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Week 9 · Chapter

Chapter 9 — Production & Costs

Principles of Microeconomics Free sample edition

The module's primary reading · ~40–50 minutes · Objective 5 (describe a firm's short-run production and costs — total, marginal, and average product; diminishing marginal returns; and fixed, variable, total, average, and marginal cost — and distinguish accounting profit from economic profit), building on Objective 1 (use the tools of economic modeling — scarcity, opportunity cost, the production possibilities frontier, comparative advantage, and the gains from trade — and distinguish positive statements (what is) from normative statements (what ought to be)) · Read it first this week; the lecture, the slide deck, the tutorial, the quiz, and the Model Workshop all build on it.

In plain language

This week you step inside a business and look at its numbers. You will see how a bakery's output grows as it adds workers to one small kitchen, and why each extra worker eventually adds less than the one before, a pattern called diminishing marginal returns (each added worker contributing less once the fixed space gets crowded). You will also take a chair workshop's costs apart and find the marginal cost (what one more chair adds to the bill) and the average cost (the bill divided by the number of chairs). Last, you will learn why a business that shows a profit on its books can still leave its owner behind, once you count the implicit costs (the earnings the owner gives up to run it).

Why you already care about this

Picture a bakery with one kitchen, one oven, and a handful of workers. On a slow morning two people roll dough and shape loaves. Add a third and the work speeds up, because one person can mix while another shapes and a third watches the oven. Add a sixth, though, and people start waiting for counter space. The sixth worker still helps, but not by much.

Now picture a furniture maker down the street. The rent and the tools cost the same whether the shop makes 2 chairs a day or 6. The wood and the paid hours do not. The sixth chair of the day costs 48 dollars to make, three times what the third chair costs. If you have ever wondered why a business does not keep growing forever, or why a small shop charges what it does, these two places hold the answer.

By the end of this chapter you will be able to:

  • tell the short run from the long run and name the fixed input in a business;
  • compute marginal product and average product from a production schedule and say where diminishing marginal returns begin;
  • split a firm's costs into fixed and variable cost and add them into total cost;
  • compute marginal cost, average fixed cost, average variable cost, and average total cost from a cost table;
  • explain why marginal cost crosses each average at its lowest point;
  • compute accounting profit and economic profit and say which one a figure is.

Carry this sentence with you: marginal is the next one; average is the whole pile divided up.

Where we are

  • Already covered: Week 1 taught opportunity cost, the value of the best alternative you give up. Weeks 3 to 7 built the supply-and-demand model and used it to measure surplus, price controls, and taxes. Week 8 added the habit of thinking at the margin: do one more unit while its extra benefit is at least its extra cost.
  • This week: the short run and the long run; total, marginal, and average product; the law of diminishing marginal returns; fixed, variable, total, average, and marginal cost; and accounting versus economic profit.
  • How they connect: until now the supply curve was a line you were given. This week you open the firm behind it and build its costs from a table, and Week 1's opportunity cost returns as the implicit cost of the owner's time and money.
  • Where we're going next: Week 10 brings a market price to this week's cost table, so this week builds the cost side that the firm will weigh against that price.

Week 1 is the chapter this one leans on most. Recall that the opportunity cost of a choice is the value of the single best alternative you give up. In Week 1, a 60-dollar concert ticket really cost 120 dollars once you counted 4 hours of missed pay at 15 dollars an hour. The same idea runs a business. An owner who could have earned a salary elsewhere gives that salary up to run the shop, and an honest count of costs includes it.

1. Separate the short run from the long run

Think about how fast a business can change. A bakery can call in another worker by tomorrow morning. It cannot build a second kitchen by tomorrow. Some inputs change quickly and some take months or years. Economists sort time by that difference, not by the calendar.

  • The short run is a period in which at least one of a firm's inputs, such as the size of its kitchen or workshop, is fixed and cannot be changed, so output grows only by adding more of the other inputs.
  • The long run is a period long enough that a firm can change every input, including the size of its building and the number of its machines.

