Production = Converting

inputs into output

 Inputs and Outputs
• To earn profit, firms must make products (output)
• Inputs are the resources used to make outputs.
• Input resources are also called FACTORS.
•Total Physical Product (TP)- total output or quantity
produced
•Marginal Product (MP)- the additional output
generated by additional inputs (workers).
Change in Total Product
Marginal Product =
Change in Inputs
•Average Product (AP)- the output per unit of input
Total Product
Average Product =
Units of Labor 2
 Fixed vs. Variable
• Fixed Resources- Resources that don’t
change with the quantity produced
– Ex: Table, scissors, and stapler
• Variable Resources- Resources that do
change with the quantity produced
– Ex: Workers, paper, and staples
Identify three fixed resources and
three variable resources for a pizza
restaurant
3
 Production Analysis
•What happens to marginal product as you hire
more workers?
•Why does this happens?
The Law of Diminishing Marginal Returns
As variable resources (workers) are added to
fixed resources (ovens, machinery, tool, etc.), the
additional output produced from each additional
worker will eventually fall.

Too many cooks in

the kitchen!
4
Notice that as you hire
more workers the
additional links each
additional worker
creates begins to
decrease
This is because of the
fixed resources and the
Law of Diminishing
Marginal Returns
5
 Three Stages of Returns
Stage I: Increasing Marginal Returns
MP rising. TP increasing at an increasing rate.
Why? Specialization.
Total
Product
Total
Product

Quantity of Labor

Marginal
and
Average Average Product
Product

Quantity of Labor 6
Marginal Product
 Three Stages of Returns
Stage II: Decreasing Marginal Returns
MP Falling. TP increasing at a decreasing rate.
Why? Fixed Resources. Each worker adds less and less.
Total
Product
Total
Product

Quantity of Labor

Marginal
and
Average Average Product
Product

Quantity of Labor 7
Marginal Product
 Three Stages of Returns
Stage III: Negative Marginal Returns
MP is negative. TP decreasing.
Workers get in each others way
Total
Product
Total
Product

Quantity of Labor

Marginal
and
Average Average Product
Product

Quantity of Labor 8
Marginal Product
 With your partner calculate MP and AP then discuss
what the graphs for TP, MP, and AP look like.
Remember quantity of workers goes on the x-axis.
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 70 9
 Identify the three stages of returns
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0 - -
1 10 10 10
2 25 15 12.5
3 45 20 15
4 60 15 15
5 70 10 14
6 75 5 12.5
7 75 0 10.71
8 70 -5 8.75 10
 More Examples of the Law of Diminishing
Marginal Returns
Example #1: Learning curve when studying for an exam
Fixed Resources-Amount of class time, textbook, etc.
Variable Resources-Study time at home
Marginal return-
▪1st hour-large returns
▪2nd hour-less returns
▪3rd hour-small returns
▪4th hour- negative returns (tired and confused)
Example #2: A Farmer has fixed resource of 8 acres
planted of corn. If he doesn’t clear weeds he will get 30
bushels. If he clears weeds once he will get 50 bushels.
Twice -57, Thrice-60. Additional returns diminishes each
time. 11
 Short-Run
Production Costs
 Definition of the “Short-Run”
• We will look at both short-run and long-run
production costs.
• Short-run is NOT a set specific amount of
time.
• The short-run is a period in which at least one
resource is fixed.
– Plant capacity/size is NOT changeable
• In the long-run ALL resources are variable
– NO fixed resources
– Plant capacity/size is changeable
Today we will examine short-run costs
13
2010 Question 19

14
 Different Economic Costs
Total Costs
FC = Fixed Costs
VC = Variable Costs
TC = Total Costs
Per Unit Costs
AFC = Average Fixed Costs
AVC = Average Variable Costs
ATC = Average Total Costs
MC = Marginal Cost 15
 Definitions
Fixed Costs:
Costs for fixed resources that DON’T change
with the amount produced
Ex: Rent, Insurance, Managers Salaries, etc.
Average Fixed Costs = Fixed Costs
Quantity
Variable Costs:
Costs for variable resources that DO change as
more or less is produced
Ex: Raw Materials, Labor, Electricity, etc.
Variable Costs
Average Variable Costs =
Quantity 16
 Definitions
Total Cost:
Sum of Fixed and Variable Costs

