WEEK 6 & 7 :

COST AND PRODUCTION

ORGANIZING
PRODUCTION
Chapter Objectives (1 of 3)

By the end of this chapter, you should be able to:

■ Calculate total revenue, given price and production data.
■ Calculate total cost, given input costs and production data.
■ Calculate profit, given price, input costs, and production data.
■ Compare economic profit and accounting profit, given data on total revenue, implicit
costs, and explicit costs.
■ Categorize a cost as explicit or implicit, given a scenario.
■ Classify a firm's costs as fixed or variable.
Chapter Objectives (2 of 3)

■ Given a graph of the production function and input costs, derive the firm's total-cost
curve.
■ Derive total product, average product, and marginal product, given data on a firm's
production technology.
■ Explain the concept of diminishing marginal product using a production function.
■ Plot a production function for a firm, given its production data.
■ Calculate a firm's various average costs at different quantities, given data on that
firm's cost structure.
Chapter Objectives (3 of 3)

• Calculate a firm's marginal cost at different quantities, given data on

that firm's cost structure.
■ Explain the shapes of the ATC, AVC, AFC, and MC curves.
■ Explain why a firm's marginal cost curve intersects the average-total-cost curve at its
minimum.
■ Explain the relationship between short-run and long-run average total costs.
■ Given a graph of the average-total-cost curve in the long run, identify the regions
that represent economies of scale, constant returns to scale, and diseconomies of
scale.
Introduction
■ The invention of the World Wide Web has paved the way for the creation of
thousands of profitable businesses, such as Facebook, Apple, and Google.
■ Most of the firms don’t make the things they sell. They buy them from other firms.
For example, Apple doesn’t make the iPhone. Intel makes its memory chip and
Foxconn assembles the iPhone.
■ Why doesn’t Apple make its iPhone?
■ How do firms decide what to make themselves and what to buy from other firms?
■ How do the millions of firms around the world make their business decisions?
 The Firm and Its Economic Problem

A firm is an institution that hires factors of production

and organizes them to produce and sell goods and
services.
The Firm’s Goal
➢ A firm’s goal is to maximize profit.
➢ If the firm fails to maximize its profit, the firm is either
eliminated or taken over by another firm that seeks
to maximize profit.
In their quest for profits, firms make three specific
decisions involving their production.
Total Revenue, Total Cost, and Profit
■ Total revenue*
• The amount a firm receives for the sale of its output
■ Total cost*
• The market value of the inputs a firm uses in production
■ Profit*
• Total revenue minus total cost

*Words accompanied by an asterisk are key terms from the chapter.

Why Opportunity Costs Matter
■ Opportunity cost
• The cost of something is what you give up to get it
■ Firm’s cost of production
• Includes all the opportunity costs of making its output of
goods and services
Explicit and Implicit Costs
■ Explicit costs*
• Input costs that require an outlay of money by the firm
■ Implicit costs*
• Input costs that do not require an outlay of money by the
firm
■ Total Costs = Explicit costs + Implicit costs

*Words accompanied by an asterisk are key terms from the chapter.

The Cost of Capital is An Opportunity
Cost
■ Implicit cost of almost every business is the opportunity cost
of the money (financial capital) that has been invested in it
• For example, economists view interest income given up
as an implicit cost
• Accountants will not show this as a cost because no
money flows out of the business to pay for it
 The Firm and Its Economic Problem

■A Firm’s Opportunity Cost of Production

A firm’s opportunity cost of production is the value of
the best alternative use of the resources that a firm
uses in production.
A firm’s opportunity cost of production is the sum of the
cost of using resources
▪ Bought in the market
▪ Owned by the firm
▪ Supplied by the firm's owner
The Firm and Its Economic Problem
–Resources Bought in the Market
–The amount spent by a firm on resources bought in the market is an opportunity
cost of production because the firm could have bought different resources to produce
some other good or service.

