Principles of Microeconomics – Mr. Lilly

Topic 7 Skills

1. Know the meaning of the expressions “short run” and “long run.”

Short run= the period of time during which it is not possible to change all inputs to production; only some inputs, such as labor, can be changed

Long run = the minimum period of time during which all inputs to production can be changed.

2. Know the meaning of the expressions “average total cost” (ATC,) “average variable cost” (AVC,) “average fixed cost” (AFC,) and “marginal cost” (MC.) Given a table showing output and total cost, be able to calculate average total cost, average variable cost, and marginal cost at each output level. Know that AVC = VC/Q, ATC = TC/Q, AFC = FC/Q, and MC = Change in TC/Change in Q. Know that ATC = AVC + AFC. Know that AFC declines as Q increases.

Average total cost (ATC) = total costs of production divided by the quantity produced (also called cost per unit)

Average variable cost (AVC) = variable costs divided by the quantity produced.

Average fixed cost (AFC) = fixed costs divided by the quantity produced.

3. Know the meaning of the expressions “diminishing returns to labor” and “increasing returns to labor.” Know that the marginal cost curve will begin to rise when output reaches the level at which the firm’s production function begins to exhibit diminishing returns to labor, and not before.

Economies of scale is also called “increasing returns to scale.”

Declining long-run ATC example: Selling electricity to homes.

Flat long-run ATC example: A recipe for lemonade.

Diseconomies of scale are also called “decreasing returns to scale.”

Increasing long-run ATC example: An outdoor adventure company specializing in mountain climbing trips up Mt. Everest.

4. Know how to draw a generic set of ATC, AVC, and MC cost curves as shown in figure 8.5 on page 194. Specifically, be able to draw such a generic set of curves following all three of the “checklist” hints shown in the inset box just to the left of figure 8.5. If shown such a generic set of curves, be able to identify the ATC curve, the AVC curve, and the MC curve. Also, be able to determine ATC, AVC, and MC if told the quantity the firm is currently producing.

5. Be able to explain why the marginal cost curve cuts through both the AVC and ATC curves at their minimum points. Also, be able to explain why the ATC and the AVC curves must grow closer and closer together as output increases. (See the discussion under “Marginal versus Average in the Classroom” and “Generic Cost Curves” on pages 193-194.)

6. Given a set of cost curves for a firm in the short run (MC, AVC, and ATC) and the coordinates for certain key points, be able to find both graphically and numerically:

a.the profit-maximizing output for the perfectly competitive firm (price -> MC->Q)

b.the revenue rectangle and amount

c.the total cost rectangle and amount, and

d.the profit rectangle and amount.

7. Know the meaning of the expressions “breakeven point,” “breakeven quantity,” and “shutdown point.” Given a set of cost curves for a firm in the short run (MC, AVC, and ATC,) be able to determine the profit-maximizing output for the perfectly competitive firm and whether the firm will operate or shut down in the short run. Be able to explain why just knowing that profits are negative at the profit-maximizing output does not allow one to conclude that the firm will shut down in the short run.

Breakeven Point = the point at which price equals the minimum of average total cost

Shutdown point = the point at which price equals the minimum of average variable cost

8. Understand why the short run supply curve of the perfectly competitive firm jumps over to the vertical axis at the point where price falls below minimum average variable cost (AVC).

9. Know the meaning of the expression “capital expansion.” Know that when a firm increases the quantity of capital it is using, that (unless the firm is in a region of its long run ATC curve exhibiting diseconomies of scale) all of the following will occur:

a.AFC will be higher at every output level than previously.

b.ATC at low levels of output will be higher than previously.

c.ATC at higher levels of output (i.e. above where the short run ATC curve was previously at its minimum) will be lower than previously.

p. 202

10. Understand why the long run ATC curve is the lower envelope of all the short run ATC curves. Know the meaning of the expressions “economies of scale,” “constant returns to scale,” “diseconomies of scale,” and “minimum efficient scale,” and the region of the long run ATC curve associated with each.

p.204

(207)economies of scale = a situation in which long-run average total cost declines as the output of a firm increases

(207)diseconomies of scale = a situation in which long-run average total cost increases as the output of a firm increases

(207)constant returns to scale = a situation in which long-run average total cost is constant as the output of a firm changes.