Average Total Cost = Total Costs

Quantity
Marginal Cost:
Additional costs of an additional output.
Ex: If the production of two more output
increases total cost from $100 to $120, the MC
$10
is _____.
Change in Total Costs
Marginal Cost =
Change in Quantity 17
 Calculating Costs
Variable Fixed Total Marginal
Output
Cost Cost Cost Cost AVC AFC ATC
0 $0 $10 $10 - - - -
1 $10 $10 $20 $10 $10 $10 $20
2 $17 $10 $27 $7 $8.50 $5 $13.50
3 $25 $10 $35 $8 $8.33 $3.33 $11.66
4 $40 $10 $50 $15 $10 $2.50 $12.50
5 $60 $10 $70 $20 $12 $2 $14
6 $110 $10 $120 $50 $18.33 $1.67 $20

Notice that the AVC + AFC = ATC

18
Calculating Costs
AVC AFC ATC
- - -
$10 $10 $20
$8.50 $5 $13.50
$8.33 $3.33 $11.66
$10 $2.50 $12.50
$12 $2 $14
$18.33 $1.67 $20

19
Costs MC
$20
ATC
$18 AVC
$16
$14
ATC and AVC get
$12 closer and closer but
$10 NEVER touch
$8
$6 Average
Fixed Cost
$4
$2 AFC

1 2 3 4 5 6 Quantity 20
Costs MC
$20
ATC
$18 AVC
$16
$14
$12
$10
Calculate TC,
$8
VC, and FC of
$6
$4
the 5th Unit
$2 AFC

1 2 3 4 5 6 Quantity 21
 How much does the 10th unit
Costs costs?
MC
$30 ATC
25
AVC
20
15 Calculate TC,
10 VC, and FC
5
AFC
0
7 8 9 10 11 Quantity 22
Per-Unit Costs (Average and Marginal)

At output Q, what
area represents:
TC 0CDQ
VC 0BEQ
FC 0AFQ or BCDE

23
 Calculating TC, VC, FC, ATC, AFC,
and MC …TRY YOURSELF
TP VC FC TC MC AVC AFC ATC
0 0 100
1 10 100
2 16 100
3 21 100
4 26 100
5 30 100
6 36 100
7 46 100
24
 Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 40.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
25
 Shifting Cost
Curves
A change in fixed costs change ATC
and AFC (but not MC)
A change in variable costs change
ATC, AVC, and MC

26
 Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
27
 Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10What if Fixed
100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 Costs increase to
21 100 121 5 7 33.3 30.3
4 26 100 126 3 6.5 25 31.5
5 30
$200
100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
28
 Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 100 - - - -
1 10 200 110 10 10 100 110
2 16 200 116 6 8 50 58
3 21 200 121 5 7 33.3 30.3
4 26 200 126 5 6.5 25 31.5
5 30 200 130 4 6 20 26
6 36 200 136 6 6 16.67 22.67
7 46 200 146 10 6.6 14.3 20.9
29
 Shifting Costs Curves
If fixed costs change ONLY AFC and ATC Change!
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 200 210
2 16 200 216 6 8 100 108
3 21 200 221 5 7 66.6 73.6
4 26 200 226 5 6.5 50 56.5
5 30 200 230 4 6 40 46
6 36 200 236 6 6 33.3 39.3
7 46 200 246 10 6.6 28.6 35.2
MC and AVC DON’T change! 30
 Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 What if the cost for
10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 variable resources
21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30
increase
100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
31
 Shifting Costs Curves

