SECTION 10 REVIEW

Module 52

1. The cost of using a resource for a particular activity is the opportunity cost of that resource. Some opportunity costs are explicit costs; they involve a direct payment of cash. Other opportunity costs, however, are implicit costs; they involve no outlay of money but represent the inflows of cash that are forgone. Both explicit and implicit costs should be taken into account when making decisions. Firms use capital and their owners’ time, so firms should base decisions on economic profit, which takes into account implicit costs such as the opportunity cost of the owners’ time and the implicit cost of capital. Accounting profit, which firms calculate for the purposes of taxes and public reporting, is often considerably larger than economic profit because it includes only explicit costs and depreciation, not implicit costs. Finally, normal profit is a term used to describe an economic profit equal to zero—a profit just high enough to justify the use of resources in an activity.

Module 53

2. A producer chooses output according to the optimal output rule: produce the quantity at which marginal revenue equals marginal cost. The marginal revenue curve shows the marginal revenue for each unit; the marginal cost curve shows the marginal cost for each unit. More generally, the principle of marginal analysis suggests that every activity should continue until marginal benefit equals marginal cost.

Module 54

3. The relationship between inputs and output is represented by a firm’s production function. In the short run, the quantity of a fixed input cannot be varied but the quantity of a variable input, by definition, can. In the long run, the quantities of all inputs can be varied. For a given amount of the fixed input, the total product curve shows how the quantity of output changes as the quantity of the variable input changes. The marginal product of an input is the increase in output that results from using one more unit of that input.

4. There are diminishing returns to an input when its marginal product declines as more of the input is used, holding the quantity of all other inputs fixed.

Module 55

5. Total cost, represented by the total cost curve, is equal to the sum of fixed cost, which does not depend on output, and variable cost, which does depend on output. Due to diminishing returns, marginal cost, the increase in total cost generated by producing one more unit of output, normally increases as output increases.

6. Average total cost (also known as average cost) is the total cost divided by the quantity of output. Economists believe that U-shaped average total cost curves are typical because average total cost consists of two parts: average fixed cost, which falls when output increases (the spreading effect), and average variable cost, which rises with output (the diminishing returns effect).

7. When average total cost is U-shaped, the bottom of the U is the level of output at which average total cost is minimized, the point of minimum-cost output. This is also the point at which the marginal cost curve crosses the average total cost curve from below. Due to gains from specialization, the marginal cost curve may slope downward initially before sloping upward, giving it a “swoosh” shape.

8. The average product of an input is the total product divided by the quantity of the input, and the average product curve shows the relationship between the average product and the quantity of the input. When labor is the only variable input and the wage is constant, average variable cost falls when average product rises, and average variable cost rises when average product falls. Likewise, marginal cost rises when marginal product falls and vice versa.

Module 56

9. In the long run, a firm can change its fixed input and its level of fixed cost. By accepting higher fixed cost, a firm can lower its variable cost for any given output level, and vice versa. The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost at each level of output. A firm moves along its short-run average total cost curve as it changes the quantity of output, and it returns to a point on both its short-run and long-run average total cost curves once it has adjusted fixed cost to its new output level.

10. As output increases, there are economies of scale if long-run average total cost decreases and diseconomies of scale if long-run average total cost increases. As all inputs are increased by the same proportion, there are increasing returns to scale if output increases by a larger proportion than the inputs; decreasing returns to scale if output increases by a smaller proportion; and constant returns to scale if output increases by the same proportion.

11. Sunk costs are expenditures that have already been made and cannot be recovered. Sunk costs should be ignored in making decisions about future actions because what is important is a comparison of future costs and future benefits.

Module 57

12. There are four main types of market structure based on the number of firms in the industry and product differentiation: perfect competition, monopoly, oligopoly, and monopolistic competition.

13. A monopolist is a producer who is the sole supplier of a good without close substitutes. An industry controlled by a monopolist is a monopoly.

14. To persist, a monopoly must be protected by a barrier to entry. This can take the form of control of a natural resource or input, increasing returns to scale that give rise to a natural monopoly, technological superiority, or government rules that prevent entry by other firms, such as patents or copyrights.

15. In a perfectly competitive market all firms are price-taking firms and all consumers are price-taking consumers—no one’s actions can influence the market price. Consumers are normally price-takers, but firms often are not. In a perfectly competitive industry, every firm in the industry is a price-taker.

16. There are two necessary conditions for a perfectly competitive industry: there are many firms, none of which has a large market share, and the industry produces a standardized product or commodity—goods that consumers regard as equivalent. A third condition is often satisfied as well: free entry and exit into and from the industry.

17. 584

    Many industries are oligopolies, in which there are only a few sellers, known as oligopolists. Oligopolies exist for more or less the same reasons that monopolies exist, but in weaker form. They are characterized by imperfect competition: firms compete but possess some market power.

18. Monopolistic competition is a market structure in which there are many competing firms, each producing a differentiated product, and there is free entry and exit in the long run. Product differentiation takes three main forms: by style or type, by location, and by quality. The extent of imperfect competition can be measured by the concentration ratio, or the Herfindahl–Hirschman Index.