Micro Unit 3 - Cost Curves

Explicit Costs

Out-of-pocket payments for resources like rent, wages, materials, and bills. Accountants look only at these costs.

Accounting Profit

Total Revenue minus Accounting Costs (Explicit Costs).

Implicit Costs

Indirect, non-monetary costs like foregone salary, foregone income, or time. Economists examine these.

Economic Costs

The sum of Explicit Costs and Implicit Costs.

Economic Profit

Total Revenue minus Economic Costs (Explicit and Implicit).

Normal Profit

Zero economic profit; the firm is covering all explicit and implicit costs.

Production Function

The process of transforming inputs (resources) into output; the quantity of output depends on the quantity of inputs.

Inputs (Factors)

The resources used to produce outputs.

Output

The products that firms make to earn profit. Total Product (TP)

Marginal Product (MP)

The additional output generated by adding one additional unit of input (like workers). Calculated as (Change in Total Product) / (Change in Inputs).

Average Product (AP)

Output per unit of input (e.g., per unit of labor). Calculated as (Total Product) / (Units of Labour).

Fixed Resources

Resources that DO NOT change with the quantity produced, such as tables, machinery, or rent.

Variable Resources

Resources that CHANGE with the quantity produced, such as workers or production materials.

Law of Diminishing Marginal Returns

As you add more variable inputs to fixed inputs, the additional output (Marginal Product) gained from each new input will eventually decrease.

Stage 1 of Returns

Increasing Marginal Returns. Total Product is increasing at an increasing rate due to specialization among workers.

Stage 2 of Returns

Diminishing Marginal Returns. Marginal Product is falling but still positive, and Total Product is increasing at a decreasing rate. Each additional worker adds less and less output.

Stage 3 of Returns

Decreasing Marginal Returns. Marginal Product is negative, and Total Product is decreasing. Caused by inputs interfering with each other (e.g., workers running by each other).

Short Run Costs

A period of production where at least one resource is FIXED and cannot be changed (e.g., factory size). Only variable costs can be changed.

Long Run Costs

A period of production where ALL resources are variable; there are no fixed resources (e.g., factory capacity/size can be changed).

Total Fixed Costs (FC)

Costs for fixed resources that DO NOT change with the amount produced (e.g., rent, insurance, full-time salaries).

Total Variable Costs (VC)

Costs for variable resources that CHANGE as more or less is produced (e.g., raw materials, labor, electricity).

Total Costs (TC)

The sum of Total Fixed Costs and Total Variable Costs (TC = FC + VC). The Total Cost at a quantity of ZERO is the Fixed Cost.

Average Fixed Costs (AFC)

Fixed Cost per unit of output. Calculated as (FC) / (Quantity).

Average Variable Costs (AVC)

Variable Cost per unit of output. Calculated as (VC) / (Quantity).

Average Total Costs (ATC)

Total Cost per unit of output. Calculated as (TC) / (Quantity) or AFC + AVC.

Marginal Costs (MC)

The additional cost of producing one additional unit of output. Calculated as (Change in TC) / (Change in Q).

Relationship between AFC and Output

AFC decreases as output (quantity) increases because a fixed cost is divided by a larger quantity.

Relationship between MC and MP

The Marginal Cost (MC) curve is the inverse of the Marginal Product (MP) curve. MC falls when MP increases (specialization) and rises when MP decreases (diminishing returns).

Relationship between MC and ATC/AVC

MC intersects both AVC and ATC at their respective minimum points. When MC is below the average cost, it pulls the average down; when MC is above, it pulls the average up.

Effect of Increased Fixed Costs

AFC and ATC increase. MC and AVC do not change.

Effect of Increased Variable Costs

TC, AVC, and MC all increase. ATC also increases. AFC stays the same.

Economies of Scale

A long-run condition where LRATC (Long-Run Average Total Cost) decreases as plant size and output increase. Per-unit cost falls as the firm gets larger, often due to mass production and specialization.

Diseconomies of Scale

A long-run condition where LRATC (Long-Run Average Total Cost) increases as plant size and output increase. Per-unit costs rise because the firm becomes too big and difficult to manage.

Constant Returns to Scale

A long-run condition where LRATC (Long-Run Average Total Cost) remains proportionate to output increases, meaning per-unit costs stay the same over a variety of plant sizes.

Long-Run Average Total Cost (LRATC) Curve

A curve composed of the lowest points of many different Short-Run Average Total Cost (SRATC) curves, representing the average cost for various plant sizes.

Why LDMR does NOT apply in the Long Run

The Law of Diminishing Marginal Returns (LDMR) does not apply in the long run because there are NO FIXED RESOURCES; all resources are variable.

Sunk Costs

Costs that have already been incurred (paid for) and are non-recoverable. These costs should be ignored when making decisions about future actions.

Sunk Cost Fallacy

The error of continuing to make bad decisions to try and justify past, non-recoverable investments. Market Structure:

Perfect Competition

Many small producers, identical products (perfect substitutes), low barrier to entry/exit. Firms are Price Takers, and demand is perfectly elastic (horizontal line). Market Structure:

Oligopoly

Few large producers, products are identical or differentiated, high barrier to entry. Firms exhibit Mutual Interdependence (worry about competitors' decisions). Market Structure:

Monopoly

One large firm that is the market, unique product (no close substitutes), and very high barriers to entry. The firm is a Price Controller. Market Structure:

Monopolistic Competition

Large number of sellers, differentiated products, low barriers to entry. Firms have some control over price and use a lot of advertising.

