1. Unit III: Costs of Production and Perfect Competition

2. Accountants vs. Economists
Accountants look at only EXPLICIT COSTS
Explicit costs (out of pocket costs) are payments paid by firms for using the resources of others.
Example: Rent, Wages, Materials, Electricity Bills
Economists examine both the EXPLICIT COSTS and the IMPLICIT COSTS
Implicit costs are the opportunity costs that firms “pay” for using their own resources
Example: Forgone Wage, Forgone Rent, Time

3. Analyzing Production

4. Inputs and Outputs To earn profit, firms must make products (output)
Inputs (FACTORS) are the resources used to make outputs.
Total Physical Product (TP)- total output or quantity produced
Marginal Product (MP)- the additional output generated by additional inputs (workers).
Marginal Product =
Change in Total Product
Change in Inputs

5. What is the general relationship between inputs and outputs?
To earn profit, firms must make something (output)
Inputs are the resources used to produce outputs.
Input resources are also called FACTORS.
Total Physical Product (TP)- total output or quantity produced
What is the general relationship between inputs and outputs?
Marginal Product (MP)- the additional output generated by additional inputs.
Marginal Product =
Change in Total Product
Change in Labor Input
Average Product (AP)- the output per unit of input
Average Product =
Total Product
Units of Labor

6. Total Product(TP) PIZZAS
Calculate the MP, identify the three stages, and explain why each stage occurs
# of Workers
(Input)
Total Product(TP) PIZZAS
Marginal Product(MP) 1 10 2 25 3 45 4 60 5 70 6 75 7 8

7. Total Product(TP) PIZZAS
Calculate the MP, identify the three stages, and explain why each stage occurs
# of Workers
(Input)
Total Product(TP) PIZZAS
Marginal Product(MP) - 1 10 2 25 15 3 45 20 4 60 5 70 6 75 7 8 -5

8. Total Product(TP) PIZZAS
Calculate the MP, identify the three stages, and explain why each stage occurs
# of Workers
(Input)
Total Product(TP) PIZZAS
Marginal Product(MP) - 1 10 2 25 15 3 45 20 4 60 5 70 6 75 7 8 -5

9. Why does MP start to fall? Too many cooks in the kitchen!
The Law of Diminishing Marginal Returns
As successive units of variable resources (workers) are added to fixed resources (machinery, tool, etc.), the additional output produced from each new worker will eventually fall.
Too many cooks in the kitchen!

10. Law of Diminishing Returns
There are three stages of returns.
Total Product
Total Product, TP
Stage I: Increasing Marginal Returns
Quantity of Labor
Average Product, AP, and
Marginal Product, MP
Average
Product
Quantity of Labor
Marginal
Product

11. Law of Diminishing Returns
There are three stages of returns.
Total Product
Total Product, TP
Stage II:
Diminishing Marginal Returns
Quantity of Labor
Average Product, AP, and
Marginal Product, MP
Average
Product
Quantity of Labor
Marginal
Product

12. Law of Diminishing Returns
There are three stages of returns.
Total Product
Total Product, TP
Stage III: Negative Marginal Returns
Quantity of Labor
Average Product, AP, and
Marginal Product, MP
Average
Product
Quantity of Labor
Marginal
Product

13. Short-Run Production Costs

14. Definitions Fixed Costs
Fixed costs (costs for fixed resources) DON’T change with the amount produced
Ex: Rent, Insurance, Managers salaries, etc.
Average Fixed Costs =
Fixed Costs
Quantity
Variable Costs
Variable costs (costs for variable resources) change as more or less is produced
Ex: raw materials, labor, electricity, etc.
Average Variable Costs =
Variable Costs
Quantity

15. Definitions Total Cost Sum of Fixed and Variable Costs Total Costs
Average Total Cost =
Total Costs
Quantity
Marginal Cost
Additional costs of and additional output.
Ex: If the production of another output increases total cost from $100 to $120, the MC is $20.
Marginal Cost =
Change in Total Costs
Change in Quantity

16. Calculating TC, VC, FC, ATC, AFC, and MCTP VC FC TC MC
AVC
AFC
ATC
100 - 1 10 2 16 3 21 4 26 5 30 6 36 7 46

17. Calculating TC, VC, FC, ATC, AFC, and MCTP VC FC TC MC
AVC
AFC
ATC
100 - 1 10
110 2 16
116 3 21
121 4 26
126 5 30
130 6 36
136 7 46
146

