CHAPTER 11: OUTPUT AND COSTS
The biggest decision that an entrepreneur makes is what industry to establish a firm. Their
background knowledge and interests drive their decision. Decision also depends on the
expectation that total revenue will exceed total cost.
Firm makes many decisions to achieve its main objective: profit maximization
To study the relationship between a firm’s output decision and its cost, we distinguish between
two decision time frames:
• The short run: time frame in which the quantity of at least one factor of production is
fixed. For most firms, capital, land, and entrepreneurship are fixed factors of production
and labour is the variable factor of production. Fixed factors of production are called the
firm’s plant: in the short run, a firm’s plant is fixed. Short run decisions are easily
• The long run: time frame in which the quantities of all factors of production can be
varied. That is the long run is a period in which the firm can change its plant. Long-run
decisions are not easily reversed.
- Sunk cost: cost incurred by the firm and cannot be changed. They are irrelevant
to firm’s current decisions.
To increase output in the short run, a firm must increase the quantity of labour employed. We
describe the relationship between output and the quantity of labour employed by using three
• Total product: the maximum output that a given quantity of labour can produce.
• Marginal product: the increase in total product that results from a one-unit increase in
the quantity of labour employed, other inputs remaining the same.
• Average product: is equal to the total product divided by the quantity of labour
Product Curves: graphs of the relationships between employment and the three product
concepts you’ve just studied. They show how total product, marginal product, and average
product change as employment changes.
1 Total Product Curve: similar to PPF. It separates attainable output levels from those that are
unattainable. Only the points on the total product curve are technologically efficient.
Marginal Product Curve: The height of a bar measures marginal product. Marginal product is
also measured by the slope of the total product curve.
The total product and marginal product curves differ across firms and types of goods. But the
shapes of the product curves are similar because almost every production process has two
• Increasing Marginal Returns initially: increasing marginal returns occur when the
marginal product of an additional worker exceeds the marginal product of the previous
worker. Arises from increased specialization and division of labour.
• Diminishing marginal returns eventually: occur when the marginal product of an
additional worker is less than the marginal product of the previous worker. Arise from the
fact that more and more workers are using the same capital and working in the same
space. As more workers are added, there is less and less for the additional workers to
do that is productive.
The law of diminishing returns: As a firm uses more of a variable factor of production, with a
given quantity of a fixed factor of production, the marginal product of the variable factor
Average Product Curve: average product is largest marginal product and average product are
equal on the graph (they cut each other). For the number of workers at which marginal product
exceeds average product, average product is increasing. For the number of workers at which
marginal product is less than average product, average product is decreasing.
2 To produce more output in the short run, a firm must employ more labour, which means that it
must increase its costs. We describe the relationship between output and cost by using three
• Total Cost: (TC) is the cost of all the factors of production it uses. We separate total cost
into total fixed cost and total variable cost.
- Total Fixed Cost (TFC): is the cost of the firm’s fixed factors. Fixed costs do not
change with output
- Total Variable Cost (TVC): is the cost of the firm’s variable factors. Total variable
cost changes as output changes.
- Total cost is the sum of total fixed cost and total variable cost. That is,
→ TC = TFC + TVC
• Marginal Cost: (MC) increase in total cost that result from a one-unit increase in total
- we calculate MC as the increase in TC divided by the increase in output (Total
- over the output range with increasing marginal returns, marginal costs falls as
- over the output range with diminishing marginal returns, marginal cost rises as
• Average Cost: average cost measures can be derived from each of the total cost
- Average Fixed Cost (AFC): total fixed cost per unit of output
- Average Variable Cost (AVC): total variable cost per unit of output
- Average Total Cost (ATC): total cost per unit of output
→ ATC = AFC + AVC (to get this, divide each term by quantity produced Q)
Why the Average Total Cost (ATC) is curve U-Shaped:
• Initially marginal product exceeds average product, which brings rising average product
and falling AVC
3 • Eventually marginal product falls below average product, which brings falling average
product and rising AVC
• The ATC curve is U-Shaped for the same reasons
The shapes of a firm’s cost curves are determined by the technology it uses:
• MC is at its minimum at the same output level at which marginal product is at its
• When marginal product is rising, marginal cost is falling
• AVC is at its minimum at the same output level at which average product is at its
• When average product is rising, average variable cost is falling
Shifts in Cost curve
• The position of a firm’s short-run cost curves depends on two factors:
- Technological change influences both the productivity curves and the cost
- An increase in productivity shifts the average and marginal product
curves upward and the average and marginal cost curves downward.
- If a technological advance brings more capital and less labour into use,
fixed costs increase and variable costs decrease
- Prices of Factors of Production:
- An increase in the price of factors of production increases costs and shifts
the cost curves.
- An increase in a fixed cost shifts the total cost (TC) and average total cost
(ATC) curves upward but does not shift the marginal cost (MC) curve.
- An increase in a variable cost shifts the total cost (TC), average total cost
(ATC), and marginal cost (MC) curves upward.
