Chapter 7
Producers in
the Short Run
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In this chapter you will learn to
1. Describe the various forms of business organizations and
the different ways that firms can be financed.
2. Explain the difference between accounting profits and
economic profits.
3. Describe the relationships between total product, average
product, and marginal product, and the law of diminishing
marginal returns.
4. Explain the difference between fixed and variable costs,
and the relationships between total costs, average costs,
and marginal costs.
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What are Firms?
Organization of Firms
Firms come in six basic types:
1. Single proprietorships
2. Ordinary partnerships
3. Limited partnerships
4. Corporations
5. State-owned enterprises
6. Non-profit organizations
Some firms are multinational enterprises (MNEs), which
operate in more than one country.
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Financing of Firms
Firms use financial capital -- equity and debt.
A firm acquires funds from its owners in return for stocks,
shares, or equity. Profits may be distributed as dividends, or
may be retained.
A firm’s creditors are lenders -- using debt instruments
(loans, bonds and securities in money markets).
APPLYING ECONOMIC CONCEPTS 7.1
Kinds of Debt Instruments
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Goals of Firms
Economists usually make two key assumptions about firms:
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
behavior of firms in various situations.
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Production, Costs, and Profits
Production
Firms use four types of inputs for production:
1. Intermediate products
2. Inputs provided directly by nature
3. Inputs provided directly by people, such as labor
services
4. Inputs provided by the services of physical capital
(machines)
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Profits
APPLYING ECONOMIC CONCEPTS 7.2
Is It Socially Responsible to Maximize
Profits?
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Production Function
The production function relates inputs to outputs. It describes
the technological relationship between the inputs that a firm
uses and the output that it produces.
In simple functional notation we have:
Q = f(L,K)
Remember that production is a flow: it is a number of units
per period of time.
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Costs and Profits
Accounting Profits = Revenues – Explicit Costs
Economic Profits = Accounting Profits – Implicit Costs
Economic profit includes both implicit and explicit costs.
Economic profit includes both implicit and explicit costs.
Implicit costs include the opportunity cost of the owner’s time
and capital.
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Economic Profits
Economic profit is sometimes called pure profit.
Economic Profit is the difference between revenues received
from the sale of output and the opportunity cost of the inputs
used to make the output.
If economic profit is positive, then the owner’s capital is
earning more than it could in its next best alternative use.
Negative economic profits are called economic losses.
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Table 7.1 Accounting versus Economic
Profit for Ruthie’s Gourmet Soup
Company
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Profits and Resource Allocation
Economic profits and losses play a crucial signaling role in the
workings of a free-market system.
Owners of factors of production move resources into industry
that make profits.
If firms are incurring economic losses, the industry’s resources
are more highly valued in other uses, and owners of the
resources will move them to those other uses.
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Profit-Maximizing Output
A firm’s (economic) profit is equal to total revenues minus
total (economic) costs:
π = TR - TC
What happens to profits as output changes depends on what
happens to both revenues and costs.
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Time Horizons for Decision Making
The short run is a period of time in which some of the firm’s
factors of production are fixed
- typically capital is fixed in the short run
Fixed factor – An input whose quantity cannot be changed in
the short run.
Variable factor – An input whose quantity can be changed
over the time period under consideration.
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The Long Run
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 very long run is the length of time over which all the
firm’s factors of production and its technological possibilities
can change.
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Production in the short run
Total, Average, and Marginal Products
Total product (TP) is the total amount of output that is
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
(usually thought of as labor):
AP = TP / L
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Figure 7.1 Total, Average, and Marginal
Products in the Short Run
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Diminishing Marginal Product
The law of diminishing returns:
As more workers are added to a production process, each
can specialize on one task, and the workers’ marginal
product initially rises.
But if there is a fixed amount of physical capital, eventually the
marginal product is likely to fall.
APPLYING ECONOMIC CONCEPTS 7.3
Three Examples of Diminishing Returns
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The Average–Marginal Relationship
If an additional worker’s output raises the average product,
the MP must exceed AP.
Similarly, if the marginal worker’s output reduces the
average product, the MP must be less than the AP.
The AP curve slopes upward as long as the MP curve is
above it (and AP slopes downward when MP is below it).
It follows that the MP curve must intersect the AP curve at
its maximum point.`
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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
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Costs in the Short Run
Marginal cost (MC) is the increase in total cost resulting from
increasing the output by one unit.
MC =
ΔTC
ΔQ
Because fixed costs do not vary with output, the only part of
TC that changes is the variable cost.
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Table 7.2 Short-Run Costs: Fixed Capital
and Variable Labor
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Figure 7.2 Total, Average, and
Marginal Cost Curves
ATC = AVC + AFC
(a vertical summation)
AFC declines steadily
as output rises — this is
called spreading the
overhead.
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Short-Run Cost Curves
The shape of the ATC curve?
•
falling AFC tends to push down ATC
•
rising MC (and thus AVC) tends to push up ATC
•
at some point the second effect overcomes the first effect and
ATC begins to rise
Cost
MC
ATC
AVC
AFC
Output
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Why U-Shaped Cost 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
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.
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Capacity
The level of output that corresponds to the minimum short-run
ATC is the capacity of the firm.
Capacity is the largest output that can be produced without
encountering rising average cost per unit.
A firm that is producing at an output less than the point of
minimum ATC is said to have excess capacity.
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Figure 7.3 An Increase in Variable
Input Prices
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