Production, Costs, and Industry Structure

This is Unit Six of Principles of Microeconomics, part one of two: what a firm is, what profit means to an economist, and how a production table becomes the cost curves every later unit uses. Carry one idea. Every cost curve is the production function in dollars: diminishing returns in the kitchen become rising marginal cost on the page, and the crossings of the cost family follow from arithmetic. By the end you will be able to separate explicit from implicit costs and compute the three profits. To build a marginal product column and name where diminishing returns begin. To turn a production table into a cost table. To compute marginal cost two ways and say why it rises. And to read the cost family and apply the crossing rule.

Six entries on the firm and its profit: what it decides, the four structures, two kinds of cost, three profits.

What a firm decides.

MIC 0501 The Firm and Its Decisions

A firm combines labor, capital, land and materials into an output worth more than the inputs, and decides what to produce, how, how much, at what price, and how many workers to hire. A bakery, a trucking company and a law office are all firms. The answers depend on costs and on the market's structure.

The four market structures.

MIC 0502 The Spectrum of Competition

Markets run from perfect competition, many firms with identical products, through monopolistic competition, many firms with similar products, to oligopoly, a few firms, and monopoly, one: wheat, restaurants, airlines, the water company. The number of firms and how alike the products are decide a firm's power over its price.

Two kinds of cost.

MIC 0503 Explicit and Implicit Costs

Explicit costs are payments the firm makes: wages, rent, materials. Implicit costs are the opportunity costs of resources the firm already owns, such as the owner's forgone salary, or the rent a shop in your own house could have charged. An implicit cost never appears in the books, and it is still a cost.

Two profits.

MIC 0504 Accounting Profit and Economic Profit

Accounting profit is revenue minus explicit costs. Economic profit is revenue minus explicit and implicit costs together, the number that decides whether the venture beats the owner's alternatives, so a firm can show an accounting profit and an economic loss at once. Every profit hereafter is economic profit.

A profit of exactly zero.

MIC 0505 Normal Profit

Normal profit is the accounting profit that makes economic profit exactly zero: enough to cover every implicit cost, so the owner does as well here as anywhere else. Neither source names the term; the course defines it because unit seven's long run turns on it.

Computing all three.

MIC 0506 Computing Economic Profit

List revenue, explicit costs, then implicit costs, what the owner's own resources would earn elsewhere. Accounting profit is revenue minus explicit costs; economic profit subtracts the implicit costs too. A bookkeeper leaves a sixty-five-thousand-dollar job, puts fifty thousand of savings earning four percent into a practice, and takes one hundred eighty thousand of revenue against forty thousand rent and a seventy-thousand assistant. Accounting profit is seventy thousand; implicit costs are sixty-seven thousand; economic profit is three thousand, so the practice beats the job, barely. The owner's salary is implicit whether or not a check is written.

Six entries on production in the short run: the production function, which inputs move, marginal product, and where it falls.

How inputs become output.

MIC 0507 The Production Function

A production function states how much output a firm gets from given inputs, with technology and the entrepreneur's decisions, and two firms in one industry can have different ones: twenty loaves from one worker and an oven, fifty from two. It describes what is physically possible, not what is cheap.

Which inputs can change.

MIC 0508 Fixed and Variable Inputs; Short Run and Long Run

A fixed input, such as a leased building, cannot be changed quickly; a variable input, such as staff, can. The short run has a fixed input and the long run has none; the bakery's oven is fixed this year. The short run is not a number of months, it ends when the fixed input can change.

What one more worker adds.

MIC 0509 Total Product and Marginal Product

Total product is the output from a given number of workers. Marginal product is the extra output from one more worker, with the other inputs fixed: two workers make fifty loaves and three make seventy, so the third's marginal product is twenty. It belongs to the added worker, a difference between two rows.

Why it eventually falls.

MIC 0510 Diminishing Marginal Product

Adding workers to a fixed input eventually adds less output with each one: the law of diminishing marginal product. The cause is the fixed input each new worker must share, as five bakers around one oven get in each other's way. Diminishing is not negative: output still rises, by less.

Building the column.

MIC 0511 Building a Marginal Product Column

Marginal product is each row's output minus the row before. Where the column rises, returns are increasing; where it falls but stays positive, diminishing returns have set in; where it turns negative, the next worker cuts output. Diminishing returns begin with the first worker whose marginal product is below the one before. Output with zero to five workers of zero, twenty, fifty, seventy, eighty and eighty-five loaves gives marginal products of twenty, thirty, twenty, ten and five: returns increase to two workers, and diminishing returns begin with the third. Read it off the differences, not off total output, which rises all the way.

The average, and the rule.

MIC 0512 Average Product and the Marginal Rule

Average product is output per worker, total product over the number of workers: seventy loaves from three is about twenty-three. Marginal product above the average pulls it up; below, pulls it down. The same rule governs every marginal and average pair in this course, including cost.

Five entries on turning production into cost: three costs, a table read backward, and costs per unit.

Attaching prices to inputs.

MIC 0513 Fixed Cost, Variable Cost, Total Cost

Fixed cost is the cost of fixed inputs, the same at any output, even zero: the bakery pays a hundred dollars a day for the oven, baking or not. Variable cost is the cost of variable inputs and rises with output; total cost is their sum. Fixed cost is total cost's intercept.

A production table read backward.