TP VC FC TC MC AVC AFC ATC

0 0 100 100 - - - -
1 11 100 110 10 10 100 110
2 18 100 116 6 8 50 58
3 24 100 121 5 7 33.3 30.3
4 30 100 126 5 6.5 25 31.5
5 35 100 130 4 6 20 26
6 43 100 136 6 6 16.67 22.67
7 55 100 146 10 6.6 14.3 20.9
32
 Shifting Costs Curves
If variable costs change MC, AVC, and ATC Change!
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 111 11 11 100 111
2 18 100 118 7 9 50 59
3 24 100 124 6 8 33.3 41.3
4 30 100 130 6 7.5 25 32.5
5 35 100 135 5 7 20 27
6 43 100 143 8 7.16 16.67 23.83
7 55 100 155 12 7.8 14.3 22.1
33
 Per Unit vs. Lump Sum
A PER UNIT tax or subsidy is effects
the VARIABLE COSTS so MC, AVC,
and ATC will shift.
This WILL effect the quantity produced
A LUMP SUM tax or subsidy only
effects FIXED COSTS so only AFC and
ATC will shift. MC stays the same.
This WILL NOT effect the quantity produced

34
Long-Run Costs

35
 Definition of the “Short-Run”
• We will look at both short-run and long-run
production costs.
• Short-run is NOT a set specific amount of
time.
• The short-run is a period in which at least one
resource is fixed.
– Plant capacity/size is NOT changeable
• In the long-run ALL resources are variable
– NO fixed resources
– Plant capacity/size is changeable
Today we will examine LONG-run costs.
36
In the long run all resources are variable. Plant
capacity/size can change.
Why is this important?
The Long-Run is used for planning. Firms use to identify
which plant size results in the lowest per unit cost.
Ex: Assume a firm is producing 100 bikes with a fixed
number of resources (workers, machines, etc.).
If this firm decides to DOUBLE the number of resources,
what will happen to the number of bikes it can produce?
There are only three possible outcomes:
1. Number of bikes will double (constant returns to scale)
2. Bikes will more than double (increasing returns to scale)
3. Bikes will less than double (decreasing returns to scale)

37
ECONOMIES OF SCALE
Why does economies of scale occur?
• Firms that produce more can better use Mass
Production Techniques and Specialization.
Example:
• A car company that makes 50 cars will have a very high average
cost per car.
• A car company that can produce 100,000 cars will have a low
average cost per car.
• Using mass production techniques, like robots, will cause total cost
to be higher but the average cost for each car would be
significantly lower.
Long Run ATC
What happens to the average total costs of a product when a firm increases its
plant capacity?
Long Run ATC curve is made up of all the different short run ATC curves of
various plant sizes. 38
Long Run AVERAGE Total Cost

Costs MC1
ATC1

$9,900,000

$50,000

$6,000

$3,00
0
0 1 100 1,000 100,000 1,000,0000
39
Quantity Cars
Long Run AVERAGE Total Cost
Economies of Scale- Long
Costs MC1 Run Average Cost falls
ATC1 because mass production
MC2 techniques are used.
$9,900,000
ATC2
$50,000

$6,000

$3,00
0
0 1 100 1,000 100,000 1,000,0000
40
Quantity Cars
Long Run AVERAGE Total Cost
Economies of Scale- Long
Costs MC1 Run Average Cost falls
ATC1 because mass production
MC2 techniques are used.
$9,900,000 MC3

ATC2
$50,000 ATC3

$6,000

$3,00
0
0 1 100 1,000 100,000 1,000,0000
41
Quantity Cars
Long Run AVERAGE Total Cost
Constant Returns to Scale-
Costs MC1 The long-run average total
ATC1 cost is as low as it can get.
MC2
$9,900,000 MC3
MC4
ATC2
$50,000 ATC3 ATC4

$6,000

$3,00
0
0 1 100 1,000 100,000 1,000,0000
42
Quantity Cars
Long Run AVERAGE Total Cost
Diseconomies of Scale-
MC1 Long run average costs
Costs
ATC1 increase as the firm gets too
big and difficult to manage.
MC2
$9,900,000 MC5
MC3
MC4 ATC5
ATC2
$50,000 ATC3 ATC4

$6,000

$3,00
0
0 1 100 1,000 100,000 1,000,0000
43
Quantity Cars
Long Run AVERAGE Total Cost
These are all short run
Costs MC1 average costs curves.
ATC1 Where is the Long Run
MC2
Average Cost Curve?
$9,900,000 MC5
MC3
MC4 ATC5
ATC2
$50,000 ATC3 ATC4