In the bakery, the kitchen and the oven are the fixed input. Workers are the variable input. In the chair workshop, the room and the set of tools are fixed, and the wood and the paid hours are variable. Everything you compute in this chapter happens in the short run, with the kitchen and the workshop held at one size.

The long run gets one paragraph this week. Given enough time, a bakery that keeps running out of oven space can build a bigger kitchen, and a busy workshop can rent a second room. Once every input can change, the crowding that drives this chapter can be undone. Later weeks return to the long run; this week stays inside one kitchen and one room.

Misconception check. Students often think the short run means "a few weeks" and the long run means "a few years." The line is not a number of days. The cure: ask "is any input still fixed?" If the kitchen cannot change yet, you are in the short run, whether that lasts a month or two years.

2. Read the bakery's schedule: total, marginal, and average product

Start with what the bakery makes. Its owner tracks how many loaves come out of the kitchen each day with different numbers of workers. That record is a production schedule, and it gives you three ways to measure output.

  • Total product is the total output a firm makes with a given amount of a variable input, such as the loaves a bakery bakes in a day with a given number of workers.
  • Marginal product is the extra output from adding one more unit of a variable input, such as one more worker, while the other inputs stay fixed.
  • Average product is output per unit of a variable input: total output divided by the number of workers or other units of that input.

The bakery's schedule below is illustrative, constructed for this course rather than taken from a real bakery. Write L for the number of workers and Q for loaves per day. MP is marginal product and AP is average product.

Dataset K: loaves per day for 0 to 6 workers in a fixed kitchen, with marginal and average product (illustrative)
Workers (L) 0 1 2 3 4 5 6
Loaves per day (total product) 0 10 25 45 60 70 75
Marginal product (MP) none 10 15 20 15 10 5
Average product (AP) none 10 12.5 15 15 14 12.5

Worked example — marginal product, one worker at a time. Subtract each day's loaves from the next.

  1. The 1st worker. 10 − 0 = 10 loaves.
  2. The 2nd worker. 25 − 10 = 15 loaves.
  3. The 3rd worker. 45 − 25 = 20 loaves.
  4. The 4th worker. 60 − 45 = 15 loaves.
  5. The 5th worker. 70 − 60 = 10 loaves.
  6. The 6th worker. 75 − 70 = 5 loaves.

In words: the first three workers each add more than the one before, and from the fourth on each adds less. The bakery still makes more bread with every hire, but the boost from each new person shrinks.

Worked example — average product. Divide total loaves by the number of workers: AP = Q ⁄ L.

  1. One worker. 10 ⁄ 1 = 10 loaves per worker.
  2. Two workers. 25 ⁄ 2 = 12.5 loaves per worker.
  3. Three workers. 45 ⁄ 3 = 15 loaves per worker.
  4. Four workers. 60 ⁄ 4 = 15 loaves per worker.
  5. Five workers. 70 ⁄ 5 = 14 loaves per worker.
  6. Six workers. 75 ⁄ 6 = 12.5 loaves per worker.

In words: output per worker rises to 15 loaves with three or four workers and then slips back. Watch how marginal product steers the average. The 3rd worker adds 20 loaves, more than the average of 12.5 so far, so the average climbs to 15. The 5th worker adds 10, less than the average of 15, so the average falls to 14. You will see the same pull again with costs in Section 7.

Misconception check. Students often mix up marginal product and average product, reading "15 loaves" for the 4th worker as "each of the four makes 15." That is the average. The cure: marginal product is what the newest worker adds, found by subtracting; average product is the total shared out, found by dividing.

3. Meet the law of diminishing marginal returns

Why does the 4th worker add less than the 3rd? Nobody got lazier. The kitchen did not shrink. What changed is that four people now share one oven and one counter. Each new worker has less room and less oven time to work with than the worker before.

  • The law of diminishing marginal returns is the pattern that, as more of a variable input is added to a fixed input, the marginal product of the variable input eventually falls. It begins after some point, not with the first worker, and it is why marginal cost eventually rises.

