Production

● average product Output per unit of a particular input.

The theory of the firm describes how a firm makes ● marginal product Additional output produced as an
cost-minimizing production decisions and how the firm’s input is
resulting cost varies with its output. increased by one unit.

The Production Decisions of a Firm ● labor productivity Average product of labor for an
1.​ Production Technology entire industry or for the economy as a whole.
2.​ Cost Constraints
3.​ Input Choices Productivity and the Standard of Living
● stock of capital Total amount of capital available for use in
factors of production Inputs into the production process production.
(e.g., labor, capital, and materials).
q= F (K,L) ● technological change Development of new technologies
allowing factors of production to be used more effectively.
production function Function showing the highest
● isoquant Curve showing all possible combinations of inputs
output that a firm can produce for every specified
that yield the same output.
combination of inputs.
● isoquant map Graph combining a number of isoquants,
● short run Period of time in which quantities of one or used to describe a production function.
more production factors cannot be changed.
● fixed input Production factor that cannot be varied. ● marginal rate of technical substitution (MRTS) Amount by
● long run Amount of time needed to make all which the quantity of one input can be reduced when one extra
production inputs variable. unit of another input is used, so that output remains constant.

Average Product: ❖​ When the isoquants are straight lines, the MRTS is
constant. Thus the rate at which capital and labor can
= Capital(K) / Labor(L)
be substituted for each other is the same no matter
Marginal Product: ​
what level of inputs is being used.
= (Q)Total Output 2- Total Output 1
● fixed-proportions production function Production function
with L-shaped isoquants, so that only one combination of labor Total Revenue
and capital can be used to produce each level of output. -​ The amount a firm receives for the sale of its output.
(Quantity x Price)
The fixed-proportions production function describes situations
in which methods of production are limited. Total Cost
-​ The market value of the inputs a firm uses in
production.
❖​ When the isoquants are L-shaped, only one
combination of labor and capital can be used to
produce a given output

Profit is the firm’s total revenue minus its total cost.

● returns to scale Rate at which output increases as inputs
Profit = Total revenue - Total cost
are increased proportionately.

● increasing returns to scale Situation in which output more

Explicit and Implicit Costs
than doubles when all inputs are doubled.
Explicit costs are input costs that require a direct outlay of
● constant returns to scale Situation in which output doubles money by the firm.
when all inputs are doubled.
Implicit costs are input costs that do not require an outlay of
● decreasing returns to scale Situation in which output less money by the firm.
than doubles when all inputs are doubled.
ECONOMIC PROFIT total revenue minus total cost, including
both explicit and implicit costs.
WHAT ARE COSTS?
ACCOUNTING PROFIT as the firm’s total revenue minus only
According to the Law of Supply:
the firm’s explicit costs.
-​ Firms are willing to produce and sell a greater quantity
of a good when the price of the good is high.
-​ This results in a supply curve that slopes upward.
 Total Costs
❖​ When total revenue exceeds both explicit and implicit ●​ Total Fixed Costs (TFC)
costs, the firm earns economic profit. ●​ Total Variable Costs (TVC)
●​ Total Costs (TC)
❖​ Economic profit is smaller than accounting profit. ●​ TC = TFC + TVC

The production function shows the relationship between Average Costs

quantity of inputs used to make a good and the quantity of Average costs can be determined by dividing the firm’s costs
output of that good. by the quantity of output it produces.

The marginal product of any input in the production process The average cost is the cost of each typical unit of product.
is the increase in output that arises from an additional unit of
that input.
Average Costs
●​ Average Fixed Costs (AFC)
Diminishing marginal product is the property whereby the
●​ Average Variable Costs (AVC)
marginal product of an input declines as the quantity of the
●​ Average Total Costs (ATC)
input increases.
●​ ATC = AFC + AVC
-​ The slope of the production function measures the
marginal product of an input, such as a worker.
-​ When the marginal product declines, the production
function becomes flatter.

THE VARIOUS MEASURES OF COST

Fixed costs are those costs that do not vary with the quantity
of output produced.

Variable costs are those costs that do vary with the quantity
of output produced.
 ● Efficient scale is the quantity that minimizes average total
Marginal Cost cost.
Marginal cost (MC) measures the increase in total cost that
arises from an extra unit of production. Three Important Properties of Cost Curves

● Marginal cost eventually rises with the quantity of output.

● The average-total-cost curve is U-shaped.

● The marginal-cost curve crosses theaverage-total-cost curve

Cost Curves and Their Shapes at the minimum of average total cost.

● The average total-cost curve is U-shaped.

