Production Function

A production function serves as the foundation for business decisions regarding

resource use and quantities of output. Below you will learn about the law of
diminishing marginal returns and how it relates to the marginal cost curve.

Production Function Key Terms:

Total Product (TP) is the number of units a firm can produce with a given
quantity of inputs. You will see total product in the chart below. With 2 workers
the firm has a total product of 6 units of output. With 3 units of labor, the firm has
9 units of total product.Average Product (AP) is the total number of units a firm
produced divided by the quantity of inputs used. At 2 workers, total product is 6,
that means average product is 3 (6/2)
Marginal Product (MP) is the change in total product (the number produced by
all workers) from hiring one more worker. If more than one worker is hired, the
marginal product is the change in output (Q) divided by the change in the
quantity of labor. With 2 workers, the firm has a total product of 6, and with 3
workers the total product is 9. The total product increased by 3 units with the
addition of 1 worker so the marginal product is 3 (3/1).
Below is a short run production function for a firm. You can see the total product,
marginal product, and average product for different units of labor (workers)
employed.
The law of diminishing marginal returns: There are three parts of a marginal
product curve. Part 1 is the increasing returns portion where hiring more workers
increases the marginal product because total product is increasing at an
increasing rate. Increasing returns occurs because of division of labor and worker
specialization. Complicated tasks are broken down and workers get very good at
their individual role in the production process.
Part 2 is the diminishing returns portion where hiring more workers decreases the
marginal product (the Total Product curve is getting less steep) because total
product is still increasing but at a decreasing rate.

Part 3 is the negative returns portion where hiring more workers results in a
negative marginal product (the total Product curve is falling). Take a look at Chart
B and the graph below for an example.

Note: Diminishing Marginal Returns is the cause of the upward sloping portion of
a firm’s marginal cost curve.
A marginal product curve tends to be shape like an upside down marginal cost
curve and an average product curve tends to be shaped like an upside down
average variable cost curve. That is because, for most businesses, the primary
variable cost of production is the cost of labor. Also, when labor is the only
variable cost the marginal cost of labor is the wage divided by the marginal
product (MC=W/MP). So when MP is rising, MC is falling, and when MP is falling,
MC is rising.
What Do I Need to Know About
Cost Curves?
Updated 9/1/2023 Jacob Reed
Costs
Implicit and explicit costs were already covered in the cost revenue, and profit review.
Below are more costs you need to know and each of them includes both implicit and
explicit costs.

The total cost curves are important, but pay special attention to the average cost
curves. They will be important on most of the Micro Graphs.
Fixed Costs: These are costs for a firm which do not change with the quantity
produced (they remain fixed). Rent, loan payments, insurance, etc will generally be the
same whether a firm produces zero units of output or ten thousand. On a graph, FC are
a horizontal line (indicating the same dollar amount for every quantity). A firm will
operate as long as losses are less than fixed costs. Otherwise the firm will temporarily
shut down. That is because fixed costs are “sunk costs” meaning they are already lost.
Variable Costs: These are the costs which change with the quantity produced. Labor,
electricity, and raw materials are all examples of variable costs because as more units
are produced more money will be spent on labor, electricity, and raw materials. If total
revenue is greater than total variable costs, the firm will operate and their losses will be
less than fixed costs. If total revenue is less than total variable costs, the firm will
temporarily shut down.
Total Costs: Variable Costs plus Fixed Costs give you Total Costs. On a graph the TC
curve is the same shape as the VC. The distance between the two curves is equal to
the value of the Fixed costs.
Marginal Cost: Marginal cost is the change in total cost divided by the change in
quantity (MC = ∆TC/∆Q). Usually the change in quantity is just 1 so MC is the cost
associated with producing just one more unit of output. The marginal cost curve
intersects the ATC and AVC at their minimum points. That relationship is because as
long as the cost of producing one more unit of output (MC) is less than the current
average the average will fall. Also, as long as the cost of producing one more unit of
output is higher than the current average, the average will rise.
The Marginal Cost curve looks like the Nike swoosh. At low quantities, the marginal cost
curve is downward sloping. That is due to specialization that causes increasing marginal
returns. The quantity where the marginal cost curve is at its minimum is
where diminishing marginal returns sets in. Diminishing marginal returns causes
marginal costs to rise at higher quantities.
Average Fixed Costs: Add up all of the fixed costs for a firm and divide by the quantity
produced (AFC = FC/Q). Continually decreases. Rarely drawn because the distance
between the ATC and AVC will be equal to the AFC at that quantity. Average fixed costs
continually decrease as output increases.
Average Variable Costs: Add up all of the variable costs for a firm and divide by the
quantity produced (AVC = VC/Q). Decreases until it intersects the MC then increases.
Looks like a smirk. Firms shut down (temporarily) when price falls below the minimum
point on the AVC.
Average Total Costs: Variable costs added to Fixed costs, then divided by Quantity
gives you the Average Total Costs (ATC=TC/Q). It decreases until it intersects the MC
then increases. Looks like a smile. The ATC tends to be a flipped average product
curve. Producing the quantity where the ATC is at its minimum is productively efficient.

