Production, Costs and Firm Behaviour
What the exam tests
Production and cost analysis links inputs to outputs and outputs to costs. The exam tests short-run returns, cost curves, scale economies and the profit-maximising and shutdown rules.
Core rules
- Short run: at least one input fixed. TP, AP = Q/L and MP = ΔQ/ΔL. MP cuts AP at AP's maximum. Diminishing marginal returns set in when MP falls.
- Long run: all inputs variable. Isoquants show input combinations for a given output; MRTS = MPL/MPK. Returns to scale describe output response when all inputs rise proportionally.
- TC = FC + VC; AC = TC/Q; MC = ΔTC/ΔQ. MC cuts AC at minimum AC. Fixed costs do not affect MC.
- Profit is maximised where MR = MC, provided price covers average variable cost in the short run. Shut down if P < AVC; exit in the long run if P < AC.
- Economies of scale lower long-run AC; diseconomies raise it.
Worked example
A competitive firm has TC = 100 + 20Q + Q², so MC = 20 + 2Q. Price is 60. Set MR = MC: 60 = 20 + 2Q, so Q = 20. TR = 1,200. TC = 100 + 400 + 400 = 900. Profit = 300. AC = 45, below price, so the firm is profitable. Because MC = 60 exceeds AC, AC is rising at this output.
Traps
- Including fixed cost in marginal cost; MC is the change in total cost.
- Confusing diminishing returns (short run, one input fixed) with diseconomies of scale (long run, all inputs variable).
- Maximising revenue or minimising AC instead of setting MR = MC.
- Shutting down whenever profit is negative; if P > AVC, producing reduces losses.
- Using accounting cost and ignoring opportunity cost.