ECON 1001: Introduction to Economics;
1
At the end of this lesson you must be able to:
 Distinguish between the long run and short run.
 Discuss the production function and its components.
 Define the law of variable proportions/ diminishing
marginal returns.
 Distinguish between output/product and product
curves.
 Distinguish between different costs and cost curves.
 Determine revenue curves.
 Fixed
and variable factors of production.
 Long run and short run.
 The production function.
 The law of diminishing marginal returns.
 Costs: fixed and variable. Marginal and average.
 Isoquants and Isocosts.
 Output and Revenue: marginal and average.
 Market Structures
 Shows
a purely technical relationship between inputs
and outputs.
 Inputs/
Factors of Production are:
-Land
-Labour
-Capital
-Entrepreneurship.
 Firms
aim to maximize profits by minimizing inputs and
maximizing outputs.

The input that is usually fixed in the short run is usually
capital such as plant and equipment, land etc. The use Fixed
inputs do not change as output changes (short-run)

The inputs that can be varied in the short run are called
variable inputs or variable factors. Variable inputs are so
called because as output changes, it is implied that the use of
these inputs also change.

Variable factors can be basic raw materials, electricity, labour
etc.
 By
varying inputs in the short run the firm varies output.
 The
total output or product is the total amount produced
during some period of time by all the inputs that the firm
uses. If one of the inputs is held constant the total
product will change as inputs of the other variable
factors are changed.
 The
variations in total product is based on the law of
diminishing returns.
 The
short run is characterized by at least
one fixed factor of production.
 The
law of diminishing returns is a short
run phenomenon which states that as more
and more of variable factor inputs are
added to a given fixed input, the contribution
of the variable inputs to total output,
decreases.
 The
law of diminishing returns implies that total product
or total output in the short run varies as it increases.
 At
first, the curve shows increasing output at an
increasing rate.
 As
the law of diminishing returns sets in, output
increases at a decreasing rate.
 Recall:
The concept of MARGINAL
 Average
output is the total output per unit of the variable
input (labour in the example).
 It can be expressed as
AP=Total Output ÷ Qty Labour
 Marginal
output is the change in total product resulting
from the use of one more unit of the variable input.
 It can be expressed as
MP= ΔTotal Output ÷ ΔQty Labour
Qty of labour
Total ouptut
(TP)
Average output
(AP)
Marginal
output (MP)
1
10
10
2
24
12
3
37
12.3
4
44
11
5
49
9.8
6
52
8.66
10
14
13
7
5
3
1
7
53
7.57
 The
TP curve shows that total output is steadily rising,
first at an increasing rate, then at a decreasing rate. This
causes both the average and the marginal product curves
to rise at first and then decline.
 Where AP reaches
 The
its maximum point, MP=AP
level of output where marginal output/ product
reaches its maximum is called the point of diminishing
marginal returns
Output
Point of diminishing returns
Total Output
Quantity of
labour
Output
Diminishing Marginal returns
Diminishing Average
returns
Average Output
Marginal Output
Quantity
of labour
 The
firm aims to maximize profits: Economic Profits/
 Economic
Profits differ from accounting profits: pure or
economic profits take into consideration the opportunity
cost of the owners’ capital as part of the firm’s cost.
Pure/ economic profit is therefore less than accounting
profit.
Refer to Lipsey-Pg 118-119
 Profit
can be expressed as Total revenue less total costs.
(TR-TC= π).
Production is carried out by firms using the factors of
production which must be paid for or rewarded for
their use. The cost of production is the total cost of the
factors used.
 The behaviour of costs is usually analyzed under two
sets of conditions: the short run and the long run.
 Just as some inputs (FOPS) can be varied in the short
run, while some are held constant (fixed), short run
costs consists of variable and fixed costs.
 The long run period will consist of only variable costs
because all the inputs can be changed in the long run.
(there are no fixed factors).

