Unit 3 - Production, Cost, and the Perfect Competition Model Guide

Production function: relation between the quantity of inputs a firm uses and the quantity of output it produces.

Fixed input: an input whose quantity doesn’t change.

Variable input: an input whose quantity can change.

Long run: time period in which all inputs can be variable.

Short run: time period in which at least 1 input is fixed.

Marginal product: change in overall output when input changes.

Marginal product of labor (MPL): \frac{\Delta Q}{\Delta L}

Diminishing marginal returns: as input increases, the output of each input will be less than the previous input.

Output: quantity produced.

Rental rate: price of capital.

Capital: goods that are used to produce goods/services.

Fixed cost: cost that doesn’t change with the amount of output produced.

Variable cost: cost that changes with the amount of output produced.

Total cost: fixed cost + variable cost.

Marginal cost: cost difference of one additional unit of output \left(\frac{\Delta TC}{\Delta Q}\right).

Average fixed cost (AFC): \frac{FC}{Q}.

Average variable cost (AVC): \frac{VC}{Q}.

Average total cost (ATC): \frac{TC}{Q}.

Long run average total cost (LRATC): same as short run ATC, but larger.

Economies of scale: LRATC declines as output increases.

Diseconomies of scale: LRATC increases as output increases.

Constant returns to scale: output increases directly in proportion to an increase in all inputs.

Profit: excess revenue that a business gets to keep.

Economic profit: revenue - explicit cost - implicit cost.

Accounting profit: revenue - explicit cost.

Implicit cost: cost that you could’ve been earning.

Profit Maximising point: where MR = MC.

If MR ≠ MC, aim for MR > MC.

Short Run:

Shutdown rule: if P > AVC, continue to produce; if AVC > P, shutdown.

Long Run:

Exit rule: if P < ATC, exit the market; firms make normal profit unless in monopoly or oligopoly.

A firm should shut down if it cannot cover its variable costs.