Production, Costs, and Profit Maximization
Core concepts
In the short run at least one input is fixed; in the long run all inputs vary. The law of diminishing marginal returns means adding variable inputs to fixed inputs eventually lowers marginal product, which raises marginal cost. Know the cost family: total, fixed, and variable cost; average fixed, average variable, and average total cost; and marginal cost. Marginal cost intersects average total cost and average variable cost at their minimum points. Economies of scale lower long-run average cost as output grows; diseconomies raise it. Economic profit subtracts implicit and explicit costs, so it is smaller than accounting profit. The profit-maximizing rule is to produce where marginal revenue equals marginal cost, provided price covers average variable cost in the short run; otherwise shut down. In perfect competition price equals marginal revenue.
Traps to watch
- Mixing accounting and economic profit by omitting implicit costs.
- Believing fixed costs affect marginal cost - they do not.
- Confusing diminishing returns (short run) with diseconomies of scale (long run).
- Shutting down when price covers average variable but not average total cost; operating limits losses.
Worked example
At output 100, marginal revenue is $12 and marginal cost is $15. Producing more adds more to cost than revenue, so reduce output until MR = MC. Rule of thumb: if MR exceeds MC, expand; if MC exceeds MR, contract.