–Resources Owned by the Firm

–If the firm owns capital and uses it to produce its output, then the firm incurs an
opportunity cost.
–The firm incurs an opportunity cost of production because it could have sold the
capital and rented capital from another firm.
–The firm implicitly rents the capital from itself.
–The firm’s opportunity cost of using the capital it owns is called the implicit rental
rate of capital.
 The Firm and Its Economic Problem
–The implicit rental rate of capital is made up of
–1. Economic depreciation
–2. Forgone interest

–Economic depreciation is the change in the market value of

capital over a given period.
–The interest forgone is the return on the funds used to
acquire the capital.
The Firm and Its Economic Problem
–Resources Supplied by the Firm’s Owner
–The owner might supply both entrepreneurship and labor.
–The return to entrepreneurship is profit.
–The profit that an entrepreneur can expect to receive on
average is called normal profit.
–Normal profit is the cost of entrepreneurship and is an
opportunity cost of production.
–In addition to supplying entrepreneurship, the owner
might supply labor but not take a wage.
–The opportunity cost of the owner’s labor is the wage
income forgone by not taking the best alternative job.
Economists and Accountants Measure
Profit Differently
■ Economic profit*
• Total revenue minus total cost, including both explicit and
implicit costs
■ Accounting profit*
• Total revenue minus total explicit cost

*Words accompanied by an asterisk are key terms from the chapter.

 Figure 1: Economists versus Accountants

■ Because economists include

all opportunity costs when
analyzing a firm, while
accountants measure only
explicit costs, economic profit
is smaller than accounting
profit.
Active Learning 1:
Economic vs Accounting Profit
■ The equilibrium rent on office space has just increased by
$500/month. Determine the effects on accounting profit
and economic profit if:
A. You rent your office space (you pay $500/month)
B. You own your office space
The following example summarizes the difference between
economic vs accounting profit.
The Firm and Its Economic Problem

■Decisions
– To maximize profit, a firm must make five basic
decisions:
– 1. What to produce and in what quantities
– 2. How to produce
– 3. How to organize and compensate its managers
and workers
– 4. How to market and price its products
– 5. What to produce itself and what to buy from other
firms
 The Firm and Its Economic Problem

■The Firm’s Constraints

The firm’s profit is limited by three features of the
environment:
▪ Technology constraints
▪ Information constraints
▪ Market constraints
 The Firm and Its Economic Problem

■Technology Constraints
➢ Technology is any method of producing a good or
service.
➢ Technology advances over time.
➢ Using the available technology, the firm can produce
more only if it hires more resources, which will
increase its costs and limit the profit of additional
output.
 The Firm and Its Economic Problem
■Information Constraints
➢ A firm never possesses complete information about
either the present or the future.
➢ It is constrained by limited information about the
quality and effort of its work force, current and future
buying plans of its customers, and the plans of its
competitors.
➢ The cost of coping with limited information limits
profit.
 The Firm and Its Economic Problem
■Market Constraints
➢ What a firm can sell and the price it can obtain are
constrained by its customers’ willingness to pay and by
the prices and marketing efforts of other firms.
➢ The resources that a firm can buy and the prices it must
pay for them are limited by the willingness of people to
work for and invest in the firm.
➢ The expenditures that a firm incurs to overcome these
market constraints limit the profit that the firm can
make.
Technological and Economic Efficiency
■Technological Efficiency
➢ Technological efficiency occurs when a firm uses
the least amount of inputs to produce a given
quantity of output.
➢ Different combinations of inputs might be used to
produce a given good, but only one of them is
technologically efficient.
➢ If it is impossible to produce a given good by
decreasing any one input, holding all other inputs
constant, then production is technologically
efficient.
 Technological and Economic Efficiency
■Economic Efficiency
➢ Economic efficiency occurs when the firm produces a
given quantity of output at the least cost.
➢ The economically efficient method depends on the
relative costs of capital and labor.
➢ The difference between technological and economic
efficiency is that technological efficiency concerns
the quantity of inputs used in production for a given
quantity of output, whereas economic efficiency
concerns the cost of the inputs used.
Technological and Economic Efficiency
–An economically efficient production process also is
technologically efficient.
–A technologically efficient process may not be
economically efficient.
–Changes in the input prices influence the value of the
inputs, but not the technological process for using them
in production.
–Table 10.3 on the next slide illustrates.
OUTPUT AND COSTS
What do McDonald’s and Campus Sweaters, a
small (fictional) producer of knitwear that we’ll
study in this chapter, have in common?
Like every firm,