18. Calculating TC, VC, FC, ATC, AFC, and MCTP VC FC TC MC
AVC
AFC
ATC
100 - 1 10
110 2 16
116 6 3 21
121 5 4 26
126 30
130 36
136 7 46
146

19. Calculating TC, VC, FC, ATC, AFC, and MCTP VC FC TC MC
AVC
AFC
ATC
100 - 1 10
110 2 16
116 6 8 58 3 21
121 5
33.3
40.3 4 26
126
6.5 25
31.5 30
130 36
136
16.67
22.67 7 46
146
6.6
14.3
20.9

20. Calculating TC, VC, FC, ATC, AFC, and MCTP VC FC TC MC
AVC
AFC
ATC
100 - 1 10
110 2 16
116 6 8 50 58 3 21
121 5 7
33.3
40.3 4 26
126
6.5 25
31.5 30
130 20 36
136
16.67
22.67 46
146
6.6
14.3
20.9

21. Calculating TC, VC, FC, ATC, AFC, and MCTP VC FC TC MC
AVC
AFC
ATC
100 - 1 10
110 2 16
116 6 8 50 58 3 21
121 5 7
33.3
40.3 4 26
126
6.5 25
31.5 30
130 20 36
136
16.67
22.67 46
146
6.6
14.3
20.9

22. Per-Unit Costs (Average and Marginal)
ATC and AVC get closer and closer but NEVER touch MC 12 11 10 9 8 7 6 5 4 3 2 1
ATC
AVC
Costs (dollars)
Average Fixed Cost
AFC
Quantity

23. Converting Average to Total At output Q, what area represents:TC VC FC
0CDQ
0BEQ
0AFQ or BCDE

24. Why is the MC curve U-shaped?12 11 10 9 8 7 6 5 4 3 2 1
Why is the MC curve U-shaped?
Costs (dollars)
Quantity

25. Why is the MC curve U-shaped?
The MC curve falls and then rises because of diminishing marginal returns
The additional cost of the first units produced fall when workers have increasing marginal returns.
As production continues, each worker adds less and less to production so the marginal cost for each unit increases.

26. 1. 2.

27. 3. 4.

28. Shifting Cost Curves

29. What if Fixed Costs increase to $200
Shifting Costs Curves TP VC FC TC MC
AVC
AFC
ATC
100 - 1 10
110 2 16
116 6 8 50 58 3 21
121 5 7
33.3
30.3 4 26
126
6.5 25
31.5 30
130 20 36
136
16.67
22.67 46
146
6.6
14.3
20.9
What if Fixed Costs increase to $200

30. Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16
100 - 1 10
110 2 16
116 6 8 50 58 3 21
121 5 7
33.3
30.3 4 26
126
6.5 25
31.5 30
130 20 36
136
16.67
22.67 46
146
6.6
14.3
20.9

31. Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 200 100 - 1 10 110 2
200
100 - 1 10
110 2 16
116 6 8 50 58 3 21
121 5 7
33.3
30.3 4 26
126
6.5 25
31.5 30
130 20 36
136
16.67
22.67 46
146
6.6
14.3
20.9

32. Which Per Unit Cost Curves Change?
Shifting Costs Curves TP VC FC TC MC
AVC
AFC
ATC
200 - 1 10
210
100
110 2 16
216 6 8 50 58 3 21
221 5 7
33.3
30.3 4 26
226
6.5 25
31.5 30
230 20 36
236
16.67
22.67 46
246
6.6
14.3
20.9
Which Per Unit Cost Curves Change?

33. ONLY AFC and ATC Increase!
Shifting Costs Curves TP VC FC TC MC
AVC
AFC
ATC
200 - 1 10
210
100
110 2 16
216 6 8 50 58 3 21
221 5 7
33.3
30.3 4 26
226
6.5 25
31.5 30
230 20 36
236
16.67
22.67 46
246
6.6
14.3
20.9
ONLY AFC and ATC Increase!

34. ONLY AFC and ATC Increase!
Shifting Costs Curves TP VC FC TC MC
AVC
AFC
ATC
200 - 1 10
210
110 2 16
216 6 8
100 58 3 21
221 5 7
66.6
30.3 4 26
226
6.5 50
31.5 30
230 40 36
236
33.3
22.67 46
246
6.6
28.6
20.9
ONLY AFC and ATC Increase!

35. If fixed costs change ONLY AFC and ATC Change!
Shifting Costs Curves
If fixed costs change ONLY AFC and ATC Change! TP VC FC TC MC
AVC
AFC
ATC
200 - 1 10
210 2 16
216 6 8
100
108 3 21
221 5 7
66.6
73.6 4 26
226
6.5 50
56.5 30
230 40 46 36
236
33.3
39.3
246
6.6
28.6
35.2
MC and AVC DON’T change!

