Unit 2.

3 - Theory of the Firm

Unit Overview

Unit 2.3.1 - Introduction to Market Structures and Long-run

Cost Theory ·Economies of scale
·Diseconomies of scale
Intro to Market Structures ·Long-run cost curves
·Pure competition
·Monopolistic competition Revenues
·Oligopoly ·Total revenue
·Monopoly ·Marginal revenue
·Average revenue
Cost theory
·Types of costs: fixed costs, variable costs Profit
·Total, average and marginal costs ·Distinction between normal (zero) and supernormal
·Accounting costs = opportunity costs = economic costs (abnormal) profit
·Profit maximization in terms of total revenue and total
Short-run costs, and in terms of marginal revenue and marginal
·Law of diminishing returns cost
·Total product, average product, marginal product ·Profit maximization assumed to be the main goal of
·Short-run cost curves firms but other goals exist (sales volume maximization,
revenue maximization, environmental concerns)

Blog posts: "Costs of Production"

 Unit 2.3 - Theory of the Firm
Unit Overview

2.3.2 - Perfect competition Efficiency in monopoly

·Assumptions of the model ·Price discrimination
·Demand curve facing the industry and the firm in >>Definition
perfect competition >>Reasons for price discrimination
·Profit-maximizing level of output and price in the >>Necessary conditions for the practice of price
short-run and long-run discrimination
·The possibility of abnormal profits/losses in the short- >>Possible advantages to either the producer or the
run and normal profits in the long-run consumer
·Shut-down price, break-even price
·Definitions of allocative and productive efficiency 2.3.4 - Monopolistic competition
·Efficiency in perfect competition ·Assumptions of the model
·Short-run and long-run equilibrium
2.3.3 - Monopoly ·Product differentiation
·Assumptions of the model ·Efficiency in monopolistic competition
·Sources of monopoly power/barriers to entry
·Natural monopoly 2.3.5 - Oligopoly
·Demand curve facing the monopolist ·Assumptions of the model
·Profit-maximizing level of output ·Colusive and non-collusive oligopoly
·Advantages and disadvantages of monopoly in ·Cartels
comparison with perfect competition ·Kinked demand curve as one model to describe
interdependent behavior (IB HL only)
·Importance of non-price competition
·Theory of contestable markets (IB HL only)
 MARKETS
THE FOUR MARKET STRUCTURES
1. Pure (or Perfect) Competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly
Research on the following characteristics
of the different market structures,
brainstorm examples of each:
1.How large is the firm (the number of firms)
2.How market prices are determined.
3.Similarity of products produced.
4.Entry and exit barriers
5.Knowledge of prices, costs, and quality and availability
of products.
6.Give five examples of each of the markets
 Unit 2.3 - Theory of the Firm
Introduction to the Four Market Structures
Examples of different market structures: Based on the characteristics of the different
market structures, brainstorm examples of each.
Most competition Least competition
Pure Monopolistic Oligopoly Monopoly
Competition competition

Practice: Different types of Market Structure - NCEE Activity 24

 Unit 2.3 - Theory of the Firm
Introduction to the Four Market Structures

Most competition Least competition

Pure (or Perfect) Monopolistic Oligopoly Monopoly
Competition competition
VERY large number of firms A few large firms Only ONE firm. The
Fairly large number of firms
dominate an industry firm IS the industry!
Each firm is so small that Firms are small relative to
changes in its own output do not A change in one firm's Significant barriers to
the industry, meaning
affect market price, i.e. firms output has significant entry exist, preventing
changes in one firms output
are price takers impact on the market new firms from entering
have only a slight impact on
price, firms are price- and competing with the
market price
makers. monopolist
Firms all produce identical
products, with no Products are slightly
differentiation Products can be iden- tical the Monopolist can
differentiated. Firms will
(such as oil) or
advertise to try and further maintain significant
differentiated (such as
Completely free entry and exit differentiate product. profits due to the lack of
Macs and Dells)
from the industry, i.e. NO Branding! Advertising! competition.
barriers to entry.
There are significant
No barriers to entry, firms Changes in the firm's
barriers to entry
All producers and consumers can enter or leave easily output cause changes in
have perfect knowledge of the price, i.e. the firm is
prices, costs, and quality and Firms will likely use
a price-maker!
availability of products advertising to try and
differentiate their
products from
competitors'
 COST OF PRODUCTION: Economic costs

Read pages 148 – 150 and answer the following:

What is the difference between revenue and profits?