COSTS IN THE SHORT RUN AND
● At very low levels of output average total cost is high IN THE LONG RUN
because fixed cost is spread over only a few units.
-​ In the short run, some costs are fixed.
● Average total cost declines as output increases. -​ In the long run, all fixed costs become variable
costs.
● Average total cost starts rising because average variable
cost rises substantially. Because many costs are fixed in the short run but variable in
the long run, a firm’s long-run cost curves differ from its
● The bottom of the U-shaped ATC curve occurs at the short-run cost curves.
quantity that minimizes average total cost. This quantity is
sometimes called the efficient scale of the firm.
Economies and Diseconomies of Scale
● Whenever marginal cost is less than average total cost,
● Economies of scale refer to the property
average total cost is falling.
whereby long-run average total cost falls as the quantity of
output increases.
● Whenever marginal cost is greater than average total cost,
average total cost is rising.
● Diseconomies of scale refer to the property whereby
long-run average total cost rises as the quantity of output
● The marginal-cost curve crosses the aver8age-total-cost
increases.
curve at the efficient scale.
● Constant returns to scale refers to the property whereby Division of Labor: workers divide up the tasks in such a
long-run average total cost stays the same as the quantity of way that each can build up a momentum and not have to
output increases.
switch jobs

Profit: The money that business makes: Revenue minus

Diminishing Returns: the notion that there exists a point
Cost
where the addition of resources increases production but does
so at a decreasing rate
Cost: the expense that must be incurred in order to produce
goods for sale
Costs
Revenue: the money that comes into the firm from the sale Fixed Costs: costs of production that we cannot change
of their goods
Variable Costs: costs ofproduction that we can change
Economic Cost: All costs, both those that must be paid as
well as those incurred in the form of forgone opportunities, of a Cost Concepts
business
Marginal Cost: the addition to cost associated with one
Accounting Cost: Only those costs that must be explicitly additional unit of output
paid by the owner of a business
Average Total Cost: Total Cost/Output, the cost per unit of
Production Function: a graph which shows how many production
resources we need to produce various amounts of output
Average Variable Cost: Total Variable Cost/Output, the
Cost Function: a graph which shows how much various average variable cost per unit of production
amounts of production cost
Average Fixed Cost: Total Fixed Cost/Output, the average
fixed cost per unit of production
Inputs to Production
Fixed Inputs: resources that you cannot change

Variable Inputs: resources that can be easily changed

FORMULA: Economic Cost versus Accounting Cost

● accounting cost Actual expenses plus depreciation

MC= TVC 2- TVC1 / Output 2- Output 1 charges for capital equipment.
ATC= TC/ Output ● economic cost Cost to a firm of utilizing economic
AVC= TVC/Output resources in production, including opportunity cost.
AFC= TFC/Output ● opportunity cost Cost associated with opportunities that
TR= Quantity x Price are forgone when a firm’s resources are not put to their best
MR= Change in TR/ Change in Quantity alternative use.
● sunk cost Expenditure that has been made and cannot be
recovered. Sunk costs are costs that have been incurred and
Marginal Revenue: additional revenue the firm receives
cannot be recovered.
from the sale of each unit

Market Forms Amortizing Sunk Costs

● amortization Policy of treating a one-time expenditure as
Perfect Competition: a situation in a market where there an annual cost spread out over some number of years.
are many firms producing the same good

Monopoly: a situation in a market where there is only one

Fixed Costs and Variable Costs
firm producing the good
● total cost (TC or C) Total economic cost of production,
consisting of fixed and variable costs.
Rules of Production
● fixed cost (FC) Cost that does not vary with the level of
output and that can be eliminated only by shutting down.
A firm should
● variable cost (VC) Cost that varies as output varies.
a.​ produce an amount such that Marginal
Revenue equals Marginal Cost (MR=MC), unless

b.​ the price is less than the average variable cost

(P<AVC).
Shutting Down
Shutting down doesn’t necessarily mean going out of user cost of capital Annual cost of owning and using a
business. capital asset, equal to economic depreciation plus forgone
interest.
By reducing the output of a factory to zero, the company could
eliminate the costs of raw materials and much of the labor. The isocost line Graph showing all possible combinations of
only way to eliminate fixed costs would be to close the doors, labor and capital that can be purchased for a given total cost.
turn off the electricity, and perhaps even sell off or scrap the
machinery. expansion path Curve passing through points of tangency
between a firm’s isocost lines and its isoquants.

marginal cost (MC) Increase in cost resulting from the Long-Run Average Cost
production of one extra unit of output.
● long-run average cost curve (LAC) Curve relating
average total cost (ATC) Firm’s total cost divided by its average cost of production to output when all inputs, including
level of output. capital, are variable.

