Difficulty: Introductory | Prerequisites: Familiarity with demand and supply (see Part 1 notes)
Source: Module 1 Glossary, Microeconomics, University of Illinois at Urbana-Champaign
Tags: fixed costs, variable costs, marginal cost, ATC, AVC, production function, short run, long run, diminishing returns, profit maximization, economic profit, accounting profit, normal profit, shutdown, firm types, ECON 101
This section covers how firms produce goods and what it costs them to do so. Understanding cost structures is essential because the supply curve you learned in Part 1 is really just the firm's marginal cost curve in disguise. This topic also introduces the different types of profit (accounting vs economic vs normal), the types of business organisation, and the rules firms use to decide how much to produce. If you are comfortable with the distinction between fixed and variable costs, and between the short run and the long run, the rest of the course's material on market structures (perfect competition, monopoly, oligopoly) will make far more sense.
Firms face fixed costs (which do not change with output) and variable costs (which do). The key decision rule is to produce where marginal revenue equals marginal cost. In the short run at least one input is fixed; in the long run everything can be adjusted. Economic profit includes opportunity costs, so a firm earning zero economic profit is still covering all its costs, including the owner's next-best alternative.
Fixed costs
Costs that are independent of the level of output.
Think of it as rent, insurance, or the cost of a factory lease: you pay the same whether you produce one unit or a thousand.
Variable costs
Costs that are related to the output produced.
In simple terms, this means: raw materials, hourly wages, electricity used on the production line. Produce more, spend more.
Total cost
The sum of fixed cost and variable cost.
Think of it as: TC = FC + VC. That is the entire equation.
Average fixed cost (AFC)
The total fixed cost per unit of output.
In simple terms, this means: spread your fixed costs over all the units you produce. The more you produce, the lower AFC gets, because you are dividing the same fixed sum by a larger number.
Average variable cost (AVC)
The total variable cost per unit of output.
Think of it as: what does each unit cost you in variable inputs alone?
Average total cost (ATC)
The sum of all costs per unit of output.
In simple terms, this means: ATC = AFC + AVC. It is your total cost divided by quantity. The U-shaped ATC curve is one of the most important diagrams in the course.
Marginal cost
The cost of producing each additional unit of output.
Think of it as: "if I make one more unit, how much extra does it cost me?" This is the cost concept that drives production decisions.
Average revenue
The price per unit sold.
In simple terms, this means: total revenue divided by quantity. In a competitive market, average revenue equals the market price.
Marginal revenue
The change in total revenue due to selling one more unit of a good.
Think of it as: "if I sell one more unit, how much extra revenue do I earn?" In perfect competition, marginal revenue equals price.
Production function
A technological relationship that specifies how much output can be produced with specific amounts of inputs.
In simple terms, this means: a recipe that tells you "with X workers and Y machines, you can produce Z units."
Capital
The buildings, machinery, equipment, and software used in producing goods and services.
Think of it as everything a firm uses to produce that is not labour or raw materials.
Short run
A period during which at least one factor of production is fixed. If capital is fixed, more output is produced by adding labour.
In simple terms, this means: you cannot build a new factory overnight. In the short run, you adjust output by hiring or firing workers, not by changing your plant size.
Long run
A period of time sufficient to enable all factors of production to be adjusted.
Think of it as: enough time has passed that the firm can expand its factory, buy new equipment, or exit the industry entirely.
Short run total product
The relationship between total output produced and the amount of labour used, for a given amount of capital.
In simple terms, this means: hold capital fixed, add workers, and track how total output changes.
Law of diminishing marginal product
When increments of a variable factor (labour) are added to a fixed amount of another factor (capital), the marginal product of the variable factor must eventually decline.
Think of it as: cramming more workers into the same factory. At first each new hire adds a lot of output. Eventually they start getting in each other's way, and each additional worker adds less.
Technological change
Innovation that can reduce the cost of production or bring new products.
In simple terms, this means: a better machine or a better process that lets the firm produce more with the same inputs, or the same output with fewer inputs.
Accounting profits
The difference between revenues and actual explicit costs incurred.
Think of it as the profit figure you see on a company's income statement. It counts only the costs you can point to on a receipt.
Economic profits
Profits measured as the difference between total revenue and total costs, where the cost term includes the opportunity cost of the resources used in production.
In simple terms, this means: economic profit also subtracts what the owner could have earned elsewhere. A firm can have positive accounting profit but zero economic profit.