Explain the meaning of economic costs.

 COST OF PRODUCTION: Economic costs
EXPLICIT AND IMPLICIT COSTS OF PRODUCTION

Short run is defined as the period of time over which firm

s cannot acquire land or capital resources to increase
production or take land or capital out of production,
but within which labour can be applied to a greater or
lesser degree in order to change output. The only variable
resource in the short run is labour.

In the long run, firms are able to acquire and put into
production all the factors of production - land, labour and
capital and other resources, to produce output.
 COST OF PRODUCTION: Economic costs
EXPLICIT AND IMPLICIT COSTS OF PRODUCTION

Short run is also known as fixed-plant period, since the

amount of capital a firm employs is fixed.

Long run is also known as variable plant period, since the

amount of all resources, including capital, can be
adjusted in the long run.

In the short run, a firm may alter the amount of labour and
raw materials it employs towards its production of output,
but not the amount of capital or land.

The short run cost faced by the firms can be either:

1. EXPLICIT or
2. IMPLICIT
 COST OF PRODUCTION: Economic costs

EXPLICIT COSTS
They are the monetary payments a firm makes to the
owners of the resources it employs in the production
output.

Examples
1. Wages for workers
2. Raw material costs
3. Energy and transport costs
4. Rent payment or retail space
5. Interest payment to banks
 COST OF PRODUCTION: Economic costs

IMPLICIT COSTS
They are opportunity costs faced by a business owner
who chooses to use his skills and resources to operate his
own enterprise rather than seek employment by someone
else. A business’s implicit cost is also known as its normal
profit.

Normal profit is the entrepreneur’s implied value of his or

her own talent; it is the cost to do business, and if a firm’s
revenues do not cover the normal profit, the firm owner
may choose to shut down and direct his or her efforts
towards another industry or area of employment.
 COST OF PRODUCTION: Economic costs
THE DIFFERENCE BETWEEN EXPLICIT AND
IMPLICIT COSTS

The cost associated with an action’s tradeoff. It is

The actual costs of an activity, and represents a
cost that is not recorded but instead implied.
 COST OF PRODUCTION: Economic costs
THE DIFFERENCE BETWEEN EXPLICIT AND
IMPLICIT COSTS

For example, an employee could take a vacation

and travel.

The explicit costs would include

- Travel expenses,
- the cost of a hotel room,
- and costs related to entertainment.

The implicit costs relate to the tradeoff, namely the

wages that the employee could have earned if the
vacation was not taken.
 COST OF PRODUCTION: Economic costs
THE DIFFERENCE BETWEEN EXPLICIT AND
IMPLICIT COSTS

QUESTION
1. Distinguish between explicit and implicit costs as the two
components of economic costs.
- Give your own example in each case.

2. Explain the meaning of economic costs.

 ECONOMIC COSTS
Normal Profits
• Treated as a cost
• Required to attract & retain
resources
Economic or Pure Profits
Economic Total
Economic Cost
Profit Revenue
 Costs of Production
Law of Diminishing Returns
Understanding Productivity:
Productivity: The amount of output attributable to a unit of input.

Examples of productivity:
1. "Better training has increased the productivity of workers“
2. "The new robot is more productive than older versions“
3. "Adding fertilizer has increased the productivity of farmland“
 Costs of Production
Law of Diminishing Returns
Understanding Productivity:

• Total product (TP) is the total output of a particular firm

Example of TP: "After hiring more workers the firm's total

product increased.“

• Marginal product of labor (MPL) is the change in total

product resulting from each additional worker.
MPL = ∆TP/∆L

• Average product of labor (APL) is the output, on average, by

each worker
APL = TP/units of L
 Costs of Production
Big Ideas
Important questions:

1) What is productivity and how does it change as resources are added to

production?