 They must decide how much to produce.

 How many people to employ.

 How much and what type of capital equipment

to use.

How do firms make these decisions?

The Behavior of Profit-Maximizing Firms
All firms must make several basic decisions to achieve what we
assume to be their primary objective—maximum profits.
Decision Time Frames
❑ The firm makes many decisions to achieve its main
objective: profit maximization.
❑ Some decisions are critical to the survival of the
firm.
❑ Some decisions are irreversible (or very costly to
reverse).
❑ Other decisions are easily reversed and are less
critical to the survival of the firm, but still influence
profit.
❑ All decisions can be placed in two time frames:
➢ The short run
➢ The long run
Decision Time Frames
■The Short Run
o The short run is a time frame in which the quantity of one
or more resources used in production is fixed.
o For most firms, the capital, called the firm’s plant, is fixed
in the short run.
o Other resources used by the firm (such as labor, raw
materials, and energy) can be changed in the short run.
o Short-run decisions are easily reversed.
o Example: Lisa’s Cookie Factory.
o We assume that the size of Lisa’s factory is fixed and that
Lisa can vary the quantity of cookies produced only
changing the number of workers she employ.
o This assumption is realistic in the SR but not in the LR ➔
Lisa cannot build a larger factory overnight, but she could
do so over the next year or two.
Decision Time Frames
■The Long Run
o The long run is a time frame in which the quantities
of all resources—including the plant size—can be
varied.
o Long-run decisions are not easily reversed.
o A sunk cost is a cost incurred by the firm and
cannot be changed.
o If a firm’s plant has no resale value, the amount
paid for it is a sunk cost.
o Sunk costs are irrelevant to a firm’s current
decisions.
Short-Run Technology Constraint

❑ To increase output in the short run ➔ a firm

must increase the amount of labor employed.
❑ Three concepts describe the relationship
between output and the quantity of labor
employed:
1. Total product
2. Marginal product
3. Average product
Short-Run Technology Constraint

■Product Schedules
➢ Total product is the total output produced in a
given period.
➢ The marginal product of labor is the change in
total product that results from a one-unit
increase in the quantity of labor employed, with
all other inputs remaining the same.
➢ The average product of labor is equal to total
product divided by the quantity of labor
employed.
The Production Function
■ Production function*
• Relationship between the quantity of inputs used to make a
good and the quantity of output of that good
■ Marginal product*
• The increase in output that arises from an additional unit of
input

*Words accompanied by an asterisk are key terms from the chapter.

 Diminishing Marginal Product
■ Diminishing marginal product*
• The property whereby the marginal product of an input
declines as the quantity of the input increases
■ Production function gets flatter as more inputs are being used
■ The slope of the production function decreases

*Words accompanied by an asterisk are key terms from the chapter.

