Ragan 15e PPT ch07

Chapter 7:
Producers in the
Short Run
Copyright © 2017 Pearson Canada Inc.

Chapter Outline/Learning Objectives
Section Learning Objectives

After studying this chapter, you will be able to
7.1 What Are Firms? 1. identify the various forms of business organization and
discuss the different ways that firms can be financed.
7.2 Production, Costs, 2. distinguish between accounting profits and economic

and Profits profits.
7.3 Production in 3. understand the relationships among total product,

the Short Run average product, and marginal product; and the law of
diminishing marginal returns.
7.4 Costs in 4. explain the difference between fixed and variable costs,
the Long Run and the relationships among total costs, average costs,
and marginal costs.
Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 2

7.1 What Are Firms?
Organizations of Firms
A firm can be organized in any one of six different ways:
1. A single proprietorship
2. An ordinary partnership
3. The limited partnership
4. A corporation
5. A state-owned enterprise
6. Non-profit organizations

7.1 What Are Firms?
Organizations of Firms
Firms that have operations in more than one country are called
multinational enterprises (MNEs).
This is unusual for single proprietorships and ordinary partnerships,

but common for limited partnerships and very common for larger
corporations.
The number and importance of MNEs have increased greatly over

the last few decades.

Financing of Firms
The money a firm raises for carrying on its business is called financial
capital.
Financial capital is distinct from physical capital, which is the firm’s

assets, such as factories, machinery, offices, and fleets of vehicles.
The basic types of financial capital used by firms are equity and debt.

Financing of Firms
Equity
In individual proprietorships and partnerships, one or more owners
provide much of the required funds.
A corporation acquires funds from its owners in return for stocks,

shares, or equities, which are basically ownership certificates.
Profits that are paid out to shareholders are called dividends.

Financing of Firms
Debt
The firm’s creditors are not owners.
They have lent money in return for some form of loan agreement or
IOU.
Firms can borrow from banks or other financial institutions.
Firms can borrow from non-bank lenders using debt instruments or

bonds.
Firms are obligated to pay the principal and interest.

Goals of Firms
Economists generally make two key assumptions about firm

behaviour:
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 behaviour

of firms in various situations.

7.1 Production, Costs, and Profits
Production
Firms use four types of inputs for production:
1. Inputs that are outputs from some other firm—intermediate

products
2. Inputs provided directly by nature
3. Inputs that are the services of labour
4. Inputs that are the services of physical capital

Production
The production function is a functional relation showing the

maximum output that can be produced by any given combination of
inputs.
The production function describes the technological relationship

between the inputs that a firm uses and the output that it produces.
In terms of functional notation:
Q = f(L,K)
Production is a flow: it is a number of units per period of time.

Costs and Profits
Explicit costs involve a purchase of goods or services by the firm.
Explicit costs include the hiring of workers, the rental of equipment,

interest payments on debt, and the purchase of intermediate inputs.
Explicit costs include depreciation—a cost that arises because of the

wearing out of physical capital—which does not involve a market
transaction.
Accounting profits = Revenues – Explicit Costs

Costs and Profits
To find economic profit, economists subtract explicit costs and

implicit costs from revenues.
Implicit costs are the costs of items for which there is no market
transaction but for which there is still an opportunity cost for the
firm.
Implicit costs include the opportunity cost of the owner’s time and
the opportunity cost of the owner’s capital.

Costs and Profits
Economic profit is the difference between the revenues received

from the sale of output and the opportunity cost of the inputs used
to make the output.
Economic profit = Revenues – (Explicit costs + Implicit costs)
Economic profit = Accounting profits – Implicit costs
Negative economic profits are called economic losses.

Table 7-1 Accounting Versus Economic Profit

Profit-Maximizing Output
When we talk about a firm’s profit, we will always mean economic

profit.
A firm's economic profit is the difference between the total revenue

(TR) each firm derives from the sale of its output and the total cost
(TC) of producing that output:
 = TR - TC

Time Horizons for Decision Making
The short run is a time period in which the quantity of some inputs,
called fixed factors, cannot be changed.
A fixed factor is usually an element of capital but it might be land, the

services of management, or even the supply of skilled labour.
Inputs that are not fixed and can be varied in the short run are called
variable factors.
The short run does not correspond to a specific length of time.

Time Horizons for Decision Making
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 long run, like the short run, does not correspond to a specific
length of time.
The very long run is the length of time over which all the firm's
factors of production and its technology can be varied.

