1. Production & Diminishing Returns
Before a firm can worry about money (Cost), it has to worry about physics (Production). How many inputs (workers) do I need to get outputs (pizza)?
Short Run vs. Long Run:
- Short Run: At least one resource is Fixed (usually the factory size or capital). You can hire more workers, but you can't build a new factory overnight.
- Long Run: All resources are Variable. You can resize everything.
The Law of Diminishing Marginal Returns
This is the most important concept in production. It states that as you add variable resources (workers) to fixed resources (ovens), the additional output produced by each new worker will eventually fall.
- Worker 1: Produces 10 pizzas.
- Worker 2: Helps organize. Output jumps to 25 pizzas (Marginal Product = 15).
- Worker 3: Kitchen gets crowded. Output goes to 35 pizzas (Marginal Product = 10).
- Worker 4: They bump into each other. Output falls.
Note: MP intersects AP at the maximum of AP. When MP > AP, Average goes up. When MP < AP, Average goes down.
2. Short Run Costs
Now we translate "Physics" into "Money." Because diminishing returns exist (efficiency falls), costs eventually rise. You need to memorize this family of 7 curves.
Key Definitions
| Fixed Costs (FC) | Costs that DO NOT change with output (e.g., Rent, Insurance). You pay this even if you produce 0 units. |
| Variable Costs (VC) | Costs that increase as you produce more (e.g., Wages, Raw Materials). |
| Marginal Cost (MC) | The cost of producing one additional unit. This is the most important curve in economics. |
The "Per Unit" Formulas
- The Nike Swoosh: MC looks like a checkmark.
- The Intersection: MC must cross ATC and AVC at their minimum points.
- The Gap: The vertical distance between ATC and AVC represents AFC. As quantity increases, AFC gets smaller, so ATC and AVC get closer together (but never touch!).
3. Perfect Competition
This is the first "Market Structure" we study. It is an idealized market (like agriculture/corn) with extreme competition.
Characteristics (Recall "MP LE")
- Many Small Firms: No single firm controls the price.
- Identical Products: Corn is corn. Buyers don't care who they buy from.
- Low Barriers: Easy to enter and exit the market.
- Price Takers: Firms have NO control over price. They take the market price.
The "Mr. DARP" Curve
Because the firm is a price taker, its demand curve is perfectly elastic (horizontal). For a perfectly competitive firm:
(Demand = Average Revenue = Marginal Revenue = Price)
Profit Maximization (The Golden Rule)
Every firm in economics follows this rule to decide quantity:
MR = MC
Produce where Marginal Revenue equals Marginal Cost.
4. Profit, Loss & The Shutdown Rule
Once you find the quantity using MR=MC, look vertically to the ATC curve to see if you are making money.
The Market
The Firm
The Firm takes the price (Pe) from the Market. Here, Price > ATC, so the firm makes an Economic Profit.
The Shutdown Rule
If a firm is losing money (Price < ATC), should it shut down immediately? Not always.
- Shut Down: If Price < AVC. (You can't even pay your workers/variable costs).
- Stay Open (Short Run): If P > AVC but P < ATC. (You cover variable costs and some fixed costs. Losing a little is better than losing all Fixed Costs).
End of Unit 3 Study Guide.