 Short-Run Technology Constraint
–Table 11.1 shows a firm’s product
schedules.
–As the quantity of labor employed
increases:
▪Total product increases.
▪ Marginal product increases
initially …
but eventually decreases.
▪ Average product decreases.
 Short-Run Technology Constraint

■Product Curves
–Product curves show how the firm’s total product,
marginal product, and average product change as the
firm varies the quantity of labor employed.
 Short-Run Technology Constraint

■Total Product Curve

➢ Figure 11.1 shows a total
product curve.
➢ The total product curve
shows how total product
changes with the quantity
of labor employed.
 Short-Run Technology Constraint

❑ The total product curve is

similar to the PPF.
❑ It separates attainable
output levels from
unattainable output levels
in the short run.
 Short-Run Technology Constraint

■Marginal Product Curve

–Figure 11.2 shows the
marginal product of labor
curve and how the marginal
product curve relates to the
total product curve.
–The first worker hired
produces 4 units of output.
Short-Run Technology Constraint
–The second worker hired
produces 6 units of
output and total product
becomes 10 units.

The third worker hired

produces 3 units of output
and total product
becomes 13 units.
And so on.
Short-Run Technology Constraint
–The height of each bar
measures the marginal
product of labor.
–For example, when labor
increases from 2 to 3,
total product increases
from 10 to 13,
–so the marginal product
of the third worker is 3
units of output.
Short-Run Technology Constraint
–To make a graph of the
marginal product of labor,
we can stack the bars in
the previous graph side by
side.

The marginal product of

labor curve passes
through the mid-points of
these bars.
 Short-Run Technology Constraint
Almost all production
processes are like the one
shown here and have:
• Increasing marginal returns
initially
• Diminishing marginal
returns eventually
 Short-Run Technology Constraint

Increasing Marginal
Returns
▪ Initially, the marginal
product of a worker exceeds
the marginal product of the
previous worker.
▪ The firm experiences
increasing marginal returns.
 Short-Run Technology Constraint
Diminishing Marginal
Returns
▪ Eventually, the marginal product
of a worker is less than the
marginal product of the
previous worker.
▪ The firm experiences
diminishing marginal returns.
Short-Run Technology Constraint
▪ Increasing marginal returns arise from increased
specialization and division of labor.
▪ Diminishing marginal returns arises because each additional
worker has less access to capital and less space in which to
work.
▪ Diminishing marginal returns are so pervasive
(general/universal) that they are elevated to the status of a
“law.”
▪ The law of diminishing returns states that:
“As a firm uses more of a variable input with a given quantity of fixed
inputs, the marginal product of the variable input eventually
diminishes.”
 Short-Run Technology Constraint
■Average Product Curve
–Figure 11.3 shows the
average product curve and
its relationship with the
marginal product curve.

When marginal product exceeds

average product, average product
increases.
 Short-Run Technology Constraint

When marginal product is

below average product,
average product decreases.

When marginal product

equals average product,
average product is at its
maximum.
 Table 1: A Production Function and Total
Cost: Chloe’s Cookie Factory
(1) (2) (3) (4) (5) (6)
Number of Output (quantity of Marginal Product Cost of Factory Cost of Workers Total Cost of Inputs
Workers cookies produced of Labor (cost of factory plus
per hour) cost of workers)

0 0 $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
6 155 5 30 60 90
 Figure 2: Chloe’s Production Function
and Total-Cost Curve
■ The production function in panel (a) shows
the relationship between the number of
workers hired and the quantity of output
produced.
■ Here, the number of workers hired (on the
horizontal axis) is from column (1) in Table 1,
and the quantity of output (on the vertical
axis) is from column (2).
■ The production function gets flatter as the
number of workers increases, reflecting
diminishing marginal product.
From the Production Function to the
Total-Cost Curve
■ Total-cost curve
• Relationship between quantity produced and total costs
■ As production rises
• Total-cost curve grows steeper
• Production function becomes flatter
 Figure 2: Chloe’s Production Function
and Total-Cost Curve
■ The total-cost curve in panel (b) shows the
relationship between the quantity of output and
total cost of production.
■ Here, the quantity of output produced (on the
horizontal axis) is from column (2) in Table 1, and
the total cost (on the vertical axis) is from column
(6).
■ The total-cost curve gets steeper as the quantity
of output increases because of diminishing
marginal product.
Short-Run Cost
▪ To produce more output in the short run, the firm must
employ more labor, which means that it must increase its
costs.
▪ Three cost concepts and three types of cost curves are
➢ Total cost
➢ Marginal cost
➢ Average cost
Short-Run Cost