What are the different costs faced by firms in the short-run and the
2) long-run?

What is the relationship between the productivity of its resources and

3) the costs faced by a firm?

Why does understanding productivity and costs matter to firms?

4)

DISCUSSION QUESTION
What is productivity, and why do firms care about it?

Blog posts: "Productivity"

 Costs of Production
Law of Diminishing Returns

Law of Diminishing Returns

States that as additional units of a variable resource
are added to fixed resources, beyond some point the
marginal product of the variable resource will decline.
 Costs of Production
Law of Diminishing Returns
Let's illustrate this with an example
EXAMPLE: PAPER CHAIN FACTORY
Instructions:
1) Use inputs (land, labor and capital) to create a product (paper chains)
2) Labor is the only variable resource. Land and capital are fixed.
3) Production rounds last one minute
4) Record production data in a data table

LAND (fixed) LABOR (variable) CAPITAL (fixed)

 Costs of Production
Law of Diminishing Returns

1. One worker has 20 Units of TP MP= ∆TP/∆L AP=TP/units of L

seconds to make the labour
longest chain possible. 0 0 - -
2. A volunteer is needed
1
to record output data
in the table to the 2
right. 3
3. As more workers are 4
added, TP, MP and AP 5
will be calculated and
6
recorded.
7
8

MP = ∆TP/∆L
L

AP = TP/units of L
L
 Costs of Production
Law of Diminishing Returns

1. One worker has 20 Units of TP MP= ∆TP/∆L AP=TP/units of L

seconds to make the labour
longest chain possible. 0 - -
0
2. A volunteer is needed
1 4 4 4
to record output data
in the table to the 2 9 5 4.5
right. 3 15
3. As more workers are 4 20
added, TP, MP and AP 24
5
will be calculated and
recorded. 6 26
7 26
8 24

MP = ∆TP/∆L
L

AP = TP/units of L
L
 Costs of Production
Law of Diminishing Returns

1. One worker has 20 Units of TP MP= ∆TP/∆L AP=TP/units of L

seconds to make the labour
longest chain possible. 0 - -
0
2. A volunteer is needed
1 4 4 4
to record output data
in the table to the 2 9 5 4.5
right. 3 15 6 5
3. As more workers are 4 20 5 5
added, TP, MP and AP 24 4 4.8
5
will be calculated and
recorded. 6 26 2 4.33
7 26 0 3.7
8 24 -2 3

MP = ∆TP/∆L
L

AP = TP/units of L
L
 Costs of Production
Law of Diminishing Returns

How is the law of diminishing returns reflected in the shape of a

Marginal Product curve? Average Product? Total Product? Draw
the typical production relationships on the graphs below.

TP Total Product
Marginal/Average Product
20

MP/AP 10 18

9 16
8 14
7
12
6
10
5
8
4
6
3
4
2

1 2
1 2 3 4 5 Units of Labor
0
1 2 3 4 5 Units of Labor
-1

-2
 Costs of Production
Law of Diminishing Returns
Marginal/Average Product
Observations:
MP/AP

Diminishing
returns sets in
1. Describe what happens to TP as more and
more labor is added to a fixed amount of
capital and land
AP
2. What is the relationship between TP and MP?
MP
3. What is the relationship between MP and AP?
0 10 20 30 40 50 Units of Labor

TP Total Product

TP
MP becomes negative,
TP begins to fall

0 10 20 30 40 50 Units of Labor
 Costs of Production
Law of Diminishing Returns
Marginal/Average Product
MP/AP

Diminishing
returns sets in

Why does a producer care

AP about the productivity of its
workers and other resources?
MP

0 10 20 30 40 50 Units of Labor

TP Total Product

TP
MP becomes negative,
TP begins to fall

0 10 20 30 40 50 Units of Labor
 SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product, TP
Total Product