$6,000

$3,00
0
0 1 100 1,000 100,000 1,000,0000
44
Quantity Cars
Long Run AVERAGE Total Cost
The law of diminishing marginal returns doesn’t apply in
the long run because there are no FIXED RESOURCES.
Costs
Economies Constant Diseconomi
of Scale Returns to es of Scale
Scale

Long Run
Average Cost
Curve

45
 Economies and
Diseconomies
Returns to Scale of Scale
(increasing and decreasing
Economies of Scale returns to scale)

LRATC = Long Run

Average Total Cost
(Long Run ATC)

Economies of scale: falling average costs as output increases. In other

words, lower average costs achieved as the firm increases its size. It
explains the downward sloping portion of the LRATC curve.
◆ Factors giving rise to Economies of Scale: specialization of labour, efficiency and
indivisibilities of large machines and mass production, spreading costs of
marketing over larger volumes of output.
Diseconomies of scale are increasing average costs as output
increases. It explains the upward sloping part of the LRATC curve
◆ Factors giving rise to Diseconomies of Scale: co-ordination and monitoring
difficulties as firm grows larger, communication difficulties and poor worker
motivation.
Minimum Efficient Scale
Point on the LRAC that represents lowest level of output at which the
lowest ATC is achieved. Economies of scale have been exhausted.
● MES & Market Structure: MES tells us if an industry is likely to
consist of many firms, few firms or even a single large monopoly
○ MES at low output level, only small fraction of total market - Industry
will have many firms of varying sizes e.g. Retail; light industry
○ MES at high output level, large proportion of total market - industry
has small number of large firms (Oligopoly) e.g. airlines, heavy industry,
car manufacturing etc.
○ “Natural Monopoly” - MES at output level so high firm can supply
whole market without exhausting its economies of scale. Single
large firm dominates entire market. Firm often has large “network
effects” e.g. firm supplying gas, electricity, water, sewage or telephones
■ Government may nationalise or heavily regulate such monopolies
 Economies of Scale: As output increases average costs of production fall.

Reasons for Economies of Scale….

• Specialisation - in small firms a manager may perform many roles (e.g. personnel,
procurement, legal affairs, marketing). This may be inefficient as not be trained for all these
roles. Larger firm can hire specialist staff, work more efficiently, reducing operating costs.
• Bulk Buying - larger firms can negotiate discounts with their suppliers for larger orders of
variable (and fixed) inputs.
• Large machines (technical specialisation) - some machinery is considered too large,
specialised or too expensive for small firms to own and operate.
• Promotional economies - sales and marketing costs tend not to scale with output. It is as
expensive to market one car as to market 10,000! So costs of promotion per unit falls.
• Transport economies - larger firms may be charged less for delivery, or because they
have large enough output to deliver they may decide to buy own transportation to reduce
costs
• Financial economies - large firms can raise financial capital (get money) more quickly and
at lower cost (lower interest rates) since banks generally consider them a lower risk than
smaller firms. Network economies - where a firm has invested in delivery network
infrastructure, increasing output by adding extra customers to that network may not add
proportionately to costs. Average costs fall as output rises.
Reasons for Diseconomies of Scale
1. Control and communication problems - As firm
grows, management finds it harder to coordinate
activity. Leads to increasing inefficiencies In the real world
economists have not
found any strong
evidence for
2. Alienation / loss of identity for labour - Workers diseconomies of
and management in larger firms start to feel they scale ever being
don’t really matter (just a small cog in a big greater than
machine).. Workers become less productive. economies of scale.

3. Increased Competition & Congestion - Real world LRAC might

increased competition in industry for raw material end up as flat at high
output levels (constant
and qualified labour. Pushes up production costs returns) rather than
for individual firms. upward sloping.
Diminishing Returns (SR) vs. Diminishing Returns to Scale (LR)
● Diminishing returns (diminishing marginal product) occur only
in the short run. Impact on costs as variable input is added to
fixed input.
● Decreasing returns to scale occurs only in the long run,
showing what happens to output when all inputs are variable.

DIMINISHING RETURNS occur in the short run. It shows what

happens to output as a variable input is added to a fixed input.

