Firms face both fixed and variable costs in the short-run. Fixed costs remain constant as output changes, while variable costs change with output level. Total costs are the sum of fixed and variable costs. As output increases, average fixed costs decline due to spreading overhead. Average and marginal costs initially fall as output rises due to increasing returns to scale, but eventually rise as diminishing returns set in. Understanding how costs change with output level and productivity is important for firms seeking to minimize costs and maximize profits.

1. Theory of the Firm
Section 2.3 HL
Discuss the following with the person next to you:
•What is the difference between profit and revenue?
•Come up with concrete examples of:
- Monopolies
- Oligopolies
- Monopolistic Competition
- Perfect Competition
• What is the goal of a firm?

2. Unit 2.3 - Theory of the Firm
Introduction to the Four Market Structures
Most competition Least competition
Pure (or Perfect) Monopolistic Oligopoly Monopoly
Competition competition
VERY large number of firms A few large firms Only ONE firm. The
Fairly large number of
dominate an industry firm IS the industry!
firms
Each firm is so small that
changes in its own output do A change in one firm's Significant barriers to
Firms are small relative to
not affect market price, i.e. output has significant entry exist,
the industry, meaning
firms are price takers impact on the market preventing new firms
changes in one firms
price, firms are price- from entering and
output have only a slight
Firms all produce identical makers. competing with the
impact on market price
products, with no monopolist
differentiation Products can be iden-
Products are slightly
tical (such as oil) or
differentiated. Firms will the Monopolist can
Completely free entry and differentiated (such as
advertise to try and maintain significant
exit from the industry, i.e. Macs and Dells)
further differentiate profits due to the lack
NO barriers to entry. product. Branding!
There are significant of competition.
Advertising!
All producers and barriers to entry
consumers have perfect Changes in the firm's
No barriers to entry, firms
knowledge of prices, costs, Firms will likely use output cause changes
can enter or leave easily
and quality and availability advertising to try and in the price, i.e. the
of products differentiate their firm is a price-maker!
products from
competitors'

3. Unit 2.3 - Theory of the Firm
Introduction to the Four Market Structures
Examples of different market structures: Based on the characteristics of the different market structures,
brainstorm examples of each.
Pure Monopolistic Oligopoly Monopoly
Competition competition
Practice: Different types of Market Structure - NCEE Activity 24

4. Unit 2.3 - Theory of the Firm
Unit Overview
Unit 2.3.1 - Introduction to Market Structures Long-run
and Cost Theory ·Economies of scale
·Diseconomies of scale
Intro to Market Structures ·Long-run cost curves
·Pure competition
·Monopolistic competition Revenues
·Oligopoly ·Total revenue
·Monopoly
·Marginal revenue
·Average revenue
Cost theory
·Types of costs: fixed costs, variable costs
·Total, average and marginal costs Profit
·Accounting costs = opportunity costs = economic ·Distinction between normal (zero) and
costs supernormal (abnormal) profit
·Profit maximization in terms of total revenue
Short-run and total costs, and in terms of marginal
·Law of diminishing returns revenue and marginal cost
·Total product, average product, marginal product ·Profit maximization assumed to be the main
·Short-run cost curves goal of firms but other goals exist (sales volume
maximization, revenue maximization,
environmental concerns)
Blog posts: “Economies of Scale” Blog posts: "Costs of Production"
Blog posts: "Productivity" Blog posts: “Law of Diminishing Returns”

5. Unit 2.3 - Theory of the Firm
Unit Overview
2.3.2 - Perfect competition Efficiency in monopoly
·Assumptions of the model ·Price discrimination
·Demand curve facing the industry and the firm in >>Definition
perfect competition >>Reasons for price discrimination
·Profit-maximizing level of output and price in the >>Necessary conditions for the practice of price
short-run and long-run discrimination
·The possibility of abnormal profits/losses in the >>Possible advantages to either the producer or
short-run and normal profits in the long-run the consumer
·Shut-down price, break-even price
·Definitions of allocative and productive efficiency 2.3.4 - Monopolistic competition
·Efficiency in perfect competition ·Assumptions of the model
·Short-run and long-run equilibrium
2.3.3 - Monopoly ·Product differentiation
·Assumptions of the model ·Efficiency in monopolistic competition
·Sources of monopoly power/barriers to entry
·Natural monopoly 2.3.5 - Oligopoly
·Demand curve facing the monopolist ·Assumptions of the model
·Profit-maximizing level of output ·Colusive and non-collusive oligopoly
·Advantages and disadvantages of monopoly in ·Cartels
comparison with perfect competition ·Kinked demand curve as one model to describe
interdependent behavior (IB HL only)
·Importance of non-price competition
·Theory of contestable markets (IB HL only)