● short-run average cost curve (SAC) Curve relating

average fixed cost (AFC) Fixed cost divided by the level of average cost of production to output when level of capital is
output. fixed.

average variable cost (AVC) Variable cost divided by the ● long-run marginal cost curve (LMC) Curve showing
level of output. the change in long-run total cost as output is increased
incrementally by 1 unit.
Diminishing Marginal Returns and Marginal Cost Economies and Diseconomies of Scale
Diminishing marginal returns means that the marginal product
● economies of scale Situation in which output can be
of labor declines as the quantity of labor employed increases. doubled for less than a doubling of cost.

As a result, when there are diminishing marginal returns, ● diseconomies of scale Situation in which a doubling of
marginal cost will increase as output increases. output requires more than a doubling of cost.
Increasing Returns to Scale: Output more than doubles Profit = Total Revenue (TR) - Total Cost (TC)
when the quantities of all inputs are doubled.

Economies of Scale: A doubling of output requires less Marginal revenue is the additional revenue per product.
than a doubling of cost.
Average revenue is the revenue per product.
Economies and Diseconomies of Scope

● economies of scope Situation in which joint output of a

single firm is greater than output that could be achieved by two
different firms when each produces a single product.

● diseconomies of scope Situation in which joint output of

a single firm is less than could be achieved by separate firms
when each produces a single product.

Profit Maximization: Pure Competition

Market is a place where buyers and sellers meet and
exchange goods or services. There are certain conditions
which create the structure of a market. It classified to:
1.​ Pure (Perfect) Competition
2.​ Monopolistic Competition EP : Equilibrium Point; point of profit maximization. MR = MC
3.​ Oligopoly
4.​ Monopoly

Monopoly
Pure Competition
●​ A firm that is the sole seller of a product without close
A purely competitive industry has the
substitutes
1.​ Many sellers
●​ The ability to influence the market price of the product
2.​ Low barriers to enter
it sells
3.​ Competitors’ products are identical
●​ Other firms cannot enter the market to compete with it
4.​ Buyers have perfect information
 ● A monopoly firm maximizes profit by producing
Increasing Q has two effects on revenue: the quantity at which marginal revenue equals
marginal cost.
➢​ Output effect: higher output raises revenue ➔​ Sets the price at which that quantity is demanded. P >
➢​ Price effect: lower price reduces revenue MR, so P > MC

Marginal revenue, MR < P ● A monopolist’s profit-maximizing level of output is below the

level that maximizes the sum of consumer and producer
➢​ To sell a larger Q, the monopolist must reduce the price
surplus.
on all the units it sells ➔​ Causes deadweight losses
➢​ Is negative if price effect > output effect
● A monopolist can often increase profits by charging different
prices for the same good based on a buyer’s willingness to
P = AR, same as for a competitive firm. pay.
➔​ Price discrimination can raise economic welfare
MR < P, whereas MR = P for a competitive firm. ➔​ Perfect price discrimination, the deadweight loss of
monopoly is completely eliminated
Price Discrimination
●​ Sell the same good at different prices to different Perfect competition (no market power)
buyers ●​ large number of relatively small buyers and sellers
●​ A firm can increase profit by charging a higher price to ●​ standardized product
buyers with higher willingness to pay ●​ very easy market entry and exit
●​ Requires the ability to separate customers according to ●​ non-price competition not possible
their willingness to pay
●​ Can raise economic welfare Oligopoly (product differentiation and/or the firm’s
dominance of the market)
SUMMARY ●​ small number of large mutually interdependent firms
● Monopoly increases production by 1 unit ●​ differentiated or standardized product
➔​ Causes the price of its good to fall, which reduces the ●​ market entry and exit difficult
amount of revenue earned on all units produced. ●​ non-price competition important
➔​ Marginal revenue is always below the price
Pricing and Output Decisions in Perfect
Competition
The point where P=MR=MC is the optimal output (Q*)

economic loss The firm incurs a loss. At optimum output,

price is below AC

Contribution margin: the amount by which total revenue

exceeds total variable cost

Shutdown point: the lowest price at which the firm would

still produce
❖​ At the shutdown point, the price is equal to the
minimum point on the AVC
❖​ If the price falls below the shutdown point, revenues fail
to cover the fixed costs and the variable costs. The firm
would be better off if it shut down and just paid its fixed
costs.

In the long run, the price in the competitivemarket will settle at

the point where firms earn a normal profit over the long run.
➔​ Economic profit invites entry of new firms
●​ Shifts the supply curve to the right
●​ Puts downward pressure on price
●​ Reduces profits to normal levels
➔​ Economic loss causes exit of firms
●​ Shifts the supply curve to the left
●​ Puts upward pressure on price
●​ Increases profits to normal levels.