Increasing and Decreasing RETURNS TO SCALE occur in the long

run. It shows what happens to output when all inputs are variable.
 Shapes of
Cost Curves
Why does marginal cost always go
down then up?
Costs MC

Quantity 52
 Relationship between Production and Cost
Output
As more workers are hired, their
marginal product increases and
then eventually decreases
because of the law of
diminishing marginal returns
MP
The additional costs (MC) of the
Quantity of labor
Costs units they produce fall when MP
MC
goes up, but eventually increase
as additional workers produce
less and less output
MP and MC are mirror
images of each other
Quantity of output 53
•Why is the MC curve U-shaped? The MC curve falls and
then rises because of diminishing marginal returns.
•Example: Assume the fixed cost is $20 and the ONLY variable cost
is the cost for each worker (Wage = $10)
Workers Total Prod Marg Prod Total Cost Marginal Cost
0 0 - $20 -
1 5 5 $30 10/5 = $2
2 13 8 $40 10/8 = $1.25
3 19 6 $50 10/6 = $1.6
4 23 4 $60 10/4 = $2.5
5 25 2 $70 10/2 = $5
6 26 1 $80 10/1 = $10
•The additional cost of the first 13 units produced falls
because workers have increasing marginal returns.
•As production continues, each worker adds less and less to
54
production so the marginal cost for each unit increases.
 Relationship between Production and Cost
Costs MC Why does ATC go down
ATC then up?
•When the marginal cost is
below the average, it pulls
the average down.
•When the marginal cost is
above the average, it pulls
Quantity the average up.
MC intersects the ATC curve at ATC’s lowest point
Example:
•The average income in the room is $50,000.
•An additional (marginal) person enters the room: Bill Gates.
•If the marginal is greater than the average it pulls it up.
•Notice that MC can increase but still pull down the average.
55
Revenue and Profit
Revenue = Price x Quantity

56
 Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
•To maximum profit firms must make the right
output
•Firms should continue to produce until the
additional revenue from each new output
equals the additional cost.
Example (Assume the price is $10)
• Should you produce…
…if the additional cost of another unit is $5
…if the additional cost of another unit is $9
…if the additional cost of another unit is $11 57
 Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
•To maximum profit firms must make the right
output
Profit Maximizing Rule
•Firms should continue to produce until the
additional revenue from each new output
MR=MC
equals the additional cost.
Example (Assume the price is $10)
• Should you produce…
…if the additional cost of another unit is $5
…if the additional cost of another unit is $9
…if the additional cost of another unit is $11 58
 Normal Profit (or zero economic profit)
• Normal profit is the minimum revenue a firm must receive to make it worthwhile to
stay in business. In other words, the total revenue that is just sufficient to cover the
economic costs (both explicit and implicit costs). A firm will continue to operate at
this point as it has covered all its opportunity costs.
● Implicit costs are opporutnity costs. Include payment for forgone income from self-owned
resources like entrepreneurship, rent if place owned, etc
● Firm earning normal profit (zero economic profit) will keep operating because covering
their opportunity cost; can’t be better off.
● Total revenue equals total economic costs where P = min ATC.
• This is called the break-even point of the firm.

• The Break-even price is same in the SR and LR; is where P = min ATC.
• Shut-down price, however, in the short run is P = minimum AVC. Firms stop producing when
price falls below minimum AVC. Between minAVC and minATC still produces even making a
loss because at least covers part of the fixed costs. Loses less by producing then by stopping to
produce.
• In the long run shut down price is P = minimum ATC. Firms stop producing when price falls
below minimum ATC as no longer stuck with fixed cost.
When economists refer to ‘costs’ they mean ‘economic costs’ (which include opportunity costs -> implicit costs)

Implicit Costs & Economics Costs

• Explicit costs are the actual costs to a firm. What firm spends
money on to produce. e.g. energy costs, labour costs, rent for factory etc.