Shifting Cost Curves: Changing a variable cost like per unit taxes or subsidies, labor
costs or raw material costs will shift the ATC, AVC, and MC upward if it is a cost
increase or downward if it is a cost decrease.

Changing a fixed cost like lump sum taxes or subsidies, rent payments, or insurance
payments, will only shift the ATC upward if it is a cost increase or downward if it is a
cost decrease.
Long-run Costs

Short-run Average Total Cost (SRATC) vs Long-run Average Total Cost

(LRATC): When a business first opens, it will have a short-run average total cost curve
for various quantities it can produce. In the short run, only variable costs can be
changed; fixed costs cannot. The firm can only change the rate of production by
changing the amount of raw materials, labor, etc. it utilizes in the production process. In
the long run, all costs (fixed and variable) can change. The firm can expand capacity, by
purchasing more machinery or building a new factory. That change gives the firm a new
short-run average total cost curve at greater quantities. As the firm continues to grow,
each new capacity creates a new short-run average total cost curve at a higher quantity.
Each possible SRATC gives way to a long-run average total cost curve which shows
average costs for all quantities the firm can produce in the long run at every possible
capacity.
Economies of scale: When the long-run average total cost curve is downward sloping,
higher quantities have a lower average cost. This occurs for many firms as they expand
and get more efficient allowing them to minimize average costs. This is called
economies of scale.
Many businesses will eventually reach a point where continuing to expand leads to the
creation of inefficient bureaucracies, etc. which increase average costs. When this
occurs, the long-run average total cost curve will be upward sloping. That is called
diseconomies of scale.

Between the downward sloping and upward sloping portions of the long run average
total cost curve there is often a flat portion where the firm is experiencing neither
economies of scale or diseconomies of scale. This area is called constant returns to
scale. Here, as the business expands production capacity, the long run average costs
do not change. The smallest quantity of output where the LRATC is at it’s lowest is also
called “Minimum Efficient Scale.” This is the production capacity a firm must reach in
order to produce at it’s most competitive cost.
Returns to scale: One of the reasons for economies of scale is that small firms can
often increase resources used by a small amount while increasing output much more.
This is called increasing returns to scale. Some firms may increase output at the same
rate as they increase resources. That is called constant returns to scale. Other firms
may increase output at a smaller rate as they increase resources. This is called
decreasing returns to scale.
The easiest way to figure out if a firm is experiencing increasing, decreasing or constant
returns to scale is to double all inputs and see what happens to output. If output also
doubles, the firm is experiencing constant returns to scale. If output more than doubles,
it is experiencing increasing returns to scale. If output less than doubles, it is
experiencing decreasing returns to scale.

Cost Curve Math

It is important to realize the shapes of all the cost curves come from a typical
firm’s actual costs. The basic formulas were shown above but your next exam
might make things a little trickier. Below is a chart with all costs for a fictitious
firm. We will use the numbers in the chart to examine different ways to find the
different costs.

