Unit 3: Production, Cost, and the Perfect Competition Model

Production

The process of turning inputs (resources) into outputs (goods and services) to earn profit.

Factors of Production (Inputs)

Resources used to produce goods and services; commonly grouped as land, labor, capital, and entrepreneurship.

Fixed Input

An input whose quantity does not change in the relevant time horizon (e.g., plant size or major machinery in the short run).

Variable Input

An input whose quantity can be changed in the relevant time horizon (often labor in the short run).

Short Run

A period in which at least one input is fixed, so the firm has limited input flexibility.

Long Run

A period in which all inputs are variable, so the firm can adjust plant size and scale of operation.

Production Function

The relationship between quantities of inputs used and the quantity of output produced, holding technology constant.

Total Product (TP)

The total quantity of output produced.

Marginal Product (MP)

The change in total output resulting from a change in one unit of an input (holding other inputs constant).

Average Product (AP)

Output per unit of input (e.g., Q ÷ L for labor).

Marginal Product of Labor (MPₗ)

The change in output when labor increases by one unit: MPₗ = ΔQ ÷ ΔL.

Average Product of Labor (APₗ)

Output per unit of labor: APₗ = Q ÷ L.

Productivity Relationships (TP, MP, AP)

MP determines TP’s slope: MP rising → TP rises at increasing rate; MP falling but positive → TP rises at decreasing rate; MP = 0 → TP max; MP < 0 → TP falls. Also, if MP > AP then AP rises; if MP < AP then AP falls.

Law of Diminishing Marginal Product

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 decrease.

Fixed Costs (FC)

Costs that do not change with output in the short run (e.g., rent, some equipment leases).

Variable Costs (VC)

Costs that change with output (e.g., labor, raw materials, energy tied to production).

Total Cost (TC)

The sum of fixed and variable costs: TC = FC + VC.

Average Fixed Cost (AFC)

Fixed cost per unit of output: AFC = FC ÷ Q; it always falls as Q rises.

Average Variable Cost (AVC)

Variable cost per unit of output: AVC = VC ÷ Q.

Average Total Cost (ATC)

Total cost per unit of output: ATC = TC ÷ Q.

Marginal Cost (MC)

The additional cost of producing one more unit: MC = ΔTC ÷ ΔQ (and in the short run MC = ΔVC ÷ ΔQ because FC does not change).

U-Shaped Marginal Cost Curve

MC typically falls at first (rising marginal product/specialization) and then rises (diminishing marginal product makes extra output require more variable input).

MC Intersects AVC at Minimum AVC

The marginal cost curve crosses the average variable cost curve at AVC’s lowest point (MC below AVC pulls AVC down; MC above AVC pushes AVC up).

MC Intersects ATC at Minimum ATC

The marginal cost curve crosses the average total cost curve at ATC’s lowest point (MC below ATC pulls ATC down; MC above ATC pushes ATC up).

Long-Run Average Total Cost (LRATC)

The lowest achievable per-unit cost at each output level when the firm can choose among all plant sizes (the long-run “planning curve”).

Returns to Scale

How output changes when all inputs are increased proportionally in the long run.

Increasing Returns to Scale

When all inputs rise by a given percentage, output rises by a greater percentage.

Constant Returns to Scale

When all inputs rise by a given percentage, output rises by the same percentage (e.g., inputs double and output doubles).

Decreasing Returns to Scale

When all inputs rise by a given percentage, output rises by a smaller percentage.

Economies of Scale

A range where LRATC falls as output increases (often due to specialization, spreading setup costs, and bulk purchasing/logistics).

Diseconomies of Scale

A range where LRATC rises as output increases (often due to coordination problems, bureaucracy, and communication delays).

Minimum Efficient Scale (MES)

The lowest output level at which LRATC is minimized (or near-minimized); beyond MES, per-unit costs don’t fall much with more output.

Accounting Profit

Revenue minus explicit costs (costs that require a direct money payment).

Economic Profit

Revenue minus explicit costs minus implicit costs (opportunity costs).

Explicit Costs

Out-of-pocket monetary payments by the firm (e.g., wages, rent payments, materials).

Implicit Costs

Opportunity costs of resources the firm already owns/uses (e.g., owner’s foregone salary).

Total Revenue (TR)

Revenue from sales: TR = P × Q.

Marginal Revenue (MR)

The additional revenue from selling one more unit: MR = ΔTR ÷ ΔQ.

Normal Profit (Zero Economic Profit)

When TR = TC in the economic sense, so the firm covers explicit and implicit costs (including opportunity cost).

Profit-Maximizing Rule (MR = MC)

A firm maximizes profit by producing the quantity where marginal revenue equals marginal cost; produce up to the last unit where MR ≥ MC.

Perfect Competition

A market model with many buyers/sellers, identical products, price-taking firms, free entry/exit in the long run, and (in the ideal model) perfect information.

Price Taker

A firm that cannot influence market price and must accept the market price as given.

Firm Demand Curve in Perfect Competition

Perfectly elastic (horizontal) at the market price because the firm can sell any quantity at that price but cannot charge more.

P = MR = AR (Competitive Firm)

In perfect competition, each additional unit sells for price P, so MR = P and average revenue AR = TR ÷ Q = P.

Shutdown Rule (Short Run)

A firm should shut down if P < AVC at the profit-maximizing quantity; operate if P ≥ AVC (even if P < ATC).

Competitive Firm’s Short-Run Supply Curve

The portion of the firm’s MC curve above the minimum of AVC (because below min AVC the firm shuts down).

Market Supply (Horizontal Summation)

The market supply curve found by adding the quantities supplied by all firms at each price.

Allocative Efficiency

Producing where marginal benefit equals marginal cost; in perfect competition (no externalities), this occurs where P = MC.

Productive Efficiency

Producing at the lowest possible cost, which occurs at the minimum of ATC.

Long-Run Competitive Equilibrium

In perfect competition with free entry/exit, firms earn normal profit and the equilibrium satisfies P = ATC and P = MC (implying production at min ATC).