Reading 15 LOS's

Question 1

LOS 15a: Calculate, interpret, and compare accounting profit, economic profit, normal profit, and economic rent

Answer 1

Accounting Profit (aka net profit, net income, and net earnings) equals revenue less all accounting costs. Accounting costs are payments to nonowner parties for goods and services supplied to the firm and do not necessarily require a cash outlay

• Accounting Profit = Total Revenue - Total accounting Costs

Economic profit (abnormal or supernormal profit) is calculated as revenue less all economic costs (include explicit and implicit). Alternatively, economic profit can be calculated as accounting profits less all implicit opportunity costs that are not included in total accounting costs.

• Economic Profit= Total Revenue- Total Economic Costs
• Economic Profit = Total revenue - (Explicit + Implicit Costs)
• Economic Profit= Accounting Profit - Total implicit opportunity costs

Economic Rent

Can be defined as the payment for a good or service beyond the minimum amount needed to sustain supply. Economic rent results when the supply of a good is fixed. Since supply is perfeclt inelastic, the demand curve determines the price and the level of economic rent.

Economic rent is created in markets where supply is tight such taht when price increases, quantity supplied does not change

Comparison of Profit Measures

• In the short run, the normal profit rate is relatively stable, which makes accounting and economic profits the variable items in the profit equation
• Over the long run, all three types of profit are variable
• A firm must make at least a normal profit to stay in business in the long run
• Accounting Profit > Normal profit —- Economic profit > 0 and firm is able to protect economic profit over the long run
• Accounting proft = Normal Profit —— Ecnomic proft = 0
• Accounting Profit < Normal Profit —– Economic Profit < 0 implies economic loss

Question 2

LOS 15b: Calculate, interpret, and compare total, average, and market revenue

Answer 2

• T_otal Revenue (TR)_ is price times quantity or the sum of individual units sold times their respective prices
• Average Revenue (AR) total revenue divided by quantity
• Marginal Revenue (MR) Change in total revenue divided by change in quantity

Total, Average, and Marginal Revenue under Perfect Competition

Prices are determined by demand and supply in the market. Once market price is determined, a firm in perfect competition can sell as many units of output as it desires at this price.

Important Takeaways In a perfectly competitive environment

• MR always equals AR, and they both equal market price
• If there is an increase in market demand, the market price increases, which results in both MR and AR shifting up, and TR pivoting upward.

Total, average, and Marginal Revenue under Imperfect Competition

Important Takeaways : In imperfect competition:

• As quantity increase, the rate of increase in TR (as measure by MR) decreases
• AR equals price at each output level
• MR is also downward sloping with a slope that is steeper than that of AR
• TR reaches its maximum point when MR equals 0

Question 3

LOS 15c: Describe the firm’s factors of production

Answer 3

The resources used by the firm in the production process are known as factors of production and include:

• Land - site location of the business
• Labor- which includes skilled and unskilled, as well as managers
• Capital- inputs used in the production process that are produced goods themselves
• Materials- goods purchases and used by the business as inputs to the production process

Question 4

LOS 15d: Calculate and interpret total, average, marginal, fixed, and variable costs

Answer 4

• Total Fixed Cost (TFC) = Sum of all fixed expenses
• Total variable Cost (TVC) = sum of all variable expenses or per unit variable cost times quantity
• Total Costs (TC) = TFC + TVC
• Average Fixed Cost (AFC) = Total fixed cost divided by quantity
• Average variable cost (AVC) = total variable cost divided by quantity
• Average Total Cost (ATC) = Total cost divided by quantity
• Marginal Cost (MC) = Change in total cost divided by change in quantity

Notes on these costs

• Total Costs initially increases at a decreasing rate. As production approaches full capacity, TC increases at an increasing rate. At 0 production, TC= 0
• TFC= the sum of all expenses that remain constant regardless of production levels. Since the cannot be arbitrarily reduced when production falls, fixed costs are the last expensesto be trimmed when firms consider downsizing.
• TVC is directly related to quantity produced and the shape of the TVC curve mirrors that of the TC curve. Whenever a firm looks to cut costs, its variable costs are the first to be considered
• MC = the increase in total costs brought about by the production of one more unit of ouput. It is important to realize that MC illustrates the slope of the TC curve at a particular level of output. MC initially decreases because of the benefits from specialization. Then it eventually increases because of diminishing marginal returns. Since more workers are requried to produce one more unit of output, the cost of producing additional units increases.

