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Flashcards · AP® Microeconomics · Unit 3

Unit 3: Production, Cost, and the Perfect Competition Model flashcards

45 cards on topics 3.1 to 3.7. Pick a topic or study the whole unit.

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3.1 The Production Function

What is a production function, and what are the short run and long run?
It shows the maximum output from each combination of inputs with given technology, in units of output. Short run: at least one input (usually capital) is fixed. Long run: all inputs can change.
How do you calculate marginal product and average product?
MP = ΔTP ÷ ΔL, a change between two rows. Average product = TP ÷ L, a ratio within one row. TP = the sum of the MPs so far, or average product × L.
What are diminishing marginal returns, and why do they happen?
As workers are added to fixed capital, MP rises at first (specialisation) then falls. Diminishing returns begin where MP starts to fall, not where it turns negative. The cause is the fixed input being shared among more workers, not worse workers.
How are MP and TP related?
MP is the slope of TP. MP positive: TP rises. MP = 0: TP is at its maximum. MP negative: TP falls. Diminishing returns do not mean TP is falling.
How are MP and average product related?
When MP is above average product, average product rises; when MP is below it, average product falls. So MP crosses average product at the maximum of average product.
TP is 60 with 3 workers and 72 with 4. Find the 4th worker's MP and the average product of 4 workers.
MP = 72 − 60 = 12. Average product = 72 ÷ 4 = 18. A 5th worker with MP 13 lowers it to 85 ÷ 5 = 17.
Can diminishing marginal returns happen in the long run?
No. They need a fixed input, and in the long run every input can change.

3.2 Short-Run Production Costs

What is the difference between fixed and variable costs?
Fixed costs do not vary with output and are paid even at zero output (TFC = TC at Q = 0). Variable costs rise with output and are zero at zero output. TC = TFC + TVC.
How do you calculate MC, AFC, AVC and ATC?
MC = ΔTC ÷ ΔQ (= ΔTVC ÷ ΔQ). AFC = TFC ÷ Q, AVC = TVC ÷ Q and ATC = TC ÷ Q. ATC = AFC + AVC.
Graph: describe the short-run cost curves.
Cost ($ per unit) on the vertical axis, output per period on the horizontal. MC falls then rises. AVC and ATC are U-shaped, and MC cuts each at its minimum. AFC falls at every output. The gap between ATC and AVC (AFC) narrows; minimum ATC is at a larger output than minimum AVC.
Why does MC fall and then rise?
Specialisation and the division of labour make MC fall at low output; diminishing marginal returns make it rise after that. With labour the only variable input, MC = wage ÷ MP, so maximum MP gives minimum MC.
A firm's insurance premium rises. Which cost curves shift?
Insurance is a fixed cost, so AFC and ATC shift up; MC and AVC do not change. A rise in a variable input price, such as wages, shifts MC, AVC and ATC up, but not AFC.
TC is $500 at Q = 0 and $740 at Q = 4. Find TFC, TVC, AVC and ATC at Q = 4.
TFC = $500. TVC = 740 − 500 = $240. AVC = 240 ÷ 4 = $60. ATC = 740 ÷ 4 = $185.
MC is $18 and ATC is $22. Is ATC rising or falling?
Falling. When MC is below an average, the average falls; when MC is above it, the average rises.

3.3 Long-Run Production Costs

What is the long run for a firm's costs?
A period long enough to change all inputs, including plant size, so there are no fixed costs: all costs are variable.
What are returns to scale?
They compare the % change in output with an equal % change in all inputs. Output rises by more: increasing returns. By the same: constant. By less: decreasing. All inputs up 40% and output up 25% is decreasing returns.
Graph: describe the long-run average total cost (LRATC) curve.
Average cost on the vertical axis, output on the horizontal. LRATC shows the lowest average cost at each output when any plant size can be chosen, touching each SRATC curve at one point. It falls (economies of scale), is flat, then rises (diseconomies). Mark the MES.
What causes economies and diseconomies of scale?
Economies: specialisation, spreading large indivisible costs, large-scale technology and bulk buying. Diseconomies: coordination, communication and monitoring problems in very large firms.
What is the minimum efficient scale (MES)?
The smallest output at which LRATC is at its minimum. LRATC of $8 at 100 units, $6 at 200, $6 at 300 and $7 at 400 gives an MES of 200. Market quantity ÷ MES shows roughly how many firms can reach the lowest cost.
How do diseconomies of scale differ from diminishing marginal returns?
Diseconomies are long run, with all inputs varying. Diminishing marginal returns are short run, with one input fixed. A rise in input prices is neither: it shifts LRATC up.