• Implicit costs are things firm doesn’t actually spend money

on, but that they could be earning on. It's the sacrificed
income arising from use of self-owned resources
• Ex: in the case of an office building owned and used by the firm, the
opportunity cost is the rental income that could have been earned if the building
were rented out (opportunity cost of foregone rental income)
• Ex2: The hours of work an owner puts into his business also has an
opportunity cost, and it equal to what the firm owner could be earning if he had
been working somewhere else (opportunity cost of foregone salary)

• Economic costs are the sum of explicit and implicit costs (total
opportunity costs incurred), whether purchased or self-owned.
 Accountants vs. Economists
Accountants look at only EXPLICIT COSTS
•Explicit costs (out of pocket costs) are payments
paid by firms for using the resources of others.
•Example: Rent, Wages, Materials, Electricity Bills
Accounting Total
Profit Accounting Costs
Revenue (Explicit Only)
Economists examine both the EXPLICIT COSTS and
the IMPLICIT COSTS
•Implicit costs are the opportunity costs that firms
“pay” for using their own resources
•Example: Forgone Wage, Forgone Rent, Time
Economic Total
Economic Costs
Profit Revenue 61
(Explicit + Implicit)
 Accountants vs. Economists
Accountants look at only EXPLICIT COSTS
•Explicit costs (out of pocket costs) are payments
paid by firms for using the resources of others.
•Example: Rent, Wages, Materials, Electricity Bills
From now
Accounting on, all costs
Total
Accounting Costs
we discuss
Profit Revenue will be(Explicit Only)
Economists ECONOMIC COSTSCOSTS and
examine both the EXPLICIT
the IMPLICIT COSTS
•Implicit costs are the opportunity costs that firms
“pay” for using their own resources
•Example: Forgone Wage, Forgone Rent, Time
Economic Total
Economic Costs
Profit Revenue 62
(Explicit + Implicit)
 Practice
Assume the following:
• David left his job as a lawyer earning $8,000 a
month to open up an ice cream shop
• Last month he sold 5,000 sundaes for $2 each
and 8,000 cones for $1 each
• His rent is $1000 per month
• His other expenses like labor, ice cream, cones,
etc. add up to $9,000 per month
• Last month he took a family vacation that cost
$5000
1. Calculate David’s accounting profit
2. Calculate David’s economic profit
3. Should David go back to being a lawyer?
4. What must be true for accounting profit if
economic profit is zero?
No Economic Profit = Normal Profit
 Normal Profit
In an efficient competitive market, firms that have
identical products will make a normal profit.
They will break even and make no economic profit
Traffic Analogy
When there is heavy traffic,
why do all lanes go the same
slow speed?
Cars leave slower lanes and
enter faster lanes.
Similarly, what happens in
perfectly competitive markets
if firms earn excessive profit?
64
Short REVIEW!!!!

65
 Fixed vs. Variable Costs
Variable costs - the more you produce, the greater the variable
cost. Include raw materials, wages, inputs of production….
Labor (workers/wage) is an example of a variable cost since producing a greater
quantity of a good or service typically requires more workers or more work hours.

Fixed costs are costs that do not change as output changes.

Whether you produce a lot or a little, the fixed costs are the same.
One example is rental payments. They do not increase if the firm produces more
and do not decrease if it produces less. Even if firm decides to shutdown, it still has
to keep paying these. Other examples include interest payments on loans,
advertisement to popularize the brand name, machinery costs, etc
Fixed costs arise only in the short-run, as in the long-run there are no fixed inputs
In the long run all costs become variable costs.
(the lease on your rental contract expires, you finish paying interest payments, etc)
 Short Run vs. Long Run
Short-run (SR)
The firms has both fixed and variable costs.
Total cost in short-run = fixed + variable costs.
The time period during which at least one input is
fixed and cannot be changed by the firm.

Long-run (LR)
Time period when all inputs can be changed.
There are no fixed costs in the Long Run!!!
Does not correspond to a particular period of time - varies by firm / industry.
Product Curves
Total product (TP)
Total quantity of output produced

Average Product (AP)

Tells us how much output each worker produces on average.
Amount of output per worker on average.
AP = Total Product
units of labor where units of labor (# of workers) is the variable input

Marginal Product (MP)

Additional output resulting from one additional worker.
Tells us by how much total output increases if we add one addition worker.
MP = △ Total Product
△units of labor where units of labor (# of workers) is the variable input
Law of Diminishing Returns
(aka Law of diminishing marginal product)

Law of Diminishing Returns states that there will be a point beyond which the
total output will continue to increase for each worker added but at a slower rate.
Additions of the input yield progressively smaller increases in output.
The law first kicks in when MP is maximum. After that, when MP starts going
down. Does not mean total produciton is decreasing (it actually still increases) but at
a slower rate. The additional unit bring in a marginal less than the unit before.
Means that the extra output produced by each additional unit of labor is
decreasing.