Normal profits
The minimum return required to induce suppliers to supply their goods and services. Normal profits are when economic profits equal zero.
Think of it as: the firm is covering all its costs, including the owner's opportunity cost. There is no incentive to leave the industry, and no incentive for new firms to enter.
Profit maximization
The goal of proprietary firms: they seek to maximise the difference between revenues and costs.
In simple terms, this means: produce where marginal revenue equals marginal cost (MR = MC). That is the golden rule.
Shutdown price
A price below AVC causes a firm to shut down in the short run.
Think of it as: if the price does not even cover the variable costs of each unit, the firm loses less money by producing nothing and just paying its fixed costs.
Short run equilibrium
Occurs when each firm maximises profit by producing a quantity where marginal revenue equals marginal cost at or above average variable cost.
In simple terms, this means: the firm is producing at MR = MC and the price is high enough that it is worth staying open.
Sole proprietor
The single owner of a business, responsible for all profits and losses.
Think of it as: you are the business. All the profit is yours, but so is all the liability.
Partnership
A business owned jointly by two or more individuals who share in the profits and are jointly responsible for losses.
In simple terms, this means: shared ownership, shared liability. Each partner's personal assets can be at risk.
Corporation / company
An organisation with a legal identity separate from its owners that produces and trades.
Think of it as: the business is its own legal "person." If the company goes bankrupt, the owners' personal assets are protected.
Shareholders
Individuals who invest in corporations and therefore are the owners. They have limited liability personally if the firm incurs losses.
In simple terms, this means: shareholders can lose their investment, but creditors cannot come after their house.
Positive economics
Studies objective or scientific explanations of how the economy functions.
Think of it as: "what is" and "what happens if." No value judgements, just cause and effect.
Normative economics
Offers recommendations that incorporate value judgements.
Think of it as: "what should be." Policy recommendations, fairness arguments, opinions about what the government ought to do.
Theory
A logical view of how things work, frequently formulated on the basis of observation.
In simple terms, this means: a simplified model of reality that helps us make predictions.
Regression line
Represents the average relationship between two variables in a scatter diagram.
Think of it as: the line of best fit drawn through a cloud of data points.
Present value of a stream of future earnings
The sum of each year's earnings divided by one plus the interest rate raised to the appropriate power.
In simple terms, this means: what a series of future payments is worth right now, accounting for the fact that money today is worth more than money tomorrow.
Total cost = fixed cost + variable cost. This identity underlies everything.
Average total cost (ATC) = total cost / quantity = AFC + AVC.
AFC falls continuously as output rises (spreading fixed costs over more units).
AVC typically falls at first, then rises, giving it a U shape. The reason is diminishing marginal returns.
ATC is also U-shaped. It reaches its minimum where MC crosses it from below.
Marginal cost (MC) is the cost of one more unit. It intersects both AVC and ATC at their minimum points. This is a key diagram to be able to draw.
TC = FC + VC
ATC = TC / Q
AFC = FC / Q
AVC = VC / Q
MC = change in TC / change in Q
In the short run, at least one factor (usually capital) is fixed. Output changes by adding or removing the variable factor (usually labour).
The short run total product curve shows total output as a function of labour, holding capital constant.
The law of diminishing marginal product: eventually, each additional worker adds less output than the previous one. This is why marginal cost eventually rises.
Diminishing marginal product does not mean total output falls. It means the rate of increase slows.
In the long run, all factors of production can be adjusted. The firm can build a bigger factory, adopt new technology, or exit entirely.
Long-run decisions include choosing the scale of operations and the mix of inputs.
Accounting profit = revenue minus explicit costs. This is the figure on the income statement.
Economic profit = revenue minus all costs (explicit and implicit, including opportunity costs). This is the figure economists care about.
Normal profit = zero economic profit. The firm covers every cost including the owner's opportunity cost. There is no reason to leave and no reason for new firms to enter.
A firm can report a healthy accounting profit while earning zero economic profit. This is a very common exam question.
In the short run, a firm should shut down if the price falls below the minimum of AVC.
At any price above AVC, the firm covers its variable costs and contributes something toward fixed costs. It is better off producing than shutting down, even if it is making a loss.
At a price below AVC, every unit produced makes the firm worse off. It loses less by producing nothing.
The firm produces where MR = MC, provided the price is at or above AVC.
In perfect competition, MR = price, so the firm produces where price = MC.
Sole proprietor: one owner, unlimited liability, simple to set up, full control.
Partnership: two or more owners, joint liability, shared decision-making.
Corporation: separate legal identity, limited liability for shareholders, can raise capital by selling shares.
Positive economics deals with "what is": testable, objective statements about how the economy works.
Normative economics deals with "what should be": value-laden recommendations.
The distinction matters because exam questions sometimes ask you to classify statements as positive or normative.
Students often think "diminishing marginal product" means total output is falling. It does not. Total output is still rising, just at a decreasing rate.
Many students confuse accounting profit and economic profit. A firm with positive accounting profit may have zero or negative economic profit once opportunity costs are included.
Students sometimes assume that a firm making a loss should always shut down. In the short run, a firm should keep producing as long as price is above AVC, because it is still covering its variable costs and part of its fixed costs.
The statement "normal profit means the firm is not making money" is wrong. Normal profit means economic profit is zero, but the firm is still earning enough to cover all its costs, including a competitive return for the owner.
Drawing and interpreting the MC, AVC, ATC diagram is tested on virtually every introductory micro exam. Know where MC crosses AVC and ATC (at their minimum points).
The distinction between accounting, economic, and normal profit appears in multiple-choice and short-answer formats.
The shutdown rule (price < AVC = shut down) is a staple exam question, often presented as a numerical problem.
Classifying statements as positive or normative is a quick, easy exam question that students sometimes get wrong through carelessness.
True or false: If a firm's accounting profit is positive, its economic profit must also be positive.
False. Economic profit subtracts opportunity costs. A firm can have positive accounting profit and zero (or negative) economic profit.
Fill in the blank: Marginal cost intersects average total cost at ATC's ________ point.
Minimum.
True or false: In the short run, a firm should shut down whenever it is making a loss.
False. It should shut down only if the price falls below average variable cost.
Fill in the blank: The law of diminishing marginal product states that eventually, each additional unit of the variable factor adds ________ output than the previous unit.
Less.
True or false: "The government should raise the minimum wage" is a positive economic statement.
False. It is a normative statement because it involves a value judgement about what should happen.
Q: A firm has fixed costs of $100, variable costs of $200, and produces 50 units. Calculate ATC, AFC, and AVC.
A: TC = $100 + $200 = $300. ATC = $300 / 50 = $6. AFC = $100 / 50 = $2. AVC = $200 / 50 = $4.
Q: A firm is currently producing at a loss. The price is $8, AVC is $6, and ATC is $10. Should the firm continue to produce in the short run? Explain.
A: Yes. The price ($8) is above AVC ($6), so the firm covers all its variable costs and contributes $2 per unit toward fixed costs. Shutting down would mean losing all $100 of fixed costs (or whatever the total is). Continuing to produce reduces the loss.
Q: Explain why the marginal cost curve intersects the average total cost curve at its minimum point.
A: When MC is below ATC, each additional unit costs less than the average, pulling ATC down. When MC is above ATC, each additional unit costs more than the average, pulling ATC up. The crossover, where MC equals ATC, is therefore the minimum of ATC.
Q: Distinguish between economic profit and accounting profit. Why does the distinction matter?
A: Accounting profit = revenue minus explicit costs. Economic profit = revenue minus explicit and implicit costs (including opportunity costs). The distinction matters because a firm earning zero economic profit is still earning enough to keep the owner in the industry. Positive economic profit attracts entry; negative economic profit drives exit.
Q: A firm is a sole proprietor. What is one advantage and one disadvantage compared to a corporation?
A: Advantage: full control and simplicity of setup. Disadvantage: unlimited personal liability. If the business fails, creditors can claim the owner's personal assets.
Cost theory connects directly to the supply curve from Part 1: in a competitive market, the firm's supply curve is its marginal cost curve above AVC. Profit types (accounting, economic, normal) become critical when studying market structures later in the course, especially for understanding why firms enter and exit industries under perfect competition. The shutdown decision reappears in the analysis of monopoly and monopolistic competition, where the same AVC rule applies.
fixed cost, variable cost, total cost, marginal cost, average total cost, ATC, average variable cost, AVC, average fixed cost, AFC, production function, short run, long run, diminishing returns, diminishing marginal product, marginal product of labour, shutdown rule, profit maximization, MR = MC, accounting profit, economic profit, normal profit, zero economic profit, opportunity cost, sole proprietor, partnership, corporation, limited liability, shareholders, positive economics, normative economics, regression, present value, time value of money, ECON 101, introductory microeconomics, Module 1