Production, Cost, and the Perfect Competition Model

A production function shows how much output a firm gets from its inputs. Marginal product is the extra output from one more unit of an input, like one more worker, and average product is output per worker. In the short run, when some inputs are fixed, adding more workers eventually brings diminishing marginal returns: each extra worker adds less output than the one before.

Total cost is fixed cost (the same at every output level, even zero) plus variable cost (which grows with output). On a graph with cost on the vertical axis and output on the horizontal axis, average fixed cost keeps falling, while average variable cost (AVC) and average total cost (ATC) are U-shaped. Marginal cost eventually rises because of diminishing marginal returns, and it crosses AVC and ATC at their lowest points. The curves shift when input prices or productivity change.

In the long run a firm can change every input, so all of its costs are variable. The long-run average total cost curve falls while there are economies of scale, is flat with constant returns to scale, and rises with diseconomies of scale. The smallest output at which it reaches its lowest cost is the minimum efficient scale, which helps decide how many firms a market can support.

Accounting profit is total revenue minus explicit costs (money actually paid out), while economic profit also subtracts implicit costs, such as the owner's time or what the owner's money could have earned elsewhere. Firms respond to economic profit. Zero economic profit is called normal profit: the owner is covering every opportunity cost, so staying in business is still worthwhile.

A firm makes the most profit by producing the quantity where marginal revenue equals marginal cost (MR = MC). Making one more unit is worth it when it adds more to revenue than to cost; past the point where MR = MC, each extra unit would lower profit.

In the short run, a firm that is losing money should keep producing if price is at least its average variable cost (AVC), meaning total revenue covers total variable cost, because the extra revenue helps pay its fixed costs. If price falls below minimum AVC, it should shut down and produce nothing, losing only its fixed costs. In the long run, with no barriers to entry, firms enter markets where there is economic profit and leave markets where they expect losses.

Perfect competition has many firms selling identical products with no barriers to entry. Each firm is a price taker: it faces a horizontal demand curve at the market price (P = MR) and produces where P = MC. Side-by-side graphs show the market's supply and demand next to one firm's cost and revenue curves. Short-run profits attract new firms and losses push firms out until, in the long run, price sits at the lowest point of each firm's average total cost curve and economic profit is zero. The market is then allocatively efficient (P = MC) and productively efficient (P = minimum ATC). After entry or exit, the long-run price ends up back where it started in a constant-cost industry, higher in an increasing-cost industry and lower in a decreasing-cost industry.