36. Shift from an increase in a Fixed CostMC
ATC1
ATC
AVC
Costs (dollars)
AFC1
AFC
Quantity

37. Shift from an increase in a Fixed CostMC
ATC1
AVC
Costs (dollars)
AFC1
Quantity

38. What if the cost for variable resources increase
Shifting Costs Curves TP VC FC TC MC
AVC
AFC
ATC
100 - 1 10
110 2 16
116 6 8 50 58 3 21
121 5 7
33.3
30.3 4 26
126
6.5 25
31.5 30
130 20 36
136
16.67
22.67 46
146
6.6
14.3
20.9
What if the cost for variable resources increase

39. Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 10 110 2 16
100 - 1 10
110 2 16
116 6 8 50 58 3 21
121 5 7
33.3
30.3 4 26
126
6.5 25
31.5 30
130 20 36
136
16.67
22.67 46
146
6.6
14.3
20.9

40. Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 11 110 10 2
100 - 1 11
110 10 2 18
116 6 8 50 58 3 24
121 5 7
33.3
30.3 4 30
126
6.5 25
31.5 35
130 20 26 43
136
16.67
22.67 55
146
6.6
14.3
20.9

41. Which Per Unit Cost Curves Change?
Shifting Costs Curves TP VC FC TC MC
AVC
AFC
ATC
100 - 1 11
111 10
110 2 18
118 6 8 50 58 3 24
124 5 7
33.3
30.3 4 30
130
6.5 25
31.5 35
135 20 26 43
143
16.67
22.67 55
155
6.6
14.3
20.9
Which Per Unit Cost Curves Change?

42. Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 11 111 10 110
100 - 1 11
111 10
110 2 18
118 7 8 50 58 3 24
124 6
33.3
30.3 4 30
130
6.5 25
31.5 5 35
135 20 26 43
143
16.67
22.67 55
155 12
6.6
14.3
20.9
MC, AVC, and ATC Change!

43. Shifting Costs Curves TP VC FC TC MC AVC AFC ATC 100 - 1 11 111 110 2
100 - 1 11
111
110 2 18
118 7 9 50 58 3 24
124 6 8
33.3
30.3 4 30
130
7.5 25
31.5 5 35
135 20 26 43
143
7.16
16.67
22.67 55
155 12
7.8
14.3
20.9
MC, AVC, and ATC Change!

44. If variable costs change MC, AVC, and ATC Change!
Shifting Costs Curves
If variable costs change MC, AVC, and ATC Change! TP VC FC TC MC
AVC
AFC
ATC
100 - 1 11
111 2 18
118 7 9 50 59 3 24
124 6 8
33.3
41.3 4 30
130
7.5 25
32.5 5 35
135 20 27 43
143
7.16
16.67
23.83 55
155 12
7.8
14.3
22.1

45. Shift from an increase in a Variable Costs
MC1 MC
ATC1
AVC1
ATC
AVC
Costs (dollars)
AFC
Quantity

46. Shift from an increase in a Variable Costs
MC1
ATC1
AVC1
Costs (dollars)
AFC
Quantity

47. Long-Run Cost Curves

48. Short-Run vs. Long-Run
The short-run is a period in which at least one resource is fixed.
Plant capacity/size is NOT changeable
In the long-run ALL resources are variable
NO fixed resources
Plant capacity/size is changeable

49. Long Run ATC
What happens to the average total costs of a product when a firm increases its plant capacity?
Example of various plant sizes:
I make looms out of my garage with one saw
I rent out building, buy 5 saws, hire 3 workers
I rent a factory, buy 20 saws and hire 40 workers
I build my own plant and use robots to build looms.
I create plants in every major city in the U.S.
Long Run ATC curve is made up of all the different short run ATC curves of various plant sizes.

