AP MICROECONOMICS
REVIEW #3 (PART 1)
Rixie
April 20, 2017
PRODUCTION & COST
Explicit & implicit costs; Accounting & economic profit;
Product measures; Cost measures
Explicit v. Implicit Costs
■ Explicit costs: direct, purchased, out-of-pocket costs
– Money is actually being exchanged
– Ex: cost of raw materials, wages, rent,
licenses/permits
■ Implicit costs: indirect, non-purchased costs
– Next-best alternatives that have been forgone
– Implicit costs ARE opportunity costs!
Accounting v. Economic Profit
■ Accounting profit =
Total revenue – Explicit costs
■ Economic profit =
Total revenue – Explicit costs – Implicit costs
■ (economic costs include both explicit & implicit costs)
Short-run v. Long-run
■ Fixed inputs: resources that go into the production process
that cannot be changed in the short run
■ Variable inputs: resources that can be adjusted in the short
run to meet changes in demand (labor is variable)
– ALL inputs are variable in the long-run!
Plant Size
(Capital)
Fixed Costs
Variable Costs
Entry/Exit of
Firms
Short Run
Fixed
Some
Some
No
Long Run
Variable
None
All
Yes
Short-run Production Measures
■ Total Product (TP) - the total quantity/output of a good produced at
each quantity of a resource employed (usually labor)
■ Marginal Product (MP) - The change in total product resulting from a
change in the input (addition of a worker)
MP = (Change in TP) / (Change in # of Inputs)
***If labor is changing one unit at a time, then: MP = Change in TP
■ Average Product (AP) - Total product divided by the number of inputs
employed (# of workers)
AP = TP / # of inputs
***Much less likely to use this one
Law of Diminishing Marginal Returns
■ As successive units of a variable resource are added
to a fixed resource, the additional output will
eventually decrease
■ It is not always more efficient to add more inputs
■ To determine when diminishing returns set in, you
must calculate marginal product (if it’s not given) and
look for the unit at which MP begins to decrease
(NOT when it becomes negative)
Short-run Cost Measures
■ Total cost = Total fixed cost + total variable cost
■ Total fixed cost = Total cost – total variable cost
– TFC is constant
■ Total variable cost = Total cost – total fixed cost
■ Marginal cost = (Change in total cost)/(change in Q
of output)
– Usually the change in Q of output is just equal to
one, so you can disregard the denominator
Short-run Cost Measures (continued)
■ Average Total Cost (ATC) =
or ATC =
TC / (Q of Output)
AFC + AVC
■ Average Variable Cost (AVC) = TVC / (Q of Output)
or AVC = ATC – AFC
■ Average Fixed Cost (AFC) =
or AFC =
TFC / (Q of Output)
ATC - AVC
Relationship between Marginal Product
& Marginal Cost
■ These measures are
inversely related:
– Marginal cost &
marginal product
– Average variable cost
& average product
■ Ex: as long as MP
increases, MC is
decreasing, and vice
versa
Know what these cost curves will typically
look like (for all market structures!)
■ Marginal cost (MC) looks
like the Nike swoosh!
■ ATC will always be above
AVC
■ ATC and AVC will always
intersect MC at their
minimums
■ Since TFC is constant,
AFC will always decrease
Long-run Average Costs
Long-run Average Costs
■ If a firm is operating on the downward sloping portion of LRAC, it is experiencing
economies of scale.
– Long-run average costs are decreasing as plant size increases
– If plant size doubles, output more than doubles
■ If a firm is operating on the flat portion of LRAC, it is experiencing constant returns
to scale.
– Long-run average costs remain constant as plant size increases
– If plant size doubles, output also doubles
■ If a firm is operating on the upward sloping portion of LRAC, it is experiencing
diseconomies of scale.
– Long-run average costs are increasing as plant size increases
– If plant size doubles, output less than doubles
Types of Efficiency (Really important to
know these!!!)
■ Productive efficiency
– Occurs when a firm is being as efficient with its
resources as possible
– Found on a graph where Price = Minimum Average Total
Cost
■ Allocative efficiency
– Occurs when the socially optimal amount of something is
being produced
– Found on a graph where Price = Marginal Cost
PERFECT COMPETITION
Graphical Analysis; Profit-maximization; Efficiency
Perfect Competition – first of four
market structures
■ As much of this information is already typed out in the Unit
3 Key Concepts Outline (PDF), most of this section will
consist of graphs/visuals
Golden Rule for Profit-Maximization in the
Product Market (all market structures)
■ Regardless of the type of market structure, profit-maximizing
firms will always produce the quantity where:
Marginal Revenue (MR) = Marginal Cost (MC)
■ This is easily identifiable on a graph – it’s where the MR and MC
curves intersect.
■ When given data in a table instead, choose the quantity where
MR = MC, or the quantity where they come as close as possible
as long as MR > MC
– Never produce a quantity with MC > MR
Identifying Profit Rectangles on Graphs
(for any market structure)
■ Find the price at the profit-maximizing quantity, then go down
or up to ATC, and over to the y-axis
■ If you had to go up to ATC, the firm is taking a loss because P
< ATC
■ If you had to go down to ATC, the firm is making a profit
because P > ATC
■ If P = ATC, there is no profit rectangle and the firm is earning
zero economic profit (breaking even)
Side-by-side graph of a P.C. market & firm
*Profit
rectangle is
outlined in
red
Side-by-side graph of a P.C. market & firm
*Loss rectangle
is outlined in red
Side-by-side graph of a P.C. market & firm
*There is no
profit rectangle
because this
firm will shut
down, & its loss
will be equal to
TFC
What happens in the long-run?
■ Short-run profits attract firms to the industry (cause entry of
firms in the long-run)
■ Short-run losses cause firms to leave the industry in the longrun
■ Entry & exit of firms causes the industry supply curve to shift
(right for entry, left for exit), which affects the market price
■ Since P.C. firms are price takers, the firm’s MR = D = AR = P
will shift up or down with the market price
■ Ultimately, in the long-run, perfectly competitive firms break
even & experience both productive & allocative efficiency
Example: short-run profits attract firms
to this industry in the long-run: