CH.
7 – THE BEHAVIOR OF PRODUCERS/FIRMS IN P RODUCT MARKETS
PART III – COST, REVENUE , & PROFIT
Composed of all direct "out-of-
Total Accounting Cost (TAC): the pocket" cost of doing businesses
way an accountant understands such as:
cost • Labor (wages) •Material
•Rent •Taxes •Machines
Cost
Composed of the above direct
Total Economic Cost (TEC): the costs plus:
way an economist understands •Opportunity cost of capital
cost invested
•Opportunity cost of used labor
Opportunity cost of capital: the benefit that could have been earned in another
alternative investment (or at least the interest that the money could have generated in a
bank account).
Opportunity cost of labor: the salary the business owner gives up in order to start their
own business (salary from another job)
Revenues (TR) = P × Q
Accounting Profit = TR – TAC
Profit
Economic Profit = TR – TEC
PART IV – THE METHOD OF P RODUCTION
L=Labor K=capital (mainly physical capital) Two different technologies, A & B
1. Labor-intensive technology:
𝐿 𝐿
( ) >( )
𝐾 𝐴 𝐾 𝐵
The labor-capital rule in technology A is greater than the labor-capital rule in
technology B.
The production of clothes (compared to producing computers) is probably labor-
intensive.
2. Capital-intensive technology:
𝐾 𝐾
( ) >( )
𝐿 𝐴 𝐿 𝐵
Technology A is capital-intensive (relative to B)
3. Determining the optimal technology of production:
It depends on:
a) Product differences (some goods are better produced using labor-
intensive technology and vice versa).
b) Cost of labor & capital (e.g. when labor becomes more expensive a firm
may want to switch to a more capital-intensive technique).
PART V – SHORT RUN VS. LONG RUN
Short run = within the coming year
Long run = beyond the 1st year
◘Industry = all the firms that
produce the same g/s in one
country or the world
Short run Long run
At the level of the firm itself •Labor is variable, capital is •Both L & K are variable.
fixed. •Explanation: enough time
•Explanation: not enough has passed to allow that.
time is available to expand
capital (called Scale of
Production).
At the level of the industry •Size of the industry is fixed •Size of industry is variable
→the number of firms (able to expand) →number
(competitors) is fixed of firms in industry Is
variable
PART VI – PRODUCTION FUNCTION & AVERAGE PRODUCT OF LABOR
A quantitative relationship between total production (TP) (quantity produced) & the
quantities of the different inputs used:
𝑇𝑃 = 𝑓(𝐿, 𝐾)
• in short run
𝑇𝑃 = 𝑓(𝐿)
because in the short run, capital is constant. There is not enough time to build more
factories, install more machines, etc.
Average production of Labor (APL) (what is, on average, the productivity of one unit of
labor [1 worker, 1 hour, etc.])
𝑇𝑃
𝐴𝑃𝐿 =
𝐿
PART VII – MARGINAL PRODUCT OF LABOR (MPL) & LAW OF DIMINISHING RETURNS
1. Marginal product is the additional TP (output) that can be produced by one
additional worker:
∆𝑇𝑃
𝑀𝑃𝐿 =
∆𝐿
There is going to be a difference between the APL and the MPL because capital is
fixed (i.e. a fixed number of machines on which only a fixed number of workers
can operate efficiently)
2. Law of diminishing marginal returns:
On the short run, with a fixed scale of operation (fixed capital), the additional output
generated from each additional worker will be smaller than the previous worker’s, until it
reaches zero.
Labor units (# of workers) Total Product (TP) Marginal Product Average Product (AP)
(MP)
0 0 - -
1 10 10 10
2 25 15 12.5
3 35 10 11.7
4 40 5 10
5 42 2 8.4
6 42 0 7
PART VIII – GRAPHICAL ILLUSTRATION
AP vs L MP vs L AP & MP vs L
Notice the point of
intersection
The point of intersection between the AP & MP curves is where AP has been maximized.
PART IX – THE RELATIONSHIP BETWEEN MP & AP
On an exam, the following grades were obtained:
Ex 1 80
Ex 2 75
Ex 3 85
Avg. grade 80
Then on exam 4,
60 → AG down
90 → AG up
When MP>AP (before intersection), AP is increasing.
When MP<AP (after intersection), AP is decreasing.
When MP=AP (at the intersection), AP has been maximized
A numerical example of different accounting and economic costs
-Business to produce electric cables
-$20,000 in a bank account with an interest of 10% (i.e. $2,000/year)
-expected output: 3,000 cables. * $10 →Expected TR = $30,000
Costs:
o Inputs (& machines) - $15,000
o Labor costs – $14,000
→ Accounting costs = $29,000
→ Accounting profit = $30,000 - $29,000 = $1,000 in profit Would have
However, been earned as
→Economic cost = $29,000 + $2,000 = $31,000 interest had the
money stayed
→Economic profit = -$1,000 in the bank