Types of cost, revenue and profit, short-run and long-run production

Economics A2 · The price system and the microeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

In the short run at least one factor of production is fixed. When more workers are added to fixed capital, the marginal product of labour eventually falls. This is the law of diminishing returns, and it makes the short-run marginal cost and average cost curves rise, giving them a U shape.

In the long run all factors are variable, so the firm can change its scale. Economies of scale make long-run average cost fall as output grows. Diseconomies of scale make it rise. The lowest output at which long-run average cost is at its minimum is the minimum efficient scale.

In economics, costs include normal profit, the minimum profit needed to keep the firm in the industry.

Rules to remember

Average product = total product ÷ number of workers. Marginal product = change in total product ÷ change in workers.
TC = TFC + TVC. ATC = TC ÷ output = AFC + AVC. MC = change in TC ÷ change in output.
AFC always falls as output rises. MC cuts AVC and ATC at their lowest points.
Returns to scale: all inputs rise by x%. Output rises by more than x% (increasing), by x% (constant) or by less than x% (decreasing).
Internal economies or diseconomies of scale: a movement along the LRAC curve as the firm grows. External ones: the whole LRAC curve shifts as the industry grows.
TR = price × quantity. AR = TR ÷ quantity = price. MR = change in TR ÷ change in quantity.
Supernormal profit: TR is greater than TC. Normal profit: TR = TC. Subnormal profit (a loss): TR is less than TC. Profit = (AR − ATC) × quantity.

Common mistake

Students confuse diminishing returns with diseconomies of scale. Diminishing returns is a short-run idea with a fixed factor. Diseconomies of scale is a long-run idea in which all factors change.

Worked example

A firm’s total cost is $520 when it makes 40 units and $600 when it makes 50 units. What is the marginal cost of each extra unit, and is average total cost rising or falling between these outputs?

MC = change in TC ÷ change in output = (600 − 520) ÷ (50 − 40) = 80 ÷ 10 = $8 per unit.
ATC at 40 units = 520 ÷ 40 = $13. ATC at 50 units = 600 ÷ 50 = $12.
MC ($8) is below ATC, so each extra unit pulls the average down.

Answer: Marginal cost is $8 per unit and average total cost is falling (from $13 to $12).

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