Ragan: Microeconomics

Seventeenth Canadian Edition

Chapter 7
Producers in the Short
Run

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Chapter Outline/Learning Objectives
Section Learning Objectives
After studying this chapter, you will be able to
7.1 What Are Firms? 1. identify forms of business organization and methods
of financing firms.
7.2 Production, Costs, and 2. distinguish between accounting profits and economic
Profits profits.
7.3 Production in the Short 3. understand the law of diminishing marginal returns
Run and the relationships among total product, average
product, and marginal product.
7.4 Firms’ Costs in the 4. explain the difference between fixed and variable
Short Run costs, and the relationships among total costs,
average costs, and marginal costs.

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7.1 What Are Firms? (1 of 2)
• 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 (general and limited)
4. A corporation (private and public)
5. A state-owned enterprise (Crown corporations)
6. Non-profit organizations

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7.1 What Are Firms? (2 of 2)
• 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.

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Financing of Firms (1 of 3)
• 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.

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Financing of Firms (2 of 3)
• 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.

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Financing of Firms (3 of 3)
• Debt
– The firm’s creditors are not owners.
– A loan with a loan agreement or IOU.
– Firms can borrow from financial institutions.
– Firms can borrow from non-bank lenders using debt
instruments or bonds.
– Firms are obligated to pay the principal and interest.

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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.

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Applying Economic Concepts 7-1
Is it Socially Responsible to Maximize Profits?
• Two competing views:
1. Unadorned capitalism/goal of profit maximization does
not serve the broader public interest.
2. Goal of maximizing profits benefits customers and
their employees, and leads to innovation, which
improves living standards.
• What about the environment?
• How does the government fit in?
• How can firms be motivated to change their
behaviour?

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7.2 Production, Costs, and Profits
• Production
– Firms use four types of inputs for production:
1. Inputs that are outputs from some other firm are called
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

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Production
• The production function shows the maximum output
that can be produced by a 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 concept

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Costs and Profits (1 of 3)
• 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

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Costs and Profits (2 of 3)
• 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.

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Costs and Profits (3 of 3)
• 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.

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Table 7-1 Accounting Versus Economic
Profit for Ruthie’s Gourmet Soup Company
(1 of 2)

Total Revenues ($) Blank 2000

Explicit Costs ($) Blank Blank
Wages and Salaries 500 Blank
Intermediate Inputs 400 Blank
Rent 80 Blank
Interest on Loan 100 Blank
Depreciation 80 Blank
Total Explicit Costs 1160 Blank

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Table 7-1 Accounting Versus Economic
Profit for Ruthie’s Gourmet Soup Company
(2 of 2)

Accounting Profit Blank 840

Implicit Costs ($) Blank Blank
Opportunity Cost of Owner’s Time 160 Blank
Opportunity Cost of Owner’s $1500 Blank Blank
Capital
(a) risk-free return of 4% 60 Blank
(b) risk premium of 3% 45 Blank
Total Implicit Costs 265 Blank
Economic Profit Blank 575

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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:

π = TR - TC

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Time Horizons for Decision Making (1 of 2)
• 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.

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Time Horizons for Decision Making (2 of 2)
• 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.

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7.3 Production in the Short Run (1 of 2)
• Total and Average 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

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7.3 Production in the Short Run (2 of 2)
• Marginal Products

– 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:

ΔTP
MP =
ΔL

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Figure 7-1 Total, Average, and Marginal
Products in the Short Run

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Diminishing Marginal Product
• Define the law of diminishing returns
• To increase output in the short run, more and more of
the variable factor is combined with a given amount of
the fixed factor.
• Each successive unit of the variable factor has less
and less of the fixed factor to work with.
• Eventually equal increases in work effort begin to add
less and less to total output.

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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
 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.

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Applying Economic Concepts 7-2
Three Examples of Diminishing Returns
• Sport Fishing
– The number of fish per person fishing has decreased
and the average hours fished for each fish caught has
increased.
• Pollution Control
– Increasing the number of filters leads to diminishing
marginal returns in pollution reduction.
• Portfolio Diversification
– At some point, adding more stocks still reduces risk but
at a decreasing rate.

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7.4 Costs in the Short Run: Defining
Short-Run Costs (1 of 2)

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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7.4 Costs in the Short Run: Defining
Short-Run Costs (2 of 2)
• Marginal cost (MC) is the increase in total cost
resulting from increasing output by one unit.

ΔTC
MC =
ΔQ

• Marginal costs are always marginal variable costs

because fixed costs do not change as output varies.

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Short-Run Cost Curves (1 of 3)
• In the above note TFC
does not change with
output.
• In the above note MC
curve intersects the ATC
and AVC curves at their
minimums.

Figure 7-2 Total, Average, and Marginal

Cost Curves

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Short-Run Cost Curves (2 of 3)
• The ATC curve is derived geometrically by vertically
adding the AFC and AFC curves.
• ATC curve declines initially as output increases,
reaches a minimum, and then rises as output
increases further.
• The ATC curve is “U-shaped”.

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Short-Run Cost Curves (3 of 3)

Figure 7-2 Total, Average, and Marginal Cost Curves

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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.

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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.

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Shifts in Short-Run Cost Curves (1 of 2)
• An increase in the price of a variable factor shifts
ATC and MC 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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Shifts in Short-Run Cost Curves (2 of 2)

Figure 7-3 An Increase in Variable Factor Prices

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Applying Economic Concepts 7-3
The Digital World: When Diminishing Returns Disappear
Altogether
– Many digital products
have large initial costs but
near zero marginal costs.
– Low of diminishing
marginal returns does not
apply – MC curve is at
the same low value for all
units.
– In this case AVC = MC
– ATC decline because of
spreading fixed costs.

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