Price Taker

A firm in perfect competition that must accept the market-determined price; its demand is perfectly elastic (horizontal).

Perfectly Competitive Firm's Revenue Curves

Marginal Revenue (MR) is constant and equal to Demand (D), Average Revenue (AR), and Price (P). (MR = D = AR = P) .

Profit Maximizing Rule

Firms must produce the level of output where Marginal Revenue equals Marginal Cost (MR = MC). This rule also applies to minimizing losses.

When to Keep Producing (Short Run Loss)

A firm should continue to produce at the MR = MC quantity even if the Price (P) is below Average Total Cost (ATC), as long as P is above Average Variable Cost (AVC).

Shut Down Rule

A firm should minimize losses by shutting down production in the short run if the Price (P) falls below the Average Variable Cost (AVC). If P < AVC, the firm can't even cover its variable costs.

Perfectly Competitive Firm's Short Run Supply Curve

The firm's supply curve is the Marginal Cost (MC) curve above the Average Variable Cost (AVC) curve.

Per Unit Tax

A tax that affects Variable Costs (as you produce more). It causes MC, AVC, and ATC to all shift, which changes the profit-maximizing Quantity Produced.

Lump Sum Tax

A tax that affects only Fixed Costs (the same tax no matter how much you produce). Only AFC and ATC will shift; MC and the profit-maximizing Quantity Produced stay the same.

Long Run Equilibrium (Perfect Competition)

A market state where all perfectly competitive firms make zero economic profit (normal profit). Firms enter if there is profit and leave if there is a loss until profit = 0.

Long Run Equilibrium Condition

The lowest point on the Average Total Cost (ATC) curve is equal to Marginal Revenue, Demand, Average Revenue, and Price (Minimum ATC = MR = D = AR = P).

Constant Cost Industry (Long Run)

An industry where new firms entering the market DO NOT increase the input costs for existing firms. An increase in demand leads to the price returning to the original long-run price after entry.

Increasing Cost Industry (Long Run)

An industry where new firms entering the market DO increase the input costs for firms already in the market, causing MC and ATC curves to shift up. After demand increases and new firms enter, the new long-run price will be higher than the original price.

Productive Efficiency

Producing output at the lowest possible cost. Graphically, this is the quantity where the Average Total Cost (ATC) curve is at its minimum point.

Allocative Efficiency

Producing the amount of output that is most desired by society (where production meets all demand). Graphically, this is the quantity where Price/Demand equals Marginal Cost (P = MC).

Efficiency in Long Run Perfect Competition

Firms are both Productively Efficient (P = Minimum ATC) and Allocatively Efficient (P = MC).

Efficiency in Short Run Perfect Competition (with profit/loss)

Firms are Allocatively Efficient (MR = MC) but NOT Productively Efficient (unless they happen to be producing at the lowest ATC point).

How do Economists and Accountants differ in their calculation of profit?

Accountants only consider Explicit Costs (out-of-pocket payments) to find Accounting Profit. Economists consider both Explicit and Implicit Costs (opportunity costs like foregone salary) to find Economic Profit.

Explain the meaning of "Diminishing Marginal Returns" using the relationship between inputs and output.

Diminishing Marginal Returns occurs in the short run when adding more units of a variable input (e.g., workers) to a fixed input (e.g., factory size) eventually causes the Marginal Product (additional output) of each new input to decrease.

How does the relationship between Marginal Product (MP) and Average Product (AP) influence the AP curve?

If MP is above AP, AP is still rising (even if MP is falling). If MP is below AP, AP starts to fall. MP always intersects AP at the AP curve's highest point.

Why do the Average Total Cost (ATC) and Average Variable Cost (AVC) curves get closer but never touch as quantity increases?

The vertical distance between ATC and AVC is the Average Fixed Cost (AFC). Since AFC continually decreases as quantity increases (Fixed Cost / larger Q), the two curves get closer but never touch.

Explain how the Law of Diminishing Marginal Returns influences the shape of the Marginal Cost (MC) curve.

At first, specialization (increasing MP) causes Marginal Cost to fall. Once diminishing marginal returns set in (decreasing MP), the Marginal Cost of producing an additional unit begins to rise, giving the MC curve its "U" shape (MC is the inverse of MP). What determines the size of the profit or loss for a firm that is following the MR = MC rule?

Why do perfectly competitive firms make zero economic profit in the long run?

The low barrier to entry/exit allows firms to enter the market if there is a short-run profit (increasing supply and dropping price) or exit if there is a short-run loss (decreasing supply and raising price). This entry/exit continues until Price equals the minimum Average Total Cost (P = Min ATC), resulting in zero economic profit.

What two types of efficiency does long-run perfect competition achieve, and what are their graphical conditions?

It achieves Productive Efficiency (P = Minimum ATC) and Allocative Efficiency (P = MC/D). Both are met because in the long run, P = MR = MC = Minimum ATC.