Read Dataset K against the law. Marginal product rises from 10 to 15 to 20 for the first three workers, because a small team can split the jobs. That early rise is specialization at work, the idea from Week 2 that people who focus on one task get more done. Then marginal product falls to 15 with the fourth worker, to 10 with the fifth, and to 5 with the sixth.

Worked example — finding where diminishing returns set in. Look for the first worker whose marginal product is smaller than the one before.

  1. Workers 1 to 3. 10, then 15, then 20 loaves: each is larger than the last, so returns are rising.
  2. Worker 4. 15 loaves, which is less than the 3rd worker's 20.
  3. Workers 5 and 6. 10 and then 5 loaves, each smaller again.

In words: diminishing marginal returns set in with the fourth worker. From that hire on, every extra worker still adds bread, but less of it, because the fixed kitchen is getting crowded.

Notice what does not happen. Total product does not fall. It keeps rising, from 45 to 60 to 70 to 75 loaves, only more slowly. Diminishing returns describe the size of each addition, not the direction of the total.

An honesty note about the model: real kitchens do not hand out marginal products in neat steps of 5 loaves. A six-row schedule is a classroom model that makes the pattern easy to see. The pattern itself, more workers squeezed into the same space eventually adding less each, shows up in kitchens, call centers, farms, and repair shops.

Pause and reflect — choose one. Pick either prompt; they count the same.

  • (a) Think of a group project or a shared kitchen where adding one more person stopped helping much. Name the fixed input everyone was sharing.
  • (b) Think of a job you have seen, such as a checkout line, a car wash, or a food truck. Describe in two sentences what happens to the help from each extra worker as the space fills up.

Misconception check. Students often think diminishing returns mean the newest worker is lazy or less skilled. In the model every worker is equally good; the 6th adds only 5 loaves because the kitchen is full. Students also often think diminishing returns start with the first worker. The cure: find the first marginal product that is smaller than the one before. Here that is the fourth worker, not the first.

4. Split the costs: fixed, variable, and total cost

Now move from loaves to dollars, and from the bakery to a chair workshop. Some of the workshop's bills arrive no matter what it makes. Others grow with every chair.

  • Fixed cost is a cost that does not change with how much a firm produces in the short run, such as rent on a workshop; the firm pays it even when it makes nothing.
  • Variable cost is a cost that rises and falls with how much a firm produces, such as materials and the pay for hours worked; it is zero when output is zero.
  • Total cost is everything a firm spends to produce a given amount of output: fixed cost plus variable cost.

Write FC for fixed cost, VC for variable cost, and TC for total cost, all in dollars per day, and Q for chairs per day. Then TC = FC + VC.

The chair workshop's numbers below are illustrative, constructed for this course. Its fixed cost is 60 dollars a day for rent and tools.

Dataset L: the chair workshop's fixed, variable, and total cost for 0 to 6 chairs, in dollars per day (illustrative)
Chairs (Q) 0 1 2 3 4 5 6
Fixed cost (FC) 60 60 60 60 60 60 60
Variable cost (VC) 0 30 50 66 88 120 168
Total cost (TC) 60 90 110 126 148 180 228

Worked example — total cost from its two parts. Add the fixed 60 dollars to each variable cost.

  1. 0 chairs. 60 + 0 = 60 dollars.
  2. 1 chair. 60 + 30 = 90 dollars.
  3. 2 chairs. 60 + 50 = 110 dollars.
  4. 3 chairs. 60 + 66 = 126 dollars.
  5. 4 chairs. 60 + 88 = 148 dollars.
  6. 5 chairs. 60 + 120 = 180 dollars.
  7. 6 chairs. 60 + 168 = 228 dollars.

In words: even on a day with no chairs, the workshop spends 60 dollars, because the rent and the tools are paid either way. Every chair it makes adds to the variable part, and the total climbs from 60 to 228 dollars.

Misconception check. Students often think a fixed cost is a cost that never changes at all, ever. It is fixed only in the short run and only with respect to output: the rent does not move when the workshop makes one more chair. The cure: ask "does this bill change if we make one more unit today?" If not, it is fixed.

5. Compute marginal cost: what one more chair adds

The question a business owner asks most often is not "what did all of today's chairs cost?" It is "what will one more chair add?" That is the marginal question from Week 8, now asked of a cost table.

