Production
and
Costs
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$
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Microeconomics - Dr. D. Foster
Supply side of the market
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Why firms exist.
Production and cost relationships.
Model of perfect competition.
Model of monopoly.
Regulation
Later: Monopolistic competition,
oligopoly, game theory, factor
markets, general equilibrium
Why do firms exist?
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They combine resources to produce
goods and services.
Why not use markets?
Transaction costs are high.
Role of managers - monitor workers to
minimize shirking.
 Chinese barge-pullers.
Firm’s objective: maximize profit
Costs & Profits
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All costs are “opportunity costs.”
Costs may be explicit or implicit.
Total cost = TC = all relevant costs.
(Economic) Profit = TR-TC
– If positive, firms will enter.
– If negative, firms will exit.
– If zero, the market is stable.
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Accounting profit may/will not
equal Economic Profit.
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Short Run vs. Long Run
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We are interested in the short run:
At least one input is fixed
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Fixed - capital; variable – labor
In the Long Run, all factors are
variable.

Next - Production & Cost
relationships
Production Relationships
Output
Total Product
= TP (=Q)
Labor
L1
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L3
From 0 to L1 there are “increasing returns.”
From L1 onwards, there are “diminishing marginal
returns.”
After L3 additional workers lower output. Why?
Production Relationships
Output
Marginal Product = MP
TP (=Q)
Average Product = AP
Labor
L1 L2
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L3
Marginal Product = MP = ΔTP/ΔL;
this shows how much the last worker (unit) adds to output.
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Average Product = AP = TP/L;
this shows how much the average worker adds to output.
Cost Relationships
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As noted, TC = TFC + TVC
TFC is fixed, by definition.
TVC can be written as w*L, where
w is the (constant) wage rate.
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Average Fixed Cost, AFC = TFC/Q
Average Variable Cost,
AVC = TVC/Q . . . or, = wL/Q = w/AP
As AP rises, AVC falls . . .
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Average Total Cost,
ATC = TC/Q = AFC + AVC
Cost Relationships
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Marginal Cost, MC = ΔTC/ΔQ or, can
be written as = ΔTVC/ΔQ (Why?)
… = Δ(wL)/ΔQ = w(ΔL)/ΔQ = w/MP
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MC
ATC
AVC
AFC
quantity (TP)
Complete the
Production
and Cost
Worksheets
Key Formulas
MP = ΔTP/ΔL
AP = TP/L
TC = TFC + TVC
TVC = w*L
AFC = TFC/Q
AVC = TVC/Q = wL/Q = w/AP
ATC = TC/Q = AFC + AVC
MC = ΔTC/ΔQ = ΔTVC/ΔQ
= Δ(wL)/ΔQ = w(ΔL)/ΔQ = w/MP
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Production
and
Costs
$
$
$
Microeconomics - Dr. D. Foster