Economics Production Factors Quiz

Learning Outcomes

• Understanding the production function is key for firms.
• Distinguishing between fixed and variable production factors is crucial, factoring in the planning horizon.
• Firms need to grasp cost curves, marginal cost curves, and average cost curves.
• Understanding scale effects and returns to scale is essential.
• Knowing the characteristics of a perfectly competitive market is vital.
• Determining the profit-maximizing output of a price-taking firm.
• Understanding the meaning and relevance of the break-even price and the shut-down price.
• Recognizing the difference and relationship between short-run and long-run supply curves.
• Understanding what determines the short-run and long-run industry supply curve is important.

Firms' Goal: Profit Maximisation

• The primary objective of any company is to maximize its profits.
• Every action within the company, including supply decisions, is ultimately geared toward this goal.
• Profit is calculated by subtracting total costs from total revenue.

The Production Function

• Companies produce goods and services for sale.
• Input transformation is essential for this production.
• Output (quantity) depends on the quantities of inputs/production factors used.
• The relationship between output and inputs defines a firm's production function.
• The production function forms the groundwork for cost analysis.

Inputs and Output

• Production factors generate income repeatedly from output sales.
• They represent a consistent source of income.
• Examples include land, labor, and capital.
  • Capital
    • Physical assets like buildings or machinery.
    • Human capital associated with employees'. Experience, education and skills.
• Other input factors are consumed during the production process (e.g., energy).
• Human capital's importance has risen considerably due to technological progress. This underscores the need for highly skilled workers.
• Fixed production factors have unchanging quantities unrelated to output levels.
• Variable production factors have amounts that can be adjusted according to the output level needed.

The Production Function: Inputs and Output (Continued)

• The production function is also known as the total product function.
• It showcases the overall production level dependent on the usage of variable production factors.
• This n-dimensional function can be graphically depicted in a (n + 1)-dimensional space.
• Due to the complexity, a simplified representation by considering only one input at a time (ceteris paribus) is a common approach.
• The production function shows increasing output with increased variable inputs if there is constant output when holding all constant.
• The slope of the production function's slope.
  • Always positive, but decreases gradually;
  • The first derivative of the production function is called the marginal product function for one variable input.
• Marginal product indicates the additional output from one more unit of an input.

The Production Function: Properties

• The production function has a positive slope for variable input.
• The marginal product eventually decreases as the input increases.
• The slope of the production function decreases over time, resulting in a concave curve.

From the Production Function to the Cost Function

• Profit maximization requires understanding costs in conjunction with production functions.
• To translate production function data into cost information, the payment for production factors must be known.
• Fixed costs (FC) are independent of output; they are associated with fixed factors.
• Variable costs (VC) vary with output; they are associated with variable factors.
• Total costs (TC) are the combined fixed and variable costs for a given output level.

Marginal Cost and Average Cost

• Derived from total costs, marginal cost (MC) shows the change in total cost with an extra unit of output.
• Mathematically, it's the first derivative of the total cost function.
• Average cost (ATC) represents the average total cost per unit of output.
• Mathamatically, it's total cost divided by quantity.

Marginal Cost (detailed)

• Marginal cost indicates how total costs change with each extra unit of production.
• Graphically, it's shown as changes in costs plotted against production.
• The slope of the marginal cost function is positive because marginal returns decrease.

Average Cost (detailed)

• Average cost (ATC) shows the average total cost for a specific output level.
• Mathamatically, it equals total costs divided by the quantity produced.
• Average total cost (ATC) equals average fixed cost (AFC) plus average variable cost (AVC).

Average Cost (detailed)

• Average fixed cost (AFC) decreases as output increases.
• Average variable cost (AVC) increases at some point due to diminishing marginal returns.
• ATC-shaped curves demonstrate typical cost behaviour.
• Economists typically see initially decreasing ATC and then increasing afterward, based on empirical data from many companies..

Realistic Cost Functions

• Economists frequently find s-shaped rather than convex curves in cost analyses.
• The s shape reflects varying marginal returns as output changes.
• A third-order polynomial model can produce a cost function that reflects the typical behaviour of s-shaped costs.
• The cost functions (variable cost, fixed cost, marginal cost, average total cost, average variable cost, and average fixed cost) can be deduced from this model.

Scale Effects and Returns to Scale

• Scale effects relate to changes in output quantity(q) affecting costs.
• Two distinct kinds exist:
  • Internal scale effects concern changes in output quantity(q) impacting a single firm's costs.
  • External scale effects concern changes in output quantity (q) impacting an entire industry's costs..

Internal Economies of Scale

• Increasing returns to scale occur when the marginal cost of producing one more unit is less than the average cost up to a point.
• This typically is the case when production benefits from increased specialization and efficient use of resources.

Diminishing Returns to Scale

• In turn, diminishing returns to scale emerge when the marginal cost of additional production goes above the average cost.
• This is often seen in large firms where communication issues or coordination difficulties overwhelm any further gains from specialization.

Constant Returns to Scale

• These occur when the marginal and average costs are equal and constant. This represents the minimum-cost output level.
• The output elasticity of costs measures the relative change in costs compared with a change in cost.

Perfect Competition and Supply Function

• Perfect competition assumes numerous small firms, homogeneous products, no barriers to entry, perfect information, and fast reaction to changes.
• Firms follow the optimal output rule: The price should equal marginal cost.
• Situations arise where necessary, and sufficient conditions for a profit maximization need to be fulfilled
• A firm's supply function in the short run is the marginal cost curve above the shut-down price.
• The industry supply function is calculated by combining individual supply curves horizontally.

Short-Run Individual Firm Supply

• The intersection of market price and marginal cost define the quantity supplied.
• The individual supply is just the portion of the marginal cost function above the shutdown price.

Short-Run Industry Supply Function

• Combining the short-run supply curves of all independent producers.
• Horizontal summation of all the individual supply functions.

Long-Run Industry Supply Function

• In the long run, the number of firms is not fixed.
• Firms can enter and exit the market based on profit conditions.
• Positive profits attract new entrants increasing supply and lowering the market price.
• Negative profits result in firms exiting reducing supply increasing the market price.
• The long-run industry supply is horizontal at the break-even price.