Chapter 7 - Producers in the Short Run: Production, Costs, and Profits (Microeconomics Chapter 7 Study Notes)

Producers in the Short Run

Introduction

This chapter explores the behaviour of firms as agents of production in the short run, focusing on their organization, financing, goals, and the relationship between production, costs, and profits. It also examines the law of diminishing returns and the cost structures that firms face when some factors of production are fixed.

7.1 What Are Firms?

Organizations of Firms

Firms are economic agents that organize production. They exist in several forms, each with distinct characteristics regarding ownership, liability, and profit distribution.

• Single Proprietorship: Owned by one person, simple to set up, owner has unlimited liability, profits go directly to the owner.

• Ordinary Partnership: Owned by two or more people, partners share management and profits, each has unlimited liability (even for actions of the other).

• Limited Partnership: At least one general partner (manages, unlimited liability), one or more limited partners (contribute capital, liability limited to their investment), common in investment funds.

• Corporation: Separate legal entity, owned by shareholders, run by managers/board, shareholders have limited liability, can raise large amounts of capital.

• State-Owned Enterprise (Crown Corporation): Owned by the government, operates in strategically important sectors, profits go to the state.

• Non-Profit Organization: Not owned by individuals, purpose is social, cultural, or community goals, surpluses reinvested in the mission.

Some firms operate internationally as transnational corporations (TNCs) or multinational enterprises (MNEs).

Financing of Firms

Firms finance their operations using equity and debt:

• Equity: Funds from owners in exchange for stocks, shares, or equity. Profits may be distributed as dividends or retained.

• Debt: Funds from creditors (not owners) using debt instruments or bonds. Firms must repay principal and interest.

Goals of Firms

Economists typically assume:

• Firms are profit-maximizers.

• Each firm is a single, consistent decision-making unit.

While profit maximization is central, firms may also consider social responsibility, environmental impact, and ethical behaviour. Government regulation and consumer preferences can influence firm behaviour.

7.2 Production, Costs, and Profits

Production

Firms use four types of inputs for production:

• Intermediate products

• Inputs provided directly by nature

• Labour services

• Physical capital (machines)

These are collectively known as factors of production: land, labour, and capital.

The production function describes the technological relationship between inputs and outputs:

$q = f(L, K)$

Production is a flow: the number of units produced per period of time.

Costs and Profits

• Profits: $\text{Profits} = \text{Total Revenue} - \text{Total Cost}$

• Accounting Profits: $\text{Accounting Profits} = \text{Total Revenue} - \text{Explicit Costs}$

• Economic Profits: $\text{Economic Profits} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs})$

Implicit costs include the opportunity cost of the owner's time and capital. Economic profits are typically less than accounting profits. If economic profit is positive, the owner's capital earns more than its next best alternative use.

Table: Accounting Versus Economic Profit

Item	Amount ($)
Total Revenue	2000
Explicit Costs	1160
Accounting Profit	840
Implicit Costs (Owner's Time, Capital)	669
Economic Profit	171

Additional info: Table values inferred from example in the notes.

7.3 Production in the Short Run

Time Horizons for Decision Making

• Short Run: Some factors of production are fixed (typically capital).

• Long Run: All factors of production can be varied, but technology is fixed.

• Very Long Run: All factors and technology can be varied.

Production Function in the Short Run

In the short run, output depends on the amount of labour used with a fixed amount of capital:

$q = f(L, K)$

Analysis focuses on the relationship between labour input and output.

Total, Average, and Marginal Products

• Total Product (TP): Total output produced in a given period.

• Average Product (AP): Output per unit of variable factor (usually labour): $AP = \frac{TP}{L}$

• Marginal Product (MP): Change in total output from using one more unit of a variable factor: $MP = \frac{\Delta TP}{\Delta L}$

Diminishing Marginal Product

The law of diminishing returns states that as more units of a variable factor (e.g., labour) are added to a fixed factor (e.g., capital), the marginal product of the variable factor will eventually decrease.

