Production Cost Functions and Competitive Markets
Lecture 5


Output and Costs in the Short Run

1. Short run - a period of time so short that at least one factor of production is fixed, usually the physical capital, like structures, machines, and equipment.

  • Total Fixed Costs (TFC) - the costs do not change when production level changes
    • Insurance premiums
    • Property taxes
    • Overhead from administration
    • Bank loans
    • Airlines, hotels, and theme parks have high fixed costs
  • Average Fixed Costs (AFC) - fixed costs per good produced
    • As production level increases, AFC will get smaller and smaller
    • "Spreading the overhead"
    • The fixed costs is spread out over more units

AFC = TFC / Output

Total Fixed Cost Average Fixed Cost
Costs Per-Unit Costs
Total Fixed Costs Average Fixed Costs
Output/Quantity Output/Quantity
  • Total Variable Costs (TVC) - the costs that varies when the production level changes.
    • Labor costs
    • Raw material costs
    • Energy costs such as electricity, water, etc.
    • Labor is a large cost for many tourist related companies
  • Average Variable Cost (AVC) - variable costs per unit of a good produced

AVC = TVC / Output

Total Variable Costs Average Variable Costs
Costs Per-Unit Costs
Total Variable Costs Average Variable Costs

2. Marginal Cost (MC) - the increase in cost as production increases by one unit.

  • MC will decline initially, reach a minimum, and then rise
  • Example: A hotel starts with 0 workers
  • Specialization of labor
    • Production gains
    • MC decreases
      • 1 worker - output is to service 10 rooms (10 rooms per worker)
      • 2 workers - output is to service 30 rooms (15 rooms per worker)
      • 3 workers - output is to service 60 rooms (20 rooms per worker)
  • Law of Diminishing Returns
    • Output increases by a smaller and smaller amount as more labor (variable resource) is added to a fixed resource
    • Production inefficiency
    • Exists only in the short run
    • MC increases
      • 50 workers - output is to service 1,000 rooms (20 rooms per worker)
      • 51 workers - output is to service 1,100 rooms (18.3 rooms per worker)
Marginal Cost
Cost per unit
Marginal Costs

3. The Total Costs and Average Curves.

Total Cost (TC) = Total Fixed Cost + Total Variable Cost


Average Total Cost (ATC) = Average Fixed Cost + Average Variable Cost.

ATC = AFC + AVC = TC / Output

  • Relationship between marginal cost and total variable costs
    • MC < ATC, then ATC is decreasing
    • MC > ATC. then ATC is increasing
    • MC intersects ATC at its minimum point
    • Example: Student's score is 80% and student took 2 tests
      • 3rd test (i.e. marginal)
      • Scores 90%, average increases
      • Scores 70%, average decreases
Total Cost Curves Average Cost Curves
Total cost Per-unit cost
Total Costs Average Cost Curves
Output/Quantity Output/Quantity

Output and Costs in the Long Run

1. Long run - is a period of time sufficient for the firm to alter all factors of production.

  • Firms can enter and exit the industry.
  • Long run differs by industry.
    • Examples: Long run for an automobile factory using lots of machines may be 7 years.
    • The long run for an internet company may be 1 year.
  • Long-Run ATC - shows the minimum average cost of producing each output level when a firm is able to vary all production resources, including factory size.
    • Allow the firm to vary among 3 factory sizes: ATC1, ATC2, ATC3. Which factory size should the firm produce at?
Long Run ATC
Per-Unit Cost
Long-run Average Total Costs
Blue arrow

ATC2 will give the factory the lowest per unit costs in the long run. The firm will be able to recuperate all its total costs, when:

Market price (P*) > = minimum of long-run ATC

2. Why unit costs differ in the long run.

Long Run ATC
Per-Unit Cost
Long-run Average Total Costs
  • Economies of scale - per-unit costs fall as output (plant size) expands
    • Financial - a larger firm has access to more financing options
    • Buying and selling - a larger firm can buy or sell in bulk, which leads to discounts
    • Mass production - large amounts of capital and machines
    • Specialization of labor - adding more labor allows workers to specialize in task that they are good at
    • Management specialization - people specialize in finance, personnel, and marketing
    • Technical specialization - a larger firm can use more expensive technology
    • Risk bearing - a larger firm can weather set backs
      • Has diversified business
      • Has more resources
    • Concentration of competitors at tourist destination
      • Competitor's advertising attracts tourists to the area
    • Examples
      • Automobile
      • Electricity
      • Natural gas
      • Telecommunications including internet services
      • Computer chips
  • Constant returns to scale - per-unit costs are constant as plant size is changed.
    • Small firms can be just as efficient as large firms.
      • Apparel
      • Food processing
      • Publishing
      • Lumber
      • Retailing
      • Wood products
  • Diseconomies of scale - per-unit costs rises as output (plant size) expands
    • Bureaucratic inefficiencies
    • More difficult to coordinate and manage workers
    • Monitoring and over site problems
    • Tourist destination - overcrowding and congestion