Increasing
Marginal
Average Product, AP, and

Quantity of Labor
Returns
Marginal Product, MP

Average
Product
Marginal
Quantity of Labor Product
 SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product, TP
Total Product

Diminishing
Marginal
Returns
Average Product, AP, and

Quantity of Labor
Marginal Product, MP

Average
Product
Marginal
Quantity of Labor Product
 SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product, TP
Total Product

Negative
Marginal
Average Product, AP, and

Quantity of Labor
Returns
Marginal Product, MP

Average
Product
Marginal
Quantity of Labor Product
 Costs of Production
Law of Diminishing Returns

Q QL TVC = MP = MC = AP = AVC =
Quantity of No. of QL X WR ΔQ/ΔQL ΔTVC/ΔQ Q/QL TVC/Q
output workers

0 0 0 - - - -
100 6
200 10
300 13
400 17
500 23
600 32
700 44
800 62
 Costs of Production
Law of Diminishing Returns

Q QL TVC = MP = MC = AP = AVC =
Quantity of No. of QL X WR ΔQ/ΔQL ΔTVC/ΔQ Q/QL TVC/Q
output workers

0 0 0 - - - -
100 6 60
200 10 100
300 13 130
400 17 170
500 23 230
600 32 320
700 44 440
800 62 620
 Costs of Production
Law of Diminishing Returns

Q QL TVC = MP = MC = AP = AVC =
Quantity of No. of QL X WR ΔQ/ΔQL ΔTVC/ΔQ Q/QL TVC/Q
output workers

0 0 0 - - - -
100 6 60 16.70
200 10 100 25.00
300 13 130 33.30
400 17 170 25.00
500 23 230 16.70
600 32 320 11.10
700 44 440 8.33
800 62 620 5.50
 Costs of Production
Law of Diminishing Returns

Q QL TVC = MP = MC = AP = AVC =
Quantity of No. of QL X WR ΔQ/ΔQL ΔTVC/ΔQ Q/QL TVC/Q
output workers

0 0 0 - - - -
100 6 60 16.70 0.60
200 10 100 25.00 0.40
300 13 130 33.30 0.33
400 17 170 25.00 0.40
500 23 230 16.70 0.60
600 32 320 11.10 0.90
700 44 440 8.33 1.20
800 62 620 5.00 1.80
 Costs of Production
Law of Diminishing Returns

Q QL TVC = MP = MC = AP = AVC =
Quantity of No. of QL X WR ΔQ/ΔQL ΔTVC/ΔQ Q/QL TVC/Q
output workers

0 0 0 - - - -
100 6 60 16.70 0.60 16.70
200 10 100 25.00 0.40 20.00
300 13 130 33.30 0.33 23.12
400 17 170 25.00 0.40 23.50
500 23 230 16.70 0.60 21.70
600 32 320 11.10 0.90 18.75
700 44 440 8.33 1.20 15.90
800 62 620 5.00 1.80 12.90
 Costs of Production
Law of Diminishing Returns

Q QL TVC = MP = MC = AP = AVC =
Quantity of No. of QL X WR ΔQ/ΔQL ΔTVC/ΔQ Q/QL TVC/Q
output workers

0 0 0 - - - -
100 6 60 16.70 0.60 16.70 0.60
200 10 100 25.00 0.40 20.00 0.50
300 13 130 33.30 0.33 23.12 0.43
400 17 170 25.00 0.40 23.50 0.425
500 23 230 16.70 0.60 21.70 0.46
600 32 320 11.10 0.90 18.75 0.53
700 44 440 8.33 1.20 15.90 0.63
800 62 620 5.00 1.80 12.90 0.775
 Costs of Production
Law of Diminishing Returns

Costs and Productivity

MC
Product/costs

AP

AC

MP

Units of Labor/ units of output

 Costs of Production
Law of Diminishing Returns
CONCLUSIONS
Explain the following as applied to the Law of
diminishing returns:

1. Increasing marginal returns :

2. Diminishing marginal returns:
3. Diminishing marginal returns and its implications to
producers
4. Negative marginal returns or product and its
implications
Blog posts: "Law of Diminishing Returns"
Practice Diminishing Returns: NCEE Workbook Activity 25
 Costs of Production
Law of Diminishing Returns

Use the information on page 155 – 156 to explain the

following:

1. The relationship between marginal and total profit.

2. The relationship between marginal and average product
 Costs of Production
Productivity and costs
Productivity and Costs: As worker productivity increases, firms get "more for their money", meaning per-unit and
marginal cost decrease. When productivity decreases, costs increase.
In the graph below, fill in the marginal and average cost curves using the
marginal and average product curves to guide you.