■Total Cost
–A firm’s total cost (TC) is the cost of all resources
used.
–Total fixed cost (TFC) is the cost of the firm’s
fixed inputs. Fixed costs do not change with output.
–Total variable cost (TVC) is the cost of the firm’s
variable inputs. Variable costs do change with output.
–Total cost equals total fixed cost plus total variable
cost. That is:
TC = TFC + TVC
Short-Run Cost
–Figure 11.4 shows a
firm’s total cost curves.

Total fixed cost is the

same at each output level.
Total variable cost
increases as output
increases.
Total cost, which is the sum
of TFC and TVC also
increases as output
increases.
Short-Run Cost
–The AVC curve gets its
shape from the TP
curve.

Notice that the TP curve

becomes steeper at low
output levels and then
less steep at high output
levels.
In contrast, the TVC curve
becomes less steep at
low output levels and
steeper at high output
levels.
Short-Run Cost

–To see the relationship

between the TVC curve
and the TP curve, lets look
again at the TP curve.
But let us add a second
x-axis to measure total
variable cost.

1 worker costs $25;

2 workers cost $50; and
so on, so the two x-axes
line up.
Short-Run Cost
–We can replace the
quantity of labor on the
x-axis with total variable
cost.

When we do that, we
must change the name of
the curve. It is now the
TVC curve.
But it is graphed with cost
on the x-axis and output
on the y-axis.
Short-Run Cost
–Redraw the graph with
cost on the y-axis and
output on the x-axis, and
you’ve got the TVC curve
drawn the usual way.

Put the TFC curve back in

the figure,
and add TFC to TVC, and
you’ve got the TC curve.
Short-Run Cost
■Marginal Cost
–Marginal cost (MC) is the increase in total cost that
results from a one-unit increase in total product.
–Over the output range with increasing marginal returns,
marginal cost falls as output increases.
–Over the output range with diminishing marginal returns,
marginal cost rises as output increases.

(change in total cost) TC

MC = =
(change in quantity) Q
Short-Run Cost
■Average Cost
–Average cost measures can be
derived from each of the total
cost measures:
–Average fixed cost (AFC) is total Fixed cost FC
fixed cost per unit of output. AFC = =
Quantity Q
–Average variable cost (AVC) is
total variable cost per unit of Variable cost VC
output. AVC = =
Quantity Q
–Average total cost (ATC) is total
cost per unit of output. Total cost TC
ATC = =
Quantity Q
ATC = AFC + AVC.
Short-Run Cost
–Figure 11.5 shows the MC,
AFC, AVC, and ATC curves.
–The AFC curve shows that
average fixed cost falls as
output increases.

The AVC curve is U-

shaped. As output
increases, average variable
cost falls to a minimum and
then increases.
Short-Run Cost
–The ATC curve is also
U-shaped.

The MC curve is very special.

For outputs over which AVC

is falling, MC is below AVC.
For outputs over which AVC
is rising, MC is above AVC.
For the output at minimum
AVC, MC equals AVC.
Short-Run Cost

Similarly, for the

outputs over which
ATC is falling, MC is
below ATC.
For the outputs over
which ATC is rising,
MC is above ATC.
For the output at
minimum ATC, MC
equals ATC.
Short-Run Cost
–The AVC curve is U-shaped because:
–Initially, MP exceeds AP, which brings rising AP and
falling AVC.
–Eventually, MP falls below AP, which brings falling AP
and rising AVC.
–The ATC curve is U-shaped for the same reasons.
–In addition, ATC falls at low output levels because AFC
is falling quickly.
Short-Run Cost
■Why the Average Total Cost Curve Is U-Shaped
➢ The ATC curve is the vertical sum of the AFC curve and the AVC
curve.
➢ The U-shape of the ATC curve arises from the influence of two
opposing forces:
1. Spreading total fixed cost over a larger output—AFC curve slopes
downward as output increases.
2. Eventually diminishing returns—the AVC curve slopes upward
and AVC increases more quickly than AFC is decreasing.
 Figure 5 Cost Curves for a Typical Firm
■ Many firms experience increasing
marginal product before
diminishing marginal product. As a
result, they have cost curves
shaped like those in this figure.