While Marginal Product (MP) is

A greater than Average Product (AP),
B
AP is increasing (MP>AP) (A)
MP curve always crosses AP curve
at its highest point (B)
 COST CURVES shifts due to two factor:
changes in resource prices
changes in technology
Which curves are affected depends on whether the
Costs Curves price change involves fixed or variable costs.

Total costs Average Costs

In the short run, a firm’s total ● Average Fixed Costs (AFC)
costs are the sum of fixed and ● Average Variable Costs (AVC)
variable costs. ● Average Total Costs (ATC)
● Marginal Cost (MC)

In the long run there are no fixed

costs, so total costs simply equal
the variable costs

AFC (Average FIXED Cost) curve falls continuously

as output increases (because fixed costs are fixed
and you divide by an ever growing quantity of
output)
Marginal Cost (Cost Curves continued…)
Marginal cost (MC)
Additional cost of producing one more unit of output.
Tells us by how much total costs increases if we produce one
more unit.
-------------------→

Kindly note that MC can also be calculated by △TVC/△Q as

TFC is fixed and doesn’t change as output changes

The MC curve intersects both the AVC and ATC curves at their
minimum points
When MC is below AVC, AVC is falling (& when above AVC, AVC is rising)
When MC is below ATC, ATC is falling (& when above ATC, ATC is rising)
Product curves (MP & AP) are
mirror images of the cost
curves (MC & AVC)

Marginal Product & Cost

As marginal product (MP) of labour
increases, the marginal cost (of
one more unit of output) falls.
Average Product & Cost
● When AP is at its maximum;
AVC is minimum (when workers
produce at their max, labour
costs per unit are at lowest)
● When AP is increasing, each
additional unit of output needs
less labour so AVC falls.
 ….further explanation
Product curves and Cost curves mirror images form each other.

When the marginal product (MP) increases, this means that the extra
output produced by each addition worker is increasing, and therefore
the extra cost of producing each addition unit of output (MC) is falling

If the additional output of each worker is rising, the additional cost of

each extra unit of output (marginal cost) must be falling / If the
additional output of each worker is falling, the additional cost of each
extra unit of output (marginal cost) must be rising

Maximum marginal product occurs when marginal cost at minimum.

◆ When AP is at maximum, AVC is at minimum.
◆ When AP is increasing, the AVC is falling
◆ When AP is falling, the AVC is increasing
 ATC = AVC+AFC
We don’t need to draw the AFC

Drawing Cost Curves curve. It can be derived from

distance between ATC and AVC.

AFC = Distance between ATC

and AVC curves.
If asked to draw cost
curves, this is a useful
template.

Be extra careful to
show MC cutting ATC
(or just AC) and AVC
at their lowest points.

Also ATC and AVC

must be converging
as output increases
(since AFC falls as
output rises)
Revenue
Total revenue (TR)
How much the firm receives from selling it’s unites (Price x Quantity)

Average Revenue (AR)

How much you receive per unit. It’s just the price. AR=TR/Q=PxQ/Q=P
AR is always equal to P (the price of the product). Therefore if you
know AR, you know the price of the product.

Marginal Revenue (MR)

Additional revenue from selling one more unit of output.
Tells us by how much total revenue increases if we produce one more
unit.
MR = △TR
△Q
MR = MC (where firms produce; not D=S)
PROFIT MAXIMIZATION level of output
Is where MR = MC (not where Demand = Supply)
When MR > MC each additional unit produced earns
more revenue than the additional cost of production.
Firm will seek to increase production to earn more profit
When MR < MC each additional unit produced earns less
revenue than the additional cost of production. Firm will
seek to reduce production to reduce losses
MR=MC is the only point where the firm cannot improve
its position. Profit is maximised.