MIC 0514 From a Production Table to a Cost Table

For each output, the workers needed are known; multiply by the wage for variable cost and add the fixed cost for total cost. Variable cost rises slowly while marginal product rises, then faster once diminishing returns make each loaf need more labor. At sixty dollars a worker and one hundred of fixed cost, outputs of zero, twenty, fifty, seventy, eighty and eighty-five loaves give variable cost of zero, sixty, one twenty, one eighty, two forty and three hundred, and total cost of one hundred, one sixty, two twenty, two eighty, three forty and four hundred. Total cost at zero output is the fixed cost, not zero.

Costs per unit.

MIC 0515 Average Cost: Total, Variable, Fixed

Average total cost is total cost over output; average variable cost, variable cost over output; average fixed cost, fixed cost over output; the first equals the other two added. At fifty loaves, two hundred twenty dollars is four forty a loaf. Average variable cost sits below average total cost by average fixed cost, and the gap narrows as output grows.

The cost of one more unit.

MIC 0516 Marginal Cost

Marginal cost is the change in total cost from one more unit of output; since fixed cost does not change, it equals the change in variable cost per extra unit. From fifty to seventy loaves adds sixty dollars: three dollars a loaf. It is what every firm in the next four units compares with the next unit's price.

Computing it from a table.

MIC 0517 Computing Marginal Cost from Variable Cost

Marginal cost between two rows is the change in variable cost over the change in output. Use variable cost, not total cost, so fixed cost never enters. Variable cost rises sixty dollars per worker while output rises twenty, thirty, twenty, ten and five loaves, so marginal cost per loaf is three, two, three, six and twelve dollars. From zero to twenty loaves it is three dollars, not eight, because the hundred of fixed cost would have been paid with no loaves at all. Dividing total cost by output for the first units reports an average as a marginal.

Seven entries on marginal cost and the averages: why it rises, the check, the U, the crossing, the whole table.

Why the numbers rise.

MIC 0518 Why Marginal Cost Rises: Wage over Marginal Product

With labor the variable input, marginal cost equals the wage divided by the marginal product of labor. As marginal product falls, each extra unit needs more labor time and marginal cost rises: sixty dollars over thirty loaves is two dollars, sixty over ten is six. Rising marginal cost is diminishing marginal product in dollars.

The check.

MIC 0519 Marginal Cost from Marginal Product

Divide the wage by each worker's marginal product; the result must match the change in variable cost over the change in output computed the long way, and a disagreement means a column has a slip. Marginal products of twenty, thirty, twenty, ten and five at a wage of sixty give three, two, three, six and twelve dollars, the same five numbers the long way gave; where marginal product peaked, marginal cost bottomed. The wage and the marginal product must share units, and the formula holds only while labor is the sole variable input.

The shape of the averages.

MIC 0520 The Shape of Average Cost

Average total cost falls at first, as fixed cost spreads over more units, then rises as diminishing returns raise each extra unit's cost: a U. The bakery's runs eight, four forty, four, four twenty-five and four seventy-one. Average variable cost is a U too, from diminishing returns alone, and bottoms out first.

Where marginal cost crosses.

MIC 0521 Marginal Crosses Average at the Minimum

Marginal cost crosses average total cost at its lowest point, and average variable cost at its lowest point. Below the average, marginal cost pulls it down; above, it pushes it up, as a quiz score below your average lowers the average. The crossing is arithmetic, not a coincidence of the drawing.

Reading a full set of curves.

MIC 0522 Reading the Cost Family

Locate three things: the minimum of average variable cost, where marginal cost crosses it from below; the minimum of average total cost, further right, where marginal cost crosses that curve; and the gap between the averages, which is average fixed cost and shrinks as output grows. Average variable cost runs three, two forty, two fifty-seven, three and three fifty-three; average total cost eight, four forty, four, four twenty-five, four seventy-one; marginal cost three, two, three, six, twelve. Average variable cost bottoms at fifty loaves, with marginal cost two before and three after; average total cost bottoms at seventy, with three before and six after. With whole-number rows the crossing is bracketed, not hit exactly.

The one average that never turns up.

MIC 0523 Average Fixed Cost Falls Forever

Average fixed cost is a fixed sum over a growing output, so it falls at every step and never turns up: a hundred dollars over twenty loaves is five, over eighty it is one twenty-five. Spreading overhead is why average total cost falls at first, and it cannot keep it falling once marginal cost climbs above.

The whole table in one pass.

MIC 0524 Building the Whole Cost Table

Build seven columns in order: variable cost, workers times the wage; total cost, variable plus fixed; marginal cost between rows; average variable cost; average fixed cost; and average total cost, which must equal the other two averages added. That equality is the check. At seventy loaves and three workers: variable cost one eighty, total cost two eighty, marginal cost three dollars, average variable cost two fifty-seven, average fixed cost one forty-three, average total cost four dollars, and two fifty-seven plus one forty-three is four. Rounding can miss by a cent; more than a cent is an error.

Look at what you can now do. You can separate explicit from implicit costs and compute accounting profit, economic profit, and the normal profit at which economic profit is zero. You can build a marginal product column from the differences between rows and name the worker at which diminishing returns begin. You can read a production table backward into variable and total cost, with fixed cost as the intercept. You can compute marginal cost as the change in variable cost over the change in output, or as the wage over marginal product, and check one against the other. And you can read the cost family: two U-shaped averages, marginal cost crossing each at its minimum, and average fixed cost falling forever. Part two turns to the long run, where every input can change and scale decides how many firms an industry holds.