Overview

This topic explains how firms turn inputs into outputs and how production costs behave in the short and long run. Understanding cost structures is essential for firms making profit-maximizing decisions about how much to produce and which inputs to use.

Key Themes and Concepts

• Production Function: Describes the relationship between inputs and outputs. Shows how output changes with varying input levels.
• Short-Run vs. Long-Run:
  • Short run: At least one input is fixed (usually capital).
  • Long run: All inputs are variable; firms can adjust all resources.
• Marginal Product (MP): Additional output produced by using one more unit of input. Shows productivity of resources.
• Diminishing Returns: As more units of a variable input are added, the marginal product eventually declines.
• Short-Run Costs:
  • Fixed cost (FC): Costs that do not change with output.
  • Variable cost (VC): Costs that change with output.
  • Total cost (TC) = FC + VC
  • Average total cost (ATC) = TC/Q
  • Marginal cost (MC): Cost of producing one more unit.
• Cost Curves: Marginal cost intersects ATC and AVC at their minimums. U-shaped curves reflect diminishing returns.
• Long-Run Costs:
  • Economies of scale: Long-run ATC falls as output increases.
  • Diseconomies of scale: Long-run ATC rises due to inefficiencies.
  • Constant returns to scale: ATC remains unchanged with output growth.
• Cost Minimization: In the long run, firms choose the input combination that produces output at the lowest cost.

Quick Tip

Costs guide firms in every production decision. Knowing where marginal cost meets marginal product helps firms set output, and understanding scale helps them plan growth. The key is always balancing cost with value — efficient firms do both.