Economic Profit and Production Quiz

Principle of Economics

• Noor Sa'adah Sabudin
• SEFB

Chapter 6: Production and Cost

• Explicit Cost and Implicit Cost
• Accounting Profit Versus Economic Profit
• Production: Short-Run Versus Long-Run
• Short-Run Production: Marginal Physical Product (MPP), Marginal Cost (MC), Average Productivity (AP)
• Graphical and numerical analysis
• Cost in the Short Run: Fixed Cost, Variable Cost, Total Cost, Average Fixed Cost, Average Variable Cost, Average Total Cost, Marginal Cost
• Relationship between production and cost
• Production and Cost in the Long Run
• Long-Run Average Total Cost Curve (LRATC)
• Economies, Constant and Diseconomies of Scale

Learning Objectives

• Explain the definitions of explicit and implicit costs.
• Explain the difference between accounting and economic profit.
• Differentiate short-run and long-run production.
• Explain short-run production (numerical/table and graph).
• Explain short-run costs (numerical/table and graph).
• Explain the relationship between marginal and average cost applied to production.
• Explain production and cost in the long run.
• Explain the concept and characteristics of economies of scale and diseconomies of scale.

The Behavior of Profit-Maximizing Firms

• All firms must make several basic decisions.
• These decisions are about output and production technology.
• The amount of each input needed also plays a crucial role.

Profits and Economic Costs

• Profit is the difference between total revenue (TR) and total cost (TC).
• π = (TR – TC)
• A firm's cost of production includes all opportunity costs of producing goods and services.
• Costs can be explicit or implicit.

Explicit Cost

• A cost incurred when an actual (monetary) payment is made.
• Examples: labor services, machinery, transport

Implicit Cost

• A cost that represents the value of resources used in production where no actual (monetary) payment is made.
• For example: wages, rent, or interest rate from the bank

Accounting Profit vs Economic Profit

• Economists measure economic profit as total revenue minus total cost, including both explicit and implicit costs.
• π = TR – (exp + imp)
• Accountants measure accounting profit as total revenue minus only explicit costs.
• π = TR – (exp)

Accounting Profit vs Economic Profit

• When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
• A firm that earns normal profit/zero economic profit earns revenue that's equal to its total costs (explicit + implicit costs).
• This level is necessary to keep resources employed in the firm.

Production: Short-Run vs Long-Run

• Fixed Input: An input that does not change according to the amount of output. (e.g., machinery, land, buildings)

• Variable Input: An input that changes according to the amount of output. (e.g., raw materials, electricity, labor)

• Short Run Period: A time frame in which at least one input is fixed, and the other inputs can be changed.

• Long Run: A time frame where all inputs are variable.

Production in the Short Run

• Output increases as labor increases in the short run (assuming at least one input, like capital, is fixed).
• Total Product (TP): Total output produced in a given period.
• Marginal Product (MP/MPP): Change in total product resulting from a one-unit increase in the quantity of labor.
• Average Product (AP/APP): Total product divided by the quantity of labor employed.

Production in the Short Run: Stages of Production

• Stage I: Proportion of fixed factors greater than variable factors. Underutilization of fixed factors. Operation involves a waste of resources.
• Stage II: Law of diminishing marginal returns. Most efficient stage. Input combinations are fully utilized.
• Stage III: Proportion of fixed factors lower than the variable factors. Increased variable factors reduce total product due to overcrowding. The producer does not operate at this stage.

Production in the Short Run: Product Curves

• Product curves show how a firm's total product, marginal product, and average product change as the quantity of labor employed changes.

• Relationship between Total Product (TP) and Marginal Product (MP)

• MP increasing, then TP increases at increasing rate.

• MP decreasing, then TP increases at decreasing rate

• MP = 0, then TP is at its maximum.

• MP negative, then TP declines.

• Relationship between Average Product (AP) and Marginal Product (MP)

• MP > AP, AP increases

• MP < AP, AP decreases

• MP = AP, AP is at maximum.

Short-Run Cost

• Total Cost (TC): Cost of all resources used.

• Total Fixed Cost (TFC): Costs of fixed inputs, doesn't change with output.

• Total Variable Cost (TVC): Cost of variable inputs, changes with output.

• TC = TFC + TVC

• Marginal Cost (MC): Increase in total cost that results from a one-unit increase in total product. MC = ∆TC/∆Q

• Average Fixed Cost (AFC): TFC / Q

• Average Variable Cost (AVC): TVC / Q

• Average Total Cost (ATC): TC / Q or AFC + AVC

Short-Run Cost: Relationship between cost curves and product curves

Long-Run Cost

• All inputs are variable in the long run.

• The behavior of long-run cost depends on the production function.

• Production Function: Relationship between maximum output attainable and the quantity of both capital and labor.

• Diminishing Marginal Product of Capital refers to output rising less as capital rises.

• The firm's production function exhibits diminishing marginal returns to labor and capital.

Long-Run Cost: Short-run Cost and Long-Run Cost

• The average cost of producing a given output varies depending on the plant size.
• The larger the plant, the greater is the output at which ATC is at minimum.

Long-Run Cost: Economies and Diseconomies of Scale

• Economies of scale: Input increases greater than output increase, meaning unit costs fall. 
• Diseconomies of scale: Input percentage increase is less than output percentage increase, meaning costs rise
• Constant Returns to Scale: Input and output change by the same percentage, keeping unit costs constant.
• Minimum efficient scale (MES): Smallest quantity of output at which long-run average cost reaches the lowest.

Long-Run Cost: Why Economies of Scale?

• Growing firms offer greater employee specialization opportunities.
• Larger firms can take advantage of highly efficient mass production and equipment, spreading setup costs over a large number of units.

Long-Run Cost: Why Diseconomies of Scale? 

• In large firms, managers can struggle with coordinating activities, communicating directions effectively, and monitoring personnel.

• Minimum Efficient Scale: The minimum quantity of output where the long-run average cost (LRAC) reaches its lowest level.

Test your knowledge on the concepts of economic profit, explicit and implicit costs, and production factors. This quiz covers important principles in economics, including the relationship between total and marginal products and the implications of varying production inputs. Perfect for students studying economic principles or professionals looking to refresh their understanding.