6. Costs of Production
Big Ideas
Important questions:
1) What is productivity and how does it change as resources
(LAND, LABOR, CAPITAL) are added to production?
2) What are the different costs faced by firms in the short-run and
the long-run?
3) What is the relationship between the productivity of its
resources and the costs faced by a firm?
4) Why does understanding productivity and costs matter to firms?
Discussion Question: What is productivity, and why
do firms care about it?
Blog posts: "Productivity"

7. Costs of Production
Law of Diminishing Returns
Understanding Productivity:
Productivity (OUTPUT) : The amount of output attributable to a unit of
input. Examples of productivity:
"Better training has increased the productivity of workers"
"The new robot is more productive than older versions"
"Adding fertilizer has increased the productivity of farmland"
Total prod. (TP or TO) is the total output of a particular firm
Example of TP: "After hiring more workers the firm's total product
increased."
Marginal prod. of labor (MPL) is the change in total product resulting from each
additional worker.
>>MPL = ∆TP/∆L
Average prod. of labor (APL) is the output, on average, by each
worker
>>APL = TP/units of L

8. Costs of Production
Law of Diminishing Returns
Law of Diminishing Returns:states that as additional units of a variable resource
are added to fixed resources, beyond some point the marginal product of the
variable resource will decline.
HUH? Let's illustrate this with an example
Example: Paper Chain Factory
Instructions:
1) Use inputs (land, labor and capital) to create a product (paper chains)
2) Labor is the only variable resource. Land and capital are fixed.
3) Production rounds last one minute
4) Record production data in a data table
LAND (fixed) LABOR (variable) CAPITAL (fixed)

9. Costs of Production
Law of Diminishing Returns
Units of labor TP MP AP
One worker has one minute
to make the longest chain
possible. 0
A volunteer is needed to 1
record output data in the
2
table to the right.
3
As more workers are
added, TP, MP and AP will 4
be calculated and recorded.
5
MP = ∆TP/∆L
L
6
AP = TP/units of L
L 7
8

10. Costs of Production
Law of Diminishing Returns
MP/ 9 Marginal/Average Product
AP 8
7 Data:
6
Units of labor TP MP AP
5
4 0
3
2
1
1
2
0
-1 1 2 3 4 5
3
-2
4
TP 18 Total Product
16
5
14
12 6
10
7
8
6 8
4
2
0 1 2 3 4 5
Units of Labor

11. Costs of Production
Law of Diminishing Returns
Marginal/Average Product
MP/AP
Observations:
Diminishing
returns sets in
Describe what happens to TP as more and more
labor is added to a fixed amount of capital and land
TP increases at an increasing rate as workers' MP
AP
increases, at a decreasing rate as MP falls, and
declines as MP becomes negative.
MP What is the relationship between TP and MP?
0 10 20 30 40 50
Units of Labor MP is the rate of increase in TP
TP Total Product
What is the relationship between MP and AP?
When MP is greater than AP, AP increases. MP
intersects AP at its highest point, and when MP is
TP less than AP, AP decreases
MP becomes negative,
TP begins to fall
Why does a producer care about the productivity of i
workers and other resources?
Because firms’ average and marginal costs in
0 10 20 30 40 50 the short-run are inversely related to the
Units of Labor productivity of its workers

12. Costs of Production
Law of Diminishing Returns
Conclusions:
·Explanation of increasing returns :
·Explanation of diminishing returns:
·Negative marginal product and implications:
·Implications of diminishing marginal returns to producers:
Blog posts: “Law of Diminishing Returns”

13. Costs of Production
Marginal/Average Product
Law of Diminishing Returns
MP/ 9
Posters for Econ.
AP 8
7 Data:
6 Units of labor TP MP AP
5
0 0
4
3
1 6
2
1 2 14
0
-1 1 2 3 4 5 3 21
-2
4 24
TP 18
Total Product
16 5 20
14
12
10
8
6
4
2 Fill in the chart and the graphs above.
0 1 2 3 4 5
Where is the law of diminishing
Units of Labor returns?

