships and partnerships, one or more owners
provide much of the required funds.

A corporation acquires funds from its owners in return for stocks,


shares, or equities, which are basically ownership certificates.

Profits that are paid out to shareholders are called dividends.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 6


Financing of Firms

Debt
The firm’s creditors are not owners.

They have lent money in return for some form of loan agreement or
IOU.

Firms can borrow from banks or other financial institutions.

Firms can borrow from non-bank lenders using debt instruments or


bonds.

Firms are obligated to pay the principal and interest.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 7


Goals of Firms

Economists generally make two key assumptions about firm


behaviour:

1. Firms are assumed to be profit-maximizers.

2. Each firm is assumed to be a single, consistent,


decision-making unit.

Based on these assumptions, economists can predict the behaviour


of firms in various situations.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 8


7.1 Production, Costs, and Profits

Production
Firms use four types of inputs for production:

1. Inputs that are outputs from some other firm—intermediate


products

2. Inputs provided directly by nature

3. Inputs that are the services of labour

4. Inputs that are the services of physical capital

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 9


Production

The production function is a functional relation showing the


maximum output that can be produced by any given combination of
inputs.

The production function describes the technological relationship


between the inputs that a firm uses and the output that it produces.

In terms of functional notation:

Q = f(L,K)
Production is a flow: it is a number of units per period of time.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 10


Costs and Profits

Explicit costs involve a purchase of goods or services by the firm.

Explicit costs include the hiring of workers, the rental of equipment,


interest payments on debt, and the purchase of intermediate inputs.

Explicit costs include depreciation—a cost that arises because of the


wearing out of physical capital—which does not involve a market
transaction.

Accounting profits = Revenues – Explicit Costs

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 11


Costs and Profits

To find economic profit, economists subtract explicit costs and


implicit costs from revenues.

Implicit costs are the costs of items for which there is no market
transaction but for which there is still an opportunity cost for the
firm.

Implicit costs include the opportunity cost of the owner’s time and
the opportunity cost of the owner’s capital.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 12


Costs and Profits

Economic profit is the difference between the revenues received


from the sale of output and the opportunity cost of the inputs used
to make the output.

Economic profit = Revenues – (Explicit costs + Implicit costs)

Economic profit = Accounting profits – Implicit costs

Negative economic profits are called economic losses.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 13


Table 7-1 Accounting Versus Economic Profit

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 14


Profit-Maximizing Output

When we talk about a firm’s profit, we will always mean economic


profit.

A firm's economic profit is the difference between the total revenue


(TR) each firm derives from the sale of its output and the total cost
(TC) of producing that output:

 = TR - TC

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 15


Time Horizons for Decision Making

The short run is a time period in which the quantity of some inputs,
called fixed factors, cannot be changed.

A fixed factor is usually an element of capital but it might be land, the


services of management, or even the supply of skilled labour.

Inputs that are not fixed and can be varied in the short run are called
variable factors.

The short run does not correspond to a specific length of time.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 16


Time Horizons for Decision Making

The long run is the length of time over which all of the firm's
factors of production can be varied, but its technology is fixed.

The long run, like the short run, does not correspond to a specific
length of time.

The very long run is the length of time over which all the firm's
factors of production and its technology can be varied.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 17


7.3 Production in the Short Run

Total, Average, and Marginal Products


Total product (TP) is the total amount produced during a given
period of time.

Average product (AP) is the total product divided by the number


of units of the variable factor used to produce it.

If we let the number of units of labour be denoted by L, then

AP = TP / L

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 18


Fig. 7-1 Total, Average, and Marginal Products in the Short Run

Marginal product is the


change in total output that
results from using one more
unit of a variable factor.

The marginal product (MP)


of labour is given by:

 TP
L
MP =

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 19


Diminishing Marginal Product

The law of diminishing returns states that if increasing amounts of a


variable factor are applied to a given quantity of a fixed factor
(holding the level of technology constant), eventually a situation will
be reached in which the marginal product of the variable factor
declines.

To increase output in the short run, more and more of the variable
factor is combined with a given amount of the fixed factor.

So each successive unit of the variable factor has less and less of the
fixed factor to work with.

And eventually equal increases in work effort begin to add less and
less to total output.
Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 20
The Average-Marginal Relationship

When an additional worker's output raises average product,


MP exceeds AP.

When an additional worker's output reduces average product, MP is


less than AP.

 the AP curve slopes upward when the MP curve


is above it and the AP curve slopes downward when the MP
curve is below it

It follows that the MP curve intersects the AP curve at its maximum


point.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 21


7.4 Costs in the Short Run

Defining Short-Run Costs

Total Cost Total Fixed Cost Total Variable Cost

TC = TFC + TVC

Average Total Cost Average Fixed Cost Average Variable Cost

ATC = AFC + AVC

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 22


Defining Short-run Costs

The total cost of producing any given level of output can be divided
into total fixed cost and total variable cost.

Total fixed cost is the cost of the fixed factor(s). It does not vary with
the level of output.

Total variable cost is the cost of the variable factors. It varies directly
with the level of output.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 23


Defining Short-run Costs

Average total cost is the total cost of producing any given number of
units of output divided by that number of units.

Average fixed cost is total fixed cost divided by the number of units
of output. Average fixed cost declines continually as output
increases. This is known as spreading overhead.

Average variable cost is total variable cost divided by the number of


units of output.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 24


Defining Short-Run Costs

Marginal cost (MC) is the increase in total cost resulting from


increasing output by one unit.

 TC
MC =
Q
Marginal costs are always marginal variable costs because fixed costs
do not change as output varies.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 25


Short-Run Cost Curves Fig. 7-2 Total, Average, and
Marginal Cost Curves

In the top graph, note that


TFC does not change with
output.

In the bottom graph, note


that the MC curve intersects
the ATC and AVC curves at
their minimums.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 26


The ATC curve is derived geometrically by vertically adding the AFC and
AFC curves.
The result is that the ATC curve declines initially as output increases,
reaches a minimum, and then rises as output increases further.
The ATC curve is “U-shaped”.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 27


Why U-Shaped MC and AVC Curves?

Key idea: Each additional worker adds the same amount to total cost
but a different amount to total output.

Eventually diminishing AP of the variable factor implies an eventually


rising AVC.

 AVC is at its minimum when AP reaches its maximum.

Eventually diminishing MP of the variable factor implies eventually


rising MC.

 MC reaches its minimum when MP reaches its maximum.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 28


Capacity

The level of output that corresponds to the minimum short-run


average total cost is the capacity of the firm.

Capacity is the largest output that can be produced without


encountering rising average costs per unit.

A firm that is producing at an output less than the point of minimum


average total cost is said to have excess capacity.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 29


Shifts in Short-Run Cost Curves
Fig. 7-3 An Increase in Variable Factor Prices
An increase in the price of a
variable factor shifts the
firm’s ATC and MC curves
upward.

An increase in the price of a


fixed factor increases the
firm’s total fixed costs, but its
variable costs are unchanged.

The ATC curve shifts upward


but the MC curve does not
change.
Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 30