3. Firms become larger through mergers

  • Merger - firm takes over and integrates another firm
  • Horizontal integration - firm takes over another firm in the same market
    • Example - one hotel chain takes over another hotel company
    • Economies of scale
    • Reduce advertising
    • Adjust discounts to maximize profits
    • If one company owns all the hotels in one area, then it may have monopoly power
  • Vertical integration - a firm takes over another firm in the supply chain
    • An airline company that services a tourist destination buys a hotel chain there
    • Company may have a cost advantage
    • Gives control over the supply, and hence the quality level
    • Note - many energy companies are vertically integrated
      • Petroleum company extracts, refines, and sells fossil fuels to consumers
  • Conglomerate - a firm takes over other firms in different, unrelated markets
    • Diversify its products and services, and reduce risks
    • Firm may leave a dying market and enter a new market
    • Example - Carlson Company
      • Hotels
      • Restaurants
      • Travel agencies
      • Marketing consultant agencies

Pure Competition

  1. Purely Competitive Firms - accepts the market price in order to sell their products. They are also called price takers
    • Characteristics:
      • All firms produce an identical product
        • Consumers do not care where they buy the product
      • A large number of firms are in the market
      • Each firm supplies only a small portion of the total supplied to the market
        • One firm cannot influence the price of the market
      • No barriers to entry or exit exist
        • Example: If one firm earns economic profit, then rival firms can easily enter the market and try to earn profits
      • The firms maximize profit by adjusting production level, but cannot influence market price.
  2. Examples
    • Agricultural markets are competitive
    • International tourist destinations can be very competitive

Output in the Short Run

1. Marginal Revenue (MR) - is the change in total revenue when output increases by one unit.

  • A tour company sells airline-hotel packages at the market price
  • Refer to the graph below
    • If the company sells one more package, it receives $1,000 (MR). If the company sells another package, it receives another $1,000 (MR).
    • If the company raises its package above the market price, then tourists do no buy it.
      • Tourists buy the package from competitors for $1,000
    • If the company sells his package below the market price, then it receives lower revenue (loses money)
    • Thus, it sells all of its packages at the market price, so MR = P* = $1,000.
Price Taker's Demand Curve
A Tour Company The Market
Price Price
Demand for a farmer's product A market
Quantity Quantity

2. Profit maximization - the price taker will expand output in the short run until:

P* = MR = MC

Note: The market price is P* and marginal cost is MC. Further, the MR = MC maximizes profits for monopolies, oligopolies, and monopolistically competitive firms, while MR = P* is only valid for price takers.

Blue arrow This rule maximize the firm's profits (or minimize its losses)

Example: If MR = $3 and MC = $2. MR > MC, the firm will collect $3 for selling that last "additional" unit that only costs $2 to produce. Profit increases by $1.

If MR = $3 and MC = $5. MR < MC, the firm will collect $3 for selling that last unit that costs $5 to produce. The firm should reduce production by 1 unit to increase profits.

  • Price takers earn profits by maximizing total revenue (TR) and minimizing total costs(TC)
    • Total Revenue (TR) = P * q
    • Profits = TR - TC
    • Taking vertical slices (adjusting output q) until TR -TC is maximized, which is shown below:
A firm is maximizing profits

The point where profit is maximized is at the production level q when MC = MR = P*

Price / Per-unit costs
A firm is maximizing profits
  • Using the marginal cost, market price, and average total cost, we can show a competitive firm earning a profit.
    • Firm earns a profit when Market Price > ATC
    • The "green" rectangle is firm's profit
  • The derivation is:

Profit = Total Revenue - Total Cost

Profit = P q - ATC q = (P - ATC) q

Price / Per-unit costs
A firm is maximizing profits

3. Losses and going out of business.

  • Firm produces quantity q where MC = MR = P
    • ATC > Market Price, the firm is earning a loss, or profit is negative.
    • Profit = Total Revenue - Total Cost
    • Profit = P q - ATC q = (P - ATC) q
    • The loss = "The red area"
Price / Per-unit costs
A firm is earning a loss
  • Short-run.
    • A firm will operate in the short run with losses, if it can cover its average variable costs.
    • Example: Hotel Room
      • AVC = $20 per room (labor), AFC = $10 (bank loan)
      • The hotel market is competitive, so P* = MR = MC
        • If P* = $15; firm cannot cover its variable costs, so it shuts down; it still pays its fixed costs
        • If P* = $20; firm covers its variable costs, but earns a loss
        • If P* = $25; firm still earns a loss, but also covers some of its fixed costs
        • If P* = $30; firm breaks even
        • If P* > $30; firm earns an economic profit
    • Shutdown - temporary halt in the production or operation of a business.
      • A firm shuts down when P* < AVC
      • The firm still pays fixed costs during the shutdown.
      • Motels, restaurants, and theme parks shutdown during off seasons
  • Long-run.
    • A firm will "go out of business" in the long run, if P < ATC.
    • Going out of business - firm permanently exits the market and avoids paying fixed costs
    • Example - art galleries have high fixed costs
      • During a recession, customer demands quickly drop
      • Thus, art galleries go out of business

