Unit 3: Production, Cost, and the Perfect Competition Model

a. Define (using graphs where appropriate) key terms and concepts relating to production and cost. b. Explain (using graphs where appropriate) how production and cost are related in the short run and long run. c. Calculate (using data from a graph or table as appropriate) the various measures of productivity and short-run and long-run costs.

• The production function explains the relationship between inputs and outputs both in the short run and the long run.
• Marginal product and average product change as input usage changes, and hence, total product changes.
• Diminishing marginal returns occur as the firm employs more of one input, holding other inputs constant, to produce a product (output) in the short run.
• Enduring understanding PRD-1: Firms’ production and cost constraints over different input and output levels shape optimal decisions in the short run and long run.

a. Define (using graphs where appropriate) key terms and concepts relating to production and cost. b. Explain (using graphs where appropriate) how production and cost are related in the short run and long run. c. Calculate (using data from a graph or table as appropriate) the various measures of productivity and short-run and long-run costs.

• Fixed costs and variable costs determine the total cost.
• Marginal cost, average (fixed, variable, and total) cost, total cost, and total variable cost change as total output changes, but total fixed cost remains constant at all output levels, including zero output.
• Production functions with diminishing marginal returns yield an upward-sloping marginal cost curve.
• Specialization and the division of labor reduce marginal costs for firms.
• Cost curves can shift in response to changes in input costs and productivity.
• Enduring understanding PRD-1: Firms’ production and cost constraints over different input and output levels shape optimal decisions in the short run and long run.

a. Define (using graphs where appropriate) key terms and concepts relating to production and cost. b. Explain (using graphs where appropriate) how production and cost are related in the short run and long run. c. Calculate (using data from a graph or table as appropriate) the various measures of productivity and short-run and long-run costs.

• In the long run, firms can adjust all their inputs, and as a result, all costs become variable.
• The relationship between inputs and outputs in the long run is described by the scale of production—increasing, decreasing, or constant returns to scale.
• The long-run average total cost is characterized by economies of scale, diseconomies of scale, or constant returns to scale (efficient scale).
• The minimum efficient scale plays a role in determining the concentration of firms in a market and the market structure.
• Enduring understanding PRD-1: Firms’ production and cost constraints over different input and output levels shape optimal decisions in the short run and long run.

a. Define the different types of profit. b. Explain how firms respond to profit opportunities. c. Calculate a firm’s profit or loss.

• Firms respond to economic profit (loss) rather than accounting profit.
• Accounting profit fails to account for implicit costs (such as cost of financial capital, compensation for risk, or an entrepreneur’s time), which, if fully compensated, result in normal profit.
• Enduring understanding CBA-2: To determine the optimal level at which to pursue an activity whose total benefits exceed total cost, rational economic agents compare marginal benefits and marginal costs.

a. Define (using graphs or data as appropriate) the profit-maximizing rule. b. Explain (using a graph or data as appropriate) the profit-maximizing level of production.

• Firms are assumed to produce output to maximize their profits by comparing marginal revenue and marginal cost.
• Enduring understanding CBA-2: To determine the optimal level at which to pursue an activity whose total benefits exceed total cost, rational economic agents compare marginal benefits and marginal costs.

Explain (using graphs or data where appropriate) firms’ short-run decisions to produce positive output levels, or long-run decisions to enter or exit a market in response to profit-making opportunities.

• In the short run, firms decide to operate (i.e., produce positive output) or shut down (i.e., produce zero output) by comparing total revenue to total variable cost or price to average variable cost (AVC).
• In the absence of barriers to entry or exit, in the long run (i.e., once factors that are fixed in the short run become variable), firms enter a market in which there are profit-making opportunities and exit a market when they anticipate economic losses.
• Enduring understanding PRD-2: Firms’ short-run decisions to produce output, and long-run decisions to enter or exit a market, are based on profitability.

a. Define (using graphs as appropriate) the characteristics of perfectly competitive markets and efficiency. b. Explain (using graphs where appropriate) equilibrium and firm decision making in perfectly competitive markets and how prices in perfectly competitive markets lead to efficient outcomes. c. Calculate (using data from a graph or table as appropriate) economic profit (loss) in perfectly competitive markets.

• A perfectly competitive market is efficient. Firms in perfectly competitive markets face no barriers to entry and have no market power.
• In perfectly competitive markets, prices communicate to consumers and producers the magnitude of others’ marginal costs of production and marginal benefits of consumption and provide incentives to act on that information (i.e., price equals marginal cost in an efficient market).
• In perfectly competitive markets, firms can sell all their outputs at a constant price determined by the market.
• At a competitive market equilibrium, firms are price takers and select output to maximize profit by producing the level of output where the marginal cost equals marginal revenue (at the price).
• At a competitive market equilibrium, the price of a product equals both the private marginal benefit received by the last unit consumed and the private marginal cost incurred to produce the last unit, thus achieving allocative efficiency.
• In a short-run competitive equilibrium, price can either be above or below its long-run competitive level resulting in profits or losses, motivating entry or exit of firms and moving prices and quantities toward long-run equilibrium.
• In a long-run perfectly competitive equilibrium, productive efficiency implies all operating firms produce at efficient scale, price equals marginal cost and minimum average total cost, and firms earn zero economic profit.
• Firms may be in a constant cost, increasing cost, or decreasing cost industry. Long-run prices depend on the portion of the long-run cost curves on which firms operate.
• A perfectly competitive market in long-run equilibrium is allocatively and productively efficient.
• Enduring understanding PRD-3: Even with a common goal of profit-maximization, market structure constrains and influences prices, output, and efficiency.