14. Costs of Production
Productivity and costs
Productivity and Costs: As worker productivity increases, firms get "more for
their money", meaning per-unit and marginal costs decrease. When productivity
decreases, costs increase.
Discussion: When productivity of workers is
Costs and Productivity rising, firms costs are falling, since they're
getting more output for workers while paying
MC them the same wages.
Product/costs
·When marginal product is increasing
(increasing returns) marginal cost is falling
AP ·When MP is at its maximum, MC is at its
minimum
AC
·When diminishing returns set in, MP begins
falling and MC begins rising
·MP intersects average product at its highest
MP point, and MC intersects average total cost at its
lowest point
Units of Labor/
units of output
Summary: Increasing marginal returns is reflected in a declining marginal cost, and
diminishing marginal returns in a rising marginal cost!

15. Costs of Production
Short-run Costs of Production
What is the short-run? "the fixed-plant period"
The short-run is the period of time over which a firm's plant size is fixed.
Capital cannot and land cannot be varied, labor is the only variable
resource. To increase output in the short-run, a firm can only increase
inputs of labor, not the other resources.
Total Costs:
Total fixed costs (TFC): These are the costs a firm faces that do not
vary with changes in short-run output. Could include rent on factory
space, interest on capital (already acquired).
Total variable costs (TVC): These are the costs a firm faces which
change with the level of output in the short-run. Could include
payment for raw materials, fuel, power, transportation services,
wages for workers, etc...
Total cost:TFC + TVC at each level of output

16. Costs of Production
Short-run Costs of Production
Resource costs in the short-run:
Rent - the payment for land: Rent is fixed in the short-run since firms cannot add this
resource to production. Rents must be paid regardless of the level of the firm's output.
Interest - the payment for capital: Interest is fixed in the short-run since firms cannot
add this resource to production. Interest must be paid on loans regardless of the level of
the firm's output.
Wages - the payment for labor: Wages are variable in the short-run, since firms can hire
or fire workers to use existing land and capital resources. Wage costs increase when new
workers are hired, and decrease when workers are laid off.
Normal profit:the minimum level of profit needed just to keep an entrepreneur operating
in his current market. If he does not earn normal profit, an entrepreneur will direct his skills
towards another market. Normal profit is a cost because if a firm does not earn normal
profit, it is not covering its costs and may shut down.
Other short-run variable costs of production:
·Transportation costs: Firms pay lower transport costs at lower levels of output.
·Raw material costs: vary with the level of output
·Manufactured inputs: fewer parts are needed from suppliers when a firm lowers output.

17. Costs of Production
Short-run Costs of Production
Graphing total costs:
TFC: Notice that regardless of the level of output, TFC remains constant. This is because these
are costs that do not vary with output.
TVC: Notice that when output is zero, TVC is zero, because you do not need to hire any workers
or use any raw materials if you're not producing anything. As output increases, TVC continues to
increase
TC: Notice that when output is zero, TC = TFC. But once the factory begins pumping out products,
TC rises with TVC. TC is the sum of TFC and TVC, since both fixed and variable costs make up
total cost.
TC
Diminishing returns:
Costs
TVC ·Notice that TC and TVC increase at a
decreasing rate at first. This is when
marginal product is increasing as more
labor is employed (firms get "more for their
money")
·However, beyond some point, costs begin
100 TFC
to increase at an increasing rate. This is
where diminishing returns set in and MP is
decreasing. The firm is getting less
0 Point at which Q of output additional output from each worker hired,
diminishing
returns sets in but must pay the same wages regardless.
(The firm gets "less for its money")

18. Costs of Production
Short-run Costs of Production
Average Costs:
Average fixed cost:AFC=TFC/Q
AFC will decline as output rises, never increases. This is because the fixed cost
(which never goes up) is “spread out” as output goes up. This is called “spreading
the overhead”
Average variable cost:AVC = TVC/Q
For simplicity, we will assume that labor is the only variable input, the labor cost per
unit of output is the AVC
Average total cost:ATC = TC/Q
Sometimes called unit cost or per unit cost. ATC also equals AFC + AVC
Marginal Cost = the additional cost of producing one more unit of
output.
MC = ∆TVC/∆Q.

