AP Microeconomics Unit 3 Notes: How Firms Produce Output and What It Costs

Production

The process a firm uses to transform inputs (resources/factors of production) into output (goods or services).

Factors of Production (Inputs)

Resources used to produce output, such as labor (L) and capital (K); they are scarce and therefore have costs.

Output

The quantity of goods or services produced by a firm (often denoted Q).

Production Function

A technical relationship showing the maximum output a firm can produce from given inputs and technology; often written as Q = f(L, K).

Short Run (Production)

The time period in which at least one input is fixed (often capital) and at least one input is variable (often labor).

Long Run (Production)

The time period in which all inputs are variable; the firm can change plant size, number of machines, and production processes.

Fixed Input

An input whose quantity cannot be changed in the short run (commonly capital, such as factory size or machines).

Variable Input

An input whose quantity can be changed in the short run (commonly labor).

Total Product (TP)

The total quantity of output produced at a given combination of inputs.

Marginal Product of Labor (MPₗ)

The additional output produced by hiring one more unit of labor while holding other inputs constant; MPₗ = ΔQ/ΔL.

Average Product of Labor (APₗ)

Output per unit of labor; APₗ = Q/L.

Law of Diminishing Marginal Returns

In the short run, as more units of a variable input are added to fixed inputs, the marginal product of the variable input will eventually decline.

Marginal Cost (MC)

The additional cost of producing one more unit of output; MC = ΔTC/ΔQ (and also MC = ΔTVC/ΔQ in the short run).

MC = w/MPₗ Relationship

When labor is the variable input and wage per worker is constant at w, marginal cost equals the wage divided by marginal product of labor: MC = w/MPₗ (so falling MP implies rising MC).

Total Fixed Cost (TFC)

Costs that do not change with output in the short run (e.g., rent, lease payments); paid even when Q = 0.

Total Variable Cost (TVC)

Costs that change as output changes, usually tied to variable inputs like labor and materials.

Total Cost (TC)

The sum of fixed and variable costs: TC = TFC + TVC.

Average Fixed Cost (AFC)

Fixed cost per unit of output; AFC = TFC/Q (falls as Q increases).

Average Variable Cost (AVC)

Variable cost per unit of output; AVC = TVC/Q.

Average Total Cost (ATC)

Total cost per unit of output; ATC = TC/Q = AFC + AVC.

Long-Run Average Total Cost (LRATC)

The lowest possible average total cost of producing each output level when all inputs are variable; formed as an “envelope” of the lowest points of many short-run ATC curves (different plant sizes).

Economies of Scale

A long-run situation where LRATC falls as output increases (larger scale lowers per-unit cost).

Diseconomies of Scale

A long-run situation where LRATC rises as output increases (larger scale raises per-unit cost, often due to coordination and bureaucracy problems).

Returns to Scale

How output changes when all inputs are increased proportionally: increasing returns (output more than proportional), constant returns (output proportional), decreasing returns (output less than proportional).

Minimum Efficient Scale (MES)

The lowest output level at which the firm achieves the minimum (or near-minimum) LRATC; indicates the smallest efficient firm size in an industry.