3.
1 The Production Function
Skill 1.A Describe economic concepts, principles, or models.
Learning Objectives: a. Define (using graphs where appropriate) key terms and concepts
relating to production and cost. b. Explain (using graphs where appropriate) how production
and cost are related in the short run and long run. c. Calculate (using data from a graph or table
as appropriate) the various measures of productivity and short-run and long-run costs
Short Run vs Long Run
Ø Long Run is when all resources used in production are variable and supply can adjust to
changes in demand.
Ø Short Run, is where at least one production input is fixed and supply cannot fully adjust to
changes in demand.
Total Product
Ø Total quantity of goods and services produced
Marginal Product
Ø Extra output that arises from an additional unit of that input
Average Product
Ø Output per unit of labor input, called productivity
Four Laws
1. Law of Diminishing Marginal Returns / Diminishing Marginal Product / Diminishing
Marginal Returns
n As a firm adds an increasing number of variable resources to at least one fixed resource,
the additional production each new worker adds will eventually decrease.
2. MP intersects AP at its highest point. MP < AP, AP is decreasing; MP > AP, AP is increasing.
3. MP is increasing, TP increases at an increasing rate; MP is decreasing, TP increases at a
decreasing rate.
4. TP is maximized when MP = 0.
3.2 Short-Run Production Costs
Skill 4.A Draw an accurately labeled graph or visual to represent an economic model or market.
Learning Objectives: a. Define (using graphs where appropriate) key terms and concepts
relating to production and cost. b. Explain (using graphs where appropriate) how production
and cost are related in the short run and long run. c. Calculate (using data from a graph or table
as appropriate) the various measures of productivity and short-run and long-run costs.
Production Costs
Ø Total fixed costs are those that do not vary with changes in output. In the short run these
costs stay constant. Examples are rent, insurance, and capital equipment.
Ø Total variable costs vary as output changes. Examples of variable costs include changes in
the number of employees, travel expenses, and energy costs related to production changes.
Ø Total Cost = Fixed Cost + Variable Costs.
Marginal Cost (MC): Marginal cost is the change in total cost / total variable cost from the
production of one more unit of output.
MC>AVC is the firm’s short term supply curve.
MC>ATC is the firm’s long term supply curve.
Average Fixed Costs (AFC) & Average Variable Costs (AVC) & Average Total Cost (ATC)
Four Laws
1. AFC decreases continuously.
2. The vertical distance between AVC and ATC is AFC.
3. Marginal cost curve and marginal product curve are mirror images. The MC curve increases
because of diminishing marginal product.
4. The MC curve intersects both the AVC and ATC at its minimum points.
3.3 Long-Run Production Costs
Skill 1.D Describe the similarities, differences, and limitations of economic concepts,
principles, or models.
Learning Objectives: a. Define (using graphs where appropriate) key terms and concepts
relating to production and cost. b. Explain (using graphs where appropriate) how production
and cost are related in the short run and long run. c. Calculate (using data from a graph or table
as appropriate) the various measures of productivity and short-run and long-run costs.
The long-run average total cost curve, or LRATC, is the relationship between output and
average total cost when fixed cost has been chosen to minimize average total cost for each level
of output.
Economies of Scale
ü The long-run average total cost curve (LRATC) decreases as output increases.
ü This is also known as increasing returns to scale, where if inputs are increased by X percent,
output increases more than X percent.
ü Sources: increased specialization & large initial setup cost.
Constant Returns to Scale
ü The long-run average total cost curve remains constant as production increases or
decreases.
ü If inputs are increased by X percent, output increases exactly X percent.
Diseconomies of Scale
ü The long-run average total cost curve increases as a firm’s output increases.
ü This is also known as decreasing returns to scale, where if inputs are increased by X percent,
output increases less than X percent.
ü Sources: coordination and communication
Minimum Efficient Scale
ü Productive efficiency is said to exist when production takes place at the lowest average
cost.
ü The output level at which lowest cost production starts is called the minimum efficient
scale (MES) of production.
3.4 Types of Profit
Skill 1.C Identify an economic concept, principle, or model using quantitative data or
calculations.
Learning Objectives: a. Define the different types of profit. b. Explain how firms respond to
profit opportunities. c. Calculate a firm’s profit or loss.
Accounting Profit = Total Revenue – Explicit Costs
Economic Profit = Total Revenue – (Explicit Cost+ Implicit Cost)
Economic Profit = Accounting Profit - Implicit Cost
Normal Profit = zero economic profit
3.5 Profit Maximization
Skill 2.A Using economic concepts, principles, or models, explain how a specific economic
outcome occurs or what action should be taken in order to achieve a specific economic outcome.
Learning Objectives: a. Define (using graphs or data as appropriate) the profit-maximizing rule.
b. Explain (using a graph or data as appropriate) the profit-maximizing level of production.
Firms maximize profits by setting quantity where marginal revenue equals marginal cost.
MR = MC
3.6 Firms’ Short-Run Decisions to Produce and Long-Run Decisions to Enter or
Exit a Market
Skill 2.A Using economic concepts, principles, or models, explain how a specific economic
outcome occurs, or what action should be taken in order to achieve a specific economic
outcome.
Learning Objectives: Explain (using graphs or data where appropriate) firms’ short-run
decisions to produce positive output levels, or long-run decisions to enter or exit a market in
response to profit-making opportunities.
Economic Loss: P < ATC
Economic Profit: P > ATC
Short-Run
ü Stay in the market: P > AVC
ü Shut Down: P < AVC
Long-Run
ü Enter the market: P > ATC
ü Exit the market: P < ATC
3.7 Perfect Competition
Skill 4.A Draw an accurately labeled graph or visual to represent an economic model or market.
Learning Objectives: a. Define (using graphs as appropriate) the characteristics of perfectly
competitive markets and efficiency. b. Explain (using graphs where appropriate) equilibrium
and firm decision making in perfectly competitive markets and how prices in perfectly
competitive markets lead to efficient outcomes. c. Calculate (using data from a graph or table
as appropriate) economic profit (loss) in perfectly competitive markets.
Four Market Structures
Characteristics of A Perfectly Competitive Firm
1. Large Numbers of Sellers
2. Identical/Homogeneous Products
3. Firms are price takers, where they have no influence on the market price of the product they
produce
Ø MR = D = AR = P is perfectly elastic regardless of how many units the firm sells. The
price stays constant and each additional unit sells for the same price regardless of the
quantity sold.
4. No barriers to entry. (firms can freely enter or exit the market)
² Short-Run Loss
Existing firms will exit the market.
² Short-Run Profit
New firms will enter the market.
² Long-Run Equilibrium
Efficiency
1. Allocative Efficiency is when a firm produces the socially optimal output level where P /
MB = MC. This output level means the exact amount that society desires is being produced.
2. Productive Efficiency is when a good is being produced where MC = ATC, which is the
lowest possible cost.
The Long-Run Industry Supply Curve
v Constant-Cost Industry: In a constant-cost industry, the firms’ cost curves are unaffected
by changes in the size of the industry.
n When demand increases, price goes up in the short run and remain constant in the long
run. Thus, the long-run industry supply curve is horizontal and perfectly elastic.
v Increasing-Cost Industry: In an increasing-cost industry, the firms’ production costs
increase with the size of the industry.
n When demand increases, price goes up in the short run and increases in the long run.
Thus, the long-run industry supply curve is upward-sloping.
v Decreasing-Cost Industry: In a decreasing-cost industry the firms’ production costs
decrease as the industry grows.
n When demand increases, price goes up in the short run and decreases in the long run.
Thus, the long-run industry supply curve is downward-sloping.