Important Relationships between Average and Marginal Cost Curves

• MC intersects ATC and AVC from below at their respective minimum points
• When MC is below AVC, AVC falls and when MC is above, AVC rises
• When MC is below ATC, ATC falls, and when MC is above, ATC rises

Question 5

LOS 15e: Determine and describe breakeven and shutdown points of production

Answer 5

The Firm’s Short Run Supply Curve

In the short run, a firm incurs fixed and variable costs of production. If the firm decides to shut down, it will still incur fixed costs in the short run and make a loss equal to total fixed costs. A firm should shut down immediately if it does not expect revenues to exceed variable costs of production.

Therefore an individual firm’s short run supply curve is the portion of its MC curve that lies above the AVC curve.

• At price levels below AVC the firm will not be willing to produce
• When price lies between AVC and ATC, the firm will remain in production in the short run as its meets all variable costs and covers a portion of its fixed costs
• To remain in business in the long run, the firm must breakeven or cover all costs. In perfect competition this breakeven point will occur where MR=AR=Price
• Once price exceeds ATC the firm makes economic profits

Question 6

LOS 15f: Describe approaches to determing the profit-maximizing level of output

Answer 6

There are 3 approaches to determining the output level at which profits are maximized.

1. The point where the difference between TR and TC is maximized
2. The point where the last unit sold adds as much to revenue as it does to costs. This is the point where MR is equal to MC.
3. The point where the revenue fro mthe last input unit equals the cost of that unit.

Some relationships to note:

• TR = TC and MR> MC – firm is operating at lower breakeven point, increase Q to enter profit territory
• TR=> TC and MR = MC – firm is at maximum profit level
• TR< TC and TR =>TVC but (TR-TVC) < TFC – find level of Q that minimizes loss in the short run; work toward finding a profitable Q in the long run; exit if you cannot find such a Q
• TR< TVC — shot down in the short-run, exit in the long-run
• TR=TC and MR < MC —- firm is operating at upper breakeven point, decrease Q to enter profit territory

Question 7

LOs 15j: Calculate and interpret total, marginal, and average product of labor

LOS 15k: Describe the phenomenon of diminishing marginal returns and calculate and interpret the profit-maximizing utilization level of an input

LOS 15l: Describe the optimal combination of resources that minimizes cost

Answer 7

Productivity

In the short-run, at least one factor of production is fixed and usually we assume that labor is the only variable factor of production. Therefore in the short run, the only way that a firm can respond to changing market conditions is by changing labor.

In the long-run, quantities of all factors or production can be vaired

Total, Average, and Marginal Product of Labor

Total product (TP) is the maximum output that a given quantity of labor can produce when working with a fixed quantity of capital units. TP does not show how efficient the firm is in producing its output. At the initial stages TP increases at an increasing rate. Latter it will increase at a decreasing rate until it become flat

Marginal Product (aka marginal return) equals the increase in total product brought about by hiring one more unit of labor, while holding quantities of all other factors of production constant. MP measures the productivity of the individual additional unit of labor. This is the slope of the TP curve. It rises intially, and then falls

Average Product (AP) equals total product of labor divided by the quantity of labor units employed. AP is a measure of overall labor productivity, and the higher it is, the more efficient the firm is.