  • Marginal cost is the change in total cost from producing one more unit of output. Because fixed cost does not change, marginal cost equals the change in variable cost, and it crosses average variable and average total cost at their lowest points.

Write MC for marginal cost, in dollars per chair.

Worked example — marginal cost from total cost. Subtract each total cost from the next.

  1. The 1st chair. 90 − 60 = 30 dollars.
  2. The 2nd chair. 110 − 90 = 20 dollars.
  3. The 3rd chair. 126 − 110 = 16 dollars.
  4. The 4th chair. 148 − 126 = 22 dollars.
  5. The 5th chair. 180 − 148 = 32 dollars.
  6. The 6th chair. 228 − 180 = 48 dollars.

Now do the same subtraction on variable cost alone: 30 − 0 = 30, 50 − 30 = 20, 66 − 50 = 16, 88 − 66 = 22, 120 − 88 = 32, and 168 − 120 = 48 dollars. The same six numbers appear, because the 60 dollars of fixed cost is in every total and cancels out of every difference.

In words: the first three chairs get cheaper to add, and after that each chair costs more than the last, until the 6th chair adds 48 dollars. Marginal cost falls and then rises.

Why does it rise? This is diminishing returns showing up in dollars. Once the fixed room fills, each extra chair takes more paid work, because the people building it are waiting for bench space and sharing tools. More hours per chair means more dollars per chair. Falling marginal product and rising marginal cost are two views of one crowded room.

In practice (your tools). In Google Sheets, type the chairs 0 to 6 in cells A2 to A8 and the total costs 60 to 228 in cells B2 to B8. In cell C3 type =B3-B2 and press Enter; it shows 30. Drag the fill handle in the corner of C3 down to C8, and column C fills with 30, 20, 16, 22, 32, and 48, one marginal cost per chair.

Misconception check. Students often include the fixed cost when they ask what one more chair costs, saying the 1st chair "costs 90 dollars." The 60 dollars of rent is paid with or without that chair. The cure: marginal cost is a difference, and the fixed cost cancels out of every difference, so the 1st chair adds 30 dollars, not 90.

6. Compute the averages: cost per chair

Marginal cost looks at the next chair. Averages look at all the chairs so far and share the bill out evenly. A business uses averages to answer "what does a typical chair cost us?"

  • Average fixed cost is fixed cost divided by the number of units produced; it falls with every extra unit because the same fixed cost is spread over more output.
  • Average variable cost is variable cost divided by the number of units produced: the variable cost per unit at that level of output.
  • Average total cost is total cost divided by the number of units produced, which also equals average fixed cost plus average variable cost.

In symbols, AFC = FC ⁄ Q, AVC = VC ⁄ Q, and ATC = TC ⁄ Q, each in dollars per chair.

Worked example — the three averages. Divide each cost by the number of chairs.

  1. Average fixed cost. 60 ⁄ 1 = 60, 60 ⁄ 2 = 30, 60 ⁄ 3 = 20, 60 ⁄ 4 = 15, 60 ⁄ 5 = 12, and 60 ⁄ 6 = 10 dollars per chair.
  2. Average variable cost. 30 ⁄ 1 = 30, 50 ⁄ 2 = 25, 66 ⁄ 3 = 22, 88 ⁄ 4 = 22, 120 ⁄ 5 = 24, and 168 ⁄ 6 = 28 dollars per chair.
  3. Average total cost. 90 ⁄ 1 = 90, 110 ⁄ 2 = 55, 126 ⁄ 3 = 42, 148 ⁄ 4 = 37, 180 ⁄ 5 = 36, and 228 ⁄ 6 = 38 dollars per chair.
  4. A check. ATC = AFC + AVC, so at 5 chairs 12 + 24 = 36 dollars, the same as 180 ⁄ 5.
Dataset L: the chair workshop's marginal cost and three average costs, in dollars per chair (illustrative)
Chairs (Q) 1 2 3 4 5 6
Marginal cost (MC) 30 20 16 22 32 48
Average fixed cost (AFC) 60 30 20 15 12 10
Average variable cost (AVC) 30 25 22 22 24 28
Average total cost (ATC) 90 55 42 37 36 38

In words: average fixed cost falls every time, because the same 60 dollars of rent is shared by more chairs. Average variable cost is lowest at 22 dollars for 3 and 4 chairs. Average total cost is lowest at 36 dollars for 5 chairs. The cheapest chair on average is not the chair with the cheapest marginal cost; the workshop's lowest marginal cost comes at the 3rd chair, but its lowest average total cost comes at 5 chairs.

Picture these numbers as curves on a graph, with chairs along the horizontal axis and dollars per chair up the vertical axis. The average-fixed-cost curve slides down and to the right the whole way, flattening as it goes. The average-variable-cost curve dips to its low of 22 at 3 and 4 chairs and then climbs. The average-total-cost curve sits above it, dips to its low of 36 at 5 chairs, and climbs again. The gap between those two average curves is average fixed cost, so it narrows as you move right. The marginal-cost curve starts at 30, drops to 16 at the 3rd chair, and then rises steeply to 48.

In practice (your tools). In the same sheet, put the variable costs 0 to 168 in cells D2 to D8. In cell E3 type =60/A3 for average fixed cost, in F3 type =D3/A3 for average variable cost, and in G3 type =B3/A3 for average total cost. Drag the three cells down to row 8. Start at row 3, not row 2: at zero chairs the averages divide by zero, and Sheets shows an error there.

Misconception check. Students often confuse marginal cost with average total cost. At 5 chairs, the 5th chair adds 32 dollars, while the average total cost of all five is 36 dollars. Those are different numbers that answer different questions. The cure: marginal asks "what does the next one add?" and average asks "what does each one cost if we share the whole bill out?"

7. See why marginal cost crosses the averages at their lowest points

There is a pattern in the table worth slowing down for. Marginal cost runs below average total cost while the average is falling, and above it once the average is rising. The same is true for average variable cost. That is not a coincidence. It is arithmetic you already use.

Think about your quiz average. Say you have taken four quizzes and your average is 80. If the fifth quiz is a 70, your average drops, because the new score is below it. If the fifth quiz is a 95, your average rises. The new score is a marginal value, and a marginal value below an average pulls the average down, while one above it pulls the average up.

Worked example — marginal cost pulling average total cost. Compare each chair's marginal cost with the average before it.

  1. The 5th chair. Its marginal cost is 32 dollars, below the average total cost of 37 dollars at 4 chairs, so ATC falls to 36.
  2. The 6th chair. Its marginal cost is 48 dollars, above the average of 36 dollars, so ATC rises to 38.

Worked example — marginal cost pulling average variable cost. Do the same with AVC.

  1. The 3rd chair. Its marginal cost of 16 dollars is below the AVC of 25 at 2 chairs, so AVC falls to 22.
  2. The 4th chair. Its marginal cost of 22 dollars equals the AVC of 22 at 3 chairs, so AVC stays at 22.
  3. The 5th chair. Its marginal cost of 32 dollars is above 22, so AVC rises to 24.

In words: as long as each new chair costs less than the average so far, the average keeps falling. The moment a new chair costs more than the average, the average turns up. So the marginal-cost curve passes through each average curve near the average's lowest point, crossing average variable cost at 22 dollars and average total cost between 5 and 6 chairs, where the average bottoms out at 36.

A caveat about reading a table: with whole chairs, marginal cost jumps from one row to the next, so it crosses an average between two rows rather than landing exactly on its lowest value. On a smooth graph the crossing sits right at the bottom of each average curve.

Misconception check. Students often think the average starts rising when marginal cost starts rising. Marginal cost starts rising at the 4th chair, yet average total cost keeps falling until 5 chairs, because the 4th and 5th chairs, at 22 and 32 dollars, still cost less than the average. The cure: the average turns up only when marginal cost climbs above the average, not when marginal cost starts to climb.

8. Count every cost: explicit and implicit costs

So far every cost has been a bill someone pays. Rent, wood, and wages all leave the bank account. But some of the most important costs of running a business never show up as a bill at all.