Costs and Productivity Discussion: When productivity of workers is

MC rising, firms costs are falling, since they're
getting more output for workers while paying
Product/costs

them the same wages.

1. When marginal product is increasing
AP (increasing returns) marginal cost is
falling
AC
2. When MP is at its maximum, MC is at its
minimum
3. When diminishing returns set in, MP
MP begins falling and MC begins rising
4. MP intersects average product at its
Units of Labor/ units of output highest point, and MC intersects average
total cost at its lowest point

Summary: Increasing marginal returns is reflected in a declining marginal

cost, and diminishing marginal returns in a rising marginal cost!
 SHORT-RUN PRODUCTION COSTS
Fixed Costs
Total Fixed Costs
Total Fixed Costs
Average Fixed Costs = Quantity

Variable Costs
Total Variable Costs
Total Variable Costs
Average Variable Costs = Quantity
 SHORT-RUN PRODUCTION COSTS
Total Cost
Total Fixed and Variable Costs
Total Costs
Average Total Cost = Quantity

Marginal Cost
Total Variable Costs
Change in Total Costs
Marginal Cost = Change in Quantity
 SHORT-RUN PRODUCTION COSTS
Summary of Definitions
Total Fixed Costs = TFC
Total Variable Costs = TVC
Total Costs = TC
Average Fixed Costs = AFC
Average Variable Costs = AVC
Average Total Costs = ATC
Marginal Cost = MC
 SHORT-RUN COSTS GRAPHICALLY
TC
Combining TVC
With TFC to get TVC
Total Cost Fixed Cost
Costs (dollars)

Total Variable Cost

Cost
TFC
Quantity
 SHORT-RUN COSTS GRAPHICALLY

MC
Plotting Average and
Marginal Costs ATC
Costs (dollars)

AVC

AFC
Quantity
PRODUCTIVITY AND COST CURVES

Average Product and

Marginal Product
AP
MP
Quantity of labor
MC
Costs (dollars)

AVC

Quantity of output
 Costs of Production
Short-run Costs of Production

What is the short-run? "the fixed-plant period"

The short-run is the period of time over which a firm's plant size is fixed. Capital cannot
and land cannot be varied, labor is the only variable resource. To increase output in the
short-run, a firm can only increase inputs of labor, not the other resources.

Total fixed costs (TFC): These are the costs a firm faces that do not vary with changes
in short-run output. Could include rent on factory space, interest on capital (already
acquired).

Total variable costs (TVC): These are the costs a firm faces which change with the
level of output in the short-run. Could include payment for raw materials, fuel, power,
transportation services, wages for workers, etc...

Total cost: TFC + TVC at each level of output

 Costs of Production
Short-run Costs of Production
Resource costs in the short-run:
1. Rent - the payment for land: Rent is fixed in the short-run since firms cannot
add this resource to production. Rents must be paid regardless of the level of the
firm's output.

2. Interest - the payment for capital: Interest is fixed in the short-run since
firms cannot add this resource to production. Interest must be paid on loans
regardless of the level of the firm's output.

3. Wages - the payment for labor: Wages are variable in the short-run, since
firms can hire or fire workers to use existing land and capital resources. Wage costs
increase when new workers are hired, and decrease when workers are laid off.

4. Normal profit: the minimum level of profit needed just to keep an entrepreneur
operating in his current market. If he does not earn normal profit, an entrepreneur
will direct his skills towards another market. Normal profit is a cost because if a
firm does not earn normal profit, it is not covering its costs and may shut down.
 Costs of Production
Short-run Costs of Production

Other short-run variable costs of production:

1. Transportation costs: Firms pay lower transport costs at lower levels

of output.