Ways to find fixed cost

1. Total cost for making a quantity of zero: The total cost in the example
above is 20 so the fixed cost is 20
2. Difference between total cost and variable cost: At the quantity of 1, the
total cost is 30 and the variable cost is 10; so, the difference is 20 (30-10).
3. Difference between average total cost and average variable cost times the
quantity: At the quantity of 2, the average total cost is 17.5 and the
average variable cost is 7.5. The difference is 10. 10 x 2 = 20, so the fixed
cost is 20.
4. Find average fixed cost times quantity: At the quantity of 4 the average
fixed cost is 5. Since 4 x 5 = 20, the fixed cost is 20.
Ways to find marginal cost
1. The change in variable cost for producing one more unit: The variable cost
for a quantity of 2 is 15 and the variable cost for 3 is $25. So, the marginal
cost for the 3rd unit produced is 10.
2. The change in total cost for one more unit: The total cost for a quantity of
4 is 60 and the total cost for 5 is 80. So, the marginal cost for the 5 th unit
produced is 20.
3. Multiply the average variable cost by the quantity to find variable cost.
Then, find the change in the variable cost for producing one more unit. At
the quantity of 4, the average variable cost is 10, so the variable cost is 40
(10 x 4 = 40). At the quantity of 5, the average variable cost is 12 so the
 variable cost is 60 (12 x 5 = 60). The change in variable cost for the 5 th unit
produced is 20 (60-40).
Ways to find variable cost
1. Add all the marginal cost up to that unit: So, if you are trying to find the
variable cost for the 6th unit, you would add the marginal cost for all
previous units produced. The marginal cost for all 6 units is 10, 5, 10, 15,
20 and 25. Add all those up and you get a variable cost of 85.
2. Total cost minus fixed cost: At a quantity of 1, the total cost is 30 and the
fixed cost is 20. So, the variable cost is 10 (30-20).
3. Average variable cost times quantity. At the quantity of 2, the average
variable cost is 7.5. Since 2 x 7.5 = 15, the variable cost for a quantity of 2
is 15.
4. Find the difference between the average total cost times the quantity and
the average fixed costs times the quantity: At the quantity of 4, the
average total cost is 15 and the average fixed cost is 5. Since 4 x 15 = 60
and 4 x 5 = 20, the total cost is 60 and the fixed cost is 20. The difference
(the variable cost) is 40 (60-20)
5. Find average variable cost times quantity: At the quantity of 5, the average
variable cost is 12. Since 5 x 12 = 60, the variable cost is 60.
Ways to find the total cost
1. Add the fixed cost and variable cost together: The first unit produced has a
fixed cost of 20 and a variable cost of 10. So the total cost of one unit is 30
(20+10).
2. Add the fixed cost and the marginal cost of each unit produced thus far: At
a quantity of 2, the fixed cost is 20. The marginal cost for the first unit is 10
and the second unit is 5. Since 20+10+5=35, the total cost of 2 units is 35
3. Add average variable cost times quantity and average fixed cost times
quantity together: At the quantity of 5, the average variable cost is 12 and
the average fixed cost is 4. Since 5 x 12 = 60 and 5 x 4 = 20, the total cost
for 5 units is 80 (60+20).
4. Find average total cost times quantity: At 6 units, the average total cost is
17.5. Since 6 x 17.5 = 105, the average total cost for 6 units is 105.
Ways to find average variable cost
1. Find variable cost (using any method above) and divide by quantity: At the
quantity of 2, the variable cost is 15. Since 15/2 = 7.5, the average
variable cost for 2 units is 7.5.
2. Difference between average total cost and average fixed cost: At the
quantity of 3, the average total cost is 15 and the average fixed cost is
6.67. Since 15 – 6.67 = 8.33.
Ways to find average total cost
1. Find total cost (using any method above) and divide by quantity: At the
quantity of 3, the total cost is 45. Since 45/3 = 15, the average total cost
for 3 units is 15.
2. Add average variable cost and average fixed cost: At the quantity of 4, the
average variable cost is 10 and the average fixed 5. Since 10 + 5 = 15, the
average total cost for 4 units is 15.
Ways to find average fixed cost
1. Find fixed cost (using any method above) and divide by quantity: At the
quantity of 5, the fixed cost is 20. Since 20/5 = 4 the average fixed cost for
5 units is 4.
2. Difference between average total cost and average variable cost: At the
quantity of 6, the average total cost is 17.5 and the average variable cost
is 14.17. Since 17.5 – 14.17 = 3.33, the average fixed cost for 6 units is
3.33.
Cost, Profit, and Revenue Run-
Down
Here is a run-down of the difference between accounting profit and economic
profit. Since this is an economics website and you’re taking an economic
principles class, economic profit is clearly the more important concept. But
make sure you remember accounting profit on exam day too!

After you read through this, practice your calculations with the 20 question Cost, Profit,
and Revenue Review game.
Revenue
Revenue is money a firm brings in from sales. Total Revenue is Price times Quantity
(TR = P x Q). You already learned about total revenue in the elasticity review.
Marginal revenue is the change in Total Revenue divided by the change in Quantity
(MR = ∆TR/∆Q). Most often the change in quantity is just one, so marginal revenue is
usually the revenue a firm brings in for producing one more unit of output.

