Notesale: Turn your study into money

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TEXTBOOK SUMMARY 5
Monday, 2 February, 2015
7:54 pm

COSTS, REVENUES AND PROFIT

7
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2 Production in the short run: law of diminishing marginal returns

Average Product (Productivity): amount of output per unit of input


The law of diminishing returns

Total Product (TP) - Output of the firm, using both fixed and variable factors of production

AP = TP/V (v - variable level of input --number of units)

Marginal Product (MP) - extra total product received from one extra unit of variable input
(resources)

MP = change in TP / change in V

When marginal returns are increasing: existing capital was not used efficiently nor to its full
capacity

When marginal returns of labour are increasing - output attributable to each additional
worker is greater than that of the previous worker hired

Law of diminishing returns: as additional units of a variable resource (in this case, labour) are
added to fixed resources (land and capital) beyond a certain point the marginal product of
the variable resources will decline

In the SR - a firm can hire more workers
In the LR - a firm can only grow by adding more capital

The Relationship between marginal and total product

MP - slope of TP curve at that point

As long as MP is positive, additional workers are adding to TP and output continues to
increase
If MP is negative, TP would fall

At first, MP is increasing - increasing marginal returns
Beyond a certain point - diminishing marginal returns
• Productivity of labour declines as it is added to fixed capital
• Slope of TP changes

The relationship between marginal and average product

When MP decreases, diminishing returns begin

MP intersects AP at its highest point - the average stays the same
• If MP is greater than AP, AP increases
• If MP is less than AP, AP falls

--> Same relationship for marginal cost and average cost


When MP starts to decline --> TP: point of inflection
When MP becomes negative --> TP starts to decrease


7
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5 on pg 159
• TP and TVC
• TVC varies with the changing productivity of the labour
• TP increases at an increasing rate and TVC increases at a decreasing rate - increasing
marginal returns
• TP increases at a decreasing rate and TVC increases at an increasing rate - diminishing
marginal returns

Therefore a firm's TVC curve is an mirror image of its total product curve

Per-unit costs: average and marginal costs

• AFC decreases as output increases
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If MC is higher than AC, the average
rises
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7 in pg 160
Not necessary to AFC shown - distance between ATC and AVC
Diminishing returns begin when MC starts to increase

Average profit (profit per unit of output) = average revenue - average total cost

Costs of production in the long run

Economies of scale and diseconomies of scale

In the LR, you can add more capital, land and labour to the production
• In the LR, a firm may vary all of its factors of production

Law of diminishing returns no longer apply in the LR since the quantity of capital that
workers have at their disposal is no longer fixed

The Long Run (variable-plant) period is therefore made up of several short run (fixed-plant)
periods
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4 Revenues: total, average and marginal revenue

Revenue is the income a firms receives from the sales of its output
• Firms seek to maximize profit, not revenue

Revenues for a perfectly competitive firm

Perfectly competitive firm- one that competes in a market with a very large number of firms
each producing an identical product, and each firm's output making up a very tiny fraction of
the total market supply -- this makes it impossible for a single firm to affect the market price
by increasing or decreasing its output unilaterally

Firms - price takers

AR = revenue per unit of output = price = MR

Fig 7
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darp)

TR increases at constant rate as output increase
Determining AR and MR - market price of the output - determined by market supply and
demand

Price x quantity = revenue when that is a perfectly elastic demand curve (when AR, MR, D
and P are the same)

Revenues for an imperfectly competitive firm

(characteristics of imperfectly competitive firm skipped)

An imperfectly competitive firm will face a downward-sloping demand curve (D=AR=P)
• Price falls as quantities increase (inverse relationship between P and Q) and this will
alter revenue

MR is not equal to price and AR
• MR equals to change in TR when it increases output by one unit
• MR is declines faster than AR and price (as firms lower price to increase output)
• Only for first unit of output will price, AR and MR be the same

TR is maximized when MR=0

MR is given by the slope of TR (MR measures the change in TR)

As long as MR is positive, TR will increase
• Since MR decreases as output increases, the slope of TR will level out until MR equals
zero, at which point the firm's TR is maximized
• When MR falls zero, the firm's TR begins to decrease

MR curve lies below the D=AR=P line at every level of output beyond one unit
• Slope of MR will be twice of that its demand curve falls at a greater rate than price
because firms must lower all of its prices in order to sell more output

The total revenues revisited

If a fall in price leads to increase in TR - demand is elastic
If a fall in price leads to decrease in TR - demand is inelastic

An imperfect competitor (a profit maximizing firm) will never wish to produce beyond the
unit elastic point (PED=1) on its demand curve
• TC continues to rise but its total revenue decreases beyond this point

Conclusions

1
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MR falls faster than AR
3
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This is where you stop producing more units
b
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When PED is elastic, you should continue to cut price
5
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Your revenue maximization point is where MR = 0 and PED = 1





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