2. Raw material costs: vary with the level of output

3. Manufactured inputs: fewer parts are needed from suppliers when a

firm lowers output.

 Costs of Production
Short-run Costs of Production
Graphing total costs:
TFC: Notice that regardless of the level of output, TFC remains constant. This is because these
are costs that do not vary with output.

TVC: Notice that when output is zero, TVC is zero, because you do not need to hire any workers
or use any raw materials if you're not producing anything. As output increases, TVC continues to
increase

TC: Notice that when output is zero, TC = TFC. But once the factory begins pumping out
products, TC rises with TVC. TC is the sum of TFC and TVC, since both fixed and variable costs
make up total cost.
DIMINISHING RETURNS:
TC
Costs
TVC ·Notice that TC and TVC increase at a decreasing
rate at first. This is when marginal product is
increasing as more labor is employed (firms get
"more for their money")

·However, beyond some point, costs begin to

increase at an increasing rate. This is where
100 TFC diminishing returns set in and MP is decreasing.
The firm is getting less additional output from each
worker hired, but must pay the same wages
0 Point at which Q of output
regardless. (The firm gets "less for its money")
diminishing
returns sets in
 Costs of Production
Short-run Costs of Production
Average Costs:
Average fixed cost: AFC=TFC/Q
AFC will decline as output rises, never increases. This is because the fixed
cost (which never goes up) is “spread out” as output goes up. This is called
“spreading the overhead”

Average variable cost: AVC = TVC/Q

For simplicity, we will assume that labor is the only variable input, the labor
cost per unit of output is the AVC

Average total cost: ATC = TC/Q

Sometimes called unit cost or per unit cost. ATC also equals AFC + AVC

Marginal Cost = the additional cost of producing one more unit of output.
MC = ∆TVC/∆Q.
 Costs of Production
Short-run Costs of Production
Graphing Average and Marginal Costs:
AFC: it declines as output increases. This is called "spreading the overhead".
ATC and AVC: At first they are declining as output increases. This is during the stage when
MP is increasing, since new labor is making better use of capital and beginning to specialize.
AVC: When AVC is at its minimum, average product is at its maximum, meaning workers
are producing the most output per worker. As more workers are added, average product
begins to go down, and AVC begins to rise.

THINGS TO NOTICE:
Costs

Short-run Costs
1. The vertical distance between ATC and
AVC equals the AFC at each level of
MC output.
2. MC intersects both AVC and ATC at
their minimum. This is because if the
ATC last unit produced cost less than the
AVC average, then the average must be
falling, and vis versa (just like your test
scores!)
3. MC is at its minimum when MP is at its
AFC
maximum, because beyond that point
diminishing returns sets in and the firm
Point at which Q
diminishing starts getting less for its money!
returns sets in
 Costs of Production
Short-run Costs of Production
Labor is the only variable resource and the wage = $200 / week
Rent and interest are fixed costs, and = $400 / week
QL TP (Q
supplied)
TFC TVC TC AFC AVC ATC MC

0 0 400
1 10
2 25
3 45
4 70
5 90
6 105

7 115
8 120

Describe and explain what happens to each of the following as output increases:
1) TFC 2) TC 3) AFC 4) AVC and ATC 5) MC
 Costs of Production
Short-run Costs of Production
Short-run Costs
Costs

Discussion Questions:
MC Short-run Costs
1. State the law of diminishing returns and
ATC explain how it determines the shape of the
AVC
marginal cost curve.

AFC 2. Explain the relationship between the

marginal cost curve and the average variable
Q
TC and average total cost curves.
Costs

TVC
3. What determines the distance between the
ATC and the AVC at a particular level of
output.