Suppose a mechanic quits a job at a garage to open her own repair shop. Nobody sends her a bill for the salary she gave up. Yet she gave it up, and if the shop earns less than that salary, she would have been better off staying. That is Week 1's opportunity cost, now inside a firm.

  • An explicit cost is a cost a firm pays out in money, such as rent, wages, materials, or insurance.
  • An implicit cost is the opportunity cost of resources the owner supplies without a money payment, such as the earnings the owner gives up to run the business and the return the owner's savings could have earned elsewhere.

Implicit costs come in two common kinds. The first is the owner's time: the pay the owner could earn working for someone else. The second is the owner's money: the interest or other return the owner's savings could earn if they were not tied up in the business. A building the owner already owns can carry an implicit cost too, in the rent it could have earned from a tenant.

Misconception check. Students often think a cost is only a cost if money changes hands. The cure: go back to Week 1. A concert's real cost included the pay you missed while you were there, even though nobody billed you for it. A business is no different: the owner's forgone salary is a real cost, every bit as real as the rent.

9. Compare accounting profit and economic profit

With two kinds of cost come two kinds of profit. The difference between them is whether the implicit costs are counted.

  • Accounting profit is revenue minus explicit costs: the profit on a firm's books, which counts only the money actually paid out.
  • Economic profit is revenue minus both explicit and implicit costs. Zero economic profit means the owner earns exactly what the owner's time and money could earn in their next-best use, and a negative value is an economic loss.

Revenue is the money a business takes in from its sales. Keep this case separate from the bakery and the workshop: it is a fresh illustrative example, constructed for this course.

Worked example — the phone-repair stand. A phone-repair stand brings in 80,000 dollars a year and pays 50,000 dollars in explicit costs for parts, the stall, and insurance. Its owner left a job paying 36,000 dollars a year. She also put her savings into tools, and those savings could have earned 1,000 dollars a year in interest.

  1. Accounting profit. 80,000 − 50,000 = 30,000 dollars a year.
  2. Implicit costs. 36,000 + 1,000 = 37,000 dollars a year.
  3. Economic profit. 80,000 − 50,000 − 37,000 = −7,000 dollars a year, an economic loss of 7,000 dollars.

In words: the stand's books show a profit of 30,000 dollars. But the owner could have earned 37,000 dollars from her old job and her savings. Running the stand leaves her 7,000 dollars a year behind her next-best choice. Positive accounting profit and an economic loss can be true at the same time.

That gap matters for decisions. An accountant asks "did the business make money?" An economist asks "did the business beat the owner's best alternative?" Both questions are fair; they are different questions. When you see a profit figure, say which one it is.

What would zero economic profit mean? Suppose the stand's revenue had been 87,000 dollars instead. Then 87,000 − 50,000 − 37,000 = 0. Zero economic profit does not mean the owner earns nothing. It means she earns exactly what her time and money would earn in their next-best use, which is 37,000 dollars, so she is doing as well as she could do elsewhere.

Pause and reflect — choose one. Pick either prompt; they count the same.

  • (a) Imagine running a small business of your own, such as a food truck, a tutoring service, or a lawn-care crew. List one explicit cost and one implicit cost you would face, in words.
  • (b) Think of someone who left a paid job to start something of their own. In two sentences, say what their implicit cost was and why a profit on the books might not settle whether the move paid off.

Misconception check. Students often call accounting profit "economic profit," or think zero economic profit means the owner earns nothing. The cure: economic profit subtracts the owner's forgone earnings too. Zero economic profit means the owner is earning a normal return on her time and money, exactly what she could earn elsewhere.

10. Check the classic wrong turns

Most mistakes this week are not deep confusions. They are a subtraction where a division belongs, a fixed cost that wanders into a marginal decision, or a profit with the wrong label. A short routine catches them.