4. A competitive firm maximizes profits when it produces at P* = MC.

  • A firm's short-run supply curve is its marginal cost curve above average variable cost.
  • Firm produces if the market price exceeds its average variable costs.
  • Law of Supply - as the price of a product increases, firms will increase quantity supplied.
A Firm's Cost Curves A Firm's Supply Curves
Price / Per-unit costs Price / Per-unit costs
A firm's average cost curves A firm's supply function
Quantity Quantity


Output Adjustments in the Long Run

  • In the long-run, firms earn zero economic profit
    • A normal rate of return, i.e. accounting profit
  • If P* > ATC, firms earn an economic profit
    • New firms enter the market
    • SR Supply increases while the price decreases until it equals P = ATC
    • Economic profit = 0
  • If P* < ATC, firms earn a loss
    • Some firms leave the market
    • SR supply decreases, while the price increases until it equals P = ATC
    • Economic profit = 0
  • Long-run equilibrium
    • The market determines the price and quantity of vacation packages
      • P* = $1,000 and market quantity = 10 (thousand)
    • Each firm supplies q quantity of travel packages
      • Earn zero economic profit
      • P* = ATC = $1,000
A Travel Firm's Long-Run Cost Curve The Travel Package Market
Price / Per-unit costs Price / Per-unit costs
A firm is earning zero economic profits A market for milk
Quantity Quantity (in thousands)
  • Example: The incomes in the United States increase
    • Consumers buy more vacation packages (travel is a luxury good)
      • The demand curve shifts right.
        • New market price is P2
        • Quantity supplied and sold is Q2
    • Firms expand output to q2
      • Earn economic profits (P2 > ATC)
    • Long-run equilibrium
      • New firms enter the travel vacation market
      • Short-run supply increases
      • Price decreases, until P1 = ATC again
    • Result:
      • Same market price, P1
      • More travel packages are offered and sold, Q3
      • More firms are in the market and all earn zero economic profit
A Travel Firm's Long Run Cost Curve The Travel Vacation Market
Price / Per-unit costs Price / Per-unit costs
A firm's average cost functions A firm's long-run supply curve
Quantity Quantity
  • Economic losses and exit
  • Example: Riots in Egypt (tastes and preferences)
    • The original demand & supply curves are D1 & S1
    • Demand curve shifts left.
      • New market price is P2
      • Quantity supplied and sold is Q2
    • Firms contract output to q2
      • Earn economic losses (P2 < ATC)
    • Long-run equilibrium
      • Some firms leave the hotel market
      • Short-run supply decreases
      • Price increases, until P1 = ATC again
    • Result:
      • Same market price, P1
      • Less hotel rooms are produced and sold, Q3
      • Less firms are in the market and all earn zero economic profit
A Hotel in Egypt The Hotel Market in Egypt
Price / Per-unit costs Price / Per-unit costs
A firm's average cost functions A firm's long-run supply curve
Quantity Quantity
  • Long-run supply - the minimum price which firms will supply various production levels when all factors of production can be adjusted.
    • The long-run supply is the black lines in the milk and rice markets
  • Constant-cost industry - industry were resource prices remain unchanged as market output is expanded
    • Long-run market supply curve is horizontal (perfectly elastic)
    • Illustrated above in milk and rice markets
    • An expanding/contracting industry has no impact on the resource markets, because it is a small industry


  • short run
  • total fixed costs (TFC)
  • average fixed costs (AFC)
  • total variable costs (TVC)
  • average variable cost (AVC)
  • marginal cost (MC)
  • specialization of labor
  • Law of Diminishing Returns
  • total cost (TC)
  • average total cost (ATC)
  • long run
  • long-run ATC
  • economies of scale
  • constant returns to scale
  • diseconomies of scale
  • merger
  • horizontal integration
  • vertical integration
  • conglomerate
  • purely competitive firm
  • price takers
  • marginal revenue (MR)
  • shutdown
  • going out of business
  • short-run supply curve
  • Law of Supply
  • long-run supply
  • constant-cost industry