3.4 Types of Profit

What is the difference between accounting profit and economic profit?
Accounting profit = TR − explicit costs. Economic profit = TR − explicit costs − implicit costs, so it is never larger than accounting profit.
What are typical implicit costs?
The owner's forgone salary, forgone interest on their own savings, forgone rent on property they own, and compensation for risk. Interest paid on a bank loan is an explicit cost.
What is normal profit?
Accounting profit that exactly covers implicit costs, so economic profit is zero and P = ATC. It is not a loss: resources earn exactly their next-best return.
TR is $50,000, explicit costs $30,000 and implicit costs $15,000. Find both profits.
Accounting profit = 50,000 − 30,000 = $20,000. Economic profit = 20,000 − 15,000 = $5,000.
How do firms respond to economic profit?
Positive: resources earn more here than elsewhere, so firms expand and new firms enter. Zero: no entry or exit. Negative: firms exit over time. Firms respond to economic, not accounting, profit.
Graph: how do you show economic profit on a cost-curve graph?
Mark the price and ATC at the chosen output q. Economic profit = (P − ATC) × q: the rectangle between the price and ATC, from 0 to q. Check that ATC includes implicit costs.

3.5 Profit Maximization

What is the profit-maximising rule?
Produce where MR = MC, on the rising part of MC. If MR exceeds MC, produce more; if MC exceeds MR, produce less. The change in profit from one more unit is MR − MC.
Does producing where MR = MC guarantee a profit?
No. It gives the largest profit or the smallest loss.
A price taker sells at $20. The MC of its 9th unit is $18 and of its 10th is $23. How many units should it make?
9. The 10th unit's MC of $23 is above MR of $20, so it would cut profit.
A firm sells 5 units at $40 each or 6 units at $37 each. What is the MR of the 6th unit?
6 × 37 − 5 × 40 = 222 − 200 = $22, less than the $37 price because the price falls on every unit.
A firm's yearly licence fee doubles. What happens to its profit-maximising output?
Nothing: a fixed cost does not change MC, so output stays the same and profit falls by the extra fee. A rise in a variable input cost raises MC and reduces output.
Where does a price-setting firm read its price?
From the demand (price) at the chosen output, not from the value of MR or MC where they cross.

3.6 Firms’ Short-Run Decisions to Produce and Long-Run Decisions to Enter or Exit a Market

When should a firm shut down in the short run?
When price is below average variable cost (TR below TVC) at the MR = MC output. If P ≥ AVC it produces, even at a loss, because fixed costs must be paid either way.
TR = $900, TVC = $700 and TFC = $500. Should the firm produce or shut down?
Produce: its result is 900 − 700 − 500 = −$300, better than the −$500 (loss = TFC) from shutting down.
What are the shutdown price and the break-even price?
Shutdown price = minimum AVC: below it, produce nothing. Break-even price = minimum ATC: below it, the firm makes an economic loss.
What is the difference between shutting down and exiting?
Shutdown is short run: output is zero but fixed costs are still paid. Exit is long run: there are no fixed costs, so producing nothing means leaving the market.
When do firms enter or exit in the long run?
Without barriers, firms enter markets with economic profit (P above ATC) and exit markets with expected economic losses (P below ATC). At P = ATC there is no entry or exit.
Minimum AVC is $12, minimum ATC is $18 and the price is $15. What happens?
Short run: produce at a loss, since P ≥ AVC. Long run: firms exit if the price is expected to stay at $15.

3.7 Perfect Competition

What are the features of perfect competition?
Many small buyers and sellers, an identical product, no barriers to entry or exit, and good information. No firm has market power.
What does a perfectly competitive firm's demand curve look like?
Horizontal at the market price, because the firm is a price taker: P = MR = AR = d. It maximises profit where MC = MR = P, on the rising part of MC.
Graph: describe a competitive firm making short-run profit and the long-run adjustment.
Draw the market and the firm side by side with the same price. Firm: horizontal P = MR line above minimum ATC; output q where MC = MR; profit rectangle (P − ATC) × q. Firms enter, market supply shifts right and the price falls until P = minimum ATC and profit is zero.
P = $14 and q = 200 where MC = MR; ATC at 200 is $11. What is the profit?
(14 − 11) × 200 = $600 economic profit. Read ATC at the chosen q, not at its minimum.
Which kinds of efficiency does perfect competition reach?
Allocative efficiency: P = MC, so marginal benefit = marginal cost. Productive efficiency: P = minimum ATC, in the long run only.
What does the long-run industry supply curve look like?
Constant-cost industry: horizontal, so after a rise in demand the long-run price is unchanged. Increasing-cost: upward-sloping, so the price ends higher. Decreasing-cost: downward-sloping, so it ends lower.
Does entry raise each firm's output?
No. Entry raises market output, but the price falls and each existing firm's output falls.

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