 In
the short run, certain costs are fixed because the
availability of resources is restricted.
 Short
run costs: the costs of output during a time
period when only some inputs can be varied
(variable costs) and when some (or at least one)
input(s) remain fixed (Fixed Cost).
 In
the long run, most costs are variable, because
the supply of skilled labour, machinery, buildings
and so on can be increased or decreased.
Total Costs=
Total Variable Costs + Total Fixed Costs.
Fixed costs are those costs that do not vary
with output.
Variable costs are those costs that vary
positively with output, rising as more is
produced and falling as less is produced.
Costs
Total costs =
TVC + TFC
Total
variable
costs
Total
Fixed
costs
Output/
quantity
Average fixed cost (AfC)=
Total FIXED cost ÷ Number of Units
produced.
Average variable cost (AvC)=
Total VARIABLE cost ÷ Number of Units
produced.
Average total cost (ATC)=
Total cost ÷ Number of Units produced.
OR
Average Fixed Costs + Average Variable Costs.
ATC is the total cost of producing any given
output divided by the number of units
produced, i.e the cost per unit
Marginal Cost=
Δ Total Cost ÷ Δ Output
MC is the increase in total cost resulting
from raising the rate of production by one
unit OR the addition to total cost of
producing one more unit of output.
The Law of diminishing returns implies
eventually increasing marginal and
average variable costs.
Units of
output (Q)
Total Cost
(TC)
Average Cost
(AC)
Marginal Cost
(MC)
1
2
3
1.10
1.60
1.75
1.10
0.80
0.58
1.10
0.50
0.15
4
5
6
2.00
2.50
3.12
0.50
0.50
0.52
0.25
0.5
0.62
7
8
9
3.99
5.12
6.30
0.57
0.64
0.70
0.87
1.13
1.18
10
8.00
0.80
1.70
Costs
Short Run Average cost curves
ATC
AVC
AFC
Output
Short Run Average cost curves
and the Marginal cost curve
Costs
ATC
AVC
MC
MC cuts AVC and
ATC at the
minimum point of
the AVC and ATC
Output
 Total
Cost: TC carry on rising as more and
more units are produced.
 Average
Cost: AC changes as output
increases. It starts by falling, reaches a
lowest level, and then starts rising again.
 Marginal
Cost: The MC of each extra unit of
output also changes with each unit produced.
It too starts by falling, reaches a lowest
level, and then starts rising.
 At
lowest levels of output, MC is less than
AC. At highest levels of output, though, MC is
higher than AC. There is a “cross-over” point
where MC is exactly equal to AC. (At 5 units
of output in example from the table).
 When marginal is greater than average,
average is rising, when marginal is less than
average, average is falling.
 The Marginal Cost curve always cuts the
Average Cost curve at the lowest point of the
Average Cost curve.

Total fixed cost (TFC) does not vary with output.

Total variable cost and the total of all costs (TC=TVC+ TFC) rise
with output, first at a decreasing rate, then at an increasing
rate.

The total cost curves give rise to average and marginal curves.

Average fixed cost (AFC) declines as output increases.

Average variable cost (AVC) and average total cost (ATC) fall and
then rise as output increases.

