Production, Costs, Revenue and Profit
Domain 4 tests your grasp of short-run cost behaviour, the shape of cost curves and the difference between accounting and economic profit.
Short run and long run
The short run has at least one fixed factor; the long run allows all factors to vary. The law of diminishing returns applies in the short run: adding variable inputs to a fixed factor eventually reduces marginal product, so marginal cost rises.
Cost curves
Total cost = total fixed cost + total variable cost. Average fixed cost falls continuously; average variable cost and average total cost are U-shaped; marginal cost cuts both AVC and ATC at their minimum points. Fixed costs do not affect marginal cost.
Economies of scale
In the long run, average cost falls with specialisation, bulk buying and technical economies, then rises through managerial diseconomies and congestion.
Revenue and profit
Total revenue = price x quantity. Normal profit is the minimum return needed to keep the entrepreneur in the industry and is treated as a cost; supernormal profit is any return above that.
Worked example
At output of 10 units, fixed cost is N$200 and variable cost is N$300, so total cost is N$500 and ATC is N$50. Price is N$45, so revenue is N$450 and the firm makes a loss of N$50. Average variable cost is N$30, which is below price, so each unit contributes N$15 towards fixed costs. The firm should keep producing in the short run but exit if price stays below AVC.
Traps that cost marks
- Saying a firm should shut down whenever it makes a loss; the shutdown rule compares price with AVC.
- Claiming fixed costs affect marginal cost.
- Confusing normal profit with zero profit or with the accountant's profit figure.