Topic 2.3 Theory of the Firm
Cost Theory
 Fixed Cost: costs that do not vary with changes in
output
example: rent
 Variable Cost: costs that vary with quantity of
output produced
example: labor, materials, fuel
 Total Cost: sum of fixed cost and variable cost at
each level of output
 TC= FC + VC
Average Total Cost: AFC + AVC or
ATC= FC/Q
Marginal Cost: The increase in total cost that
arises from an additional unit of output
MC= ∆TC/ ∆Q
Accounting Cost + Opportunity Cost =
Economic Cost
Average Fixed Cost: Fixed costs divided by
the quantity output
AFC= FC/Q
Average Variable Cost: Variable costs
divided by the quantity of output
AVC= VC/Q
Short-Run
Law of Diminishing Returns:
each additional unit of variable input eventually
yields a decreasing output
Long-Run
 Economies of scale: long-run ATC as Q
 Diseconomies of scale: long-run ATC as Q
Revenues
Total Revenue: The total amount of money
received from the sale of a good or service at
any given quantity of output.

Marginal Revenue: The additional revenue
added to the total revenue that is
gained from selling one more unit.
Average Revenue: Total revenue divided by
the number of units sold
Profit
 An increase in wealth that an investor has from
making an investment taking into account all of the
costs of that investment including the opportunity
cost
 Normal profit: minimum profit necessary to attract
or retain producers in a perfectly competitive
market. Usually equal to the opportunity costs.
 Supernormal profit: profit that exceeds normal
profit.
Profit (continued)
Thou shalt produce where
MC=MR
Perfect Competition
>Numerous buyers and sellers of which none
are able to influence the market.
>Everyone is privy to all information
>Products are homogeneous
>No barriers to entry and no barriers to exit.
Perfect Competition
 Thou shalt produce where MC = MR.
 Efficiency in perfect Competition is both
allocatively and productively efficient
 Allocative efficiency occurs when output is at
society's optimum level. P=MC
 Productive efficiency is when a firm produces at
the lowest possible cost per unit. AC=MC
Perfect Competition
Monopoly
>One firm
>Unique product, no close substitutes
>Considerable control over price
>Entry of additional firms are blocked
>No effort in advertising
Monopoly (continued)
 Sources of Power
1. Status secured by patents, economies of
scale, or resources ownership
2. Not regulated by government
3. Costs of production make a single producer
more efficient than a large number of
producers
Monopoly
Monopoly vs. Perfect Competition
Disadvantages
 higher price
 lower output
 abnormal profit
 Produces where Average costs are higher
(inefficient)
Advantages
 Capable of using economies of scale therefore
reducing costs and increasing output
Natural Monopoly
Monopoly that arises because a single firm
can supply a good or service to an entire
market at a smaller cost than could two or
more
Monopolistic Competition
Large number of small firms.
(Almost) perfect knowledge.
Differentiated products.
No barriers to entry or exit.
In the short-run abnormal profits can be
earned (at MC=MR)
In the long-run only normal profits can be
earned.
Oligopoly
Competition between a few firms
many buyers, few sellers
differentiated products
Barriers to entry present
If one firm reduces its price competitors will
follow example
Oligopoly (continued)
Non-collusive Oligopoly: firms compete
against each other in a normal way
Collusive Oligopoly: firms try to come to an
agreement to reduce the amount of
competition.
Cartels: OPEC
Price Discrimination
Different people are charged different prices
for exactly the same good.
Conditions
>Time
>Income
>Age