Economics Relationships

Explain the relationship between a firm’s short-run production function and its short-run cost function. Focus on the marginal product of an input and the marginal cost of production. (Question 3, p. 290)

In economic analysis, the cost function is basically the production function expressed in monetary rather than physical units. Total variable cost is simply a mirror image of total product. They are related as follows: When a firm’s marginal product is increasing, its marginal cost of production is decreasing, and vice versa. It is the law of diminishing returns.

Use the model of perfect competition described in this chapter to explain, illustrate, or elaborate on the following statements. (Question 6, p. 338)

a. “Increasing competition from new firms entering the market is good because it means one is in a good business.”

In a perfect competition, there are a very large number of relatively small firms competing in this market. The product is “standardized”, or basically conventional, and it is very easy to enter and exit the market in perfect competition – there are zero entry and exit barriers.

When new firms enter the market, it basically tells you that your product is in demand and other firms see that this is a good market to enter. It does provide competition for your firm, which then forces you to produce at the lowest possible cost, or at least below the cost levels of your competitors. And, as you find yourself with more competition, the point where marginal revenue equals marginal cost (MR=MC) shifts downward, making the price decrease.

b. “One important difference between an entrepreneur and a manager is that the former gets into a market before demand increases, while the latter gets into the market after the shift.”

Entrepreneurs are risk-takers. They are go-getters and see an opportunity and take it. They enter the market knowing the demand will go up. They own their own firm. Of course, it is better to enter a...