Ragan: Economics

Fifteenth Canadian Edition

Chapter 7

Producers in the
Short Run

Copyright © 2017 Pearson Canada Inc. 8-1

 Course Schedule
Unit Chapter / Topic
1 Chapter 1: Economic Issues and Concepts
Chapter 2: Economic Theories, Data and Graph
2 Chapter 3: Demand, Supply, and Price
3 Chapter 4: Elasticity
Chapter 5: Markets in Action/Price Controls and Market Efficiency
4 Chapter 6: Consumer Behavior
5 Chapter 7: Productions in the Short Run
Chapter 8: Productions in the Long Run
6 Chapter 9: Competitive Markets
Mid Exam (1.30 hours)
7 Chapter 10: Monopoly, Cartels, and Price Discrimination
Chapter 11: Imperfect Competition and Strategic Behavior
8 Chapter 12: Economic Efficiency and Public Policy
9 Chapter 13: How Factor Markets Work
10 Chapter 16: Market Failures and Government Intervention
11 Final Exam (2.30 hours)
 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 Production 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 © 2014 Pearson Canada Inc. Chapter 7, Slide 3

7.1 What Are Firms?

Organizations of Firms (six basic types)

1.Single proprietorships: one owner- manager
2.Ordinary partnerships: two or more joint owners
3.Limited partnerships: two types of partners
a.General partner take part in the running of the
business and are liable for the firm's debts.
b.Limited partners take no part in the running of the
business, and their liability is limited to the amount
they actually invest in the enterprise.

Chapter 7, Slide 4
 7.1 What Are Firms?

4. Corporations: Own Identity, owners are not doing anything by

themselves, having Board of Director, shares are not traded in stock
exchange.

5. State-owned corporations: State own Business, Board of Director,

In Canada, state-owned enterprises are called Crown Corporations.

Examples: Canadian Broadcasting Corporation, VIA Rail , Canada

Post, and the Bank of Canada. 

6. Non-profit organizations: established with the exploit objective

of providing goods or services co customers but having any profits
that are generated remain with the organization and not claimed by
individuals.
Copyright © 2014 Pearson Canada Inc. Chapter 7, Slide 5
 Organizations of Firms

MNEs: Firms that have locations in more than one

country are often called multinational enterprises
(MNEs).

For a more detailed discussion of multinational enterprises, and

MyEconLa especially their role in determining flows of foreign investment,
b look for Multinational Enterprises and Foreign Direct Investment
in the Additional Topics section of this book's MyEconLab.
www.myeconlab.com

Copyright © 2014 Pearson Canada Inc. Chapter 7, Slide 6

 Financing of Firms
Financial Capital: The money a firm raises for caring business is
called financial capital.

Real Capital: The firm's physical assets, such as factories, machinery,

offices, vehicles, and stocks of materials and finished goods.

Basic Types of Financial Capital : Equity and Debt

a.Equity: Equity is the funds provided by owners of firm.

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

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

Copyright © 2014 Pearson Canada Inc.

Chapter 7, Slide 7
 stocks, shares, or equities

© 2014 Pearson Education Canada Inc. 8

 Types of Financial Capital
a. Debt: is the funds borrowed from creditors (individuals or
institutions) outside of the firm.

The firm 's creditors are not owners; they have lend money in return
for some form of loan agreement.

• Commercial banks
• Financial Institutions
• Non Bank Lender
• Bonds

Copyright © 2014 Pearson Canada Inc. Chapter 7, Slide 9

 Bond

© 2014 Pearson Education Canada Inc. 10

 Goals of Firms

Economists usually make two key assumptions about firms:

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

behavior of firms in various situations.

But are firms interested in more than just profits?

Copyright © 2014 Pearson Canada Inc. Chapter 7, Slide 11

 Production, Costs and Profits

The Production
Firms use four types of inputs for production:

1. Intermediate products

2. Inputs provided directly by nature

3. Inputs provided directly by people, such as labour services

4. Inputs provided by the services of physical capital (machines)

Production Function

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

We assume that the firm’s goal is to maximize profit.

Profit = Total revenue – Total cost

the amount a the market

firm receives value of the
from the sale inputs a firm
of its output uses in
production
 Costs as Opportunity Costs
A firm’s cost of production includes all the opportunity costs of making its
output of goods and services. And this is true whether the costs are implicit
or explicit both are important for firms’ decisions.