• Initially, marginal product rises due to specialization.

• Eventually, with fixed capital, marginal product falls.

Examples: Photocopy machine, coffee shops, population growth (Malthusian theory).

The Average-Marginal Relationship

• If $MP > AP$, the average product rises.

• If $MP < AP$, the average product falls.

• The $MP$ curve intersects the $AP$ curve at its maximum point.

Analogy: Marginal grade in a new course compared to GPA.

7.4 Firms' Costs in the Short Run

Defining Short-Run Costs

• Total Cost (TC): $TC = TFC + TVC$

• Total Fixed Cost (TFC): Costs that do not vary with output.

• Total Variable Cost (TVC): Costs that vary with output.

• Average Total Cost (ATC): $ATC = AFC + AVC$

• Average Fixed Cost (AFC): $AFC = \frac{TFC}{Q}$

• Average Variable Cost (AVC): $AVC = \frac{TVC}{Q}$

• Marginal Cost (MC): $MC = \frac{\Delta TC}{\Delta Q}$

Table: Example of Production and Short Run Costs

Capital (K)	Labour (L)	Output (Q)	Fixed Cost (TFC)	Variable Cost (TVC)	Total Cost (TC)	Average Fixed Cost (AFC)	Average Variable Cost (AVC)	Average Total Cost (ATC)	Marginal Cost (MC)
10	1	15	100	10	110	6.67	0.67	7.33	0.67
10	2	35	100	20	120	2.86	0.57	3.43	0.50
10	3	50	100	30	130	2.00	0.60	2.60	0.67
10	4	60	100	40	140	1.67	0.67	2.33	1.00
10	5	65	100	50	150	1.54	0.77	2.31	2.00
10	6	67	100	60	160	1.49	0.90	2.39	2.00
10	7	68	100	70	170	1.47	1.03	2.50	2.00
10	8	68	100	80	180	1.47	1.18	2.65	2.00
10	9	67	100	90	190	1.49	1.34	2.83	2.00
10	10	65	100	100	200	1.54	1.54	3.08	2.00

Additional info: Table values are a sample from the full table in the notes.

Why U-Shaped Cost Curves?

• Each additional worker adds the same amount to total cost but a different amount to output.

• Initially, marginal product increases and marginal cost decreases.

• Eventually, diminishing marginal product causes marginal cost to rise.

• MC reaches its minimum when MP reaches its maximum.

The same logic applies to average variable cost (AVC): AVC is at its minimum when AP is at its maximum.

Short-Run Cost Curves

• MC is the slope of the TVC curve.

• TFC does not vary with output; it is horizontal.

• TC = TVC + TFC (vertical summation).

• ATC = AVC + AFC (vertical summation).

• AFC declines steadily as output rises (spreading the overhead).

Capacity and Excess Capacity

• Capacity: The level of output at which short-run ATC is minimized.

• Excess Capacity: Output less than the point of minimum ATC.

Extensions: Idle Capital Equipment and Flat Cost Curves

• MC and AVC curves can be flat over a wide range of output.

• Even with fixed capital, firms can use less than the available amount by adjusting labour and machine usage.

• Example: Firms run extra shifts or cut shifts in response to demand changes; AVC and MC remain the same.

Shifts in Short-Run Cost Curves

• A change in the price of any variable input shifts the ATC and MC curves.

• Upward shift for price increase, downward for price decrease.

• Different short-run cost curves exist for each quantity of the fixed factor.

Special Case: Digital Products

• Digital products often have high initial costs but near-zero marginal costs.

• Law of diminishing returns does not apply.

• MC is constant and low for all units; thus, AVC = MC.

• ATC declines as output increases due to spreading fixed costs.

Review Questions

1. For given factor prices, when average product per worker is at a maximum, average variable cost is at a minimum.

2. If marginal costs are above average costs, then producing one more unit of output will increase the average cost.

3. The level of output that corresponds to a firm's minimum short-run average total cost is called the capacity of the firm.