  • Step one: marginal or average? Marginal values come from subtracting one row from the next; average values come from dividing by the quantity.
  • Step two: where does the pattern turn? Diminishing returns begin at the first marginal product smaller than the one before, not at the first worker.
  • Step three: does fixed cost belong? Fixed cost is in total cost and average total cost, never in marginal cost.
  • Step four: which profit? Accounting profit subtracts explicit costs only; economic profit subtracts implicit costs too.

Worked example — checking a classmate's work. A classmate writes: "The 5th chair costs 36 dollars, because ATC is 36 at 5 chairs. Diminishing returns at the bakery start with the first worker. And the phone-repair stand earns an economic profit of 30,000 dollars."

  1. The 5th chair. The 5th chair adds 180 − 148 = 32 dollars. The 36 dollars is average total cost, the whole bill shared over five chairs.
  2. Diminishing returns. Marginal product rises from 10 to 15 to 20 before it falls, so diminishing returns set in with the fourth worker.
  3. The stand's profit. 30,000 dollars is accounting profit. Its economic profit is 30,000 − 37,000 = −7,000 dollars, a loss.

In words: the corrected statement is "the 5th chair adds 32 dollars while the average total cost of five chairs is 36; diminishing returns begin with the fourth worker; and the stand earns an accounting profit of 30,000 dollars but an economic loss of 7,000."

Misconception check. Students often treat a falling total as the sign of diminishing returns, waiting for loaves to drop before they call it. Total product at the bakery never falls; it rises from 60 to 70 to 75. The cure: diminishing returns show up in marginal product first, while the total is still growing.

Key terms

  • Short run — A period in which at least one of a firm's inputs, such as the size of its kitchen or workshop, is fixed and cannot be changed, so output grows only by adding more of the other inputs. (first used: 1. Separate the short run from the long run)
  • Long run — A period long enough that a firm can change every input, including the size of its building and the number of its machines. (first used: 1. Separate the short run from the long run)
  • Total product — The total output a firm makes with a given amount of a variable input, such as the loaves a bakery bakes in a day with a given number of workers. (first used: 2. Read the bakery's schedule: total, marginal, and average product)
  • Marginal product — The extra output from adding one more unit of a variable input, such as one more worker, while the other inputs stay fixed. (first used: 2. Read the bakery's schedule: total, marginal, and average product)
  • Average product — Output per unit of a variable input: total output divided by the number of workers or other units of that input. (first used: 2. Read the bakery's schedule: total, marginal, and average product)
  • Law of diminishing marginal returns — The pattern that, as more of a variable input is added to a fixed input, the marginal product of the variable input eventually falls; it begins after some point, not with the first worker, and it is why marginal cost eventually rises. (first used: 3. Meet the law of diminishing marginal returns)
  • Fixed cost — A cost that does not change with how much a firm produces in the short run, such as rent on a workshop; the firm pays it even when it makes nothing. (first used: 4. Split the costs: fixed, variable, and total cost)
  • Variable cost — A cost that rises and falls with how much a firm produces, such as materials and the pay for hours worked; it is zero when output is zero. (first used: 4. Split the costs: fixed, variable, and total cost)
  • Total cost — Everything a firm spends to produce a given amount of output: fixed cost plus variable cost. (first used: 4. Split the costs: fixed, variable, and total cost)
  • Marginal cost — The change in total cost from producing one more unit of output; because fixed cost does not change, it equals the change in variable cost, and it crosses average variable and average total cost at their lowest points. (first used: 5. Compute marginal cost: what one more chair adds)
  • Average fixed cost — Fixed cost divided by the number of units produced; it falls with every extra unit because the same fixed cost is spread over more output. (first used: 6. Compute the averages: cost per chair)
  • Average variable cost — Variable cost divided by the number of units produced: the variable cost per unit at that level of output. (first used: 6. Compute the averages: cost per chair)
  • Average total cost — Total cost divided by the number of units produced, which also equals average fixed cost plus average variable cost. (first used: 6. Compute the averages: cost per chair)
  • Explicit cost — A cost a firm pays out in money, such as rent, wages, materials, or insurance. (first used: 8. Count every cost: explicit and implicit costs)
  • Implicit cost — The opportunity cost of resources the owner supplies without a money payment, such as the earnings the owner gives up to run the business and the return the owner's savings could have earned elsewhere. (first used: 8. Count every cost: explicit and implicit costs)
  • Accounting profit — Revenue minus explicit costs: the profit on a firm's books, which counts only the money actually paid out. (first used: 9. Compare accounting profit and economic profit)
  • Economic profit — Revenue minus both explicit and implicit costs; zero economic profit means the owner earns exactly what the owner's time and money could earn in their next-best use, and a negative value is an economic loss. (first used: 9. Compare accounting profit and economic profit)