19. Theory of the Firm
Section 2.3 HL
Price
Quantity of output
Draw a graph to represent revenue and explain it.

20. Costs of Production
Short-run Costs of Production
Graphing Average and Marginal Costs:
AFC: it declines as output increases. This is called "spreading the overhead".
ATC and AVC: At first they are declining as output increases. This is during the stage when MP is
increasing, since new labor is making better use of capital and beginning to specialize.
AVC: When AVC is at its minimum, average product is at its maximum, meaning workers are producing
the most output per worker. As more workers are added, average product begins to go down, and AVC
begins to rise.
Costs
Short-run Costs Things to notice:
·the vertical distance between ATC and
AVC equals the AFC at each level of
MC output.
ATC
·MC intersects both AVC and ATC at their
minimum. This is because if the last unit
AVC
produced costs less than the average,
then the average must be falling, and vis
versa (just like your test scores!)
AFC
·MC is at its minimum when MP is at its
Point at which Q maximum, because beyond that point
diminishing
returns sets in
diminishing returns sets in and the firm
starts getting less for its money!

21. Costs of Production
Short-run Costs of Production
Labor is the only variable resource and the wage = $200 / week
Rent and interest are fixed costs, and = $400 / week
QL TP (Q TFC TVC TC AFC AVC ATC MC
supplied
)
0 0 400
1 10
2 25
3 45
4 70
5 90
6 105
7 115
8 120
Describe and explain what happens to each of the following as output increases:
1) TFC 2) TC 3) AFC 4) AVC and ATC 5) MC

22. Costs of Production
Short-run Costs of Production
Labor is the only variable resource and the wage = $200 / week
Rent and interest are fixed costs, and = $400 / week
QL TP (Q TFC TVC TC AFC AVC ATC MC
supplied
)
0 0 400
1 10
2 25
3 45
4 70
5 90
6 105
7 115
8 120
Describe and explain what happens to each of the following as output increases:
1) TFC 2) TC 3) AFC 4) AVC and ATC 5) MC

23. Costs of Production
Short-run Costs of Production
Costs
Short-run Costs
Discussion Questions: Short-run Costs
MC
ATC
AVC
1) State the law of diminishing returns
and explain how it determines the
AFC
shape of the marginal cost curve.
Q
TC
Costs
TVC 2) Explain the relationship between the
marginal cost curve and the average
variable and average total cost curves.
3) What determines the distance
TFC
between the ATC and the AVC at a
Point at which
particular level of output.
Q
diminishing
returns sets in

24. Costs of Production
Short-run vs. Long-run costs
Long-run is the variable plant period, meaning that firms can open up new plants, add
capital to existing plants, or close plans and remove capital if need be.
Economies of scale: are the cost advantages that a business obtains due to
expansion. As new plants open, ATC declines. WHY?
·better specialization, division of labor, bulk buying, lower interest on loans,
lower per unit transport costs, larger and more efficient machines, etc...
Also called "Increasing returns to scale"
Minimum Efficient Scale (MES): The minimum level of output a firm must
achieve to achieve the lowest average total cost.
Diseconomies of Scale: When a firm becomes "too big for its own good" it
experiences diseconomies of scale. Continuing to add plants and increase output
causes ATC to rise. WHY? Mostly due to control and communications problems,
trying to coordinate production across a wide geographic area may make firm less
efficient.
Also called "Decreasing returns to scale"
Blog posts: “Economies of Scale”

25. Theory of the Firm
Section 2.3 HL
Define economies of scale in your own
words and explain why they are
possible.
You may use your notes but not your
book.

26. Costs of Production
Short-run vs. Long-run costs
Graphing long-run ATC: The gray curves represent all the SR ATC
curves the firm experiences as it opens new plants. As it opens its first
10 plants, ATC declines, while for plants 11-16 ATC remains constant.
Costs
Beyond 16 plants the firm's ATC begins to rise, indicating it has gotten
too big.
ATC LR
Economies Diseconomies
of scale of scale
Constant returns
to scale
MES
Q
Blog posts: "Economies of Scale"

27. FIXED COST (FC)
VARIABLE COST (VC)
Costs TOTAL COST (TC)
Quantity of output

28. AFC
AVC
MC
Costs ATC
Quantity of output

29. TP (TO)
WHAT GOES HERE?
WHAT GOES HERE?

30. AP (AO)
MP (MO)
WHAT GOES HERE?
WHAT GOES HERE?

31. TC
TR
COSTS $
Quantity of Output

32. MC
MR
COSTS $
Quantity of Output

33. LRAC (LRATC)
COSTS $
Quantity of Output