4 In the long run, all inputs are variable and all costs are variable.
• The Production Function:
- The behaviour of long-run costs depends upon the firm’s production function.
- The firm’s production function is the relationship between the maximum output
attainable and the quantities of both capital and labour.
• Diminishing Returns: occur with each of the four plant sizes as the quantity of labour
increases. As the firm increases the quantity of labour employed, the marginal product of
labour (eventually) diminishes.
• Diminishing Marginal Product of Capital:
- Diminishing returns also occur with each quantity of labour as the quantity of
- The marginal product of capital is the increase in output resulting from a one-unit
increase in the amount of capital employed, holding constant the amount of
- A firm’s production function exhibits diminishing marginal returns to labour (for a
given plant) as well as diminishing marginal returns to capital (for a quantity of
- For each plant, diminishing marginal product of labour creates a set of short run,
U-Shaped cost curves for MC, AVC, and ATC.
• Short-Run Cost and Long-Run Cost
- The average cost of producing a given output varies and depends on the firm’s
- The larger the plant, the greater is the output at which ATC is at a minimum.
- The firm has 4 different plants: 1, 2, 3 , or 4 knitting machines.
- Each plant has a short-run ATC curve
- The firm can compare the ATC for each output at different plants.
- Long run average cost curve (LRAC): the relationship between the lowest
attainable average total cost and output when the firm can change both the plant
it uses and quantity of labour it employs. Consists of 4 short-run ATC curves
5 • Economies and Diseconomies of Scale
- Economies of Scale: are features of a firm’s technology that lead to falling long-
run average cost as output increases
- Diseconomies of Scale: are features of a firm’s technology that lead to a rising
long-run average cost as output increases
- Constant returns to Scale: are features of a firm’s technology that lead to
constant long-run average cost as output increases.
• Minimum Efficient Scale:
- Defined as the smallest output at which long-run average cost reaches its lowest
- If the long-run average cost curve is U-shaped, the minimum point identifies the
minimum efficient scale output level.
- A firm experiences economies of scale up to some output level
- Beyond that output level, it moves into constant returns to scale or diseconomies
CHAPTER 12: PERFECT COMPETITION
Perfect Competition: is a market in which
• Many firms sell identical products to buyers
• There are no restriction on entry into the market
• Established firms have no advantage over new ones
• Sellers and buyers are well informed about prices
Perfect competition arises:
• When firm’s minimum efficient scale is small relative to market demand so there is room
for many firms in the industry
• And when each firm is perceived to produce a good or service that has no unique
characteristics, so consumers don’t care which firm they buy from
6 • In perfect competition, each firm is a price taker
• A price taker is a firm that cannot influence the price of a good or service because its
production is an insignificant part of the total market.
• No single firm can influence the price—it must “take” the equilibrium market price.
• Each firm’s output is a perfect substitute for the output of the other firms, so the demand
for each firm’s output is perfectly elastic.
Economic Profit and Revenue:
• The firm’s goal is to maximize economic profit, which equals total revenue minus total
• A firms total revenue equals price, P, multiplied by quantity sold, Q, or P x Q.
• A firm`s marginal revenue is the change in total revenue that results from a one-unit
increase in the quantity sold.
• The demand for a firm`s product is perfectly elastic because one firm`s sweater is a
perfect substitute for another firm`s sweater
• The market demand is not perfectly elastic because a sweater is not a perfect substitute
for other goods.
• The goal of the competitive firm is to maximize economic profit, given constraints it
faces. To achieve its goal, a firm must decide:
1. How to produce at minimum cost
2. What quantity to produce
3. Whether to enter or exit a market
The Firm`s Output Decision—Marginal Analysis and Supply Decision:
• The firm can use marginal analysis to determine the profit-maximizing output
• Because marginal revenue is constant and marginal cost eventually increases as output
increases, profit is maximized by producing the output at which marginal revenue, MR,
equals marginal cost, MC.
7 Temporary Shutdown Decision:
• If the firm makes an economic loss it must decide to exit the market or to stay in the
• If the firm decides to stay in the market, it must decide whether to produce something or
to shut down temporarily
• The decision will be the one that minimizes the firm’s loss
• The firm’s loss equals Total Fixed Cost (TFC) plus Total Variable Cost (TVC) minus Total
- Economic loss = TFC + TVC – TR
- = TFC + (AVC – P) x Q
• If the firm shuts down, Q is zero and the firm still has to pay its TFC
• So the firm incurs an economic loss equal to TFC
• This economic loss is the largest that the firm must bear
• A firm’s shutdown point is the price and quantity at which it is indifferent between
producing and shutting down
• This point is where AVC is at its minimum
• It is also the point at which the MC curve crosses the AVC curve
8 • At the shutdown point, the firm is indifferent between producing and shutting down
• The firm incurs a loss equal to TFC from either action
The Firm’s Supply Curve:
• A perfectly competitive firm’s supply curve shoes how the firm’s profit maximizing output
varies as the market price varies, other things remaining the same.