■ Notice that marginal cost and

average variable cost fall for a
while before starting to rise.
Active Learning 3: Calculating Costs
Q TC VC AFC AVC ATC MC
0 $50 n/a n/a n/a
1 10 $10 $60.00 $10
2 30 80
3 16.67 20 36.67 30
4 100 150 12.50 37.50
5 150 30
6 210 260 8.33 35 43.33 60
Short-Run Cost
■Cost Curves and Product Curves
–The shapes of a firm’s cost curves are determined by the
technology it uses.
–We’ll look first at the link between total cost and total
product and then …
–at the links between the average and marginal product
and cost curves.
Short-Run Cost

–Total Product and

Total Variable Cost
–Figure 11.6 shows
when output is plotted
against labor, the
curve is the TP curve.
–When output is
plotted against
variable cost, the
curve is the TVC curve
… but it is flipped over.
Short-Run Cost
■Average and Marginal Product and Cost
–The firm’s cost curves and product curves
are linked:
 MC is at its minimum at the same output
level at which MP is at its maximum.
 When MP is rising, MC is falling.
 AVC is at its minimum at the same output
level at which AP is at its maximum.
 When AP is rising, AVC is falling.
Short-Run Cost

–Figure 11.7
shows these
relationships.
Short-Run Cost
■Shifts in the Cost Curves
The position of a firm’s cost curves depends on
two factors:
▪ Technology
▪ Prices of factors of production
Short-Run Cost
❑ Technology
–Technological change influences both the product
curves and the cost curves.
–An increase in productivity shifts the product curves
upward and the cost curves downward.
–If a technological advance results in the firm using
more capital and less labor, fixed costs increase and
variable costs decrease.
➔ In this case, average total cost increases at low
output levels and decreases at high output levels.
Short-Run Cost
❑ Prices of Factors of Production
–An increase in the price of a factor 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.
Long-Run Cost
–In the long run, all inputs are variable and all costs
are variable.
■The Production Function
–The behavior of long-run cost 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 labor.
Long-Run Cost
–Table 11.3 shows a firm’s
production function.
–As the size of the plant
increases, the output that a
given quantity of labor can
produce increases.
–But for each plant, as the
quantity of labor increases,
diminishing returns occur.
Long-Run Cost
–Diminishing Marginal Product of Capital
–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 labor employed.
–A firm’s production function exhibits diminishing marginal
returns to labor (for a given plant) as well as diminishing
marginal returns to capital (for a quantity of labor).
–For each plant, diminishing marginal product of labor
creates a set of short run, U-shaped cost curves for MC, AVC,
and ATC.
Long-Run Cost
■Short-Run Cost and Long-Run Cost
–The average cost of producing a given output varies and
depends on the firm’s plant.
–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 Cost

ATC1 is the ATC curve for a plant with 1

knitting machine.
Long-Run Cost

ATC2 is the ATC curve for a plant with 2 knitting machines.

Long-Run Cost

ATC3 is the ATC curve for a plant with 3 knitting machines.

Long-Run Cost

ATC4 is the ATC curve for a plant with 4 knitting machines.

Long-Run Cost

–The long-run average cost curve is made up

from the lowest ATC for each output level.
–So, we want to decide which plant has the
lowest cost for producing each output level.
–Let’s find the least-cost way of producing a
given output level.
–Suppose that the firm wants to produce 13
sweaters a day.
Long-Run Cost

13 sweaters a day cost $7.69 each on ATC1.