50. 5 Various Plant Capacities
Long Run ATC
5 Various Plant Capacities
Unit Costs
Output

51. The long-run ATC is the result of all of the short-run ATC curves.
Unit Costs
Output

52. Why is LRATC U Shaped?
The law of diminishing marginal returns doesn’t apply in the long run because all resources are variable.
LRATC
Unit Costs
Output

53. Three Areas on the LRATC Curve
Economies of Scale- LRATC is falling as mass production techniques can be utilized.
Economies
of scale
Unit Costs
long-run ATC
Output

54. Three Areas on the LRATC Curve
Constant Returns to Scale- The average total cost is as low as it can get.
Economies
of scale
Constant returns
to scale
Unit Costs
long-run ATC
Output

55. Three Areas on the LRATC Curve
Diseconomies of Scale- The LRATC is increasing as the firm gets too big and difficult to manage.
Economies
of scale
Constant returns
to scale
Diseconomies
of scale
Unit Costs
long-run ATC
Output

56. Perfect Competition

57. FOUR MARKET MODELS Characteristics of Pure Competition:
Many small firms
Identical products (perfect substitutes)
Firms are “Price Takers”
Easy for firms to enter and exit the industry
No control over price.
No need to advertise
Examples: Corn or Avocado farmers, TJ hammocks
Pure
Competition
Monopolistic
Competition
Pure
Monopoly
Oligopoly
Market Structure Continuum

58. Demand for Perfectly Competitive Firms (A Horizontal straight line)
Why are they Price Takers?
If a firm charges above the market price, NO ONE will buy. They will go to other firms
There is no reason to price low because consumers will buy just as much at the market price.
Since the price is the same at all quantities demanded, the demand curve and MR for each firm is…
Perfectly Elastic
(A Horizontal straight line)

59. Maximizing PROFIT

60. Profit Maximizing Rule
MR = MC
Maximizing PROFIT

61. Draw a FIRM making a profit

62. Draw a FIRM making a profitMC
ATC MR
Profit
Price P Q
Quantity

63. Draw a FIRM making a loss

64. Draw a FIRM making a lossMC
ATC
Price P
Loss MR Q
Quantity

65. Don’t forget that averages show PER UNIT COSTS
How much output should be produced?
How much is Total Revenue? How much is Total Cost?
Is there profit or loss? How much? $9 8 7 6 5 4 3 2 1 MC
MR=Price
Cost and Revenue
Profit = $18
ATC
AVC
Don’t forget that averages show PER UNIT COSTS
Total Cost=$45
Total Revenue =$63

66. the MR=MC rule still applies
Loss Minimization Position
What would happen if the price is lowered from $7 to $5…
the MR=MC rule still applies
…but the output changes.

67. How much output should be produced?
How much is Total Revenue? How much is Total Cost?
Is there profit or loss? How much? MC $9 8 7 6 5 4 3 2 1
ATC
Cost and Revenue
AVC
Loss =$7
MR=Price
Total Cost = $42
Total Revenue=$35

68. What would happen if the price is lowered from $5 to $4…
…the firm must SHUT-Down
A firm should continue to produce as long as the price is above the AVC.
Even though they are losing money, they are still paying some of their fixed costs.
When the price falls below AVC then the firm should minimize its losses by shutting down.
This is called the…
Shutdown Point

69. Minimum AVC is shut down point
SHUT DOWN! Produce Zero MC $9 8 7 6 5 4 3 2 1
ATC
Cost and Revenue
AVC
Minimum AVC is shut down point

70. Producing nothing is cheaper than staying open.
SHUT DOWN!
Producing nothing is cheaper than staying open. MC $9 8 7 6 5 4 3 2 1
ATC
Cost and Revenue
AVC
Fixed Costs
MR=Price
Total Cost
Total Revenue

72. Supply Revisited

73. Marginal Cost & Supply Break-even Point (No Economic Profit) MR5MC P5
MR5
ATC
MR4 P4
Cost and Revenue, (dollars)
AVC P3
MR3 P2
MR2
MR1 P1
Do not
Produce –
Below AVC Q2 Q3 Q4 Q5
Quantity Supplied

74. Supply = Marginal Cost above AVC
Marginal Cost & Supply
Supply = Marginal
Cost above AVC
This is the
Supply Curve
Supply= MC P5
MR5
MR4 P4
Cost and Revenue, (dollars) P3
MR3 P2
MR2
MR1 P1 Q2 Q3 Q4 Q5
Quantity Supplied

75. What if variable costs increase?
Marginal Cost & Short-Run Supply
MC2 S2
Cost and Revenue, (dollars)
MC1
AVC1
Quantity Supplied S1
AVC2
What if variable costs increase?
Supply Curve shifts to the Left

76. Marginal Cost & Short-Run Supply
Cost and Revenue, (dollars)
MC1
AVC1
Quantity Supplied S1
Lower Costs Move
the Supply Curve
to the Right
MC2 S2
AVC2