7.3 Production in the Short Run
Total, Average, and Marginal Products

Total product (TP) is the total amount 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.
If we let the number of units of labour be denoted by L, then
AP = TP / L

Fig. 7-1 Total, Average, and Marginal Products in the Short Run
Marginal product is the

change in total output that
results from using one more
unit of a variable factor.
The marginal product (MP)

of labour is given by:
 TP
L
MP =

Diminishing Marginal Product
The law of diminishing returns states that if increasing amounts of a

variable factor are applied to a given quantity of a fixed factor
(holding the level of technology constant), eventually a situation will
be reached in which the marginal product of the variable factor
declines.
To increase output in the short run, more and more of the variable
factor is combined with a given amount of the fixed factor.
So each successive unit of the variable factor has less and less of the
fixed factor to work with.
And eventually equal increases in work effort begin to add less and
less to total output.
The Average-Marginal Relationship
When an additional worker's output raises average product,

MP exceeds AP.
When an additional worker's output reduces average product, MP is

less than AP.
 the AP curve slopes upward when the MP curve

is above it and the AP curve slopes downward when the MP
curve is below it
It follows that the MP curve intersects the AP curve at its maximum

point.

7.4 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

Defining Short-run Costs
The total cost of producing any given level of output can be divided
into total fixed cost and total variable cost.
Total fixed cost is the cost of the fixed factor(s). It does not vary with
the level of output.
Total variable cost is the cost of the variable factors. It varies directly
with the level of output.

Defining Short-run Costs
Average total cost is the total cost of producing any given number of
units of output divided by that number of units.
Average fixed cost is total fixed cost divided by the number of units
of output. Average fixed cost declines continually as output
increases. This is known as spreading overhead.
Average variable cost is total variable cost divided by the number of

units of output.

Defining Short-Run Costs
Marginal cost (MC) is the increase in total cost resulting from

increasing output by one unit.
 TC
MC =
Q
Marginal costs are always marginal variable costs because fixed costs
do not change as output varies.

Short-Run Cost Curves Fig. 7-2 Total, Average, and
Marginal Cost Curves
In the top graph, note that

TFC does not change with
output.
In the bottom graph, note

that the MC curve intersects
the ATC and AVC curves at
their minimums.

The ATC curve is derived geometrically by vertically adding the AFC and
AFC curves.
The result is that the ATC curve declines initially as output increases,
reaches a minimum, and then rises as output increases further.
The ATC curve is “U-shaped”.

Why U-Shaped MC and AVC 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 an 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.

Capacity
The level of output that corresponds to the minimum short-run

average total cost is the capacity of the firm.
Capacity is the largest output that can be produced without

encountering rising average costs per unit.
A firm that is producing at an output less than the point of minimum

average total cost is said to have excess capacity.

Shifts in Short-Run Cost Curves
Fig. 7-3 An Increase in Variable Factor Prices
An increase in the price of a
variable factor shifts the
firm’s ATC and MC curves
upward.
An increase in the price of a

fixed factor increases the
firm’s total fixed costs, but its
variable costs are unchanged.
The ATC curve shifts upward

but the MC curve does not
change.

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Chapter 7:

Copyright © 2017 Pearson Canada Inc.

Section Learning Objectives

7.2 Production, Costs, 2. distinguish between accounting profits and economic

7.3 Production in 3. understand the relationships among total product,

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 2

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 3

This is unusual for single proprietorships and ordinary partnerships,

The number and importance of MNEs have increased greatly over

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 4

Financial capital is distinct from physical capital, which is the firm’s

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 5

A corporation acquires funds from its owners in return for stocks,

Profits that are paid out to shareholders are called dividends.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 6

Firms can borrow from banks or other financial institutions.

Firms can borrow from non-bank lenders using debt instruments or

Firms are obligated to pay the principal and interest.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 7

Economists generally make two key assumptions about firm

1. Firms are assumed to be profit-maximizers.

2. Each firm is assumed to be a single, consistent,

Based on these assumptions, economists can predict the behaviour

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 8

1. Inputs that are outputs from some other firm—intermediate

2. Inputs provided directly by nature

3. Inputs that are the services of labour

4. Inputs that are the services of physical capital

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 9

The production function is a functional relation showing the

The production function describes the technological relationship

In terms of functional notation:

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 10

Explicit costs involve a purchase of goods or services by the firm.

Explicit costs include the hiring of workers, the rental of equipment,

Explicit costs include depreciation—a cost that arises because of the

Accounting profits = Revenues – Explicit Costs

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 11

To find economic profit, economists subtract explicit costs and

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 12

Economic profit is the difference between the revenues received

Economic profit = Revenues – (Explicit costs + Implicit costs)

Economic profit = Accounting profits – Implicit costs

Negative economic profits are called economic losses.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 13

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 14

When we talk about a firm’s profit, we will always mean economic

A firm's economic profit is the difference between the total revenue

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 15

A fixed factor is usually an element of capital but it might be land, the

The short run does not correspond to a specific length of time.

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 16

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 17

Total, Average, and Marginal Products

Average product (AP) is the total product divided by the number

If we let the number of units of labour be denoted by L, then

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 18

Marginal product is the

The marginal product (MP)

Copyright © 2017 Pearson Canada Inc. Chapter 7, Slide 19

The law of diminishing returns states that if increasing amounts of a

When an additional worker's output raises average product,

When an additional worker's output reduces average product, MP is