Two important relationships between MP and AP

1. MP intersects AP from above through the maximum point of AP
2. When MP is above AP, AP rises, and when MP is below, AP falls

The productivity of different input factos is compared on the basis of output per unit of input costs. If a firm uses a combination of labor and capital, the least-cost optimization formula would be given by:

• MP_L / P_L = MP_K / P_K

In order to determine the profit-maximizing quantity of an input unit, we compare revenue value of the unit’s MP to the cost of the unit. Marginal Revenue Product (MRP) of labor measures the increase in total revenue from selling the additional output produced by the last unit of labor employed. It is calculated as:

• MRP of labor = Change in total revenue / Change in quantity of labor

For a firm in perfect competition :

• MRP = Marginal Product x Product Price

A profit maximizing firm will hire more labor until:

• MRP_labor = P_labor

In case the firm uses more than one factor of production, profits are maximized when the MRP of each factor equals the price of each factor unit. This means the ratio of the factor’s MRP to its price should be 1.

Question 8

LOS 15g: Describe how economies of scale and diseconomies of scale affect costs

Answer 8

The production function shows how different quantities of factos of production affect the total product. As more and more factors are added, we will experience diminishing marginal returns from our factors of production.

The optimal output level for each plant is when its ATC curve is at is minimum. The long-run average cost (LRAC) curve illustrates the relationship between the lowest attainable average total cost and output when all factors of production are variable,

Economies of Scale or increasing returns to scale refer to reductions in the firm’s average costs that are associated with the use of large plant sizes to produce large quantities of output. They are present over the range of output when the LRAC curve is falling. Economies of scale occur because mass production is more economical, the specialization of labor and equipment improves productivity, and costs such as advertising can be spread across more units of output. When a firm is operating here it should aim to expand capacity

Diseconomies of Scale or decreasing returns to scale occur in the upward sloping region of the LRAC curve. A typical reason for these is inefficiences in management, supervision, and communication. When a firm is operating here, is should look to downsize and reduce costs.

Question 9

LOS 15h: Distinguish between short-run and long-run profit maximization

Answer 9

Equilibrium in the Short-Run

In perfect competition, each firm takes the price offered by the market, so the only decision in the producers hands is how much to produce. In the short-run firms will maximize profits when MR = MC. Whether the firm makes a profit or loss depends on the position of the AC curve relative to demand:

• If AC is tangent to demand curve, the firm makes only normal profits as price will equal AC
• If the AC curve is above demand, the firm will experience an economic loss
• If the AC curve is below demand, the firm will make economic profit

These scenarios are only possible in the short-run

Equilibrium in the Long-Run

In the long run, in perfect cometition (where there are no barriers to entry), firms can easily enter the industry when they see profits, and leave the industry when the see loss.

Economic Profits

If firms in a particular industry are making profits, entrepeneurs will flock to the industry to capture some of the economic profits available. This will cause market supply to increase, pushing market prices down, until economic profits are eliminated and only normal profits are available.

Takeaways

1. There are no LR economic profits in a perfectly competitive industry
2. In the LR, price equals minimum average cost and firms make normal profits

Economic Losses

If an industry is making economic losses, participating entrepreneurs will exit. This will have the supply fall, as prices rise, and eventually those that stick it out will experience normal profits

Question 10

LOS 15i: Distinguish among decreasing-cost, constant-cost, and increasing cost industries and describe long run supply of each

Answer 10

External Economies are factors outside the control of the firm that decrease average costs for individual firms as industry output increases.

External Diseconomies are factors outside the control of the firm that increase average costs for individual firms as industry output increases.

Constant Cost Industries supply increases by as much as the initial increase in demand such that prices return to their orignal levels in the long run. As a result, the long run supply curve is perfeclty elastic

In industries with external economies (decreasing-cost industries) the presence of a larger number of firms lowers costs for all firms. Firms are able to bring down prices as they incur lower resource costs. The magnitude of the shift in supply is greater than that of the intial shift in demand. The long-run supply curve is downward sloping

In industries with external diseconomies (increasing-cost industries) an increase in demand boosts prices, but as more firms enter, average costs for all firms rise. Since the industry faces higher production costs, firms will charge a higher price for their output. Supply increases by less than the intial increase in demand. This results in prices that are higher than original levels, and a long-run supply curve that is upward sloping