77. Perfect Competition in the Long-Run

78. (No Economic Profit=Normal Profit)
In the Long-run…
Firms will enter if there is profit
Firms will leave if there is loss
All firms break even, they make NO economic profit
(No Economic Profit=Normal Profit)
In long run equilibrium the firm is efficient.
(Price = Minimum ATC)

79. Firm making a normal profit
LONG-RUN EQUILIBRIUM
FOR A COMPETITIVE FIRM MC
ATC
Price P MR
Price = MC = Minimum ATC
Firm making a normal profit Q
Quantity

80. What happens when there is a change in price?
LONG-RUN EQUILIBRIUM
FOR A COMPETITIVE FIRM
What happens when
there is a change
in price? MC
ATC
Price P MR
When at Long-Run Equilibrium, there is no incentive to enter or leave the industry. Q
Quantity

81. Changes in the long-run equilibrium
PROFIT MAXIMIZATION IN THE LONG RUN
Changes in the long-run equilibrium S1 P Q
100
100,000
Industry
Firm
(price taker)
$60 50 40 MC
ATC MR D1

82. What happens when demand increases?
PROFIT MAXIMIZATION IN THE LONG RUN
What happens when demand increases?
Economic
Profits S1 P Q
100
100,000
Industry
Firm
(price taker)
$60 50 40 MC
ATC MR D2 D1

83. PROFIT MAXIMIZATION IN THE LONG RUN
New competitors enter. This increases supply and lowers price back to equilibrium.
Zero Economic
Profits S1 P Q
100
100,000
Industry
Firm
(price taker)
$60 50 40 S2 MC
ATC MR D2 D1

84. Firm Industry Result is Long-Run Equilibrium Again.
The ONLY change is the industry’s output
Zero Economic
Profits S1 P Q
100
100,000
Industry
Firm
(price taker)
$60 50 40 S2 MC
ATC MR D2 D1

85. Firm Industry Decreases in demand, losses, and the
PROFIT MAXIMIZATION IN THE LONG RUN
Decreases in demand, losses, and the
reestablishment of long-run equilibrium S1 P Q
100
100,000
Industry
Firm
(price taker)
$60 50 40 MC
ATC MR D1

86. Firm Industry A decrease in demand creates losses… Economic Losses P Q
PROFIT MAXIMIZATION IN THE LONG RUN
A decrease in demand creates losses…
Economic
Losses S1 P Q
100
100,000
Industry
Firm
(price taker)
$60 50 40 MC
ATC MR D1 D2

87. Firm Industry Competitors with losses leave, decrease supply, and
PROFIT MAXIMIZATION IN THE LONG RUN
Competitors with losses leave, decrease supply, and
prices return to zero economic profits. S3
Return to Zero
Economic Profits S1 P Q
100
100,000
Industry
Firm
(price taker)
$60 50 40 MC
ATC MR D1 D2

88. Firm Industry Result is Long-Run Equilibrium Again. Zero Economic P
PROFIT MAXIMIZATION IN THE LONG RUN
Result is Long-Run Equilibrium Again.
Zero Economic
Profits S1 P Q
100
100,000
Industry
Firm
(price taker)
$60 50 40 S2 MC
ATC MR D2 D1

90. Efficiency

91. 1. Productive Efficiency 2. Allocative Efficiency
PURE COMPETITION AND EFFICIENCY
In general, efficiency is the optimal use of societies scarce resources
Perfect Competition forces producers to use limited resources to their fullest.
Inefficient firms have higher costs and are the first to leave the industry.
Perfectly competitive industries are extremely efficient
There are two kinds of efficiency:
1. Productive Efficiency
2. Allocative Efficiency

92. Price = Minimum ATC Productive Efficiency
PURE COMPETITION AND EFFICIENCY
Productive Efficiency
The production of a good in a least costly way. (Minimum amount of resources are being used)
Graphically it is where…
Price = Minimum ATC

93. Allocative Efficiency
PURE COMPETITION AND EFFICIENCY
Allocative Efficiency
The distribution of resources towards the production of products most wanted by society.
Graphically it is where…
Price(Marginal Benefit) = MC

94. Productive Efficiency in the Long-Run Optimal amount being produced
Long-Run Equilibrium MC
ATC MR P
Price
The marginal benefit to society (as measured by the price) equals the marginal cost. Q
Optimal amount being produced
Quantity

95. equilibrium perfectly competitive firms have
Long-Run Equilibrium
In long run
equilibrium perfectly
competitive firms have
both productive
and allocative
efficiency MC
ATC
Price MR P
P = Minimum ATC = MC Q
Quantity