Home / Courses / Microeconomics / Unit 3

Microeconomics Unit 3: Production, cost and perfect competition

Firms maximize profit where marginal revenue equals marginal cost, and in perfect competition entry and exit drive long-run economic profit to zero.

Covers: The production function and diminishing returns, short-run costs, long-run costs and economies of scale, types of profit, profit maximization, perfect competition in the short and long run

Study guide

A firm's production function shows how output depends on inputs. In the short run at least one input is fixed. Marginal product is the extra output from one more worker; it eventually falls because of the law of diminishing marginal returns. Costs follow from production: fixed costs don't change with output, variable costs do, and total cost is their sum. Average total cost (ATC), average variable cost (AVC) and average fixed cost (AFC) are per-unit costs, and marginal cost (MC) is the cost of one more unit. MC crosses ATC and AVC at their minimum points, and the curves are U-shaped because of diminishing returns. In the long run all inputs are variable; the long-run ATC curve shows economies of scale (falling costs), constant returns and diseconomies of scale.

Accounting profit is revenue minus explicit costs, while economic profit also subtracts implicit costs (opportunity costs). Zero economic profit is normal profit, meaning the firm covers all its opportunity costs. Every firm maximizes profit by producing where marginal revenue equals marginal cost (MR = MC). A firm should shut down in the short run if price falls below minimum AVC, and exit in the long run if price is below ATC.

Perfect competition has many firms, identical products, easy entry and exit, and price-taking firms. Each firm's demand curve is perfectly elastic at the market price, so P = MR = AR. In the short run firms can earn profits or losses. In the long run, profits attract entry, increasing supply and lowering price, while losses cause exit, until firms earn zero economic profit at the minimum of ATC. Perfect competition is both productively efficient (P = minimum ATC) and allocatively efficient (P = MC).

In a constant-cost industry, entry doesn't change input prices, so the long-run industry supply curve is horizontal. After a demand increase, price returns to its original level once new firms enter. In an increasing-cost industry, input prices rise as the industry grows, so long-run supply slopes upward. In a decreasing-cost industry it slopes downward. On a firm's graph, economic profit equals (P − ATC) × Q at the profit-maximizing quantity, a rectangle between price and ATC. If ATC is above price, the same rectangle shows a loss. With total revenue and total cost curves, profit is greatest where the vertical gap between TR and TC is largest.

A change in fixed cost (like a lump-sum tax or license fee) shifts ATC and AFC but not MC, so it doesn't change the short-run profit-maximizing quantity. Only profit changes. A per-unit cost change shifts MC and does change output. AFC = TFC ÷ Q falls continuously as output rises, because the fixed cost is spread over more units. As a result, the gap between ATC and AVC (which equals AFC) narrows. ATC = AVC + AFC, and MC = ΔTC ÷ ΔQ = ΔTVC ÷ ΔQ.

When market demand rises, the price rises in the short run and existing firms produce more and earn profits. New firms then enter, market supply shifts right, and price falls back to minimum ATC (for a constant-cost industry). The adjustment works in reverse when demand falls.

Key ideas

• Diminishing marginal returns make cost curves U-shaped.
• MC crosses ATC and AVC at their minimums.
• Economic profit subtracts implicit costs; zero economic profit is normal profit.
• All firms maximize profit where MR = MC.
• Long-run perfect competition gives zero economic profit and efficiency.

Formulas and rules

Common mistakes

• Confusing accounting profit with economic profit.
• Shutting down when P < ATC in the short run; the rule is P < AVC.

Words to know

Production function

The relationship between inputs and output.

Short run

A period when at least one input is fixed.

Long run

A period when all inputs can change.

Marginal product

Extra output from one more unit of an input.

Diminishing marginal returns

Each extra worker adds less output when other inputs are fixed.

Fixed cost

A cost that doesn't change with output.

Variable cost

A cost that rises with output.

Average total cost (ATC)

Total cost per unit of output.

Average variable cost (AVC)

Variable cost per unit of output.

Marginal cost (MC)

The cost of producing one more unit.

Economies of scale

Long-run average cost falls as output grows.

Diseconomies of scale

Long-run average cost rises as output grows.

Explicit cost

A direct payment, like wages or rent.

Implicit cost

An opportunity cost, like forgone salary.

Accounting profit

Revenue minus explicit costs.

Economic profit

Revenue minus explicit and implicit costs.

Normal profit

Zero economic profit; all opportunity costs are covered.

Profit-maximizing rule

Produce where MR = MC.

Shutdown rule

Shut down in the short run if P < minimum AVC.

Perfect competition

Many firms, identical products, free entry, price takers.

Price taker

A firm that must accept the market price.

Productive efficiency

Producing at minimum ATC.

Allocative efficiency

Producing where P = MC.

Sample practice questions

21 more questions like these, from level 1 to 5, are in the practice set.