• Because the firm produces the output at which marginal cost equals marginal revenue,
and because marginal revenue equals price, the firm’s supply curve is linked to its
marginal cost curve
• But at a price below the shutdown point, the firm produces nothing.
Output, Price, and Profit in the Short Run—Market Supply in the Short Run:
• The short run market supply curve shows the quantity supplied by all the firms in the
market at each price when each firm’s plant and the number of firms remain the same.
The quantity supplied by the market at a given price is the sum of the quantities
supplied by all the firms in the market
• Short-run Equilibrium: market demand and short-run market supply determine the
market price and market output.
9 • Changes in demand bring changes in short-run market equilibrium. If demand
increases and the demand curve shifts rightward (D3), the market price rises. If the
demand decreases and the demand curve shift leftward (D1), the price falls. If the
demand curve shifts farther than (D1), the market price remains at the same price as
(D1) because market supply curve is horizontal at that price.
Profits and Losses in the Short-Run:
• Economic profit (or loss) per sweater is price, P, minus average total cost, ATC. So
economic profit (or loss) is (P – ATC) x Q. If price equals average total cost, a firm
breaks even – the entrepreneur makes normal profit. If price exceeds average total cost
the firm makes an economic profit. If the price is less than average total cost, the firm
incurs an economic loss.
Three Short-run outcomes for the firm
Entry and Exit:
• New firms enter a market in which existing firms are making an economic profit
• As new firms enter a market, the market price falls and the economic profit of each firm
• Entry occurs in a market when new firms come into the market and the number of firms
• Exit occurs when existing firms leave a market (normally when they are having an
economic loss) and the number of firms decreases
• As firms leave a market, the market price rises and the economic loss incurred by the
remaining firms decreases
• Entry and exit stop when firms make zero economic profit
• Entry results in an increase in the market output, but each firm’s output decreases.
Because the price falls, each firm moves down its supply curve and produces less.
Because the number of firms increases, the market produces more.
11 • Exit results in a decrease in market output, but each firm’s output increases. Because
the price rises, each firm moves up its supply curve and produces more. Because the
number of firms decreases, the market produces less.
• Check page 284 for example on the graphs work!
• When economic profit and economic loss have been eliminated and entry and exit
stopped, a competitive market is in long-term equilibrium. (this rarely happens)
Changing Taste and Advancing Technology
• Changes in technology are constantly lowering the costs of production
• The demand for and supply of some items increases and the demand for and supply of
• The market for recorded music illustrates changes in demand that arise from changing
tastes and changes in supply that arise from advances in technology
Permanent Change in Demand:
• A decrease in demand shifts the market demand curve leftwards.
• These graphs illustrates the effects of a permanent decrease in demand when the
market is in long-run equilibrium
External Economies and Diseconomies:
• External Economies are factors beyond the control of an individual firm that lower the
firm’s costs as the market output increases.
12 • External Diseconomies are factors outside the control of a firm that raise the firm’s
costs as the market output increases.
• Long-run market supply curve shows how the quantity supplied in a market varies as
the market price varies after all the possible adjustments have been made, including
changes in each firm’s plant and the number of firms in the market.
• New technologies are constantly discovered that lower cost techniques of production
• New technology enables firms to produce at lower average cost and lower marginal cost
—firms’ cost curves shifts downward
• Firms that adopt the new technology make an economic profit (cost curves shift
• With lower costs, firms are willing to supply a given quantity at a lower price or,
equivalently, they are willing to supply a larger quantity at a given price. (market supply
increases and market supply curve shifts rightward.
Efficient Use of Resources:
• Resources are used efficiently when we produce the goods and services that people
value most highly. If someone can be better off without anyone else be worse off,
resources are not being used efficiently.
- (Ex. suppose we produce a computer that no one wants and no one will ever
use, and, at the same time, some people are clamouring for more video games.
If we produce fewer computes and reallocate the unused resources to produce
more video games, some people will be better off and no one will be worse off)
• This situation arises when marginal social benefit equals marginal social cost
• When market for a good or service is in equilibrium, the gains from trade are maximized
CHAPTER 13: MONOPOLY
Monopoly is a market:
• That produces a good or service for which no close substitute exists
• In which there is one supplier that is protected from competition by a barrier preventing
the entry of new firms selling that good or service
How monopoly arises:
Monopoly has two key features:
13 • No close substitutes
- if a good has a close substitute, that firm effectively faces competition from the
producers of the substitute
- a monopoly sells a good that has no close substitute
• Barrier to entry
- A constraint that protects a firm from potential competitors is called a barrier to
- Three types of barriers are:
Natural Barrier to Entry:
• They create a natural monopoly
- Natural monopoly is an industry in which economies of scale enable one firm to
supply the entire market at the lowest possible cost. (Ex. Firms that deliver gas,
water, electricity to our homes)
• An ownership barriers to entry occurs if one