Costs
There are two types of costs you need to know in microeconomics. Explicit costs and
implicit costs. These ideas were touched on in the opportunity cost review, but here we
are going to use terminology as it relates to a firm (business).
Explicit cost: Explicit costs are the out of pocket costs paid by the business owner.
Explicit costs for this website are the hosting fees, the cost of the software, etc.
Implicit cost: Implicit costs are the implied costs, or the value of opportunities lost
(aside from out of pocket money costs). The implicit costs associated with producing
this website include the value of my evening leisure time.

Profit
In microeconomics there are actually two types of profit you need to know: accounting
profit and economic profit.
Accounting Profit: Accounting Profit is what most people think of as profit and
although it isn’t nearly as important as economic profit, it shows up on many economics
exams.
Accounting profit is total revenue minus explicit costs. For this website, accounting profit
would be the revenue generated for the ads minus the web hosting fees and the cost of
the software.

Note: Accounting profit is always higher than economic profit.

Economic Profit: Economic Profit is much more important to economists than

accounting profit. Economic profit is Total Revenue minus Explicit and Implicit costs. So
for this website, economic profit would subtract not only the hosting and software costs
but also the cost of my time (labor) for creating the content.
On every one of the firm graphs, both implicit and explicit costs are contained within
the cost curves. So if a firm is making a profit, it is an economic profit. If they are
suffering a loss, it is an economic loss. If they are making zero economic profit
(breaking even), they are still making an accounting profit.
Breaking Even or Zero Economic Profit (AKA – Normal Profit)
When a firm is earning zero economic profit, its total revenue equals its total costs (both
implicit and explicit). On the firm graphs, price will equal the average total cost (ATC).
When that occurs, the entrepreneur will be earning whatever they could be earning
doing the next best alternative. A teacher who quits teaching to become a street
performer would break even (earn zero economic profit) if they earn a teacher’s salary
by street performing. This person would still be earning an accounting profit. They would
have to earn more than a teacher’s salary to be earning an economic profit.
Profit Maximization
One way to determine the profit maximizing quantity for a firm to produce is to
look at total revenue versus total profit. Total revenue, for a perfectly competitive
firm, will increase at a constant rate. The total cost will increase at varying rates.
When total revenue is below total cost, the firm earns a negative economic profit.
When total revenue equals total cost, the firm breaks even (earns zero economic
profit). When the total revenue is greater than total cost, the firm earns a positive
economic profit. Economic profit is maximized where total revenue is greater
than total cost by the largest margin. In the graph, to the right, Qf is the profit
maximizing quantity.
Businesses follow this same logic. The only difference is that for a business the
marginal benefit is called marginal revenue. A firm will maximize profit (total revenue –
total cost) if they produce until marginal revenue (MR) is equal to marginal cost (MC).
Producing less than the MR=MC quantity will mean MR is greater than MC so profit can
be increased by producing more. Producing more than the MR=MC quantity means MC
is greater than MR so profit will increase if less is produced. So, profit maximizing firms
will continue to produce as long as the marginal revenue is greater than or equal to the
marginal cost, but not produce any units where the marginal revenue is less than the
marginal cost.
Keys to Understanding Perfectly
Competitive Markets
Like All Profit Maximizing Firms:
• Produce the quantity where MR=MC
• Price at Demand
• Temporarily shut down when price falls below Average Variable Cost
(AVC) at the profit maximizing quantity.
• Profit/loss is determined by the gap between the ATC and the firm’s
demand curve at the profit maximizing quantity (MR=MC).

Number of Sellers: Many

Product Difference: None. All products in this market are identical.

Ability to Affect price: None

Graph: Usually drawn with 2 graphs. One for the market (AKA industry) and one for the
firm. The market graph is a standard supply and demand graph with an equilibrium price
and quantity. Since the firm is a price taker (no ability to affect price), the firm’s demand
curve is horizontal (perfectly elastic) at the market price. This demand curve is also the
firm’s average revenue (AR), marginal revenue (MR), and price (P). Together the 4
curves in one form what is often labeled MRDARP. The firm produces the quantity
where MR=MC.
Note: The cost curves for perfect competition are the same as a monopoly and
monopolistically competitive firm. The AVC and AFC are rarely needed in this graph.