Summary

  • In the short run at least one input is fixed; in the long run every input can change.
  • Marginal product is what one more worker adds; average product is output per worker.
  • Diminishing marginal returns begin when marginal product starts to fall, not at the first worker.
  • Total cost is fixed cost plus variable cost.
  • Marginal cost is the change in total cost from one more unit; fixed cost never enters it.
  • Each average cost is a cost divided by the number of units.
  • A marginal value below an average pulls the average down; one above pulls it up.
  • Marginal cost crosses average variable and average total cost near their lowest points.
  • Accounting profit subtracts explicit costs; economic profit subtracts implicit costs too.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

  1. A car wash with two fixed wash bays (an illustrative case) washes 0, 8, 20, 30, 36, and 38 cars a day with 0 to 5 workers. Compute each worker's marginal product and say which worker brings in diminishing marginal returns.
  2. A weekend screen-printing stall (an illustrative case) rents its press for 12 dollars a day. Its variable cost is 0, 36, 52, 72, and 104 dollars for 0 to 4 batches of shirts. Compute total cost, marginal cost, average variable cost, and average total cost for 1 to 4 batches.
  3. Using your numbers from item 2, explain in two sentences why average total cost falls from 2 to 3 batches and rises from 3 to 4 batches.
  4. A graphic designer (an illustrative case) leaves a job paying 48,000 dollars a year to work for herself. Her studio takes in 90,000 dollars a year and pays 30,000 dollars in explicit costs. She works from a spare room she could have rented out for 2,000 dollars a year. Compute her accounting profit and her economic profit, and say what each figure means.

Answers (worked reasoning — read after attempting)

  1. Subtract each day's total from the next: 8 − 0 = 8, 20 − 8 = 12, 30 − 20 = 10, 36 − 30 = 6, and 38 − 36 = 2 cars. Marginal product rises from 8 to 12 and then falls to 10, so diminishing marginal returns set in with the third worker. Total cars still rise with every worker; each new worker adds fewer because the two bays are shared.
  2. Total cost adds the 12-dollar rental: 12 + 36 = 48, 12 + 52 = 64, 12 + 72 = 84, and 12 + 104 = 116 dollars. Marginal cost subtracts each total from the next: 48 − 12 = 36, 64 − 48 = 16, 84 − 64 = 20, and 116 − 84 = 32 dollars. Average variable cost is 36 ⁄ 1 = 36, 52 ⁄ 2 = 26, 72 ⁄ 3 = 24, and 104 ⁄ 4 = 26 dollars per batch. Average total cost is 48 ⁄ 1 = 48, 64 ⁄ 2 = 32, 84 ⁄ 3 = 28, and 116 ⁄ 4 = 29 dollars per batch. Average total cost is lowest, 28 dollars, at 3 batches.
  3. The 3rd batch adds 20 dollars, which is below the average total cost of 32 dollars at 2 batches, so it pulls the average down to 28. The 4th batch adds 32 dollars, which is above the average of 28, so it pulls the average up to 29; that is why marginal cost crosses average total cost near its lowest point.
  4. Accounting profit is 90,000 − 30,000 = 60,000 dollars a year, the profit on her books. Her implicit costs are 48,000 + 2,000 = 50,000 dollars, so economic profit is 60,000 − 50,000 = 10,000 dollars a year. She earns 10,000 dollars more than her old job and the room's rent would have paid her, so working for herself beats her next-best choice. Calling the 60,000 dollars "economic profit" would be the classic slip.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the price-taking firm brings a market price to this cost table and asks how many chairs to make.

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