Marginal cost (MC) does the same, intersecting the ATC and AVC
at their minimum points.
 The
law of diminishing returns implies
eventually increasing marginal and average
variable cost.
 Short-run average and variable cost curves
are assumed to be U shaped- the rising
portion reflects diminishing average and
marginal RETURNS.
 The marginal cost curve cuts the average
variable cost curve at its minimum- this is
the firm’s capacity output, any output
beyond this point will be at increasing costs.
 In
the short-run, the firm will continue to
produce so long as it is able to meet its
AVERAGE VARIABLE COSTS.
 In the long run, the firm must cover all
costs to continue operations.
 The short run supply curve therefore
becomes the Marginal COST curve that
lies above average variable costs. The
long run supply curve becomes the
Marginal cost curve that lies above
average total costs.
Short Run Average cost curves
and the Marginal cost curve
Costs
ATC
Long run
supply
curve
MC
AVC
Short run supply
curve
Output
 The
output that corresponds to the minimum
short-run average total cost is often called
capacity.
 Whereas
short-run output decisions are
concerned with diminishing returns because
of fixed factors, long run output decisions
are concerned with economies of scale when
all factor inputs are variable.
 Economies of Scale: factors which cause
average cost to decline in the LONG RUN as
output increases.
 Diseconomies of Scale: factors which cause
average cost to increase in the LONG RUN as
output expands.
What are some examples?
 While
Economies of Scales looks at the
impact of large SCALE production on average
cost,
RETURNS TO SCALE looks at the impact of
increasing ALL the inputs (the scale of inputs)
on either improving or declining productivity
(the scale of production).
-economies of scale and returns to scale are
related.
 The
Long Run Average Cost curve (LRAC) is
the boundary between cost levels that are
attainable, with known technology and
given input prices, and those that are
unattainable.
 ABOVE LRAC: Attainable
 BELOW LRAC: Unattainable
 Decreasing Costs: From 0 to Q1, the firm
has falling average costs: by expanding
output, the firm experiences a reduction
in cost per unit of output.
 Q1
is described as the minimum efficient
scale.
 Increasing Costs: Any output greater than Q1
shows that the firm encounters rising long
run average costs and therefore decreasing
returns.
Can be illustrated using Isoquants and Isocosts curves
The Isoquant shows all the combinations of factor inputs (Capital and
Labour) that produce a given level of output. Recall Indifference
Curve
The Isocost shows all the combinations of factor inputs (Capital an
Labour) that can be afforded by the firm. Recall Budget Line
The optimum level of production is found where
MPk = Pk
MPl Pl
i.e: Where the slope of the Isoquant is equal to the slope of the
isocost
i.e: where the MRTS = MRMS
 Total
Revenue: The total amount of money
that the firm receives from the sale of
output over some period of time.
$ Price x Quantity Sold.
 Marginal
Revenue: The change in TR resulting
from a unit change in the sales per period of
time.
Change in TR / Change in Quantity Sold
 Average
Revenue: TR divided by the number
of units sold OR price per unit sold.
 Average
Revenue= Marginal Revenue
 Above the AR/MR Curve: No Sales
 Below the AR/MR Curve: No Sense
 Whatever the size of the output, the price
that a product can fetch in the market
remains the same.
Price
Quantity
TR
AR
(TR/Q)
MR
(∆TR/∆Q)
$5
1
$5
$5
$5
$5
2
$10
$5
$5
$5
3
$15
$5
$5
$5
4
$20
$5
$5
$5
5
$25
$5
$5
Market
supply
$P
$5
equilibrium
$P
$5
Price = AR = MR
Market
demand
Market Equilibrium
Qty
Price Taker’s AR and MR
Qty
A
firm that exerts a significant effect on
the price of the product it sells by
altering its rate of production and sales.
 The Marginal Revenue curve is twice as
steep as the Average Revenue Curve.
 Average Revenue varies with output, it
declines with rising output.
 Marginal Revenue lies above the x axis as
long as total revenue is increasing and lies
below the x axis when total revenue is
decreasing
Price
Quantity
TR
AR
(TR/Q)
MR
(∆TR/∆Q)
$5
1
$5
$5
$5
$4
2
$8
$4
$3
$3
3
$9
$3
$1
$2
4
$8
$2
-$1
$1
5
$5
$1
-$3
Price
Price Setter’s MR and AR
AR = Price
Qty
MR
 The
FIRM in ANY MARKET STRUCTURE
will ALWAYS PRODUCE AN OPTIMUM
OUTPUT Where MARGINAL COST=
MARGINAL REVENUE.
 If marginal revenue is greater than