Long-Run Cost

13 sweaters a day cost $6.80 each on ATC2.

Long-Run Cost

13 sweaters a day cost $7.69 each on ATC3.

Long-Run Cost

13 sweaters a day cost $9.50 each on ATC4.

Long-Run Cost

The least-cost way of producing 13 sweaters a day is to

use 2 knitting machines.
Long-Run Cost
■Long-Run Average Cost Curve
–The long-run average cost curve is the
relationship between the lowest attainable
average total cost and output when both the
plant and labor are varied.
–The long-run average cost curve is a planning
curve that tells the firm the plant that minimizes
the cost of producing a given output range.
–Once the firm has chosen its plant, the firm
incurs the costs that correspond to the ATC curve
for that plant.
Long-Run Cost

Figure 11.9 illustrates the long-run average cost (LRAC)

curve.
The Relationship between Short-Run
and Long-Run Average Total Cost
■ Many decisions are
• Fixed in the short run
• Variable in the long run
■ Firms have greater flexibility in the long-run
■ Long-run cost curves differ from short-run cost curves
• Much flatter than short-run cost curves
■ Short-run cost curves
• Lie on or above the long-run cost curves
Long-Run Cost
Figure 11.9 illustrates economies and diseconomies of scale .
Long-Run Cost
–Minimum Efficient Scale
–A firm experiences economies of scale up to some output
level.
–Beyond that output level, it moves into constant returns
to scale or diseconomies of scale.
–Minimum efficient scale is the smallest quantity of output
at which the long-run average cost reaches its lowest level.
–If the long-run average cost curve is U-shaped, the
minimum point identifies the minimum efficient scale
output level.
Figure 6 Average Total Cost in the Short
and Long Runs
■ Because fixed costs are
variable in the long run,
the average-total-cost
curve in the short run
differs from the average-
total-cost curve in the
long run.
Economies and Diseconomies of Scale
■ Economies of scale*
• Long-run average total cost falls as the quantity of output
increases
■ Constant returns to scale*
• Long-run average total cost stays the same as the quantity of
output changes
■ Diseconomies of scale*
• Long-run average total cost rises as the quantity of output
increases
*Words accompanied by an asterisk are key terms from the chapter.
 Table 3 The Many Types of Cost: A
Summary (1 of 2)
Term Definition Mathematical Description
Explicit costs Costs that require an outlay of money
by the firm
Implicit costs Costs that do not require an outlay of
money by the firm
Fixed costs Costs that do not vary with the quantity FC
of output produced
Variable costs Costs that vary with the quantity of VC
output produced
Total cost The market value of all the inputs that TC = FC + VC
a firm uses in production
 Table 3 The Many Types of Cost: A
Summary (2 of 2)
Term Definition Mathematical Description
Average fixed cost Fixed cost divided by the AFC = FC/Q
quantity of output
Average variable cost Variable cost divided by the AVC = VC/Q
quantity of output
Average total cost Total cost divided by the ATC = TC/Q
quantity of output
Marginal cost The increase in total cost that MC = ΔTC/ΔQ
arises from an extra unit of
production
Long-Run Directions

TABLE 9.2 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short Run

Short-Run Condition Short-Run Decision Long-Run Decision

Profits TR > TC P = MC: operate Expand: new firms enter

Losses 1. TR  TVC P = MC: operate Contract: firms exit

(loss < total fixed cost)

2. TR < TVC Shut down: Contract: firms exit

loss = total fixed cost

Long-Run Costs: Economies and Diseconomies of Scale

increasing returns to scale, or economies of scale An

increase in a firm’s scale of production leads to lower costs
per unit produced.

constant returns to scale An increase in a firm’s scale of

production has no effect on costs per unit produced.

decreasing returns to scale, or diseconomies of scale

An increase in a firm’s scale of production leads to higher
costs per unit produced.