Production, Cost, and the Perfect Competition Model

Notes

Production

• Short run: at least one input (like factory size) is fixed. Long run: all inputs can change.
• Marginal product (MP): the extra output from one more worker. The law of diminishing marginal returns: eventually each added worker adds less output.

Costs

• Fixed costs (FC) don't change with output; variable costs (VC) do. $TC = FC + VC$.
• $\displaystyle ATC = \frac{TC}{Q}$, $\displaystyle AVC = \frac{VC}{Q}$, $\displaystyle AFC = \frac{FC}{Q}$. Marginal cost $\displaystyle MC = \frac{\Delta TC}{\Delta Q}$.
• MC crosses ATC and AVC at their minimum points.
• Long-run average total cost (LRATC): economies of scale (falling costs), constant returns, then diseconomies of scale.
• Accounting profit = revenue − explicit costs. Economic profit = revenue − explicit − implicit costs (opportunity costs). Normal profit means zero economic profit.

Profit maximization

Every firm maximizes profit by producing where MR = MC.

Perfect competition

• Many firms, identical products, easy entry and exit, and firms are price takers: $P = MR = AR = D$ for each firm (a horizontal demand curve).
• Profit: if $P > ATC$, economic profit; if $P < ATC$, a loss.
• Shutdown rule: in the short run, shut down if $P < AVC$ (minimum). Keep producing at a loss if $AVC \le P < ATC$, because you cover some fixed costs.
• Long run: profits attract new firms (supply shifts right, price falls); losses cause exit. In long-run equilibrium, $P = MC = \text{minimum } ATC$, and firms earn zero economic profit.
• Perfect competition is allocatively efficient ($P = MC$) and productively efficient (producing at minimum ATC).