marginal cost then the firm should
increase output, if marginal cost is
greater than marginal revenue, the firm
should decrease output.
 The
profit level is determined by looking at
the position on the Average Revenue Curve in
comparison to the Average Cost curve when
the optimum level of output is determined.
1-Equilibrium/Profit Max output is where
MC=MR.
2-Revenue is determined from the Average
Revenue Curve.
3-Cost is measured from the Average Cost
Curve.
4- Profit is the difference in area between AC
and AR.
A
market Structure refers to the
characteristics of an Industry such as
-number of buyers
-number of sellers
-nature of product- product homogeneity or
differentiation
-barriers to entry and exit
-information availability
 The market structure affects market
conduct.
Perfect
Competition
Monopoly
Oligopoly
Duopoly
Monopolistic Competition
 Each
Firm is a PRICE TAKER- there are many
buyers and sellers. No one firm has
influential power.
 The product is homogenous- the products of
every firm are identical to each other, it
makes no difference to the buyer from whom
he buys the product.
 There are no barriers to entry or exit all
firms have the choice to enter into or exit
the market.
 There
is perfect knowledge-all buyers and
sellers know the prices at which all
transactions are taking place and what the
possible alternatives are. No consumer or
firm can deviate because of any special
information known. Everyone knows the
same thing.
 The
profit level is determined by looking at
the position on the Average Revenue Curve in
comparison to the Average Cost curve when
the optimum level of output is determined.
1-Equilibrium/Profit Max output is where
MC=MR.
2-Revenue is determined from the Average
Revenue Curve.
3-Cost is measured from the Average Cost
Curve.
4- Profit is the difference in area between AC
and AR.
 Normal
Profits- that level of profits that is
just sufficient to induce the firm to stay in
the industry.
 Supernormal/Above Normal Profits- excess
profits.
 Subnormal Profits/Losses- occurs when the
firm earns less profits than what is necessary
to induce it to remain in the industry.
 In
the short-run, the firm will continue to
produce so long as it is able to meet its
AVERAGE VARIABLE COSTS.
 In the long run, the firm must cover all
costs to continue operations.
 The short run supply curve therefore
becomes the Marginal COST curve that
lies above average variable costs. The
long run supply curve becomes the
Marginal cost curve that lies above
average total costs.
1. Profit (P >ATC)
2. Loss (ATC>P>AVC)
3. Loss (P<AVC)
NUMERICAL EXAMPLE
Price = $6
Output where MC=MR is = 10
Total Revenue = $6 x 10 = $60
TVC = $50
TFC = $30
Total Cost = $80
Total Revenue- Total Cost : $60-$80 = -$20 (Loss)
If the firm, shuts down Output= 0
Total Revenue = 0 x $6 = 0
Total Costs= TFC= $30
Total Revenue- Total Costs = $0- $30 = -$30 (Loss)
Short Run Average cost curves
and the Marginal cost curve
Costs
ATC
Long run
supply
curve
MC
AVC
Short run supply
curve
Output
A
MONOPOLY IS SAID TO EXIST WHEN THERE IS
ONE FIRM/ PRODUCER IN A MARKET
PRODUCING SIGNIFICANT % OF INDUSTRY
OUTPUT. A MONOPOLY IS A PRICE SETTER.
 One
seller
 Imperfect knowledge
 The firm can be a price setter OR
quantity setter, that is, the firm can
choose either price or quantity and the
other variable would be determined by
the existing demand curve. This demand
curve is downward sloping, illustrating
the negative relationship between price
and quantity. (what does this say?)
 Demand = Average revenue, but AR is not
equal to MR. (Diagram)
 Because
the firm is the sole producer of the
commodity, it benefits from economies of
scale and large scale production.
 The firm is capable of making supernormal
profits in the long run- this is because there
are barriers to entry and exit.
 The monopoly always produces in the elastic
region on the demand curve
 In
the short-run the monopoly is capable of
making normal, subnormal, and above
normal profits.
 Short-run equilibrium is determined under a
monoploy at the point where MR=MC.
However monopoly price is found by taking a
vertical to the AR curve and across to the
price axis. (Diagram)
 Whether
the firm is making sub-normal,
normal or ab-normal profits depends upon
the value of the AC curve in relation to its AR
at equilibrium quantity.
 Due to the existence of barriers to entry and
exit, the monopoly is capable of making
profits (above-normal) in the long run.