Explicit Costs and Implicit Costs

A firm’s cost of production include both explicit costs and

implicit costs.
• Explicit costs
Costs that require an outlay of money.
For example, paying wages to workers.
• Implicit costs
Costs that Do not require an outlay of Money.
For example, the opportunity cost of the owner’s time.
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business. The interest rate is 5%.

Case 1: Borrow $100,000.

• Explicit Cost = $100,000 x 5% = $5000 (interest on loan)

Case 2: Use $40,000 of your savings & borrow other $60,000.

• Explicit Cost = $60,000 x 5% = $3,000 (interest on loan)

• implicit cost = $40,000 x 5% = $2,000 (foregone interest you

could have earned on your $40,000).

In both cases, total (exp + imp) costs are $5000.

Economic Profit versus Accounting Profit
Accountants measure the Accounting Profit (AP) as the firm’s total
revenue minus only the firm’s explicit costs.

AP = Total Revenue – Explicit Costs

Economists measure a firm’s Economic Profit (EP) as total revenue

minus total cost, including both explicit and implicit costs.

EP = Total Revenue – Total Costs

(where total cost = explicit costs + implicit costs)

When total revenue exceeds both explicit and implicit costs, the firm
earns economic profit.

Economic profit is smaller than accounting profit.

 Economists versus Accountants
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs
Table 7-1 Accounting Versus Economic Profit
for Ruth’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
Accounting Profit Blank 840
Implicit Costs ($) Blank Blank
Opportunity Cost of Owner’s Time 160 Blank
Opportunity Cost of Owner’s Blank Blank
$1500 Capital
Table 7-1 Accounting Versus Economic Profit
for Ruth’s Gourmet Soup Company (2 of 2)
(a) risk-free return of 4% 60 Blank
(b) risk premium of 3% 45 Blank
Total Implicit Costs 265 Blank
Economic Profit Blank 575

Economic profits are less than accounting profits because of implicit costs.
The table shows a simplified version of a real profit-and-loss statement.
Accounting profits are computed as revenues minus explicit costs (including
depreciation), and in the table are equal to $840 for the period being
examined. When the correct opportunity cost of the owner’s time (in excess
of what is recorded in wages and salaries) and capital are recognized as
implicit costs, the firm appears less profitable. Economic profits are still
positive but equal only $575.
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 (1 of 2)

Short Run: The short run is a time period in which the quantity of
some inputs, called fixed factors, cannot be changed.

Fixed factors: 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.

Variable factors: 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 (2 of 2)

Long Run: 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.

Very long run: 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
Figure 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:

ΔTP
MP 
ΔL
© 2014 Pearson Education Canada Inc. 26
Figure 7-1 Total, Average, and Marginal Products in the
Short Run
The Average-Marginal Relationship

• With 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.

In other words

• 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.
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.
7.4 Costs in the Short Run

Defining Short-Run Costs

Defining Short-Run Costs (1 of 3)

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 (2 of 3)

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..

Average variable cost is total variable cost divided by the number of

units of output.
Defining Short-Run Costs (3 of 3)

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.
34
Short-Run Cost Curves (1 of 2) Figure 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.
Short-Run Cost Curves (2 of 2)
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”.
Capacity of a firm

• 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

Figure 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.
 Activity 5

You might be able to relate to this unit’s discussion in the sense of

seeking out a new, more profitable future for yourselves and your
families.
 
A carpenter quits his job at a furniture factory to open his own
cabinetmaking business. In his first two years of operation, his
sales average $100 000 and his operating costs for wood,
workshop and tool rental, utilities, and miscellaneous expenses
average $70 000. Now his old job at the furniture factory is again
available. Should he take it or remain in business for himself? How
would you make this decision? (Hint: Of course it will depend on
how much the job will offer him as salary. Are there any other
considerations?)

Copyright © 2014 Pearson Canada Inc. Chapter 8, Slide 39

 Videos - Short Run Production
https://www.bing.com/videos/search?
q=production+in+short+run&&view=detail&mid=41F4BB6F3B3CA9434BCF4
1F4BB6F3B3CA9434BCF&&FORM=VRDGAR

Long run Production

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q=production+in+long+run&&view=detail&mid=72360BBD4899BF370CB272
360BBD4899BF370CB2&&FORM=VRDGAR

Difference

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q=difference+between+shortrun+and+long+run+production&&view=detail&
mid=B62C6228E56CD8A47C3BB62C6228E56CD8A47C3B&&FORM=VRDGAR

© 2014 Pearson Education Canada Inc. 40