Perfectly Competitive Market and Firm - Long Run Equilibrium

Barriers to entry: A barrier to entry is anything that makes it difficult for entrepreneurs
to enter the market and compete. Barriers to entry can be high start up costs, customer
loyalty, government regulation, etc. In perfectly competitive markets, barriers to entry
are low. That means, when firms are earning economic profits, competing firms seek
that profit and enter the market in the long run. When firms enter the market, prices fall
and economic profit goes to zero. When firms are earning economic losses, firms exit
the market (as resources will be more profitable elsewhere) in the long run, causing
prices to rise until economic losses are zero. In the end, low barriers to entry (and exit)
mean competitive markets earn zero economic profit in the long run.
On the graph, when firms enter the market it shifts the market supply curve to the right,
decreasing the market price and MR=D=AR=P until firms break even. When there are
economic losses in the short run, firms exit the market in the long run which shifts the
market supply curve to the left, increasing price and MR=D=AR=P until the firm breaks
even.

Note: Firms cannot enter or exit the market in the short run. The number of firms can
only change in the long run.
 Perfectly Competitive Market and Firm Short-Run Profit to Long-Run

Perfectly Competitive Market and Firm Short-Run Loss to Long-Run

Long-run Profit: No, due to the low barriers to entry.

Allocatively Efficient: Yes, because price equals marginal cost in both the short-run
and long-run.

Productively Efficient: Productive efficiency occurs when the firm is producing at the
minimum of the average total cost (ATC) curve (where it intersects the MC). In the short
run, perfectly competitive firms are not productively efficient, but in the long run they
are.
Firm’s supply curve: Below the ATC there is an average variable cost curve (AVC)
that isn’t always drawn in . The minimum point on the AVC correlates to the lowest price
a firm would be willing to accept. If the market price is above the AVC, the firm will
produce the quantity where MR=MC. As the price falls, profit will fall but the firm will
continue to produce where MR=MC. If the price continues to fall, the firm will produce
lower quantities as long as the price stays above the AVC.

Firm Supply Curve (For Any Firm)

If the price falls below the AVC, the firm shuts down (temporarily) as the firm will only
lose it’s fixed costs if it shuts down. Producing at a price below the AVC would cause
the firm to lose more than their fixed costs. If the price equals the minimum of the AVC,
the firm will produce that quantity; it is the lowest quantity the firm would produce. As a
result, the firm’s supply curve is the MC curve above the AVC.

Note: This is true for all firms. The supply curve for all firms is the MC above the AVC.

Perfect competition total revenue and total cost: Profit maximizing firms produce
where MR=MC. An alternative way to find the profit maximizing quantity is to look at a
firm’s total cost and total revenue. A perfectly competitive firm’s total revenue curve
rises at a constant rate (it is an upward sloping straight line). That is because the
marginal revenue is equal to the price and does not change. When you graph total cost
and total revenue on the same graph, you can also find the profit maximizing quantity by
finding the quantity where the total revenue is farthest above the total cost. In the graph
above, Qf would be the profit maximizing quantity. Q1 and Q2 both result in an
economic loss.

Total Cost vs Total Revenue for Profit

Market long-run supply curve: The market supply curve is actually a short-run supply
curve. That is because in the short run, the market can produce more at high prices and
less at low prices. The long-run supply curve is a perfectly elastic (horizontal) curve at
the bottom of the firm’s ATC. That is because the market price will always return to the
bottom of the ATC in the long run. If there is an increase in demand, the price will
increase and create short-term profits. Those profits will cause firms to enter the market
increasing the market quantity even more, but decreasing the price back to the long-run
price. If there is a decrease in demand, the price will fall and create short-term losses.
Those losses will cause firms to exit the market decreasing the quantity more and
returning the market price back to the bottom of the ATC. As a result, in the long-run the
market can produce any quantity at the long-run price.
 Long Run Market Supply Curve - Perfect Competition

Increasing Cost Industry: Generally questions regarding perfectly competitive firms

will be about constant cost industries. Those are industries where the firm’s cost curves
do not shift based on the equilibrium output in the market.
You could see a question or two (on the AP Micro Exam) about an increasing cost
industry. That would be a product where an increase in the market equilibrium quantity
would cause an increase in costs for the individual firm. So an increase in Qe would
cause the ATC and MC to shift upward for the firm.
 Perfect Competition - Increasing Cost Industry

Increasing cost industries occur because the long run average total cost curve for the
industry as a whole is upward sloping. Precious metals are an example increasing cost
industry because as more gold and silver is produced (through mining) the cost of
producing more constantly increases; as gold and silver become more and more difficult
and costly to mine.

A decreasing cost industry is just the opposite. Cost curves will shift downward as
industry output increases. This is as a result of the industry’s long-run average total cost
curve sloping downward. These industries capture economies of scale. Microchips are
an example of a product in a decreasing cost industry. The more that are produced, the
cheaper production typically gets.