TFC

Point at which Q
diminishing
returns sets in
 Costs of Production
Productivity and costs
Relationships between MC, ATC and AVC
Illustrate the relationship b/w Total Fixed Illustrate the relationship b/w Average
Cost, Total Variable Cost, and Total Cost Fixed Cost, Average Variable Cost,
Averate Total Cost and Marginal Cost

Costs
Costs

Quantity of output Quantity of output

1. When MC is below ATC and AVC, what is happening to the average costs
curve? Why?
2. How is the law of diminishing returns reflected in the shape of the MC curve?
3. How is Average fixed cost implied in your diagram without even having to
draw it?
 Costs of Production
Short-run vs. Long-run costs
Graphing long-run ATC: The gray curves represent all the SR
ATC curve the firm experiences as it opens new plants. As it
opens its first 10 plants, ATC declines, while for plants 11-16 ATC
Costs

remains constant. Beyond 16 plants the firm's ATC begins to rise,

indicating it has gotten too big.

ATC LR

Economies Diseconomies
of scale of scale
Constant returns
to scale
MES
Q
Blog posts: "Economies of Scale"
 Costs of Production
Short-run vs. Long-run costs
Long-run is the variable plant period, meaninig that firms can open up new
plants, add capital to existing plants, or close plans and remove capital if
need be.
Economies of scale: the range of plant size over which increasing output
leads to lower and lower average total cost. As new plants open, ATC
declines. WHY?
·better specialization, division of labor, bulk buying, lower interest on
loans, lower per unit transport costs, larger and more efficient machines,
etc…

Also called "Increasing returns to scale”

1. Specialization
2. Division of labour
3. Bulk buying
4. Financial economies
5. Transport economies
6. Large machines
7. Promotional economies
 Costs of Production
Short-run vs. Long-run costs

Minimum Efficient Scale (MES): The minimum level of output a firm

must achieve to achieve the lowest average total cost.

Diseconomies of Scale: When a firm becomes "too big for its own good" it
experiences diseconomies of scale. Continuing to add plants and increase
output causes ATC to rise. WHY? Mostly due to control and
communications problems, trying to coordinate production across a wide
geographic may make firm less efficient.

Also called "Decreasing returns to scale”

1. Control and communication problems

2. Alienation and loss of identity
 Costs of Production
Quick Quiz
Unit 2.3.1 Quiz:

State the law of diminishing returns and explain

how it affects a firm's short-run costs of
production?
(10 marks)
 Costs of Production
Quick Quiz
Unit 2.3.1 Quiz:
State the law of diminishing returns and explain how it affects a firm's short-
run costs of production?
(10 marks)

The law of diminishing returns states that as more units of a variable

resource (such as labor) are added to fixed resources, the amount of
output attributable to additional units will eventually decline, due to
the lack of tools and space available to additional workers.

Assuming constant wages, a firm's short-run costs are inversely

related to the output of its workers. As additional labor creates
increasing marginal product, the firm's marginal costs will decline.
When diminishing returns result in less additional output for each
worker hired, the marginal cost to the firm of increasing output will
begin to increase.
 Costs of Production
Quick Quiz
Unit 2.3.1 Quiz:

Explain the relationship in the short run between the

marginal costs of a firm and its average total costs.
(10 marks)
 Costs of Production
Quick Quiz
Unit 2.3.1 Quiz:
Explain the relationship in the short run between the marginal costs of a firm and its
average total costs.
(10 marks)

The short-run refers to the "fixed-plant period" when capital and land
are fixed and labor is the only variable resource. As output increases
in the SR, marginal product of labor increases at first due to increased
specialization, then diminishes as more labor is added to fixed land
and capital. Marginal cost, which is the cost to the firm of the last unit
produced, will fall as MP increases since the firm gets more output
per dollar spent on inputs, then increases as MP decreases.
 Costs of Production
Quick Quiz
Unit 2.3.1 Quiz:
Explain the relationship in the short run between the marginal costs of a firm and its
average total costs.
(10 marks)

Average total cost, which is the cost per unit of output, will fall as
long as the marginal cost is lower than the average. MC will
eventually increase due to diminishing returns, and intersect ATC at
its lowest point. When MC is higher than ATC, ATC will begin to rise
since the last unit produced cost more to the firm than the average
cost.